UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

Commission File Number: 000-30700

Crown Media Holdings, Inc.

(Exact Name of Registrant as Specified in Its Charter)

12700 Ventura Boulevard,

Suite 200

Studio City, California  91604

(Address of Principal Executive Offices and Zip Code)

(818) 755-2400

(Registrant’s Telephone Number, Including Area Code)

(Former Name, Former Address, and Former Fiscal Year,

if Changed Since Last Report.)

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 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  ý     No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes  ý     No o

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

As of November 2, 2005, the number of shares of Class A Common Stock, $.01 par value outstanding was 74,054,524, and the number of shares of Class B Common Stock, $.01 par value, outstanding was 30,670,422.

TABLE OF CONTENTS

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In this Form 10-Q the terms “Crown Media Holdings” or the “Company,” refer to Crown Media Holdings, Inc.  and, unless the context requires otherwise, subsidiaries of Crown Media Holdings that operate or have operated our businesses, Crown Media United States, LLC (“Crown Media United States”), Crown Media Distribution, LLC (“Crown Media Distribution”), and, until completion of the sale of our international business in April 2005, Crown Media International, LLC (“Crown Media International”) and Crown Entertainment Limited (“Crown Entertainment”). The term “common stock” refers to our Class A common stock and Class B common stock, unless the context requires otherwise.

The names Hallmark, Hallmark Entertainment and other product or service names are trademarks or registered trademarks of their owners.

PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements (Unaudited)

CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value and number of shares)

See accompanying notes to unaudited condensed consolidated financial statements.

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See accompanying notes to unaudited condensed consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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CROWN MEDIA HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months Ended September 30, 2004 and 2005

1. Business and Organization

Organization

Crown Media Holdings, Inc. (“Crown Media Holdings,” “Crown Media” or the “Company”), through its subsidiaries, owns and operates pay television channels (collectively the “Hallmark Channel” or the “channel”) dedicated to high quality, entertainment programming for adults and families, in the United States and, prior to the sale of its international business, in various countries throughout the world. Domestically, the Hallmark Channel is operated and distributed by Crown Media United States, LLC (“Crown Media United States”). Significant investors in Crown Media Holdings include Hallmark Entertainment Investments Co. (“Hallmark Entertainment Investments”), a subsidiary of Hallmark Cards, Incorporated (“Hallmark Cards”), the National Interfaith Cable Coalition, Inc. (“NICC”), and, indirectly through their investments in Hallmark Entertainment Investments, Liberty Media Corporation (“Liberty Media”) and J.P. Morgan Partners (BHCA), L. P. (“J.P. Morgan”). The international operations of the Hallmark Channel were operated in the United Kingdom, by Crown Entertainment Limited (“Crown Entertainment”) and elsewhere by Crown Media International, LLC (“Crown Media International”). Crown Media International commenced its operations outside the United States in 1995.

Sale of the International Business

In April 2005, the Company completed the sale of  its international business to a group of investors comprised of Equity Partners, 3i and U.K. executive David Elstein (collectively, “Sparrowhawk,” the “buyer” or the “buyer of  international business”). The sale included the international versions of the Hallmark Channel distributed outside the United States, the international rights to over 580 titles in the Crown Media film library, and the Network Operations Center based in Denver, Colorado.  The Company received cash proceeds of $209.3 million, net of the prepayment described below, and recognized an accounting loss of $1.3 million from the sale. Approximately $4.7 million of transaction costs were incurred by the Company in connection with the sale.

In accordance with the conditions of the sale, the Company has accrued $24.6 million which represents the estimated present value of the cash that is expected to be paid to or on behalf of the buyer at various times through December 31, 2015.  Included in this amount is $16.7 million of estimated payments, which was determined using the contractual payments due on certain lease arrangements that were assumed by the buyer. Payments to the buyer are due at or about the same time the buyer is obligated to pay the lessor.  In addition, the Company agreed to pay the buyer approximately $3.2 million in cash, which was determined as the difference between $4.0 million and the estimated net realizable value of receivables of $0.8 million.  Also, the Company has estimated a liability of approximately $4.5 million to pay the estimated residual and participation costs that the buyer would otherwise be obligated to pay to third parties through April 2015.  The amount of this liability could fluctuate based upon the actual internal usage or sales of these films by the buyer. Any revisions to these estimated liabilities will be reflected as gain (loss) from the sale of discontinued operations in future periods.

The Company will continue to use the Network Operations Center sold to Sparrowhawk for the distribution of the domestic channel pursuant to a $25.3 million, seven year technical services agreement with the buyer. The Company made a prepayment under the technical services agreement to the buyer in the amount of $12.7 million upon closing of the sale transaction and the balance is payable monthly in equal installments through the expiration of the agreement. The unused portion of the prepayment is classified as Prepaid and Other Assets in the accompanying condensed consolidated balance sheet and will be amortized to operating expense over the life of the contract. A deferred credit of $7.6 million ($6.8 million as of September 30, 2005) was recorded to reflect the amount by which the $25.3 million contract exceeded the estimated fair value of the related services. The deferred credit will be amortized over the life of the contract, resulting in a reduction of operating expenses in future periods.

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Subsequent to the sale, the Company has no continuing economic involvement with the operations of the international business.

Strategic Alternatives for the Company

The Company announced on August 18, 2005, that its Board of Directors has authorized the Company to explore strategic alternatives for the Company, including a potential sale of the Company to a third party.  In support of this initiative, a Special Committee of independent directors of the Board of Directors is overseeing the process. There can be no assurance that the Company will enter into or consummate any transaction, or as to terms or timing thereof.

Liquidity

As of September 30, 2005, the Company had $9.4 million in cash and cash equivalents on hand and $40.0 million available under its bank credit facility. The $40.0 million of the availability under the bank credit facility is subject to the approval of Hallmark Cards prior to the Company being able to draw such funds. As of September 30, 2005, the Company had borrowed $180.0 million under its bank credit facility, which matures May 31, 2006.

The Company’s principal sources of funds are currently available cash on hand, cash generated by operations, amounts available for borrowing under its bank credit facility and potentially, tax sharing payments. As noted above, the Company’s ability to access the remaining $40.0 million under the bank credit facility is subject to Hallmark’s approval.  There can be no assurance that Hallmark Cards will approve such additional drawings and, if such drawings are not approved, the Company will need alternative sources of funding or will need to significantly curtail expenses. The Company expects that additional payments under the tax sharing agreement, if any, will be less in the future than they have been in the past assuming that the Company’s financial performance improves as indicated by internal projections. Furthermore, the tax sharing payments can be affected by Hallmark Cards’ tax position and its ability to utilize the Company’s tax losses.

The Company’s liquidity is also impacted by the results of its operations.   The ability of the existing sources of liquidity to be sufficient to fund the Company’s operations, depend upon the Company’s future operating results meeting expectations.  In particular, continued growth in subscriber revenue, advertising revenue, and library sales are required.  As a result, any decline in the popularity of the Hallmark Channel, any significant future modifications to the Company’s distribution agreements, an economic decline in the advertising market, an increase in program acquisition costs, an increase in competition or other adverse operating conditions would impact the Company’s liquidity and its ability to fund the current level of operations.  To the extent that the Company requires additional capital and additional drawings on the bank credit facility are either not available or insufficient, the Company would seek additional financing from the issuance of debt or equity securities or from strategic transactions which provide capital.

