- Quarterly Report (10-Q)

Share Name	Share Symbol	Market	Type
Digital Domain Media Group Com USD0.01	NYSE:DDMG	NYSE	Ordinary Share

	Price Change	% Change	Share Price	High Price	Low Price	Open Price	Shares Traded	Last Trade
	0.00	0.00%	0.554				0.00	01:00:00

Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2012

o 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: 001-35325

Digital Domain Media Group, Inc.

(Exact name of registrant as specified in its charter)

Florida		27-0449505
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification Number)

10250 SW Village Parkway

Port St. Lucie, FL 34987

(Address of principal executive offices)

(Zip Code)

(772) 345-8000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes o No x

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (. § 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

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

Large accelerated filer o		Accelerated filer o

Non-accelerated filer x (Do not check if a smaller reporting company)		Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

At August 14, 2012, there were 43,563,481 shares of Digital Domain Media Group, Inc.’s common stock outstanding.

Table of Contents

Ta ble of Contents

Part I	Financial Information

	Item 1	Financial Statements

			a)	Condensed Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011	1

			b)	Condensed Consolidated Statements of Operations and Comprehensive Loss for the Three and Six Months Ended June 30, 2012 and 2011 (unaudited)	3

			c)	Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011 (unaudited)	4

			d)	Notes to Condensed Consolidated Financial Statements	6

	Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations			23

	Item 3	Quantitative and Qualitative Disclosures About Market Risk			38

	Item 4	Controls and Procedures			38

Part II	Other Information

	Item 1	Legal Proceedings			40

	Item 1A	Risk Factors			41

	Item 2	Unregistered Sales of Equity Securities and Use of Proceeds			42

	Item 6	Exhibits			43

	Signatures

Table of Contents

Part I. Financial Information

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)

	June 30,		December 31,
	2012		2011
	(Unaudited)
Assets
Current assets:
Cash and cash equivalents	$	6,584	$	29,413
Cash, held in trust - short-term	2,490		2,449
Contracts and other receivable	14,119		3,110
Tax credits receivable	2,365		2,365
Prepaid expenses and other assets	4,746		5,335
Total current assets	30,304		42,672
Cash, held in trust - long-term	4,153		4,233
Restricted cash	71		71
Property and equipment - net	78,483		80,141
Trade name	15,410		15,410
Unpatented technology - net	18,811		20,106
Other intangible assets - net	6,674		7,105
Goodwill	18,081		18,081
Deferred debt issuance costs - net	3,566		3,022
Film inventory	29,358		6,925
Other assets	114		75
Total assets	$	205,025	$	197,841

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

Table of Contents

D IGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)

	June 30,			December 31,
	2012			2011
	(Unaudited)
Liabilities, Preferred Stock and Stockholders’ Equity (Deficit)
Current liabilities:
Accounts payable and accrued liabilities	$	33,773		$	21,474
Advance payments and deferred revenue	15,693			8,442
Deferred grant revenue from governmental agencies, short-term	2,988			2,988
Deferred land grant revenue, short-term	525			525
Government lease obligation, short-term	4,774			3,399
Short-term convertible and other notes payable - net	8,091			17,612
Warrant and other debt-related liabilities, short-term	5,599			6,462
Earn out liability, short-term	428			400
Unearned revenue, short-term	378			361
Current portion of capital lease obligations	904			763
Total current liabilities	73,153			62,426
Capital lease obligations, net of current portion	163			530
Warrant and other debt-related liabilities	57,018			20,930
Deferred grant revenue from governmental agencies	9,153			9,547
Long-term convertible and other notes payable - net	6,302			455
Deferred income tax liability	6,189			6,189
Deferred revenue land grant, net of current portion	19,513			19,775
Earn out liability, net of current portion	2,288			2,774
Government lease obligation - net	35,002			36,155
Unearned revenue, net of current portion	2,992			3,172
Other long-term liabilities	3,083			—
Total liabilities	214,856			161,953

Commitments and contingencies
Convertible preferred stock, $0.01 par value, 25,000,000 shares authorized at June 30, 2012 and December 31, 2011, respectively; including Preferred Stock A series 100,000 designated, respectively; no shares issued or outstanding at June 30, 2012 and December 31, 2011, respectively.	—			—
Stockholders’ equity (deficit):
Common stock, $0.01 par value and 100,000,000 shares authorized at June 30, 2012 and December 31, 2011, 45,480,823 and 39,515,326 shares issued, and 43,563,481 and 39,384,003 outstanding as of June 30, 2012 and December 31, 2011, respectively.	456			396
Additional paid-in capital	237,424			213,651
Accumulated other comprehensive income	49			34
Accumulated deficit	(234,533		)	(183,802		)
Treasury stock, at cost	(14,812		)	(829		)
Total stockholders’ equity (deficit) before non-controlling interests	(11,416		)	29,450
Non-controlling interests	1,585			6,438
Total stockholders’ equity (deficit)	(9,831		)	35,888
Total liabilities, preferred stock and stockholders’ equity (deficit)	$	205,025		$	197,841

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

Table of Contents

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In Thousands, Except Share and Per Share Data)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)
Statements of Operations:
Revenues:
Production revenues	$	28,707		$	21,496		$	58,865		$	59,400
Grant revenues from governmental agencies	879			808			1,757			1,461
Licensing revenue	3,290			—			3,380			—
Tuition revenue	89			—			104			—
Total revenues	32,965			22,304			64,106			60,861
Costs and expenses:
Cost of revenues, excluding depreciation and amortization	34,136			18,660			67,058			49,582
Depreciation expense	4,128			2,806			7,759			5,676
Selling, general and administrative expenses	16,767			20,768			27,746			31,617
Amortization of intangible assets	862			862			1,725			1,725
Total costs and expenses	55,893			43,096			104,288			88,600
Operating loss	(22,928		)	(20,792		)	(40,182		)	(27,739		)
Other income (expenses):
Interest and finance (expense) credit:
Issuance of and changes in fair value of warrant and other debt-related liabilities	(3,584		)	(46,295		)	700			(75,260		)
Amortization of discount and issuance costs on notes payable	(1,987		)	(3,545		)	(3,586		)	(6,558		)
Losses on debt extinguishments	(7,016		)	(2,226		)	(7,016		)	(2,226		)
Interest expense on notes payable	(925		)	(708		)	(1,595		)	(1,210		)
Interest expense on capital and governmental lease obligations	(658		)	6			(1,328		)	(312		)
Other income (expense), net	375			437			728			1,504
Loss before income taxes	(36,723		)	(73,123		)	(52,279		)	(111,801		)
Income tax expense	—			—			9			250
Net loss before non-controlling interests	(36,723		)	(73,123		)	(52,288		)	(112,051		)
Net loss attributable to non-controlling interests	825			1,264			1,558			1,067
Net loss attributable to common stockholders	$	(35,898	)	$	(71,859	)	$	(50,730	)	$	(110,984	)

Statements of Comprehensive Loss:
Net loss attributable to common stockholders	$	(35,898	)	$	(71,859	)	$	(50,730	)	$	(110,984	)
Unrealized gain (loss) from foreign currency translation	(22		)	7			15			70
Comprehensive loss	$	(35,920	)	$	(71,852	)	$	(50,715	)	$	(110,914	)

Weighted average number of common shares outstanding:
Basic	41,907,598			15,885,271			40,942,009			15,052,696
Diluted	45,129,012			15,885,271			44,163,423			15,052,696

Basic loss per share:
Loss before non-controlling interests	$	(0.88	)	$	(4.60	)	$	(1.28	)	$	(7.44	)
Net loss attributable to non-controlling interests	0.02			0.08			0.04			0.07
Basic loss per share attributable to common stockholders	$	(0.86	)	$	(4.52	)	$	(1.24	)	$	(7.37	)

Diluted loss per share:
Loss before non-controlling interests	$	(0.97	)	$	(4.60	)	$	(1.34	)	$	(7.44	)
Net loss attributable to non-controlling interests	0.02			0.08			0.04			0.07
Diluted loss per share attributable to common stockholders	$	(0.95	)	$	(4.52	)	$	(1.30	)	$	(7.37	)

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

Table of Contents

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

	Six Months Ended
	June 30,
	2012			2011
	(Unaudited)
Cash flows from operating activities:
Net loss before non-controlling interests	$	(52,288	)	$	(112,051	)
Adjustments to reconcile net loss before non-controlling interests to net cash used in operating activities:
Depreciation and amortization of property and equipment and intangible assets	9,484			7,401
Amortization of discount on and issuance costs of notes payable	3,586			6,558
Interest added to principal on notes payable	271			124
Changes related to fair value of warrant and other debt - related liabilities	(700		)	75,260
Loss on debt extinguishments	7,016			2,226
Stock-based compensation	6,428			14,604
Interest on government obligations	517			104
Decrease in earn out liability	(458		)	—
Changes in operating assets and liabilities:
Contracts receivable	(6,116		)	(759		)
Prepaid expenses and other assets	208			(2,861		)
Film inventory	(22,433		)	(749		)
Accounts payable and accrued liabilities	13,691			(105		)
Advance payments and deferred revenue	7,272			(10,664		)
Deferred revenue from governmental entities	(657		)	4,575
Unearned revenue	(163		)	—
Net cash used in operating activities	(34,342		)	(16,337		)
Cash flows from investing activities:
Purchases of property and equipment	(5,879		)	(10,061		)
Changes in restricted cash	—			907
Net cash used in investing activities	(5,879		)	(9,154		)
Cash flows from financing activities:
Proceeds from sale of common stock	10,500			22,001
Proceeds from issuance of notes payable	46,000			4,000
Exercise of Series B preferred stock put	—			(5,000		)
Payments of stock issuance costs	(158		)	(2,245		)
Deferred offering costs paid	—			(2,641		)
Repayments on notes payable	(27,770		)	(554		)
Payments on capital and governmental lease obligations	(2,440		)	(717		)
Payments of debt issuance costs	(3,209		)	(63		)
Purchase of treasury stock	(5,712		)	—
Net cash provided by financing activities	17,211			14,781
Effect of exchange rates on cash and cash equivalents	181			33
Net decrease in cash and cash equivalents	(22,829		)	(10,677		)
Cash and cash equivalents at beginning of period	29,413			11,986
Cash and cash equivalents at end of period	$	6,584		$	1,309

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

Table of Contents

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

	Six Months Ended
	June 30,
	2012			2011
	(Unaudited)
Supplemental disclosure of cash flow information - cash paid during the period for:
Interest	$	543		$	1,072
Non-cash investing and financing activities:
Warrants issued as compensation in connection with financings and other transactions	30,014			2,000
Unamortized debt discounts eliminated upon debt extinguishments	6,004			3,429
Write-off of deferred debt issue costs upon debt extinguishments	1,940			—
Write-off of warrant and other debt-related liabilities upon debt extinguishments	1,876			—
Debt discounts established after debt extinguishments	(2,804		)	(1,204		)
Increase in debt from debt restructuring	2,380			—
Deferred offering costs included in accounts payable and accrued liabilities at period end	450			348
Purchase of property and equipment in accounts payable at period end	717			1,417
Purchase of property and equipment with assets held in trust	—			20,997
Amortization of discount on bond obligation	195			41
Bond interest capitalized to construction-in-progress	—			864
Shares issued from exchange of subsidiary shares	3,297			50
Shares issued from deposits collected in the prior period	—			60
Stock issued not collected	—			23
Private placement costs in accounts payable at period end	—			280

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

Table of Contents

DIGITAL DOMAIN MEDIA GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. COMPANY BACKGROUND AND OVERVIEW

Description of Business — Digital Domain Media Group, Inc., formerly known as Digital Domain Holdings Corporation and Wyndcrest DD Florida, Inc., a Florida corporation incorporated on January 7, 2009 (the “Inception Date”), and subsidiaries (collectively, “Digital Domain Media Group” or the “Company”) is a digital production and animation company focused on the creation of original content animation feature films and the development of computer-generated imagery, including three-dimensional stereoscopic (“3D”) imagery, for large-scale feature films and transmedia advertising.

On November 18, 2011, the Company completed its initial public offering of its common stock. The Company sold 4.92 million shares of its common stock at an initial public offering price of $8.50 per share. The gross proceeds received in the offering totaled $41.8 million, before deducting commissions and other then unpaid offering costs of $4.4 million. The common stock is listed on the New York Stock Exchange under the ticker symbol “DDMG”.

Liquidity and Capital Resources — The Company has a history of losses, including a $52.3 million and $144.2 million net loss before non-controlling interests, respectively, for the six months ended June 30, 2012 and the year ended December 31, 2011, respectively. The Company has a limited operating history, had negative working capital of $42.8 million and a stockholders’ deficit of $9.8 million as of June 30, 2012. For the six months ended June 30, 2012 and the year ended December 31, 2011, the Company used $34.3 million and $44.4 million, respectively, in cash flows from operations. The Company has worked to improve its working capital and its cash flow shortfalls through equity and debt funding. The Company raised gross proceeds of $19.5 million in equity capital in a private placement in February and March 2011, gross proceeds of $26.0 million in another private placement consummated in August 2011, and gross proceeds of $41.8 million in its initial public offering completed in November 2011. Additionally, upon completion of the IPO, convertible debt and warrants representing $94.0 million of debt and warrant liabilities reflected on the Company’s balance sheet were automatically converted or exercised, as applicable, into the Company’s common stock. In June 2012, the Company raised gross proceeds of $10.5 million of equity capital in a private placement.

2. COLLABORATIVE ARRANGEMENTS

Joint Marketing VFX Services Agreement

Reliance MediaWorks (“RMW”) Redefined VFX Production Services and New Licensing Agreements

On August 1, 2012, RMW and DDMG redefined their previous agreement to include a contract for RMW to train Indian visual effects professionals to staff the new production studio that DDMG is developing in Abu Dhabi. The companies will continue to collaborate on visual effects and 2D-to-3D conversion services work for feature films; however, DDMG will compensate RMW on the basis of work performed, without the guaranteed minimum included in the prior agreement. Terms of the new agreement allow DDMG to reduce its unutilized labor expense moving forward. Additionally, under the new partnership, RMW also licensed DDMG’s technology patents covering 2D-to-3D conversion for $3.2 million.

Previously, on July 8, 2011 Digital Domain Productions, Inc. (“DDPI”), a wholly owned subsidiary of our subsidiary Digital Domain, entered into a Joint Marketing and Production VFX Services Agreement with RelianceMediaWorks Limited, a film and entertainment services company headquartered in Mumbai, India. The term of this agreement was to be three years, subject to Digital Domain Productions, Inc.’s option to extend for a fourth year. Pursuant to the terms of this agreement, RMW was responsible for creating and staffing studio facilities in both Mumbai and London, England, through which DDPI was to provide VFX services to its clients worldwide. In consideration of RMW’s obligation to provide Digital Domain Productions, Inc. with turnkey studio facilities in these two cities, DDPI had agreed to guarantee to RMW specified minimum monthly levels of production revenues generated at these facilities from DDPI’s VFX projects.

From the inception of these agreements through June 30, 2012, the Company recognized $7.4 million in expense, including $4.7 million expensed during the six months ended June 30, 2012. Through that date, we had paid $2.9 million to RMW and the remaining $4.5 million is included in accounts payable and accrued liabilities on the accompanying condensed consolidated balance sheet.

Co-Production in Feature Film Project

On February 15, 2011, the Company entered into an Investment and Production Agreement with Ender’s Game Holdings LLC (“EGH”) and OddLot Entertainment LLC (“OLE”) effective as of April 18, 2011, to provide financing and production services to co-produce the VFX action movie Ender’s Game . Principal photography for Ender’s Game began February 27, 2012, in New Orleans. The picture has a production budget slightly in excess of $100 million and is scheduled for theatrical release in the fall of 2013. Distribution services are to be provided by Summit Entertainment. As of June 30, 2012 the Company had provided $17.2 million in financing, which is included in film inventory on the accompanying condensed consolidated balance sheet. See Note 10 for further discussion.

Table of Contents

Digital Domain Galloping Horse Studio

On March 30, 2012, the Company entered into an Amended and Restated Formation and Joint Venture Agreement (“the Agreement”) with Beijing Galloping Horse Film Co., Ltd. (“GH”), a corporation organized under the laws of the People’s Republic of China (the “PRC”) and a shareholder of the Company, which amends and restates the “Digital Domain Galloping Horse Studio” Alliance Term Sheet entered into by and between the parties, dated November 18, 2011. Pursuant to the Agreement, the parties have agreed to form a joint venture company for the purpose of creating, owning and operating a studio to be located in the PRC to (i) provide computer-generated animation and digital visual effects (including high-quality 3D content and conversion into 3D of existing film and TV libraries originally created in 2D) (collectively, “VFX”) services (the “VFX Business”) in the PRC, Taiwan, Hong Kong and Macau (the “Territory”), and (ii) develop a range of media and entertainment services, including, without limitation, proprietary technologies and entertainment properties, as may be agreed upon by the parties (the “China Studio”). The Company and GH are each initially to own 50% of the equity interests in the JV, with each party having the right to designate two members of the JV’s four member board of directors.

Pursuant to the Agreement, (A) GH is obligated to (i) contribute and assign to the JV certain specified VFX contracts awarded to it, (ii) provide the land for the China Studio to the JV, under a nominal cost lease, (iii) fund the construction and build-out costs for the China Studio, in an amount not to exceed $50,000,000, and (iv) provide temporary professional facilities for the use of the China Studio under a nominal cost lease to the JV; and (B) the Company is obligated to (i) grant to the JV, for the term thereof, an exclusive, worldwide (with respect to marketing), royalty-free site license to use only in the Territory in connection with the VFX Business of the JV the intellectual property rights of the Company and its subsidiaries relating to the VFX Business, (ii) design and supervise the build-out of the China Studio’s professional facilities, and (iii) provide, at its cost, training for the professional personnel to be employed by the JV and to provide VFX services on behalf of the JV. Pursuant to the Agreement, each of the Company and GH has agreed that the other party will be its exclusive partner for all VFX-related services that it performs in the Territory, the Company has agreed not to compete with the VFX Business of the JV in the Territory, and GH has agreed not to compete with the VFX Business of the JV in any location worldwide, including the Territory. The transfer by either party of its equity interests in the JV is subject to a number of restrictions under the Agreement. Upon either party’s default under a material term of the Agreement, or the occurrence of any other “default event” with respect to either party, the Agreement provides the non-defaulting party with a number of remedies, including the right to buy-out the defaulting party’s equity interest in the JV at a price equal to 70% of the fair market value of such interest.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation and Consolidation — the consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). In the opinion of management, these financial statements, including unaudited financial statements for the interim periods, contain all adjustments, consisting of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows for the periods presented. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for the full years. Included are the following consolidated financial statements:

· Consolidated balance sheets as of June 30, 2012 (unaudited) and December 31, 2011,

· Consolidated statements of operations and comprehensive loss for the three and six months ended June 30, 2012 and 2011 (unaudited) and

· Consolidated statements of cash flows for the six months ended June 30, 2012 and 2011 (unaudited).

