Unassociated Document

See accompanying notes to condensed financial statements

CONDENSED BALANCE SHEETS

ASSETS	September 30, 2008			December 31,
CURRENT ASSETS:	(unaudited)			2007
Cash and cash equivalents	$	494,355		$	236,995
Accounts receivable, net of allowance for doubtful accounts of $0		150,551			19,053
Deferred financing costs, current		394,642			596,917
Prepaid expenses		26,217			21,885
Deferred processing fees		109,043			40,560

Total Current Assets		1,174,808			915,410

PROPERTY AND EQUIPMENT, net		102,521			129,643
DEFERRED FINANCING COSTS, net of current portion		-			331,146
OTHER ASSETS		26,121			26,097

Total Assets	$	1,303,450		$	1,402,296

LIABILITIES AND STOCKHOLDERS’ DEFICIT
CURRENT LIABILITIES:
Accounts payable	$	2,731,296		$	647,976
Accrued expenses		545,664			619,805
Accrued expenses - registration rights agreement		177,607			166,297
Deferred revenue		3,220,738			629,442
Notes payable, net of discount		-			705,298
Current portion of convertible notes payable, net of discount		1,693,973			-
Current portion of capital lease obligation		28,583			24,271

Total Current Liabilities		8,397,861			2,793,089

CONVERTIBLE NOTES PAYABLE, less current portion		91,290			1,235,035

CAPITAL LEASE OBLIGATION, less current portion		21,692			41,347

Total Liabilities		8,510,843			4,069,471

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS’ DEFICIT:
Common stock, no par value; 50,000,000 shares authorized; 16,809,390 and 13,944,597 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively		5,840,305			4,788,349
Additional paid-in capital		8,957,352			7,105,428
Accumulated deficit		(22,005,050	)		(14,560,952	)

Total Stockholders’ Deficit		(7,207,393	)		(2,667,175	)

Total Liabilities and Stockholders’ Deficit	$	1,303,450		$	1,402,296

Part I, Item 1. Financial Statements (continued)

CONDENSED STATEMENTS OF OPERATIONS

(UNAUDITED)

	For the Three Months Ended						For the Nine Months Ended
	September 30,			September 30,			September 30,			September 30,
	2008			2007			2008			2007

REVENUES:
Net sales	$	1,202,715		$	544,956		$	2,420,623		$	1,839,535

OPERATING EXPENSES:
Advertising		2,658,895			106,325			3,905,961			351,775
Product development		121,710			118,355			325,571			398,306
Selling, general and administrative		1,672,480			888,435			3,537,637			2,879,388
Depreciation and amortization		9,828			25,172			29,484			75,786
Total Operating Expenses		4,462,913			1,138,287			7,798,653			3,705,255

LOSS FROM OPERATIONS		(3,260,198	)		(593,331	)		(5,378,030	)		(1,865,720	)

OTHER EXPENSE:
Other expense		-			-			-			4,415
Loss on registration rights agreement		-			-			216,540			69,787
Interest expense		673,232			680,944			1,848,928			1,792,219
Total Other Expenses		673,232			680,944			2,065,468			1,866,421

LOSS BEFORE INCOME TAX EXPENSE		(3,933,430	)		(1,274,275	)		(7,443,498	)		(3,732,141	)

INCOME TAX EXPENSE		200			-			600			800

NET LOSS	$	(3,933,630	)	$	(1,274,275	)	$	(7,444,098	)	$	(3,732,941	)

Basic and fully diluted net loss per share	$	(0.24	)	$	(0.10	)	$	(0.49	)	$	(0.30	)

Weighted Average Shares Outstanding:
Basic and fully diluted		16,249,557			12,272,803			15,084,239			12,225,013

See accompanying notes to condensed financial statements

Part I, Item 1. Financial Statements (continued)

CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	For the Nine Months Ended
	September 30, 2008			September 30, 2007
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(7,444,098	)	$	(3,732,941	)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss on registration rights agreement		216,540			69,787
Amortization of debt discount		953,732			871,171
Depreciation and amortization		29,484			75,786
Compensation expense from vested stock options		177,747			332,694
Amortization of deferred financing costs		533,421			643,975
Shares issued for penalties and interest		258,549			--
Shares issued for services		344,000			73,578
Deferred compensation		-			192,444
Changes in operating assets and liabilities:
Accounts receivable		(131,498	)		(22,940	)
Prepaid and other assets		(4,332	)		25,244
Deferred processing fees		(68,483	)		79,995
Other assets		(24	)		6,990
Accounts payable and accrued expenses		1,964,988			272,621
Deferred revenue		2,591,296			(69,859	)
Cash Flows Used In Operating Activities:		(578,678	)		(1,181,455	)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of fixed assets		--			(5,425	)
Cash Flows Used In Investing Activities		--			(5,425	)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from notes payable		160,000			650,000
Payment of notes payable		(349,000	)		-
Principal payments on capital lease obligation		(17,705	)		(12,802	)
Proceeds from sale of stock, net of cash issuance costs		1,042,743			-
Cash Flows Provided by Financing Activities		836,038			637,198

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		257,360			(549,682	)

CASH AND CASH EQUIVALENTS, beginning of period		236,995			549,682

CASH AND CASH EQUIVALENTS, end of period	$	494,355		$	-

See accompanying notes to condensed financial statements

Part I, Item 1. Financial Statements (continued)

CONDENSED STATEMENTS OF CASH FLOWS

(UNAUDITED)

	For the Nine Months Ended
	September 30, 2008		September 30, 2007
Supplemental disclosures of cash flow information:
Income taxes paid	$	39	$	17,857
Cash paid for interest	$	36,203	$	9,274

Supplemental schedule of non-cash financing activities:
Assets acquired through capital lease obligation	$	2,362	$	--
Discount on note payable	$	36,092	$	128,038
Warrants issued in connection with sale of stock	$	903,239	$	--
Conversion of notes payable and accrued interest to common stock and warrants	$	1,060,217	$	--
Warrants issued in connection with debt conversion	$	115,193	$	--
Convertible notes payable issued as payment for accrued interest and penalties	$	91,290
Deferred financing costs to be paid by issuance of stock	$	--	$	528,036

See accompanying notes to condensed financial statements

NOTE 1 - INTERIM FINANCIAL STATEMENTS

These unaudited interim financial statements have been prepared by CyberDefender Corporation (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial statements. The information furnished herein reflects all adjustments (consisting of normal recurring accruals and adjustments) that are, in the opinion of management, necessary to fairly present the operating results for the respective periods. Certain information and footnote disclosures normally present in annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. These unaudited interim financial statements should be read in conjunction with the audited financial statements and footnotes for the Company for its year ended December 31, 2007 included in the Company’s Annual Report on Form 10-K. The results for the nine-month interim period ended September 30, 2008 are not necessarily indicative of the results to be expected for the full year ending December 31, 2008.