The Company expects to continue making investments in programming, marketing and distribution during the next twelve months ending September 30, 2006. However, the Company’s liquidity position has demanded that all areas of expenses, including programming, marketing and distribution be closely reviewed and monitored.  The Company reduced expenses in certain areas during the third quarter of 2005 and expects that similar expense reductions will occur in the fourth quarter of 2005. The Company’s principal uses of funds for the remainder of 2005 are expected to include the payment of operating expenses, licensing of programming, subscriber acquisition fees and interest under its bank credit facility.

The Company currently believes that cash on hand, cash generated by operations and the remaining availability under its bank credit facility (assuming that Hallmark Cards approves additional borrowings and assuming that the banks draw down on an irrevocable letter of credit provided by Hallmark Cards which supports the bank credit facility, or the banks extend such facility beyond May 31, 2006), which are currently its principal sources of funds, will be sufficient to fund the current level of operations and meet its liquidity needs through September 30, 2006.

The Company’s bank credit facility will expire on May 31, 2006.   If the Company is not able to arrange for the extension, refinancing or replacement of the bank credit facility prior to its maturity and the bank draws down on the irrevocable letter of credit, Hallmark Cards would acquire all obligations and the rights of the lending banks under the bank credit facility.  In that event, Hallmark Cards could demand payment of outstanding amounts at any time.

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However, Hallmark Cards has also confirmed to the Company that it will not request any reimbursement of amounts drawn on such letter of credit prior to October 31, 2006.  Hallmark Cards also confirmed that it and its wholly-owned subsidiaries will not request payment of the license fees and other amounts payable to affiliates of Hallmark Cards prior to October 31, 2006 (see note 9).

As consideration for extending the demand period for the possible reimbursement of amounts drawn on the letter of credit supporting the credit facility, the Company agreed to convert its license fees payable to Hallmark affiliates, which were approximately $133.0 million, to a promissory note bearing interest at LIBOR plus 3% per annum.  The term of the promissory note began on October 1, 2005 and is payable in full on October 31, 2006.

Due to the Company’s liquidity needs, the Company anticipates that prior to October 31, 2006, it will be necessary to either extend or refinance (i) the bank credit facility and (ii) the license fees ($133.0 million) and (iii) other amounts ($70.0 million) payable to affiliates of Hallmark Cards. In the alternative or as part of a combination of actions, the Company would consider various alternatives as indicated above, including refinancing the bank credit facility, raising additional capital through the issuance of equity or debt securities or entering into strategic alternatives.

Upon maturity of the credit facility on May 31, 2006, the lending group led by JP Morgan Chase has the right to elect to forego the receipt of cash to pay the principal amount of the credit facility in full, which is provided for under the terms of an irrevocable letter of credit provided by Hallmark Cards described in note 9, but instead can elect to initiate a process to foreclose on the Company’s assets. Such foreclosure proceedings could affect our ability to continue our operations. Prior to any such possible foreclosure proceedings, the Company would consider various alternatives as indicated above.  As a result, the outstanding borrowings under the credit facility of $180.0 million at September 30, 2005, have been classified as a current liability.

2. Summary of Significant Accounting Policies and Estimates

Interim Financial Statements

In the opinion of management, the accompanying condensed consolidated balance sheets and related interim consolidated statements of operations and comprehensive loss and cash flows, include all adjustments, consisting of normal recurring items necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America. Interim results are not necessarily indicative of results for a full year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes to those statements for the year ended December 31, 2004, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

Basis of Presentation

The condensed consolidated financial statements include the consolidated accounts of Crown Media Holdings, including those of its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

In February 2005, the Company signed a definitive agreement to complete the sale of its international business and, accordingly, classified the operating results of the international business as discontinued operations in the accompanying statements of operations for all periods presented. The Company’s discontinued operations consisted of the international channel operations and the international rights to the film library assets.

Use of Estimates

The Company’s condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). These accounting principles require the Company to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions made when accounting for items and matters such as customer retention patterns,

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allowance for bad debts, useful lives of assets, ultimate revenue used in the film asset amortization calculations, cash flow projections used in various asset valuations, income taxes, reserves and other provisions for contingencies are reasonable, based on information available at the time they are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the consolidated financial statements, as well as the reported amounts of revenue and expenses during the periods presented. Actual results could differ from these estimates.

Film Assets and Film Library Impairment

The Company amortizes its film assets using the individual-film-forecast-computation method over a maximum period of 9.25 years from the date of acquisition. The individual-film-forecast-computation method amortizes such assets in the same ratio that current period actual revenue bears to estimated ultimate future revenues.

On a quarterly basis, the Company assesses whether events or circumstances have changed indicating that the fair value of a film is lower than its unamortized cost or carrying value. If the carrying value of any individual film asset exceeds its fair value, the film asset is written-down to its estimated fair value. A discounted cash flow model, based on management’s anticipated ultimate future revenue of the film, is used to estimate the fair value of the individual films. The Company considers the following factors, among others, in estimating ultimate future revenue for each film:  (a) the operating environment expected for the next several years, (b) the size of the library as a whole, (c) historical license fee revenue per film, (d) each title’s age, quality, and marketability, (e) existing sales plans including the amount of product desired to be sold each year, (f) future performance estimates, (g) assumptions and estimates underlying past and future estimates, and (h) risk factors that could effect future operations of the Library.  In estimating a film’s fair value, the Company considers those cash outflows necessary to generate the film’s cash inflows such as exploitation, residual and participation costs and taxes.  The discount rate used in the Company’s discounted cash flow model is based upon management’s estimate of the rate a lender would require related to the risks and uncertainties surrounding the timing and probability of the cash flow estimates.

The Company reviews its estimates of ultimate future revenues and participation costs as of each reporting date to reflect currently available information. Estimated ultimate future revenues are based on the history of each film and similar films, sales and marketing plans, and other factors, all of which require significant judgment and estimation by management. Differences between amortization expense determined using the new estimates and any amounts previously expensed during that current fiscal year are charged or credited to the statement of operations in the period in which the estimates are revised.

For use of the film assets on the Hallmark Channel and the Hallmark Movie Channel, the Company estimates the fair value of the internal usage based upon the portion of the film’s ultimate revenues attributable to the term of the license window. The Company first calculates the amount of cost attributable to the internal use using the individual-film-forecast-computation method described above and then expenses such amounts ratably over the term of the license window.

In the third quarter of 2004, the Company bifurcated the carrying value of each film between its international and domestic licensing rights using the relative discounted cash flows for each film, internationally and domestically, assuming the continued operations of both the international and domestic channel. The estimated fair value of the domestic rights was based upon the discounted cash flows attributable to estimated future third party sales and internal use at September 30, 2004. A non-cash impairment charge was recorded in the third quarter 2004 for each film where the estimated fair value was less than its carrying value at September 30, 2004.  The resulting non-cash impairment charge of $19.3 million is included in impairment of film assets on the accompanying statement of operations for the three and nine months ended September 30, 2004.

In the third quarter of 2005, the Company reviewed each of its film asset titles for impairment. The Company computed the fair value of the rights to each film using indications of fair value. The estimated fair value of the domestic rights was based upon the discounted cash flows attributable to estimated future third party sales and internal use at September 30, 2005. A non-cash impairment charge was recorded in the third quarter 2005 for each film where the estimated fair value was less than its carrying value at September 30, 2005.  The resulting non-cash

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impairment charge of $22.9 million is included in impairment of film assets on the accompanying statement of operations for the three and nine months ended September 30, 2005.