The accompanying consolidated financial statements include the accounts of Digital Domain Media Group, Inc. its majority-owned subsidiaries, Digital Domain, Inc. and Digital Domain Institute, Inc. (“DDI”); and its wholly-owned subsidiaries Tradition Studio, Inc., Digital Domain Stereo Group, Inc., DDH Land Holdings LLC, DDH Land Holdings II, LLC, Digital Domain International, Inc. and Digital Domain Tactical, Inc. All significant intercompany accounts and transactions have been eliminated in consolidation.

The accompanying consolidated financial statements include certain reclassifications of prior period amounts in order to conform to current period presentation.

Use of Estimates — US GAAP requires management to make estimates and assumptions in the preparation of these interim consolidated financial statements that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.

Table of Contents

Digital Imagery Revenue — The Company recognizes digital imagery revenue from fixed-price contracts, each consisting of an accepted written bid and agreed-upon payment schedule, for the development of digital imagery and image creation for the entertainment and advertising industries. Contracts to provide digital imagery are accounted for in accordance with FASB ASC Subtopic 605-35, Accounting for Performance of Construction-Type and Certain Production-Type Contracts . Revenue recognition is initiated when persuasive evidence of an arrangement with a customer is established, which is upon entry by the Company, or Digital Domain (“DD”) and the customer into a legally enforceable agreement. In accounting for the contracts, the cost-to-cost measures of the percentage-of-completion method of accounting are utilized in accordance with FASB ASC Subtopic 605-35. Under this method, revenues, including estimated earned fees or profits, are recorded as costs are incurred. For all contracts, revenues are calculated based on the percentage of total costs incurred compared to total estimated costs at completion. Contract costs include direct materials, direct labor costs and indirect costs related to contract performance, such as indirect labor, supplies and tools. These costs are included in cost of revenues.

The customer contracts in the digital imagery business represent binding agreements to provide digital effects to the customers’ specifications. The contracts contain subjective standards applicable to the delivered digital effects and objective specifications that relate to the technical format for the digital effects delivered to customers. In all instances, the customer receives complete ownership rights in and to the digital effects as the effort progresses. In the event of a termination of a contract, ownership in the digital effects transfers to the customer, and the Company or DD as the contractor is entitled to receive reimbursement of costs incurred up to that point and a reasonable profit. The contracts contain production schedules setting forth a timeline for production and a final delivery date for the completed digital effects.

Payments for the services are received over the term of the contract, including payments required to be delivered in advance of work to fund a portion of the costs to produce the digital effects. Cash received from customers in excess of costs incurred and gross profit recognized on the related projects are recorded as advance payments. Unbilled receivables represent revenues recognized in excess of amounts billed. The digital effects produced are delivered to the customer at the end of the contract and the customer is not required to deliver the final scheduled payment until receipt and acceptance of the digital effects.

A review of uncompleted contracts is performed on an ongoing basis. Amounts representing contract change orders or claims are included in revenues only when they meet the criteria set forth in FASB ASC Subtopic 605-35. In the period in which it is determined that a loss will result from the performance of a contract, the entire amount of the estimated ultimate loss is charged against income. Changes in estimates of contract sales, costs and profits are recognized in the current period based on the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. A significant change in one or more projects could have a material adverse effect on the consolidated financial position or results of operations.

Fair Value of Financial Instruments

The Company utilized the following assumptions for determination of the fair value of warrant and other-debt related liabilities and warrants issued to service providers as of June 30, 2012 and December 31, 2011, respectively (fair value stated in thousands):

	Comvest			Falcon			Comvest						Senior
	Common Stock			Notes			Capital II			Senior			Notes						PIPE			Galloping
	Conversion			Bridge			Protective			Notes			Conversion			PIPE			Adjustment			Horse
Fair Value of Warrant Liabilities	Rights			Warrants			Put			Warrants			Warrants			Warrants			Right			Put

June 30, 2012 (unaudited)
Fair value of liability	$	14,624		$	4,119		—			$	6,395		$	28,408		$	1,414		$	6,177		$	1,480
Term in months	48			18			—			58			58			65			65			6
Risk free interest rate	0.84		%	0.33		%	—			0.70		%	0.70		%	0.81		%	0.81		%	0.16		%
Volatility	55.30		%	32.61		%	—			53.30		%	53.30		%	51.30		%	51.30		%	42.63		%
Dividend rate	—			—			—			—			—			—			—			—

December 31, 2011
Fair value of liability	$	17,748		$	3,914		$	5,730		—			—			—			—			—
Term in months	54			24			54			—			—			—			—			—
Risk free interest rate	0.71		%	0.24		%	0.71		%	—			—			—			—			—
Volatility	75.93		%	39.59		%	75.93		%	—			—			—			—			—
Dividend rate	—			—			—			—			—			—			—			—

Warrants Issued to Service Providers	Provider Award 1			Provider Award 2			Provider Award 3			Provider Award 4

June 30, 2012 (unaudited)
Warrants issued to service providers	$	767		$	808		$	309		$	478
Term in months	60			24			24			24
Risk free interest rate	1.03		%	0.26		%	0.33		%	0.26		%
Dividend rate	—			—			—			—

December 31, 2011
Warrants issued to service providers	$	—		$	—		$	—		$	—
Term in months	—			—			—			—
Risk free interest rate	—			—			—			—
Dividend rate	—			—			—			—

Table of Contents

Assets Measured at Fair Value on a Non-Recurring Basis

During 2010, the Company acquired two parcels of land in connection with grants from governmental entities. These parcels of land were valued on May 25, 2010 and September 27, 2010 for $10.5 million and $9.8 million, respectively. The valuations were determined using Level 3 inputs. These amounts are included in Property and equipment-net and deferred land grant revenue in the accompanying consolidated balance sheet as of June 30, 2012. The Company moved into its new headquarters building in December 2011 where one of these parcels of land is located. Accordingly, the Company began the recognition of the grant revenue related to this land grant in 2012. The Company recognized $0.3 million of such grant revenue in the six months ended June 30, 2012.

As of June 30, 2012, Goodwill and intangible assets other than goodwill relate to the acquisition of Digital Domain, which occurred on October 15, 2009 and the acquisition of In-Three, which occurred on November 22, 2010. The fair value of Goodwill and intangible assets other than goodwill is subjective and based on estimates rather than precise calculations. The fair value measurement for Goodwill and intangible assets other than goodwill uses significant unobservable inputs that reflect management’s assumptions about the estimates that market participants would use in measuring fair value including assumptions about risk. A combination of valuation techniques is used, including (i) an income approach, which utilizes a discounted cash flow analysis using the Company’s weighted-average cost of capital rate, and (ii) the market approach, which compares the fair value of the subject company to similar companies that have been sold whose ownership interests are publicly traded.

Earnings Per Share — Basic earnings per share is computed based upon the weighted-average number of shares outstanding, including nominal issuances of common share equivalents, for each period presented. Fully-diluted, earnings per share is computed based upon the weighted-average number of shares and dilutive share equivalents outstanding for each period presented. Due to the Company’s net losses for the three and six months ended June 30, 2012 and 2011, respectively, the inclusion of dilutive common share equivalents in the calculation of diluted earnings per share would be anti-dilutive. These common stock equivalents include stock options, warrants, convertible debt securities and rights to exchange shares of DDI’s common stock for shares of the Company’s Common Stock. Thus, the common share equivalents have been excluded from the computation of diluted earnings per share for the three and six months ended June 30, 2012 and 2011, respectively.

The potential dilutive securities outstanding that were excluded from the computation of diluted net loss per share for the following periods, because their inclusion would have had an anti-dilutive effect, are summarized as follows:

	Three Months Ended June 30,		Six Months Ended June 30,
	2012	2011	2012	2011

Stock options issued under 2010 stock plan	6,161,872	3,578,499	6,161,872	3,578,499
Investor warrants	703,842	1,012,502	703,842	1,012,502
Convertible stock of subsidiary	—	1,869,160	—	1,869,160
Lender warrants	11,077,107	9,360,847	11,077,107	9,360,847
Convertible preferred stock	—	6,527,023	—	6,527,023
Placement agent and other warrants	1,391,132	202,500	1,391,132	202,500
Total	19,333,953	22,550,531	19,333,953	22,550,531

Certain dilutive share equivalents including a warrant and convertible note are dilutive in the calculation of diluted earnings per share. The effects of these dilutive share equivalents on loss per share are summarized as follows:

	Three Months Ended						Six Months Ended
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)
Reconciliation of diluted loss per share:
Loss before non-controlling interests	$	(36,723	)	$	(73,123	)	$	(52,288	)	$	(112,051	)
Adjustment for effect of as-if converted securities, net of tax:
Convertible note	(6,767		)	—			(6,767		)	—
	(43,490		)	(73,123		)	(59,055		)	(112,051		)
Net loss attributable to non-controlling interests	825			1,264			1,558			1,067
Net loss attributable to common stockholders	$	(42,665	)	$	(71,859	)	$	(57,497	)	$	(110,984	)

Weighted average number of common shares outstanding:
Basic	41,907,598			15,885,271			40,942,009			15,052,696
Adjustment for effect of as-if converted securities, net of tax:
Convertible note	3,221,414			—			3,221,414			—
Diluted	45,129,012			15,885,271			44,163,423			15,052,696

Diluted loss per share:
Loss before non-controlling interests	$	(0.97	)	$	(4.60	)	$	(1.34	)	$	(7.44	)
Net loss attributable to non-controlling interests	0.02			0.08			0.04			0.07
Diluted loss per share attributable to common stockholders	$	(0.95	)	$	(4.52	)	$	(1.30	)	$	(7.37	)

Table of Contents

Segment Reporting — Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company’s reportable segments are Feature Films, Commercials and Animation. The management approach is used as the conceptual basis for identifying reportable segments and is based on the way that management organizes within the enterprise for making operating decisions, allocating resources, and monitoring performance, which is primarily based on the sources of revenue.

4. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2012, the FASB issued ASU No. 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU amends current guidance by allowing an entity the option to first assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with Subtopic 350-30. An entity also has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. The provisions of this ASU are effective for annual periods beginning after September 15, 2012, with early adoption permitted. The impact on the Company’s consolidated financial statements upon adoption of this guidance has not yet been determined by the Company.

In September 2011, the FASB issued ASU No. 2011-08, Intangibles — Goodwill and Other (Topic 350): Testing Goodwill for Impairment . This ASU amends current guidance to allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under this amendment, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. ASU No. 2011-08 applies to all companies that have goodwill reported in their financial statements. The provisions of this ASU are effective for reporting periods beginning after December 15, 2011. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (‘‘ASU No. 2011-05’’). This ASU improves the comparability, consistency, and transparency of financial reporting and increases the prominence of items reported in other comprehensive income (‘‘OCI’’) by eliminating the option to present components of OCI as part of the statement of changes in stockholders’ equity. The amendments in ASU No. 2011-05 require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Under either method, adjustments must be displayed for items that are reclassified from OCI to net income, in both net income and OCI. This ASU does not change the current option for presenting components of OCI gross or net of the effect of income taxes, provided that such tax effects are presented in the statement in which OCI is presented or disclosed in the notes to the financial statements. Additionally, this ASU does not affect the calculation or reporting of earnings per share. For public entities, the amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and are to be applied retrospectively, with early adoption permitted. The adoption of this guidance is for disclosure purposes only.

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurements (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S.GAAP and IFRSs (‘‘ASU No. 2011-04’’). This ASU amends the wording used to describe many of the requirements in US GAAP for measuring fair value and disclosing information about fair value measurements. The amendments in ASU No. 2011-04 achieve the objectives of developing common fair value measurement and disclosure requirements in US GAAP and IFRSs and improving their understandability. Some of the requirements clarify the FASB’s intent about the application of existing fair value measurement requirements while other amendments change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The amendments in this ASU are effective prospectively for interim and annual periods beginning after December 15, 2011, with no early adoption permitted. The adoption of this guidance is for disclosure purposes only and did not have any impact on the Company’s consolidated financial statements.

Table of Contents

5. NON-CONTROLLING INTERESTS

Changes in the non-controlling interest amounts of our subsidiaries for the six months ended June 30, 2012 (unaudited) were as follows (in thousands):

Balance at December 31, 2011	$	6,438
Issuance of common stock upon exchange of stock in subsidiary	(3,297		)
Foreign currency translation gain	2
Net loss attributable to non-controlling interests	(1,558		)
Balance at June 30, 2012 (unaudited)	$	1,585

During the six months ended June 30, 2012, the Company’s subsidiary Digital Domain realized a net loss of $11.3 million. Pursuant to the requirements under FASB ASC Topic 810, Consolidation , the Company allocates Digital Domain’s earnings to non-controlling interests based on the percentage of common stock of Digital Domain not owned by the Company. Intercompany transactions are eliminated in consolidation but impact the net earnings of each of the respective entities and as such affect amounts allocated to non-controlling interests. During the six months ended June 30, 2012, $9.8 million of Digital Domain’s net loss was allocated to accumulated deficit representing the Company’s proportionate holdings in Digital Domain common stock outstanding (an average of 86.7%) and the remaining 13.3% of Digital Domain’s net loss, amounting to $1.5 million, was allocated to non-controlling interests. During the six months ended June 30, 2011, $4.5 million of Digital Domain’s net loss was allocated to accumulated deficit representing the Company’s proportionate holdings in Digital Domain common stock outstanding (an average of 81.0%), and the remaining 19.0% of Digital Domain’s net loss, amounting to $1.1 million, was allocated to non-controlling interests.

In a similar manner, the Company’s subsidiary Digital Domain Institute, Inc. (“DDI”) incurred a net loss of $1.5 million during the six months ended June 30, 2012. Of this amount, $1.4 million was allocated to the accumulated deficit and $0.1 million was allocated to non-controlling interests. During the six months ended June 30, 2012, certain stockholders of DDI exchanged 3,250,000 shares of DDI stock for 2,699,776 shares of the Company’s common stock. Upon these exchanges, the Company reclassified $3.3 million of equity attributable to non-controlling interests to additional paid in capital.

6. CONTRACTS RECEIVABLE

The following shows the elements of accounts receivable from contracts as of June 30, 2012 (unaudited) and December 31, 2011 (in thousands):

Table of Contents

	June 30,			December 31,
	2012			2011
	(unaudited)
Costs incurred on uncompleted contracts	$	60,519		$	46,700
Accrued profit on uncompleted contracts	13,559			15,412
	74,078			62,112
Less billings to date	(83,732		)	(68,404		)
Unbilled receivables and advance payments on uncompleted contracts	$	(9,654	)	$	(6,292	)


Unbilled Receivables:

Unbilled receivables	$	4,400		$	513
Advance payments	(14,054		)	(6,805		)
	$	(9,654	)	$	(6,292	)

Summary:

Billed:
Completed contracts	$	1,417		$	900
Contracts in process	4,181			1,033
Retained	—			—
	5,598			1,933
Unbilled	4,400			513
	$	9,998		$	2,446

In addition to contract receivables, the Company had other receivables of $4.1 million as of June 30, 2012. Other receivables include $3.2 million in licensing fees for the prior use of patented technology converting 2D content to 3D, see Note 2 for further discussion; $0.6 million in foreign tax receivables; and $0.3 million in grant and royalty receivables.

7. GRANTS AND TAX INCENTIVES FROM GOVERNMENTAL ENTITIES

In November 2009, as amended on February 22, 2010, the Company entered into a Grant Agreement and a Lease Agreement with the City of Port St. Lucie, Florida (‘‘the City’’) calling for the City to provide to the Company a $10.0 million cash grant (‘‘City Cash Grant’’) and approximately $50.0 million in the form of a land donation and construction financing assistance (the ‘‘Building and Land Grant’’). These awards were granted as an incentive to locate operations in the State of Florida and specifically in Port St. Lucie, and to incent hiring activities, among other things, both of which will provide economic advantages to the general community.

In connection with the Building and Land Grant discussed above, the City issued bonds of $39.9 million on April 27, 2010 for the purpose of financing the construction of a building and installation of related equipment and certain associated expenses. The funds received under the bond issuance were deposited in a construction fund, which is used to fund construction expenses and equipment purchases.

The proceeds from the bonds were recorded in Cash, held in trust, and the obligation as Government lease obligation in the condensed consolidated balance sheet as of June 30, 2012. Through June 30, 2012 (unaudited) and December 31, 2011, the following activities have been recognized (in thousands):

Table of Contents

	Cash Held in Trust			Payments From Operating Cash			Property & Equipment, Net		Government Lease Obligation, Net			Accrued Interest on Leases			Interest Expense		Accrued Construction Expenses to be Funded by Cash, Held in Trust
Balance at December 31, 2010	$	31,219		$	—		$	7,686	$	(38,301	)	$	(661	)	$	57	$	—
Construction in progress - paid by December 31, 2011	(18,644		)	—			18,644		—			—			—		—
Construction costs held in retainer	—			—			1,789		—			—			—		(1,789		)
Recognition of interest expense, capitalized and expensed, net	—			—			1,859		(413		)	(1,973		)	527		—
Purchase of property and equipment place into service	(3,920		)	—			3,920		—			—			—		—
Amortization of OID and issuance costs	—			—			117		(117		)	—			—		—
Issuance cost made available for construction uses	—			—			63		(63		)	—			—		—
Payment of accrued interest, net	(1,973		)	—			—		—			1,973			—		—
Balance at December 31, 2011	6,682			—			34,078		(38,894		)	(661		)	584		(1,789		)
Construction in progress - paid by June 30, 2012	(1,789		)	—			—		—			—			—		1,789
Payment to the City	2,740			(2,740		)	—		—			—			—		—
Recognition of interest expense, capitalized and expensed, net	—			—			—		(326		)	(885		)	1,211		—
Payment by the City for interest	(990		)	—			—		—			990			—		—
Balance at June 30, 2012 (unaudited)	$	6,643		$	(2,740	)	$	34,078	$	(39,220	)	$	(556	)	$	1,795	$	—

In addition to the amounts disclosed above, the Company incurred $0.7 million of primarily internal costs associated with the building project that are capitalized in accordance with ASC 310-20, and will pay approximately $0.4 million of costs over-runs accrued in the Company’s Consolidated Balance Sheet as of June 30, 2012. The Company also incurred $3.2 million for leasehold improvements related to the building project.