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Business

The Company, based in Los Angeles, California, is a provider of secure content management software. The Company develops and licenses security software and related services. The Company continues to bring to market advanced solutions to combat and prevent online information theft, unwanted advertisements, spam, Internet viruses, spyware and related computer threats.

Going Concern and Management’s Plans

Historically, the Company’s revenues were derived from subscriptions to CyberDefender Anti-Spyware 2006, which included the initial download and one year of updates. The license to use the software was renewed annually with incentives for early renewals. The Company acquired new users with an online direct purchase offer. The offer, to scan a computer for spyware and then pay for removal of spyware, was broadcast in emails, banners and search ads.

In November 2006, the Company launched its new Internet security suite called CyberDefender FREE 2.0 that is free to the subscriber. Revenues are earned from advertising networks which pay the Company to display advertisements inside the software. CyberDefender Early Detection Center is a version of the same software, without the advertising, which is paid for by the subscriber. The annual subscription rate for the version without ads ranges from $11.99 to $39.99, depending on the marketing or distribution channels used by the Company.

On September 27, 2007, the Company announced the launch of CyberDefenderULTIMATE™ and CyberDefenderCOMPLETE™. These are enhanced versions of its security software. For an annual fee, CyberDefenderULTIMATE™ provides year round support for any software or hardware connected to a subscriber’s computer while CyberDefenderCOMPLETE™ provides a one-time fix to a customer’s computer and a year-round unlimited anti-malware support for a subscriber’s computer. These new security suites also include 2 gigabytes of online backup. These products are sold through an annual subscription for $59.95 to $199.95.

The Company’s financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses of $7,444,098 and $3,732,941 during the nine months ended September 30, 2008 and 2007, respectively, and has negative working capital of $7,223,053 and an accumulated deficit of $22,005,050 at September 30, 2008, which raises substantial doubt about its ability to continue as a going concern. Until sales of the products provide the Company with the revenue it needs to attain profitability, the Company intends to continue to raise money for operating capital through sales of its securities or by borrowing money. From inception through September 30, 2008, the Company has raised $5,235,000 from debt financing and $1,810,000 from equity financing to develop software and to build out a management team capable of delivering its products to market. The Company’s ability to continue as a going concern is dependent upon its ability to develop additional sources of capital. Management cannot assure that any financing arrangements will be available in amounts or on terms acceptable to the Company. If additional financing is not available or is not available on acceptable terms, the Company may be unable to continue its operations. The accompanying condensed financial statements do not include any adjustments that might result from the outcome of these uncertainties.

The Company currently has no firm agreements with any third parties for any future transactions and future financings.

To conform to the current year's presentation, as a result of management's continuing analysis of its operating activities, the Company reclassified approximately $374,000 for the three months ended September 30, 2007 that was previously classified as interest expense to selling, general and administrative expense with no effect on previously reported net loss.

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Reclassification

Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates made by management are, among others, realization of accounts receivables, recoverability of long-lived assets, determination of useful lives of intangibles, value of shares and options/warrants granted and valuation of deferred tax assets. Actual results could differ from those estimates and assumptions.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and investments with original maturities of three months or less.

Property and Equipment

Property and equipment are recorded at cost. Expenditures for major additions and improvements are capitalized and minor replacements, maintenance, and repairs are charged to expense as incurred. When equipment is retired or otherwise disposed of, the cost and accumulated depreciation are removed from the accounts and any resulting gain or loss is included in the results of operations for the respective period. Depreciation is provided over the estimated useful lives of the related assets ranging from three to seven years, using the straight-line method. Total depreciation expense was $29,484 and $25,786 for the nine months ended September 30, 2008 and 2007, respectively.

Equipment under Capital Lease

The Company leases certain of its furniture and other equipment under agreements accounted for as capital leases. The assets and liabilities under capital lease are recorded at the lesser of the present value of aggregate future minimum lease payments, including estimated bargain purchase options, or the fair value of the assets under lease. Assets under capital lease are depreciated using the straight-line method over their estimated useful lives.

Fair Value of Financial Instruments

Unless otherwise specified, the Company believes the carrying value of financial instruments approximates their fair value.

The Company recognizes revenue from the sale of software licenses under the guidance of Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition,” as amended by SOP No. 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions” and SEC Staff Accounting Bulletin (“SAB”) No. 101 “Revenue Recognition in Financial Statements” as amended by SAB 104.

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Revenue Recognition

Specifically, the Company recognizes revenues from its products when all of the following conditions for revenue recognition are met:

i.		persuasive evidence of an arrangement exists,
ii.		the product or service has been delivered,
iii.		the fee is fixed or determinable, and
iv.		collection of the resulting receivable is reasonably assured.

The Company currently sells three products, CyberDefender Early Detection Center (“EDC”), an antivirus and anti spyware software, CyberDefenderULTIMATE™ and CyberDefenderCOMPLETE™, over the Internet. The Company also offers a backup CD of the EDC software for an additional fee. CyberDefenderCOMPLETE™ offers customers one-time technical support and a license for EDC, while CyberDefenderULTIMATE™ offers customers unlimited technical support for a specified period and a license for EDC. Customers order the product and simultaneously provide their credit card information to the Company. Upon receipt of authorization from the credit card issuer, the Company provides technical support if the customer purchased CyberDefenderULTIMATE™ or CyberDefenderCOMPLETE™ and licenses the customer to download EDC over the Internet. As part of the sales price, the Company provides renewable product support and content updates, which are separate components of product licenses and sales. Term licenses allow customers to use the Company’s products and receive product support coverage and content updates for a specified period, generally twelve months. The Company invoices for product support, content updates and term licenses at the beginning of the term. These revenues contain multiple element arrangements where “vendor specific objective evidence” (“VSOE”) may not exist for one or more of the elements. EDC and CyberDefenderULTIMATE™ are in substance a subscription and the entire fee is deferred until the month subsequent to the delivery date of the product and is recognized ratably over the term of the arrangement according to the guidance in SOP 97-2 paragraph 49. Revenue is recognized immediately for the sale of the backup CD and for the portion of the sale of CyberDefenderCOMPLETE™ that relates to the one-time technical support as the Company believes that all of the elements necessary for revenue recognition have occurred.

The Company also uses third parties to sell its software and therefore evaluates the criteria of Financial Accounting Standards Board ("FASB") Emerging Issues Task Force ("EITF") Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent,” in determining whether it is appropriate to record the gross amount of revenue and related costs or the net amount earned as commissions. The Company is the primary obligor, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, establishes product specifications, and has the risk of loss. Accordingly, the Company's revenue is recorded on a gross basis.

The Company also offers two products which are free to the subscriber, CyberDefender FREE 2.0 and MyIdentityDefender Toolbar. Revenues are earned from advertising networks which pay the Company to display advertisements inside the software or through the toolbar search. Under the guidance of SAB 104, the Company recognizes revenue from the advertising networks monthly based on a rate determined either by the quantity of the ads displayed or the performance of the ads based on the amount of times the ads are clicked by the user. Furthermore, advertising revenue is recognized provided that no significant Company obligations remain at the end of a period and collection of the resulting receivable is probable. The Company’s obligations do not include guarantees of a minimum number of impressions.