Cash and Cash Equivalents

Cash and cash equivalents include highly liquid investments with original maturities of three months or less that are readily convertible into cash and are not subject to significant risk from fluctuations in interest rates. As a result, the carrying amount of cash and cash equivalents approximates fair value.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is based upon the Company’s assessment of probable loss related to uncollectible accounts receivable.  The Company uses a number of factors in determining the allowance, including, among other things, collection trends.  The Company’s bad debt expense was $183,000 for the three months ended September 30, 2004, and bad debt recovery was $831,000 for the nine months ended September 30, 2004. The Company’s bad debt recovery was $115,000 for the three months ended September 30, 2005, and bad debt expense was $1.0 million for the nine months ended September 30, 2005.

Program License Fees

Program license fees are paid in connection with the acquisition of the rights to air programs acquired from others. Program rights are generally deferred and then amortized on a straight-line basis over their contractual license periods or anticipated usage. Crown Media Holdings periodically evaluates the realizability of these deferred license fees in relation to the estimated future revenues.

Estimates of net realizable value for program license fees are determined using future estimated advertising revenues and anticipated patterns of programming usage on a day part basis as it pertains to programming licensed to the channel. These estimates of expected annual future estimated revenues are compared to net book value of the program license fee assets to determine if the programming assets are expected to be recovered. Where the analysis indicates the costs are in excess of the estimated net realizable value, additional amortization is provided.

Subscriber Acquisition Fees

Subscriber acquisition fees are generally required to be paid to obtain carriage on domestic pay distributors systems. Under certain of these agreements with pay distributors, Crown Media United States is obligated to pay subscriber acquisition fees if defined subscriber levels are met or in order to obtain additional carriage of the Hallmark Channel by those pay distributors. Such costs are accrued when Crown Media United States receives notice from the distributors that they have met the contractual penetration percentage or subscriber count.

Subscriber acquisition fees are amortized over the contractual life of the distribution agreements (ranging from 4 to 9 years) as a reduction of subscriber fee revenue. If the amortization expense exceeds the subscriber fee revenue recognized on a per distributor basis, the excess amortization is included as a component of cost of services. Crown Media Holdings assesses the recoverability of these costs periodically by comparing the net carrying amount to the estimates of future subscriber fee and advertising revenues. It also assesses the recoverability when events such as changes in distributor relationships occur or other indicators suggest impairment.

Property and Equipment

Property and equipment are stated at historical cost. Equipment under capital leases are initially recorded at the present value of the minimum lease payments.

Depreciation on equipment is calculated using the straight-line method over the estimated useful lives of the assets. Equipment held under capital leases and leasehold improvements are amortized straight-line over the shorter of the lease term or estimated useful life of the asset.

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When property and equipment is sold or otherwise disposed of, the cost and related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is included in income. The costs of normal maintenance and repairs are charged to expense when incurred.

Long-Lived Assets

The Company reviews long-lived assets, other than goodwill and other intangible assets with indefinite lives, for impairment whenever facts and circumstances indicate that the carrying amounts of the assets may not be recoverable. An impairment loss is recognized if the carrying amount of the asset is not recoverable and exceeds its fair value. Recoverability of assets to be held and used is measured by comparing the carrying amount of an asset to the estimated undiscounted future net cash flows expected to be generated by the asset. If the asset’s carrying value is not recoverable, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds its fair value. The Company determines fair values by using a combination of comparable market values and discounted cash flows, as appropriate.

Goodwill is reviewed for impairment annually on November 30 or whenever an event occurs or circumstances change that indicates fair value might be below carrying value. Goodwill is carried at historical cost if the estimated fair value is greater than the carrying amounts. However, if estimated fair value is less than the carrying amount, goodwill is reduced to estimated fair value through an impairment charge to the Company’s consolidated statements of operations.

Revenue Recognition

Subscriber revenue from pay television distributors is recognized as revenue when an agreement is executed, programming is provided, the price is determinable, and collectibility is reasonably assured. Subscriber fees from pay television distributors are recorded net of amortization of subscriber acquisition costs in accordance with Emerging Issues Task Force No. 01-9 (“EITF No. 01-9”) , Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products) . If the amortization expense exceeds the revenue recognized on a per distributor basis, the excess amortization is included as a component of cost of services. To more fully comply with EITF No. 01-9, $230,000 and $687,000, which previously were reported as subscriber acquisition fee amortization expense, have been reclassified as components of subscriber fees revenue for the three and nine months ended September 30, 2004, respectively.

Advertising revenues are recognized as earned in the period in which the advertising is telecast. Revenue is recognized as commercial spots or long form programming are aired and as ratings guarantees to advertisers are achieved. Advertising revenues are recorded net of agency commissions. Agency commissions are calculated based on a stated percentage applied to gross billing revenue for the Company’s broadcasting operations. Customers remit the gross billing amount to the agency and the agency remits gross billings less their commission to the Company. Payments received in advance of being earned are recorded as deferred revenue.

Revenue from film asset licensing agreements is recognized in accordance with Statement of Position (“SOP”) 00-02, Accounting by Producers or Distributors of Films. Revenues are recognized when all of the following have occurred:  an agreement is executed, the film is available for exhibition by the licensee, the license fee is fixed or determinable, collectibility is reasonably assured and the cost of each film is known or reasonably determinable. Revenue from film asset licensing agreements containing multiple film titles is allocated among the various film titles based on their relative estimated fair values. Payments received from licensees prior to the availability of a film are recorded as deferred revenue. Fees payable with terms in excess of one year are discounted for revenue recognition purposes at the customer’s estimated incremental borrowing rate in accordance with Accounting Principles Board (“APB”) Opinion No. 21, Interest on Receivables and Payables.

Taxes on Income

Pursuant to the tax sharing agreement entered into with Hallmark Cards in March 2003, the Company’s results of operations for tax purposes became a part of the Hallmark Cards consolidated federal tax return as of and

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subsequent to March 2003.  However, the Company continues to account for income taxes on a separate return basis. Accordingly, the Company accounts for income taxes using an asset and liability method which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and net operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be applied to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company reduces deferred tax assets by a valuation allowance if it is more likely than not that some portion or all of the deferred tax assets will not be realized. Any payments received from Hallmark Cards under the tax sharing agreement are recorded as an increase in additional paid-in capital and any future utilization of deferred tax assets generated after March 2003 will be recorded as a reduction in paid-in capital, to the extent payments were previously received from Hallmark Cards for such benefits under the tax sharing agreement.

Stock-Based Compensation

The Company accounts for its stock-based employee compensation plan using the intrinsic value method under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, compensation cost for stock options issued to employees is measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the exercise price of the underlying stock options. In December 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS No. 123. SFAS No. 148 requires certain additional disclosures of the estimated fair value of stock-based compensation. Such estimated fair value is determined through the use of the Black-Scholes option pricing model. SFAS No. 123, Accounting for Stock-Based Compensation, encourages, but does not require, companies to record compensation cost for stock-based employee compensation plans at fair value.

