-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Hhn6ryN9JwmbUuIt2l+DiRWpQ1HmYQbjCZzVU+fGAZWbdUlLm+gX0LNCVttLo7qd eMQYVpkxFt0hd7RZERGP3w== 0001047469-98-022311.txt : 19980601 0001047469-98-022311.hdr.sgml : 19980601 ACCESSION NUMBER: 0001047469-98-022311 CONFORMED SUBMISSION TYPE: S-4/A PUBLIC DOCUMENT COUNT: 7 FILED AS OF DATE: 19980529 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: STAR TELECOMMUNICATIONS INC CENTRAL INDEX KEY: 0001026486 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 770362681 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-4/A SEC ACT: SEC FILE NUMBER: 333-53335 FILM NUMBER: 98634744 BUSINESS ADDRESS: STREET 1: 223 EAST DE LA GUERRA STREET STREET 2: STE 202 CITY: SANTA BARBARA STATE: CA ZIP: 93101 BUSINESS PHONE: 8058991962 MAIL ADDRESS: STREET 1: 223 EAST DE LA GUERRA STREET CITY: SANTA BARBARA STATE: CA ZIP: 93101 S-4/A 1 S-4/A AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MAY 29, 1998 REGISTRATION NO. 333-53335 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ AMENDMENT NO. 1 TO FORM S-4 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------------- STAR TELECOMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) DELAWARE 4813 77-0362681 (State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer incorporation or organization) Classification Code Number) Identification No.)
223 EAST DE LA GUERRA STREET SANTA BARBARA, CALIFORNIA 93101 (805) 899-1962 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) ------------------------------ KELLY D. ENOS CHIEF FINANCIAL OFFICER STAR TELECOMMUNICATIONS, INC. 223 EAST DE LA GUERRA STREET SANTA BARBARA, CALIFORNIA 93101 (805) 899-1962 (Name, address, including zip code, and telephone number, including area code, of agent for service) ------------------------------ COPIES TO: TIMOTHY F. SYLVESTER, ESQ. MARTIN E. WEISBERG, ESQ. RIORDAN & MCKINZIE PARKER CHAPIN FLATTAU & KLIMPL, LLP 300 SOUTH GRAND AVENUE, 29TH FLOOR 1211 AVENUE OF THE AMERICAS LOS ANGELES, CALIFORNIA 90071 NEW YORK, NEW YORK 10036 (213) 629-4824 (212) 704-6000 APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE OF THE SECURITIES TO THE PUBLIC: As soon as practicable after the Registration Statement becomes effective. If the securities being registered on this Form are being offered in connection with the formation of a holding company and there is compliance with General Instruction G, check the following box. / / If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / If the form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. / / CALCULATION OF ADDITIONAL REGISTRATION FEE
PROPOSED MAXIMUM TITLE OF EACH CLASS OF AMOUNT TO OFFERING PRICE SECURITIES TO BE REGISTERED BE REGISTERED(1) PER UNIT Common Stock, par value $0.001 per share................................ 830,401 shares $19,670,123.69 TITLE OF EACH CLASS OF AMOUNT OF ADDITIONAL SECURITIES TO BE REGISTERED REGISTRATION FEE(3) Common Stock, par value $0.001 per share................................ $262.55
(1) The number of shares of common stock, par value $0.001 per share (the "STAR Common Stock"), of STAR Telecommunications, Inc. ("STAR") to be registered has been determined based on the product of (a) the sum of, as of May 14, 1998, (i) 7,054,844 outstanding shares of common stock, par value $0.01 per share (the "UDN Common Stock"), of United Digital Network, Inc. ("UDN"), (ii) 275,000 shares of UDN Common Stock issuable upon conversion of a convertible debenture issued by UDN and (iii) 771,634 shares of UDN Common Stock subject to outstanding options and warrants and (b) an exchange ratio of 0.1025 share of STAR Common Stock for each share of UDN Common Stock, as provided in the Agreement and Plan of Merger, dated as of November 19, 1997, as amended January 30, 1998 and April 6, 1998, by and among STAR, UDN and IIWII Corp (the "Merger Agreement"). (2) Estimated solely for purposes of calculating the registration fee pursuant to Rule 457(f)(1) of the Securities Act of 1933, as amended (the "Securities Act"), based on the average of the high and low sales price of a share of STAR Common Stock reported on the Nasdaq National Market on May 27, 1998. (3) The Registrant submitted $5,540.14 with the initial filing of this Registration Statement on May 21, 1998 covering securities with a proposed maximum aggregate offering price of $18,780,112.50. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- [LOGO] May 28, 1998 Dear Stockholder: You are cordially invited to attend a Special Meeting of Stockholders of United Digital Network, Inc. ("UDN") at McCarthy Tetrault, Main Board Room, 13th Floor, 777 Dunsmuir Street, Vancouver, B.C., Canada, on June 30, 1998 beginning at 10:00 a.m. local time. The purpose of the Special Meeting is set forth below and in the accompanying Notice of Special Meeting of Stockholders and is described in detail in the accompanying Proxy Statement/Prospectus. On November 19, 1997, UDN entered into an Agreement and Plan of Merger and on January 30, 1998 and April 6, 1998, entered into amendments thereto (as amended, the "Merger Agreement"), with STAR Telecommunications, Inc. ("STAR") and IIWII Corp., a wholly-owned subsidiary of STAR ("Newco"), pursuant to which Newco will be merged with and into UDN (the "Merger"), with UDN surviving as a wholly-owned subsidiary of STAR. Subject to the terms and conditions of the Merger Agreement, each share of common stock, par value $0.01 per share, of UDN ("UDN Common Stock"), outstanding immediately prior to the effective time of the Merger (the "Effective Time") will be converted into the right to receive that portion of a share (the "Exchange Ratio") of common stock, par value $0.001 per share, of STAR ("STAR Common Stock") determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price, which would result in an Exchange Ratio of 0.074545. As of May 27, 1998, based on a closing sales price for STAR Common Stock of $23.625, the Exchange Ratio was 0.086772 share of STAR Common Stock for each share of UDN Common Stock. Cash will be paid in lieu of any fractional shares of STAR Common Stock. In order to accomplish the Merger, stockholders of UDN are being asked to approve and adopt the Merger Agreement and the transactions contemplated thereby. AFTER CAREFUL CONSIDERATION, THE UDN BOARD OF DIRECTORS AND A SPECIAL COMMITTEE OF THE BOARD HAS DETERMINED THAT THE MERGER IS FAIR AND IN THE BEST INTERESTS OF UDN AND ITS STOCKHOLDERS. ACCORDINGLY, THE BOARD AND THE SPECIAL COMMITTEE HAVE, BY UNANIMOUS VOTE OF ALL MEMBERS PRESENT, APPROVED THE MERGER AGREEMENT AND RELATED TRANSACTIONS AND RECOMMEND THAT YOU VOTE "FOR" THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY. Madison Securities, Inc. has acted as financial advisor to UDN in connection with the Merger and delivered a written opinion (the "Madison Opinion") to the Board of Directors and the Special Committee that, as of May 7, 1998 and subject to the assumptions and the limitations of the opinion, the Exchange Ratio is fair to the holders of UDN Common Stock (other than STAR and its affiliates) from a financial point of view. A copy of the Madison Opinion is included as ANNEX B to the Proxy Statement/Prospectus and should be read in its entirety. Consummation of the Merger is subject to certain conditions, including the approval and adoption of the Merger Agreement and the other transactions contemplated thereby by UDN's stockholders and the review by, or receipt of certain approvals from, regulatory authorities. You are urged to read the accompanying Proxy Statement/Prospectus, which provides you with a description of the terms of the proposed transaction. A copy of the Merger Agreement is included as ANNEX A to the Proxy Statement/Prospectus. IT IS IMPORTANT THAT YOUR SHARES BE REPRESENTED AT THE SPECIAL MEETING. WHETHER OR NOT YOU PLAN TO ATTEND THE SPECIAL MEETING IN PERSON, YOU ARE URGED TO COMPLETE, DATE AND SIGN THE ENCLOSED PROXY CARD AND RETURN IT IN THE ENCLOSED POSTAGE PAID ENVELOPE AS PROMPTLY AS POSSIBLE. If you have any questions prior to the UDN Special Meeting or need further assistance, please call D.F. King & Co., Inc., our proxy solicitor, at (800) 848-2998. Thank you for your time and attention to the accompanying Notice of Special Meeting and Proxy Statement/Prospectus. Very truly yours, John R. Snedegar President [LOGO] NOTICE OF SPECIAL MEETING OF STOCKHOLDERS OF UNITED DIGITAL NETWORK, INC. TO BE HELD JUNE 30, 1998 ------------------------ NOTICE IS HEREBY GIVEN that a Special Meeting of Stockholders (the "Special Meeting") of United Digital Network, Inc., a Delaware corporation ("UDN"), will be held at McCarthy Tetrault, Main Board Room, 13th Floor, 777 Dunsmuir Street, Vancouver, B.C., Canada on June 30, 1998 beginning at 10:00 a.m., local time, for the following purposes: 1. To consider and vote upon a proposal to approve and adopt the Agreement and Plan of Merger, dated as of November 19, 1997, as amended January 30, 1998 and April 6, 1998 (as amended, the "Merger Agreement"), by and among UDN, STAR Telecommunications, Inc., a Delaware corporation ("STAR"), and IIWII Corp., a Delaware corporation and a wholly-owned subsidiary of STAR ("Newco"), and the transactions contemplated thereby, including, among other things, the merger ("Merger") of Newco with and into UDN, pursuant to which each share of common stock, par value $0.01 per share, of UDN ("UDN Common Stock") outstanding immediately prior to the effective time of the Merger (the "Effective Time") will be converted into the right to receive that portion of a share (the "Exchange Ratio") of common stock, par value $0.001 per share, of STAR ("STAR Common Stock") determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price, which would result in an Exchange Ratio of 0.074545. Cash will be paid in lieu of any fractional shares of STAR Common Stock. As of May 27, 1998, based on a closing price for STAR Common Stock of $23.625, the Exchange Ratio was 0.086772 share of STAR Common Stock for each share of UDN Common Stock. As a result of the Merger, UDN will become a wholly-owned subsidiary of STAR. The Merger and related matters are described in greater detail in, and a copy of the Merger Agreement is attached as ANNEX A to the accompanying Proxy Statement/Prospectus; and 2. To transact such other business as may properly come before the Special Meeting or any adjournments or postponements thereof. Only stockholders of record at the close of business on May 26, 1998, the record date for the Special Meeting, will be entitled to vote at the Special Meeting. Approval of the proposal described in item 1 above requires the affirmative vote of the holders of a majority of the outstanding shares of UDN Common Stock entitled to be voted with respect to such proposal. IT IS IMPORTANT THAT YOUR SHARES BE REPRESENTED AT THE SPECIAL MEETING, WHETHER OR NOT YOU PLAN TO ATTEND THE SPECIAL MEETING IN PERSON, YOU ARE URGED TO COMPLETE, DATE AND SIGN THE ENCLOSED PROXY CARD AND RETURN IT IN THE ENCLOSED POSTAGE-PAID ENVELOPE AS PROMPTLY AS POSSIBLE. THE ENVELOPE REQUIRES NO POSTAGE IF MAILED IN THE UNITED STATES. Any stockholder who signs and mails a proxy may revoke such proxy by delivering written notice of such revocation to the Secretary of UDN prior to the time voting is declared closed or by attending the Special Meeting and voting in person. Please see the accompanying Proxy Statement/Prospectus for further details regarding the treatment of proxies at the Special Meeting. By Order of the Board of Directors Janine Thomas SECRETARY Irvine, California May 28, 1998 ------------------------ PLEASE SIGN AND DATE THE ENCLOSED PROXY AND RETURN IT IN THE ENCLOSED POSTAGE-PREPAID ENVELOPE ------------------------ PLEASE DO NOT MAIL ANY STOCK CERTIFICATES AT THIS TIME UNITED DIGITAL NETWORK, INC. PROXY STATEMENT --------------------- STAR TELECOMMUNICATIONS, INC. PROSPECTUS 830,401 SHARES OF COMMON STOCK --------------------- This Proxy Statement/Prospectus and the accompanying annexes (the "Proxy Statement/Prospectus") are being furnished to the stockholders of United Digital Network, Inc., a Delaware corporation ("UDN"), in connection with the solicitation of proxies by the Board of Directors of UDN for use at a special meeting of stockholders of UDN to be held on June 30, 1998, and any and all adjournments and postponements thereof (the "Special Meeting"). At the Special Meeting, UDN's stockholders will be asked to consider a proposal to approve and adopt the Agreement and Plan of Merger, dated as of November 19, 1997, as amended January 30, 1998 and April 6, 1998 (as amended, the "Merger Agreement"), by and among STAR Telecommunications, Inc., a Delaware corporation ("STAR"), IIWII Corp., a Delaware corporation and wholly-owned subsidiary of STAR ("Newco"), and UDN and the transactions contemplated thereby. Pursuant to the Merger Agreement, Newco will merge with and into UDN (the "Merger"), and UDN will become a wholly-owned subsidiary of STAR. As a result of the Merger, each share of common stock, par value $0.01 per share, of UDN ("UDN Common Stock") outstanding immediately prior to the effective time (the "Effective Time") of the Merger (other than treasury shares, which shares will be cancelled, and shares as to which dissenters' rights have been perfected) will be converted into the right to receive that portion of a share (the "Exchange Ratio") of common stock, par value $0.001 per share, of STAR ("STAR Common Stock") determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price, which would result in an Exchange Ratio of 0.074545. As of May 27, 1998, based on a closing price for STAR Common Stock of $23.625, the Exchange Ratio was 0.086772 share of STAR Common Stock for each share of UDN Common Stock. Cash will be paid in lieu of any fractional shares of STAR Common Stock. STAR has filed a Registration Statement on Form S-4 (the "Registration Statement") with the Securities and Exchange Commission (the "Commission") under the Securities Act of 1933, as amended (the "Securities Act"), with respect to the shares of STAR Common Stock to be issued to the stockholders of UDN pursuant to the Merger Agreement. This Proxy Statement/Prospectus constitutes the prospectus of STAR filed as part of the Registration Statement. Completion of the Merger is conditioned upon, among other things, the Registration Statement being declared effective by the Commission and the shares of STAR Common Stock to be issued in the Merger being authorized for listing on the Nasdaq National Market. On November 18, 1997, the last full day of trading prior to the announcement of the execution of the Merger Agreement, the last reported sale prices of STAR Common Stock and UDN Common Stock, as reported on the Nasdaq National Market and Vancouver Stock Exchange, were $15.183 (adjusted to give effect to the Stock Split (as defined herein)) and $2.15, respectively. On March 31, 1998, STAR effected a 2.05-for-1 stock split in the form of a stock dividend to the holders of all shares of STAR Common Stock outstanding as of February 20, 1998 with the payment of 1.05 shares for each such outstanding share of STAR Common Stock. On May 27, 1998, the last trading day prior to the date of this Proxy Statement/Prospectus, the last reported sale prices of STAR Common Stock and UDN Common Stock, as reported on the Nasdaq National Market and Vancouver Stock Exchange, were $23.625 and $1.625, respectively. This Proxy Statement/Prospectus and the accompanying form of proxy are first being mailed to stockholders of UDN on or about May 28, 1998. ------------------------ THE SHARES OF STAR COMMON STOCK TO BE ISSUED IN CONNECTION WITH THE MERGER HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROXY STATEMENT/ PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE. ------------------------ SEE "RISK FACTORS" BEGINNING ON PAGE 22 FOR A DISCUSSION OF CERTAIN MATTERS THAT SHOULD BE CONSIDERED BY THE STOCKHOLDERS OF UDN WITH RESPECT TO THE MERGER. ------------------------ THE DATE OF THIS PROXY STATEMENT/PROSPECTUS IS MAY 28, 1998. TABLE OF CONTENTS
PAGE ---- AVAILABLE INFORMATION..................................................... 5 SUMMARY................................................................... 7 The Companies........................................................... 7 The Special Meeting..................................................... 8 The Merger.............................................................. 9 The Merger Agreement.................................................... 11 Other Considerations.................................................... 14 Risk Factors............................................................ 15 Selected Historical Financial Information (STAR)........................ 16 Selected Historical Financial Information (UDN)......................... 18 Comparative Per Share Data.............................................. 20 Summary Pro Forma Financial Information................................. 21 RISK FACTORS.............................................................. 22 Operating Results Subject to Significant Fluctuations................... 22 Ability to Continue and Manage Growth; Commercial Market................ 23 Risks Inherent in Acquisition Strategy.................................. 23 Risks Associated with Growth of Telecommunications Network and Customer Base.................................................................. 24 Risks of International Telecommunications Business...................... 24 Potential Adverse Effects of Government Regulation...................... 25 Risks of Network Failure................................................ 27 Dependence on Key Personnel............................................. 28 Significant Competition................................................. 28 Customer Concentration.................................................. 29 Need for Additional Capital to Finance Growth and Capital Requirements.......................................................... 29 Volatility of Stock Price............................................... 29 Control of Company by Named Officers, and Directors..................... 29 Effect of Certain Charter Provisions; Anti-Takeover Effects of Certificate of Incorporation, Bylaws and Delaware Law................. 30 Shares Eligible for Future Sale......................................... 30 Year 2000 Computer Program Failure...................................... 31 No Assurance that STAR Will Realize Anticipated Benefits from the Merger................................................................ 31 Interests of Certain Persons in the Merger.............................. 31 Maintenance of UDN's Customer Base...................................... 31 UDN's Dependence on Third Party Transmission Facilities................. 32 Dependence on Key Personnel of UDN...................................... 32 Dilution of Voting Power................................................ 32 Certain Federal Income Tax Consequences................................. 33 THE SPECIAL MEETING....................................................... 35 THE MERGER................................................................ 37 General Description..................................................... 37 Effective Time.......................................................... 37 Background of the Merger................................................ 37 UDN's Reasons for the Merger; Recommendations of the UDN Board and Special Committee..................................................... 39 Opinion of Madison Securities, Financial Advisor to UDN................. 40 STAR's Reasons for the Merger........................................... 43 The Merger Agreement.................................................... 43
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PAGE ---- Resale of Shares of STAR Common Stock Issued in the Merger; Affiliates............................................................ 49 Accounting Treatment of the Merger...................................... 50 Interests of Certain Persons in the Merger.............................. 50 Regulatory Approvals.................................................... 50 Stock Exchange Listing.................................................. 51 Delisting and Deregistration of UDN Common Stock........................ 51 Comparative Stock Prices................................................ 51 APPRAISAL RIGHTS OF STOCKHOLDERS.......................................... 52 COMPARATIVE RIGHTS OF STOCKHOLDERS........................................ 55 Number of Directors..................................................... 55 Classification.......................................................... 55 Removal of Directors; Filling Vacancies on the Board of Directors....... 55 Limitation on Directors' Liability...................................... 56 Indemnification......................................................... 56 Restrictions on Business Combinations/Corporate Control Dividends....... 57 PRO FORMA FINANCIAL INFORMATION........................................... 59 NOTES TO PRO FORMA FINANCIAL INFORMATION.................................. 65 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF STAR...................................................... 67 BUSINESS OF STAR.......................................................... 75 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF UDN....................................................... 91 BUSINESS OF UDN........................................................... 95 MANAGEMENT OF STAR AND UDN................................................ 99 Officers and Directors of STAR.......................................... 99 STAR Board Composition.................................................. 100 STAR Director Compensation.............................................. 100 STAR Executive Compensation............................................. 101 STAR Compensation Committee Interlocks and Insider Participation........ 102 STAR 1997 Omnibus Stock Incentive Plan.................................. 102 STAR 1996 Outside Director Nonstatutory Stock Option Plan............... 103 STAR Employment Agreements and Change of Control Arrangements........... 104 Officers and Directors of UDN........................................... 105 UDN Director Compensation............................................... 106 UDN Executive Compensation.............................................. 106 UDN Employment Agreements............................................... 107 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............................ 109 PRINCIPAL STOCKHOLDERS OF STAR............................................ 111 PRINCIPAL STOCKHOLDERS OF UDN............................................. 113 DESCRIPTION OF STAR CAPITAL STOCK......................................... 115 Common Stock............................................................ 115 Preferred Stock......................................................... 115 Anti-Takeover Effects of Provisions of Certificate of Incorporation, Bylaws and Delaware Law............................................... 115 Registration Rights..................................................... 116 Transfer Agent and Registrar............................................ 117 CERTAIN INCOME TAX CONSEQUENCES........................................... 117 Certain United States Federal Income Tax Considerations................. 117 Certain Canadian and Foreign Tax Consequences........................... 118 LEGAL MATTERS............................................................. 118 EXPERTS................................................................... 119
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PAGE ---- FUTURE STOCKHOLDER PROPOSALS.............................................. 119 INDEX TO FINANCIAL STATEMENTS............................................. F-1 ANNEXES ANNEX A: AGREEMENT AND PLAN OF MERGER.................................... A-1 ANNEX B: MADISON SECURITIES OPINION...................................... B-1 ANNEX C: SECTION 262 OF THE GENERAL CORPORATION LAW OF THE STATE OF DELAWARE........................................................ C-1
4 AVAILABLE INFORMATION STAR is subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith, files reports, proxy statements, registration statements and other information with the Commission. The reports, proxy statements, registration statements and other information filed by STAR with the Commission may be inspected and copied at the public reference facilities maintained by the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549, and at the Commission's Regional Offices at Seven World Trade Center, 13th Floor, New York, New York 10048 and Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661-2511. Copies of such material may be obtained by mail from the Public Reference Section of the Commission at 450 West Fifth Street, N.W., Washington, D.C. 20549, at prescribed rates. The Commission also maintains a Web Site at http://www.sec.gov which contains reports, proxy statements, registration statements and other information regarding registrants that file electronically with the Commission. STAR's Common Stock is listed on the Nasdaq National Market under the symbol "STRX." UDN's Common Stock is listed on the Vancouver Stock Exchange under the symbol "UDN.V." Reports, proxy statements and other information filed by STAR may be inspected at the offices of the Nasdaq National Market, Reports Section, 1735 K Street, Washington, D.C. 20006. Reports, proxy statements and other information filed by UDN may be inspected at the offices of the Vancouver Stock Exchange, 609 Granville Street, Vancouver, British Columbia, Canada V7Y 1H1. After consummation of the Merger, UDN will no longer be required to file reports, proxy statements or other information with the Vancouver Stock Exchange. STAR has filed with the Commission the Registration Statement with respect to the STAR Common Stock to be issued pursuant to the Merger Agreement, of which this Proxy Statement/Prospectus constitutes a part. The information contained herein with respect to STAR and its affiliates has been provided by STAR, and the information contained herein with respect to UDN and its affiliates has been provided by UDN. This Proxy Statement/Prospectus does not contain all of the information set forth in the Registration Statement and the exhibits thereto, certain items of which were omitted in accordance with the rules and regulations of the Commission. For further information, reference is hereby made to the Registration Statement. Any statements contained herein concerning the contents of any contract, agreement or other document referred to herein and filed as an exhibit to the Registration Statement or otherwise filed with the Commission are not necessarily complete. With respect to each such contract, agreement or other document filed with the Commission as an exhibit, reference is made to the exhibit for a more complete description of the matter involved, and each such statement is qualified in its entirety by such reference. NO PERSON IS AUTHORIZED BY STAR OR UDN TO GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION, OTHER THAN THOSE CONTAINED IN THIS PROXY STATEMENT/PROSPECTUS, IN CONNECTION WITH THE SOLICITATION AND THE OFFERING MADE BY THIS PROXY STATEMENT/PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS SHOULD NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED. THIS PROXY STATEMENT/PROSPECTUS DOES NOT CONSTITUTE THE SOLICITATION OF A PROXY OR AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO PURCHASE, ANY SECURITIES IN ANY JURISDICTION IN WHICH SUCH SOLICITATION OR OFFERING MAY NOT LAWFULLY BE MADE. NEITHER THE DELIVERY OF THIS PROXY STATEMENT/PROSPECTUS NOR ANY DISTRIBUTION OF SECURITIES MADE HEREUNDER SHALL IMPLY THAT THERE HAS BEEN NO CHANGE IN THE INFORMATION SET FORTH HEREIN OR IN THE AFFAIRS OF STAR OR UDN SINCE THE DATE HEREOF. ------------------------ THIS PROXY STATEMENT/PROSPECTUS CONTAINS CERTAIN "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, 5 AS AMENDED. FORWARD-LOOKING STATEMENTS ARE STATEMENTS OTHER THAN HISTORICAL INFORMATION OR STATEMENTS OF CURRENT CONDITION. SOME FORWARD-LOOKING STATEMENTS MAY BE IDENTIFIED BY USE OF SUCH TERMS AS "EXPECTS," "ANTICIPATES," "INTENDS," "ESTIMATES," "BELIEVES" AND WORDS OF SIMILAR IMPORT. THESE FORWARD-LOOKING STATEMENTS RELATE TO PLANS, OBJECTIVES AND EXPECTATIONS FOR FUTURE OPERATIONS. IN LIGHT OF THE RISKS AND UNCERTAINTIES INHERENT IN ALL SUCH PROJECTED OPERATION MATTERS, THE INCLUSION OF FORWARD-LOOKING STATEMENTS IN THIS PROXY STATEMENT/PROSPECTUS SHOULD NOT BE REGARDED AS A REPRESENTATION BY STAR, UDN OR ANY OTHER PERSON THAT THE OBJECTIVES OR PLANS OF STAR OR UDN WILL BE ACHIEVED OR THAT ANY OF STAR'S OR UDN'S OPERATING EXPECTATIONS WILL BE REALIZED. REVENUES AND RESULTS OF OPERATIONS ARE DIFFICULT TO FORECAST AND COULD DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS CONTAINED IN THIS PROXY STATEMENT/PROSPECTUS. FORWARD-LOOKING STATEMENTS MAY BE DEEMED TO INCLUDE THOSE SET FORTH IN "SUMMARY," REGARDING STAR'S INTRODUCTION INTO SERVICE OF VARIOUS INTERNATIONAL GATEWAY SWITCHES, COMMITMENTS TO ACQUIRE UNDERSEA CABLES AND VARIOUS ASPECTS OF STAR'S STRATEGY. SUCH FORWARD-LOOKING STATEMENTS MAY BE DEEMED TO INCLUDE STATEMENTS IN "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION OF STAR," REGARDING STAR'S STRATEGY TO LOWER ITS COST OF SERVICES AND IMPROVE ITS GROSS MARGIN AND ITS BELIEF THAT PRICE DECLINES MAY BE OFFSET IN PART BY INCREASED CALLING VOLUMES AND DECREASED COSTS AND ITS BELIEF IN THE SUFFICIENCY OF CAPITAL RESOURCES. FORWARD-LOOKING STATEMENTS IN "BUSINESS OF STAR" MAY BE DEEMED TO INCLUDE PROJECTED GROWTH IN INTERNATIONAL TELECOMMUNICATIONS TRAFFIC, STAR'S STRATEGY OF MARKETING ITS SERVICES TO FOREIGN-BASED LONG DISTANCE PROVIDERS, EXPANDING ITS U.S. AND DEVELOPING EUROPEAN AND ASIAN SWITCHING CAPABILITIES, EXPANDING INTO COMMERCIAL MARKETS AND PURSUING ACQUISITIONS. ACTUAL RESULTS COULD DIFFER FROM THOSE PROJECTED IN ANY FORWARD-LOOKING STATEMENTS FOR THE REASONS DETAILED IN THE "RISK FACTORS" SECTION OF THIS PROXY STATEMENT/ PROSPECTUS, BEGINNING ON PAGE 22, OR ELSEWHERE IN THIS PROXY STATEMENT/ PROSPECTUS. NEITHER STAR NOR UDN UNDERTAKES ANY OBLIGATION TO RELEASE PUBLICLY THE RESULTS OF ANY FUTURE REVISIONS IT MAY MAKE TO ANY OF ITS FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF, TO REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS OR TO REFLECT ANY CHANGE IN STAR'S OPERATING STRATEGY. 