Deferred Processing Fees

The Company uses a third party to process its product sales. The Company pays a direct acquisition fee to the processor for each completed sale. These direct acquisition fees are deferred and recognized ratably over the term of the arrangement of the associated sale in accordance with FASB Technical Bulletin 90-1, “Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts.” The third party processor refunds any direct acquisition fee on any credit card chargeback or on any product that is returned. The refunds are matched against the associated chargebacks and product returns.

Reserves for Product Returns

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

The Company’s policy with respect to product returns is defined in its End User License Agreement (“EULA”), which states “...products purchased that are downloadable are refundable within the first 30 days after the date of purchase.” Product returns are generally received within 30 days of the original sale and are charged against the associated sale upon receipt of the return. A chargeback occurs after a customer is automatically charged for a renewal license and subsequently, within 30 days of renewal, decides not to continue using the license or the credit card processed for renewal is no longer valid. The Company’s third party processor of renewal sales is usually notified within 30 days by customers that they no longer wish to license the Company’s product. The third party processor reduces the amounts due to the Company as a result of any chargeback during the preceding 30 day period. As a result, a majority of chargebacks occur within 30 days of the rebilling event and are recorded prior to closing the previous month’s accounting records. The Company may voluntarily accept returns from a customer. The returns are charged against revenues upon receipt. As of September 30, 2008 and December 31, 2007, the Company had $0 accrued for customer returns and chargebacks, based on historical returns.

Concentrations of Risk

Revenues are concentrated in the software industry which is highly competitive and rapidly changing. Significant technological changes in the industry or customer requirements, or the emergence of competitive products with new technologies or capabilities could adversely affect operating results.

The Company maintains all cash in bank accounts, which at times may exceed federally insured limits. The Company has not experienced a loss in such accounts.

For the nine months ended September 30, 2008 and 2007 advertising purchased from four vendors accounted for 94% and 47% of the Company’s total advertising expense, respectively.

Income Taxes

The Company has adopted the liability method of accounting for income taxes pursuant to Statement of Financial Accounting Standard (“SFAS”) No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, deferred income taxes are recorded to reflect tax consequences on future years for the differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statements carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets, including tax loss and credit carryforwards, and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Deferred income tax expense represents the change during the period in the deferred tax assets and deferred tax liabilities. The components of the deferred tax assets and liabilities are individually classified as current and non-current based on their characteristics. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.

Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (“FIN 48”). FIN 48 prescribes recognition thresholds that must be met before a tax position is recognized in the financial statements and provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. Under FIN 48, an entity may only recognize or continue to recognize tax positions that meet a “more likely than not” threshold. The Company did not make any adjustment to opening retained earnings as a result of the implementation.

CYBERDEFENDER CORPORATION

Based on its evaluation, the Company has concluded that there are no significant uncertain tax positions requiring recognition in its financial statements. The Company’s evaluation was performed for the tax years ended December 31, 2004 through 2007 for U.S. Federal Income Tax and for the tax years ending December 31, 2003 through 2007 for the State of California Income Tax.

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Income Taxes (Continued)

The Company does not have any unrecognized tax benefits as of September 30, 2008 that, if recognized, would affect the Company’s effective income tax rate.

The Company’s policy is to recognize interest and penalties related to income tax issues as components of income tax expense. The Company did not recognize or have any accrual for interest and penalties relating to income taxes as of September 30, 2008.

Software Development Costs

The Company accounts for software development costs in accordance with SFAS No. 86, “Computer Software to Be Sold, Leased, or Otherwise Marketed.” Such costs are expensed prior to achievement of technological feasibility and thereafter are capitalized. There have been very limited software development costs incurred between the time the software and its related enhancements have reached technological feasibility and its general release to customers. As a result, all software development costs have been charged to product development expense. For the nine months ended September 30, 2008 and 2007, product development costs were $325,571 and $398,306, respectively. Further, as discussed in Note 3, the Company acquired the CyberDefender ^TM software application during 2005.

Advertising Expenses

Advertising expenses are expensed as incurred and consist primarily of various forms of media purchased from Internet-based marketers and search engines. For the nine months ended September 30, 2008 and 2007, advertising expense amounted to $3,905,961 and $351,775, respectively.

Recently Issued Accounting Pronouncements

The Company has adopted all accounting pronouncements effective before September 30, 2008 which are applicable to the Company.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of SFAS No. 115.” SFAS No. 159 permits companies to choose to measure certain financial instruments and certain other items at fair value and requires unrealized gains and losses on items for which the fair value option has been elected to be reported in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. There was no impact on the Company’s financial statements from the adoption of this standard.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This statement clarifies the definition of fair value, establishes a framework for measuring fair value and expands the disclosures on fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. FASB Staff Position No. FAS 157-2 (“FSP 157-2”), “Effective Date of FASB Statement No. 157,” was issued in February 2008. FSP 157-2 delays the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value at least once a year, to fiscal years beginning after November 15, 2008, and for interim periods within those fiscal years. Effective January 1, 2008, we adopted SFAS 157 for financial assets and liabilities recognized at fair value on a recurring basis. The partial adoption of SFAS 157 for financial assets and liabilities had no impact on our financial position, results of operations or cash flows. Management does not expect the adoption of the FSP to have a material impact on our financial statements.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. Management does not currently expect the adoption of SFAS No. 162 to have a material impact on the financial statements.

In accordance with SFAS No. 128, “Earnings Per Share”, the basic loss per common share is computed by dividing net loss available to common stockholders by the weighted average number of common shares outstanding. Diluted loss per common share is computed similar to basic loss per common share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. As of September 30, 2008 and 2007, there were 11,432,958 and 9,649,692 shares of potentially dilutive securities outstanding, respectively. As the Company reported a net loss, none of the potentially dilutive securities were included in the calculation of diluted earnings per share since their effect would be anti-dilutive for that reporting period.

NOTE 2 - NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Loss Per Share

Stock Based Compensation

The Company adopted SFAS No. 123 (Revised 2004), “Share Based Payment” (“SFAS No. 123R”), under the modified-prospective transition method on January 1, 2006. SFAS No. 123R requires companies to measure and recognize the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. Share-based compensation recognized under the modified-prospective transition method of SFAS No. 123R includes share-based compensation based on the grant-date fair value determined in accordance with the original provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all share-based payments granted prior to and not yet vested as of January 1, 2006 and share-based compensation based on the grant-date fair value determined in accordance with SFAS No. 123R for all share-based payments granted after January 1, 2006. For non-employee stock based compensation, the Company recognizes an expense in accordance with SFAS No. 123 and values the equity securities based on the fair value of the security on the date of grant. For stock-based awards the value is based on the market value of the stock on the date of grant or the value of services, whichever is more readily available. Stock option awards are valued using the Black-Scholes option-pricing model.