Had compensation expense for these plans been determined consistent with SFAS No. 123, Crown Media Holdings’ net loss and loss per share would have been increased to the following pro forma amounts for the three and nine months ended September 30, 2004 and 2005:

Pro Forma Effects

(In thousands, except per share amounts)

Net Loss per Share

Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed based on the weighted average number of common shares and potentially dilutive common shares outstanding. The calculation of diluted net loss per share excludes potential common shares if the effect would be antidilutive. Potential common shares consist of incremental common shares issuable upon the exercise of stock options. Approximately 1.4 million and 403,000 stock options for both the three and nine months ended September 30, 2004 and 2005, respectively, have been excluded from the calculations of loss per share because their effect would have been antidilutive.

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Translation of Foreign Currency

Through April 26, 2005, the balance sheets and statements of operations and comprehensive loss of certain Crown Media Holdings’ foreign subsidiaries were measured using local currency as the functional currency. Revenues, expenses and cash flows of such subsidiaries were translated into United States dollars at the average exchange rates prevailing during the period. Assets and liabilities were translated at the rates of exchange at the balance sheet date. Translation gains and losses were deferred as a component of accumulated other comprehensive income (loss). Foreign currency transaction gains and losses recorded upon the remeasurement of financial assets and liabilities denominated in currencies other than the functional currency of the subsidiary were included in determining net loss for the period. In conjunction with the sale of the international business, the cumulative foreign currency translation gain of approximately $3.1 million was realized as a component of the loss on sale of discontinued operations in the accompanying consolidated statement of operations.

Concentration of Credit Risk

Financial instruments, which potentially subject Crown Media Holdings to a concentration of credit risk, consist primarily of cash, restricted cash, cash equivalents and accounts receivable. Generally, Crown Media Holdings does not require collateral to secure receivables. Crown Media Holdings has no significant off-balance sheet financial instruments with risk of accounting losses.

Reclassifications

Certain reclassifications have been made to conform prior periods’ financial information to the current presentation.

Recently Issued Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. The amendments made by SFAS No. 153 are based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged. Further, the amendments eliminate the narrow exception for nonmonetary exchanges of similar productive assets and replace it with a broader exception for exchanges of nonmonetary assets that do not have commercial substance. Previously, APB Opinion No. 29 required that the accounting for an exchange of a productive asset for a similar productive asset or an equivalent interest in the same or similar productive asset should be based on the recorded amount of the asset relinquished. APB Opinion No. 29 provided an exception to its basic measurement principle (fair value) for exchanges of similar productive assets. The FASB believes that exception required that some nonmonetary exchanges, although commercially substantive, be recorded on a carryover basis. By focusing the exception on exchanges that lack commercial substance, the FASB believes SFAS No. 153 produces financial reporting that more faithfully represents the economics of the transactions. SFAS No. 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after the date of issuance. The provisions of SFAS No. 153 shall be applied prospectively. The Company does not anticipate that the adoption of SFAS No. 153 will have a significant impact on the Company’s overall results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment. SFAS No. 123R replaced SFAS No. 123, Accounting  for  Stock-Based  Compensation, and superseded Accounting  Principles  Board  Opinion No. 25,  Accounting  for Stock  Issued to Employees.  SFAS No. 123R will require compensation cost  related  to share-based payment  transactions to be recognized in the financial  statements. As permitted by SFAS No. 123, Crown Media Holdings elected to follow the guidance of APB Opinion No. 25, which allowed companies to use the intrinsic value method of accounting to value their share-based payment transactions with employees.  Based on this method, Crown Media Holdings did not recognize compensation expense in its financial statements as the stock options granted had an exercise price equal to the fair market value of the underlying  common  stock on the date of the grant.  SFAS No. 123R requires measurement of the cost of share-based payment transactions to employees at the fair value of the award on the grant date and  recognition  of expense  over the requisite service or vesting period. SFAS No. 123R allows implementation  using a modified version of prospective  application,  under which compensation  expense for the unvested portion of previously granted awards and all new

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awards will be recognized on or after the date of adoption.  SFAS No. 123R also allows companies to adopt SFAS No. 123R by restating previously issued financial statements, basing the amounts on the expense  previously  calculated  and  reported in their pro forma footnote  disclosures  required under SFAS No. 123. The provisions of SFAS No. 123R will be adopted by Crown Media Holdings using the modified prospective method beginning January 1, 2006.

In March 2005, the SEC staff issued guidance on FASB Statement No. 123 (revised 2004), Share-Based Payment, SFAS No. 123R. Staff Accounting Bulletin (“SAB”) No. 107 was issued to assist preparers by simplifying some of the implementation challenges of SFAS No. 123R while enhancing the information that investors receive.  SAB No. 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS No. 123R, specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB No. 107 include: (a) valuation models – SAB No. 107 reinforces the flexibility allowed by SFAS No. 123R to choose an option-pricing model that meets the standard’s fair value measurement objective; (b) expected volatility – the SAB provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term – the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances.  The Company will apply the principles of SAB No. 107 in conjunction with its adoption of SFAS No. 123R.

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections—Replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS 154). SFAS 154 replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. Opinion No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle. SFAS 154 defines retrospective application as the application of a different accounting principle to prior accounting periods as if that principle had always been used or as the adjustment of previously issued financial statements to reflect a change in the reporting entity. SFAS 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate affected by a change in accounting principle. We are required to adopt the provisions of SFAS 154 as of January 1, 2006, although earlier adoption is permitted.

3. Subscriber Acquisition Fees

Subscriber acquisition fees are comprised of the following:

Of the net balance at September 30, 2005, the Company expects $21.1 million will be recognized as a reduction of subscriber fee revenue and $69.2 million will be recognized as subscriber acquisition fee expense in future periods.

As of December 31, 2004, and September 30, 2005, the consolidated balance sheets also reflect subscriber acquisition fees payable of $35.9 million and $12.0 million, respectively. For the three months ended September 30, 2004 and 2005, Crown Media United States made cash payments of $10.7 million and $1.3 million, respectively. For the nine months ended September 30, 2004 and 2005, Crown Media United States made cash payments of $14.2 million and $31.1 million, respectively.

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4. Program License Fees

Program license fees are comprised of the following:

Amortization of program license fees for continuing operations, which is included as a component of programming cost in the accompanying consolidated statements of operations, was $21.6 million and $29.2 million for the three months ended September 30, 2004 and 2005, respectively, and $60.7 million and $85.6 million for the nine months ended September 30, 2004 and 2005, respectively.

At December 31, 2004, and September 30, 2005, $7.7 million and $4.8 million of program license fees, respectively, were included in prepaid and other assets on the accompanying condensed consolidated balance sheets as the Company had made payments, but the airing windows had not commenced.

License fees payable are comprised of the following:

5. Property and Equipment

Property and equipment are comprised of the following:

Depreciation expense related to property and equipment was $786,000 and $853,000 for the three months ended September 30, 2004 and 2005, respectively. Depreciation expense related to property and equipment was $2.6 million for both the nine months ended September 30, 2004 and 2005, respectively.

Software and other intangible assets of $3.2 million and $1.8 million as of December 31, 2004, and September 30, 2005, respectively, have been included in prepaid and other assets in the accompanying condensed consolidated balance sheets.

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6. Reorganization

In October 2002, the Company reorganized its operations in order to concentrate its efforts on the Hallmark Channel in the U.S.  The following table displays the activity and balances of the reorganization accrual account from December 31, 2003, to September 30, 2005, which is included in the current portion of accounts payable and accrued liabilities in the accompanying condensed consolidated balance sheets.