Upon completion of the project in December 2011, the Company evaluated the transaction under FASB ASC Subtopic 360-20 to determine whether a sale transaction had occurred such that the Company would record a sale-leaseback under FASB ASC 840-40. As the Company has retained substantially all the benefits and risks incident to ownership of the property sold and the Company has the option to purchase the building and equipment at the end of the lease term ASC 360-20-40-38 dictates that the transaction must be accounted for as a financing transaction.

In accordance with being considered the owner of the asset under construction during the construction phase of the project and continuing to be deemed the owner upon occupancy of the building, the Company accounts for the building and equipment, related depreciation, lease obligations, accrued interest, and cash held in trust, on its consolidated balance sheets and in its statements of operations. Interest expense associated with the lease is being recognized using an effective rate of 7.6% based on the Company’s cash flows to service the lease requirements pursuant to the lease agreement. In accordance with FASB ASC 310-20, the Company considered the initial amounts held to service interest during the construction phase and the debt service reserve, as fees paid at the inception of the loan.

8. PROPERTY AND EQUIPMENT

Property and equipment as of June 30, 2012 (unaudited) and December 31, 2011 consisted of the following (in thousands):

	June 30,			December 31,
	2012			2011
	(Unaudited)
Building	$	27,590		$	27,590
Land	21,330			21,330
Computer equipment	25,159			23,763
Computer software	15,829			13,017
Leasehold improvements	8,200			6,902
Machinery and equipment	2,910			2,823
Office equipment, furniture and fixtures	5,367			4,864
Total property and equipment - cost	106,385			100,289
Less accumulated depreciation and amortization	(27,902		)	(20,148		)
Total property and equipment - net	$	78,483		$	80,141

Computer software in the table above includes capitalized costs related to internally developed computer software. The Company capitalized $0.4 million of internally developed software costs during the six months ended June 30, 2012. There were no additions to such capitalized costs for the six months ended June 30, 2011. The gross carrying amount of capitalized costs associated with internally developed computer software as of June 30, 2012 (unaudited) and December 31, 2011 $4.9 million and $4.5 million, respectively. As of June 30, 2012 (unaudited) and December 31, 2011, the accumulated depreciation on the capitalized costs associated with internally developed computer software was $2.1 million and $1.8 million, respectively.

Table of Contents

The capitalized costs related to internally developed software are being depreciated on a straight-line basis over each asset’s estimated useful life that ranges from three to four years.

As of June 30, 2012 (unaudited) and December 31, 2011, the gross carrying amount of property and equipment recorded under capital leases were each $4.5 million. As of these dates, the accumulated depreciation on these leased assets was $3.6 million and $3.0 million, respectively.

Depreciation and amortization expense on property and equipment totaled $7.8 million, and $5.7 million for the six months ended June 30, 2012 and 2011, respectively (unaudited).

9. INTANGIBLE ASSETS AND GOODWILL

Goodwill and indefinite-lived intangible assets are tested for impairment at least annually and more frequently if events or changes in circumstances indicate the assets may be impaired. The Company determined there were no events or changes in circumstances that indicate that carrying values of goodwill, indefinite-lived intangible assets, or other intangible assets subject to amortization may not be recoverable as of June 30, 2012 and December 31, 2011.

The following table provides information regarding changes in goodwill and indefinite-lived intangible assets during the six months

ended June 30, 2012 (unaudited, in thousands):

Goodwill & intangible assets not subject to amortization:

	Goodwill		Trade Name
Balance, December 31, 2011	$	18,081	$	15,410
Changes recognized upon acquisitions or impairment	—		—
Balance, June 30, 2012 (unaudited)	$	18,081	$	15,410

The following tables present information regarding intangible assets with finite lives, all of which were recorded upon the acquisitions of Digital Domain and In-Three, at June 30, 2012 (unaudited) and December 31, 2011 (dollars in thousands):

	June 30, 2012 (Unaudited)
								Remaining
	Gross Carrying		Accumulated					Lives
	Amount		Amortization			Net Amount		(Months)
Unpatented technology	$	25,910	$	(7,099	)	$	18,811	102
Patents	420		(42		)	378		162
Titanic participation rights	1,800		(330		)	1,470		147
Customer relationships	300		(55		)	245		147
Proprietary software	5,900		(1,319		)	4,581		207
Total identified intangible assets	$	34,330	$	(8,845	)	$	25,485

	December 31, 2011
								Remaining
	Gross Carrying		Accumulated					Lives
	Amount		Amortization			Net Amount		(Months)
Unpatented technology	$	25,910	$	(5,804	)	$	20,106	108
Patents	420		(28		)	392		168
Titanic participation rights	1,800		(270		)	1,530		153
Customer relationships	300		(45		)	255		153
Proprietary software	5,900		(972		)	4,928		213
Total identified intangible assets	$	34,330	$	(7,119	)	$	27,211

Amortization expense for intangible assets with finite lives was $1.7 million for both of the six months ended June 30, 2012 and 2011.

The estimated future amortization expense as of June 30, 2012 (unaudited) is as follows (in thousands):

Table of Contents

	June 30,
	2012
	(Unaudited)
2012 (remaining 2012 at June 30, 2012)	$	1,725
2013	3,451
2014	2,984
2015	2,984
2016	2,984
Thereafter	11,357
Total	$	25,485

10. FILM INVENTORY

Film inventory as of June 30, 2012 (unaudited) and December 31, 2011 are summarized as follows (in thousands):

	June 30, 2012		December 31, 2011
	(unaudited)
In-production:
Animation	$	11,330	$	3,926
Live-action	17,201		2,205
Total in-production	28,531		6,131
In-development	827		794
Total film inventory	$	29,358	$	6,925

11. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

Accounts payable and accrued liabilities as of June 30, 2012 (unaudited) and December 31, 2011 are summarized as follows (in thousands):

	June 30, 2012		December 31, 2011
	(unaudited)
Accounts payable	$	10,342	$	6,491
Accrued wages and employee benefits	8,120		4,954
Accrued professional fees	1,145		1,302
Accrued outsource labor	4,512		2,149
Accrued tax credits	2,365		2,365
Accrued litigation settlement	5,000		—
Other accrued expenses	2,289		4,213
Total accounts payable and accrued liabilities	$	33,773	$	21,474

12. INCOME TAXES

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and for income tax purposes. A deferred income tax asset is recognized if realization of such asset is more likely than not, based upon the weight of available evidence which includes historical operating performance and the Company’s forecast of future operating performance. The Company evaluates the realizability of its deferred income tax assets and a valuation allowance is provided, as necessary. During this evaluation, the Company reviews its forecasts of income in conjunction with the positive and negative evidence surrounding the realizability of its deferred income tax assets to determine if a valuation allowance is needed.

The Company files income tax returns in the U.S. federal jurisdiction, various U.S. states and Canada. Because of the Company’s history of tax losses, all income tax returns filed remain open to examination by U.S federal, Canadian and state tax authorities. The Company believes that it has made adequate provision for all income tax uncertainties pertaining to these open tax years.

The Company recognized income tax expense of $0.3 million for the six months ended June 30, 2011 for foreign income taxes based on the then expected effective income tax rate. No federal, state and local tax benefit was recorded during the six months ended June 30, 2012 and 2011, respectively, for the Company’s pretax loss, because the future realizability of such benefits was not considered to be more likely than not.

Table of Contents

13. NOTES PAYABLE AND RELATED FINANCING TRANSACTIONS

Summaries of convertible and other notes payable as of June 30, 2012 (unaudited) and December 31, 2011 are as follows (in thousands):

	June 30, 2012 (Unaudited)
	Convertible			Convertible			Other
	Senior			Subordinated			Notes			Net
	Notes			Note			Payable			Debt
Face amount	$	35,375		$	8,000		$	3,000		$	46,375
Unamortized discount	(29,218		)	(2,764		)	—			(31,982		)
Net debt	6,157			5,236			3,000			14,393
Less current portion	(5,091		)	—			(3,000		)	(8,091		)
Long-term portion	$	1,066		$	5,236		$	—		$	6,302

	December 31, 2011
	Comvest			Comvest			Comvest
	Convertible			Lender			Revolver			Net
	Note Payable			Note Payable			Note Payable			Debt
Face amount	$	8,000		$	12,000		$	7,400		$	27,400
Unamortized discount	(7,545		)	(1,120		)	(668		)	(9,333		)
Net debt	455			10,880			6,732			18,067
Less current portion	—			(10,880		)	(6,732		)	(17,612		)
Long-term portion	$	455		$	—		$	—		$	455

Principal maturities of debt at June 30, 2012 (unaudited) are as follows (in thousands):

	June 30,
	2012

2012 (remaining 2012 at June 30, 2012)	$	4,273
2013	7,636
2014	7,636
2015	7,636
2016	15,637
2017	3,557
Total face amount	46,375
Less amounts representing debt discount	(31,982		)
Net debt	$	14,393

The changes in net debt for the six months ended June 30, 2012 (unaudited) and the year ended December 31, 2011 are as follows (in thousands):

	Comvest			Comvest			Comvest			Convertible			Convertible			Other
	Convertible			Lender			Revolver			Senior			Subordinated			Notes		Total
	Note Payable			Note Payable			Note Payable			Notes			Note			Payable		Net Debt
Net debt, December 31, 2011	$	455		$	10,880		$	6,732		$	—		$	—		—		$	18,067
New borrowings	—			—			—			35,000			8,000			3,000		46,000
Capitalization of loan modification fee	—			100			—			—			—			—		100
Recognition of debt discounts	(44		)	(165		)	(41		)	(30,014		)	(2,804		)	—		(33,068		)
Amortization of debt discounts	349			539			311			1,171			40			—		2,410
Capitalized interest	218			—			53			—			—			—		271
Debt restructuring	2,380			—			—			—			—			—		2,380
Debt extinguishments	4,860			746			397			—			—			—		6,003
Debt repayments	(8,218		)	(12,100		)	(7,452		)	—			—			—		(27,770		)
Net debt, June 30, 2012 (unaudited)	$	—		$	—		$	—		$	6,157		$	5,236		$	3,000	$	14,393

Interest and Financing Expense — The components of interest expense for the three and six months ended June 30, 2012 and 2011 are as follows (unaudited, in thousands):

Table of Contents

	Three Months Ended					Six Months Ended
	June 30,					June 30,
	2012		2011			2012			2011
Issuance of and changes in fair value of warrant and other debt-related liabilities	$	3,584	$	46,295		$	(700	)	$	75,260
Amortization of discount and issuance costs on notes payable	1,987		3,545			3,586			6,558
Losses on debt extinguishments	7,016		2,226			7,016			2,226
Interest expense on notes payable	925		708			1,595			1,210
Interest expense on capital and governmental lease obligations	658		(6		)	1,328			312
Total interest expense	$	14,170	$	52,768		$	12,825		$	85,566

Debt transactions in the six months ended June 30, 2012 — On February 23, 2012, the convertible note with Comvest was restructured. This restructuring included amending Comvest’s protective put (see Note 14) from $4.50 per share to $6.00 per share. Additionally, certain loan covenants were amended and Comvest forgave certain penalty interest payments due Comvest for breaches of loan covenants. The Company received a redemption feature to allow the Company to redeem 50% of the post-conversion shares of the convertible note at the purchase price of $6.00 per share prior to the expiration of the protective put. The effect of this restructuring was to increase the carrying value of the Comvest convertible note by $2.4 million and decrease warrant liabilities by the same amount.

On March 19, 2012, the Company borrowed $3.0 million from Legend Pictures Funding, LLC (“Legendary Pictures”). This note bears simple interest at a rate of 8% per annum. The maturity date of this note is July 18, 2012. On July 18, 2012, Legendary Pictures extended the maturity due date of the $3.0 million convertible note issued to it by the Company on March 19, 2012 (the “Legendary Note”) from July 18, 2012 to July 23, 2012. The Company has received an extension and an agreement with Warner Brothers, a related party of Legendary Pictures and is a customer of the Company. This agreements states that the loan with Legendary Pictures will be repaid once the Company collects on its accounts receivable with Warner Brothers.

On March 30, 2012, the Company incurred a liability to Comvest of $0.3 million for a waiver upon default of certain loan covenants. This amount was recognized as additional debt discount and was allocated to the three Comvest notes based on the face value of the notes at that time.

The Comvest convertible note gives the Company the option to pay the interest expense each month in cash or in-kind by adding the monthly interest to the face amount of the note. The Company elected this option for the period from February 1, 2012 through May 7, 2012. The Company paid monthly interest at 10% per annum related to the Comvest revolver note payable. Beginning January 1, 2012, the Company incurred an additional interest expense each month of 2% per annum, which was added to the revolver note face value. The total amount of capitalized interest recorded for these two loans during the six months ended June 30, 2012 aggregated $0.3 million.

Comvest charged the Company $0.1 million for certain actions it took on the Company’s behalf. This amount was added to the Comvest Lender Note Payable during the six months ended June 30, 2012.

Sale and Issuance of Convertible Notes and Warrants

On May 6, 2012, the Company entered into a securities purchase agreement (the “May 2012 Purchase Agreement”) with a group of institutional investors (the “May 2012 Purchasers”) pursuant to which we issued and sold to the May 2012 Purchasers senior secured convertible notes in the aggregate original principal amount of $35.0 million (the “Senior Notes”) and warrants (the “May 2012 Warrants”) to initially purchase up to 1,260,288 shares of our Common Stock, for an aggregate purchase price of $35.0 million. The initial conversion price of the Senior Notes was $9.72 per share, subject to adjustment as provided in the Senior Notes. The initial exercise price of the May 2012 Warrants was $9.72 per share, subject to adjustment as provided in the May 2012 Warrants. Such issuance and sale were consummated on May 7, 2012.

On June 7, 2012, in connection with the PIPE offering (see Note 15), each of the May 2012 Purchasers entered into a Consent and Waiver pursuant to which the Company and each of the May 2012 Purchasers agreed that, notwithstanding any contrary provisions of the Senior Notes and the May 2012 Warrants, immediately after giving effect to the issuance and sale of securities pursuant to the PIPE offering, the conversion price of the Senior Notes and the exercise price of the May 2012 Warrants were each adjusted so as to equal $6.00. As of June 30, 2012, the Senior Notes, inclusive of estimated future interest, and the May 2012 Warrants were convertible or exercisable, as applicable, into 8,491,233 and 2,041,666 shares of our Common Stock, respectively.

The indebtedness evidenced by the Senior Notes bears interest at 9.0% per annum, compounded quarterly, payable quarterly in arrears, and matures on the fifth anniversary of the issuance date. Upon the occurrence of an Event of Default (as such term is defined in the Senior Notes), the interest rate shall be adjusted to a rate of 15.0% per annum. The Purchasers may require the Company to redeem all or any portion of the Senior Notes upon the occurrence of an Event of Default (as such term is defined in the Senior Notes) or a Change of Control (as such term is defined in the Senior Notes).

Such redemption amount would be based on the then outstanding principal, accrued interest, and foregone interest (the “Make Whole Amount”), collectively referred to as the “Conversion Amount”, except in certain situations, the amount subject to redemption shall be redeemed by the Company at a price equal to the greater of (i) the product of (A) the Conversion Amount to be redeemed multiplied by (B) the Redemption Premium, and (ii) the product of (X) the Conversion Rate with respect to the Conversion Amount in effect at such time as the Holder delivers an Event of Default Redemption Notice multiplied by (Y) the product of (1) the Redemption Premium multiplied by (2) the greatest Closing Sale Price of the Common Stock on any Trading Day during the period commencing on the date immediately preceding such Event of Default and ending on the date the Company makes the entire payment required to be made.

The redemption amount in regard to a Change of Control is calculated a price equal to the greatest of (i) the product of (w) the Change of Control Redemption Premium multiplied by (y) the Conversion Amount being redeemed, (ii) the product of (x) the Change of Control Redemption Premium multiplied by (y) the product of (A) the Conversion Amount being redeemed multiplied by (B) the quotient determined by dividing (I) the greatest Closing Sale Price of the Common Stock during the period beginning on the date immediately preceding the earlier to occur of (I) the consummation of the Change of Control and (2) the public announcement of such Change of Control and ending on the date the Purchasers deliver the Change of Control Redemption Notice by (II) the Conversion Price then in effect and (iii) the product of (y) the Change of Control Redemption Premium multiplied by (z) the product of (A) the Conversion Amount being redeemed multiplied by (B) the quotient of (I) the aggregate cash consideration and the aggregate cash value of any non-cash consideration per share of Common Stock to be paid to the holders of the shares of Common Stock upon consummation of such Change of Control (any such non-cash consideration constituting publicly-traded securities shall be valued at the highest of the Closing Sale Price of such securities as of the Trading Day immediately prior to the consummation of such Change of Control, the Closing Sale Price of such securities on the Trading Day immediately following the public announcement of such proposed Change of Control and the Closing Sale Price of such securities on the Trading Day immediately prior to the public announcement of such proposed Change of Control) divided by (II) the Conversion Price then in effect (the “Change of Control Redemption Price”).

In addition, the Purchasers can redeem the Senior Notes starting at the 30 month anniversary of the inception date (the “30 Month Put Right”). The 30 Month Put Right, if exercised, would result payment of the then outstanding principal, accrued interest and the then Make-Whole Amount. The Senior Notes also contain, among other things, certain affirmative and negative covenants, including, without limitation, limitations on indebtedness, registration and listing requirements, liens and restricted payments and certain financial covenants.

So long as the Senior Notes are outstanding, the Company’s Available Cash, as defined, shall as of (a) July 2, 2012 equal or exceed $7.5 million, (b) the last Trading Day in each calendar month in the Fiscal Quarter ending September 30, 2012 shall equal or exceed $7.5 million, (c) September 30, 2012 shall equal or exceed $10 million and (d) the last Trading Day in each calendar month in the Fiscal Quarter ending December 31, 2012 and each Fiscal Quarter thereafter shall equal or exceed $10 million (the “Available Cash Test”).