6 SUMMARY THIS SUMMARY HIGHLIGHTS SELECTED INFORMATION FROM THIS PROXY STATEMENT/PROSPECTUS AND MAY NOT CONTAIN ALL OF THE INFORMATION THAT IS IMPORTANT TO YOU. TO UNDERSTAND THE MERGER FULLY AND FOR A MORE COMPLETE DESCRIPTION OF THE LEGAL TERMS OF THE MERGER, STOCKHOLDERS SHOULD READ CAREFULLY THIS ENTIRE DOCUMENT, INCLUDING THE ANNEXES. SEE "AVAILABLE INFORMATION." UDN'S STOCKHOLDERS SHOULD ALSO CAREFULLY CONSIDER THE INFORMATION SET FORTH BELOW IN "RISK FACTORS." UNLESS OTHERWISE INDICATED, THE INFORMATION IN THIS PROXY STATEMENT/ PROSPECTUS GIVES EFFECT TO A 2.05-FOR-1 STOCK SPLIT PAID ON MARCH 31, 1998 IN THE FORM OF A STOCK DIVIDEND TO THE HOLDERS OF ALL SHARES OF STAR COMMON STOCK OUTSTANDING ON FEBRUARY 20, 1998 WITH THE PAYMENT OF 1.05 SHARES FOR EACH SUCH OUTSTANDING SHARE OF STAR COMMON STOCK (THE "STOCK SPLIT"). REFERENCES TO A FISCAL YEAR REFER TO THE FISCAL YEAR BEGINNING IN THAT YEAR (E.G., THE FISCAL YEAR BEGINNING MAY 1, 1996 AND ENDING APRIL 30, 1997 IS REFERRED TO HEREIN AS "FISCAL 1996"). ALL REFERENCES TO DOLLAR AMOUNTS ARE SET FORTH IN U.S. DOLLARS, UNLESS OTHERWISE NOTED. THE COMPANIES STAR AND NEWCO STAR Telecommunications, Inc. ("STAR") is an emerging multinational carrier focused primarily on the international long distance market. STAR offers highly reliable, low cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 foreign countries through a flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with long distance providers. STAR has grown its revenues rapidly by capitalizing on the deregulation of international telecommunications markets, combining sophisticated information systems with flexible routing and leveraging management's industry expertise. STAR has increased its revenues from $46.3 million in 1995 to $376.2 million in 1997. STAR serves the large and growing international long distance telecommunications market. According to industry sources, worldwide gross revenues in this market were over $60 billion in 1996 and the volume of international traffic on the public telephone network is expected to grow at a compound annual growth rate of approximately 13% from 1996 through the year 2000. STAR markets its services to large global carriers seeking lower rates and high quality overflow capacity, as well as to small and medium-sized long distance companies that do not have the critical mass to invest in their own international transmission facilities or to obtain volume discounts from the larger facilities-based carriers. During the fourth quarter of 1997, STAR provided switched international long distance services to 105 customers and currently provides these services to nine of the top forty global carriers. STAR has also recently focused on building a customer base overseas, particularly in Europe, and has opened offices in Dusseldorf, Frankfurt, Hamburg and Munich, Germany and London, England. In addition, STAR has begun to market its international long distance services directly to certain commercial customers in the U.S. and overseas. STAR currently operates international gateway switching facilities in New York, Los Angeles, Dallas and London, England. In 1998, STAR plans to put into service switches in Atlanta, Chicago, Miami and Seattle; Dusseldorf, Frankfurt, Hamburg and Munich, Germany; Paris, France; and Tokyo, Japan. STAR's switching facilities are linked to a proprietary reporting system, which STAR believes provides it with a competitive advantage by permitting management on a real-time basis to determine the most cost-effective termination alternatives, monitor customer usage and manage gross margins by route. STAR holds ownership positions in a number of digital undersea fiber optic cables, has recently added capacity on the TPC-5 undersea fiber optic cable system and has entered into commitments to acquire transmission capacity on three additional undersea fiber optic cable systems, Gemini, AC-1 and China-US. 7 STAR was incorporated in Nevada in September 1993 as STAR Vending, Inc. and was reincorporated in Delaware as STAR Telecommunications, Inc. in April 1997. IIWII Corp. ("Newco"), which is a wholly-owned subsidiary of STAR, was incorporated in Delaware on July 15, 1997 for the purpose of effecting the Merger. Newco has no material assets and has not engaged in any activities except in connection with such proposed Merger. STAR's and Newco's executive offices are located at 223 East De La Guerra Street, Santa Barbara, California 93101. Its telephone number at that location is (805) 899-1962. UDN United Digital Network, Inc. ("UDN") is a provider of voice and data long distance services, travelcard services, international long distance, prepaid calling cards and various other telecommunication services to residential, small to medium-sized commercial customers, switchless resellers, agents and wholesale purchasers. The principal market for its long distance services is the central and southwest United States. UDN operates primarily through its wholly-owned subsidiaries, Advanced Management Services, Inc., CTN-Custom Telecommunications Network of Arizona, Inc. and United Digital Network of Texas, Inc. UDN offers an array of services designed to afford its customers an integrated telecommunications solution to their telecommunications needs. UDN was incorporated in Canada under the British Columbia Company Act on June 2, 1980, reincorporated in 1995 as a Wyoming corporation and subsequently merged into a wholly-owned Delaware subsidiary and accordingly now exists as a Delaware corporation. Since its entry into the telecommunications business in 1992, UDN's long distance revenues have grown from $13,000 in 1992 to approximately $24 million for the fiscal year ended April 30, 1997. UDN's growth has resulted from a two-pronged growth strategy. First, a plan of acquiring selected types of long distance companies has produced four major acquisitions that have been integrated into UDN's operations. Second, a direct sales force, complemented by a growing agent network, has produced significant internal growth during the last two years. From fiscal year ended April 30, 1995 through December 31, 1997, UDN's customer base increased from approximately 2,000 to over 22,000 customers nationwide. UDN has focused on retention of its customer base, exploration of opportunities for expanding its product lines and continuing to search for additional strategic acquisitions. UDN's executive offices are located at 18872 MacArthur Blvd., Suite 300, Irvine CA, 92612. Its telephone number at that location is (714) 833-8050. THE SPECIAL MEETING PURPOSE At the Special Meeting, UDN's stockholders will be asked to approve and adopt the Merger Agreement and the transactions contemplated thereby and to transact any other business that properly may come before the meeting or any adjournments or postponements thereof. TIME, PLACE AND DATE The Special Meeting will be held at McCarthy Tetrault, Main Board Room, 13th Floor, 777 Dunsmuir Street, Vancouver, B.C., Canada, on June 30, 1998, at 10:00 a.m. local time. RECORD DATE; QUORUM; VOTES REQUIRED Holders of shares of UDN Common Stock as of the close of business on May 26, 1998, which has been set as the "Record Date," will be entitled to vote at the Special Meeting. As of the close of business on the 8 Record Date, 7,054,844 shares of UDN Common Stock were outstanding and entitled to vote. The presence, in person or by proxy, of holders of record of a majority of the issued and outstanding shares of UDN Common Stock is necessary to constitute a quorum for the transaction of business at the Special Meeting. Approval of the Merger Agreement and the transactions contemplated thereby will require the affirmative vote of the holders of record of a majority of all outstanding shares of UDN Common Stock. See "The Special Meeting." VOTING OF PROXIES The Proxy accompanying this Proxy Statement/Prospectus is solicited on behalf of UDN's Board of Directors for use at the Special Meeting. UDN's stockholders are requested to complete, date and sign the accompanying Proxy and promptly return it in the enclosed envelope (which requires no postage if mailed in the United States) to UDN's transfer agent. All properly executed Proxies received by UDN's transfer agent prior to the vote at the Special Meeting that are not revoked will be voted in accordance with the instructions indicated on the Proxies or, if no direction is indicated, to approve and adopt the Merger Agreement. A Proxy may be revoked at any time before its exercise by filing with Janine Thomas, the Secretary of UDN, at 18872 MacArthur Blvd. #300, Irvine, California 92612, an instrument of revocation or a duly executed proxy bearing a later date, or by attendance at the Special Meeting and electing to vote in person. Attendance at the Special Meeting will not in and of itself constitute revocation of a Proxy. John Snedegar, President of UDN, has entered into a Proxy Agreement with STAR pursuant to which Mr. Snedegar granted STAR a proxy to vote his outstanding shares of UDN Common Stock in favor of the Merger. Mr. Snedegar beneficially owns 11.8% of the outstanding shares of UDN Common Stock. SOLICITATION OF PROXIES AND EXPENSES UDN will bear the cost of the solicitation of Proxies from its stockholders. D.F. King & Co., Inc. has been selected to act as the Proxy solicitor. In addition to solicitation by mail, the directors, officers and employees of UDN may solicit Proxies from UDN's stockholders by telephone, telegram, letter or in person. UDN will request brokers, custodians, nominees and other record holders to forward copies of this Proxy Statement/Prospectus, Proxies and other soliciting materials to persons for whom they hold shares of UDN Common Stock and to request authority for the exercise of Proxies. In such cases, UDN, upon request of the record holders, will reimburse such holders for their reasonable expenses. THE MERGER REASONS FOR THE MERGER Each of the Board of Directors and the Special Committee (the "Special Committee") of UDN and the Board of Directors of STAR have unanimously approved the terms of the Merger for several reasons. By joining the operations of STAR and UDN, the Merger will create for STAR a network of independent sales agents targeted at residential and small to medium-sized commercial customers with a demand for international calling services at competitive rates. The Merger provides UDN with a large, well-capitalized parent with a developing, switch-based network. No assurances can be made, however, that the Merger will be successful for STAR or UDN. In reaching a decision to recommend the Merger, each of the UDN and STAR Boards of Directors and the UDN Special Committee considered a number of factors in addition to those set forth above. See "The Merger--UDN's Reasons for the Merger; Recommendations of the UDN Board and Special Committee" and "--STAR's Reasons for the Merger." RECOMMENDATIONS TO UDN STOCKHOLDERS THE UDN BOARD OF DIRECTORS (THE "UDN BOARD") AND THE UDN SPECIAL COMMITTEE BELIEVE THAT THE MERGER IS FAIR AND IN THE BEST INTERESTS OF UDN 9 AND ITS STOCKHOLDERS AND UNANIMOUSLY RECOMMEND THAT UDN STOCKHOLDERS VOTE FOR THE PROPOSAL TO APPROVE AND ADOPT THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY. SEE "THE MERGER--UDN'S REASONS FOR THE MERGER; RECOMMENDATIONS OF THE UDN BOARD AND SPECIAL COMMITTEE." OWNERSHIP OF STAR AFTER THE MERGER Based on an Exchange Ratio of 0.086772, STAR anticipates issuing 636,025 shares of STAR Common Stock to UDN stockholders in the Merger, which will constitute approximately 1.5% (on a fully diluted basis) of the outstanding STAR Common Stock after the Merger. The actual amounts will be based on the numbers of outstanding shares of both companies and the Exchange Ratio at the time of the Merger. See "The Merger--The Merger Agreement." MANAGEMENT AND OPERATIONS FOLLOWING THE MERGER It is contemplated that after the Merger, UDN will continue to operate as a separate entity. STAR does not presently intend to change the domicile, name or material operations of UDN, other than to provide certain billing services to UDN pursuant to a Management Services Agreement (as defined) to be entered into between the parties. STAR has advised UDN, however, that Christopher E. Edgecomb, Mary A. Casey and Kelly D. Enos will be named as the Directors of UDN. STAR currently intends that the existing officers of UDN will retain their offices after the Effective Time, but may appoint additional officers of UDN from time to time. See "Management of STAR and UDN--Officers and Directors of UDN." OTHER INTERESTS OF OFFICERS AND DIRECTORS IN THE MERGER In considering the UDN Board's recommendation that UDN stockholders vote in favor of the Merger Agreement and the transactions contemplated thereby, UDN stockholders should be aware that John Snedegar, President of UDN, and Dale Christensen, Chief Operating Officer and Chief Financial Officer of UDN, have employment agreements that provide them with bonuses and severance benefits which would take effect if Mr. Snedegar or Mr. Christensen exercises his right to terminate his employment agreement upon consummation of the Merger. See "Management of STAR and UDN--UDN Employment Agreements." In addition, Christopher E. Edgecomb, Chief Executive Officer of STAR, owns 136,000 shares of UDN Common Stock, David Vaun Crumly, Executive Vice President--Sales and Marketing of STAR, owns 2,500 shares of UDN Common Stock and holds options to purchase 18,750 shares of UDN Common Stock and John Snedegar, President of UDN, owns 30,750 shares of STAR Common Stock and options to acquire 10,250 shares of STAR Common Stock. Mr. Snedegar is a Director of both STAR and UDN. See "The Merger--Interests of Certain Persons in the Merger." OPINIONS OF FINANCIAL ADVISOR In deciding to approve the Merger, the UDN Board and UDN Special Committee conditioned their approval on the receipt of the opinion of their financial advisor, Madison Securities, Inc. ("Madison Securities"), as to the fairness of the Exchange Ratio to the stockholders of UDN from a financial point of view. This opinion is attached to this Proxy Statement/Prospectus as ANNEX B. Stockholders of UDN are encouraged to read this opinion in its entirety as it contains the assumptions made, the procedures followed, the other matters considered and the limits of the review conducted by Madison Securities in arriving at its opinion. For purposes of delivering this opinion, Madison Securities performed a variety of analyses, including comparing the historical stock prices and financial multiples of UDN and STAR to each other and to those of other selected public companies, comparing the financial terms of the Merger to those of other publicly 10 announced transactions and analyzing the relative values and contributions of UDN and STAR based upon historical and projected future financial performance and anticipated benefits of the Merger as provided by the management of UDN and STAR. See "The Merger--Opinion of Madison Securities, Financial Advisor to UDN." CERTAIN INCOME TAX CONSEQUENCES The Merger has been structured so that, in general, none of UDN, STAR or their respective stockholders will recognize any gain or loss for U.S. federal incomes tax purposes in the Merger (except for any cash received by UDN stockholders in lieu of fractional shares and stockholders exercising dissenters' rights); provided STAR and UDN comply with certain representations and warranties. Stockholders of UDN and dissenting stockholders of UDN who are residents in or citizens of Canada or another foreign jurisdiction may, as a result of the Merger (or the exercise of appraisal rights in respect of the Merger) realize or be required to realize a gain or loss on the exchange of shares under the Merger (or upon the exercise of, or any payment being made in connection with, appraisal rights) or experience other tax consequences. See "Certain Income Tax Consequences." ACCOUNTING TREATMENT Consummation of the Merger is conditioned upon receipt of a letter from UDN's independent public accountants stating that UDN will qualify as a poolable entity and the receipt of a letter from STAR's independent public accountants stating that the Merger will qualify as a pooling of interests, which means that STAR will restate its historical consolidated financial statements to include the assets, liabilities, stockholders' equity and results of operations of UDN. See "The Merger--Accounting Treatment of the Merger." APPRAISAL RIGHTS OF UDN STOCKHOLDERS Under Delaware law, holders of UDN Common Stock who have not voted in favor of the Merger Agreement and who have fully complied with the applicable provisions of Delaware Law have the right to require UDN to purchase for cash their shares at the fair market value thereof (as determined by agreement with UDN or by a court) in lieu of shares of STAR Common Stock that they would otherwise receive in the Merger. Such stockholders exercising such rights ("Dissenting Stockholders") must (i) abstain from voting or vote such shares against the Merger Agreement, and (ii) deliver to UDN, prior to the taking of the vote on the Merger Agreement, written notice of such Dissenting Stockholders' intent to demand payment for such shares. Dissenting Stockholders must also comply with the other requirements of Section 262 of the Delaware Law, the full text of which is attached to this Proxy Statement/ Prospectus as ANNEX C. Any deviation from or failure to comply with all such requirements may result in the forfeiture of the appraisal rights of Dissenting Stockholders. See "Appraisal Rights of Stockholders." THE MERGER AGREEMENT A COPY OF THE MERGER AGREEMENT IS ATTACHED AS ANNEX A TO THIS PROXY STATEMENT/PROSPECTUS. UDN'S STOCKHOLDERS ARE STRONGLY ENCOURAGED TO READ THE MERGER AGREEMENT AS IT IS THE LEGAL DOCUMENT THAT GOVERNS THE MERGER AND THE TRANSACTIONS CONTEMPLATED THEREBY. THE DISCUSSION OF THE MERGER AGREEMENT IS QUALIFIED IN ITS ENTIRETY BY THE FULL TEXT THEREOF, ATTACHED HERETO AS ANNEX A. TERMS OF THE MERGER AGREEMENT The Merger Agreement provides that, following the approval and adoption of the Merger Agreement and the transactions contemplated thereby by the stockholders of UDN and the satisfaction or waiver of certain other conditions, Newco will be merged with and into UDN. As a result, UDN will become a wholly-owned subsidiary of STAR after the Merger. The Merger will become effective when a certificate of 11 merger is accepted for filing by the Secretary of State of the State of Delaware. See "The Merger--The Merger Agreement." MERGER CONSIDERATION As a result of the Merger, UDN's stockholders will receive for each share of UDN Common Stock a portion of a share (the "Exchange Ratio") of STAR Common Stock determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price, which will result in an Exchange Ratio of 0.074545. As of May 27, 1998, the Exchange Ratio was 0.086772 share of STAR Common Stock for each share of UDN Common Stock. No fractional shares will be issued. Instead, UDN stockholders will receive cash in lieu of any fractional shares of the STAR Common Stock. See "The Merger--The Merger Agreement" and "--The Merger Agreement--Fractional Shares." A VOTE TO APPROVE AND ADOPT THE MERGER AGREEMENT BY UDN'S STOCKHOLDERS WILL BE DEEMED APPROVAL OF THE EXCHANGE RATIO. UDN STOCKHOLDERS SHOULD NOT SEND IN THEIR STOCK CERTIFICATES UNTIL INSTRUCTED TO DO SO AFTER THE MERGER IS FINAL. ASSUMPTION OF UDN STOCK OPTIONS AND WARRANTS At or prior to the Effective Time, STAR and UDN shall take all action necessary to cause the assumption by STAR as of the Effective Time of the options and warrants to purchase UDN Common Stock outstanding as of the Effective Time (the "UDN Options" and "UDN Warrants," respectively). Each of the UDN Options and UDN Warrants shall be converted without any action on the part of the holder thereof into an option or warrant to purchase a certain number of shares of STAR Common Stock (based on the Exchange Ratio) on substantially equivalent terms as of the Effective Time. As of the Record Date, 469,375 shares of UDN Common Stock were subject to outstanding UDN Options and 302,259 shares of UDN Common Stock were subject to outstanding UDN Warrants. In addition, UDN carries $1,050,000 in convertible debentures, of which $550,000 will be converted into 275,000 shares of UDN Common Stock upon consummation of the Merger. See "The Merger--The Merger Agreement--Treatment of UDN Stock Options and Warrants." CONDITIONS TO THE MERGER Completion of the Merger depends upon the satisfaction of a number of conditions, including, but not limited to, the following: (a) the Registration Statement shall have been declared effective by the Commission; (b) the approval and adoption of the Merger Agreement and the transactions contemplated thereby by the requisite vote of the holders of the outstanding shares of UDN Common Stock entitled to vote thereon at the Special Meeting; (c) the approval for listing on the Nasdaq National Market of the STAR Common Stock issuable to the stockholders of UDN pursuant to the Merger Agreement; (d) the approval of governmental authorities, including the Federal Communications Commission (the "FCC") and state public utility commissions ("PUCs"), required for the transfer of ownership or control of UDN; (e) the receipt by UDN of the opinion of Madison Securities that the Exchange Ratio contemplated by the Merger Agreement is fair, from a financial point of view, to the UDN stockholders; 12 (f) not more than 5% of the outstanding shares of UDN Common Stock exercising appraisal rights; and (g) the receipt by STAR of letters from Arthur Andersen LLP approving the accounting treatment of the Merger as a "pooling of interests" and from Price Waterhouse LLP that UDN is a poolable entity, and the SEC shall not have objected to such accounting treatment. Certain conditions to the Merger may be waived by the party entitled to assert the condition. See "The Merger--The Merger Agreement--Conditions." REGULATORY APPROVALS The Merger is subject to the requirements of the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the rules and regulations promulgated thereunder (the "HSR Act"). The HSR Act prohibits consummation of the Merger until certain information has been furnished to the Antitrust Division of the Department of Justice and to the Federal Trade Commission and a required waiting period has expired. The Department of Justice or the Federal Trade Commission may still challenge the Merger on antitrust grounds before or after the Merger is final. Consummation of the Merger is contingent upon the receipt of approvals from the FCC, various PUCs and various municipalities with respect to the Merger. STAR and UDN have previously made the necessary filings with these government agencies. See "The Merger--Regulatory Approvals." NEGOTIATIONS Pursuant to the Merger Agreement, and subject to certain conditions and exceptions, UDN has agreed not to, directly and indirectly, solicit, initiate or participate in discussions or negotiations with or the submission of any offer or proposal by or provide any information to, any corporation, partnership, person or other entity or group (other than STAR or Newco) concerning a proposal to acquire (by means of a tender or exchange offer, merger, consolidation, business combination or otherwise) all or a substantial portion of the outstanding shares of UDN Common Stock or the assets of UDN and its subsidiaries. UDN, however, may take certain actions with respect to the above-described transactions where doing so is necessary for the UDN Board to comply with its fiduciary responsibilities under applicable laws as advised by counsel in writing. See "The Merger--Negotiations." TERMINATION OF THE MERGER AGREEMENT UDN and STAR may agree, by mutual written consent, to terminate the Merger Agreement without completing the Merger. Moreover, either UDN or STAR may terminate the Merger Agreement if, among other things, any of the following occurs: (a) the UDN Board of Directors fails to recommend, withdraws, modifies or amends its approval or recommendation of the Merger and the transactions contemplated by the Merger Agreement; (b) the requisite approval of the UDN stockholders is not received; (c) the other party breaches any of its representations and warranties or fails to perform any of its covenants and agreements, which breaches and failures are, in the aggregate, material in the context of the transactions contemplated by the Merger Agreement; or (d) the Merger is not completed on or before July 15, 1998; provided that if such failure is the result of an injunction or order of a court or governmental or regulatory body resulting from an action or proceeding commenced by any party which is not a governmental authority, then at the request of either party, the deadline date shall be extended for a reasonable period of time, not in excess of 120 days, to permit the parties to have such injunction vacated or order reversed. 13 TERMINATION FEES The Merger Agreement requires UDN to pay to STAR a termination fee of $2.0 million if the Merger Agreement terminates for certain reasons. See "The Merger--The Merger Agreement--Termination Fee." OTHER AGREEMENTS In connection with the execution of the Merger Agreement on November 19, 1997 and the first amendment thereto on January 30, 1998, STAR loaned $2.5 million and $2.0 million to UDN, respectively. Pursuant to separate promissory notes executed by UDN in favor of STAR, interest on the outstanding principal amount of the notes will be repaid quarterly, plus interest at the "Prime Rate" per annum (as reported in the WALL STREET JOURNAL) plus 1%, which rate shall be reset quarterly. Upon execution of the Merger Agreement, John R. Snedegar, President of UDN, executed a Proxy Agreement granting STAR an irrevocable proxy to vote all shares of UDN Common Stock held, beneficially or of record, by Mr. Snedegar in favor of the Merger and in opposition of any other proposal for any merger, reorganization, recapitalization, sale of assets or stock of UDN or any of its subsidiaries. As of May 18, 1998, Mr. Snedegar held 831,647 shares, or approximately 11.8%, of the outstanding UDN Common Stock. STAR and UDN have agreed to use their reasonable efforts to enter into a billing outsourcing agreement (the "Management Services Agreement"), which will provide, among other things, for the management by STAR of UDN's customer billings on terms at least as favorable as the terms of UDN's present outsourcing agreement. OTHER CONSIDERATIONS COMPARATIVE RIGHTS OF STOCKHOLDERS OF UDN AND STAR The rights of UDN stockholders are currently governed by Delaware law, UDN's Certificate of Incorporation and UDN's Bylaws. After the Merger, UDN stockholders will become STAR stockholders and their rights will be governed by Delaware law, STAR's Certificate of Incorporation and STAR's Bylaws. There are various differences between the existing rights of UDN stockholders and the rights of STAR stockholders, including, among others, certain provisions of STAR's Certificate of Incorporation that may have the effect of deterring or making it more difficult for a third party to acquire control of STAR. See "Comparative Rights of Stockholders." STOCK EXCHANGE LISTING STAR intends to apply to have the shares of STAR Common Stock to be issued in the Merger listed on the Nasdaq National Market. The listing on the Nasdaq National Market of the STAR Common Stock issuable in the Merger is a condition to UDN's obligation to consummate the Merger. See "The Merger-- Stock Exchange Listing." COMPARATIVE STOCK PRICES Shares of STAR Common Stock are listed on the Nasdaq National Market and shares of UDN Common Stock are listed on the Vancouver Stock Exchange. On November 18, 1997, the last full trading day prior to the public announcement of the proposed Merger, UDN Common Stock closed at $2.15 per share, and STAR Common Stock closed at $15.183 per share. On March 31, 1998, STAR effected a 2.05-for-1 stock split in the form of a stock dividend to the holders of all shares of STAR Common Stock outstanding as of February 20, 1998 with the payment of 1.05 shares for each such outstanding share of STAR Common Stock. On May 27, 1998, the last full trading day prior to the date of this Proxy Statement/ Prospectus, UDN Common Stock closed at $1.625 per share, and STAR Common Stock closed at $23.625 per share. STAR has never paid cash dividends on the STAR Common Stock and does not intend to pay such dividends in the foreseeable future. In addition, STAR is restricted by its revolving credit facility from 14 paying cash dividends without the lender's consent. UDN has never paid dividends on the UDN Common Stock and does not intend to pay dividends prior to consummation of the Merger. See "The Merger-- Comparative Stock Prices." RESALE RESTRICTIONS At or prior to the Effective Time, the STAR Common Stock issuable in connection with the Merger shall have been registered under the Securities Act. Accordingly, all shares of STAR Common Stock received by UDN stockholders in the Merger will be freely transferable in the U.S., except that the stockholders deemed "affiliates" of UDN at the time the Merger becomes final are subject to certain regulatory restrictions and restrictions relating to the publication of the combined operating results of STAR and UDN under the Merger Agreement regarding the resale of their shares of STAR Common Stock. For the UDN stockholders resident in jurisdictions other than the U.S., the free transferability of the STAR Common Stock may vary dependent on the laws of that jurisdiction and, accordingly, each stockholder of UDN Common Stock so affected should consult their legal or other advisors. See "The Merger--Resale of Shares of STAR Common Stock Issued in the Merger; Affiliates." RISK FACTORS The information set forth under "Risk Factors" should be reviewed and carefully considered by the stockholders of UDN in evaluating the Merger Agreement. 15 SELECTED CONSOLIDATED FINANCIAL DATA OF STAR TELECOMMUNICATIONS, INC. The following selected consolidated financial data should be read in conjunction with STAR's Consolidated Financial Statements and Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR," each of which is included elsewhere in this Proxy Statement/Prospectus. The consolidated statements of operations data for the years ended December 31, 1995, 1996 and 1997, and the balance sheet data at December 31, 1996 and 1997 are derived from audited financial statements included elsewhere in this Proxy Statement/Prospectus. The consolidated statement of operations data for the year ended December 31, 1994 and the consolidated balance sheet data at December 31, 1994 are unaudited and are derived from unaudited financial statements not included in this Proxy Statement/Prospectus. The consolidated balance sheet data at December 31, 1995 is derived from audited financial statements not included in this Proxy Statement/Prospectus. Although incorporated in 1993, STAR did not commence business until 1994.