7. Credit Facility

 The Company has a credit agreement with a syndicate of banks, led by JP Morgan Chase Bank, under which the banks have extended to the Company a secured revolving credit facility of up to $220.0 million.  The Company and the lending banks originally entered into the facility in 2001 and have subsequently amended the terms of this facility, with the most recent amendment on March 1, 2005.  The facility is guaranteed by the Company’s subsidiaries and is secured by all tangible and intangible property of Crown Media Holdings and its subsidiaries.  The original bank credit facility encompassed a term loan of $100.0 million and a revolving line of credit of $220.0 million, inclusive of up to $20.0 million of letters of credit available to be issued at the Company’s request.  Upon the consummation of sale of the international business, the Company repaid and retired the $100.0 million term loan along with $95.0 million on the revolving line of credit under the credit facility. The credit facility now consists of the revolving line of credit of $220.0 million, which includes up to $20.0 million of letters of credit.  In addition, following such closing, any borrowings by the Company of amounts in excess of the $180.0 million under the revolving line of credit requires approval of Hallmark Cards.

Each loan under the bank credit facility bears interest at a Eurodollar rate or an alternate base rate as the Company may request at the time of borrowing in accordance with the credit agreement.  The Eurodollar rate is based on the London interbank market for Eurodollars, and remains in effect for the time period of the loan ranging from one, two, three, six or twelve months.  The alternate rate is based upon the prime rate of JP Morgan Chase Bank, a certificate of deposit rate or the Federal Funds effective rate, which is adjusted whenever the rates change.  The Company is required to pay a commitment fee of 0.2% per annum (0.5% prior to March 1, 2005) of the committed, but not outstanding, amounts under the revolving credit facility, payable in quarterly installments.

On March 1, 2005, we entered into Amendment No. 8 to the agreement for our bank credit facility.  This amendment extended the maturity date to May 31, 2006, as well as made a number of other significant changes to the bank credit facility including elimination of certain financial covenants, changes to and waivers of financial covenants concerning 2004 violations and the future compliance, and a reduction in the interest rates and commitment fees under the credit facility. See “Hallmark Letter of Credit” in note 9 below regarding an irrevocable letter of credit of Hallmark Cards issued as credit support for obligations under the credit facility.

Amendment No. 8 waived the Company’s non-compliance with the following financial covenants:  (1) capital expenditures in 2004; (2) cash program acquisition guarantees in 2004; (3) trailing 12-month EBITDA for the

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quarter ended December 31, 2004; (4) cash payments to television distributors for subscribers in 2004; (5) net worth at December 31, 2004; (6) leverage ratio for the quarter ended December 31, 2004; and (7) interest coverage ratio for the 2004 year.  Amendment No. 8 also deleted the net worth covenant; amended the limit on the Company’s cash program guarantees in 2005; amended the quarterly EBITDA requirements for the remainder of the loan term; revised the EBITDA definition, including adding all non-cash expenses to consolidated net income in determining EBITDA; and amended the limit of cash payments to television distributors for subscribers, the minimum number of subscribers and the minimum gross subscriber revenue.  Further, pursuant to Amendment No. 8, the limitation on Restricted Payments was amended to allow us to make certain payments to Hallmark Cards or its affiliates. The Company was in compliance with its debt covenants at September 30, 2005.

At December 31, 2004, and September 30, 2005, Crown Media Holdings had outstanding borrowings of $310.0 million and $180.0 million, respectively, under the credit facility and there were no letters of credit outstanding. At September 30, 2005, the entire outstanding balance bore interest at the Eurodollar rate (4.84% at September 30, 2005). Interest expense on borrowings under the credit facility for the three months ended September 30, 2004 and 2005, was $3.5 million, and $2.1 million, respectively, and for the nine months ended September 30, 2004 and 2005, interest expense was $9.9 million, and $8.0 million, respectively.

8.  Classification of Credit Facility as a Current Liability

The outstanding borrowings under the credit facility of $180.0 million at September 30, 2005, have been classified as a current liability.  Such balance sheet classification was deemed necessary as the bank has the right, at the maturity date, at its discretion, to either draw upon the outstanding letter of credit supplied by Hallmark Cards in order to receive payment in full of the outstanding principal amount under the credit facility (see note 9) or to initiate other actions including foreclosure of the Company’s assets. As this is outside the control of the Company, the obligation does not meet the requirements as long-term debt even though Hallmark Cards has committed to not request reimbursement from the Company prior to October 31, 2006 in the event the banks exercise their rights under the irrevocable letter of credit described in note 9.

9. Related Party Long-Term Obligations

Hallmark Letter of Credit

Pursuant to Amendment No. 8 to the bank credit facility, Hallmark Cards provided an irrevocable letter of credit issued to JP Morgan Chase Bank by Citibank, N.A. in the amount of $320.0 million, as credit support for the Company’s obligations under the credit facility.  The letter of credit was reduced to $220.0 million upon the consummation of the sale of the Company’s international business and the reduction of the aggregate outstanding credit exposure of its lenders to $220.0 million.  Drawdowns under the letter of credit may be made for amounts due and payable under the credit facility. Amounts in excess of $180.0 million require the concurrence of Hallmark Cards.  Any proceeds received by JP Morgan Chase Bank from drawing under this support letter of credit will not be applied to repay the Company’s obligations, but will be used to purchase on the part of Hallmark Cards from the bank lenders subordinated participations in our obligations under its bank credit facility, junior in payment to the bank lenders under the bank credit facility.  The support letter of credit automatically expires on May 31, 2006. The Company pays to Hallmark Cards, as compensation for the support letter of credit, the amounts resulting from the 2% reduction in the interest rate and the 0.3% reduction in the commitment fee payable by the Company under the bank credit facility as provided in Amendment No. 8.

Senior Unsecured Note

In August 2003, the Company issued a senior unsecured note to HC Crown for $400.0 million. A portion of the proceeds was used to repurchase the Company’s outstanding trust preferred securities, and the balance of the proceeds, after expenses, was used to reduce amounts outstanding under its bank credit facility.

The senior unsecured note payable to HC Crown does not require cash payments until August 2007. Instead, the principal amount of the senior unsecured note accretes at 10.25% per annum, compounding semi-annually, to $596.6 million at August 5, 2007.  From that date, interest at 10.25% per annum will be payable semi-annually on the accreted value of the senior unsecured note to HC Crown.  The note matures on August 5, 2011, and is pre-payable

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by Crown Media Holdings at any time after August 5, 2004, without penalty. At December 31, 2004 and September 30, 2005, $460.9 million and $496.9 million, respectively, of principal and accrued interest were included in the senior unsecured note payable in the accompanying condensed consolidated balance sheet. The note purchase agreement for the senior unsecured note contains certain covenants which restrict on the part of the Company, among other matters, from the incurrence of any additional indebtedness, the repurchase or other acquisitions of the Company’s stock, investments in other parties and the incurrence of liens on the Company’s assets.  As a fee for the issuance of the notes, the Company paid $3.0 million to HC Crown, which was initially capitalized and is being amortized as additional interest expense over the term of the note payable.