NOTE 3 - INTANGIBLE

In January 2005, the Company entered into an asset purchase agreement with Unionway Int’l, LLC whereby the Company purchased certain assets of Unionway Int’l, LLC that principally included the software application Cyber-Defender™ and associated rights for $200,000 through the issuance of a note payable. The software technology purchased from Unionway Int’l, LLC is the core of the Company’s existing product. The asset is being amortized over the expected life of three years on a straight line basis. The amortization for the nine months ended September 30, 2008 and 2007 is $0 and $50,000, respectively and the accumulated amortization is $200,000 as of September 30, 2008 and December 31, 2007.

NOTE 4 - STOCKHOLDERS’ EQUITY

Common Stock

On October 18, 2007, the Company began an offering of units. Each unit consisted of 25,000 shares of common stock and a warrant to purchase 18,750 shares of common stock at an exercise price of $1.25 per share. The warrants have a term of five years. Pursuant to the warrant agreements, from and after the warrant issue date, in the event the Company sells Common Stock for less than the then exercise price or issues securities convertible into or exercisable for common stock at a conversion price or exercise price less than the then exercise price (a “Dilutive Issuance”), then the exercise price shall be multiplied by a fraction, the numerator of which is the number of shares of common stock sold and issued at the closing of such Dilutive Issuance plus the number of shares which the aggregate offering price of the total number of shares of common stock sold and issued at the closing of such Dilutive Issuance would purchase at the then exercise price, and the denominator of which is the number of shares of common stock issued and outstanding on the date of such Dilutive Issuance plus the number of additional shares of common stock sold and issued at the closing of such Dilutive Issuance. As of September 30, 2008, the exercise price per share of the warrants has not been reduced as a result of any Dilutive Issuance. The purchase price was $25,000 per unit. During the fourth quarter of 2007, the Company issued 654,500 shares and raised $654,500 through this offering. The 490,875 warrants issued in connection with the units were valued at $436,248 using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 142%. Issuance costs consisted of a 7% cash fee and additional warrants at $1.00 per share to purchase 7% of the number of shares of common stock sold in the offering with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 142%.

NOTE 4 - STOCKHOLDERS’ EQUITY (Continued)

During February and March, 2008, the Company issued 175,000 shares and raised $175,000 through this offering. The 131,250 warrants issued in connection with the units were valued at $118,058 using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 146-148%. Issuance costs consisted of a 7% cash fee and additional warrants at $1.00 per share to purchase 7% of the number of shares of common stock sold in the offering with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 146%. In May 2008 the Company updated the agreement with the placement agent to increase both the cash and warrant placement fees from 7% to 9% as well as to provide to the placement agent a 2.5% cash expense allowance. During June, 2008, the Company issued 400,000 shares and raised $354,000, net of placement fees, through this offering. The 300,000 warrants issued in connection with the units were valued at $271,438 using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 3.88%, a dividend yield of 0% and volatility of 111%. Issuance costs consisted of a 9% cash fee, 2.5% expense allowance and additional warrants at $1.00 per share to purchase 9% of the number of shares of common stock sold in the offering with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 146%. During July and August, 2008, the Company issued 580,500 shares and raised $513,743, net of placement fees, through this offering. The 435,375 warrants issued in connection with the units were valued at $468,931 using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 3.88%, a dividend yield of 0% and volatility of 110-116%. Issuance costs consisted of a 9% cash fee, 2.5% expense allowance and additional warrants at $1.00 per share to purchase 9% of the number of shares of common stock sold in the offering, valued at $44,811 with the following assumptions: term of 5 years, a risk-free interest rate of 3.88%, a dividend yield of 0% and volatility of 110-116%. Issuance costs of $9,065 and $45,815 were recorded in accrued expenses on the accompanying balance sheet as of September 30, 2008 and December 31, 2007, respectively.

On February 12, 2008, the Company entered into a consulting agreement with New Castle Consulting. Pursuant to this agreement, New Castle will provide investor relations services to the Company for a period of 6 months in exchange for an immediate payment of $4,500, a monthly fee of $4,500 the payment of which began in March 2008, the issuance of 100,000 shares of restricted common stock valued at $100,000 and an indemnity. As the shares were unforfeitable upon issuance and there was no guarantee of future benefit to be provided, the value of the shares was expensed upon issuance to selling, general and administrative expense in the quarter ended March 31, 2008.

On February 14, 2008, the Company entered into a consulting agreement with Kulman IR. Pursuant to this agreement, Kulman will provide investor relations services to us for a period of 12 months in exchange for a monthly fee of $3,500, the issuance of 100,000 shares of restricted common stock valued at $100,000, the payment of pre-approved expenses incurred by Kulman in discharging its obligations under the agreement and cross-indemnities. In regards to the stock that was issued, 50,000 shares vested immediately, 25,000 shares vested on August 7, 2008 and the remaining 25,000 shares were to vest on October 7, 2008. During August 2008, the Company terminated the agreement and cancelled the 25,000 unvested shares. As there was no guarantee of future benefit to be provided, the value of the vested shares was expensed upon issuance to selling, general and administrative expense in the quarter ended March 31, 2008.

On July 15, 2008, the Company entered into a consulting agreement with Frontier Capital Partners L.L.C. (“Frontier”) pursuant to which Frontier agreed to provide investor relations and other business advisory services. The agreement term was 3 months, but the agreement could be terminated by either party upon 5 days written notice. The agreement also includes provisions allowing immediate termination in the event of dissolution, bankruptcy or insolvency and for cause. The Company has agreed to issue to Frontier 125,000 shares of its restricted common stock as compensation for these services. 75,000 of these shares, valued at $81,000, were issued immediately (upon execution of the agreement) and are deemed to be a non-refundable retainer. The remaining 50,000 shares, valued at $63,000, were issued 46 days after execution of the agreement. As the shares were unforfeitable upon issuance and there was no guarantee of future benefit to be provided, the value of the shares was expensed upon issuance to selling, general and administrative expense in the quarter ended September 30, 2008.

On August 14, 2008, a holder of warrants to purchase 98,121 shares of common stock of the Company at a price of $1.01 per share exercised the warrants under Section 3(c) of the warrant document which allows for cashless exercise of the warrants. As a result, the Company issued 37,985 shares of its common stock.

See Note 5 for additional shares issued during the nine months ended September 30, 2008 related to the convertible notes payable.

NOTE 4 - STOCKHOLDERS’ EQUITY (Continued)

Stock options

In January 2005, the Company adopted the CyberDefender Corporation 2005 Stock Option Plan (sometimes called the CyberDefender Corporation 2005 Equity Incentive Plan and referred to herein as the “2005 Plan”), which consists of equity programs that provide for the granting of Incentive Stock Options or Nonstatutory Stock Options, the issuance of stock appreciation rights, stock purchase rights and awards of stock. Under the terms of the 2005 Plan, the exercise price of options granted may be equal to, greater than or less than the fair market value on the date of grant, the options have a maximum term of ten years and generally vest over a period of service or attainment of specified performance objectives. The maximum aggregate amount of options that may be granted from the 2005 Plan is 931,734 shares.