In addition, so long as this Note is outstanding, the Company’s Free Cash Flow, as defined (a) in the aggregate for the Fiscal Quarters ending June 30, 2012 and September 30, 2012 shall not be less than $3.0 million, (b) in the aggregate for the Fiscal Quarters ending June 30, 2012, September 30, 2012 and December 31, 2012 shall not be less than $5 million and (c) in any Fiscal Quarter thereafter, shall be greater than or equal to zero (the “Free Cash Flow Test”).

The Senior Notes will amortize in equal monthly installments commencing on the earlier of (i) the effective date of the initial registration statement filed in accordance with the terms of the Registration Rights Agreement (as defined below) or (ii) the six-month anniversary of the closing date. The Senior Notes may be converted into shares of the Company’s common stock, at the option of the holders thereof, at any time following issuance of the Senior Notes. The Senior Notes are redeemable at the option of the Company if the Company’s common stock trades at a level equal to 175% of the initial conversion price for any 30 consecutive trading days commencing on the date of issuance of the Senior Notes.

If the quotient of the Volume Weighted Average Price “(VWAP”) of the Common Stock for each Trading Day in the thirty (30) consecutive Trading Day period ending and including the Trading Day immediately preceding such date of determination, divided by (II) thirty (30) is less than $4.42 prior to an installment payment being due, the installments are due in cash.

Also, if the (I) the sum of the VWAP of the Common Stock for each Trading Day in the thirty (30) consecutive Trading Day period ending and including the Trading Day immediately preceding such date of determination, divided by (II) thirty (30) is less than $3.54, the Maturity Date shall automatically be modified to the earlier of (x) the Maturity Date in effect immediately prior to the initial occurrence of a Price Installment Failure and (y) the later of (x) November 7, 2013 and (y) the ninetieth (90th) calendar day after the date of the such initial Price Installment Failure.

Table of Contents

On certain Adjustment Dates (as such term is defined in the Senior Notes), the conversion price applicable to the Senior Notes will be adjusted to the lesser of (a) the then-current conversion price and (b) the market price of the Company’s common stock on such date. The Senior Notes have anti-dilution protection in the event that the Company issues securities at an equivalent value less than the conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Company has agreed to pay each amortization payment in shares of the Company’s common stock, provided that certain conditions are met. The conversion rate applicable to any amortization payment in shares of the Company’s common stock will be the lower of (a) the conversion price then in effect and (b) a price equal to 85.0% of (i) the aggregate of the volume-weighted average prices of the Company’s shares of common stock for each of the ten lowest trading days during the 20 consecutive trading day period ending on the applicable amortization payment date, divided by (ii) 10. The Senior Notes also have anti-dilution protection in the event that the Company issues securities at an equivalent value less than the applicable conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions.

The obligations of the Company under the Senior Notes are secured pursuant to the terms of a security and pledge agreement (the “Security Agreement”) and a Canadian security and pledge agreement (the “Canadian Security Agreement”) covering all of the assets of the Company and its subsidiaries (other than inactive subsidiaries) (the “Collateral”) and conferring on the Purchasers, subject to Permitted Liens (as such term is defined in the Purchase Agreement), a first-priority security interest in the Collateral. The Security Agreement also contains customary representations, warranties and covenants. In addition, all of the obligations of the Company under the Senior Notes are guaranteed by certain of the Company’s subsidiaries pursuant to the terms of a guaranty (the “Guaranty”).

Under the terms of the Warrants, the holders thereof are entitled to exercise during the five-year period beginning on the closing date. On certain Adjustment Dates (as defined in the Warrants), the exercise price applicable to the Warrants will be adjusted to the lesser of (a) the then-current exercise price and (b) the market price of the Company’s common stock on such date. The exercise price of the Warrants is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Company is generally prohibited from issuing shares of common stock upon exercise of the Warrants if such exercise would cause the Company to breach its obligations under the rules or regulations of the New York Stock Exchange, or such other stock market on which the Company’s common stock is then traded.

The Senior Notes and May 2012 warrants both contain provisions that can require cash settlement in the event that the Company cannot deliver common shares as requirement by the provisions of these agreements. In certain cases, the Purchaser may buy the equivalent number of shares in the market place and put the value of such shares back to the Company. Accordingly, at inception, the Company bifurcated from the host instrument, among other things the conversion features as well as the various redemption features discussed above and valued such items as a compound derivative using a Monte Carlo model. At inception, these derivatives were recorded as a liability, with an offsetting debt discount in the amount of $25.0 million. At June 30, 2012, the value of such of such compound derivative was $28.4 million, with the difference being recorded in the condensed consolidated statement of operations as a change in the fair value of warrant and other debt-related liabilities. The May 2012 Warrants were also recorded at inception as warrant liabilities and valued at $5.0 million using a Monte Carlo model, with an offsetting debt discount. At June 30, 2012, the value of the 2012 Warrants was $6.4 million, with the difference being recorded in the condensed consolidated statement of operations as a change in the fair value of warrant and other debt-related liabilities.

As discussed in Note 15 and above, the provisions of the transactions on May 7, 2012 and June 8, 2012, in which the Senior Notes, May 2012 Warrants, Subordinated Note, and the PIPE offering contain provisions to adjust the conversion price of convertible notes and/or the exercise price of warrants, while increasing the number of common shares that such warrants are exercisable into, or issuing additional shares of common stock to the June 2012 Purchaser for no additional consideration on such Adjustment Dates as previously described. As these conditions are deemed outside of the control of the Company, the Company cannot conclude that it will have a sufficient number of authorized shares to settle its equity based contracts at the settlement date. The Company could; however, as of June 30, 2012, settle all of its equity based contracts based on then existing conversion prices of convertible notes and exercise prices of warrants. Accordingly, the Company, as of May 7, 2012, has adopted a sequencing approach based on earliest issuance date such that the classification of equity based instruments issued prior to May 7, 2012 would not be impacted as of the balance sheet date. Additionally, these warrants may be put to the Company upon a change of control at the option of the warrant holder.

In connection with the financing transaction described above, the Company entered into a registration rights agreement (the “Registration Rights Agreement”) pursuant to which it agreed to file a registration statement with the Securities and Exchange Commission (the “Commission”) relating to the offer and sale by the Purchasers of the shares of the Company’s common stock issuable upon the conversion of the Senior Notes and the exercise of the Warrants. Pursuant to the terms of the Registration Rights Agreement, the Company is required to file the registration statement within 30 days of the closing date and to use its reasonable best efforts for the registration statement to be declared effective 90 days after the closing date. The Company accounts for registration rights payments in accordance with ASC 825-20,”Accounting for Registration Payment Arrangements (“ASC 825-20”). As of June 30, 2012, the Company assessed at that point in time that it would more likely than not comply with the requirements of the Registration Rights Agreements and that any resulting penalties would be immaterial.

The Senior Notes and the Warrants were issued pursuant to an exemption from registration afforded by Section 4(2) of the Securities Act of 1933, as amended, as transactions not involving a public offering. In connection with these transactions, the Company paid a placement agent fee of $2.4 million to the sole placement agent for the offering of the Senior Notes and the Warrants.

As a condition to the sale of the Senior Notes and the Warrants, two persons who are directors, executive officers and greater than 5% shareholders of the Company, who beneficially own an aggregate of 11,937,984 shares of the Company’s common stock, entered into a voting agreement (the “Voting Agreement”), pursuant to which they agreed not to sell, pledge, hypothecate or otherwise transfer their shares during the six-month period commencing on the closing date of the financing transaction, subject to certain exceptions for estate planning and similar purposes.

On August 2, 2012, the Company was advised by the Staff of the SEC that due to the large number of shares covered thereby compared to the number of outstanding shares held by non-affiliates of the Company, and the nature of the offering and the selling security holders, the offering described in the resale Registration Statement on Form S-1 filed by the Company on June 11, 2012 appears to the Staff to be a primary offering and is accordingly not eligible to be conducted on a continuous or delayed basis pursuant to Rule 415(a)(1)(i) of the Securities Act of 1933 on Form S-1. The Company is currently considering its response. Pursuant to the terms of the registration rights agreements entered into between the Company and each of the holders of the Senior Notes and the Subordinated Note, in the event that all of the shares of the Company’s common stock underlying the Senior Notes, the Subordinated Note and certain other securities held by such holders are not covered by an effective Registration Statement, the Company may be liable for certain registration delay penalties under the terms of such registration rights agreements.

Exchange of Outstanding Debt with Existing Lender

On May 6, 2012, concurrently with the execution and delivery of the Purchase Agreement, the Company entered into an Omnibus Consent and Agreement re Restructuring (the “Restructuring Agreement”) with Comvest Capital II, L.P. (“Comvest”), pursuant to which, among other things, the Company agreed to (i) use a portion of the proceeds received by it in connection with the financing transaction described above to make payments to Comvest with respect to the outstanding loans to the Company held by Comvest, such that the aggregate outstanding principal balance thereof was reduced to $8.0 million, and (ii) repurchase all but 145,000 shares (the “Retained Shares”) of the Company’s common stock received by Comvest upon full exercise of an outstanding warrant to purchase shares of the Company’s common stock held by Comvest for $2.5 million. The aggregate amount paid to Comvest in satisfaction of outstanding indebtedness and in repurchasing such shares, as described above, was $22.5 million, plus certain fees and expenses that the Company agreed to pay.

In connection with the foregoing, the Company and Comvest entered into a Debt Exchange Agreement (the “Debt Exchange Agreement”), pursuant to which, among other things, the Company exchanged the remaining outstanding original principal balance under its outstanding loans held by Comvest for a new secured convertible note in favor of Comvest with an original principal amount of $8.0 million (the “Subordinated Note”), which Subordinated Note, inclusive of any and all accrued interest on the Subordinated Note and other fees, costs and amounts owing thereunder, is convertible into shares of the Company’s common stock, in accordance with the terms thereof. The debt exchange transaction was consummated on May 7, 2012.

Table of Contents

The indebtedness evidenced by the Subordinated Note bears interest at 10.0% per annum, compounded quarterly, payable quarterly in arrears, and matures on June 30, 2016. Upon the occurrence of an Event of Default (as such term is defined in the Subordinated Note), the interest rate shall be adjusted to a rate of up to 21.0% per annum, with the actual rate of such penalty interest to be contingent upon the nature of the Event of Default. Comvest may require the Company to redeem all or any portion of the Subordinated Note upon the occurrence of an Event of Default (as such term is defined in the Subordinated Note). Such redemption amount would be based on the then outstanding principal and accrued interest, and any Non-Principal amounts collectively referred to as the “Comvest Conversion Amount”, except in certain situations, the amount subject to redemption shall be redeemed by the Company at a price equal to the greater of (i) the product of (A) the Comvest Conversion Amount to be redeemed multiplied by (B) the Redemption Premium, and (ii) the product of (X) the Conversion Rate with respect to the Conversion Amount in effect at such time as the Company delivers an Event of Default Redemption Notice multiplied by (Y) the product of (1) the Redemption Premium multiplied by (2) the greatest Closing Sale Price of the Common Stock on any Trading Day during the period commencing on the date immediately preceding such Event of Default and ending on the date the Company makes the entire payment required to be made. The Subordinated Note also contains, among other things, certain affirmative and negative covenants, including, without limitation, limitations on indebtedness, liens and restricted payments and certain financial covenants.

The initial conversion price under the Subordinated Note is (i) $2.50 per share for payment of any portion of the original principal amount and (ii) $5.50 per share for payment of any other amounts owing thereunder, subject to adjustment as provided in the Subordinated Note. On certain Adjustment Dates (as such term is defined in the Subordinated Note Agreement), the conversion price applicable to the Subordinated Note will be adjusted to the lesser of (a) the then-current conversion price and (b) the market price of the Company’s common stock on such date. The Subordinated Note has anti-dilution protection in the event that the Company issues securities at an equivalent value less than the conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions. The Subordinated Note has anti-dilution protection in the event that the Company issues securities at an equivalent value less than the applicable conversion price, and the conversion price is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions.

The obligations of the Company under the Subordinated Note are secured pursuant to the terms of a security and pledge agreement (the “Comvest Security Agreement”) and a Canadian security and pledge agreement (the “Comvest Canadian Security Agreement”) covering all of the Collateral and conferring on Comvest, subject to Permitted Liens (as such term is defined in the Debt Exchange Agreement), a security interest in the Collateral. The Comvest Security Agreement also contains customary representations, warranties and covenants. In addition, all of the obligations of the Company under the Subordinated Note are guaranteed by certain of the Company’s subsidiaries pursuant to the terms of a guaranty (the “Comvest Guaranty”). The Company also entered into a subordination and intercreditor agreement (the “Subordination Agreement”) with Comvest and the collateral agent for the Senior Notes, setting forth the seniority and respective rights to collateral among Comvest and the holders of the Senior Notes.

The Subordinated Note contains provisions that can require cash settlement in the event that the Company cannot deliver common shares as requirement by the provisions of these agreements. In certain cases, the Purchaser may buy the equivalent number of shares in the market place and put the value of such shares back to the Company. Accordingly, at inception, the Company bifurcated from the host instrument, among other things the conversion features as well as the various redemption feature discussed above and valued such items as a compound derivative using a Monte Carlo model. At inception, the Company recorded the difference of the derivatives under the Comvest Convertible Note and the Subordinated Note of $0.8 million in loss on debt extinguishment. At inception the fair value of the Subordinated Note derivatives was $20.8 million. At June 30, 2012, the value of such of such compound derivative was $14.6 million with the difference being recorded in the condensed consolidated statement of operations as a change in the fair value of warrant and other debt-related liabilities. Conversion and Exercisability Considerations. In addition, the Company recorded the Subordinated Note at fair value and recognized a debt discount of $2.8 million.

In connection with the debt exchange transaction, the Company entered into a registration rights agreement with Comvest (the “Comvest Registration Rights Agreement”) pursuant to which it agreed to file a registration statement with the Commission relating to the offer and sale of the shares of the Company’s common stock issuable upon conversion of the Subordinated Note and the Retained Shares. Pursuant to the agreement, the Company is required to file the registration statement within 30 days of the closing date and to use its reasonable best efforts for the registration statement to be declared effective 90 days after the closing date of the debt exchange transaction. The Company accounts for registration rights payments in accordance with ASC 825-20,”Accounting for Registration Payment Arrangements (“ASC 825-20”). As of June 30, 2012, the Company assessed at that point in time that it would more likely than not comply with the requirements of the Registration Rights Agreements and that any resulting penalties would be immaterial.

Upon payoff of the Comvest loans on May 7, 2012, The Company wrote off $1.9 million of unamortized deferred debt issue costs, $6.0 million of unamortized debt discounts and $1.9 million of a net asset position in warrant liabilities. These losses were partially offset by a credit of $2.8 million to discount the Subordinated Note to fair value for a net loss on debt extinguishments of $7.0 million.

14. WARRANTS, OPTIONS AND OTHER DEBT-RELATED LIABILITIES

Summaries of warrant and other debt-related liabilities as of June 30, 2012 (unaudited) and December 31, 2011 are as follows (unaudited, in thousands):

Table of Contents

	June 30,		December 31,
	2012		2011
Short-term warrant liabilities:
Comvest Capital II fee warrants	$	—	$	2,548
Galloping Horse put	1,480		—
Digital Domain Bridge Warrants	4,119		3,914
Total short-term warrant liabilities	5,599		6,462
Long-term warrant liabilities:
Comvest Capital II conversion warrants	14,624		15,200
Comvest Capital II protective put	—		5,730
Senior Notes warrants	6,395		—
Senior Notes conversion warrants	28,408		—
PIPE warrants	1,414		—
PIPE adjustment right	6,177		—
Total long-term warrant liabilities	57,018		20,930
Total warrant liabilities	$	62,617	$	27,392

The following table summarizes the warrant and other debt-related liabilities transactions from December 31, 2011 through June 30, 2012 (unaudited, in thousands):

	Comvest Capital II			Galloping Horse Put			Senior Notes Warrants		Senior Notes Conversion Warrants		PIPE Warrants			PIPE Adjustment Right			Digital Domain Bridge Warrants		Total
Balance, December 31, 2011	$	23,478		$	—		$	—	$	—	$	—		—			$	3,914	$	27,392
Debt restructuring (see Note 13)	(2,380		)	—			—		—		—			—			—		(2,380		)
Recognition of put liability	—			1,917			—		—		—			—			—		1,917
Issuance of warrants, recognized as debt discounts	—			—			5,029		24,985		—			—			—		30,014
Issuance of warrants, recognized as additional paid in capital	—			—			—		—		1,742			6,322			—		8,064
Exercise of warrants	(3,565		)	—			—		—		—			—			—		(3,565		)
Debt extinguishments	1,875			—			—		—		—			—			—		1,875
Changes in fair value of warrants	(4,784		)	(437		)	1,366		3,423		(328		)	(145		)	205		(700		)
Balance, June 30, 2012 (unaudited)	$	14,624		$	1,480		$	6,395	$	28,408	$	1,414		$	6,177		$	4,119	$	62,617

15. SALE OF COMMON STOCK

PIPE Offering

On June 7, 2012,the Company entered into a securities purchase agreement (the “June 2012 Purchase Agreement”) with a group of institutional investors (the “June 2012 Purchasers”) pursuant to which it agreed to issue and sell to the June 2012 Purchasers an aggregate of 1,500,004 shares of our Common Stock at a purchase price of $7.00 per share, and warrants (the “June 2012 Warrants”) to purchase up to 600,000 additional shares of our Common Stock at an exercise price (subject to adjustment) of $8.05 per share, for an aggregate purchase price of $10.5 million (the “June 2012 Offering”). Such issuance and sale were consummated on June 8, 2012.

Under the terms of the June 2012 Purchase Agreement, on the date that is thirty trading days after the date of effectiveness of a resale registration statement covering the shares of Common Stock issued in connection with the June 2012 Offering and the shares of Common Stock underlying the June 2012 Warrants (and potentially on five other specified share adjustment dates), if the per-share purchase price paid by the June 2012 Purchasers in the June 2012 Offering is less than 85% of the average of the ten lowest dollar-volume-weighted prices of the Common Stock during the 20-trading-day period ending on such date, then the Company agreed to issue to the June 2012 Purchasers, for no additional consideration, such number of shares of its Common Stock equal to the difference between (x) the number of shares of our Common Stock that would have been issued in the June 2012 Offering if the per-share purchase price for such shares had been equal to 85% of the average of the ten lowest volume-weighted prices of the Common Stock during the 20-trading-day period ending on such date and (y) the number of shares of the Common Stock originally issued at the closing of the June 2012 Offering.