Line of Credit Payable to HC Crown

On December 14, 2001, the Company executed a $75.0 million promissory note with HC Crown maturing on the earlier of six months from the termination of the credit facility or December 21, 2007.  This line of credit is subordinate to the bank credit facility. The rate of interest under this line of credit is equal to LIBOR plus three percent, payable quarterly. At both December 31, 2004, and September 30, 2005, borrowings under the note were $75.0 million. Accrued interest on the note of $6.1 million and $9.8 million are included in line of credit and interest payable to HC Crown as of December 31, 2004, and September 30, 2005, respectively, on the accompanying condensed consolidated balance sheets.

Hallmark Obligations

By a letter dated October 1, 2005, which supplemented previous letters dated February 28, 2005, and August 1, 2005, Hallmark Cards confirmed to the Company that neither Hallmark Cards nor any of its wholly-owned subsidiaries would demand payment from the Company until October 31, 2006, at the earliest, on (1) license fees and intercompany debt and payables outstanding as of December 31, 2004, and September 30, 2005, and (2) any reimbursements on the letter of credit supporting the bank line of credit if drawn to pay the bank credit facility which matures on May 31, 2006. Therefore, the Company has classified the license fees and payables to Hallmark affiliates as non-current liabilities on the accompanying condensed consolidated balance sheet.

10. Related Party Transactions

Tax Sharing Agreement

On March 11, 2003, Crown Media Holdings became a member of Hallmark Cards consolidated federal tax group and entered into a federal tax sharing agreement with Hallmark Cards (the “tax sharing agreement”). Hallmark Cards includes Crown Media Holdings in its consolidated federal income tax return.  Accordingly, Hallmark Cards has benefited from past tax losses and may benefit from future federal tax losses, which may be generated by Crown Media Holdings.  Based on the tax sharing agreement, Hallmark Cards has agreed to pay Crown Media Holdings all of the benefits realized by Hallmark Cards as a result of including Crown Media Holdings in its consolidated income tax return.  These benefits are estimated and paid 75% in cash on a quarterly basis and the balance when Crown Media Holdings becomes a federal taxpayer.  A final true-up calculation is completed within 15 days after Hallmark Cards files its consolidated federal income tax return for the year.  Pursuant to the true-up calculation, Crown Media Holdings is obligated to reimburse Hallmark Cards the amount that any estimated payments have exceeded the actual benefit realized by Hallmark Cards and Hallmark Cards is obligated to pay Crown Media Holdings the amount that any actual benefit exceeds the estimated payments.  Under the tax sharing agreement, at Hallmark Cards’ option, the non-interest bearing balance of the 25% in federal tax benefits may be applied as an offset against any amounts owed by Crown Media Holdings to any member of the Hallmark Cards consolidation group under any loan, line of credit or other payable, subject to limitations under any loan indentures or contracts restricting such offsets. During the third quarter of 2005, Hallmark Cards used $30.0 million of the approximately $40.0 million balance of this 25% balance to offset intercompany debt.

The Company received $15.9 million and $34.7 million under the tax sharing agreement during the three months ended September 30, 2004 and 2005, respectively. The Company received $39.5 million and $56.1 million under the tax sharing agreement during the nine months ended September 30, 2004 and 2005, respectively. These receipts have been recorded as an addition to paid-in capital. See “Liquidity” in Note 1 above.

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Costs Incurred on Crown Media Holdings’ Behalf

Since inception, Hallmark Entertainment has at times paid certain costs on behalf of Crown Media Holdings. Non-interest bearing unreimbursed costs of $4.5 million and $5.9 million are included in payable to affiliates in the accompanying condensed consolidated balance sheets as of December 31, 2004, and September 30, 2005, respectively.

Services Agreement with Hallmark Cards

Crown Media Holdings entered into an Intercompany Services Agreement with Hallmark Cards, effective January 1, 2003, under which Hallmark Cards agreed for a term of three years to provide Crown Media Holdings with tax, risk management, health safety, environmental, insurance, legal, treasury and cash management services and real estate consulting services.  Under the agreement, the Company agreed to pay Hallmark Cards $515,000 per year for these services, plus out-of-pocket expenses and third party fees, payable in arrears on the last business day of each quarter. However, the Company has not been paying these amounts as they are due. For each of the three months ended September 30, 2004 and 2005, Crown Media Holdings had accrued $129,000 under the agreement. For each of the nine months ended September 30, 2004 and 2005, Crown Media Holdings had accrued $386,000 under the agreement. At December 31, 2004, and September 30, 2005, non-interest bearing unpaid accrued service fees and unreimbursed expenses of $8.6 million and $9.8 million, respectively, were included in payable to affiliates in the accompanying condensed consolidated balance sheets.

Film Asset Services Agreement with Hallmark Entertainment

The Company entered into a film asset services agreement with Hallmark Entertainment, under which Hallmark Entertainment provides Crown Media Holdings with services related to the administration, distribution and other exploitation of the Company’s film assets. In consideration for the services provided by Hallmark Entertainment, Crown Media Holdings was, prior to the sale of the Company’s international operations, obligated to pay a service fee of $1.5 million per year, payable in quarterly installments of $375,000. At December 31, 2004, and September 30, 2005, non-interest bearing unpaid accrued service fees of $375,000 and $188,000 were included in payable to affiliates in the accompanying condensed consolidated balance sheets. Following the sale of the Company’s international operations, the annual fee for these services was reduced to $750,000 per year and such amount has been prorated for the period April 26, 2005, through December 31, 2005.

Trademark Agreement with Hallmark Cards

Crown Media United States has a trademark license agreement with Hallmark Licensing, Inc. for use of the “Hallmark” mark for the Hallmark Channel and for the Hallmark Movie Channel.  During the third quarter of 2005, Hallmark Cards extended the trademark license agreements for the Hallmark Channel and the Hallmark Movie Channel to September 1, 2006. The Company is not required to pay any fees under the trademark license agreements.

Program License Agreements with Hallmark Entertainment Distribution

Crown Media United States has licensed programming for distribution in the United States from Hallmark Entertainment Distribution since 1998.  Prior to October 11, 2005, this programming was provided pursuant to a program license agreement dated January 1, 2001.  The term of this prior agreement would have automatically renewed on December 31, 2005 for another three years. On October 11, 2005, the Company entered into a new program license agreement with Hallmark Entertainment Distribution which supersedes the prior agreement and is retroactive to January 1, 2005.

Under the new agreement, Crown Media United States licenses certain television movies and mini-series from Hallmark Entertainment Distribution for exhibition via all forms of television over the Hallmark Channel and the Hallmark Movie Channel in the United States and its territories and possessions, including Puerto Rico. The prior agreement had limited the license to the Hallmark Channel and did not include Puerto Rico in the broadcast territory. The term of the new agreement expires on December 31, 2008.  The license is exclusive to Crown Media United States in the broadcast territory during the term against all forms of television. While the prior agreement

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provided that Hallmark Entertainment Distribution was the exclusive source of original programming, under the new agreement Crown Media United States may freely license original programs from third party licensors during the term.

While the prior agreement did not require Hallmark Entertainment Distribution to produce and deliver a minimum number of original movies or original mini-series to Crown Media United States, under the new agreement, Hallmark Entertainment Distribution is required to produce and deliver to Crown Media United States, and Crown Media United States is required to order and license from Hallmark Entertainment Distribution, 13 original Movies and 3 original mini-series in 2005, 31 original movies and 6 original mini-series in 2006 and 18 original movies and 3 original mini-series in 2007.  Crown Media United States may elect to reduce the number of original movies required to be licensed under the new agreement in 2006 by up to six original movies (and, under certain conditions, to reduce the number of original mini-series to be licensed in 2006 by up to three) and may elect to completely cancel its obligation to license any original movies and original mini-series in 2007.  Under certain conditions, Hallmark Entertainment Distribution may similarly reduce or eliminate the number of original movies or original mini-series that it is required to produce under the new agreement in those years.