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, ----------------------------------------------------- ---------------------- 1994 1995 1996 1997 1997 1998 ----------- ------- -------- -------- -------- -------- (UNAUDITED) (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AND PER MINUTE DATA) CONSOLIDATED STATEMENTS OF OPERATIONS DATA(1): Revenues.............................. $20,915 $46,283 $237,991 $376,198 $ 84,827 $129,269 Cost of services...................... 12,775 31,897 205,585 325,237 73,726 111,593 ----------- ------- -------- -------- -------- -------- Gross profit........................ 8,140 14,386 32,406 50,961 11,101 17,676 Operating expenses: Selling, general and administrative.................... 4,782 10,086 34,331 35,381 7,720 11,561 Depreciation and amortization....... 30 186 1,151 4,245 820 1,879 Merger expense...................... -- -- -- 286 -- 314 ----------- ------- -------- -------- -------- -------- Total operating expenses............ 4,812 10,272 35,482 39,912 8,540 13,754 ----------- ------- -------- -------- -------- -------- Income (loss) from operations....... 3,328 4,114 (3,076) 11,049 2,561 3,922 Other income (expense): Interest income..................... 3 22 110 492 21 283 Interest expense.................... -- (64) (601) (1,633) (398) (618) Legal settlements and expenses...... -- -- (100) (1,653) -- -- Other............................... (7) (33) 39 208 51 (160) ----------- ------- -------- -------- -------- -------- Income (loss) before provision for income taxes...................... 3,324 4,039 (3,628) 8,463 2,235 3,427 Provision for income taxes............ 1 66 592 2,895 341 1,534 ----------- ------- -------- -------- -------- -------- Net income (loss)..................... $ 3,323 $ 3,973 $ (4,220) $ 5,568 $ 1,894 $ 1,893 ----------- ------- -------- -------- -------- -------- ----------- ------- -------- -------- -------- -------- Pro forma net income (loss) (unaudited)(2)...................... $ 1,994 $ 2,407 $ (5,163) $ 5,373 $ 1,347 ----------- ------- -------- -------- -------- ----------- ------- -------- -------- -------- Diluted income per share.............. $ 0.05 -------- -------- Pro forma diluted income (loss) per share (unaudited)(3)................ $ 0.12 $ 0.13 $ (0.24) $ 0.17 $ 0.05 ----------- ------- -------- -------- -------- ----------- ------- -------- -------- -------- Weighted average number of diluted common shares outstanding(3)........ 16,865 18,020 21,939 31,625 28,494 37,714
16
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, ----------------------------------------------------- ---------------------- 1994 1995 1996 1997 1997 1998 ----------- ------- -------- -------- -------- -------- (UNAUDITED) (UNAUDITED) (IN THOUSANDS, EXCEPT PER SHARE AND PER MINUTE DATA) OTHER CONSOLIDATED FINANCIAL AND OPERATING DATA(1): EBITDA(4)............................. $ 3,351 $ 4,267 $ (1,986) $ 13,849 $ 3,432 $ 5,641 Capital expenditures(5)............... 57 2,175 13,018 24,732 3,237 33,734 Wholesale billed minutes of use....... -- 38,106 479,681 863,295 187,349 324,439 Wholesale revenue per billed minute of use(6).............................. $-- $0.4102 $ 0.4288 $ 0.3997 $ 0.4036 $ 0.3701
DECEMBER 31, MARCH 31, --------------------------------------------- ----------- 1994 1995 1996 1997 1998 ----------- --------- --------- ---------- ----------- (UNAUDITED) (IN THOUSANDS) (UNAUDITED) CONSOLIDATED BALANCE SHEET DATA(1): Working capital (deficit)............................ $ 2,007 $ 1,222 $ (6,342) $ 15,846 $ 8,342 Total assets......................................... 5,105 18,316 54,000 113,553 144,312 Total long-term liabilities, net of current portion.. -- 904 5,870 12,271 26,280 Retained earnings (deficit).......................... 1,839 1,596 (5,968) (1,397) (607) Stockholders' equity................................. 2,197 3,047 7,911 44,014 50,727
- ------------------------ (1) Does not reflect the acquisition of UDN, which remains subject to the approval of UDN's stockholders and to various regulatory approvals. (2) The pro forma net income or loss per share assumes that both STAR and LD Services, Inc. ("LDS"), which was acquired by STAR on November 30, 1997, had been C-Corporations for all periods presented. (3) See Note 2 of Notes to STAR Consolidated Financial Statements for an explanation of the method used to determine the number of shares used in computing pro forma net income (loss) per share. (4) EBITDA represents earnings before interest income and expense, income taxes, depreciation and amortization expense. EBITDA does not represent cash flows as defined by generally accepted accounting principles and does not necessarily indicate that cash flows are sufficient to fund all of STAR's cash needs. EBITDA should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other measures of STAR's liquidity determined in accordance with generally accepted accounting principles. (5) Includes assets financed with capital leases or notes. See Note 2 of Notes to STAR Consolidated Financial Statements. (6) Represents wholesale gross call usage revenue per billed minute. Amounts exclude other revenue related items such as finance charges. 17 SELECTED CONSOLIDATED FINANCIAL DATA OF UNITED DIGITAL NETWORK, INC. The following selected consolidated financial data should be read in conjunction with UDN's Consolidated Financial Statements and Notes thereto and with "Management's Discussion and Analysis of Financial Condition and Results of Operations of UDN," which are included elsewhere in this Proxy Statement/Prospectus. The statement of income data for the years ended April 30, 1995, 1996 and 1997, and the balance sheet data at April 30, 1996 and 1997 are derived from audited financial statements included elsewhere in this Proxy Statement/Prospectus. The statement of operations data for the years ended April 30, 1993 and 1994 and the balance sheet data at April 30, 1993, 1994 and 1995 are derived from audited financial statements not included in this Proxy Statement/Prospectus. The data presented for the nine-month periods ended January 31, 1997 and 1998 are derived from unaudited financial statements and include, in the opinion of UDN's management, all adjustments necessary to present fairly the data for such periods. The results for an interim period are not necessarily indicative of the results to be expected for a full fiscal year.
NINE MONTHS ENDED YEAR ENDED APRIL 30, JANUARY 31, ----------------------------------------------------- -------------------- 1993 1994 1995 1996 1997 1997 1998 --------- --------- --------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT FOR PER SHARE AND PER MINUTE DATA) CONSOLIDATED STATEMENT OF INCOME DATA: Revenues................................. $ 2,495 $ 1,465 $ 2,338 $ 8,027 $ 24,012 $ 16,774 $ 23,941 Cost of revenues......................... 1,619 1,186 1,918 6,030 18,455 12,870 19,047 --------- --------- --------- --------- --------- --------- --------- Gross profit............................. 876 279 420 1,997 5,557 3,904 4,894 Operating expenses: Selling, general and administrative.... 962 1,278 1,941 2,675 5,155 3,458 6,345 Provision for doubtful accounts........ -- -- 75 229 693 245 3,055 Depreciation and amortization.......... 498 270 273 584 901 674 783 --------- --------- --------- --------- --------- --------- --------- Total operating expenses................. 1,460 1,548 2,289 3,488 6,749 4,377 10,183 --------- --------- --------- --------- --------- --------- --------- Loss from operations..................... (584) (1,269) (1,869) (1,491) (1,192) (473) (5,289) Other income (expense): Interest income........................ 1 1 2 43 28 20 26 Interest expense....................... (148) (110) (87) (150) (661) (447) (726) Other.................................. (719) (119) (64) (485) --------- --------- --------- --------- --------- --------- --------- Loss before income tax benefit, extraordinary gain and discontinued operations............................. (1,450) (1,378) (2,073) (1,662) (1,825) (900) (6,474) Income tax benefit, net of tax........... -- -- -- -- 50 23 -- Extraordinary gain on debt restructuring.......................... -- -- -- -- 97 45 -- Loss from discontinued operations........ -- (128) -- -- -- -- -- Net loss................................. $ (1,450) $ (1,506) $ (2,073) $ (1,662) $ (1,678) $ (832) $ (6,474) --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- --------- Net loss per share (basic and diluted)... $ (1.41) $ (.96) $ (0.92) $ (0.45) $ (0.31) $ (0.16) $ (0.99) Weighted average shares.................. 1,028 1,568 2,253 3,707 5,359 5,250 6,542
18
NINE MONTHS ENDED YEAR ENDED APRIL 30, JANUARY 31, ----------------------------------------------------- -------------------- 1993 1994 1995 1996 1997 1997 1998 --------- --------- --------- --------- --------- --------- --------- (IN THOUSANDS, EXCEPT FOR PER SHARE AND PER MINUTE DATA) OTHER CONSOLIDATED FINANCIAL AND OPERATING DATA: EBITDA................................... $ (805) $ (1,126) $ (1,713) $ (928) $ (166) $ (266) $ (4,965) Cash provided by (used in) operating activities............................. (348) (1,149) (1,819) (1,345) (3,324) 787 (1,248) Cash used in investing activities........ (1,368) (31) (239) (658) (948) (875) (353) Cash provided by (used in) financing activities............................. 1,660 (1,528) 2,063 2,956 3,755 (722) 2,008 Capital expenditures..................... 408 189 194 186 674 577 412
APRIL 30, ------------------------------- JANUARY 31, 1995 1996 1997 1998 --------- --------- --------- ----------- (IN THOUSANDS) (UNAUDITED) CONSOLIDATED BALANCE SHEET DATA: Cash................................................................ $ 121 $ 1,074 $ 556 $ 964 Working capital deficit............................................. (1,487) (2,041) (3,184) (10,297) Total assets........................................................ 4,522 10,587 13,196 13,844 Total long-term liabilities, net of current portion................. 653 2,061 1,995 493 Retained deficit.................................................... (5,498) (7,161) (8,839) (15,313) Total stockholders' equity (deficit)................................ 1,116 2,806 3,089 (2,627)
19 COMPARATIVE PER SHARE DATA The following table presents certain historical, pro forma and pro forma equivalent per share financial data for UDN Common Stock and STAR Common Stock. The pro forma data does not purport to be indicative of the results of future operations or the results that would have occurred had the Merger been consummated at the beginning of the periods presented. The information presented herein should be read in conjunction with the Unaudited Pro Forma Financial Data, including the notes thereto, appearing elsewhere in this Proxy Statement/Prospectus.
STAR UDN PRO FORMA HISTORICAL HISTORICAL COMBINED(1) ----------- ----------- ------------- EARNING (LOSS) PER DILUTED COMMON SHARE FOR: Year ended December 31, 1995................................................ $ 0.13 $ (0.92) $ 0.07 Year ended December 31, 1996................................................ $ (0.24) $ (0.45) $ (0.28) Year ended December 31, 1997................................................ $ 0.17 $ (0.31) $ 0.02 Three months ended March 31, 1998........................................... $ 0.05 $ (0.08) $ 0.04 BOOK VALUE PER COMMON SHARE AT: March 31, 1998.............................................................. $ 1.42 $ (0.39) $ 1.33
- ------------------------ (1) The pro forma combined earnings per common share are based on the combined weighted average number of common and common equivalent shares of UDN Common Stock and STAR Common Stock outstanding for each period and on the Exchange Ratio as of May 27, 1998. The pro forma combined book value per common share is based on the pro forma number of common shares outstanding at the end of the period. 20 SUMMARY UNAUDITED PRO FORMA FINANCIAL DATA The following table presents summary unaudited pro forma financial data that was derived from the unaudited pro forma financial data included elsewhere in this Proxy Statement/Prospectus and should be read in conjunction therewith and with the related notes thereto. The following summary unaudited pro forma financial data is presented assuming the Merger will be accounted for as a pooling of interests, whereby STAR will restate its historical consolidated financial statements to include the assets, liabilities, stockholders' equity (deficit) and results of operations of UDN. The statement of operations data set forth below reflects the combination of the historical operating results of STAR for the years ended December 31, 1995, 1996 and 1997 and the three months ended March 31, 1998 with the historical operating results of UDN for the 12 months ended January 31, 1996, 1997 and 1998 and the three months ended March 31, 1998. The balance sheet data set forth below reflects the combination of the historical balance sheet data of STAR and of UDN as of March 31, 1998. STAR reports its financial data on the basis of a December 31 fiscal year and UDN reports its financial data on the basis of an April 30 fiscal year.
YEARS ENDED DECEMBER 31, ------------------------------- THREE MONTHS ENDED 1995 1996 1997 MARCH 31, 1998 --------- --------- --------- ------------------- (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS) (UNAUDITED) STATEMENT OF OPERATIONS DATA: REVENUES............................................ $ 51,951 $ 257,417 $ 406,224 $ 136,557 COST OF SERVICES.................................... 36,196 220,377 348,717 116,811 --------- --------- --------- -------- Gross profit...................................... 15,755 37,040 57,507 19,746 --------- --------- --------- -------- OPERATING EXPENSES: Selling, general and administrative............... 12,580 38,894 47,211 13,974 Depreciation and amortization..................... 670 1,969 5,255 2,150 --------- --------- --------- -------- Total operating expenses:......................... 13,250 40,863 52,466 16,124 --------- --------- --------- -------- Income (loss) from operations..................... 2,505 (3,823) 5,041 3,622 --------- --------- --------- -------- OTHER INCOME (EXPENSE): Interest income................................... 10 114 499 205 Interest expense.................................. (155) (1,049) (2,546) (789) Legal settlement and expenses..................... -- (100) (1,653) -- Other income (expense)............................ (216) 56 (198) (160) --------- --------- --------- -------- Total other income (expense):....................... (361) (979) (3,898) (744) --------- --------- --------- -------- Income (loss) before provision for income taxes... 2,144 (4,802) 1,143 2,878 PROVISION FOR INCOME TAXES.......................... 858 1,485 417 1,534 --------- --------- --------- -------- NET INCOME (LOSS)................................... $ 1,286 $ (6,287) $ 726 $ 1,344 --------- --------- --------- -------- --------- --------- --------- -------- Earnings (loss) per common share: Basic............................................. $ 0.07 $ (0.28) $ 0.02 $ 0.04 Diluted........................................... $ 0.07 $ (0.28) $ 0.02 $ 0.04 Weighted average number of common shares outstanding: Basic............................................. 18,309 22,377 29,418 36,224 Diluted........................................... 18,309 22,377 32,233 38,355
AS OF MARCH 31, 1998 -------------- BALANCE SHEET DATA: Working capital deficit......................................................................... $ 1,665 Total assets.................................................................................... 152,990 Long term obligations (including current portion)............................................... 33,851 Stockholders equity............................................................................. $ 48,547
21 RISK FACTORS THE FOLLOWING RISK FACTORS SHOULD BE CONSIDERED CAREFULLY IN ADDITION TO THE OTHER INFORMATION CONTAINED IN THIS PROXY STATEMENT/PROSPECTUS IN CONSIDERING WHETHER TO APPROVE AND ADOPT THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY. THIS PROXY STATEMENT/PROSPECTUS CONTAINS, IN ADDITION TO HISTORICAL INFORMATION, "FORWARD-LOOKING STATEMENTS" WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT THAT INVOLVE RISKS AND UNCERTAINTIES. STAR'S ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT MAY CAUSE SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THOSE SET FORTH BELOW AND ELSEWHERE IN THIS PROXY STATEMENT/PROSPECTUS. SEE "DESCRIPTION OF FORWARD-LOOKING STATEMENTS." REFERENCES HEREIN TO STAR SHALL BE DEEMED TO INCLUDE STAR AND UDN AFTER THE MERGER. OPERATING RESULTS SUBJECT TO SIGNIFICANT FLUCTUATIONS STAR's quarterly operating results are difficult to forecast with any degree of accuracy because a number of factors subject these results to significant fluctuations. As a result, STAR believes that period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indications of future performance. FACTORS INFLUENCING OPERATING RESULTS, INCLUDING REVENUES, COSTS AND MARGINS. STAR's revenues, costs and expenses have fluctuated significantly in the past and are likely to continue to fluctuate significantly in the future as a result of numerous factors. STAR's revenues in any given period can vary due to factors such as call volume fluctuations, particularly in regions with relatively high per-minute rates; the addition or loss of major customers, whether through competition, merger, consolidation or otherwise; the loss of economically beneficial routing options for the termination of STAR's traffic; financial difficulties of major customers; pricing pressure resulting from increased competition; and technical difficulties with or failures of portions of STAR's network that impact STAR's ability to provide service to or bill its customers. STAR's cost of services and operating expenses in any given period can vary due to factors such as fluctuations in rates charged by carriers to terminate STAR's traffic; increases in bad debt expense and reserves; the timing of capital expenditures, and other costs associated with acquiring or obtaining other rights to switching and other transmission facilities; changes in STAR's sales incentive plans; and costs associated with changes in staffing levels of sales, marketing, technical support and administrative personnel. In addition, STAR's operating results can vary due to factors such as changes in routing due to variations in the quality of vendor transmission capability; loss of favorable routing options; the amount of, and the accounting policy for, return traffic under operating agreements; actions by domestic or foreign regulatory entities; the level, timing and pace of STAR's expansion in international and commercial markets; and general domestic and international economic and political conditions. Further, a substantial portion of transmission capacity used by STAR is obtained on a variable, per minute and short term basis, subjecting STAR to the possibility of unanticipated price increases and service cancellations. Since STAR does not generally have long term arrangements for the purchase or resale of long distance services, and since rates fluctuate significantly over short periods of time, STAR's gross margins are subject to significant fluctuations over short periods of time. STAR's gross margins also may be negatively impacted in the longer term by competitive pricing pressures. EXAMPLES OF FACTORS AFFECTING OPERATING RESULTS. STAR has in the past encountered significant difficulties in the collection of accounts receivable from certain of its customers. For example, in the fourth quarter of 1996 and the first quarter of 1997, Hi-Rim Communications, Inc. ("Hi-Rim"), formerly one of STAR's major customers and Cherry Communications, Inc. ("CCI"), STAR's largest customer in 1996, experienced financial difficulties and were unable to pay in full, on a timely basis, outstanding accounts receivable. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR." In early 1997, STAR implemented more stringent credit policies and monitoring systems. There can be no assurance, however, that if STAR experiences similar difficulties in the collection of future accounts receivable from its customers, STAR's financial condition and results of operations would not be materially adversely affected. 22 ABILITY TO CONTINUE AND MANAGE GROWTH; COMMERCIAL MARKET STAR has increased revenues from $46.3 million in 1995 to $376.2 million in 1997, with revenues increasing in each of the last eleven quarters. Such growth should not be considered indicative of future revenue growth or operating results. If revenue levels fall below expectations, net income is likely to be disproportionately adversely affected because a proportionately smaller amount of STAR's operating expenses varies with its revenues. This effect is likely to increase as a greater percentage of STAR's cost of services are associated with owned and leased facilities. There can be no assurance that STAR will be able to achieve or maintain profitability on a quarterly or annual basis in the future. It is likely that in some future quarter STAR's operating results will be below the expectations of public market analysts and investors. In such event, the price of STAR Common Stock would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR." As part of STAR's significant revenue growth, it has expanded, and plans to continue to expand, the number of its employees and the geographic scope of its operations. Additionally, an important component of STAR's strategy is to grow and expand through acquisition. These factors have resulted, and will continue to result, in increased responsibilities for management personnel and have placed, and will continue to place, increased demands upon STAR's operating and financial systems, which may lead to unanticipated costs and divert management's attention from day-to-day operations. STAR may also be required to attract, train and retain additional highly qualified management, technical, sales and marketing and customer support personnel. The process of locating such personnel with the combination of skills and attributes required to implement STAR's strategy is often lengthy. The inability to attract and retain additional qualified personnel could materially and adversely affect STAR. STAR expects that its expansion into foreign countries will lead to increased financial and administrative demands, such as increased operational complexity associated with expanded network facilities, administrative burdens associated with managing an increasing number of foreign subsidiaries and relationships with foreign partners and expanded treasury functions to manage foreign currency risks. STAR's accounting systems and policies have been developed as STAR has experienced significant growth. There can be no assurance that STAR's personnel, systems, procedures and controls will be adequate to support STAR's future operations. See "--Dependence on Key Personnel," "Business of STAR--Employees" and "Management of STAR and UDN." With the acquisition of LDS, STAR began providing service to the commercial market, which is more labor intensive than the wholesale market, and as a result has higher overhead costs. STAR also may be required to update and improve its billing systems and procedures and/or hire new management personnel to handle the demands of the commercial market. There can be no assurance that STAR will be able to effectively manage the costs of and risks associated with its expansion into the commercial market. RISKS INHERENT IN ACQUISITION STRATEGY An important component to STAR's strategy is to grow and expand through acquisitions. This growth strategy is dependent on the continued availability of suitable acquisition candidates and subjects STAR to a number of risks. STAR has recently completed two acquisitions, LD Services ("LDS") on November 30, 1997, and T-One on March 10, 1998. Additionally, on November 19, 1997, STAR entered into the Merger Agreement to acquire UDN. The acquisition of UDN is subject to approval of UDN's stockholders and to various regulatory approvals, and STAR may not complete this acquisition. These acquisitions have placed significant demands on STAR's financial and management resources, as the process for integrating acquired operations presents a significant challenge to STAR's management and may lead to unanticipated costs or a diversion of management's attention from day-to-day operations. There can be no assurance that STAR will be able to successfully integrate these acquisitions or any other acquisitions made by STAR in the future into Company operations. Integrating acquisitions may require integration of financial and call routing systems, network and other physical facilities and personnel. Difficulties in integrating these and other acquisitions can cause system degradation, added costs and loss of personnel or customers. 23 Additionally, STAR may incur unknown liabilities despite management's efforts to investigate the operations of the acquired business. The impact of these risks, and other risks arising as a result of STAR's acquisition strategy, could adversely affect STAR's operating results. RISKS ASSOCIATED WITH GROWTH OF TELECOMMUNICATIONS NETWORK AND CUSTOMER BASE Historically, STAR has relied primarily on leased transmission capacity for the delivery of its telecommunications services. STAR's telecommunications expenses have in the past primarily been variable, based upon minutes of use, consisting largely of payments to other long distance carriers, customer/carrier interconnect charges, leased fiber circuit charges and switch facility costs. During 1997, however, STAR made considerable capital expenditures in order to expand its network, and intends to continue to do so in the future. See "Business of STAR--Network." Although STAR's strategy is to seek to establish significant traffic volumes prior to investing in fixed-cost facilities, the development of such facilities entails significant costs and prior planning, which are based in part on STAR's expectations concerning future revenue growth and market developments. As STAR expands its network and the volume of its network traffic, its cost of revenues will increasingly consist of fixed costs arising from the ownership and maintenance of its switches and undersea fiber optic cables. While STAR believes that in the long-term these investments will allow it to reduce its cost of service and to enhance its service offerings, in the short-term, cost increases and a decrease in STAR's operating margins may occur. If STAR's traffic volume were to decrease, or fail to increase to the extent expected or necessary to make efficient use of its network, STAR's costs as a percentage of revenues could increase significantly, which could have a material adverse effect on STAR's business, financial condition or results of operations. In addition, STAR's business depends in part on its ability to obtain transmission facilities on a cost-effective basis. Because undersea fiber optic cables typically take several years to plan and construct, carriers generally make investments well in advance, based on a forecast of anticipated traffic. Therefore, STAR's operations are subject to the risk that it will not adequately anticipate the amount of traffic over its network, and may not procure sufficient cable capacity or network equipment in order to ensure the cost- effective transmission of customer traffic. Although STAR participates in the planning of undersea fiber optic transmission facilities, it does not control the construction of such facilities and must seek access to such facilities through partial ownership positions. If ownership positions are not available, STAR must seek access to such facilities through lease arrangements on negotiated terms that may vary with industry and market conditions. There can be no assurance that STAR will be able to continue to obtain sufficient transmission facilities or access to undersea fiber optic cable on economically viable terms. The failure of STAR to obtain telecommunications facilities that are sufficient to support its network traffic in a manner that ensures the reliability and quality of its telecommunications services may have a material adverse effect on its business, financial condition or results of operations. RISKS OF INTERNATIONAL TELECOMMUNICATIONS BUSINESS STAR has to date generated a substantial majority of its revenues by providing international telecommunications services to its customers on a wholesale basis. The international nature of STAR's operations involves certain risks, such as changes in U.S. and foreign government regulations and telecommunications standards, dependence on foreign partners, tariffs, taxes and other trade barriers, the potential for nationalization and economic downturns and political instability in foreign countries. In addition, STAR's business could be adversely affected by a reversal in the current trend toward deregulation of telecommunications carriers. STAR will be increasingly subject to these risks to the extent that STAR proceeds with the planned expansion of its international operations. RISK OF DEPENDENCE ON FOREIGN PARTNERS. STAR will increasingly rely on foreign partners to terminate its traffic in foreign countries and to assist in installing transmission facilities and network switches, complying with local regulations, obtaining required licenses, and assisting with customer and vendor relationships. STAR may have limited recourse if its foreign partners do not perform under their 24 contractual arrangements with STAR. STAR's arrangements with foreign partners may expose STAR to significant legal, regulatory or economic risks. RISKS ASSOCIATED WITH FOREIGN GOVERNMENT CONTROL AND HIGHLY REGULATED MARKETS. Governments of many countries exercise substantial influence over various aspects of the telecommunications market. In some cases, the government owns or controls companies that are or may become competitors of STAR or companies (such as national telephone companies) upon which STAR and its foreign partners may depend for required interconnections to local telephone networks and other services. Accordingly, government actions in the future could have a material adverse effect on STAR's operations. In highly regulated countries in which STAR is not dealing directly with the dominant local exchange carrier, the dominant carrier may have the ability to terminate service to STAR or its foreign partner and, if this occurs, STAR may have limited or no recourse. In countries where competition is not yet fully established and STAR is dealing with an alternative operator, foreign laws may prohibit or impede new operators from offering services in these markets. RISKS ASSOCIATED WITH FOREIGN CURRENCY FLUCTUATIONS. STAR's revenues and cost of long distance services are sensitive to foreign currency fluctuations. STAR expects that an increasing portion of STAR's net revenue and expenses will be denominated in currencies other than U.S. dollars, and changes in exchange rates may have a significant effect on STAR's results of operations. Although STAR utilizes hedging instruments to reduce the risk of foreign currency fluctuations, STAR will not be fully protected from these risks and the instruments themselves involve a degree of risk. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR." FOREIGN CORRUPT PRACTICES ACT. STAR is also subject to the Foreign Corrupt Practices Act ("FCPA"), which generally prohibits U.S. companies and their intermediaries from bribing foreign officials for the purpose of obtaining or keeping business. STAR may be exposed to liability under the FCPA as a result of past or future actions taken without STAR's knowledge by agents, strategic partners and other intermediaries. Such liability could have a material adverse effect on STAR's business, operating results and financial condition. POTENTIAL ADVERSE EFFECTS OF GOVERNMENT REGULATION STAR's business is subject to various U.S. and foreign laws, regulations, agency actions and court decisions. STAR's U.S. international telecommunications service offerings are subject to regulation by the FCC. The FCC requires international carriers to obtain authorizations under Section 214 of the Communications Act of 1934, as amended, prior to acquiring international facilities by purchase or lease, or providing international service to the public. Prior FCC approval is also required to transfer control of a certificated carrier. STAR must file reports and contracts with the FCC and must pay regulatory fees, which are subject to change. STAR is also subject to the FCC policies and rules discussed below. The FCC could determine, by its own actions or in response to a third party's filing, that certain of STAR's services, termination arrangements, agreements with foreign carriers, transit or refile arrangements or reports do not or did not comply with FCC policies and rules. If this occurred, the FCC could order STAR to terminate noncompliant arrangements, fine STAR or revoke STAR's authorizations. Any of these actions could have a material adverse effect on STAR's business, operating results and financial condition. FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's international private line ("IPL") resale policy limits the conditions under which a carrier may connect IPLs to the public switched telephone network ("PSTN") at one or both ends to provide switched services, commonly known as International Simple Resale ("ISR"). A carrier generally may only offer ISR services to a foreign country if the FCC has found (a) the country is a member of the World Trade Organization ("WTO") and at least 50% of the U.S. billed and settled traffic to that country is settled at or below the FCC's benchmark settlement rate or (b) the country is not a WTO member, but it offers U.S. carriers equivalent opportunities to engage in ISR and at least 50% of the U.S. billed and settled traffic is settled at or below the applicable benchmark. STAR's FCC authority currently permits it to provide ISR service to Canada, the U.K., Sweden, New 25 Zealand, Australia and the Netherlands. The FCC is currently reviewing U.S. carrier applications to provide ISR to Belgium, Chile, Denmark, Finland, France, Germany, Hong Kong, Norway and Luxembourg, among other routes. Upon grant of any such ISR application to a given country, the FCC's rules also would permit STAR to provide ISR service to that country. Certain of STAR's termination arrangements with foreign operators may be inconsistent with the FCC's IPL resale policy and STAR's existing ISR authorization. FCC INTERNATIONAL SETTLEMENTS POLICY. The FCC's International Settlement Policy ("ISP") limits the arrangements which U.S. international carriers may enter into with foreign carriers for exchanging public switched telecommunications traffic, which the FCC terms International Message Telephone Service ("IMTS"). This policy does not apply to ISR services. The ISP requires that U.S. carriers receive an equal share of the accounting rate and receive inbound traffic in proportion to the volume of U.S. outbound traffic which they generate. The ISP and other FCC policies also prohibit a U.S. carrier and a foreign carrier which possesses sufficient market power on the foreign end of the route to affect competition adversely in the U.S. market from entering into exclusive arrangement involving services, facilities or functions on the foreign end of a U.S. international route which are necessary for providing basic telecommunications and which are not offered to similarly situated U.S. carriers. It is possible that the FCC could find that certain of STAR's arrangements with foreign operators are inconsistent with the ISP. FCC POLICIES ON TRANSIT AND REFILE. STAR uses both transit and refile arrangements to terminate its international traffic. The FCC routinely approves transit arrangements by U.S. international carriers. The FCC's rules also permit carriers in many cases to use ISR facilities to route traffic via a third country for refile through the PSTN. The extent to which U.S. carriers may enter into refile arrangements consistent with the ISP is currently under review by the FCC. Certain of STAR's transit or refile arrangements may violate the ISP or other FCC policies. RECENT AND POTENTIAL FCC ACTIONS. Regulatory action that may be taken in the future by the FCC may intensify the competition which STAR faces, impose additional operating costs upon STAR, disrupt certain of STAR's transmission arrangements or otherwise require STAR to modify its operations. Future FCC action may also provide STAR additional competitive flexibility by, for example, eliminating or substantially reducing the tariff requirements applicable to STAR's interstate and international telecommunications services. The FCC is encouraging new market entrants by implementing the WTO Basic Telecommunications Agreement (the "WTO Agreement") and through other actions. The FCC may approve pending mergers which could produce more effective competitors in STAR's markets. The FCC may increase regulatory fees charged to STAR and its competitors by eliminating the exemption for carriers which provide only international services or through other actions, which could raise STAR's costs of service without assurance that STAR and its competitors could pass fee increases through to their customers. See "Business of STAR--Government Regulation." STATE. The intrastate long distance telecommunications operations of STAR and its subsidiaries are subject to various state laws and regulations, including prior certification, notification, registration and/or tariff requirements. The vast majority of states require that STAR and its subsidiaries apply for certification to provide intrastate telecommunications services. Certificates of authority can generally be conditioned, modified or revoked by state regulatory authorities for failure to comply with state laws and regulations. Fines and other penalties, including revocation of a certificate of authority, may be imposed. In 1997, prior to STAR's acquisition of LDS, LDS settled disputes with the California Public Utilities Commission (the "California PUC") and with the District Attorney of Monterey, California regarding LDS' alleged unauthorized switching of long distance customers (the "Settlements"). As part of the Settlements, LDS was subject to fines and restrictions on its business operations in California. In addition, the FCC has received numerous informal complaints against LDS regarding the alleged unauthorized switching of long distance customers, which complaints currently remain under review. 26 Following STAR's acquisition of LDS and in order to comply with the Settlements, STAR has imposed strict restrictions on certain former LDS employees, restricting these employees with respect to California intrastate telecommunications operations. Additionally, STAR has taken a number of steps to reduce the risk of a repeat occurrence regarding the alleged unauthorized switching of commercial customers in California. If STAR inadvertently fails to comply with such guidelines or if such guidelines are determined to be inadequate to comply with the Settlements, STAR may be subject to penalties or revocation of its certificate of authority. See "Business of STAR--Government Regulation--Actions Against LDS." FOREIGN REGULATIONS. STAR is also subject to regulation in foreign countries, such as the U.K. and Germany, in connection with certain of its business activities. For example, STAR's use of transit, ISR or other routing arrangements may be affected by laws or regulations in either the transited or terminating foreign jurisdiction. Foreign countries, either independently or jointly as members of the International Telecommunications Union ("ITU"), or other supra-national organizations such as the European Union or the WTO, may have adopted or may adopt laws or regulatory requirements regarding such services for which compliance would be difficult or expensive, that could force STAR to choose less cost-effective routing alternatives and that could adversely affect STAR's business, operating results and financial condition. To the extent that it seeks to provide telecommunications services in other non-U.S. markets, STAR is subject to the developing laws and regulations governing the competitive provision of telecommunications services in those markets. STAR currently plans to provide a limited range of services in Mexico, Belgium and France, as permitted by regulatory conditions in those markets, and to expand its operations as these markets implement scheduled liberalization to permit competition in the full range of telecommunications services in the next several years. The nature, extent and timing of the opportunity for STAR to compete in these markets will be determined, in part, by the actions taken by the governments in these countries to implement competition and the response of incumbent carriers to these efforts. There can be no assurance that the regulatory regime in these countries will provide STAR with practical opportunities to compete in the near future, or at all, or that STAR will be able to take advantage of any such liberalization in a timely manner. See "Business of STAR--Government Regulation." REGULATION OF CUSTOMERS. STAR's customers are also subject to actions taken by domestic or foreign regulatory authorities that may affect the ability of customers to deliver traffic to STAR. Regulatory sanctions have been imposed on certain of STAR's customers in the past. While such sanctions have not adversely impacted the volume of traffic received by STAR from such customers to date, future regulatory actions could materially adversely affect the volume of traffic received from a major customer, which could have a material adverse effect on STAR's business, financial condition and results of operations. RISKS OF NETWORK FAILURE Any system or network failure that causes interruptions in STAR's operations could have a material adverse effect on its business, financial condition or results of operations. STAR's operations are dependent on its ability to successfully expand its network and integrate new and emerging technologies and equipment into its network, which are likely to increase the risk of system failure and to cause strain upon the network. STAR's operations also are dependent on STAR's protection of its hardware and other equipment from damage from natural disasters such as fires, floods, hurricanes and earthquakes, other catastrophic events such as civil unrest, terrorism and war and other sources of power loss and telecommunications failures. Although STAR has taken a number of steps to prevent its network from being affected by natural disasters, fire and the like, such as building redundant systems for power supply to the switching equipment, there can be no assurance that any such systems will prevent STAR's switches from becoming disabled in the event of an earthquake, power outage or otherwise. The failure of STAR's network, or a significant decrease in telephone traffic resulting from effects of a natural or man-made disaster, could have a material adverse effect on STAR's relationship with its customers and STAR's business, operating results and financial condition. See "Business of STAR--Network." 27 DEPENDENCE ON KEY PERSONNEL STAR's success depends to a significant degree upon the efforts of senior management personnel and a group of employees with longstanding industry relationships and technical knowledge of STAR's operations, in particular, Christopher E. Edgecomb, STAR's Chief Executive Officer. STAR maintains and is the beneficiary under a key person life insurance policy in the amount of $10.0 million with respect to Mr. Edgecomb. STAR believes that its future success will depend in large part upon its continuing ability to attract and retain highly skilled personnel. Competition for qualified, high-level telecommunications personnel is intense and there can be no assurance that STAR will be successful in attracting and retaining such personnel. The loss of the services of one or more of STAR's key individuals, or the failure to attract and retain other key personnel, could materially adversely affect STAR's business, operating results and financial condition. See "Management of STAR and UDN." SIGNIFICANT COMPETITION The international telecommunications industry is intensely competitive and subject to rapid change. STAR's competitors in the international wholesale switched long distance market include large, facilities-based multinational corporations and smaller facilities-based providers in the U.S. and overseas that have emerged as a result of deregulation, switch-based resellers of international long distance services and international joint ventures and alliances among such companies. STAR also competes abroad with a number of dominant telecommunications operators that previously held various monopolies established by law over the telecommunications traffic in their countries. International wholesale switched service providers compete on the basis of price, customer service, transmission quality, breadth of service offerings and value-added services. Additionally, the telecommunications industry is in a period of rapid technological evolution, marked by the introduction of competitive product and service offerings, such as the utilization of the Internet for international voice and data communications. STAR is unable to predict which technological development will challenge its competitive position or the amount of expenditures that will be required to respond to a rapidly changing technological environment. Further, the number of STAR's competitors is likely to increase as a result of the competitive opportunities created by a new Basic Telecommunications Agreement concluded by members of the WTO in April 1997. Under the terms of the WTO Agreement, starting February 5, 1998, the United States and over 65 countries have committed to open their telecommunications markets to competition, foreign ownership and adopt measures to protect against anticompetitive behavior. As a result, STAR believes that competition will continue to increase, placing downward pressure on prices. Such pressure could adversely affect STAR's gross margins if STAR is not able to reduce its costs commensurate with such price reductions. COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES. A majority of the U.S.-based international telecommunications services revenue is currently generated by AT&T Corp. ("AT&T"), MCI Communications Corp. ("MCI") and Sprint Corporation ("Sprint"). STAR also competes with WorldCom, Inc. ("WorldCom"), Pacific Gateway Exchange, Inc., and other U.S.-based and foreign long distance providers, including the Regional Bell Operating Companies ("RBOCs"), which presently have FCC authority to resell and terminate international telecommunication services. Many of these competitors have considerably greater financial and other resources and more extensive domestic and international communications networks than STAR. STAR's business would be materially adversely affected to the extent that a significant number of such customers limit or cease doing business with STAR for competitive or other reasons. Consolidation in the telecommunications industry could not only create even larger competitors with greater financial and other resources, but could also adversely affect STAR by reducing the number of potential customers for STAR's services. EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began providing long distance service to the commercial market, a market that is subject to intense competition from a number of well capitalized companies. The commercial market is also characterized by the lack of customer loyalty, with commercial customers regularly changing service providers. There can be no assurance that STAR will 28 be able to compete successfully in the commercial market. See "Business of STAR--Strategy--Expansion into Commercial Market." CUSTOMER CONCENTRATION While the list of STAR's most significant customers varies from quarter to quarter, STAR's five largest customers accounted for approximately 30% of its revenues in 1997. STAR could lose a significant customer for many reasons, including the entrance into the market of significant new competitors with lower rates than STAR, downward pressure on the overall costs of transmitting international calls, transmission quality problems, changes in U.S. or foreign regulations or unexpected increases in STAR's cost structure as a result of expenses related to installing a global network or otherwise. NEED FOR ADDITIONAL CAPITAL TO FINANCE GROWTH AND CAPITAL REQUIREMENTS STAR believes that it must continue to enhance and expand its network and build out its telecommunications network infrastructure in order to maintain its competitive position and continue to meet the increasing demands for service quality, capacity and competitive pricing. STAR's ability to grow depends, in part, on its ability to expand its operations through the ownership and leasing of network capacity, which requires significant capital expenditures, that are often incurred prior to STAR's receipt of the related revenue. STAR believes that, based upon its present business plan and its existing cash resources and expected cash flow from operating activities, STAR will have sufficient cash to meet its currently anticipated working capital and capital expenditure requirements for at least twelve months. If STAR's growth exceeds current expectations, if STAR obtains one or more attractive opportunities to purchase the business or assets of another company, or if STAR's cash flow from operations after the end of such period is insufficient to meet its working capital and capital expenditure requirements, STAR will need to raise additional capital from equity or debt sources. There can be no assurance that STAR will be able to raise such capital on favorable terms or at all. If STAR is unable to obtain such additional capital, STAR may be required to reduce the scope of its anticipated expansion, which could have a material adverse effect on STAR's business, financial condition or results of operations. VOLATILITY OF STOCK PRICE The market price of the shares of STAR Common Stock has risen since STAR's initial public offering in June 1997 and is trading at a high multiple of STAR's earnings. The market price for such shares has been highly volatile and may be significantly affected by factors such as actual or anticipated fluctuations in STAR's operating results, the announcement of potential acquisitions by STAR, changes in federal and international regulations, activities of the largest domestic providers, industry consolidation and mergers, conditions and trends in the international telecommunications market, adoption of new accounting standards affecting the telecommunications industry, changes in recommendations and estimates by securities analysts, general market conditions and other factors. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the shares of emerging growth companies like STAR. These broad market fluctuations may adversely affect the market price of the STAR Common Stock. CONTROL OF COMPANY BY NAMED OFFICERS AND DIRECTORS Upon the consummation of the Merger, STAR Named Officers (as defined below) and directors in the aggregate will beneficially own approximately 37.4% of the outstanding shares of STAR Common Stock and STAR's Chief Executive Officer will beneficially own approximately 31.5% of the outstanding shares. These stockholders may be able to exercise control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions. Such concentration of ownership may have the effect of delaying or preventing a change in control of STAR. See "Principal Stockholders of STAR." 29 EFFECT OF CERTAIN CHARTER PROVISIONS; ANTI-TAKEOVER EFFECTS OF CERTIFICATE OF INCORPORATION, BYLAWS AND DELAWARE LAW STAR's Board of Directors has the authority to issue up to 5,000,000 shares of Preferred Stock and to determine the price, rights, preferences, privileges and restrictions, including voting and conversion rights of such shares, without any further vote or action by STAR's stockholders. The rights of the holders of STAR Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. The issuance of Preferred Stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of STAR. STAR has no current plans to issue shares of Preferred Stock. STAR is also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which will prohibit STAR from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 could have an effect of delaying or preventing a change in control of STAR. In addition, STAR's Amended and Restated Certificate of Incorporation provides for a classified Board of Directors such that approximately only one-third of the members of the Board will be elected at each annual meeting of stockholders. Classified boards may have the effect of delaying, deferring or discouraging changes in control of STAR. Further, certain provisions of STAR's Amended and Restated Certificate of Incorporation and Bylaws and of Delaware law could delay or make more difficult a merger, tender offer or proxy contest involving STAR. Additionally, certain federal regulations require prior approval of certain transfers of control of telecommunications companies, which could also have the effect of delaying, deferring or preventing a change in control. See "Business of STAR--Government Regulation," "Description of STAR Capital Stock-- Preferred Stock" and "--Anti-takeover Effects of Provisions of the Certificate of Incorporation, Bylaws and Delaware Law." SHARES ELIGIBLE FOR FUTURE SALE Upon completion of the Merger, STAR will have approximately 42,391,619 shares of STAR Common Stock outstanding (assuming no exercise of any of the options to purchase shares of STAR Common Stock outstanding and vested as of May 15, 1998) of which approximately 9,430,000 will be registered pursuant to the Securities Act. Approximately 1,911,000 additional shares which are not currently registered will be available for immediate unrestricted sale in the public market on the date of this Proxy Statement/ Prospectus and approximately 1,601,000 additional shares will be available for immediate sale on the date of this Proxy Statement/Prospectus, subject to the public information, volume limitation and notice provisions of Rule 144 adopted under the Securities Act. Approximately 410,000 shares will be available for sale within 45 days after the date of this Proxy Statement/Prospectus, subject to the Rule 144 public information, volume limitations and notice provisions. Approximately 1,875,000 shares will be available for sale in the public market on June 13, 1998 upon the expiration of certain lock-up agreements, subject to the Rule 144 public information, volume limitation and notice provisions described below. Upon the expiration of certain additional lock-up agreements, on July 28, 1998, (i) approximately 16,246,000 shares will be available for sale in the public market, subject to the Rule 144 public information, volume limitation and notice provisions and (ii) approximately 2,050,000 shares will be available for unrestricted sale in the public market. Approximately 849,000 shares issued in the LDS acquisition will be available for sale after November 30, 1998. Certain stockholders holding approximately 7,153,000 shares of STAR Common Stock are entitled to registration rights with respect to their shares of STAR Common Stock. Sales of substantial amounts of such shares in the public market, or the prospect of such sales, could adversely affect the market price of the STAR Common Stock. Such sales also might make it more difficult for STAR to sell equity securities or equity related securities in the future at a time and price that STAR deems appropriate. See "Description of STAR Capital Stock." 30 YEAR 2000 COMPUTER PROGRAM FAILURE A significant percentage of the software that runs most of the computers in the United States relies on two-digit date codes to perform computations and decision-making functions. Commencing on January 1, 2000, these computer programs may fail from an inability to interpret date codes properly, misinterpreting "00" as the year 1900 rather than 2000. STAR believes that STAR's billing, credit and call tracking systems are Year 2000 compliant and do not use programs with the two-digit date code flaw. At the same time, a number of the computers of STAR's customers and vendors that interface with STAR's systems may run on programs that have Year 2000 problems and may disrupt STAR's billing, credit and tracking systems. Failure of any of the computer programs integral to STAR's key customers and vendors could adversely affect STAR's business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR." NO ASSURANCE THAT STAR WILL REALIZE ANTICIPATED BENEFITS FROM THE MERGER The Merger involves the combination of certain aspects of two companies that have operated independently. Accordingly, there can be no assurance that UDN can be successfully integrated into STAR or that STAR and its stockholders (including persons who become stockholders as a result of the Merger) will ultimately realize any of the anticipated benefits of the Merger. In addition, the integration of the STAR and UDN operations and accounting, personnel administrative and legal functions involves the risk that key employees, who can not be easily replaced, in those operations and functions will leave even when offered continuing employment. The integration approach adopted by STAR with respect to UDN requires the devotion of a significant amount of time by senior executives, which may detract from business operations and development of the combined companies. In determining that the Merger is fair and in the best interests of its stockholders, each of the UDN Board and the UDN Special Committee considered the cost savings, operating efficiencies and other synergies expected to result following the consummation thereof. See "The Merger--UDN's Reasons for the Merger; Recommendations of the UDN Board and Special Committee" and "--STAR's Reasons for the Merger." There can be no assurance that any of such cost savings, operating efficiencies or other synergies will be accomplished as rapidly as currently expected or at all or that such savings and synergies will not be offset by increases in other expenses or operating losses, including losses due to problems integrating the two companies. INTERESTS OF CERTAIN PERSONS IN THE MERGER In considering the recommendation of the Merger by the UDN Board and Special Committee, the stockholders of UDN should be aware that John Snedegar, President of UDN, and Dale Christensen, Chief Operating Officer and Chief Financial Officer of UDN, have employment agreements that provide them with bonuses and severance benefits which would take effect if Mr. Snedegar or Mr. Christensen exercises his right to terminate his employment agreement upon consummation of the Merger. See "Management of STAR and UDN--UDN Employment Agreements." In addition, certain directors and officers of UDN or its subsidiaries may also be directors and/or officers of other companies whose principal business is similar to that of UDN. It is possible, therefore, that a conflict may arise between their duties as directors or officers of UDN or its subsidiaries and their duties as directors or officers of such other companies. Such interests, together with other relevant factors, were considered by the UDN Board and Special Committee in making their recommendation and approving the Merger Agreement. See "The Merger--Interests of Certain Persons in the Merger." MAINTENANCE OF UDN'S CUSTOMER BASE Customers are not obligated to purchase any minimum usage amount and can discontinue service, without penalty, at any time. There can be no assurance that customers will continue to buy their long distance telephone service through UDN. In the event that a significant portion of UDN's customers decide to purchase long distance service directly from another long distance service provider, there can be 31 no assurance that UDN will be able to replace its customer base from other sources. Loss of a significant portion of UDN's customers would have a material adverse effect on its results of operations and financial condition. A high level of customer attrition is inherent in the long distance industry, and UDN's revenues are also affected by such attrition. Attrition results from a variety of factors including termination of customers by UDN for non-payment and the initiatives of existing and new competitors as they engage in, among other things, national advertising campaigns, telemarketing programs and the issuance of cash or other forms of incentives. Although UDN is aware of the significance of attrition on its business, telecommunications providers generally find it difficult to measure customer attrition in a consistently meaningful manner due to, among other factors, the wide range of revenues attributable to individual customers, the fact that service to an individual customer may be provided by more than one underlying carrier and the variety of reasons for changes in the volume of service provided to an individual customer. UDN'S DEPENDENCE ON THIRD PARTY TRANSMISSION FACILITIES UDN does not own all of the transmission facilities needed to complete long distance telephone calls. Therefore, UDN's operator