Under the terms of the June 2012 Warrants, the holders thereof are entitled to exercise the June 2012 Warrants to purchase up to an aggregate of 600,000 shares of the Company’s Common Stock at an initial exercise price of $8.05 per share, during the five-year period beginning six months after the initial exercise date of December 8, 2012. The June 2012 Warrants are subject to full-ratchet antidilution protection, solely with respect to the exercise price thereof, which protection will be triggered upon the Company’s issuance of any shares of its Common Stock or securities convertible or exercisable into, or exchangeable for, shares of the Company’s Common Stock at a per-share purchase price below the then-existing exercise price of the June 2012 Warrants. The exercise price of the June 2012 Warrants is also subject to adjustment for stock splits, stock dividends, recapitalizations, and similar transactions.

The PIPE Adjustment Share requirements and the June 2012 warrants both contain provisions that can require cash settlement in the event that the Company cannot deliver common shares as requirement by the provisions of these agreements. In certain cases, the Purchaser may buy the equivalent number of shares in the market place and put the value of such shares back to the Company. Accordingly, at inception, the Company bifurcated from the host common stock instrument, among other things the right to receive additional shares of common stock at the Adjustment Dates (the “PIPE Adjustment Shares”) and valued this derivative, along with the warrant using a Monte Carlo modeling simulation.

At the date of inception, the Adjustment Shares derivative was valued at $6.3 million and recorded as a reduction of Additional Paid-In Capital, with an offsetting liability in Warrant and Other Debt-Related Liabilities. At June 30, 2012, the value of such of such compound derivative was $6.2 million with the difference being recorded in the condensed consolidated statement of operations as a change in the fair value of warrant and other debt-related liabilities. The fair value of the warrants at inception was $1.8 million, also recorded as a reduction of additional paid-in capital, with an offsetting liability in warrant and other debt-related liabilities. At June 30, 2012, the value of such of the warrants was $1.4 million with the difference being recorded in the condensed consolidated statement of operations as a change in the fair value of warrant and other debt-related liabilities.

Conversion and Exercisability Considerations

As discussed in Note 13 and above, the provisions of the transactions on May 7, 2012 and June 8, 2012, in which the Senior Notes, May 2012 Warrants, Subordinated Note, and the PIPE offering contain provisions to adjust the conversion price of convertible notes and/or the exercise price of warrants, while increasing the number of common shares that such warrants are exercisable into, or issuing additional shares of common stock to the June 2012 Purchaser for no additional consideration on such Adjustment Dates as previously described. As these conditions are deemed outside of the control of the Company, the Company cannot conclude that it will have a sufficient number of authorized shares to settle its equity based contracts at the settlement date. The Company could; however, as of June 30, 2012, settle all of its equity based contracts based on then existing conversion prices of convertible notes and exercise prices of warrants. Accordingly, the Company, as of May 7, 2012, has adopted a sequencing approach based on earliest issuance date such that equity based instruments issued prior to May 7, 2012 would not be impacted as of the balance sheet date.

16. SEGMENT INFORMATION

Segment financial information for the three and six months ended June 30, 2012 and 2011, respectively, is as follows (unaudited, in thousands):

Table of Contents

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)
Revenues:
Digital Production:
Feature Films	$	21,606		$	15,482		$	49,194		$	47,087
Commercials	7,101			6,014			9,671			12,313
Animation	—			—			—			—
Corporate/Other	4,258			808			5,241			1,461
Total revenues	32,965			22,304			64,106			60,861

Costs and expenses:
Digital Production:
Feature Films	26,484			13,667			56,630			39,898
Commercials	7,842			5,518			10,973			10,662
Animation	—			—			—			—
Corporate/Other	21,567			23,911			36,685			38,040
Total costs and expenses	55,893			43,096			104,288			88,600

Operating (loss) income:
Digital Production:
Feature Films	(4,878		)	1,815			(7,436		)	7,189
Commercials	(741		)	496			(1,302		)	1,651
Animation	—			—			—			—
Corporate/Other	(17,309		)	(23,103		)	(31,444		)	(36,579		)
Net operating loss	$	(22,928	)	$	(20,792	)	$	(40,182	)	$	(27,739	)

Revenues:
United States	$	24,125		$	18,902		$	46,727		$	50,114
Canada	8,840			3,402			17,379			10,747
Total	$	32,965		$	22,304		$	64,106		$	60,861

17. COMMITMENTS AND CONTINGENCIES

Litigation

Wyndcrest DD Florida, Inc., et al. adv. Carl Stork. On March 29, 2010, we (under our former name “Wyndcrest DD Florida, Inc.”) sued former Digital Domain Chief Executive Officer and director Carl Stork in Brevard County Florida Circuit Court to enforce a February 2010 stock purchase agreement pursuant to which we purchased Mr. Stork’s Digital Domain shares. The case was voluntarily dismissed on December 16, 2010. On September 8, 2010, Mr. Stork filed suit against us in Los Angeles County Superior Court seeking rescission of the agreement and compensatory and punitive damages. The case was removed to the United States District Court for the Central District of California. This case went to trial by jury in July 2012. Settlement was reached between the parties following the trial before verdict was rendered by the jury. The Company has recorded a litigation settlement liability of $5.0 million as of June 30, 2012 related to this settlement. Management believes it is likely that it will ultimately receive full recovery from its insurance carrier.

JK-DD, LLC and Jeffrey Kukes v. John C. Textor, et al. On August 12, 2010, the plaintiffs, who are stockholders of Digital Domain, filed suit against the defendants in Palm Beach County, Florida, Circuit Court seeking rescission of a 2007 settlement agreement that resolved a prior partnership dispute between Mr. Kukes and Mr. Textor pursuant to which the plaintiffs obtained their shares of Digital Domain common stock. The plaintiffs also seek damages for alleged dilution of the value of such shares. The defendants believe the Complaint is an attempt to reverse a valid, binding settlement agreement and are aggressively defending against the claims. On September 27, 2010, the defendants filed a motion to dismiss the plaintiffs’ claims. The plaintiffs subsequently dismissed two of the three counts in their original complaint, mailed defendants a draft amended complaint naming Digital Domain Media Group, Inc. as a defendant, and filed a separate new action against Mr. Textor and his wife, individually. The plaintiffs’ draft amended complaint against the Company has not been filed. Both cases are in discovery, and as such we cannot reliably predict the outcome. No trial date has been set in either case.

4580 Thousand Oaks Boulevard Corporation v. In Three, Inc., et al. On April 21, 2011, the plaintiff, the former commercial landlord of In-Three, Inc., filed suit in California Superior Court (Ventura County) seeking approximately $4.6 million in unpaid rent and operating expenses allegedly owed pursuant to a lease agreement between the plaintiff and In-Three. The subject lease pre-dated our acquisition of certain assets of In-Three and was specifically not assumed by us in that transaction. Notwithstanding, the plaintiff originally named us and our subsidiaries Digital Domain Productions and DDSG (formerly “DD3D, Inc.”), as defendants but voluntarily dismissed its claims against all Digital Domain defendants on June 24, 2011. Subsequently, on October 5, 2011, the plaintiff’s counsel sent a letter to us requesting that we voluntarily stipulate to a court order permitting the filing of an amended complaint which would have added us back into the lawsuit as a defendant.

Table of Contents

We have refused to stipulate to the filing of an amended complaint on the grounds that such an amendment would be futile as, in our judgment, no lawful basis exists for advancing any claims against us. The plaintiff responded by conducting additional discovery pertinent to the asset purchase transaction to determine whether sufficient evidence exists to support the proposed amended complaint.

In-Three has responded to such discovery, and the plaintiff, thus far, has chosen not to seek leave of court to file the proposed amended complaint. In consequence, we are not defendants in this litigation. The case is currently in trial only as to In-Three. In-Three has acknowledged its contractual indemnity obligation to us pursuant to the asset purchase transaction and, accordingly, will represent us in defense of this action if necessary.

On July 18, 2012, the Company and Prime Focus World NV announced a settlement agreement whereby the Company is to license its 3D conversion technology to Prime Focus World. The agreement settles and terminates the patent infringement litigation files by the Company against Price Focus World in 2011. Under the terms of the agreement, the Company and Price Focus World are to collaborate on visual effects and 2D-to-3D conversion services work for feature films.

Other —We are involved from time to time in routine litigation arising in the ordinary course of conducting our business. In the opinion of management, no pending routine litigation will have a material adverse effect on our consolidated financial condition or results of operations.

Contractual Obligations

Digital Domain Institute and Studio in Abu Dhabi

On May 21, 2012, a subsidiary of the Company entered into an agreement with an entity wholly owned by the government of Abu Dhabi to develop and operate a production studio and institute in the Media Zone of Abu Dhabi. Under the terms of this agreement, the Company is required to place into escrow $19.0 million no later than 180 days from that date. These funds will be released to the Company’s operating cash over a five-year period beginning at the commencement of the fourth year of the agreement.

New Agreement with RMW

On August 7, 2012, DDMG and RMW redefined their previous July 8, 2011, Joint Marketing and VFX Agreement. The two companies will continue to collaborate on visual effects and 2D-to-3D conversion services work for feature films. However, DDMG will compensate RMW on the basis of work performed without the guaranteed minimum included in the prior agreement.

18. STOCK OPTION EXPENSE

The Company recognized $6.4 million and $14.6 million in stock option compensation during the six months ended June 30, 2012 and 2011, respectively. In April of 2012, the Company issued four awards of warrants to acquire common stock in connection with the Company’s activities in the Middle East region. As these warrants related to activities already conducted, the Company recognized an expense of $2.4 million as stock based compensation expense during the six months ended June 30, 2012.

During the six months ended June 30, 2011, the Company granted stock options to the former Chief Executive Officer of the Company’s subsidiary Digital Domain to purchase shares of the Company’s Common Stock which vested immediately resulting in a charge of $3.3 million for that period. Additional stock option compensation expense recognized during that period was $2.5 million for the Company’s CEO for a stock option of Digital Domain and $6.5 million of expense recognized for exchanges of Digital Domain’s common stock for the Company’s common stock.

19. SUBSEQUENT EVENTS

Subsequent events have been evaluated through the date on which the consolidated financial statements have been issued. The following subsequent events occurred subsequent to June 30, 2012:

On July 2, 2012, the Company filed a Registration Statement on Form S-8 with the Securities and Exchange Commission (“SEC”) registering shares of its common stock issuable pursuant to the exercise of employee, director and consultant stock options under the 2010 Stock Plan.

On July 12, 2012, effective as of June 30, 2012, the Company entered into separate amendment agreements with each of the six holders of the Senior Notes (collectively, the “First Amendment Agreement”). Pursuant to the terms of the First Amendment Agreement, the Company and the note holders amended the Senior Notes to change the first measurement date with regard to the Available Cash Test thereunder (the “Measurement Date”) from June 30, 2012 to the first business day thereafter, or, July 2, 2012. The Company had Available Cash (as defined in the Senior Notes) as of the first Measurement Date in an amount of $7,759,072, which was in excess of that required under the Available Cash Test as of that date.

On July 13, 2012, the Company reached agreement with Workday Solutions to deploy and maintain Workday Financials and Workday Human Capital Management data services for a five-year contractual period.

On July 18, 2012, the Company and Prime Focus World NV announced a settlement agreement whereby the Company is to license its 3D conversion technology to Prime Focus World. The agreement settles and terminates the patent infringement litigation filed by the Company against Prime Focus World in 2011. Under the terms of the agreement, the Company and Prime Focus World willare to collaborate on visual effects and 2D-to-3D conversion services work for feature films.

On July 18, 2012, Legendary Pictures extended the maturity due date of the $3.0 million convertible note issued to it by the Company on March 19, 2012 (the “Legendary Note”) from July 18, 2012 to July 23, 2012. The Company has received an extension and an agreement with Warner Brothers, a related party of Legendary Pictures and is a customer of the Company. This agreements states that the loan with Legendary Pictures will be repaid once the Company collects on its accounts receivable with Warner Brothers. On August 13, 2012, Legendary Pictures agreed to terminate the note and guarantee from John Textor in exchange for $3.2 million receivable assignment and extension of Maturity Date until September 30, 2013.

In July, 2012, a jury trial began in the matter of Wyndcrest DD Florida, Inc., et al. adv. Carl Stork . Settlement was reached between the parties following trial before verdict was rendered by the jury. See Note 17 for further description of this settlement.

On August 2, 2012, the Company was advised by the Staff of the SEC that due to the large number of shares covered thereby compared to the number of outstanding shares held by non-affiliates of the Company, and the nature of the offering and the selling security holders, the offering described in the resale Registration Statement on Form S-1 filed by the Company on June 11, 2012 appears to the Staff to be a primary offering and is accordingly not eligible to be conducted on a continuous or delayed basis pursuant to Rule 415(a)(1)(i) of the Securities Act of 1933 on Form S-1. Pursuant to the terms of the registration rights agreements entered into between the Company and each of the holders of the Senior Notes and the Subordinated Note, in the event that all of the shares of the Company’s common stock underlying the Senior Notes, the Subordinated Note and certain other securities held by such holders are not covered by an effective Registration Statement, the Company may be liable for certain registration delay penalties under the terms of such registration rights agreements.

On August 14, 2012, the Company and RMW finalized a new agreement to replace the earlier July 8, 2011 Joint Marketing and Production VFX Services Agreement. See Notes 2 and 17 for further disclosure.

On August 13, 2012, DDMG announced that it was retained Wells Fargo Securities, LLC as its Exclusive Financial Advisor to assist the Company with its evaluation of strategic alternatives in order to maximize shareholder value.

Table of Contents

Part I. Financial Information

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis is intended to help the reader understand the results of operations and financial condition of Digital Domain Media Group, Inc. The following discussion should be read in conjunction with our Form S-1/A and the unaudited Condensed Consolidated Financial Statements and the notes thereto included in this Quarterly Report on Form 10-Q. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which are subject to the “safe harbor” created by those sections. Forward-looking statements are based on our management’s beliefs and assumptions and on information currently available to our management. All statements other than statements of historical fact are “forward-looking statements” for purposes of these provisions. In some cases you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” and “potential,” and similar expressions intended to identify forward-looking statements. Such forward-looking statements are subject to risks, uncertainties and other important factors that could cause actual results and the timing of certain events to differ materially from future results expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” in this Quarterly Report. Furthermore, such forward-looking statements speak only as of the date of this report. Except as required by law, we undertake no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.

Overview

We are an award-winning digital production company. Since our inception in 1993, we have been a leading provider of computer-generated imagery animation and VFX for major motion picture studios and advertisers. Our company, work and employees have been recognized with numerous entertainment industry awards and nominations, including seven awards issued by the Academy of Motion Picture Arts and Sciences (the ‘‘Academy’’) — three Academy Awards for Best Visual Effects and four awards for Scientific and Technical Achievement .

Our Business

Digital Production

We are one of the leading digital production companies. We offer our clients innovative, end-to-end solutions across multiple media platforms spanning the entire content production process from idea generation and pre-production to design, directing, live-action production and post-production. We have three key digital production business units: Digital Domain Productions — VFX for feature films and advertising; Mothership Media, Inc. — digital advertising and marketing solutions; and In-Three— creation and conversion of 3D content.

Animation Studio

Our animation feature film business focuses on the development of our original full-length, family-oriented CG animated feature films. Our business is led by a creative storytelling team of accomplished directors, producers, story artists and animators who joined us from leading companies in the family animation film industry. To house this business, we are currently leasing a 64,000 square foot building while we complete the construction of an 115,000 square foot facility. Since establishing our animation studio in 2009, we have executed Grant Agreements with the State of Florida and the City of Port St. Lucie, Florida to provide grant packages consisting of $80.0 million in cash, land and low interest financing to help us establish this studio. We have also been certified for $20.0 million in potential tax credits from the State of Florida to offset the expenses of producing our first several projects.

Education

We founded Digital Domain Institute, Inc. (“DDI”), a for-profit post-secondary educational institution in partnership with Florida State University, (“FSU”). In April 2011, we entered into agreements with FSU establishing what we believe is a first-of-its-kind public/private education partnership whereby DDI graduates will receive fully-accredited four-year Bachelor degrees from FSU. Working closely with FSU’s College of Motion Picture Arts and the Florida Department of Education, we have designed a curriculum for DDI that we expect will produce workforce-ready graduates possessing both traditional motion picture arts and state-of-the-art technical animation and visual effects CG skills. We expect to also provide our graduates with the skills to compete in the broader digital economy, which includes commercial applications such as military simulation, medical simulation, architecture, engineering, software development and related technologies. We believe this partnership between DDI and FSU represents a cutting-edge collaboration between an industry-leading technology and entertainment-company and one of the nation’s top film schools.

Key Metrics

The Company relies on certain key performance indicators to manage and assess our business activities. The key indicator described below assists us in evaluating growth trends, establishing budgets, recruiting and hiring employees, and assessing our overall operational efficiencies.

Table of Contents

The Company discusses revenue and cash flow from operating activities, respectively, under “Results of Operations” and “Liquidity and Capital Resources” below. An important measure of our quarterly and annual performance, Non-GAAP Adjusted EBITDA, is discussed below.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or U.S. GAAP. Accounting principles generally accepted in the United States of America require our management to make estimates and assumptions in the preparation of our condensed consolidated financial statements that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates.

The most significant areas that require management judgment are fair values of consideration issued and net assets acquired in connection with business combinations; revenue and cost recognition; collectability of contract receivables; deferred grant revenues; deferred income tax valuation allowances; amortization of long-lived assets and intangible assets; impairment of long-lived assets, intangible assets and goodwill; accrued expenses; advance billings and deferred revenue; recognition of stock-based compensation; calculation of the warrant and other debt-related liabilities allocation of equity to non-controlling interests, debt modification accounting and contingencies and litigation. The accounting policies for these areas are discussed in this section and in the notes to our accompanying consolidated financial statements. However, estimates inherently relate to matters that are uncertain at the time the estimates are made, and are based upon information presently available. Actual results may differ significantly from these estimates under different assumptions, judgments, or conditions.