On October 30, 2006, the Company adopted the Amended and Restated 2006 Equity Incentive Plan (“2006 Plan”) that provides for the granting of Incentive Stock Options or Nonstatutory Stock Options, the issuance of stock appreciation rights, stock purchase rights and awards of stock. Under the terms of the 2006 Plan, the exercise price of options granted may be equal to, greater than or less than the fair market value on the date of grant, the options have a maximum term of ten years and generally vest over a period of service or attainment of specified performance objectives. The maximum aggregate amount of stock based awards that may be granted from the 2006 Plan is 1,375,000 shares.

On March 31, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial Officer, an option to purchase 20,000 shares of common stock under the 2006 Plan, at a price of $1.00 per share with an estimated fair value of $17,344 using the Black-Scholes option pricing model with the following assumptions: expected term of 5.1 years, a risk-free interest rate of 4.62%, a dividend yield of 0%, volatility of 128% and a forfeiture rate of 4%.

On April 16, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial Officer, an option to purchase 20,000 shares of common stock under the 2006 Plan, at a price of $1.00 per share with an estimated fair value of $17,269 using the Black-Scholes option pricing model with the following assumptions: expected term of 5.1 years, a risk-free interest rate of 2.84%, a dividend yield of 0%, volatility of 169% and a forfeiture rate of 4%.

On April 16, 2008, the Company granted to Steve Asetre, a consultant, an option to purchase 15,700 shares of common stock under the 2006 Plan, at a price of $1.25 per share with an estimated fair value of $9,115 using the Black-Scholes option pricing model with the following assumptions: expected term of 2.50 years, a risk-free interest rate of 2.09%, a dividend yield of 0%, volatility of 118% and a forfeiture rate of 0%.

On April 16, 2008, the Company granted to Tawab Rahmani, a consultant, an option to purchase 75,000 shares of common stock under the 2006 Plan, at a price of $1.00 per share with an estimated fair value of $46,380 using the Black-Scholes option pricing model with the following assumptions: expected term of 2.50 years, a risk-free interest rate of 2.09%, a dividend yield of 0%, volatility of 118% and a forfeiture rate of 0%.

On April 16, 2008, the Company granted to Sean Whiteley, a consultant, an option to purchase 40,000 shares of common stock under the 2006 Plan, at a price of $1.00 per share with an estimated fair value of $27,131 using the Black-Scholes option pricing model with the following assumptions: expected term of 3.25 years, a risk-free interest rate of 2.28%, a dividend yield of 0%, volatility of 118% and a forfeiture rate of 0%.

In June 2008, the Company granted to employees, options to purchase 160,000 shares of common stock under the 2006 Plan, at prices ranging from $1.01 to $1.10 per share with an estimated fair value of $131,891 using the Black-Scholes option pricing model with the following assumptions: expected term of 6.1 years, a risk-free interest rate of 3.54% to 3.84%, a dividend yield of 0%, volatility of 166-167% and forfeiture rates of 4% to 20%.

On August 6, 2008, the Company granted to Michael Barrett, the Company’s Chief Financial Officer, an option to purchase 10,000 shares of common stock under the 2006 Plan, at a price of $1.30 per share with an estimated fair value of $12,094 using the Black-Scholes option pricing model with the following assumptions: expected term of 5.1 years, a risk-free interest rate of 3.24%, a dividend yield of 0%, volatility of 158% and a forfeiture rate of 4%.

NOTE 4 - STOCKHOLDERS’ EQUITY (Continued)

In August and September 2008, the Company granted to employees, options to purchase 75,000 shares of common stock under the 2006 Plan, at prices ranging from $1.07 to $1.44 per share with an estimated fair value of $89,826 using the Black-Scholes option pricing model with the following assumptions: expected terms of 5-6 years, a risk-free interest rate of 2.88% to 3.23%, a dividend yield of 0%, volatility of 157-161% and forfeiture rates of 20%.

A summary of stock option activity for the 2005 Plan and 2006 Plan is as follows:

	Nine Months ended
	September 30, 2008					September 30, 2007
	Number of Options			Weighted Average Exercise Price		Number of Options			Weighted Average Exercise Price

Outstanding, beginning of period		1,316,384		$	0.75		1,441,613		$	0.74

Granted		415,700		$	1.10		300,500		$	1.00

Exercised		—			—		—			—

Cancelled		(323,667	)	$	1.05		(395,729	)	$	1.00

Outstanding, end of period		1,408,417		$	0.78		1,346,384		$	0.74

Exercisable, end of period		1,067,557		$	0.68		689,129		$	0.68

The weighted-average grant date fair value of options granted during the nine months ended September 30, 2008 and 2007 was $0.93 and $0.89 per option, respectively.

As of September 30, 2008 and 2007, 340,860 and 657,255 of the options granted are not vested with an estimated remaining value of $245,167 and $551,600, respectively. At September 30, 2008, 1,067,557 of these options were exercisable with a weighted average remaining contractual term of 7.32 years. The weighted average remaining contractual life of all options outstanding at September 30, 2008 is 7.72 years.

The Company recorded compensation expense associated with the issuance and vesting of stock options of $177,747 and $332,694 for the nine months ended September 30, 2008 and 2007, respectively.

There were no stock options exercised during the nine months ended September 30, 2008 and 2007.

NOTE 5 - CONVERTIBLE NOTES PAYABLE

On September 12, 2006, the Company entered into a Securities Purchase Agreement with 13 accredited investors pursuant to which it sold 10% secured convertible debentures (the “Debentures”) in the aggregate principal amount of $3,243,378 and common stock purchase warrants to purchase an aggregate of 3,243,378 shares of the Company’s common stock at $1.00 per share (the “Base Conversion Price”) that also included a registration rights agreement. The debenture holders have the right to convert the Debentures into 3,243,378 shares of common stock. The Debentures mature on September 12, 2009 and bear interest at the rate of 10% per year, payable quarterly. If, during the time that the Debentures are outstanding, the Company sells or grants any option to purchase (other than options issued pursuant to a plan approved by our board of directors), or sells or grants any right to reprice its securities, or otherwise disposes of or issues any common stock or common stock equivalents entitling any person to acquire shares of the Company’s common stock at a price per share that is lower than the conversion price of the debentures or that is higher than the Base Conversion Price but lower than the daily volume weighted average price of the common stock, then the conversion price of the Debentures will be reduced. As of September 30, 2008, the conversion price of the Debentures has not been reduced.

Under the terms of the agreement, the Company is obligated to register for resale at least 130% of the shares of its common stock issuable upon the conversion of the Debentures and the exercise of the common stock purchase warrants. However, the agreement also prohibits the Company from registering shares of common stock on a registration statement that total more than one-half of the issued and outstanding shares of common stock, reduced by 10,000 shares.