services, direct dial long distance, "800" service, wholesale long distance service and prepaid calling cards are largely dependent upon the contractual arrangements with facilities- based carriers for the transmission of calls on a cost-effective basis. While UDN believes it has ample access to transmission facilities at competitive rates and expects to continue to have such access in the foreseeable future, due to the possibility of unforeseen changes in industry conditions, the continued availability of transmission facilities at historical rates cannot be assured. In addition, UDN has entered into buying arrangements with other carriers for the provision of originating and terminating long distance services, primarily in those areas where UDN does not have its own network facilities. Several of these contracts have monthly minimum usage requirements for the term of the contract and contain penalties if these minimums are not met. UDN is currently meeting the minimum usage requirements in its contracts, however, there is no assurance that UDN will be able to continue meeting these minimum usage requirements. If they are not met, the resulting penalties will severely reduce UDN's gross margin and will negatively impact UDN's results of operations. DILUTION OF VOTING POWER Consummation of the Merger will result in an approximate 1.5% increase in the number of shares of STAR Common Stock outstanding. In exchange for 100% of the outstanding UDN Common Stock, stockholders of UDN will receive approximately 1.5% of the outstanding voting stock of STAR upon the consummation of the Merger. Thus, the stockholders of STAR will experience a very slight dilution of their relative voting authority after the Merger. CERTAIN INCOME TAX CONSEQUENCES CERTAIN UNITED STATES FEDERAL INCOME TAX CONSEQUENCES The following discussion addresses certain material United States federal income tax consequences of the Merger to stockholders of UDN Common Stock who hold their shares as capital assets (within the meaning of Section 1221 of the Internal Revenue Code of 1986, as amended (the "Code")). The discussion is based on the current provisions of the Code, applicable Treasury Regulations, judicial authority and administrative rulings and practice. It does not address all aspects of federal income taxation that may be relevant to particular UDN stockholders in light of their specific circumstances, or to certain types of stockholders subject to special treatment under the federal income tax laws, including without limitation, insurance companies, tax-exempt organizations, foreign persons, financial institutions or broker-dealers, and stockholders who acquired their UDN Common Stock pursuant to the exercise of employee stock options or in other compensatory transactions. This discussion also does not address the state, local, foreign or other federal tax consequences of the Merger. There can be no assurance that the Internal Revenue Service will not take a contrary view to any expressed herein. No rulings have been or will be 32 requested from the Internal Revenue Service with respect to the tax consequences of the Merger. Moreover, legislative, judicial or administrative changes or interpretations may be forthcoming that could alter or modify the statements and conclusions set forth herein, possibly with retroactive effect. ALL UDN STOCKHOLDERS ARE URGED TO CONSULT THEIR OWN TAX ADVISORS AS TO THE SPECIFIC TAX CONSEQUENCES TO THEM OF THE MERGER, INCLUDING THE APPLICABILITY AND EFFECT OF ANY FEDERAL, STATE, LOCAL AND FOREIGN TAX LAWS, AND POSSIBLE CHANGES IN APPLICABLE TAX LAWS. Based on the assumptions set forth below, the Merger should qualify as a tax-free reorganization under Section 368(a)(1) of the Code. As a result, no gain or loss will be recognized by a stockholder whose shares of UDN Common Stock are converted into shares of STAR Common Stock, except to the extent of any cash received in lieu of fractional shares of STAR Common Stock. Each stockholder receiving cash in lieu of a fractional share of STAR Common Stock will be treated as having received such fractional share interest and as having sold it for the cash received, recognizing gain or loss equal to the difference between the amount of cash received and the portion of that stockholder's basis in the shares of UDN Common Stock allocable to the fractional share interest. Such gain or loss will generally be treated as capital gain or loss (long-term or short-term depending on the stockholder's holding period), unless the payment transaction is essentially equivalent to a dividend within the meaning of Section 302 of the Code (a "Dividend Transaction"). The tax basis of the STAR Common Stock exchanged therefor (except for the basis attributable to any fractional share interest in STAR Common Stock), and the holding period of the STAR Common Stock will include the holding period of the UDN Common Stock surrendered in the Merger. A stockholder who exercises his appraisal rights with respect to a share of UDN Common Stock and receives payment for such stock in cash will recognize capital gain or loss (long-term or short-term depending on the the stockholder's holding period) measured by the difference between the amount of cash received and the stockholder's basis in such share, provided the appraisal transaction is not a Dividend Transaction. A transaction is not a Dividend Transaction with respect to a UDN stockholder if, after taking into account shares owned actually and constructively within the meaning of Section 318 of the Code, there is a meaningful reduction in the stockholder's proportionate interest in the corporation. Under this rule, the Internal Revenue Service has ruled that a redemption of a fractional share for cash in the context of a reorganization transaction (such as the Merger) is generally not a Dividend Transaction. In addition, the Internal Revenue Service has ruled that any reduction in the percentage interest of a small minority shareholder in a publicly held corporation who exercises no control over corporate affairs should constitute a meaningful reduction. The tax discussion set forth herein is based on the accuracy of certain representations made by STAR and UDN, including the following: (i) the Merger will be consummated in accordance with the Merger Agreement; (ii) following the Merger, UDN will hold substantially all (i.e., 90% of net asset value and 70% of gross asset value) of its own properties and substantially all of Newco's properties, and will continue its historic business or use a significant portion of its historic business assets in a business; (iii) UDN has not redeemed, and persons related to UDN have not acquired (other than in exchange for STAR or UDN stock), an amount of UDN stock, and UDN has not made any extraordinary distributions with respect to its stock, prior to and connection with the Merger, that would in the aggregate, reduce the value of all outstanding UDN stock immediately prior to the Merger (after giving effect to such redemptions, acquisitions, and distributions) to a value of less than 50 percent of the value of all of the outstanding stock of UDN stock immediately prior to the Merger determined without regard to such redemptions, acquisitions and distributions; and (iv) in connection with the Merger, neither STAR nor any person related to STAR, will acquire any UDN Common Stock for consideration other than STAR Common Stock (other cash paid for fractional share and dissenters' shares) or redeem any of the STAR Common Stock issued in the Merger. 33 If the Merger were not to constitute a reorganization under Section 368(a)(1) of the Code, each UDN stockholder would recognize gain or loss equal to the difference between the fair market value of the STAR Common Stock received and cash received in lieu of fractional share and such stockholder's basis in the shares of UDN Common Stock exchanged therefor. Such gain or loss would be long-term or short-term capital gain or loss, depending upon the stockholder's holding period with respect to the UDN Stock. Because the former UDN stockholders will own less than 50 percent of STAR after the Merger, the Merger will be treated as an "ownership change" with respect to UDN for purposes of Section 382 of the Code. As a result, the ability of STAR to use any net operating losses of UDN from periods prior to the Effective Time will generally be limited to an annual amount equal to the total value (determined immediately prior to the Merger) of the stock of UDN multiplied by a long-term tax-exempt interest rate factor (as published by the Internal Revenue Service on a monthly basis). CERTAIN CANADIAN AND FOREIGN TAX CONSEQUENCES Stockholders of UDN and dissenting stockholders of UDN who are residents in, or citizens of, Canada or another foreign jurisdiction should be aware that the Merger (or the exercise of appraisal rights in respect of the Merger) may result in the holder realizing or being required to record a gain or loss on the exchange of shares under the Merger (or upon the exercise of, or any payment being made in connection with, appraisal rights) or result in other tax consequences to such holders. Such tax consequences, if any, are not described herein. Such stockholders are urged to consult their own Canadian or foreign tax, legal or other financial advisors, as applicable, as to the implications of the Merger to them under such income tax laws. 34 THE SPECIAL MEETING This Proxy Statement/Prospectus is being furnished to holders of UDN Common Stock in connection with the solicitation of proxies by the UDN Board for use at the Special Meeting. This Proxy Statement/ Prospectus and accompanying form of proxy are first being mailed to the stockholders of UDN on or about May 28, 1998. THE SPECIAL MEETING PURPOSE; TIME AND PLACE. At the Special Meeting, holders of UDN Common Stock will be asked to vote upon a proposal (the "Proposal") to approve and adopt the Merger Agreement and the transactions contemplated thereby and such other matters as may properly come before the Special Meeting. The Special Meeting will be held at McCarthy Tetrault, Main Board Room, 13th Floor, 777 Dunsmuir Street, Vancouver, B.C., Canada, June 30, 1998, starting at 10:00 a.m., local time. The UDN Board and the Special Committee have determined that the Merger is fair and in the best interests of UDN and its stockholders and have unanimously approved the Merger Agreement. THE UDN BOARD AND THE SPECIAL COMMITTEE UNANIMOUSLY RECOMMEND THAT THE STOCKHOLDERS OF UDN VOTE "FOR" THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY AT THE SPECIAL MEETING. See "The Merger--UDN's Reasons for the Merger; Recommendations of the UDN Board and Special Committee." For a discussion of (i) the interests that certain directors and executive officers of UDN have with respect to the Merger that are different from, or in addition to, the interests of stockholders of UDN generally and (ii) information regarding the treatment of options and warrants to purchase UDN Common Stock and other rights of certain directors and executive officers of UDN, see "The Merger--Interests of Certain Persons in the Merger." Such interests, together with other relevant factors, were considered by the UDN Board and the Special Committee in making their recommendation and approving the Merger Agreement. VOTING RIGHTS; VOTES REQUIRED FOR APPROVAL. The UDN Board has fixed the close of business on May 26, 1998, as the record date for voting at the Special Meeting (the "Record Date"). Only holders of record of shares of UDN Common Stock on the Record Date are entitled to notice of and to vote at the Special Meeting. On the Record Date, there were 7,054,844 shares of UDN Common Stock outstanding and entitled to vote at the Special Meeting, held by approximately 163 stockholders of record. Each holder of record, as of the Record Date, of UDN Common Stock is entitled to cast one vote per share. The presence, in person or by proxy, of the holders of a majority of the outstanding shares of UDN Common Stock entitled to vote is necessary to constitute a quorum at the Special Meeting. The affirmative vote, in person or by proxy, of the holders of a majority of the shares of UDN Common Stock outstanding on the Record Date is required to approve and adopt the Proposal. SHARE OWNERSHIP OF MANAGEMENT. At the close of business on May 15, 1998, directors and executive officers of UDN, as a group, were the beneficial owners of an aggregate of 1,713,464 shares (approximately 24.3%) of the UDN Common Stock then outstanding. As of May 15, 1998, directors and executive officers of STAR, as a group, were beneficial owners of an aggregate of approximately 15,930,974 shares (approximately 37.8%) of the STAR Common Stock then outstanding. The vote of the STAR stockholders is not required to approve the Merger. PROXIES. All shares of UDN Common Stock represented by properly executed proxies received prior to or at the Special Meeting and not revoked will be voted in accordance with the instructions indicated in such proxies. IF NO INSTRUCTIONS ARE INDICATED ON A PROPERLY EXECUTED RETURNED PROXY, HOWEVER, SUCH PROXIES WILL BE VOTED FOR THE APPROVAL OF THE PROPOSAL. A properly executed proxy marked "ABSTAIN", although counted for purposes of determining whether there is a quorum and for purposes of determining the 35 aggregate voting power and number of shares represented and entitled to vote at the Special Meeting, will not be voted and will have the effect of a vote against the Proposal. The UDN Board is not currently aware of any business to be acted upon at the Special Meeting other than the proposed Merger. If, however, other matters are properly brought before the Special Meeting, or any adjournments or postponements thereof, the persons appointed as proxies will have discretion to vote or act thereon according to their judgment. Such adjournments may be for the purpose of soliciting additional proxies. Shares represented by proxies voting against the approval and adoption of the Proposal will be voted against a proposal to adjourn the Special Meeting for the purpose of soliciting additional proxies. UDN does not currently intend to seek an adjournment of its Special Meeting. The persons named in the accompanying instrument of proxy are directors or officers of UDN. A stockholder has the right to appoint a person to attend and act for him on his behalf at the Special Meeting other than the persons named in the enclosed instrument of proxy. To exercise this right, a stockholder shall strike out the names of the persons named in the instrument of proxy and insert the name of his nominee in the blank space provided, or complete another instrument of proxy. The completed instrument of proxy should be deposited at UDN's transfer agent at Montreal Trust Company, 4th Floor--510 Burrard Street, Vancouver, British Columbia, V6C 3B9 prior to the time of the Special Meeting. The instrument of proxy must be signed by the stockholder or by his attorney in writing, or, if the stockholder is a corporation, it must either be under its common seal or signed by a duly authorized officer. In addition to revocation in any other manner permitted by law, a stockholder may revoke a proxy either by (a) signing a proxy bearing a later date and depositing it at the place and within the time aforesaid, or (b) signing and dating a written notice of revocation (in the same manner as the instrument of proxy is required to be executed as set out in the notes to the instrument of proxy) and either depositing it at the place and within the time aforesaid or with the Chairman of the Special Meeting on the day of the Special Meeting or on the day of any adjournment thereof, or (c) registering with Janine Thomas, the Secretary of UDN, at the Special Meeting as a stockholder present in person, whereupon such proxy shall be deemed to be have been revoked. It is the policy of UDN to keep confidential proxy cards, ballots and voting tabulations that identify individual stockholders, except where disclosure is mandated by law and in other limited circumstances. The cost of the solicitation of proxies will be paid by UDN for UDN proxies. In addition to solicitation by mail, arrangements will be made with brokerage houses and other custodians, nominees and fiduciaries to send proxy materials to beneficial owners; and UDN will, upon request, reimburse them for their reasonable expenses. UDN has retained D.F. King & Co., Inc. to aid in the solicitation of proxies and to verify certain records related to the solicitation at a fee of $5,000, plus expenses. To the extent necessary in order to ensure sufficient representation at the Special Meeting, UDN may request by telephone or facsimile transmission the return of proxy cards. The extent to which this will be necessary depends entirely upon how promptly proxy cards are returned. Stockholders are urged to send in their proxies without delay. UDN will indemnify D.F. King & Co., Inc. against certain liabilities and expenses in connection with the proxy solicitation, including liabilities under the federal securities laws. STOCKHOLDERS SHOULD NOT SEND IN ANY STOCK CERTIFICATES WITH THEIR PROXY CARDS. A TRANSMITTAL FORM WITH INSTRUCTIONS FOR THE SURRENDER OF STOCK CERTIFICATES FOR UDN COMMON STOCK WILL BE MAILED TO FORMER UDN STOCKHOLDERS AS SOON AS PRACTICABLE AFTER THE CONSUMMATION OF THE MERGER. 36 THE MERGER GENERAL DESCRIPTION The Merger Agreement provides for a business combination between STAR and UDN in which Newco, a wholly-owned subsidiary of STAR, will be merged with and into UDN and the holders of UDN Common Stock would receive shares of STAR Common Stock in a transaction intended to qualify as a tax-free reorganization for United States federal income tax purposes and as a pooling of interests for accounting purposes. As a result of the Merger, UDN would become a wholly-owned subsidiary of STAR. EFFECTIVE TIME OF THE MERGER The Merger will become effective upon the filing of a Certificate of Merger (the "Certificate of Merger") with the Secretary of State of the State of Delaware (the "Effective Time"). The Certificate of Merger will be filed as promptly as practicable after the approval by UDN's stockholders has been obtained and all other conditions to the Merger have been satisfied or waived. It is presently expected that the Merger will be consummated on or about June 30, 1998 or as soon thereafter as such conditions are satisfied. BACKGROUND OF THE MERGER The terms of the Merger Agreement and the related agreements are the result of arm's-length negotiations between representatives, legal advisors and financial advisors of STAR and UDN. The following is a brief discussion of the background of these negotiations, which resulted in the Merger Agreement and related transactions. STAR actively pursues opportunities to enhance its business through strategic and synergistic acquisitions. These acquisitions may focus on entering new territories, enlarging STAR's presence in an existing territory, adding capacity or expanding into new market segments, such as the commercial market. In furtherance of this objective, STAR acquired LDS, certain non-operating entities and majority ownership in another entity on November 30, 1997 and acquired T-One Corp. on March 10, 1998. UDN has been evaluating a number of strategic options to provide it with the necessary resources to fuel UDN's continued growth and to remain competitive in an industry undergoing rapid consolidation and change. These options included remaining independent but obtaining additional private equity to fund expansion and further acquisitions; selling UDN to another company in the industry; or selling an interest in UDN to a financial investor, with a plan of a subsequent initial public offering of its shares in the United States or sale of UDN to a strategic investor. In July 1997, UDN engaged Madison Securities, Inc. to act as placement agent in a private placement of equity to fund UDN's growth. Pursuant to the private placement, UDN would have offered 30 units at a purchase price of $100,000 per unit, with each unit consisting of 62,500 shares of UDN Common Stock and a warrant to purchase 20,000 additional shares of UDN Common Stock. At a price of $1.60 per share, the consummation of the private placement would have resulted in a substantial dilutive effect on the stockholders of UDN. On October 31, 1997, John Snedegar, the President of UDN and a member of the Board of Directors of STAR, was attending a STAR board meeting in Santa Barbara, California. After the board meeting, Mr. Snedegar advised Christopher Edgecomb, Chief Executive Officer of STAR, that UDN was in the process of completing a private placement financing, which, if completed, would be dilutive to UDN's stockholders. Mr. Edgecomb expressed an interest, on behalf of STAR, for STAR to acquire UDN but he added that STAR would not be interested in acquiring UDN after the completion of the financing because an acquisition of UDN after the financing would greatly increase the aggregate cost of UDN to STAR. Mr. Snedegar and Mr. Edgecomb discussed a general price range of approximately $2.50 per share. Mr. Edgecomb immediately arranged a meeting with STAR's management team and Mr. Snedegar to 37 discuss the possible merger of STAR and UDN. Mary Casey, President and Secretary of STAR, David Vaun Crumly, Executive Vice President of STAR, and Kelly Enos, Chief Financial Officer of STAR, together with Mr. Edgecomb, represented STAR at the meeting. Mr. Snedegar presented UDN's business plan, which included financial projections, at the meeting and agreed to deliver to Ms. Enos a copy of the UDN private placement memorandum, as well as its historical financial statements. During the period from October 31 through November 17, 1997, the date of the next STAR board meeting, which was held in Las Vegas, Nevada, Mr. Snedegar delivered historical financial information to Ms. Enos, and STAR commenced its initial due diligence investigation of UDN. In addition, during that period, Mr. Snedegar informed the members of the UDN Board of the discussions with STAR, and the UDN Board after analyzing the private placement and other alternatives presently under consideration, advised Mr. Snedegar to pursue the merger discussions with STAR. At the November 17 meeting of the STAR Board, Mr. Edgecomb discussed the anticipated advantages of acquiring UDN. The reasons for the Merger discussed by Mr. Edgecomb, as well as the other members of the STAR Board, are discussed at length under the caption "STAR's Reasons for the Merger." At the November 17 meeting, the STAR Board, with Mr. Snedegar abstaining from voting on the proposed transaction, authorized Mr. Edgecomb to pursue detailed discussions with UDN management to pursue a possible merger with UDN. On November 18, 1997, at the request of STAR a second meeting was held at the offices of STAR in Santa Barbara, California. The meeting was attended by Mr. Snedegar and Phil Pearce, an outside director of UDN, Dale Christensen, Chief Operating Officer and Chief Financial Officer of UDN, on behalf of UDN, and Mr. Edgecomb and Ms. Enos on behalf of STAR. The respective legal counsel of STAR and UDN also attended. Periodically during the course of the meeting, Mr. Sledge, the Chairman of the Board of UDN was added to the meeting telephonically. At that meeting, the representatives of STAR and UDN actively negotiated various terms of the Merger Agreement, including those related to the exchange ratio, a loan of $2.5 million to be made by STAR to UDN before consummation of the Merger, a break-up fee, representations and warranties, conditions to closing, indemnification and the operation of UDN during the pendency of the transaction. The negotiations were principally conducted by Messrs. Sledge and Pearce on behalf of UDN, while consulting with Mr. Snedegar. By November 18, 1997, negotiations of the principal terms of the Merger Agreement were completed. All of the members of the UDN Board participated in a special telephonic meeting, held on November 18, 1997 at approximately 5:00 p.m. (California time). Also participating in the meeting were Mr. Christensen, and Martin Eric Weisberg, Esq., a partner of the law firm of Parker Chapin Flattau & Klimpl, LLP, UDN's legal counsel. Mr. Snedegar reported to the Board generally about the negotiations with STAR and the status of UDN's private placement with Madison Securities. Prior to the meeting the members of UDN's Board had been furnished with a term sheet which outlined the salient terms and conditions of the Merger and the related proposed loan from STAR. Mr. Weisberg reviewed the terms set forth on the term sheet with the Board and responded to numerous questions regarding, among other things, the break-up fee, UDN's ability to engage in merger discussions with other third parties, the terms for the repayment of the loan if the Merger was not consummated, STAR's due diligence as a condition to closing, and the requirement that UDN would have to obtain a "fairness opinion" from an independent investment bank. Mr. Weisberg responded that UDN's negotiating team had obtained various concessions from STAR in these and other areas, but advised that STAR was not willing to further modify the terms. Mr. Pearce added that, given the fact that Madison Securities had advised UDN that it was about to commence the initial closing under the private placement, it was imperative to decide at this meeting whether or not to proceed with the Merger. Mr. Snedegar did not participate in the deliberations of UDN's Board. The UDN Board, absent Mr. Snedegar, discussed the entire transaction in detail. At this meeting, the Board debated and discussed the reasons for the Merger set forth under the caption "UDN's Reasons for the Merger; Recommendations of the UDN Board and Special Committee." The UDN Board also decided to retain an independent investment bank to render an opinion as to the entire fairness of the Merger and related loan transaction to UDN. The Board determined that Madison Securities should be 38 considered for this role since Madison Securities had done extensive due diligence, including a valuation analysis, on UDN in connection with the private placement. At that meeting the UDN Board unanimously approved the terms of the proposed transaction and determined to engage Madison Securities to render the fairness opinion. The Merger Agreement was signed on November 19, 1997. During November and December 1997, STAR's due diligence investigation continued and UDN finalized the schedules to the Merger Agreement. As a result of STAR's investigation, and specifically the discovery of certain bad debt exposure of UDN due to fraud by one of its former customers, in January 1998, the Merger Agreement was amended to reduce the consideration to be received by UDN stockholders and STAR agreed to loan UDN an additional $2.0 million on substantially the same terms as the $2.5 million loaned in connection with the execution of the Merger Agreement. At a special telephonic meeting of the UDN Board on January 24, 1998, the UDN Board discussed and unanimously approved the terms of a first amendment to the Merger Agreement, which was signed on January 30, 1998. In March 1998, in light of the vast increase in the price of STAR Common Stock, the Merger Agreement was further amended to provide for a minimum Exchange Ratio to be received by UDN stockholders. In addition, based on the advice of STAR regulatory counsel, the parties agreed to clarify the regulatory approvals to be obtained prior to consummation of the Merger. The second amendment to the Merger Agreement was signed on April 6, 1998. UDN'S REASONS FOR THE MERGER; RECOMMENDATIONS OF THE UDN BOARD AND SPECIAL COMMITTEE The UDN Board and the Special Committee have carefully considered the terms of the proposed Merger and believe that the Merger and the related transactions are fair and in the best interests of UDN and its stockholders. In reaching this determination, the UDN Board and the Special Committee consulted with their financial and legal advisors and with senior management and considered a number of factors, including, without limitation, the following: (i) the consideration to be received by the UDN stockholders in the Merger reflected an appropriate valuation of UDN; (ii) the ability of the combined company to better compete in a rapidly consolidating international long distance industry; (iii) a review of the possible alternatives to a sale of UDN; (iv) that the Merger consideration represented a premium for UDN Common Stock on the last trading day prior to the public announcement of the execution of the Merger Agreement; (v) the financial presentation of UDN's financial advisor and the advisor's opinion as of May 7, 1998 that the terms of the Merger are fair to the stockholders of UDN from a financial point of view; (vi) that STAR is a public company that has experienced substantial growth in revenues and income and has a management team with a proven track record; (vii) the Merger consideration represents a substantial premium over the $1.60 per share which would have been received by UDN in the Madison Securities private placement and such private placement would have resulted in substantial dilution to UDN existing stockholders; (viii) that by providing UDN with the opportunity to combine with a company having state-of-the-art switching equipment, a history of a high level of customer and technical support and strong financial performance, the Merger would support a major strategic objective of UDN to provide the resources to allow the combined entity to rapidly expand into highly fragmented international markets; 39 (ix) the potential efficiencies, synergies and cost savings expected to be realized as a result of the combination of the operations of STAR and UDN, including the combination of billing systems and sales and marketing service and utilization of switches and transmission facilities; (x) that the addition of STAR's facilities in complementary geographic areas, as well as in new markets, would improve the combined entity's ability to pursue its growth strategy; (xi) information with respect to the financial condition, business, operations and prospects of both STAR and UDN on a historical and prospective basis, including certain information reflecting the two companies on a pro forma combined basis, and treating the Merger as a pooling of interests for accounting purposes; (xii) the tax-free nature of the Merger; (xiii) the Exchange Ratio and recent trading prices for UDN Common Stock and STAR Common Stock; and (xiv) the terms of the Merger Agreement. The foregoing list of the information and factors considered by the UDN Board is not intended to be exhaustive. In view of the variety of factors considered in connection with