The license term for the original movies and original mini-series is three years (or five years with respect to certain holiday-themed programs and programs delivered in 2005), and Crown Media United States has the right to exhibit the programs on 30 days during the license term (with unlimited runs per exhibition day). The new agreement also grants Crown Media United States the right to an additional 15 exhibition days to six specified original movies during their initial license term. Hallmark Entertainment Distribution has an option to extend the license term of the original mini-series for an additional three-year period (thereby obligating Crown Media United States to pay an additional fee equal to 50% of the fee paid for the initial license term). Hallmark Entertainment Distribution’s option under the prior agreement to also extend the license term of the original movies for an additional three-year period was eliminated under the new agreement. Instead, Crown Media United States has a right of first negotiation on a product-by-product basis with respect to a potential second license term for original movies delivered on or after January 1, 2005.

In addition to the original movies and original mini-series referred to above, Crown Media United States also agreed to license from Hallmark Entertainment Distribution (a) specified previously-licensed programs for a second three-year license term as to which Hallmark Entertainment Distribution had the option to extend under the prior agreement, and (b) specified second run movies and mini-series (i.e. those previously broadcast by one other television network) for an initial three-year license term, with an option in favor of Hallmark Entertainment Distribution to extend the license term for an additional three-year period (for an additional licensee fee equal to 50% of the fee paid for the initial term). The new agreement limits the number of such pictures that Crown Media United States may be required to license from Hallmark Entertainment Distribution during 2006 through 2008 to a maximum of 15 per year, compared to a maximum of 50 per year under the prior agreement.

The new agreement provides for additional licensing fees for original movies and original mini-series, provided that the additional license fees payable by Crown Media United States to Hallmark Entertainment Distribution for such movies and mini-series delivered in 2005 are not payable by Crown Media United States to Hallmark Entertainment Distribution until July 1, 2006. The license fees payable for the remaining programming is unchanged from the prior agreement.

Under the new agreement, Crown Media United States for the first time is granted pay per view, video on demand and internet/interactive rights to original movies and original mini-series in their initial three-year term, subject to sharing the net revenues therefrom equally with Hallmark Entertainment Distribution. Crown Media United States may sublicense its rights to the programs licensed under the new agreement to a third party for exhibition in any television media, subject to Hallmark Entertainment Distribution’s prior approval, not to be unreasonably withheld; provided, however, that Crown Media United States has the right to sublicense its pay per view, video on demand or internet/interactive rights with respect to original movies and original mini-series during their initial license term to a third party without Hallmark Entertainment Distribution’s prior approval. If the total compensation Crown Media United States receives from such sublicenses for any program exceeds the license fee it is obligated to pay Hallmark Entertainment Distribution for the program, such excess is divided equally between Hallmark Entertainment Distribution and Crown Media United States.

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Crown Media United States did not sub-license any licensed programming to third parties during the three and nine months ended September 30, 2004 and 2005.  Amounts due to Hallmark Entertainment Distribution as a result of these sub-licensing agreements have been included in license fees payable to affiliates in the accompanying balance sheets as noted below.

Programming costs related to the Hallmark Entertainment Distribution program license agreements were $5.0 million and $7.6 million for the three months ended September 30, 2004 and 2005, respectively. Programming costs related to the Hallmark Entertainment Distribution program license agreements were $14.3 million and $21.5 million for the nine months ended September 30, 2004 and 2005, respectively. As of December 31, 2004, and September 30, 2005, $152.0 million and $146.4 million, respectively, are included in license fees payable to affiliates in the accompanying condensed consolidated balance sheets. The Company obtained a letter from Hallmark Cards whereas Hallmark Cards and its subsidiaries will not demand payment of these license fees prior to August 31, 2006.

11. Company Obligated Mandatorily Redeemable Preferred Interest and NICC License Agreements

VISN owns a $25.0 million company obligated mandatorily redeemable preferred interest in Crown Media United States (the “preferred interest”) issued in connection with an investment by the Company in Crown Media United States. On November 13, 1998, the Company, Vision Group, VISN and Henson Cable Networks, Inc. signed an amended and restated company agreement governing the operation of Crown Media United States, which agreement was further amended on February 22, 2001, January 1, 2002, March 5, 2003, January 1, 2004 and November 15, 2004  (the “company agreement”).

 Under the company agreement, the members agreed that if during any year ending after January 1, 2005 and prior to December 31, 2009, Crown Media United States has net profits in excess of $10.0 million, and the preferred interest has not been redeemed, Crown Media United States will redeem the preferred interest in an amount equal to the lesser of: (i) such excess net profits; (ii) $5.0 million; or (iii) the amount equal to the preferred liquidation preference on the date of redemption.  Crown Media United States may voluntarily redeem the preferred interest at any time, however, it is obligated to do so on the date of redemption (December 31, 2010). Due to the mandatory redemption provision of the preferred interest, on July 1, 2003, the preferred interest was remeasured at fair value and reclassified to non-current liabilities in accordance with the provisions of SFAS No. 150.

Under the company agreement, Crown Media United States is also obligated to make certain payments for programming to NICC.  Specifically, Crown Media United States may be required to pay license fees to NICC or fund production costs consisting of: (i) a total of $5.3 million per year, with consumer price index escalations, for two recurring programming blocks produced by NICC; (ii) up to $10.0 million per year for an additional recurring “signature” series program block co-produced by NICC and Crown Media United States; (iii) up to $600,000 per “non-dramatic” holiday special produced by NICC; and (iv) up to $1.0 million per “dramatic” holiday special co-produced by NICC and Hallmark Entertainment.

In addition, Crown Media United States agreed to advance NICC $3.0 million per year in 2002 through 2005 to help fund NICC’s cost of expanding its production operations to produce the aforementioned “signature” series.   These advances will be recovered from the license fees payable for this programming when such programming is produced and accepted by Crown Media United States for distribution on the channel. The Company is expensing these amounts as incurred given the uncertainty surrounding whether or not the programming will be produced and/or accepted. These expenses are included as components of affiliate programming costs in the accompanying consolidated statements of operations.

In May 2005, we received a letter from National Interfaith Cable Coalition, Inc. threatening litigation. The letter claims that, among other things, the Company and Hallmark Entertainment have not honored their commitments relating to the production and financing of NICC programming under the company agreement. NICC alleges that we and Hallmark Entertainment have materially breached the agreement, causing substantial damages to NICC in an amount which exceeds $100.0 million.  The letter further indicated that NICC intended to file litigation for breaches of the Amendment unless we agreed, by June 1, 2005, to enter into a new, extended agreement with NICC for the production, promotion and funding of programming.  While we believe that the Company and Hallmark

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Entertainment have not breached the company agreement, the Company has been in negotiations with NICC to try to amicably resolve these issues and NICC has not yet filed litigation.  We cannot, however, predict at this time whether these negotiations will successfully resolve NICC’s claims or whether there will be litigation. Accordingly, we have not provided for any amount of loss in these condensed financial statements for this matter.