If a registration statement was not filed within 30 days of the sale of the Debentures, or was not effective 120 days from the date of the sale of the Debentures, which was January 10, 2007, or if the Company did not respond to an SEC request for information during the registration period within 10 days of notice, the Company was required to pay to each holder of its Debentures an amount in cash, as partial liquidated damages and not as a penalty, equal to 1.5% of the aggregate subscription amount paid by each holder. The Company, (1) will not be liable for liquidated damages with respect to any warrants or warrant shares, (2) in no event will the Company be liable for liquidated damages in excess of 1.5% of the aggregate subscription amount of the holders in any 30-day period, and (3) the maximum aggregate liquidated damages payable to a holder is eighteen percent (18%) of the aggregate subscription amount paid by such holder up to a maximum aggregate liquidated damages of 18% of the total amount of the secured convertible debentures, or $583,808. If the Company fails to pay any partial liquidated damages in full within seven days after the date payable, the Company will pay interest at a rate of 18% per annum to the holder, accruing daily from the date such partial liquidated damages are due until such amounts, plus all such interest, are paid in full. The partial liquidated damages apply on a daily pro-rata basis for any portion of a month.

Pursuant to Amendments No. 1 and No. 2 to the Registration Rights Agreement, the holders of the Company’s Debentures agreed to extend the filing date of the registration statement to November 3, 2006, and agreed to waive their rights to enforce the liquidated damages clause for the initial filing of the registration statement. The Company did not meet the 10 day response period for responding to an SEC request for additional information nor did the Company meet the target registration statement effectiveness date of January 10, 2007. The holders did not agree to waive the liquidated damages that accrued due to the Company’s failure to meet the 10 day period for responding to an SEC request for additional information nor have the holders agreed to waive the liquidated damages that accrued due to the Company’s failure to have the registration statement declared effective by January 10, 2007.

In accordance with FASB Staff Position Emerging Issues Task Force (“FSP EITF”) 00-19-02, “Accounting for Registration Payment Arrangements,” the Company believed, at the time the Debentures were issued, that it was probable that it would be in violation of certain filing provisions within the Registration Rights Agreement and recorded $111,897 as a discount to the 10% secured convertible debentures. At December 31, 2006, the Company estimated its liquidated damages to be $225,415 and therefore recorded an additional expense of $113,518 in loss on registration rights agreement in the statement of operations. On March 23, 2007 the Company entered into a Consent and Waiver agreement as more fully described below that determined the actual liquidated damages to be $169,917 calculated through March 23, 2007 and covering the period through April 30, 2007, resulting in a $55,498 decrease to the liability.

NOTE 5 - CONVERTIBLE NOTES PAYABLE (Continued)

The Company was also required to make an interest payment to the Debenture holders on April 1, 2007. The Consent and Waiver allowed the Company to make the April 1 interest payment and pay the liquidated damages in one of two ways to be chosen by each holder. For payment of the Debenture holder’s pro rata portion of the April 1 interest payment, the Debenture holder could choose to increase the principal amount of his Debenture by his pro-rata share of the accrued interest amount or accept shares of the Company’s common stock valued at $0.85 per share for this purpose. For payment of the Debenture holders pro rata portion of the liquidated damages, each Debenture holder has the same choice, that is, either to increase his Debenture by the pro rata liquidated damages amount or accept shares of the Company’s common stock valued at $0.85 per share for this purpose. If all the Debenture holders were to choose to accept shares of the Company’s common stock in payment of the April 1 interest payment and the liquidated damages, the Company could be required to issue up to a total of 566,336 shares of the Company’s common stock. The Consent and Waiver allowed the Company to issue these shares without triggering the anti-dilution rights included in the original offering documents. The Company issued 180,187 shares in November and December 2007 as partial payment for these liquidated damages valued at $153,167. At December 31, 2007, $16,750 of these damages remained in accrued expenses - registration rights agreement. The Company issued 15,407 shares in January and February 2008 as partial payment for these liquidated damages valued at $13,097. At September 30, 2008, $3,653 of these damages remained in accrued expenses - registration rights agreement. The Company issued 190,090 shares in November and December 2007 as partial payment for the April 1 interest payment of $161,580. At December 31, 2007, $17,179 remained in accrued interest. The Company issued 15,669 shares in January and February 2008 as partial payment for the April 1 interest payments of $13,319.

The Consent and Waiver allowed the Company to issue to Oceana Partners, LLC, without triggering the anti-dilution rights, 50,000 shares of common stock in consideration for research coverage for a 12-month period.

The Company did not meet the April 30, 2007 date for its registration statement to be declared effective by the SEC. The registration statement became effective on July 19, 2007. As a result, the Company incurred additional liquidated damages for the period May 1 through July 19, 2007 of $132,726. On September 21, 2007 the Company received from the holders of the Debentures a second Consent and Waiver. The holders of the Debentures agreed to accept shares of the Company’s common stock at $0.85 per share instead of cash as payment for the interest due on July 1, 2007 and October 1, 2007 and for damages incurred under the Registration Rights Agreement. The Company issued 135,063 shares in February 2008 as partial payment for these liquidated damages valued at $106,518. At September 30, 2008, $26,208 of these damages remained in accrued expenses - registration rights agreement. The Company issued 94,952 shares in February 2008 as partial payment for the July 1 and October 1, 2007 interest payments of $110,147.

The Company did not meet the August 18, 2007 date to file a second registration statement. As a result, the Company incurred additional liquidated damages for the period August 18 through December 19, 2007 of $194,603. The Company received from the holders of the Debentures a third Consent and Waiver, dated February 13, 2008 and amended on August 19, 2008. The third Consent and Waiver waived the requirement included in the Debentures and the Registration Rights Agreement that the Company file a second registration statement, waived the liquidated damages that accrued from and after December 19, 2007 and waived the payment of any interest that would have accrued on the liquidated damages. The holders of the Debentures agreed to accept either additional debentures or shares of the Company’s common stock at $0.85 per share instead of cash as payment for the interest due on January 1, 2008 and as payment of the liquidated damages accrued prior to December 19, 2007 under the Registration Rights Agreement. In September 2008 the Company issued $64,422 in additional debentures, with a term of 18 months and which are convertible at $0.85 per share, which included $4,422 of interest. At September 30, 2008, $128,603 remained in accrued expenses - registration rights agreement.

According to the terms of the Debentures, the Company is to make interest payments quarterly on January 1, April 1, July 1 and October 1 until September 2009, when the principal amount and all accrued but unpaid interest will be due. To date, holders of the Debentures have agreed to accept the Company’s securities as payment of the interest obligation, in lieu of cash. The Company failed to make the interest payments that were due on April 1, and July 1, 2008, totaling $139,169. On September 22, 2008 the Company received from the holders of the Debentures a fourth Consent and Waiver of defaults of the Debentures. The holders of the Debentures agreed to accept either additional debentures or shares of the Company’s common stock at $0.85 per share instead of cash as payment for the interest due on April 1, July 1, and October 1, 2008, totaling $205,207. In September 2008 the Company issued $26,868 in additional debentures, with a term of 18 months and which are convertible at $0.85 per share, which included $1,868 of penalty interest.