its evaluation of the Merger, the UDN Board did not find it practicable to and did not quantify or otherwise assign relative weights to the specific factors considered in reaching its determination. In addition, individual members of the UDN Board may have given different weights to different factors. THE UDN BOARD AND THE SPECIAL COMMITTEE UNANIMOUSLY RECOMMEND THAT THE STOCKHOLDERS OF UDN VOTE "FOR" THE APPROVAL AND ADOPTION OF THE MERGER AGREEMENT AND THE TRANSACTIONS CONTEMPLATED THEREBY. OPINION OF MADISON SECURITIES, FINANCIAL ADVISOR TO UDN On May 7, 1998, Madison Securities presented its fairness opinion to the UDN Board, together with a written opinion dated May 7, 1998, that, as of such date, the consideration to be received by UDN's stockholders pursuant to the Merger Agreement was fair to such stockholders from a financial point of view. Madison Securities has confirmed its written opinion as of the date of this Proxy Statement/ Prospectus. Based on conditions then prevailing, Madison Securities had rendered a similar opinion on April 13, 1998, as to the consideration provided for in the Merger Agreement. THE FULL TEXT OF THE OPINION OF MADISON SECURITIES DATED THE DATE OF THIS PROXY STATEMENT/PROSPECTUS IS ATTACHED AS ANNEX B TO THIS PROXY STATEMENT/PROSPECTUS. UDN'S STOCKHOLDERS ARE URGED TO READ THIS OPINION IN ITS ENTIRETY. MADISON SECURITIES' OPINION IS DIRECTED ONLY TO THE FAIRNESS OF THE CONSIDERATION TO BE PAID IN THE MERGER TO UDN'S STOCKHOLDERS FROM A FINANCIAL POINT OF VIEW AND DOES NOT CONSTITUTE A RECOMMENDATION TO ANY OF UDN'S STOCKHOLDERS AS TO HOW SUCH STOCKHOLDER SHOULD VOTE AT THE MEETING. THE SUMMARY OF THE OPINION OF MADISON SECURITIES SET FORTH IN THIS PROXY STATEMENT/PROSPECTUS IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO THE FULL TEXT OF SUCH OPINION. In rendering its opinion, Madison Securities (i) reviewed the Merger Agreement; (ii) reviewed certain publicly available financial statements and other information of STAR and UDN, respectively; (iii) reviewed certain internal financial statements and other financial and operating data concerning UDN and STAR prepared by the management of UDN and STAR, respectively; (iv) discussed the past and current operations and financial condition and the prospects of STAR, including information relating to certain strategic, financial and operational benefits anticipated from the Merger, with senior executives of STAR; (v) discussed the past and current operations and financial condition and the prospects of UDN, 40 including information relating to certain strategic, financial and operational benefits anticipated from the Merger, with senior executives of UDN; (vi) reviewed the pro forma impact of the Merger on the earnings per share and consolidated capitalization of STAR and UDN, respectively; (vii) reviewed the reported prices and trading activity for the STAR Common Stock; (viii) compared the financial performance of UDN and STAR and the prices and trading activity of the UND Common Stock and the STAR Common Stock with that of certain other publicly-traded companies and their securities; (ix) reviewed the financial terms, to the extent publicly available, of certain comparable acquisition transactions; (x) reviewed and discussed with the senior managements of UDN and STAR the strategic rationale for the Merger and certain alternatives to the Merger; (xi) reviewed the Merger Agreement and the agreements to be entered in connection therein; and (xii) considered such other factors as they deemed appropriate. In connection with its view, Madison Securities did not independently verify any of the foregoing information and relied on such information as being complete and accurate in all material respects. With respect to the financial forecasts, Madison Securities assumed that they had been reasonably prepared based on reflecting the best currently available estimates and judgments of the managements of STAR and UDN as to the future financial performance of STAR and UDN. In addition, Madison Securities did not make an independent evaluation or appraisal of any of the assets of STAR and UDN. In connection with rendering its opinion, Madison Securities considered a variety of valuation methods. The material valuation methods used are summarized below. These analyses taken together provided the basis for Madison Securities' opinion. For purposes of its analysis, Madison Securities assumed a price for The UDN Common Stock of $2.05 per share: (1) Comparable Company Analysis. Using publicly available information, Madison Securities compared selected historical operating financial, stock data and financial ratios for UDN and certain other companies which, in Madison Securities' judgment, were comparable to UDN for the purpose of this analysis. Because there was no publicly-traded company directly comparable to UDN, the comparable company analysis was comprised of eight companies that Madison Securities deemed most similar to UDN. These companies are CCT Communications Corporation, DCI Telecommunications, Equalnet Holdings Corporation, Group Long Distance, l-Link Inc., Trescom International, USTel Inc. and Worldport Communications, Inc. (the "Selected Companies"). The financial information analyzed included earnings per share for the latest twelve months ("LTM"), fiscal 1997 and estimates for fiscal 1998; book value per share; price multiples for LTM earnings per share, fiscal 1997 earnings per share and estimated 1998 earnings per share; market capitalization; profitability; and a multiple of firm value to revenue, earnings before interest and taxes ("EBIT"), and earnings before interest, taxes, depreciation and amortization ("EBITDA"). This analysis showed that the Selected Companies operate in businesses similar to UDN's and are similar in size to UDN. Market capitalization ranged from $9.0 million to $230.0 million. The average market capitalization was $87.5 million compared to UDN's $16 million. The Selected Companies reported annual earnings per share ranging from -$10.07 to $0.42. The average annual EPS were -$1.91, compared with UDN's -$0.31. The average estimated 1998 earnings per share were -$0.28. Share prices ranged from $1.31 to $11.31. The average price was $6.36. The average Price/Sales ratio was 10.82, compared to UDN's 0.46. The average operating margins were -42.92%, compared to 7.6% for UDN. To summarize, UDN has much higher profitability than the average Selected Company, and at $2.05, its Price/Sales multiple is lower than the average Selected Company. (2) Selected Transaction Analysis. Madison Securities examined recent IPOs of four telecommunications companies. Included in the analysis were Global Telesystems, Nextlink Communications, Startec Global Communication and USN Communications (The "IPO Companies"). This analysis showed that the average offered price per share was $16.25, and the average number of shares offered was 9.3 million. 1997 earnings of these companies ranged from -$15.55 per share to $0.32 per share, averaging -$5.71 per share. The average estimated 1998 earnings per share were -$3.15. Profitability analysis showed that the average operating margin was -132.85% (range -207.60% to 2.44%). Price/ 41 Sales ratios ranged from 1.79 to 35.28, averaging 15.34. Offered Price/Sales ratios ranged from 0.86 to 15.22, averaging 7.81. The analysis of recent telecommunications IPOs confirmed the findings of the analysis in the preceeding paragraph of the Selected Companies. UDN has much higher profitability than the average IPO Company, and at $2.05 per share, its Price/Sales multiple is lower than the average IPO Company. (3) Trading History of the Common Stock. Madison Securities analyzed the price and trading volume history for the common stock of the Selected Companies, UDN and STAR from December 16, 1997, through the date of the fairness opinion. See "SUMMARY--Comparative Per Share Data (Unaudited)". The trading history of the Selected Companies' common stock was reviewed to examine trends in the industry and to examine industry factors affecting UDN Common Stock. The trading history of the STAR Common Stock was examined to evaluate the market price of the STAR Common Stock in light of historical trading levels and volumes. It was noted that the price of the Company's Common Stock had been trading in anticipation of the Merger and, since the announcement of the Merger, the price of the UDN Common Stock has been tied to the price of the STAR Common Stock. In preparing its opinion to the UDN Board, Madison Securities performed a variety of financial and comparative analyses, including those described above. This summary of such analyses does not purport to be a complete description of the analyses underlying Madison Securities' opinion. The preparation of a fairness opinion is a complex analytical process involving various determinations as to the most appropriate and relevant methods of financial analyses and the application of those methods to the particular circumstances. Therefore, such opinion is not readily susceptible to a summary description. In arriving at its opinion Madison Securities did not attribute any particular weight to any analysis or factor considered by it, but rather made qualitative judgments as to the significance and relevance of each analysis and factor. Madison Securities believes that its analyses must be considered as a whole and that selecting portions of its analyses and other factors considered by it, without considering all analyses and factors, could create a misleading view of the processes underlying its opinion. Madison Securities made numerous assumptions with respect to industry performance, general business and economic conditions and other matters, many of which are beyond the control of the company and Madison Securities. Any estimates contained in Madison Securities' analyses are not necessarily indicative of actual values, which may be significantly more or less favorable than as set forth therein. Estimates of the financial value of companies do not purport to be appraisals or necessarily reflect the prices at which companies actually may be sold. Because such estimates are inherently subject to uncertainty, neither UDN, STAR, Madison Securities nor any other person is responsible for their accuracy. In rendering its opinion, Madison Securities expressed no view as to the range of values at which the STAR Common Stock may trade following consummation of the Merger, nor did Madison Securities make any recommendations to UDN's stockholder with respect to how such holders should vote on the Merger or to the advisability of disposing of or retaining STAR Common Stock following the Merger. The UDN Board selected Madison Securities as its financial advisor because Madison Securities is a regionally recognized investment banking firm with experience in transactions similar to the Merger. In addition, Madison Securities has provided financial advisory and financial services for UDN and has received fees for the rendering of such services. As a part of its investment banking business Madison Securities is continually engaged in the valuation of businesses and their securities. Madison Securities will receive, upon completion of the Merger, total fees of approximately $100,000 for acting as financial advisor for UDN and preparing its fairness opinion. UDN has also agreed to reimburse Madison Securities for its reasonable expenses, including attorney's fees, and to indemnify Madison Securities against certain liabilities in connection with its engagement. 42 STAR'S REASONS FOR THE MERGER The STAR Board has unanimously approved the Merger, with Messrs. Edgecomb and Snedegar abstaining. In reaching this determination, the STAR Board consulted with STAR management, as well as its financial and legal advisors, and considered a number of factors, including, without limitation, the following: (i) that by providing STAR with the opportunity to acquire a company having a significant sales force of independent agents with a number of medium-sized commercial customers with a demand for international calling services at competitive rates, the Merger would support a major strategic objective of STAR to continue its expansion into the commercial market; (ii) the potential efficiencies and cost savings expected to be realized as a result of the combination of the operations of STAR and UDN, including the registration by UDN and its subsidiaries under the respective public utility and common carrier rules and regulations of more than 30 states; (iii) that the addition of UDN's switch in Dallas and its other facilities in complementary geographic areas, as well as in new markets, would improve the combined entity's ability to pursue its growth strategy; (iv) information with respect to the financial condition, business, operations and prospects of both STAR and UDN on a historical and prospective basis, including certain information reflecting the two companies on a pro forma combined basis, and treating the Merger as a pooling of interests for accounting purposes; (v) the tax-free nature of the Merger; (vi) the terms of the Merger Agreement; and (vii) the opportunity to create a combined company with greater competitive strengths and business opportunities than would be possible for STAR on a stand-alone basis. The foregoing list of the information and factors considered by the STAR Board is not intended to be exhaustive. In view of the variety of factors considered in connection with its evaluation of the Merger, the STAR Board did not find it practicable to and did not quantify or otherwise assign relative weights to the specific factors considered in reaching its determination. In addition, individual members of the STAR Board may have given different weights to different factors. The Board also consulted with its financial and legal advisors as it deemed appropriate in the context of its review and approval of the Merger. THE MERGER AGREEMENT The following is a brief description of certain terms and provisions set forth in the Merger Agreement. This description does not purport to be complete and is qualified in its entirety by reference to the Merger Agreement, which is attached hereto as ANNEX A and is incorporated herein by reference. Capitalized terms used herein without definition shall have the respective meanings ascribed thereto in the Merger Agreement. Holders of UDN Common Stock are strongly encouraged to read the Merger Agreement in its entirety. Pursuant to the terms of the Merger Agreement, at the Effective Time, (i) Newco will be merged with and into UDN, (ii) each outstanding share of common stock of Newco will be converted into approximately 7,564 shares of common stock of the surviving corporation (the"Surviving Corporation"), and (iii) the separate existence of Newco will cease and UDN will succeed to all the rights, privileges, powers and franchises and be subject to all the restrictions, disabilities and duties of the constituent corporations to the Merger (the "Constituent Corporations") in accordance with the Delaware General Corporation Law (the "DGCL"). UDN will remain as the Surviving Corporation in the Merger and will continue to exist as a wholly-owned subsidiary of STAR. 43 At the Effective Time, each share of UDN Common Stock then issued and outstanding will be converted into the right to receive consideration per share (the "Merger Consideration") consisting of that portion of a share (the "Exchange Ratio") of STAR Common Stock determined by dividing $2.05 by the average closing price of STAR's Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price. The Exchange Ratio shall be adjusted as may be necessary and appropriate to reflect any and all stock splits, reverse stock splits, reclassifications and similar capital events that affect STAR Common Stock. Notwithstanding the foregoing, all treasury shares will be cancelled pursuant to the Merger Agreement. All shares of UDN Common Stock with respect to which appraisal rights have been demanded and perfected in accordance with Section 262(d) of the DGCL (the "Dissenting Stock") shall not be converted into the right to receive the Merger Consideration at or after the Effective Time, and the holder thereof shall be entitled only to such rights as are granted by the DGCL. See "Rights of Dissenting Stockholders." No fractional shares of STAR Common Stock will be issued in the Merger. Rather, holders of UDN Common Stock whose shares are converted in the Merger will be entitled to a cash payment in lieu of fractional shares, as described under "--Exchange of Certificates" and "--Fractional Shares." A description of certain material differences between the rights of holders of STAR Common Stock and UDN Common Stock is set forth under "Comparative Rights of Stockholders." EFFECTIVE TIME. The "Effective Time" shall mean the day on which the Merger will become effective upon the filing, in accordance with Section 251 of the DGCL, of a duly executed certificate of merger with the Delaware Secretary of State, which will occur upon satisfaction or waiver of all conditions set forth in the Merger Agreement. DIRECTORS AND OFFICERS OF THE SURVIVING CORPORATION. The Merger Agreement provides that the directors of Newco at the Effective Time will be the initial directors of the Surviving Corporation and the officers of UDN at the Effective Time will be the initial officers of the Surviving Corporation. Each of these directors will hold office from the Effective Time until their respective successors have been duly elected and qualified in accordance with the Certificate of Incorporation and Bylaws of the Surviving Corporation. DIRECTORS AND OFFICERS OF STAR. The current directors of STAR, including Mr. Snedegar, President and a Director of UDN, will remain as directors of STAR following the Effective Time. The current officers of STAR will remain as officers of STAR following the Effective Time. See "--Interests of Certain Persons in the Merger--Directors and Officers of the Combined Company." EXCHANGE OF CERTIFICATES. UDN STOCKHOLDERS SHOULD NOT SUBMIT THEIR STOCK CERTIFICATES EVIDENCING SHARES OF UDN COMMON STOCK FOR EXCHANGE UNLESS AND UNTIL THE TRANSMITTAL INSTRUCTIONS AND A FORM OF LETTER OF TRANSMITTAL ARE RECEIVED OR OBTAINED FROM U.S. STOCK TRANSFER CORPORATION (THE "EXCHANGE AGENT"). As soon as practicable after the Effective Time, the Exchange Agent shall send a notice and a letter of transmittal to each holder of record of UDN Common Stock immediately prior to the Effective Time advising such holder of the effectiveness of the Merger and the procedure for surrendering to the Exchange Agent the certificate or certificates to be exchanged pursuant to the Merger. Holders of UDN Common Stock, upon surrender of their certificates together with a duly completed letter of transmittal, will receive the Merger Consideration without interest thereon. FRACTIONAL SHARES. No certificates or scrip representing a fractional share interest in STAR Common Stock will be issued. In lieu of any such fractional share interest, each holder of UDN Common Stock who otherwise would be entitled to receive a fractional share interest in STAR Common Stock in the Merger will be paid cash upon surrender of UDN Common Stock in an amount (rounded to the nearest whole US $0.01) equal to the product of such fraction multiplied by the Average Price. 44 REPRESENTATIONS AND WARRANTIES. The Merger Agreement contains various customary representations and warranties of UDN relating to, among other things: (a) UDN's and its subsidiaries' organization and similar corporate matters; (b) UDN's capital structure; (c) the authorization, execution, delivery and enforceability of the Merger Agreement and related matters; (d) the absence of (i) conflicts under charter documents or bylaws, (ii) the need (except as specified) for governmental or other filings, permits, authorizations, consents or approvals with respect to the Merger Agreement and the transactions contemplated thereby, (iii) violations of, conflicts with, breaches of, or defaults under any agreement, lien, instrument, order or decree and (iv) violations of laws; (e) subject to certain exceptions, absence of certain specified material changes or events; (f) litigation; (g) labor matters; (h) employee benefit matters and matters relating to the Employee Retirement Income Security Act of 1974, as amended; (i) owned and leased real property; (j) environmental matters; (k) tax matters; (l) the accuracy of information to be supplied in connection with the Registration Statement, the Joint Proxy Statement/Prospectus and any other documents to be filed with the SEC, the British Columbia Securities Commission, the Vancouver Stock Exchange or any other regulatory agency; (m) financial statements and reports; (n) material liabilities; (o) intellectual property; (p) material agreements; (q) insurance; (r) certain accounting matters; (s) the hiring of brokers or finders; and (t) transactions with affiliated parties. The Merger Agreement also contains various customary representations and warranties of STAR relating to, among other things: (a) STAR'S organization and similar corporate matters; (b) STAR'S capital structure; (c) authorization, execution, delivery and enforceability of the Merger Agreement and related matters; (d) the absence of (i) conflicts under charter documents or bylaws, (ii) the need (except as specified) for governmental filings, permits, authorizations, consents or approvals with respect to the Merger Agreement and in the transactions contemplated thereby, (iii) violations of, conflicts with, breaches of, or defaults under any agreement, lien, instrument, order or decree and (iv) violations of laws; (e) documents filed by STAR with the SEC and the accuracy of the information contained therein; (f) litigation; (g) the accuracy of information to be supplied in connection with the Registration Statement, the Joint Proxy Statement/Prospectus and any other documents to be filed with the SEC, the British Columbia Securities Commission, the Vancouver Stock Exchange or any other regulatory agency; (h) the shares of STAR Common Stock to be issued in the Merger; (i) financial statements and reports; and (j) the hiring of brokers or finders. BUSINESS OF UDN PENDING THE MERGER. UDN has agreed that, among other things, prior to the Effective Time, unless STAR otherwise agrees in writing or unless otherwise expressly provided by the Merger Agreement or the Disclosure Schedules thereto: (a) the business of UDN and of its subsidiaries will be conducted in the ordinary course and consistent with past practice; (b) neither UDN nor its subsidiaries will (i) amend its Certificate of Incorporation or Bylaws; (ii) declare, set aside or pay any dividend; (iii) make any redemption, retirement or purchase of its capital stock; (iv) split, combine or reclassify its capital stock; (v) issue, grant, sell or pledge any shares of its capital stock, except upon exercise of outstanding stock options and warrants; (vi) other than any promissory notes evidencing loans from STAR to UDN, incur any material indebtedness for borrowed money, except material indebtedness for borrowed money incurred under existing credit facilities; (vii) waive, release, grant or transfer any rights of material value; (viii) transfer, lease, license, sell, mortgage, pledge, dispose of or encumber any material assets; (ix) fail to use their reasonable commercial efforts to preserve intact its business organization, to keep available the services of its operating personnel and to preserve the goodwill of those having business relationships with UDN and its subsidiaries; (x) increase the compensation payable to any of its officers or directors; (xi) adopt any new, or make any payment not required by any existing, stock option, bonus, profit-sharing, pension, retirement, deferred compensation, or other payment or employee compensation plan; (xii) grant any stock option or stock appreciation rights or issue any warrants; (xiii) enter into or amend any employment or severance agreement; (xiv) make any loan or advance to, or enter into any written contract with any officer or director; (xv) assume, guarantee, endorse or otherwise become responsible for the obligations of any other individual, firm or corporation or make any loans or advances to any individual, firm or corporation; (xvi) make any investment of a capital nature other than in the 45 ordinary course of business; (xvii) enter into, modify, amend or terminate any material contract; (xviii) take any action, other than reasonable and usual actions in the ordinary course of business and consistent with past practice, with respect to accounting policies or procedures, except for changes required by GAAP; (xix) settle or compromise any material federal, state, local or foreign income tax proceeding or audit; or (xx) enter into an agreement to do any of the things described above. ACQUISITION PROPOSALS. UDN has agreed that neither UDN nor any of its subsidiaries, nor the directors, officers, attorneys, financial advisors, or other authorized persons of any of them, shall, directly or indirectly, solicit, initiate or participate in discussions or negotiations with or the submission of any offer or proposal by or provide any information to, any corporation, partnership, person, or other entity or group (other than Newco or STAR or any officer or other authorized representative of Newco or STAR) concerning the acquisition (by means of a tender or exchange offer, merger, consolidation, business combination or otherwise) of all or a substantial portion of the outstanding shares of UDN Common Stock or of the assets of UDN and its subsidiaries (all such transactions being referred to herein as "Third Party Transactions"), or, except as may be consistent with fiduciary responsibilities under applicable law as advised in writing by outside counsel, participate in any negotiation regarding any Third Party Transaction or otherwise cooperate in any way with any effort or attempt by any other person to effectuate a Third Party Transaction. However, the UDN Board may furnish such information to or enter into discussions and/or negotiations with any corporation, partnership, person or other entity or group that makes an unsolicited offer to engage in a Third Party Transaction with UDN that the UDN Board in good faith determines, with the assistance of its financial advisor, may represent a transaction more favorable to UDN's stockholders when compared to the Merger and the Merger Consideration if, and only to the extent that, the UDN Board determines after consultation with outside legal counsel that the failure to take such action would be inconsistent with the compliance by the UDN Board with its fiduciary duties to the UDN stockholders under applicable law, provided that such party shall enter into a confidentiality agreement on substantially the terms contained in the Merger Agreement, UDN shall notify STAR as to the contents of information being provided and UDN shall diligently enforce its rights under such confidentiality agreement. UDN will promptly communicate to STAR the identity of any potential third party purchaser making any such proposal or contact and, prior to the execution of any agreement relating to any such Third Party Transaction, shall also communicate the proposed terms and conditions thereof. UDN agrees not to release any third party from, or waive any provision of, any confidentiality or standstill agreement to which UDN is a party. TREATMENT OF UDN STOCK OPTIONS AND WARRANTS. On the Effective Time, STAR shall assume the duties and obligations of UDN, and STAR shall be vested with the powers, rights and privileges of UDN, under (a) the warrants of UDN that remain outstanding at the Effective Time and (b) the options of UDN that remain outstanding at the Effective Time. As of the Effective Time, STAR shall have reserved for issuance and continue to maintain sufficient shares of registered STAR Common Stock to issue the required shares of STAR Common Stock pursuant to the exercise of such warrants and options after the Effective Time, subject to appropriate adjustment in the exercise price thereof, based on the Exchange Ratio. 