Digital Imagery Revenue — The Company recognizes digital imagery revenue from fixed-price contracts, each consisting of an accepted written bid and agreed-upon payment schedule, for the development of digital imagery and image creation for the entertainment and advertising industries. Contracts to provide digital imagery are accounted for in accordance with FASB ASC Subtopic 605-35, Accounting for Performance of Construction-Type and Certain Production-Type Contracts . Revenue recognition is initiated when persuasive evidence of an arrangement with a customer is established, which is upon entry by the Company, or Digital Domain (“DD”) and the customer into a legally enforceable agreement. In accounting for the contracts, the cost to- cost measures of the percentage-of-completion method of accounting are utilized in accordance with FASB ASC Subtopic 605-35. Under this method, revenues, including estimated earned fees or profits, are recorded as costs are incurred. For all contracts, revenues are calculated based on the percentage of total costs incurred compared to total estimated costs at completion. Contract costs include direct materials, direct labor costs and indirect costs related to contract performance, such as indirect labor, supplies and tools. These costs are included in cost of revenues.

Changes in estimates of contract sales, costs and profits are recognized in the current period based on the cumulative effect of the changes on current and prior periods. Hence, the effect of the changes on future periods of contract performance is recognized as if the revised estimates had been the original estimates. A significant change in one or more projects could have a material adverse effect on the consolidated financial position or results of operations.

Fair Value of Financial Instruments — we have adopted FASB ASC Subtopic 820-10, Fair Value Measurements , which clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosure on fair value measurements.

Table of Contents

FASB ASC Subtopic 820-10 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. FASB ASC Subtopic 820-10 also establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. FASB ASC Subtopic 820-10 describes three levels of inputs that may be used to measure fair value:

Level 1: Quoted prices for identical assets or liabilities in active markets.

Level 2: Observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 3: Unobservable inputs that are supported by little or no market activity and that relate to financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation.

Our financial instruments, including Cash and cash equivalents; Cash, held in trust; Contract receivables; Accounts payable and accrued liabilities; Advance payments and deferred revenue and Contract obligations are carried at amounts that approximate fair value due to the short maturity of such instruments.

Our loans are carried at the principal amount less unamortized discounts and debt issuance costs.

Certain non-financial assets are measured at fair value on a nonrecurring basis. Accordingly, these assets are not measured and adjusted to fair value on an ongoing basis but are subject to periodic impairment tests. These items primarily include long-lived assets, Goodwill and Other intangible assets.

Warrants and other debt-related liabilities are measured at fair value on a recurring basis using Level 3 inputs. In valuing warrant and other debt-related liabilities, a combination of valuation techniques is used including the income approach (based on the cash outlays estimated to be paid by us) and the market approach (which allocates the resulting value to various classes of equity using the option pricing method). The value of the warrants is then calculated by multiplying the resulting fair value per share of our Common Stock by the number of shares of our Common Stock into which the warrants are exercisable.

The fair value of warrant liabilities and the fair value of warrants issued to service providers were determined utilized Level 3 inputs.

Non-GAAP Adjusted EBITDA

Non-GAAP Adjusted EBITDA represents net income (loss) adjusted for (1) interest expense, net of interest income, (2) income tax provision (benefit), (3) depreciation and amortization, (4) amortization of intangible assets, (5) stock-based compensation expense, (6) amortization of debt and equity issuance costs, (7) other (income) expense and (8) our grant receipts from government agencies that were received in a given period so that these receipts are reflected on a cash basis. Items (1) through (7) are excluded from net income (loss) internally when evaluating our operating performance. Item (8) is included as we believe this adjustment for grant receipts is indicative of our core operating performance both because it reflects our ability to secure and receive grant receipts in a given period and because such receipts are matched with the expenses associated with initiating the business operations that those grant receipts were designed, in part, to offset. Management believes Non-GAAP Adjusted EBITDA allows investors to make a more meaningful comparison between our operating results over different periods of time, as well as with those of other companies in our industry, because it both includes grant receipts from government agencies and excludes items such as interest expense and other adjustments related to financing activities that we believe are not representative of our operating performance.

We believe that Non-GAAP Adjusted EBITDA, which is a non-GAAP financial measure, when viewed with our results under U.S. GAAP and the accompanying reconciliations, provides useful information about our operating performance and period-over-period growth, and provides additional information that is useful for evaluating our operating performance. Additionally, we believe that Non-GAAP Adjusted EBITDA provides a more meaningful comparison of our operating results against those of other companies in our industry, as well as on a period-to-period basis, because this measure both includes grant receipts from government agencies and matches such receipts with the expenses that those grant receipts were designed, in part, to offset and excludes items that are not representative of our operating performance, such as the fair value adjustments associated with our historical financings as a private company. We believe that including these costs and excluding cash grant receipts in our results of operations results in a lack of comparability between our operating results and those of our peers in the industry, the majority of which do not have comparable start-up costs or amortization costs related to intangible assets. However, Non-GAAP Adjusted EBITDA is not a measure of financial performance under U.S. GAAP and, accordingly, should not be considered as an alternative to net income (loss) as an indicator of operating performance.

Table of Contents

A reconciliation of net loss, a U.S. GAAP measure, to Non-GAAP Adjusted EBITDA, is provided in “Results of Operations” presented below.

Results of Operations

The following table sets forth certain information regarding the Company’s unaudited condensed consolidated results of operations for the three and six months ended June 30, 2012 and 2011 (in thousands):

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)
Revenues:
Revenues	$	28,707		$	21,496		$	58,865		$	59,400
Grant revenues from governmental agencies	879			808			1,757			1,461
Licensing revenue	3,290			—			3,380			—
Tuition revenue	89			—			104			—
Total revenues	32,965			22,304			64,106			60,861
Costs and expenses:
Cost of revenues, excluding depreciation and amortization	34,136			18,660			67,058			49,582
Depreciation expense	4,128			2,806			7,759			5,676
Selling, general and administrative expenses	16,767			20,768			27,746			31,617
Amortization of intangible assets	862			862			1,725			1,725
Total costs and expenses	55,893			43,096			104,288			88,600
Operating loss	(22,928		)	(20,792		)	(40,182		)	(27,739		)
Other income (expenses):
Interest and finance (expense) credit:
Issuance of and changes in fair value of warrant and and other debt-related liabilities	(3,584		)	(46,295		)	700			(75,260		)
Amortization of discount and issuance costs on notes payable	(1,987		)	(3,545		)	(3,586		)	(6,558		)
Losses on debt extinguishments	(7,016		)	(2,226		)	(7,016		)	(2,226		)
Interest expense on notes payable	(925		)	(708		)	(1,595		)	(1,210		)
Interest expense on capital and governmental lease obligations	(658		)	6			(1,328		)	(312		)
Other income (expense), net	375			437			728			1,504
Loss before income taxes	(36,723		)	(73,123		)	(52,279		)	(111,801		)
Income tax expense	—			—			9			250
Net loss before non-controlling interests	(36,723		)	(73,123		)	(52,288		)	(112,051		)
Net loss attributable to non-controlling interests	825			1,264			1,558			1,067
Net loss attributable to common stockholders	$	(35,898	)	$	(71,859	)	$	(50,730	)	$	(110,984	)

Non-GAAP Adjusted EBITDA	$	(9,292	)	$	(2,550	)	$	(18,449	)	$	(507	)

A reconciliation of net loss before non-controlling interests, a U.S. GAAP measure, to Non-GAAP Adjusted EBITDA, a non-GAAP measure, is presented in the table below (in thousands):

Table of Contents

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)

Net loss before non-controlling interests	$	(36,723	)	$	(73,123	)	$	(52,288	)	$	(112,051	)
Add back (reverse) charges (income) pertaining to:
Losses on debt extinguishment	7,016			2,226			7,016			2,226
Share-based compensation	4,550			10,195			6,428			14,604
Income tax expense	—			—			9			250
Interest expense, net	3,570			4,247			6,509			8,080
Depreciation expense	4,128			2,806			7,759			5,676
Amortization of intangible assets	862			862			1,725			1,725
Changes related to fair value of warrant and other debt-related liabilities	3,584			46,295			(700		)	75,260
Other EBITDA addbacks:
Grant cash receipts in excess of (less than) grant revenue recognized	(879		)	3,942			493			3,289
Settlement of litigation	4,600			—			4,600			—
Write-off of deferred offering costs	—			—			—			434
Non-GAAP Adjusted EBITDA	$	(9,292	)	$	(2,550	)	$	(18,449	)	$	(507	)

Operating Segments

FASB ASC Topic 280, Segment Reporting, establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and assess performance. Our three operating segments are Feature Films, Commercials and Animation. These segments are presented in the way the Company internally manages and monitors our performance. Our reporting systems present various data used by management to operate the business. However, certain expenses are not allocated to the various segments (primarily consisting of support staff salaries and benefits, fees for outside professional services, insurance costs, and utilities costs, all of which are included in selling, general and administrative expenses), and thus a reconciliation is provided between the consolidated financial statements and the data related to the combined segments. Interest and other income are not allocated to the various segments, as the chief operating decision maker does not evaluate segment operations beyond the income (loss) from operations level.

Our digital production business (containing the segments of Feature Films and Commercials) has historically dominated our operations. The revenue for each of the segments is derived from external customers. A majority of all revenues have been generated in the United States from customers located in the United States.

The table below sets forth certain unaudited information regarding the results of operations of our segments for the three and six months ended June 30, 2012 and 2011 (in thousands):

Table of Contents

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2012			2011			2012			2011
	(Unaudited)						(Unaudited)
Feature Films
Revenues	$	21,606		$	15,482		$	49,194		$	47,087
Cost of revenues	26,435			13,296			56,444			39,172
S,G&A	49			371			186			726
Operating income	$	(4,878	)	$	1,815		$	(7,436	)	$	7,189

Commercials
Revenues	$	7,101		$	6,014		$	9,671		$	12,313
Cost of revenues	7,701			5,364			10,614			10,410
S,G&A	141			154			359			252
Operating income (loss)	$	(741	)	$	496		$	(1,302	)	$	1,651

Animation /Content
Revenues	$	—		$	—		$	—		$	—
Cost of revenues	—			—			—			—
S,G&A	—			—			—			—
Operating income	$	—		$	—		$	—		$	—

Corporate & Other
Revenues	$	4,258		$	808		$	5,241		$	1,461
Cost of revenues	—			—			—			—
Depreciation, excluding depreciation and amortization	4,128			2,806			7,759			5,676
S,G&A (excluding stock-based compensation)	12,027			10,048			20,773			16,035
Stock-based compensation and share exchange expense	4,550			10,195			6,428			14,604
Amortization	862			862			1,725			1,725
Operating loss	$	(17,309	)	$	(23,103	)	$	(31,444	)	$	(36,579	)

Consolidated
Revenues	$	32,965		$	22,304		$	64,106		$	60,861
Cost of revenues	34,136			18,660			67,058			49,582
Depreciation, excluding depreciation and amortization	4,128			2,806			7,759			5,676
S,G&A (excluding stock-based compensation)	12,217			10,573			21,318			17,013
Stock-based compensation and share exchange expense	4,550			10,195			6,428			14,604
Amortization	862			862			1,725			1,725
Operating income (loss)	$	(22,928	)	$	(20,792	)	$	(40,182	)	$	(27,739	)

Table of Contents

Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011

Summary of operating results

The operating loss increased $2.1 million to $22.9 million for the three months ended June 30, 2012 from $20.8 million for the same period of the prior year. The gross margin, defined as revenues less cost of revenues, declined $4.8 million, primarily due to an increase in the direct costs of production as a result of competitive and other pressures. Additional detail on the components included in our cost of revenues is provided below. Stock-based compensation decreased from $10.2 million to $4.6 million. Other selling, general and administrative (“S,G&A”) expenses increased by $1.6 million over the prior period to $12.2 million. Depreciation and amortization increased $1.3 million over the prior period.

Interest and other financing costs decreased $38.6 million to $14.2 million for the three months ended June 30, 2012 from $52.8 million for the same period of the prior year. The principal causes of this decrease included a $42.7 million decrease in the non-cash changes in fair value of warrant and other debt-related liabilities and a $1.6 million decrease in the amortization of debt discounts and deferred debt issue costs. These decreases were partially offset by an increase in losses on debt extinguishments of $4.8 million.

The decrease in interest expense, partially offset by the increase in the operating loss, was the principal causes of an improvement of $36.4 million in the net loss before non-controlling interests for the three months ended June 30, 2012. The net losses before non-controlling interests were $36.7 million and $73.1 million for the three months ended June 30, 2012 and 2011, respectively. These variances are explained in greater detail below.

Revenues

Total revenues increased $10.7 million to $33.0 million for the three months ended June 30, 2012 from $22.3 million for the same period of the prior year. This increase was due to a $6.1 million increase in feature film revenues, a $3.3 million increase in licensing revenues, a $1.1 million increase in commercial revenues and an increase in grant and other revenues of $0.2 million.

Feature film revenues increased to $21.6 million for the three months ended June 30, 2012, of which revenues from eight features accounted for virtually all of this total. Feature film revenues for the three months ended June 30, 2011 aggregated $15.5 million, of which revenues from five feature films accounted for virtually this entire total.

Commercials revenues increased to $7.1 million for the three months ended June 30, 2012 from $6.0 million for the same period of the prior year. In the three months ended June 30, 2012, we recognized revenue from 11 projects of which one project represented 44.1% of the total. In the three months ended June 30, 2011, we recognized $1.7 million from one relatively large commercial project as well as another $3.0 million from eight other substantial commercial projects.

Grant revenues from governmental sources

Grant revenues from governmental sources increased by $0.1 million during the three months ended June 30, 2012 as compared to the corresponding period of the prior year. Effective January 1, 2012, we began to recognize revenue from the deferred land grant of $10.5 million from the City of Port St. Lucie related to the parcel of land where our new headquarters building is located. We moved into this building in December 2011. We recognized $0.1 million of grant revenues related to this deferred land grant during the three months ended June 30, 2012.

Licensing and tuition revenues

We recognized $3.4 million of licensing and tuition revenues during the three months ended June 30, 2012. This amount included a one-time licensing fee of $3.2 million from one customer for use of our proprietary products. There were no such revenues for the same period of the prior year.

Cost of revenues

The table below lists sets forth the components of cost of revenues (in thousands):

	Three Months Ended June 30,
	2012				2011
	Amount		% of Total Revenue		Amount		% of Total Revenue
	(Unaudited)				(Unaudited)
Cost of Revenues:
Direct cost of revenues	$	22,164	67.2	%	$	15,132	67.8	%
Unutilized labor	4,355		13.2	%	2,125		9.5	%
Production and other costs	7,617		23.2	%	1,403		6.4	%
Total cost of revenues	$	34,136	103.6	%	$	18,660	83.7	%

Table of Contents

Our direct cost of revenues represents the labor required to deliver projects to customers. Unutilized labor represents expenses related to the staff that we retain while we await the start of new projects. Production and other costs represent that portion of our overhead that is allocated to cost of revenues.

Our direct cost of revenues increased during the three months ended June 30, 2012 and 2011 were 67.2% and 67.8% of revenues. Absent the one-time licensing fee of $3.2 million recognized during the three months ended June 30, 2012, our direct costs of revenues increased to 74.5% of revenues. Of this 6.7% increase, 3.5% is due to the inclusion of co-production revenues of $3.6 million with 100% direct costs of revenues. During the three months ended June 30, 2012, our largest project generated $6.5 million of revenues with direct costs of revenues of 111.6%. During the three months ended June 30, 2011, our largest project generated $8.5 million of revenues with direct costs of revenues of 60.5%. Competitive pressures, product mix changes and other factors contributed to the remaining increase in the direct cost percentage of revenues.

Our unutilized labor increased $2.2 million to $4.4 million during the three months ended June 30, 2012 as compared to the same period of the prior year. We retained digital artists in anticipation of future projects, including those projects in which we are an equity investor. Unutilized labor costs were 13.2% and 9.5% of total revenues for the three months ended June 30, 2012 and 2011, respectively.

Our production and other costs increased $6.2 million during the three months ended June 30, 2012 to $7.6 million as compared to the same period of the prior year. These production and other costs as a percent of revenues were 23.2% and 6.4% of total revenues for the three months ended June 30, 2012 and 2011, respectively. This increase was related primarily to costs for a major project. We are recognizing these costs as incurred while revenues related to these costs will not be realized until a point in the future.

Depreciation expense

The $1.3 million increase in depreciation expense in the three months ended June 30, 2012 as compared to the same period of the prior year is virtually all due to the growth of our fixed assets in our Florida operations. Of the total increase, $0.3 million was due to the depreciation of our new headquarters building that we moved into in December 2011. Additionally, we depreciated $0.2 million of assets for that new building in the three months ended June 30, 2012. The remainder of the increase is due to general growth in our operations.

Selling, general and administrative expenses (“S,G&A”)

The composition of the S,G&A expenses for the three months ended June 30, 2012 and 2011 are as follows (in thousands):

	Three Months Ended
	June 30,
	2012		2011
	(Unaudited)
Share-based compensation expense:
Senior executive option grant	$	—	$	128
Chief executive officer option grant	—		2,502
Stock exchanges of subsidiary stock	—		6,498
Warrants issued to service providers	2,362		—
Other share-based compensation expense	2,188		1,067
Total share-based compensation expense	4,550		10,195
Payroll- related expenses	3,166		5,464
Rent and occupancy costs	1,368		1,991
Professional fees	5,613		1,018
Other S,G&A expenses	2,070		2,100
Total S,G&A	$	16,767	$	20,768

A decrease of $5.6 million in share-based compensation expense, partially offset by an increase in other S,G&A expenses of $1.6 million resulted in a total decrease of $4.0 million of S,G&A expenses for the three months ended June 30, 2012 as compared to the same period of the prior year.

In April of 2012, the Company issued four awards to acquire common stock in connection with the Company’s activities in the Middle East region. As these warrants related to activities already conducted, the Company recognized an expense of $2.4 million as stock based compensation expense during the three months ended June 30, 2012.

During the three months ended June 30, 2011, our Chief Executive Officer was issued options to purchase shares of Digital Domain and we recognized a compensation charge of $2.5 million for this option grant. Additionally, the Chief Executive Officer exercised this option and exchanged the shares of Digital Domain for shares of the Company’s common stock. We recognized a charge of $6.5

Table of Contents

million related to this exchange. Other share-based compensation expense increased $1.1 million due to the increased number of participants.

Other S,G&A expenses increased $1.6 million to $12.2 million in the three months ended June 30, 2012 from $10.6 million for the same period of the prior year. On August 2, 2012, we reached settlement with Carl Stork, the former Digital Domain Chief Executive Officer and director, whereby we are to pay $5.0 million to Mr. Stork. We had previously accrued $0.4 million. Accordingly, we recognized $4.6 million of additional legal expense during the three months ended June 30, 2012. Other decreases were primarily due to an increase in the costs allocated to unutilized labor and production and other costs within cost of revenues. Payroll-related expenses decreased $2.3 million due to an increase of these expenses classified as unutilized labor and other production costs within costs of revenue.