NOTE 5 - CONVERTIBLE NOTES PAYABLE (Continued)

The holders of certain shares and warrants for the purchase of common stock issued in conjunction with the sale of the Company’s previously issued Secured Convertible Promissory Notes from November 2005 through March 2006, which were converted on September 12, 2006, also have certain registration rights. These holders agreed to defer their rights to require registration of their securities on the registration statement the Company filed; however, they have maintained the rights to piggyback on future registration statements filed by the Company.

The Company has accounted for the Debentures according to Statement of Financial Accounting Standards (“SFAS”) No. 133 “Accounting for Derivative Instruments and Hedging Activities,” EITF 00-19 “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock,” FSP EITF 00-19-2, EITF 98-5 “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios” and EITF 00-27 “Application of Issue No. 98-5 to Certain Convertible Instruments.” The Company has accounted for the registration rights arrangement under the guidance of FSP EITF 00-19-2 and the warrants as permanent equity under the guidance of SFAS No. 133 and EITF 00-19. The value of the Debentures was allocated between the Debentures, the registration rights arrangement and the warrants, including the beneficial conversion feature, which amounted to $63,689, $111,897 and $3,067,792, respectively. The discount of $3,179,689 related to the registration rights arrangement and the warrants, including the beneficial conversion feature, is being amortized over the term of the Debentures. The Company amortized $758,938 and $793,470 to interest expense for the nine months ended September 30, 2008 and 2007. The remaining unamortized warrant and beneficial conversion feature value is recorded as a discount on the Debentures on the accompanying balance sheet.

In addition, as part of the transaction, the Company paid $217,000, issued 1,000,515 shares of common stock in November 2006 valued at $1,000,515 and issued 217,000 unit purchase options with each unit consisting of 1 share of common stock and a warrant to purchase 1 share of common stock for $1.00 per share in November 2006. The unit purchase options were valued at $374,531 using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.62%, a dividend yield of 0%, and volatility of 128%. These costs, totaling $1,592,046, are being amortized over the term of the Debentures. The Company recorded amortization of $379,411 and $398,012 to interest expense during the nine months ended September 30, 2008 and 2007 related to the Debentures. The unamortized amount is recorded as part of the deferred financing costs in the accompanying balance sheets.

In November and December 2007, certain holders of the 10% Secured Convertible Debentures converted $460,000 of notes and $48,406 of accrued interest into 508,406 shares of common stock at $1.00 per share. The unamortized discount of $253,481 on the converted notes was recorded as interest expense at the time of the conversion.

In August 2008, certain holders of the 10% Secured Convertible Debentures converted $300,000 of notes and $15,468 of accrued interest, accrued liquidated damages and penalty interest into 315,468 shares of common stock at $1.00 per share and 86,601 warrants to purchase shares of the Company’s common stock at $1.25 per share. The unamortized discount of $103,310 on the converted notes was recorded as interest expense at the time of the conversion.

Convertible notes payable consist of the following:

	September 30, 2008			December 31, 2007
10% debentures outstanding	$	2,574,668		$	2,783,378
Unamortized discount on debentures		(789,405	)		(1,548,343	)
Convertible notes payable, net	$	1,785,263		$	1,235,035

7.41% Senior Secured Original Issue Discount Notes

NOTE 6 - NOTES PAYABLE

In April and May 2007, the Company sold $405,000 in face amount of its 7.41% Senior Secured Original Issue Discount Notes (“7.41% Notes”) and warrants to purchase 187,500 shares of the Company’s common stock for a purchase price of $375,000. The 7.41% Notes are due one year from issuance with interest at 7.41% payable at maturity. One warrant to purchase 5 shares of the Company’s common stock was issued for every $10 of purchase price paid. The warrants may be exercised at a price of $1.20 per share for a period of 5 years beginning nine months after issuance of the warrant. Pursuant to the warrant agreements, if the Company issues common stock or common stock equivalents at a price lower than the warrant exercise price (the “Base Share Price”), then the warrant exercise price will be reduced to equal the Base Share Price and the number of warrant shares issuable will be increased so that the aggregate exercise price, after taking into account the decrease, will be equal to the aggregate exercise price prior to the adjustment. As of September 30, 2008, the exercise price per share of the warrants has not been reduced as a result of the issuance of any of the Company’s common stock or common stock equivalents. The Company has accounted for the debentures according to SFAS 133, EITF 00-19, EITF 98-5 and EITF 00-27. The Company has accounted for the warrants as permanent equity under the guidance of SFAS 133 and EITF 00-19. The value of the 7.41% Notes was allocated between the original issue discount (“OID”), the warrants and the debentures which amounted to $30,000, $112,229 and $262,771, respectively. The discount related to the OID and warrants of $142,229 will be amortized over the one year term of the 7.41% Notes. The warrants issued in connection with the 7.41% Notes were valued using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.69%, a dividend yield of 0% and volatility of 124%.

In August 2007, the Company sold $297,000 in face amount of the 7.41% Notes and warrants to purchase 137,500 shares of the Company’s common stock for a purchase price of $275,000. The value of the 7.41% Notes was allocated between the OID, the warrants and the debentures which amounted to $22,000, $86,020 and $188,980, respectively. The discount related to the OID and the warrants of $108,020 will be amortized over the term of the 7.41% Notes. The warrants issued in connection with the 7.41% Notes were valued using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.60%, a dividend yield of 0% and volatility of 134%.

In October 2007, the Company sold $162,000 in face amount of the 7.41% Notes and warrants to purchase 75,000 shares of the Company’s common stock for a purchase price of $150,000. The value of the 7.41% Notes was allocated between the OID, the warrants and the debentures which amounted to $12,000, $44,103 and $105,897, respectively. The discount related to the OID and the warrants of $56,103 will be amortized over the term of the 7.41% Notes. The warrants issued in connection with the 7.41% Notes were valued using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.50%, a dividend yield of 0% and volatility of 116%.

The Company recorded $158,702 and $77,701 of interest expense related to the amortization of the discount related to 7.41% Notes and warrants for the nine months ended September 30, 2008 and 2007, respectively.

As part of the Consent and Waiver, as described above in Note 5, the holders of the Debentures agreed to allow the Company to sell the $864,000 face amount of 7.41% Notes in exchange for warrants to purchase 150,000 shares of the Company’s common stock at an exercise price of $1.00 per share. The warrants were valued at $128,038 using the Black-Scholes option pricing model with the following assumption: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 124%. These costs were recorded as deferred financing costs and will be amortized over the term of the 7.41% Notes. As part of the issuance of the 7.41% Notes certain officers of the Company transferred to Oceana Partners and Carlin Capital 400,000 shares of common stock valued at $1.00 per share. The value of $400,000 was recorded as deferred financing cost and will be amortized over the term of the 7.41% Notes. The transfer of shares from the officers was recorded in additional paid-in capital.