During the three months ended September 30, 2004 and 2005, Crown Media United States paid NICC $653,000 and $4.5 million, respectively, and during the nine months ended September 30, 2004 and 2005, $7.9 million and $9.7 million, respectively, related to the company agreement, as amended.

12. Employee Incentives

In April 2003, the Company’s Board of Directors approved actions to provide additional incentives to encourage retention of its employees. Crown Media Holdings’ then outstanding stock options held by employees had exercise prices significantly above the market value of its Class A common stock.  The Company made an offer in May 2003 to senior management and vice presidents, totaling approximately 55 persons, to exchange their options for restricted stock units (“RSUs”).  The exchange ratio was one RSU for every 2.5 options for shares of the Company’s Class A common stock, resulting in a total of 5,126,732 options exchanged for 2,050,693 RSUs. Each RSU, upon vesting, represents the right to receive one share of Class A common stock or the value of the share in cash at the time of vesting.  The determination of whether RSUs will be settled in cash or common stock is made by the Company’s Board of Directors. The RSUs vest over three years in one-third increments on the anniversary of the grant date each year and the Company is accruing expense related to the RSUs ratably over each increment’s vesting period using the price of our Class A common stock on the last day of the reporting period.

Options for 279,254 shares of common stock owned by certain executives and vice presidents that were not exchanged are subject to variable plan accounting in which compensation is remeasured at each reporting date until the options are exercised, expire unexercised or are forfeited.

In May 2004, the Company’s Board of Directors approved an additional grant to employees of 1,065,000 RSUs. The Employment RSUs, which constitute 70% of the award granted in 2004, vest in equal one-third installments over the next three years on the anniversary of the grant date each year. The Company is accruing expense related to the Employment RSUs ratably over each installment’s vesting period using the price of our Class A common stock on the last day of the reporting period. The Performance RSUs, constituting 30% of the award granted in 2004, vest on the 3^rd anniversary of the grant date, provided that the price of the Crown common stock is $14 or higher on that date. The Company will begin to accrue compensation expense for the Performance RSUs when it becomes probable that the price of the Company’s stock will be $14 or more on the 3^rd anniversary of the grant date or upon a change in control.

The Company is recording compensation expense based on the fair value of the common stock or cash equivalent required to settle the RSUs at each reporting period end during the vesting period of the RSUs. Such compensation expense is calculated using variable plan accounting.

The Company recorded $2.5 million and $3.0 million, of compensation expense associated with the RSUs during the three months ended September 30, 2004 and 2005, respectively, and $8.3 million, of compensation expense during both the nine months ended September 30, 2004 and 2005, respectively, which has been recorded as a liability for RSUs in the accompanying consolidated balance sheet and is included in selling, general and administrative expense in the accompanying consolidated statement of operations. The Company settled certain RSUs during the three months ended March 31, 2005, for approximately $4.2 million in cash. Additionally, in conjunction with the close of the international transaction, the Company immediately vested and settled RSUs held by individuals employed by the international business in May 2005 for approximately $4.0 million in cash.  In June 2005, the Company settled the contractually vested RSUs for approximately $3.8 million in cash. In August 2005, the Company immediately vested and settled RSUs held by one employee of the Company for approximately $139,000 in cash.

In June 2005, the Company’s Board of Directors approved a grant to those Directors who were not employees of the Company or of Hallmark Cards or its affiliated companies, of 70,884 RSUs.  The grant was intended to satisfy

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incentive compensation obligations to these Directors for 2003 and 2004.  The grant was subject to approval of the Company’s shareholders of a change in the Company’s Amended and Restated 2000 Long Term Incentive Plan to permit the grant of RSUs to Directors. In July 2005, the shareholders approved this amendment to the Long Term Incentive Plan. The RSUs vest in equal one-third installments over three years on the anniversary of the grant dates each year. The Company is accruing expense related to the RSUs ratably over each installment’s vesting period using the price of our Class A common stock on the last day of the reporting period. Since the effective dates of these grants were in May 2003 and May 2004 and some portions of the grants had, therefore, vested, in August 2005, the Company settled the vested RSUs held by these Directors for approximately $353,000 in cash.

In August 2005, the Company’s Board of Directors approved an additional grant to employees of 828,000 RSUs. The Employment RSUs, which constitute 50% of the award granted in 2005, vest in equal one-third installments over the next three years on the anniversary of the grant date each year. The Company is accruing expense related to the Employment RSUs ratably over each installment’s vesting period using the price of our Class A common stock on the last day of the reporting period. The Performance RSUs, constituting 50% of the award granted in 2005, vest on the 3^rd anniversary of the grant date, provided that the price of the Crown common stock is $14 or higher on that date. The Company will begin to remeasure compensation expense each period for the Performance RSUs if and when it becomes probable that the price of the Company’s stock will be $14 or more on the 3^rd anniversary of the grant date or upon a change in control.

In August 2005, the Company’s Board of Directors approved an additional grant to one executive of 115,000 RSUs. The Employment RSUs, which constitute 50% of the award granted in 2005, vest in equal one-third installments on dates which are three months, six months and nine months, respectively, after the grant date. The Company is accruing expense related to the Employment RSUs ratably over each installment’s vesting period using the price of our Class A common stock on the last day of the reporting period. The Performance RSUs, constituting the remaining 50% of the award granted in 2005, vest on the 3^rd anniversary of the grant date, provided that the price of the Crown common stock is $14 or higher on that date. The Company will begin remeasure compensation expense each period for the Performance RSUs if and when it becomes probable that the price of the Company’s stock will be $14 or more on the 3^rd anniversary of the grant date or upon a change in control.

In August 2005, the Board of Directors authorized several contingent employee compensation benefits in contemplation of a possible change in control of the Company. For the purpose of these benefits, a “change in control” occurs upon (i) a 20% change in ownership of the Company, (ii) a change in a majority of the Board of Directors, or (iii) a sale of all or substantially all of the assets of the Company.  A transaction bonus equal to 40% of employees’ base compensation will be paid upon a change in control.  At its discretion, the Company may pay an unspecified portion of the transaction bonus in March 2006 if a change in control has not yet occurred.  A longevity-and title-based severance benefit provides for salary, wage and bonus payments, extended health insurance coverage, and outplacement services to employees who are terminated as a result of the change in control.  Most of the executive officers of the Company are subject to employment contracts, some of which contain provisions for benefits in addition to those referred to above.  Except for the portion of the transaction bonus that may be paid prior to a change in control, the Company will not recognize the transaction bonuses and severance compensation as liabilities until a change in control, if any, occurs.  Based on its personnel roster in October 2005, the Company estimates that the cost of the transaction bonuses and severance benefits would be approximately $25.0 million to $45.0 million.

13. Segment Reporting

The Company’s continuing operations are currently organized into two principal divisions representing operating segments: domestic channel and film distribution. The Company evaluates performance and allocates resources based on the results of these segments. The key operating performance criteria used in this evaluation include revenue, segment income (loss) and total assets.  The results of operations of our international channel operating segment are not included in the segment reporting as they are classified separately as discontinued operations in the Company’s consolidated financial statements (see note 14).

The following tables present the Company’s segment information for the periods indicated (in thousands):

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Three Months Ended September 30, 2004

Three Months Ended September 30, 2005

Nine Months Ended September 30, 2004