Interest Expense

We recognize two types of interest expense. These types include the interest expense that is paid in cash, such as interest on our notes payable and on our capital lease and government lease obligations. We also recognize non-cash interest expense, such as for the issuances of and changes in the fair value of warrant liabilities, amortization of debt discounts and deferred debt issuance costs and losses on debt extinguishments. The composition of interest expense for the three months ended June 30, 2012 and 2011 is as follows (in thousands):

	Three Months Ended
	June 30,
	2012		2011
	(Unaudited)
Cash-based interest expense:
Interest expense on notes payable	$	925	$	708
Interest expense on capital and governmental lease obligations	658		(6		)
Total cash-based interest expense	1,583		702
Non-cash based interest expense:
Changes in fair value of warrant and other debt-related liabilities	3,584		46,295
Amortization of discount and issuance costs on notes payable	1,987		3,545
Losses on debt extinguishments	7,016		2,226
Total non-cash-based interest expense	12,587		52,066
Net interest expense	$	14,170	$	52,768

The total cash-based interest expense increased $0.9 million and the non-cash interest expense decreased $39.5 million for a net decrease in interest expense of $38.6 million for the three months ended June 30, 2012 as compared to the same period of the prior year.

Interest expense on notes payable increased $0.2 million for the three months ended June 30, 2012 as compared to the same period of the prior year, primarily due to increased level of indebtedness.

The interest expense on capital and governmental leases increased $0.7 million in the three months ended June 30, 2012 as compared to the same period of the prior year. This was due to the interest we pay on the government bond obligation.

Changes in fair value of warrant and other debt-related liabilities

We recognize warrant liabilities for warrants issued in connection with various debt transactions. These warrants are recorded initially at fair value and are adjusted to fair value at each financial reporting date. These fair values are obtained from a third-party independent valuation firm.

During the three months ended June 30, 2012 and 2011, we recognized an increase in the fair value of warrant liabilities of $3.6 million and $46.3 million, respectively. These increases were due primarily to an increase in fair value of our common stock, as well as additional warrants issued.

Amortization of discount and issuance costs on notes payable

During the three months ended June 30, 2012 and 2011, we amortized debt discounts of $2.0 million and $3.5 million, respectively. This decrease was due to the write off of existing debt discounts and deferred debt issue costs in the fourth quarter of 2011 for the Palm Beach Capital loans. The Comvest loans, the Senior Notes and the Subordinated Note had relatively lower level of debt discounts and deferred debt issue costs that were amortized in the three months ended June 30, 2012 as compared to the loans that existed during the three months ended June 30, 2011.

Table of Contents

Losses on debt extinguishments

Upon payoff of the Comvest loans on May 7, 2012 (see Note 13 to our condensed consolidated financial statements), we wrote off $1.9 million of unamortized deferred debt issue costs, $6.0 million of unamortized debt discounts and $1.9 million of a net asset position in our warrant liabilities. These losses were partially offset by a credit of $2.8 million to discount the Subordinated Note to fair value (see Note 13 to our Condensed Consolidated Financial Statements) for a net loss on debt extinguishments of $7.0 million.

During the three months ended June 30, 2011, the convertible note payable issued to a Palm Beach Capital fund was modified to extend the voluntary conversion feature from June 30, 2011 to December 20, 2011. This modification was accounted for as a debt extinguishment. The principal amount of the loan at the date was $4.3 million and the unamortized discount on the loan was $3.4 million. Therefore, the carrying value of the loan before the modification was $0.9 million. Upon modification, the fair value of the loan was $3.1 million. Consequently, we recognized a loss on debt extinguishment of $2.2 million to adjust the carrying value of the loan to fair value.

Other income

Other income was $0.4 million for the three months ended June 30, 2012 and 2011.

Income taxes

We recognized no tax expense for both of three months ended June 30, 2012 and 2011.

Net loss attributable to non-controlling interests

During the three months ended June 30, 2012 and 2011, the net loss of the Company’s subsidiary Digital Domain (“DD”) was $6.1 million and $6.7 million, respectively. The portions of DD not owned by us during these same periods were 13.3% and 19.0%, respectively. Therefore, the net loss attributable to non-controlling interests related to DD was $0.8 million and $1.3 million during the three months ended June 30, 2012 and 2011, respectively.

Another subsidiary, Digital Domain Institute (“DDI”), was funded in July and August of 2011. During the three months ended June 30, 2012, DDI realized a net loss of $1.0 million. The portion of DDI not owned by us during this period was 0.7%. Therefore, the Company did not attribute a significant loss of DDI to non-controlling interests.

Table of Contents

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011

Summary of operating results

The operating loss increased $12.5 million to $40.2 million for the six months ended June 30, 2012 from $27.7 million for the same period of the prior year. The gross margin, defined as revenues less cost of revenues, declined $14.2 million, primarily due to increases in unutilized labor as we elected to maintain our trained and experienced work force and infrastructure in anticipation of future projects, including those projects in which we hold an ownership stake. Additional detail on the components included in our cost of revenues is provided below. Stock-based compensation decreased from $14.6 million to $6.4 million. Other selling, general and administrative (“S,G&A”) expenses increased by $4.4 million over the prior period to $21.3 million. Depreciation and amortization increased $2.1 million over the prior period.

Interest and other financing costs decreased $72.7 million to $12.8 million for the six months ended June 30, 2012 from $85.5 million for the same period of the prior year. The principal causes of this decrease included a $76.0 million decrease in the non-cash changes in fair value of warrant and other debt-related liabilities and a $3.0 million decrease in the amortization of debt discounts and deferred debt issue costs. These decreases were partially offset by an increase in losses on debt extinguishments of $4.8 million.

The decrease in interest expense, partially offset by the increase in the operating loss, was the principal cause of an improvement of $59.8 million in the net loss before non-controlling interests for the six months ended June 30, 2012. The net losses before non-controlling interests were $52.3 million and $112.1 million for the six months ended June 30, 2012 and 2011, respectively. These variances are explained in greater detail below.

Revenues

Total revenues increased $3.2 million to $64.1 million for the six months ended June 30, 2012 as compared to $60.9 million for the six months ended, June 30, 2011. This increase was primarily attributed to a one-time licensing fee of $3.2 million from one customer for use of our proprietary products. Additionally, feature film revenue increased $2.0 million, commercial revenue decreased $2.6 million and grant and other revenues increased $0.6 million in these respective periods.

Feature film revenues increased to $49.1 million for the six months ended June 30, 2012, of which revenues from seven features accounted for $45.5 million of this total. Feature film revenues for the six months ended June 30, 2011 aggregated $47.1 million, of which revenues from four feature films accounted for $44.7 million of this total.

Commercials revenues decreased to $9.7 million for the six months ended June 30, 2012 from $12.3 million for the same period of the prior year. In the six months ended June 30, 2011, we recognized $4.5 million from one relatively large commercial project. During the six months ended June 30, 2012, our largest commercial project generated $3.1 million of revenue.

Grant revenues from governmental sources

Grant revenues from governmental sources increased by $0.3 million during the six months ended June 30, 2012 as compared to the corresponding period of the prior year. Effective January 1, 2012, we began to recognize revenue from the deferred land grant of $10.5 million from the City of Port St. Lucie related to the parcel of land where our new headquarters building is located. We moved into this building in December 2011. We recognized $0.3 million of grant revenues related to this deferred land grant during the six months ended June 30, 2012.

Licensing and tuition revenues

We recognized $3.5 million of licensing and tuition revenues during the six months ended June 30, 2012. This amount included a one-time licensing fee of $3.2 million from one customer for use of our proprietary products. There were no such revenues for the same period of the prior .

Cost of revenues

The table below lists sets forth the components of cost of revenues (in thousands):

	Six Months Ended June 30,
	2012			2011
	Amount	% of Total Revenue		Amount	% of Total Revenue
	(Unaudited)			(Unaudited)
Cost of Revenues:
Direct cost of revenues	$45,004	70.2	%	$38,661	63.5	%
Unutilized labor	9,067	14.1	%	2,612	4.3	%
Production and other costs	12,987	20.3	%	8,309	13.7	%
Total cost of revenues	$67,058	104.6	%	$49,582	81.5	%

Table of Contents

Our direct cost of revenues increased during the six months ended June 30, 2012 to 70.2% of revenue from 63.5% of revenue for the same period of the prior year. Of this 6.7% increase, 3.0% is due to the inclusion of co-production revenues of $5.8 million at 100% direct costs of revenues. During the six months ended June 30, 2012, our largest project generated $21.9 million of revenues with direct costs of revenues of 88.4%. During the six months ended June 30, 2011, our largest project generated $19.1 million of revenues with direct costs of revenues of 60.2%. Competitive pressures, product mix changes and other factors contributed to the remaining increase in the direct cost percentage of revenues.

Our unutilized labor increased $6.5 million to $9.1 million during the six months ended June 30, 2012 as compared to $2.6 million for the same period of the prior year. We retained digital artists in anticipation of future projects, including those projects in which we are an equity investor. These costs were 14.1% and 4.3% of total revenues for the six months ended June 30, 2012 and 2011, respectively.

Our production and other costs increased $4.7 million during the six months ended June 30, 2012 to $13.0 million as compared to the same period of the prior year. These production and other costs as a percent of revenues were 20.3% and 13.7% for the six months ended June 30, 2012 and 2011, respectively.

Depreciation expense

The $2.1 million increase in depreciation expense in the six months ended June 30, 2012 as compared to the same period of the prior year is virtually all due to the growth of our fixed assets in our Florida operations. Of the total increase, $0.7 million was due to the depreciation of our new headquarters building that we moved into in December 2011. Additionally, we depreciated $0.3 million of assets for that new building in the six months ended June 30, 2012. The remainder of the increase is due to the general growth in our operations.

Selling, general and administrative expenses (“S,G&A”)

The composition of the S,G&A expenses for the six months ended June 30, 2012 and 2011 are as follows (in thousands):

	Six Months Ended
	June 30,
	2012		2011
	(Unaudited)
Share-based compensation expense:
Senior executive option grant	$	—	$	3,383
Chief executive officer option grant	—		2,502
Stock exchanges of subsidiary stock	—		6,498
Warrants issued to service providers	2,362		—
Other share-based compensation expense	4,066		2,221
Total share-based compensation expense	6,428		14,604
Payroll- realated expenses	7,270		8,845
Rent and occupancy costs	2,981		3,121
Professional fees	7,164		1,808
Other S,G&A expenses	3,903		3,239
Total S,G&A	$	27,746	$	31,617

A decrease of $8.2 million in share-based compensation expense, partially offset by an increase in other S,G&A expenses of $4.3 million resulted in a net decrease of $3.9 million of S,G&A expenses for the six months ended June 30, 2012 as compared to the same period of the prior year.

On August 2, 2012, we reached settlement with Carl Stork, the former Digital Domain Chief Executive Officer and director, whereby we are to pay $5.0 million to Mr. Stork. We had previously accrued $0.4 million. Accordingly, we recognized $4.6 million of additional legal expense during the six months ended June 30, 2012.

During the six months ended June 30, 2011, we granted stock options to the former Chief Executive Officer of our subsidiary Digital Domain to purchase shares of the Company’s Common Stock which vested immediately resulting in a charge of $3.3 million. Our Chief Executive Officer was issued options to purchase shares of Digital Domain and we recognized a compensation charge of $2.5 million for this option grant during this period. Additionally, the Chief Executive Officer exercised this option and exchanged the shares of Digital Domain for shares of the Company’s common stock. We recognized a charge of $6.5 million related to this exchange. Other share-based compensation expense increased $1.8 million due to the increased number of participants.

Table of Contents

Payroll-related expenses decreased $1.6 million due an increase of these expenses classified as unutilized labor and other production costs within costs of revenues.

Interest Expense (Credit)

We recognize two types of interest expense. These types include the interest expense that is paid in cash, such as interest on our notes payable and on our capital lease and government lease obligations. We also recognize non-cash interest expense (credit), such as for the issuances of and changes in the fair value of warrant liabilities, amortization of debt discounts and deferred debt issuance costs and losses on debt extinguishments. The composition of interest expense (credit) for the six months ended June 30, 2012 and 2011is as follows (in thousands):

	Six Months Ended
	June 30,
	2012			2011
	(Unaudited)
Cash-based interest expense:
Interest expense on notes payable	$	1,595		$	1,210
Interest expense on capital and governmental lease obligations	1,328			312
Total cash-based interest expense	2,923			1,522
Non-cash based interest expense (credit):
Changes in fair value of warrant and other debt-related liabilities	(700		)	75,260
Amortization of discount and issuance costs on notes payable	3,586			6,558
Losses on debt extinguishments	7,016			2,226
Total non-cash-based interest expense (credit)	9,902			84,044
Net interest expense	$	12,825		$	85,566

The total cash-based interest expense increased $1.4 million and the non-cash interest expense decreased $74.1 million for a net decrease in interest expense of $72.7 million for the six months ended June 30, 2012 as compared to the same period of the prior year.

Interest expense on notes payable increased $0.4 million in the six months ended June 30, 2012 as compared to the same period of the prior year, primarily due to increased level of indebtedness.

The interest expense on capital and governmental lease obligations increased $1.0 million in the six months ended June 30, 2012 as compared to the same period of the prior year. This was due to the interest we pay on the government bond obligation.

Changes in fair value of warrant and other debt-related liabilities

During the six months ended June 30, 2012, we recognized a decrease in the fair value of warrant liabilities of $0.7 million, primarily related to decreases in the value of our common stock. During the six months ended June 30, 2011, we recognized an increase in the fair value of warrant and other debt-related liabilities of $75.3 million due primarily to an increase in warrants issued and an increase in the fair value of our common stock.

Amortization of discount and issuance costs on notes payable

During the six months ended June 30, 2012 and 2011, we amortized debt discounts of $3.6 million and $6.6 million, respectively. This decrease was due to the write off of existing debt discounts and deferred debt issue costs in the fourth quarter of 2011 for the Palm Beach Capital loans. The Comvest loans, the Senior Notes and the Subordinated Note had relatively lower level of debt discounts and deferred debt issue costs that were amortized in the six months ended June 30, 2012 as compared to the loans that existed during the six months ended June 30, 2011.

Losses on debt extinguishments

Table of Contents

Other income

Other income decreased $0.8 million to $0.7 million for the six months ended June 30, 2012 as compared to $1.5 million during the same period of the prior year. A third-party wanted to occupy the space occupied by our Digital Domain subsidiary. That third-party paid Digital Domain to vacate the space. We recognized $1.3 million of this revenue during the six months ended June 30, 2011.

Income taxes

During the six months ended June 30, 2011, we recognized certain Canadian tax liabilities aggregating $0.3 million. There was no such recognition during the six months ended June 30, 2012.

Net loss attributable to non-controlling interests

During the six months ended June 30, 2012 and 2011, the net losses of the Company’s subsidiary Digital Domain (“DD”) were $11.3 million and $5.6 million, respectively. The portions of DD not owned by us during these same periods were 13.3% and 19.0%, respectively. Therefore, the net loss attributable to non-controlling interests related to DD was $1.5 million and $1.1 million for the six months ended June 30, 2012 and 2011, respectively.

Another subsidiary, Digital Domain Institute (“DDI”), was funded in July and August of 2011. During the six months ended June 30, 2012, DDI realized a net loss of $1.5 million. The portion of DDI not owned by us during this period was 3.7%. Therefore, the net loss attributable to non-controlling interests related to DDI was $0.1 million.

Liquidity and Capital Resources

As of June 30, 2012, we had a deficit in working capital of $42.8 million.

Sale and issuance of Convertible Notes and Warrants

As is more fully described in Note 13 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report, we entered into a securities purchase agreement (the “May 2012 Purchase Agreement”) with a group of institutional investors (the “May 2012 Purchasers”) pursuant to which we issued and sold to the May 2012 Purchasers senior secured convertible notes in the aggregate original principal amount of $35.0 million (the “Senior Notes”) and warrants (the “May 2012 Warrants”) to initially purchase up to 1,260,288 shares of our Common Stock, for an aggregate purchase price of $35.0 million. The initial conversion price of the Senior Notes was $9.72 per share, subject to adjustment as provided in the Senior Notes. The initial exercise price of the May 2012 Warrants was $9.72 per share, subject to adjustment as provided in the May 2012 Warrants. Such issuance and sale were consummated on May 7, 2012.

On June 7, 2012, in connection with the PIPE offering (see Note 15) to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report, each of the May 2012 Purchasers entered into a Consent and Waiver pursuant to which the Company and each of the May 2012 Purchasers agreed that, notwithstanding any contrary provisions of the Senior Notes and the May 2012 Warrants, immediately after giving effect to the issuance and sale of securities pursuant to the PIPE offering, the conversion price of the Senior Notes and the exercise price of the May 2012 Warrants were each adjusted so as to equal $6.00. As of June 30, 2012, the Senior Notes, inclusive of estimated future interest, and the May 2012 Warrants were convertible or exercisable, as applicable, into 8,491,233 and 2,041,666 shares of our Common Stock, respectively.

The Senior Notes bear interest at 9.0% per annum and mature on the fifth anniversary of the issuance date. Upon the occurrence of an Event of Default (as such term is defined in the Senior Notes), the interest rate shall be adjusted to a rate of 15.0% per annum. The Purchasers may require us to redeem all or any portion of the Senior Notes upon the occurrence of an Event of Default or a Change of Control (as such terms are defined in the Senior Notes)

The Senior Notes will amortize in equal monthly installments commencing on the earlier of (i) the effective date of the initial registration statement filed in accordance with the terms of the Registration Rights Agreement (see Note 13 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report) or (ii) the six-month anniversary of the closing date. The Senior Notes may be converted into shares of our common stock, at the option of the holders thereof, at any time following issuance of the Senior Notes. The Senior Notes are redeemable at our option if our common stock trades at a level equal to 175% of the initial conversion price for any 30 consecutive trading days commencing on the date of issuance of the Senior Notes. The initial conversion price of the Senior Notes is $9.72, subject to adjustment as provided in the Senior Notes.