NOTE 6 - NOTES PAYABLE (Continued)

The Company recorded amortization of deferred financing costs of $154,011 and $245,963 to financing expense related to the 7.41% Notes during the nine months ended September 30, 2008 and 2007, respectively.

Pursuant to the Registration Rights Agreement the Company signed in connection with the offering of the 7.41% Notes, the Company was required to register 125% of the number of shares underlying the related Warrants. The Company was required to file a registration statement for this purpose within 180 days following the date that the units were sold, and the Company would be in default of the Registration Rights Agreement if it failed to file the registration statement within 30 days following the expiration of the 180 day period. As of September 30, 2008, the Company was in default of the Registration Rights Agreement as to holders of $405,000 in principal amount of the 7.41% Notes. Subsequent to September 30, 2008, the Company has obtained a Consent and Waiver from the holders of the 7.41% Notes in relation to the liquidated damages under the Registration Rights Agreement and accordingly has recorded $19,143 and $16,821 in accrued expenses - registration rights agreement as of September 30, 2008 and December 31, 2007, respectively. Pursuant to the Consent and Waiver the Company will issue its securities to pay the liquidated damages.

On June 23, 2008, certain holders of the 7.41% Notes converted their notes in the face amount of $216,000 plus accrued interest of $19,101 into 235,101 shares of the Company’s common stock and warrants to purchase 176,327 shares of the Company’s common stock at an exercise price of $1.25 per share. The conversion ratio was determined in accordance with a most favored nation provision included in the securities purchase agreement which permitted the noteholders to convert their 7.41% Notes at a price per share identical to the price per share at which the units described in Note 4 above were offered.

On August 6, 2008, certain holders of the 7.41% Notes converted their notes in the face amount of $459,000 plus accrued interest of $31,032 and penalties of $19,616 into 509,648 shares of the Company’s common stock and warrants to purchase 382,230 shares of the Company’s common stock at an exercise price of $1.25 per share. The conversion ratio was determined in accordance with a most favored nation provision included in the securities purchase agreement which permitted the noteholders to convert their 7.41% Notes at a price per share identical to the price per share at which the units described in Note 4 above were offered.

During the nine months ended September 30, 2008, the Company repaid 7.41% Notes in the face amount of $189,000 and accrued interest on those notes of $17,196. At September 30, 2008 all of the 7.41% Notes were converted or paid in full.

7.41% Notes payable consist of the following:

		September 30, 2008		December 31, 2007
7.41% notes outstanding	$	-	$	864,000
Unamortized discount on notes		-		(158,702	)
7.41% notes payable, net	$	-	$	705,298

Note Payable to Shareholder

In March 2008, Gary Guseinov pledged 750,000 shares of his common stock in CyberDefender Corporation to Michael and Casey DeBaecke in exchange for a loan of $160,000 made to the Company. The pledge is non-recourse to Mr. Guseinov in the event the collateral is foreclosed upon due to the Company’s failure to pay the loan. So long as there is no event of default in connection with the loan, Mr. Guseinov may continue to vote the shares at any annual or special meeting of the shareholders. The loan is due to be repaid on the earlier of two months from signing of the loan document or two days following the Company’s receipt of over $500,000 in new equity capital following the date of the promissory note evidencing the loan. Additionally, the Company issued warrants to purchase 40,000 shares of the Company’s stock. The warrants may be exercised at a price of $1.25 per share for a period of 5 years. The discount related to the warrants of $36,092 will be amortized over the term of the note. The warrants issued in connection with the note were valued using the Black-Scholes option pricing model with the following assumptions: term of 5 years, a risk-free interest rate of 4.52%, a dividend yield of 0% and volatility of 148%. The Company recorded amortization of $36,092 to interest expense during the nine months ended September 30, 2008. The loan plus accrued interest was paid in full on July 30, 2008.

CYBERDEFENDER CORPORATION

NOTES TO CONDENSED FINANCIAL STATEMENTS

(UNAUDITED)

NOTE 7 - COMMITMENTS AND CONTINGENCIES

Litigation

On September 18, 2007, a former employee of the Company alleged that the Company owed him approximately $50,000 in additional pay and demanded payment. The Company settled the lawsuit on June 3, 2008 and is in compliance with the payment terms as of September 30, 2008. The remaining amount is recorded in accrued expenses on the accompanying balance sheet at September 30, 2008.

Guarantees and Indemnities

During the normal course of business, the Company has made certain indemnities and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include certain agreements with the Company’s officers, under which the Company may be required to indemnify such person for liabilities arising out of their employment relationship. The duration of these indemnities and guarantees varies and, in certain cases, is indefinite. The majority of these indemnities and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make. The Company hedges some of the risk associated with these potential obligations by carrying general liability insurance. Historically, the Company has not been obligated to make significant payments for these obligations and no liabilities have been recorded for these indemnities and guarantees in the accompanying statement of financial position.

On October 30, 2006, the Company entered into Indemnification Agreements with Mr. Guseinov, Mr. Ivankovich, the former Chief Financial Officer, Mr. Liu and Mr. Barash, on November 6, 2007 the Company entered into an Indemnification Agreement with Mr. John LaValle, a former director, and on February 1, 2008 the Company entered into an Indemnification Agreement with Mr. Michael Barrett, all of whom are sometimes collectively referred to in this discussion as the “indemnified parties” or individually referred to as an “indemnified party.” The agreements require the Company to provide indemnification for the indemnified parties for expenses (including attorneys’ fees, expert fees, other professional fees and court costs, and fees and expenses incurred in connection with any appeals), judgments (including punitive and exemplary damages), penalties, fines and amounts paid in settlement (if such settlement is approved in advance by the Company, which approval shall not be unreasonably withheld) actually and reasonably incurred by the indemnified parties in connection with any threatened, pending or completed action or proceeding (including actions brought on the Company’s behalf, such as shareholder derivative actions), whether civil, criminal, administrative or investigative, to which he is or was a party, a witness or other participant (or is threatened to be made a party, a witness or other participant) by reason of the fact that he is or was a director, officer, employee or agent of the Company or any of its subsidiaries. The indemnification covers any action or inaction on the part of the indemnified party while he was an officer or director or by reason of the fact that he is or was serving at the Company’s request as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise. In the event of any change, after the date of the Indemnification Agreements, in any applicable law, statute or rule which expands the right of a California corporation to indemnify a member of its board of directors or an officer, such changes shall be within the purview of the indemnified parties’ rights and the Company’s obligations under the Indemnification Agreements.

The Indemnification Agreements are effective as of the date they were signed and may apply to acts or omissions of the indemnified parties which occurred prior to such date if the indemnified party was an officer, director, employee or other agent of the Company, or was serving at our request as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, at the time such act or omission occurred. All obligations under the Indemnification Agreements will continue as long as an indemnified party is subject to any actual or possible matter which is the subject of the Indemnification Agreement, notwithstanding an indemnified party’s termination of service as an officer or director.