46 INDEMNIFICATION. Under the Merger Agreement, for a period of six years from the Effective Time, STAR has agreed to ensure and guarantee that all provisions with respect to indemnification as set forth in UDN's certificate of incorporation, bylaws or indemnification agreements in each case, as in effect on the date of the Merger Agreement in favor of persons who served as directors, officers, employees or agents of UDN and certain subsidiaries on or before the Effective Time shall not be amended, repealed or modified. CONFIDENTIALITY. Subject to applicable law and to subpoena, STAR, Newco and UDN and its subsidiaries have agreed to hold, and to cause each of their affiliates, employees, officers, directors and other representatives to hold, in strict confidence, and to not use to the detriment of the other party, any information or data furnished to them in connection with the transactions contemplated by the Merger Agreement, except for information or data generally known or available to the public. If the transactions contemplated by the Merger Agreement are not consummated, such confidence shall be maintained and all such information and data as requested shall be returned. EXPENSES AND FEES. If the Merger is consummated, all reasonable fees and expenses incurred in connection with the Merger and the transactions contemplated thereby will be paid by the Surviving Corporation. If the Merger is not consummated, each party shall bear its own fees and expenses. In addition, in certain circumstances, UDN shall pay to Newco a termination fee. See "--Termination Fee." CONDITIONS. The respective obligations of STAR and UDN to effect the Merger are subject to the satisfaction of the following conditions at or prior to the Effective Time: (a) the effectiveness of the Registration Statement, of which this Proxy Statement/Prospectus is a part, and the absence of a stop order or proceedings seeking a stop order; (b) the approval and adoption of the Merger Agreement and the transactions contemplated thereby by the requisite vote of UDN stockholders; (c) the absence of any statute, rule, regulation, preliminary or permanent injunction or other order by any United States, Canadian or state governmental authority, agency, commission or court of competent jurisdiction prohibiting consummation of the Merger; (d) the expiration or termination of any waiting period applicable to the consummation of the Merger under the HSR Act; (e) the receipt by or on behalf of STAR of all necessary regulatory approvals from the FCC and all PUCs required for the transfer of ownership or control over UDN (which condition may be waived by STAR); (f) the authorization for listing of the shares of STAR Common Stock to be issued in connection with the Merger on the Nasdaq National Market upon official notice of issuance; and (g) the absence of any action or proceeding by or before any court or governmental authority or other regulatory or administrative agency or commission of competent jurisdiction which would require either party to take any action which would result in a material adverse effect to their respective businesses. In addition, the obligations of UDN to effect the Merger are subject to the satisfaction at or prior to the Effective Time of the following additional conditions: (a) each of STAR and Newco shall have performed in all material respects its obligations under the Merger Agreement required to be performed by it on or prior to the Effective Time; (b) the representations and warranties of STAR and Newco contained in the Merger Agreement shall be true and correct in all material respects as if such representations and warranties were made as of the Effective Time, except as contemplated by the Merger Agreement; (c) there shall not have been any material adverse change in the financial condition, results of operations, properties or business of STAR and its subsidiaries; (d) UDN shall have received a certificate of the President or Vice President of STAR with respect to clauses (a), (b) and (c); (e) UDN shall have received an opinion of counsel in form reasonably agreed to by the parties; and (f) UDN shall have received the opinion of its financial advisors that the Merger and the other transactions contemplated by the Merger Agreement are fair, from a financial point of view, to the UDN stockholders. The obligations of STAR and Newco to effect the Merger are subject to the satisfaction at or prior to the Effective Time of the following additional conditions: (a) Each of UDN and its subsidiaries shall have performed in all material respects its obligations under the Merger Agreement required to be performed by it on or prior to the Effective Time; (b) the representations and warranties of UDN contained in the Merger Agreement shall be true and correct in all material respects as if such representations and 47 warranties were made as of the Effective Time, except as contemplated by the Merger Agreement; (c) there shall not have been any material adverse change in the financial condition, results of operations, properties or business of UDN; (d) STAR and Newco shall have received a certificate of the President or Vice President of UDN with respect to clauses (a), (b) and (c); (e) Newco shall have received letters of resignation from the members of UDN's Board of Directors; (f) STAR shall have received an opinion of counsel from counsel to UDN in form reasonably agreed to by the parties; (g) holders of no more than 5% of the outstanding shares of UDN Common Stock shall have validly exercised their appraisal rights; (h) each affiliate of UDN shall have executed and delivered an Affiliate Agreement; and (i) STAR shall have received letters (i) from Arthur Andersen LLP approving the accounting treatment of the Merger as a "pooling of interests" and (ii) from Price Waterhouse LLP that UDN has taken no action in the past two years that would prevent the application of a "pooling of interests" accounting treatment to the Merger, and the SEC shall not have objected to such accounting treatment. TERMINATION. The Merger Agreement may be terminated at any time prior to the Effective Time and before approval by the UDN stockholders in a number of circumstances which include, among others: (a) by mutual consent of Newco and UDN; (b) by Newco or UDN, if (i) the Board of Directors of UDN shall have failed to recommend, or withdrawn, modified or amended in any respect its approval or recommendation of the Merger and of the transactions contemplated by the Merger Agreement or the Board of Directors of UDN shall have resolved to do any of the foregoing or (ii) the stockholders of UDN shall have failed to vote in favor of the Merger Agreement and the Merger and, in the case of UDN seeking termination pursuant to (b)(i) above, UDN having paid to Newco the Termination Fee, as defined below; (c) by Newco if (i) there has occurred a material adverse change in the financial condition, operations, or business of UDN and its subsidiaries taken as a whole, or (ii) there is a material breach of any of the representations and warranties of UDN, or if UDN fails to comply in any material respect with any of its covenants or agreements, which breaches or failures are, in the aggregate, material in the context of the transactions contemplated by the Merger Agreement; (d) by UDN (i) if there has occurred a material adverse change in the financial condition, operations, or business of STAR or (ii) there is a material breach of any of the representations and warranties of STAR or Newco, or if STAR or Newco fails to comply in any material respect with any of its covenants or agreements, which breaches or failures are, in the aggregate, material in the context of the transactions contemplated by the Merger Agreement; (e) by either Newco or UDN, if on or before July 15, 1998 the Merger shall not have been consummated; provided that such failure has not been caused by that party's material breach of the Merger Agreement; provided further that if any condition to the Merger Agreement shall fail to be satisfied by reason of the existence of an injunction or order of any court or governmental or regulatory body resulting from an action or proceeding commenced by any party which is not a government or governmental authority, then at the request of either party the deadline date referred to above shall be extended for a reasonable period of time, not in excess of 120 days, to permit the parties to have such injunction vacated or order reversed; and (f) by UDN, if it has not received the opinion of its financial advisors that the Merger and the other transactions contemplated by the Merger Agreement are fair, from a fiscal point of view, to the stockholders of UDN. In the event of such termination and abandonment, no party hereto (or any of its directors or officers) shall have any liability or further obligation to any other party to the Merger Agreement, except for the Termination Fee, if required, and except that nothing herein will relieve any party from liability for any wilful breach of the Merger Agreement prior to such termination or abandonment. TERMINATION FEE. If the Merger Agreement is terminated by either Newco or UDN, pursuant to clause (b)(i) above (a) after receipt of a bona fide Third-Party Transaction proposal or (b) prior to receipt of the fairness opinion described in clause (f) above, then UDN shall, simultaneously with such termination, pay to Newco by wire transfer of immediately available funds, $2.0 million (the "Termination Fee"). AMENDMENT AND WAIVER. Subject to applicable law, the Merger Agreement may be amended by STAR and UDN solely by action of their respective Boards of Directors. Any such amendment must be in 48 writing and signed by both of the parties. At any time prior to the Effective Time, the parties may (i) extend the time for the performance of any of the obligations or other acts of the other parties to the Merger Agreement, (ii) waive any inaccuracies in the representations and warranties of the other party, and (iii) waive compliance by the other party with any of the agreements or conditions to the Merger Agreement. Any agreement on the part of such a party to any such extension or waiver shall be valid only if set forth in an instrument in writing signed on behalf of such party. PROMISSORY NOTES. Upon execution of the Merger Agreement and the first amendment thereto and in connection with the Merger, UDN issued promissory notes to STAR in the principal amount of $2.5 million and $2.0 million, respectively (the "Promissory Notes"). The Promissory Notes provide for, among other things: (a) interest equal to the "Prime Rate" (as reported in the WALL STREET JOURNAL on the date of each Promissory Note and as reset on each Reset Date (defined as each date that interest is payable under each Promissory Note until the principal amount of each Promissory Note is paid in full)) per annum plus one percent (1%); (b) interest shall be paid quarterly in arrears commencing on February 18, 1998 and April 1, 1998, respectively; (c) the outstanding principal amount of the Promissory Note shall become automatically due and payable in full (i) upon the closing of a Third Party Transaction, (ii) in nine months from the issuance date of the Promissory Note, if UDN terminates the Merger Agreement because it has not received the opinion of its financial advisor that the Merger and the other transactions contemplated by the Merger Agreement are fair, from a financial point of view, to the stockholders of UDN, or the stockholders of UDN shall have failed to vote in favor of the Merger Agreement and the Merger, or (iii) in six months from the date of termination, if the Merger Agreement is terminated by either STAR or UDN for any reason whatsoever pursuant to the Merger Agreement (other than as specified in the preceding clause); and (d) the interest rate shall be 15% commencing on the date which is six months from the date of termination if termination is terminated by STAR pursuant to Section 8.1(b)(ii) of the Merger Agreement. MANAGEMENT SERVICES AGREEMENT. STAR and UDN have agreed to use their reasonable efforts to enter into a billing outsourcing agreement (the "Management Services Agreement") which will provide, among other things, for the management by STAR of UDN's customer billings on terms at least as favorable as the terms of UDN's present outsourcing agreement. PROXY AGREEMENT. Upon execution of the Merger Agreement, John R. Snedegar, President of UDN, executed a Proxy Agreement granting STAR an irrevocable proxy to vote all shares of UDN Common Stock held, beneficially or of record, by Mr. Snedegar, and to express consent, in favor of the Merger pursuant to the Merger Agreement and any transaction that is reasonably necessary or appropriate to implement the Merger and in opposition of any proposal for the amendment of UDN's certificate of incorporation or bylaws. The obligations of Mr. Snedegar under the Proxy Agreement shall terminate on the earlier of the Effective Time or termination of the Merger Agreement for any reason. As of May 28, 1998, Mr. Snedegar held 831,647 shares, or approximately 11.8%, of outstanding UDN Common Stock. RESALE OF SHARES OF STAR COMMON STOCK ISSUED IN THE MERGER; AFFILIATES The shares of STAR Common Stock to be issued in the Merger will be freely transferable in the U.S., except that shares issued to any UDN stockholder who may be deemed to be an "affiliate" (as defined under the Securities Act, and generally including, without limitation, directors, certain executive officers and beneficial owners of 10% or more of a class of capital stock) of UDN for purposes of Rule 145 under the Securities Act may be resold by them only in transactions permitted by the resale provisions of Rule 145 or as otherwise permitted under the Securities Act and only after publication by STAR of at least 30 days of combined operating results of STAR and UDN. The Merger Agreement provides that UDN shall cause such affiliate to deliver to STAR at or prior to the Effective Time, a letter agreement from each of them to the effect that such affiliate will not offer or sell or otherwise dispose of any shares of STAR Common Stock issued to such affiliate in or pursuant to the Merger in violation of the Securities Act or the rules and regulations promulgated thereunder. This Proxy Statement/Prospectus does not cover resales of 49 shares of STAR Common Stock received by any person who may be deemed to be an affiliate of UDN. For the UDN stockholders resident in jurisdictions other than the U.S., the free transferability of the STAR Common Stock may vary dependent on the laws of that jurisdiction and, accordingly, each stockholder so affected should consult their legal or other advisors. ACCOUNTING TREATMENT OF THE MERGER The Merger is expected to be accounted for by the pooling of interests method in accordance with generally accepted accounting principles, which means that STAR will restate its historical consolidated financial statements to include the historical assets, liabilities, stockholders' equity and results of operations of UDN. INTERESTS OF CERTAIN PERSONS IN THE MERGER In reviewing the actions of the UDN Board with respect to the Merger Agreement and the transactions contemplated thereby, UDN stockholders should be aware that certain members of UDN's management and the UDN Board have interests in the Merger that are in addition to the interests of UDN stockholders generally. DIRECTORS OF STAR. Mr. Snedegar, President and a director of UDN, also serves as a director of STAR. Mr. Snedegar owns 30,750 shares of STAR Common Stock and options to acquire 10,250 shares of STAR Common Stock, which represents beneficial ownership of less than 1% of the outstanding STAR Common Stock. SEVERANCE PAYMENTS, NONCOMPETITION PAYMENTS AND BONUSES. Each of Messrs. Snedegar and Christensen is a party to an employment agreement with UDN which provides that in the event that there is a change in control of UDN, each may elect to terminate the agreement and upon such termination, each will be entitled to a severance payment equal to his monthly salary times the number of months remaining in the term of the employee agreement which expires on May 31, 2000, in the case of John Snedegar, and six (6) months, in the case of Dale Christensen. See "Certain Relationships and Related Transactions-- UDN Employment Agreements". STOCK OPTION PLANS. At the close of business on the UDN Record Date, the senior management of UDN held outstanding options to purchase an aggregate of 75,000 shares of UDN Common Stock, at exercise prices ranging from $1.64 to $2.04 per share, all of which are currently vested. On the Effective Time, STAR shall assume the duties and obligations of UDN, and STAR shall be vested with the powers, rights and privileges of UDN under the options to purchase UDN Common Stock outstanding at the Effective Time. REGULATORY APPROVALS Under the HSR Act, and the rules promulgated thereunder by the Federal Trade Commission (the "FTC"), the Merger may not be consummated until notification and certain information has been furnished to the FTC and the Antitrust Division of the Department of Justice (the "Antitrust Division") and specified waiting period requirements have been satisfied. STAR and UDN each intend to file notification and report forms with respect to the Merger under the HSR Act with the FTC and the Antitrust Division. The required waiting period with respect to the Merger will expire within thirty days of such filings, unless early termination is granted or a request for additional information is issued. At any time before or after consummation of the Merger, the Antitrust Division or the FTC could take such action under the antitrust laws as it deems necessary or desirable in the public interest, including seeking to enjoin the consummation of the Merger or seeking divestiture of substantial assets of STAR or UDN or any of their respective subsidiaries. At any time before or after the Effective Time, and notwithstanding that the HSR Act waiting period has expired, any state could take such action under its antitrust laws as it deems necessary or desirable. Such action could include seeking to enjoin the consummation of the Merger or seeking divestiture of substantial assets of STAR or UDN or 50 the Surviving Corporation. Private parties also may seek to take legal action under the antitrust laws under certain circumstances. Prior to the change in ownership or management of UDN or the transfer of control over UDN's certificate of public convenience and necessity and daily operations, STAR must obtain all necessary regulatory approvals from the FCC and all PUCs required for the transfer of ownership or control over UDN. STAR is currently in the process of obtaining all such necessary regulatory approvals. STOCK EXCHANGE LISTING It is a condition to the consummation of the Merger that the shares of STAR Common Stock issuable to the stockholders of UDN pursuant to the terms of the Merger Agreement be authorized for listing on the Nasdaq National Market. DELISTING AND DEREGISTRATION OF UDN COMMON STOCK If the Merger is consummated, UDN Common Stock will be delisted from the Vancouver Stock Exchange. COMPARATIVE STOCK PRICES STAR Common Stock has been traded on the Nasdaq National Market under the symbol "STRX" since June 12, 1997. UDN Common Stock has been traded on the Vancouver Stock Exchange under the symbol "UDN.V" since August 9, 1996. The following table sets forth, for the calendar periods indicated, the high and low trading prices per share of STAR Common Stock on the Nasdaq National Market, adjusted to reflect the Stock Split, and the UDN Common Stock on the Vancouver Stock Exchange.
STAR UDN COMMON STOCK COMMON STOCK(1) ----------------------- ----------------------- HIGH LOW HIGH LOW ---------- --------- ---------- --------- 1996 First Quarter........................... -- -- 2 5/8 1 7/8 Second Quarter.......................... -- -- 2 1/4 1 3/8 Third Quarter........................... -- -- 2 1/8 1 3/8 Fourth Quarter.......................... -- -- 2 1 5/8 1997 First Quarter........................... -- -- 2 1 1/2 Second Quarter (from June 12, 1997 for STAR Common Stock).................... 7 3/8 4 41/64 2 3/8 1 3/8 Third Quarter........................... 11 53/64 6 7/32 3 1 5/8 Fourth Quarter.......................... 17 11/16 9 33/64 2 1/4 1 3/4 1998 First Quarter........................... 28 3/64 14 33/64 2 1/8 1 3/8 Second Quarter (through May 28, 1998)... 37 3/8 23 3/8 1 7/8 1 5/8
- ------------------------ (1) All amounts set forth in U.S. dollars, based on the exchange rate of US dollars for each Canadian dollar on the date the UDN Common Stock reached the high and low noted above. STAR has never paid cash dividends on STAR Common Stock and has no intention of paying cash dividends in the foreseeable future. STAR's existing revolving credit facility prohibits the payment of cash dividends without the lender's consent. UDN has never paid cash dividends on UDN Common Stock and has no intention of paying dividends in the foreseeable future. 51 On March 31, 1998, STAR effected the Stock Split. The reported closing sale price of STAR Common Stock on the Nasdaq National Market on November 18, 1997, the last full day of trading for STAR Common Stock prior to the announcement by STAR and UDN of the execution of the Merger Agreement, was $15.183 per share (adjusted to reflect the Stock Split). The closing sale price of UDN Common Stock on the Vancouver Stock Exchange on such date was $2.15 per share. On May 27, 1998, the last trading day prior to the date of this Proxy Statement/Prospectus, the last reported sale price of STAR Common Stock on the Nasdaq National Market was $23.625 per share, and the last reported price of UDN Common Stock on the Vancouver Stock Exchange was $1.625 per share. Following the Merger, STAR Common Stock will continue to be traded on the Nasdaq National Market. At such time, UDN Common Stock will cease to be quoted on the Vancouver Stock Exchange, and, since UDN will be a wholly-owned subsidiary of STAR, there will be no further market for such stock. See "--Delisting and Deregistration of UDN Common Stock." APPRAISAL RIGHTS OF STOCKHOLDERS GENERAL Since UDN's state of incorporation is Delaware, dissenting stockholders who comply with the applicable provision of the Delaware Law will be eligible for appraisal rights in the Merger. If the Merger is consummated, any stockholder who votes against or abstains from voting for the Merger has the right, upon compliance with the provisions set forth in Section 262 of the Delaware Law, more particularly described below, to have his or her shares of UDN Common Stock appraised and to receive payment in cash for the fair value of such stock exclusive of any element of value arising from the accomplishment or expectation of the Merger. The following summary does not purport to be a complete statement of the law in Delaware relating to dissenters' appraisal rights, and the following summary is qualified in its entirety by the statutory provisions of the Delaware Law which are attached to this Proxy Statement/Prospectus as ANNEX C. THE FOLLOWING SUMMARY AND ANNEX C SHOULD BE REVIEWED CAREFULLY BY ANY STOCKHOLDER WHO WISHES TO EXERCISE APPRAISAL RIGHTS, OR WISHES TO PRESERVE THE ABILITY TO DO SO. A STOCKHOLDER MAY WISH TO CONSULT COUNSEL, SINCE FAILURE TO COMPLY WITH THE PROCEDURES SET FORTH BELOW COULD RESULT IN THE LOSS OF SUCH RIGHTS. Payments to Dissenting Stockholders, if any, made in connection with the exercise of appraisal rights will be taxable transactions for federal income tax purposes. DELAWARE LAW When the Merger is effected, stockholders of UDN who comply with the procedures prescribed in Section 262 of the Delaware Law ("Section 262") will be entitled to a judicial determination of the "fair value" of their shares (exclusive of any element of value arising from the accomplishment or expectation of the Merger) and to receive from UDN payment of such fair value in cash. Shares of UDN Common Stock which are outstanding immediately prior to the Effective Time and with respect to which appraisal shall have been properly demanded in accordance with Section 262 shall not be converted into the right to receive the Merger Consideration at or after the Effective Time unless and until the holder of such shares withdraws his or her demand for such appraisal or becomes ineligible for such appraisal. The following is a brief summary of the statutory procedures to be followed by a stockholder of UDN in order to dissent from the Merger and perfect appraisal rights under the Delaware Law. THIS SUMMARY IS NOT INTENDED TO BE COMPLETE AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SECTION 262, THE TEXT OF WHICH IS INCLUDED AS ANNEX C OF THIS PROXY STATEMENT/PROSPECTUS. ANY STOCKHOLDER CONSIDERING DEMANDING APPRAISAL IS ADVISED TO CONSULT LEGAL COUNSEL. A written demand for appraisal of shares of UDN Common Stock must be delivered to UDN by a stockholder seeking appraisal before the taking of the vote on the Merger Agreement. This written demand must be separate from any proxy or vote abstaining from or voting against approval of the Merger 52 Agreement. Voting against approval of the Merger Agreement, abstaining from voting or failing to vote with respect to approval of the Merger Agreement will not constitute a demand for appraisal within the meaning of Section 262. STOCKHOLDERS ELECTING TO EXERCISE THEIR APPRAISAL RIGHTS UNDER SECTION 262 MUST NOT VOTE FOR APPROVAL OF THE MERGER AGREEMENT. A VOTE BY A STOCKHOLDER AGAINST APPROVAL OF THE MERGER AGREEMENT IS NOT REQUIRED IN ORDER FOR THAT STOCKHOLDER TO EXERCISE APPRAISAL RIGHTS. HOWEVER, IF A STOCKHOLDER RETURNS A SIGNED PROXY BUT DOES NOT SPECIFY A VOTE AGAINST APPROVAL OF THE MERGER AGREEMENT OR A DIRECTION TO ABSTAIN, THE PROXY, IF NOT REVOKED, WILL BE VOTED FOR APPROVAL OF THE MERGER AGREEMENT, WHICH WILL HAVE THE EFFECT OF WAIVING THAT STOCKHOLDER'S APPRAISAL RIGHTS. A written demand for appraisal must reasonably inform UDN of the identity of the stockholder of record and that such stockholder intends thereby to demand appraisal. Accordingly, a demand for appraisal should be executed by or for the stockholder of record, fully and correctly, as such stockholder's name appears on the stock certificates. If UDN Common Stock is owned of record in a fiduciary capacity, such as by a trustee, guardian or custodian, such demand must be executed by the fiduciary. If, for example, a stockholder holds shares of UDN Common Stock through a broker, who in turn holds shares through a central securities depository nominee, such as Cede & Co., a demand for appraisal of such shares must be made by or on behalf of such depository nominee. If UDN Common Stock is owned of record by more than one person, as in a joint tenancy or tenancy in common, such demand must be executed by or for all joint owners. An authorized agent, including an agent for two or more joint owners, may execute the demand for appraisal for a stockholder of record; however, the agent must identify the record owner and expressly disclose the fact that, in exercising the demand, he is acting as agent for the record owner. A record owner, such as a broker, who holds UDN Common Stock as a nominee for others, may exercise appraisal rights with respect to the UDN Common Stock held for all or less than all beneficial owners of UDN Common Stock as to which the holder is the record owner. In such case, the written demand must set forth the number of shares of UDN Common Stock covered by such demand. Where the number of shares of UDN Common Stock is not expressly stated, the demand will be presumed to cover all shares of UDN Common Stock outstanding in the name of such record owner. Beneficial owners who are not record owners and who intend to exercise appraisal rights should instruct the record owner to comply strictly with the statutory requirements with respect to the delivery of written demand prior to the taking of the vote on the Merger. A UDN stockholder who elects to exercise appraisal rights must mail or deliver the written demands for appraisal to: Secretary, United Digital Network, Inc., 18872 MacArthur Boulevard, Suite 300, Irvine, California 92612; or should deliver such demand to UDN in person at the Special Meeting. The written demand for appraisal should specify the stockholder's name and mailing address and the number of shares of UDN Common Stock covered by the demand, and should state that the stockholder is thereby demanding appraisal in accordance with Section 262. Within ten days after the Effective Time, UDN must provide notice as to the date of effectiveness of the Merger to all stockholders who have duly and timely delivered demands for appraisal and who have not voted for approval of the Merger Agreement. Within 120 days after the Effective Time, any Dissenting Stockholder is entitled, upon written request, to receive from UDN a statement setting forth the aggregate number of shares not voted in favor of approval of the Merger Agreement and with respect to which demands for appraisal have been received by UDN and the number of holders of such shares. Such statement must be mailed within 10 days after the written request therefor has been received by UDN. Within 120 days after the Effective Time, either UDN or any Dissenting Stockholder may file a petition in the Delaware Court of Chancery demanding a determination of the fair value of shares of UDN Common Stock of all dissenting stockholders. If a petition for an appraisal is timely filed, after a hearing 53 on such petition, the Delaware Court of Chancery will determine which of the UDN stockholders are entitled to appraisal rights and thereafter will appraise the shares of UDN Common Stock owned by such stockholders, determining the fair value of such shares, exclusive of any element of value arising from the accomplishment or expectation of the Merger, together with the fair rate of interest to be paid, if any, upon the amount determined to be fair value. In determining fair value, the Delaware Court of Chancery is to take into account all relevant factors. In WEINBERGER V. UOP, INC., ET AL., the Delaware Supreme Court discussed the factors that could be considered in determining fair value in an appraisal proceeding, stating that "proof of value by any techniques or methods which are generally considered acceptable in the financial community and otherwise admissible in court" should be considered and the "[f]air price obviously requires consideration of all relevant factors involving the value of a company." The Delaware Supreme Court stated that in making this determination of fair value the court and the appraiser may consider "all factors and elements which reasonably might enter into the fixing of value," including "market value, asset value, dividends, earnings prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of the merger and which throw any light on future prospects of the merged corporation." The Delaware Supreme Court has construed Section 262 to mean that "elements of future value, including the nature of the enterprise, which are known or susceptible of proof as of the date of the merger and not the product of speculation, may be considered." However, such court noted that Section 262 provides that fair value is to be determined "exclusive of any element of value arising from the accomplishment or expectation of the merger." Upon the filing of any such petition by a dissenting stockholder, service of a copy thereof shall be made upon STAR, which shall within 20 days of such service file in the office of the Register in Chancery in which the petition was filed a duly verified list containing the names and addresses of all stockholders who have demanded payment for their shares and with whom agreements as to the value of their shares have not been reached by STAR. If such petition is filed by STAR, the petition shall be accompanied by such duly verified list. Stockholders considering whether to seek appraisal should bear in mind that the fair value of their UDN Common Stock determined under Section 262 could be more than, the same as, or less than the value of the Merger Consideration to be exchanged in the Merger, and that opinions of investment banking firms as to fairness from a financial point of view are not necessarily opinions as to fair value under Section 262. Moreover, the Surviving Corporation reserves the right to assert in any appraisal proceeding that, for purposes thereof, the "fair value" of the UDN Common Stock is less than the value of the Merger Consideration. The cost of the appraisal proceeding may be determined by the Delaware Court of Chancery and taxed upon the parties as the court deems equitable in the circumstances. Upon application of a dissenting stockholder, the court may order that all or a portion of the expenses incurred by any dissenting stockholder in connection with the appraisal proceeding, including, without limitation, reasonable attorneys' fees, and the fees and expenses of experts, be charged pro rata against the value of all shares entitled to appraisal. In the absence of such a determination or assessment, each party bears its own expenses. A dissenting stockholder who has duly demanded appraisal in compliance with Section 262 will not, after the Effective Time, be entitled to vote for any purpose the UDN Common Stock