Exchange of Outstanding Debt with Existing Lender

As is more fully described in Note 13 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report, we entered into an agreement on May 6, 2012 (the “Restructuring Agreement”) with Comvest, pursuant to which, among other things, we agreed to (i) use a portion of the proceeds received from the Senior Notes described above to make payments to Comvest with respect to the outstanding loans to us by Comvest, such that the aggregate outstanding principal balance thereof was reduced to $8.0 million (the aggregate outstanding principal for these loans on that date was $27.7 million), and (ii) repurchase all but 145,000 shares (the “Retained Shares”) of our common stock received by Comvest upon full exercise of an outstanding warrant to purchase shares of our common stock held by Comvest.

Table of Contents

The aggregate amount paid to Comvest in satisfaction of outstanding indebtedness and in repurchasing such shares as well as the borrowing of the Subordinated Note of $8.0 million, as described above, was $22.5 million, plus certain fees and expenses we agreed to pay.

In connection with the foregoing, we entered into an agreement with Comvest (the “Debt Exchange Agreement”) pursuant to which, among other things, we exchanged the remaining outstanding original principal balance under the outstanding loans held by Comvest for a new secured convertible note in favor of Comvest with an original principal amount of $8.0 million (the “Subordinated Note”), which Subordinated Note, inclusive of any and all accrued interest of the Subordinated Note and other fees, costs and amounts owing thereunder, is convertible into shares of our common stock.

The Subordinated Note bears interest at 10.0% per annum and matures on June 30, 2016. Upon the occurrence of an Event of Default (as such term is defined in the Subordinated Note), the interest rate shall be adjusted to a rate of up to 21.0% per annum, with the actual rate of such penalty interest to be contingent upon the nature of the Event of Default. Comvest may require us to redeem all or any portion of the Subordinated Note upon the occurrence of an Event of Default.

The Senior Notes and the Subordinated Note contain provisions that can require cash settlement in the event that the Company cannot deliver common shares as required by the provisions of these agreements.

As further described in Note 13 to the condensed consolidated financial statements, the Senior Notes and Subordinated Note are redeemable at the option of the holders, all or in part, in the event of default. In addition, the Senior Notes, May 2012 Warrants and June 2012 Warrants are redeemable by the Holder in the event of a Change of Control (as defined).

For the Senior Notes, such redemption amounts would be based on the then outstanding principal, accrued interest, and foregone interest (the “Make Whole Amount”), collectively referred to as the “Conversion Amount”, except in certain situations, the amount subject to redemption in the event of default shall be redeemed at a price adjusted for changes in stock prices and other factors.

The redemption amount in regard to a Change of Control for the Senior Notes is based on the trading prices on our common stock and other factors.

In addition, the Senior Note Purchasers can redeem the Senior Notes starting at the 30 month anniversary of the inception date (the “30 Month Put Right”). The 30 Month Put Right, if exercised, would result payment of the then outstanding principal, accrued interest and the then Make-Whole Amount.

Registration Rights Agreements

In connection with the Purchase Agreement and the Restructuring Agreement, we entered into registration rights agreements whereby we agreed to file a registration statement with the Securities and Exchange Commission within 30 days of the closing date and to use our reasonable and best efforts for such registration statement to be declared effective 90 days after the closing date.

Issuance of Common Stock

As is more fully described in Note 15 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report, we entered into a Private Investment in Public Entity (the “PIPE”) on June 8, 2012 with a group of institutional investors. In connection with this PIPE, we issued 1,500,000 shares of its common stock at a price of $7.00 per share for gross proceeds of $10.5 million. We incurred $0.9 million of offering expenses related to this transaction. We issued 600,000 of warrants to these investors to purchase our common stock at an exercise price of $8.05 that expire in five years. We recognized the fair value of these warrants at date of issue of $8.1 million as long-term warrant liabilities. The net infusion to stockholders’ equity for the PIPE was $1.5 million.

Future Liquidity

On May 21, 2012, we entered into an agreement with an entity wholly owned by the government of Abu Dhabi to develop and operate a production studio and institute in the Media Zone of Abu Dhabi. Under the terms of this agreement, we are required to place into escrow $19.0 million by no later than 180 days from that date. These funds will be released to our operating cash over a five-year period beginning at the commencement of the fourth year of the agreement.

Other known uses of cash other than for operations within one year subsequent to June 30, 2012 include $8.1 million of debt principal payments (of which $5.1 million may be paid in stock), $5.0 million of litigation settlement payments and a $1.5 million payment on our lease obligation to the City of Port St. Lucie.

Our future capital requirements will depend on many factors, including our revenue growth, our ability to obtain advance payments from our customers, the timing and extent of the expansion of our involvement in feature film production and the timing of introductions of new products and enhancements to existing products. Although we currently are not a party to any agreement or letter of intent with respect to potential material investments in, or acquisitions of, complementary businesses, services or technologies, we may enter into these type of arrangements in the future, which could also require us to seek additional capital in the form of debt, finance facilities, or equity capital. Such funds may not be available on terms favorable to us or at all. In addition, the Company announced that it will evaluate a variety of alternatives including, but not limited to, a strategic minority investment in the Company or in a specific business segment, joint ventures and/or business combinations with strategic partners, the sale or spin-off of the Company’s assets or operating subsidiaries, or the outright sale of the Company.

As we continue to build our feature animated film, co-production and education line of business, we believe we will enter into contracts for our traditional VFX and animation services to feature film and commercials clients which will adequately fund operations for those services and provide additional liquidity to support our newer lines of business. We also believe that through our revenues from those VFX and animation services contracts; through the re-financing of debt; through the strategic alternatives discussed above; and through co-production arrangements for our animated feature film projects as described in “Financing and Co-Production Arrangements, as filed in our Annual Report as of December 31, 2011, we have sufficient sources of cash to support our operations in 2012.

Cash Flows for the Six Months Ended June 30, 2012 and 2011 (Unaudited)

We used net cash from operating activities aggregating $34.3 million and $16.3 million for the six months ended June 30, 2012 and 2011, respectively. The net cash operating loss for the six months ended June 30, 2012 and 2011 was $26.1 million and $5.8 million, respectively. We invested $22.4 million and $0.7 million in the six months ended June 30, 2012 and 2011, respectively, in film inventory. During the six months ended June 30, 2012, we generated cash flows of $14.2 million from other assets and liabilities, primarily due to reductions in deferred revenue and increases in accounts payable and accrued liabilities.

Table of Contents

During the six months ended June 30, 2011, we used cash of $9.8 million from other assets and liabilities primarily due to reductions in deferred revenue.

During the six months ended June 30, 2012 and 2011, we used cash from investing activities of $5.9 million and $9.2 million, respectively. These amounts were virtually all purchases of property and equipment to support our growing operations, except for a release of restricted cash of $0.9 million during the six months ended June 30, 2011.

We generated net cash flows of $17.2 million from financing activities during the six months ended June 30, 2012. We sold 1.5 million shares of our common stock in a private transaction for $10.5 million and had paid $0.2 million of related costs through that date (see Note 15 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report). We borrowed $3.0 million in a short-term note, $35.0 million of Senior Notes and $8.0 million in a Subordinated Note. We paid $3.2 million for various fees for these borrowings. We used a portion of these net proceeds to pay off the loans with Comvest aggregating $27.8 million (see Note 13 to our Condensed Consolidated Financial Statements contained elsewhere in this quarterly report for additional information regarding these debt transactions). We paid our first installment of our capital lease for our new headquarters building of $2.4 million. Additionally, we paid $3.2 million to purchase 526,784 shares of our common stock in connection with our stock buy-back program. We also purchased a portion of the shares issued to Comvest upon its exercise of warrants aggregating $2.5 million during this period.

We generated net cash flows of $14.8 million from financing transactions during the six months ended June 30, 2011. During that period, we sold 2,025,001 shares of our common stock to a group of investors in a private placement at a price per share of $9.63. The aggregate gross proceeds of this offering were $19.5 million. Through June 30, 2011, we paid $2.2 million in commissions and other expenses related to this private placement. We borrowed $4.0 million in new financings during this period. We exercised our option to on the Series B put right for $5.0 million. Other cash uses in this period included $2.6 million of deferred offering costs and $0.6 million of repayment of notes payable.

Part I. Financial Information

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. Our cash and cash equivalents balance as of December 31, 2011 and June 30, 2012 was held in money market accounts or invested in investment grade commercial paper with maturities of less than 90 days. Management does not believe that the Company has any material exposure to changes in the fair value of these investments as a result of changes in interest rates. Any future declines in interest rates will, however, reduce future investment income. As our cash held in trust is held at the City of Port St. Lucie, Florida, the City has the market risk on this financial instrument.

Digital Domain’s Vancouver subsidiary’s functional currency is the Canadian dollar. Assets and liabilities of this office are translated into U.S. dollars using exchange rates as of the respective balance sheet date, and revenues and expenses are translated into U.S. dollars using average exchange rates for the respective period covered. The effects of foreign currency translation adjustments are included as a component of accumulated other comprehensive income in stockholders’ equity. Currently, the Company does not hedge against translation gain and loss risks as the Company considers the net impact to our financial statements to be immaterial.

In addition, one of our subsidiaries has issued warrants to third parties that can be settled at the request of the holder for cash under certain conditions. A 10% increase or decrease in the underlying value of our subsidiary can result in a $0.5 million change in the ultimate settlement value of these instruments.

Part I. Financial Information

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Exchange Act, that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognizes that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. Based on their evaluation at the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were not effective at the reasonable assurance level due to the material weakness in our internal controls over financial reporting described below.

Table of Contents

In connection with the preparation of our financial statements for the year ended December 31, 2010, we identified several significant deficiencies and material weaknesses in our internal controls over financial reporting. A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect financial statement misstatements on a timely basis. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company’s financial reporting. We identified the following control deficiencies as significant deficiencies as of December 31, 2010 and remain control deficiencies as of June 30, 2012:

· our company had not maintained sufficient records of the actions and meeting minutes of its board and did not have a systemic process to manage its contracts and agreements; and

· our company had not maintained sufficient controls over the financial reporting for its Canadian subsidiary.

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following significant deficiencies were identified as material weaknesses as of December 31, 2010 and remain material weaknesses as of June 30, 2012:

· our company lacked control over the revenue recognition reporting for its Canadian subsidiary; and

· our company had not implemented an adequate process to consolidate its intercompany accounts and as a result could not conduct a monthly close on a timely basis.

While we have taken a number of remedial actions to address these significant deficiencies and material weaknesses, we cannot predict the outcome of our remediation efforts at this time. Each of the significant deficiencies and material weaknesses described above could result in a misstatement of our accounts or disclosures that would result in a material misstatement of our annual or interim consolidated financial statements that would not be prevented or detected. We cannot assure you that the measures we have taken to date, or any measures we may take in the future, will be sufficient to remediate the significant deficiencies or material weaknesses described above or avoid potential future significant deficiencies or material weaknesses.

Changes in Internal Control over Financial Reporting

We have begun taking numerous steps and plan to take additional steps to remediate the underlying causes of this material weakness, primarily through the development and implementation of formal policies, improved processes and documented procedures, as well as the hiring of additional accounting and finance personnel. The actions that we are taking are subject to ongoing senior management review, as well as audit committee oversight. We will not be able to assess whether the steps we are taking will fully remediate the material weakness in our internal control over financial reporting until we have completed our implementation efforts and sufficient time passes in order to evaluate their effectiveness. We may also conclude that additional measures may be required to remediate the material weakness in our internal controls over financial reporting which may necessitate additional implementation and evaluation time. We will continue to assess the effectiveness of our internal controls over financial reporting and take steps to remediate the known material weakness expeditiously.

Except as otherwise described herein, there has been no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Table of Contents

Part II. Other Information

Item 1. Legal Proceedings

Litigation

JK-DD, LLC and Jeffrey Kukes v. John C. Textor, et al. On August 12, 2010 the plaintiffs, who are stockholders of Digital Domain, filed suit against the defendants in Palm Beach County, Florida, Circuit Court seeking rescission of a 2007 settlement agreement that resolved a prior partnership dispute between Mr. Kukes and Mr. Textor pursuant to which the plaintiffs obtained their shares of Digital Domain common stock. The plaintiffs also seek damages for alleged dilution of the value of such shares. The defendants believe the Complaint is an attempt to reverse a valid, binding settlement agreement and are aggressively defending against the claims. On September 27, 2010, the defendants filed a motion to dismiss the plaintiffs’ claims. The plaintiffs subsequently dismissed two of the three counts in their original complaint, mailed defendants a draft amended complaint naming Digital Domain Media Group, Inc. as a defendant, and filed a separate new action against Mr. Textor and his wife, individually. The plaintiffs’ draft amended complaint against the Company has not been filed. Both cases are in discovery, and as such we cannot reliably predict the outcome. No trial date has been set in either case.

Table of Contents

Part II. Other Information

Item 1A. Risk Factors

Our operations and financial results are subject to various risks and uncertainties, including the following risks and the risks described elsewhere in this Quarterly Report on Form 10-Q, which could adversely affect our business, financial condition, operating results and cash flows and the trading price of our Common Stock.

There have been no material changes from the risk factors as previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2011, other than the following:

The terms of our current indebtedness restrict our operations.

Our ability to finance future operations and growth is limited by the covenants contained in our Senior Notes and the Subordinated Note. These covenants restrict our ability, among other things to:

· dispose of assets;

· engage in mergers or consolidations;

· issue shares of our capital stock or securities exercisable for or convertible into shares of our capital stock;

· incur debt;

· pay dividends;

· repurchase our capital stock;

· create liens on our assets;

· make capital expenditures;

· make investments or acquisitions; and

Table of Contents

· engage in transactions with our affiliates.

Our Senior Notes also require us to comply with certain financial covenants. These covenants may significantly limit our ability to respond to changing business and economic conditions and to secure additional financing, and we may be prevented from engaging in transactions, including acquisitions, that might be considered important to our business strategy or otherwise beneficial to us.

Our ability to comply with the restrictive covenants contained in the Senior Notes and the Subordinated Note may be affected by events that are beyond our control. The breach of any of these covenants would result in a default under the Senior Notes or the Subordinated Note. In the event of a default under the Senior Notes or the Subordinated Note, the holders of such notes could declare all amounts owing thereunder to be immediately due and payable. A default that is not cured or that cannot be cured under the Senior Notes would constitute a default under the Subordinated Note, and vice versa. We cannot assure you that we would be able to repay all amounts due under the Senior Notes and the Subordinated Note in the event that these amounts are declared immediately due and payable upon a breach of the Senior Notes or the Subordinated Note.

Part II. Other Information

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following sets forth information regarding securities sold or issued by the Company without registration under the Securities Act during the period commencing on April 1, 2012 and ending on June 30, 2012:

a) Sales of Unregistered Securities

In April 2012, we issued an aggregate of 1,038,375 shares of its Common Stock in exchange for an aggregate of 1,250,000 shares of common stock of Digital Domain Institute, Inc., a subsidiary of ours, pursuant to exchange rights previously granted to the minority shareholders of Digital Domain Institute, Inc. under share exchange option agreements entered into among us, Digital Domain Institute, Inc., and each of such shareholders.

In April 2012, we issued to an employee options to purchase an aggregate of 100,000 shares of our Common Stock at a price of $5.70.

In May 2012, we issued 623,025 shares of its Common Stock in exchange for an aggregate of 750,000 shares of common stock of Digital Domain Institute, Inc., pursuant to exchange rights previously granted to a minority shareholder of Digital Domain Institute, Inc. under a share exchange option agreement entered into among us, Digital Domain Institute, Inc., and such shareholder.

In May 2012, we issued 223,167 shares of our Common Stock in connection with the cashless exercise of warrants previously issued to a placement agent who received such warrants as partial compensation for services provided in connection with private placements of shares of our Common Stock in 2011.

In May 2012, we borrowed $35.0 million from a group of institutional investors in the form of a convertible note payable, which can be converted at the election of the note holders and is convertible into 8,491,233 shares of our common stock. These note holders were also issued 2,041,672 warrants to purchase our common stock.

In May 2012, we borrowed $8.0 million in the form of a convertible note, which is convertible into 3,221,414 shares of our common stock at the election of the note holder.

In June 2012, we entered into a Private Investment in Public Entity (the “PIPE”) with a group of institutional investors. In connection with this PIPE, we issued 1,500,004 shares of its common stock at a price of $7.00 per share for gross proceeds of $10.5 million. We issued 600,000 of warrants to these investors to purchase our common stock at an exercise price of $8.05 that expire in five years.

Each of the above-described transactions was exempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereof or Regulation D or Rule 701 promulgated thereunder, as transactions not involving a public offering or involving the issuance of securities in certain compensatory circumstances. With respect to each transaction listed above, no general solicitation was made by either us or any person acting on our behalf; the securities sold are subject to transfer restrictions; and the certificates representing the securities contain an appropriate legend stating that such securities have not been registered under the Securities Act and may not be offered or sold other than pursuant to an effective registration statement under the Securities Act or an applicable exemption from the registration requirements thereof.

Table of Contents

Part II. Other Information

Item 6. Exhibits

31.1 Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2 Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1 Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS††		XBRL Instance Document

101.SCH††		XBRL Taxonomy Schema Linkbase Document

101.CAL††		XBRL Taxonomy Calculation Linkbase Document

101.DEF††		XBRL Taxonomy Definition Linkbase Document

101.LAB††		XBRL Taxonomy Labels Linkbase Document

101.PRE††		XBRL Taxonomy Presentation Linkbase Document

††

In accordance with Rule 406T of Regulation S-T, the information in these exhibits is furnished and deemed not filed or part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933, is deemed not filed for purposes of section 18 of the Exchange Act of 1934, and otherwise is not subject to liability under these sections.

Table of Contents

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

			Digital Domain Media Group, Inc.

			By:
	Date: August 14, 2012		/s/ John C. Textor
			John C. Textor
			Chief Executive Officer (Principal Executive Officer) and Chairman of the Board of Directors


			By:
	Date: August 14, 2012		/s/ John M. Nichols
			John M. Nichols
			Chief Financial Officer (Principal Financial and Accounting Officer)

Table of Contents

Index to Exhibits

Exhibit Number		Description of Document

31.1		Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2		Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1		Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2		Certification of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

101.INS††		XBRL Instance Document

101.SCH††		XBRL Taxonomy Schema Linkbase Document

101.CAL††		XBRL Taxonomy Calculation Linkbase Document

101.DEF††		XBRL Taxonomy Definition Linkbase Document

101.LAB††		XBRL Taxonomy Labels Linkbase Document

101.PRE††		XBRL Taxonomy Presentation Linkbase Document

††

Market Data

News

Trading Tools

Markets

Discover

Hot Features

Follow Feed

Options Flow

Monitor

DDMG Digital Domain Media Group Com USD0.01