subject to such demand or to receive payment of dividends or other distributions on such UDN Common Stock, except for dividends or other distributions payable to stockholders of record at a date prior to the Effective Time. At any time within 60 days after the Effective Time, any dissenting stockholder will have the right to withdraw his or her demand for appraisal and to accept the Merger Consideration. After this period, a dissenting stockholder may withdraw his or her demand for appraisal only with the consent of UDN. If no petition for appraisal is filed with the Delaware Court of Chancery within 120 days after the Effective Time, dissenting stockholders' rights to appraisal shall cease and they shall be entitled only to receive the Merger Consideration. Inasmuch as UDN has no obligation to file such a petition, any stockholder who desires such a petition to be filed is advised to file it on a timely basis. However, no petition timely filed in 54 the Delaware Court of Chancery demanding appraisal shall be dismissed as to any stockholder without the approval of the Delaware Court of Chancery, and such approval may be conditioned upon such terms as the Delaware Court of Chancery deems just. A vote for the Merger will constitute a waiver of appraisal rights. A failure to vote against the Merger will not, under Delaware law, constitute a waiver of appraisal rights. If a stockholder returns a proxy which does not contain instructions as to how it should be voted, such proxy will be voted in favor of the Merger and, accordingly, appraisal rights will be waived. As described above, a vote against the Merger is not sufficient to perfect appraisal rights. A stockholder's failure to make the written demand prior to the Special Meeting as described above will constitute a waiver of appraisal rights. FAILURE TO TAKE ANY REQUIRED STEP IN CONNECTION WITH THE EXERCISE OF APPRAISAL RIGHTS MAY RESULT IN THE TERMINATION OR WAIVER OF SUCH RIGHTS. COMPARATIVE RIGHTS OF STOCKHOLDERS Upon consummation of the Merger, the stockholders of UDN will become stockholders of STAR, a Delaware corporation, and their rights will be governed by STAR's Amended and Restated Certificate of Incorporation (the "STAR Charter") and Bylaws (the "STAR Bylaws"), which differ in certain material respects from UDN's Restated Certificate of Incorporation (the "UDN Charter") and Amended Bylaws (the "UDN Bylaws"). As stockholders of STAR, the rights of the former stockholders of UDN will continue to be governed by the DGCL. The following comparison of the STAR Charter and the STAR Bylaws, on the one hand, and the UDN Charter and the UDN Bylaws, on the other, is not intended to be complete and is qualified in its entirety by reference to the STAR Charter, the STAR Bylaws, the UDN Charter and the UDN Bylaws. Copies of STAR's Charter and the STAR Bylaws are available for inspection at the principal executive office of STAR, and copies will be sent to the holders of UDN Common Stock upon request. Copies of the UDN Charter and the UDN Bylaws are available for inspection at the principal executive office of UDN, and copies will be sent to holders of UDN Common Stock upon request. NUMBER OF DIRECTORS The DGCL provides that a corporation's board of directors shall consist of at least one member and that the authorized number of directors may be fixed in the corporation's certificate of incorporation or in the bylaws. The STAR Bylaws provide that the authorized number of directors constituting the STAR Board shall be established by the STAR Board pursuant to a resolution adopted by a majority of the total number of authorized directors and is currently set at six. The UDN Bylaws provide that the authorized number of directors constituting the UDN Board shall be six until such Bylaws are amended by resolution duly adopted by the UDN Board or the stockholders of UDN. The UDN Board currently consists of five members. CLASSIFICATION The STAR Bylaws provide that the STAR Board will be divided into three classes, and each class generally serves for a term of three years. The term of only one class of directors expires annually, so it is only possible to elect one class of the Board of Directors (or approximately one-third) in any one year. The UDN Board is not classified. REMOVAL OF DIRECTORS; FILLING VACANCIES ON THE BOARD OF DIRECTORS Under the DGCL, any director or the entire board of directors generally may be removed, with or without cause, by the holders of a majority of the shares entitled to vote at an election of directors, provided, however, that directors serving on a classified board may be removed only for cause unless the corporation's charter provides otherwise. The STAR Bylaws provide that any director may be removed 55 only for cause by a majority of the outstanding shares of stock entitled to vote at an election of directors. As the UDN Charter contains no provision concerning removal of directors, under the DGCL, UDN stockholders representing a majority of the outstanding shares of stock entitled to vote at an election of directors may remove a UDN director only for cause. The DGCL generally provides that all vacancies on the board of directors, including vacancies caused by an increase in the number of authorized directors, may be filled by a majority of the remaining directors even if they constitute less than a quorum. Both the STAR Bylaws and the UDN Bylaws provide that vacancies and newly created directorships resulting from an increase in the authorized number of directors may be filled by a majority of the directors then in office, even if less than a quorum, or by a sole remaining director. LIMITATION ON DIRECTORS' LIABILITY The DGCL permits a corporation to include in its certificate of incorporation a provision limiting or eliminating the liability of its directors to such corporation or its stockholders for monetary damages arising from a breach of fiduciary duty, except for: (i) a breach of the duty of loyalty to the corporation, (ii) acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) a declaration of a dividend or the authorization of the repurchase or redemption of stock in violation of the DGCL or (iv) any transaction from which the director derived an improper personal benefit. Both the STAR Charter and the UDN Charter eliminate director liability to the maximum extent permitted by the DGCL. INDEMNIFICATION The DGCL provides in general that a corporation may indemnify any person, including its directors, officers, employees and agents, who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than actions by or in the right of the corporation) by reason of the fact that he or she is or was a representative of or serving at the request of the corporation, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him or her in connection with the action, suit or proceeding if he or she acted in good faith and in a manner he or she reasonably believed to be in, or not opposed to, the best interests of the corporation and, with respect to any criminal proceeding, had no reasonable cause to believe his or her conduct was unlawful. The DGCL permits similar indemnification in the case of actions by or in the right of the corporation, provided that indemnification is not permitted for (i) breach of duty of loyalty to the company, (ii) acts or omissions not in good faith or constituting intentional misconduct or knowing violation of the law, (iii) declaration of an improper dividend, stock purchase or redemption of shares or (iv) any transaction from which the director derived an improper personal benefit. In general, no indemnification for expenses in derivative actions is permitted under the DGCL where the person has been adjudged liable to the corporation, unless a court finds him or her entitled to such indemnification. However, to the extent that a present or former director or officer of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding, or in defense of any claim, issue or matter, he or she shall be indemnified against expenses (including attorneys' fees) actually and reasonably incurred by him or her in connection therewith. The DGCL also provides that the indemnification permitted or required by the DGCL is not exclusive of any other rights to which a person seeking indemnification may be entitled. 56 The UDN Charter provides that UDN shall indemnify any person acting as director or officer of UDN and any person serving at the request of UDN as a director or officer of another corporation, joint venture, partnership, trust or other enterprise, to the fullest extent permitted by the DGCL and provides that UDN may enter into indemnification agreements with each of its directors and officers providing a contractual right of indemnification to the maximum extent permitted by law. The language in the STAR Bylaws provides for indemnification of directors to the full extent permitted by the DGCL and provides that the STAR Board in its discretion may indemnify any person, other than a director, made a party to any action, suit or proceeding by reason of the fact that such person, their testator or intestate, is or was an officer or employee of the corporation. RESTRICTIONS ON BUSINESS COMBINATIONS/CORPORATE CONTROL Section 203 of the DGCL applies to a broad range of business combinations (as defined in the DGCL) between a Delaware corporation and an interested stockholder (as defined). The DGCL definition of "business combination" includes mergers, sales of assets, issuance of voting stock and certain other transactions. An "interested stockholder" is defined as any person who owns, directly or indirectly, 15.0% or more of the outstanding voting stock of a corporation. The DGCL prohibits a corporation from engaging in a business combination with an interested stockholder for a period of three years following the date on which the stockholder became an interested stockholder, unless (i) the board of directors approved the business combination before the stockholder became an interested stockholder, or the board of directors approved the transaction that resulted in the stockholder becoming an interested stockholder, (ii) upon consummation of the transaction which resulted in the stockholder becoming an interested stockholder, such stockholder owned at least 85.0% of the voting stock outstanding when the transaction began other than shares held by directors who are also officers and by certain employee stock plans, or (iii) the board of directors approved the business combination after the stockholder became an interested stockholder and the business combination was approved at a meeting by at least two-thirds of the outstanding voting stock not owned by such stockholder. Both STAR and UDN are subject to the provisions of Section 203 of the DGCL. STOCKHOLDER ACTION BY WRITTEN CONSENT; SPECIAL MEETINGS. The DGCL provides that, unless otherwise provided in the certificate of incorporation, any action that may be taken or is required to be taken at any annual or special meeting of stockholders may be taken without a meeting, without prior notice and without a vote, if a consent in writing, setting forth the action so taken, is signed by the holders of outstanding stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted. The UDN Charter currently permits such action without a meeting. The STAR Charter provides that any action required or permitted to be taken by the stockholders of STAR may be taken without an annual or special meeting only by the unanimous written consent of all stockholders entitled to vote on such action. Under the DGCL, a special meeting of the stockholders may be called by the board of directors or such other person as may be authorized the certificate of incorporation or bylaws. The STAR Bylaws provide that special meetings of stockholders may be called by the President and shall be called by the President or Secretary at the request in writing of a majority of the STAR Board. The UDN Bylaws provide that special meetings of the stockholders of UDN may be called only by the UDN Board, the Chairman of the Board or the holders of shares entitled to cast not less than 10% of the votes at such meeting. AMENDMENT OR REPEAL OF THE CHARTER AND BYLAWS. Under the DGCL, a corporation may amend its certificate of incorporation, from time to time, in any and as many respects as may be desired, so long as its certificate of incorporation as amended would contain only such provisions as it would be lawful and proper to insert in an original certificate of incorporation. The DGCL also provides that a certificate of incorporation may confer on the board of directors the power to amend the bylaws. Additionally, under the DGCL, a corporation's bylaws may be amended by the stockholders entitled to vote, which power may not 57 be divested or limited where the board also has such power. The STAR Bylaws provide that such Bylaws may be altered, amended or repealed or new bylaws may be adopted by the STAR Board or by stockholders holding at least seventy-five percent (75%) of the STAR outstanding capital stock. The UDN Bylaws provide that such Bylaws may be amended or repealed or new bylaws may be adopted by the UDN Board and by the affirmative vote of the holders of a majority of the outstanding shares of stock entitled to vote generally in the election of directors. CUMULATIVE VOTING. Under the DGCL, cumulative voting of stock applies only when so provided in the certificate of incorporation of a corporation. Neither the STAR Charter nor the UDN Charter provides for cumulative voting. STOCKHOLDER VOTE FOR MERGER. Except with respect to certain mergers between parent and subsidiary corporations, the DGCL generally requires the affirmative vote of a majority of the outstanding shares of the constituent corporations in a merger; provided, that where a corporation's certificate of incorporation provides for more or less than one vote per share on any matter, the required vote is a majority of the combined voting power of the corporation's stock. Under the DGCL, holders of stock which is not by its terms entitled to vote on such a transaction are entitled to notice of the meeting at which the proposed transaction is considered. The DGCL does not require, unless provided for in a corporation's charter (and neither the STAR Charter nor the UDN Charter so provides), a stockholder vote of the surviving corporation in a merger, however, if (a) the merger agreement does not amend the existing certificate of incorporation, (b) each outstanding or treasury share of the surviving corporation before the merger is unchanged after the merger, (c) the number of shares to be issued by the surviving corporation in a merger does not exceed 20.0% of the shares outstanding immediately prior to such issuance; and (d) certain other conditions are satisfied. Neither STAR's Charter, the UDN Charter, the STAR Bylaws nor the UDN Bylaws provide for any additional notice or voting requirement with respect to a merger other than those required by the DGCL. DIVIDENDS. The DGCL permits a corporation to pay dividends out of surplus (defined as the excess, if any, of net assets over capital) or, if no surplus exists, out of its net profits for the fiscal year in which such dividends are declared and/or for its preceding fiscal year, provided, that dividends may not be paid out of net profits if the capital of such corporation is less than the aggregate amount of capital represented by the outstanding stock of all classes having a preference upon the distribution of assets. The STAR Bylaws provide that dividends upon the capital stock of the corporation may be declared by the STAR Board at any regular or special meeting, pursuant to law. STAR has not declared or paid cash dividends on the STAR Common Stock since its initial public offering and does not intend to pay such dividends in the foreseeable future. Additionally, STAR's existing credit facility restricts the payment of cash dividends. According to the UDN Bylaws, subject to limitations contained in the DGCL and the UDN Charter, holders of shares of UDN Common Stock are entitled to receive such dividends as may be declared by the UDN Board. UDN has never declared or paid dividends on the UDN Common Stock and does not intend to pay dividends prior to the consummation of the Merger. 58 UNAUDITED PRO FORMA FINANCIAL DATA The following unaudited pro forma financial data is presented assuming the Merger will be accounted for as a pooling of interests, whereby STAR will restate its historical consolidated financial statements to include the assets, liabilities, stockholders' equity (deficit) and results of operations of UDN. The statement of operations data included in the unaudited pro forma financial data reflects the combination of the historical operating results of STAR for the years ended December 31, 1995, 1996 and 1997 and the three months ended March 31, 1998 with the historical operating results of UDN for the twelve month periods ended January 31, 1996, 1997 and 1998 and the three months ended March 31, 1998. The balance sheet data included in the unaudited pro forma financial data reflects the combination of the historical balance sheet data of STAR and of UDN as of March 31, 1998. The unaudited pro forma financial data does not purport to present the financial position or results of operations of STAR had the transactions and events assumed therein occurred on the dates specified, nor are they necessarily indicative of the results of operations that may be achieved in the future. The unaudited pro forma financial data does not give effect to certain cost savings that STAR management believes may be realized as a result of the Merger. There can be no assurances that such cost savings, if any, will be achieved. See "Forward-Looking Statements." The unaudited pro forma condensed combined statements of operations do not reflect certain non-recurring costs expected to be incurred in connection with the Merger. These costs are expected to include investment advisory fees and legal, accounting and other professional fees and certain charges associated with the combination of STAR and UDN. The unaudited pro forma financial data is based on certain assumptions and adjustments described in the Notes to the unaudited pro forma financial data included in this Proxy Statement/Prospectus and should be read in conjunction therewith and with "Management's Discussion and Analysis of Financial Condition and Results of Operations of STAR," "Management's Discussion and Analysis of Financial Condition and Results of Operations of UDN" and the consolidated financial statements of STAR and UDN and the related notes thereto, included elsewhere in this Proxy Statement/Prospectus. 59 UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES AT MARCH 31, 1998 (DOLLARS IN THOUSANDS)
STAR UDN MARCH 31, MARCH 31, MERGER PRO FORMA 1998 1998 ADJUSTMENTS COMBINED ---------- ----------- ----------- ----------- ASSETS: Cash and cash equivalents....................................... $ 5,285 $ 1,113 $ -- $ 6,398 Short-term investments.......................................... 2,978 -- -- 2,978 Trade and notes receivable...................................... 51,024 4,859 (5,808) 50,075 Receivable from related parties................................. 303 -- -- 303 Other current assets............................................ 16,057 257 -- 16,314 ---------- ----------- ----------- ----------- Total current assets........................................ 75,647 6,229 (5,808) 76,068 Property and equipment, net..................................... 67,814 2,122 -- 69,936 Intangible assets, net.......................................... -- 5,893 -- 5,893 Other long-term assets.......................................... 851 242 -- 1,093 ---------- ----------- ----------- ----------- $ 144,312 $ 14,486 $ (5,808) $ 152,990 ---------- ----------- ----------- ----------- ---------- ----------- ----------- ----------- LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT): Payable to stockholders......................................... $ 82 $ 1,025 $ (550) $ 557 Current portion of long-term obligations........................ 6,314 1,205 -- 7,519 Note payable.................................................... -- 4,500 (4,500) -- Accounts payable and accrued expenses........................... 23,242 10,056 (1,308) 31,990 Accrued network cost............................................ 37,667 -- -- 37,667 ---------- ----------- ----------- ----------- Total current liabilities................................... 67,305 16,786 (6,358) 77,733 ---------- ----------- ----------- ----------- Long-term obligations........................................... 25,902 430 -- 26,332 Other long-term liabilities..................................... 378 -- -- 378 ---------- ----------- ----------- ----------- Total long-term liabilities................................. 26,280 430 -- 26,710 ---------- ----------- ----------- ----------- STOCKHOLDERS' EQUITY (DEFICIT).................................. Common Stock of STAR (50,000,000 shares authorized, 35,798,210 actual shares and 36,434,235 pro forma shares issued and outstanding)................................................ 36 -- -- 36 Common Stock of UDN (100,000 shares authorized, 6,993,817 actual shares and no pro forma shares)...................... -- 69 (69) -- Additional paid-in capital.................................... 51,308 12,890 69 64,817 550 Deferred compensation......................................... (10) -- -- (10) Retained earnings (deficit)................................... (607) (15,689) -- (16,296) ---------- ----------- ----------- ----------- Total stockholders' equity (deficit).......................... 50,727 (2,730) 550 48,547 ---------- ----------- ----------- ----------- Total liabilities and stockholders' equity (deficit)........ $ 144,312 $ 14,486 $ (5,808) $ 152,990 ---------- ----------- ----------- ----------- ---------- ----------- ----------- -----------
60 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES FOR THE YEAR ENDED DECEMBER 31, 1995 (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
UDN STAR YEAR ENDED YEAR ENDED JANUARY 31, MERGER PRO FORMA DECEMBER 31, 1995 1996 ADJUSTMENTS COMBINED ----------------- --------------- ----------- ---------------- REVENUES..................................... $ 46,283 $ 5,711 $ (43) $ 51,951 COST OF SERVICES............................. 31,897 4,342 (43) 36,196 -------- ------- ----------- ------- Gross profit............................... 14,386 1,369 -- 15,755 -------- ------- ----------- ------- OPERATING EXPENSES: Selling, general and administrative........ 10,086 2,494 -- 12,580 Depreciation and amortization.............. 186 484 -- 670 -------- ------- ----------- ------- Total operating expenses..................... 10,272 2,978 -- 13,250 -------- ------- ----------- ------- Income (loss) from operations.............. 4,114 (1,609) -- 2,505 -------- ------- ----------- ------- OTHER INCOME (EXPENSE): Interest income............................ 22 (12) -- 10 Interest expense........................... (64) (91) -- (155) Other expense.............................. (33) (183) -- (216) -------- ------- ----------- ------- Total other income (expense)................. (75) (286) -- (361) -------- ------- ----------- ------- Income (loss) before provision for income taxes.................................... 4,039 (1,895) -- 2,144 PRO FORMA PROVISION FOR INCOME TAXES......... 1,632 -- (774) 858 -------- ------- ----------- ------- Pro forma Net Income (Loss).................. $ 2,407 $ (1,895) $ 774 $ 1,286 -------- ------- ----------- ------- -------- ------- ----------- ------- Pro forma Net Income (Loss) per common share: Basic...................................... $ 0.13 $ 0.07 Diluted.................................... $ 0.13 $ 0.07 Weighted average number of common shares outstanding: Basic...................................... 18,020 289 18,309 Diluted.................................... 18,020 289 18,309
61 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES FOR THE YEAR ENDED DECEMBER 31, 1996 (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
UDN STAR YEAR ENDED YEAR ENDED JANUARY 31, MERGER PRO FORMA DECEMBER 31, 1996 1997 ADJUSTMENTS COMBINED ----------------- --------------- -------------- ---------------- REVENUES.................................. $ 237,991 $ 19,685 $ (259) $ 257,417 COST OF SERVICES.......................... 205,585 15,051 (259) 220,377 ----------------- ------- -------------- ---------------- Gross profit............................ 32,406 4,634 -- 37,040 ----------------- ------- -------------- ---------------- OPERATING EXPENSES: Selling, general and administrative..... 34,331 4,563 -- 38,894 Depreciation and amortization........... 1,151 818 -- 1,969 ----------------- ------- -------------- ---------------- Total operating expenses.................. 35,482 5,381 -- 40,863 ----------------- ------- -------------- ---------------- Loss from operations.................... (3,076) (747) -- (3,823) ----------------- ------- -------------- ---------------- OTHER INCOME (EXPENSE): Interest income......................... 110 4 -- 114 Interest expense........................ (601) (448) -- (1,049) Legal settlement and expenses........... (100) -- -- (100) Other income............................ 39 17 -- 56 ----------------- ------- -------------- ---------------- Total other income (expense).............. (552) (427) -- (979) ----------------- ------- -------------- ---------------- Loss before provision for income taxes................................. (3,628) (1,174) -- (4,802) PRO FORMA PROVISION (BENEFIT) FOR INCOME TAXES................................... 1,535 (50) -- 1,485 ----------------- ------- -------------- ---------------- Pro Forma Net Loss........................ $ (5,163) $ (1,124) $ -- $ (6,287) ----------------- ------- -------------- ---------------- ----------------- ------- -------------- ---------------- Pro forma loss per common share: Basic................................... $ (0.24) $ (0.28) Diluted................................. $ (0.24) $ (0.28) Weighted average number of common shares outstanding: Basic................................... 21,939 438 22,377 Diluted................................. 21,939 438 22,377
62 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES FOR THE YEAR ENDED DECEMBER 31, 1997 (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
UDN STAR YEAR ENDED YEAR ENDED JANUARY 31, MERGER PROFORMA DECEMBER 31, 1997 1998 ADJUSTMENTS COMBINED ----------------- --------------- ----------- ---------------- REVENUES..................................... $ 376,198 $ 31,179 $ (1,153) $ 406,224 COST OF SERVICES............................. 325,237 24,633 (1,153) 348,717 ----------------- ------- ----------- ---------------- Gross profit............................... 50,961 6,546 -- 57,507 ----------------- ------- ----------- ---------------- OPERATING EXPENSES: Selling, general and administrative........ 35,667 11,544 -- 47,211 Depreciation and amortization.............. 4,245 1,010 -- 5,255 ----------------- ------- ----------- ---------------- Total operating expenses..................... 39,912 12,554 -- 52,466 ----------------- ------- ----------- ---------------- Income from operations..................... 11,049 (6,008) -- 5,041 ----------------- ------- ----------- ---------------- OTHER INCOME (EXPENSE): Interest income............................ 492 35 (28) 499 Interest expense........................... (1,633) (941) 28 (2,546) Legal settlement and expenses.............. (1,653) -- -- (1,653) Other income (expense)..................... 208 (406) -- (198) ----------------- ------- ----------- ---------------- Total other income (expense)................. (2,586) (1,312) -- (3,898) ----------------- ------- ----------- ---------------- Income (loss) before provision for income taxes.................................... 8,463 (7,320) -- 1,143 PRO FORMA PROVISION FOR INCOME TAXES......... 3,090 -- (2,673) 417 ----------------- ------- ----------- ---------------- Pro Forma Net Income (Loss).................. $ 5,373 $ (7,320) $ 2,673 $ 726 ----------------- ------- ----------- ---------------- ----------------- ------- ----------- ---------------- Pro forma earnings per common share: Basic...................................... $ 0.19 $ 0.02 Diluted.................................... $ 0.17 $ 0.02 Weighted average number of common shares outstanding: Basic...................................... 28,868 550 29,418 Diluted.................................... 31,625 608 32,233
63 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES FOR THE THREE MONTHS ENDED MARCH 31, 1998 (DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
STAR UDN THREE MONTHS THREE MONTHS ENDED ENDED MERGER PRO FORMA MARCH 31, 1998 MARCH 31, 1998 ADJUSTMENTS COMBINED -------------- -------------- ----------- ----------- REVENUES............................................... $ 129,269 $ 8,673 $ (1,385) $ 136,557 COST OF SERVICES....................................... 111,593 6,603 (1,385) 116,811 -------------- ------- ----------- ----------- Gross profit......................................... 17,676 2,070 -- 19,746 -------------- ------- ----------- ----------- OPERATING EXPENSES: Selling, general and administrative.................. 11,875 2,099 -- 13,974 Depreciation and amortization........................ 1,879 271 -- 2,150 -------------- ------- ----------- ----------- Total operating expenses............................... 13,754 2,370 -- 16,124 -------------- ------- ----------- ----------- Income (loss) from operations........................ 3,922 (300) -- 3,622 OTHER INCOME (EXPENSE): Interest income...................................... 283 14 (92) 205 Interest expense..................................... (618) (263) 92 (789) Other expense........................................ (160) -- -- (160) -------------- ------- ----------- ----------- Total other income (expense)........................... (495) (249) -- (744) -------------- ------- ----------- ----------- Income (loss) before provision for income taxes...... 3,427 (549) -- 2,878 PROVISION FOR INCOME TAXES............................. 1,534 -- -- 1,534 -------------- ------- ----------- ----------- Net Income (Loss)...................................... $ 1,893 (549) -- 1,344 -------------- ------- ----------- ----------- -------------- ------- ----------- ----------- Net Income per common share: Basic................................................ $ 0.05 $ 0.04 Diluted.............................................. $ 0.05 $ 0.04 Weighted average number of common shares outstanding: Basic................................................ 35,629 595 36,224 Diluted.............................................. 37,714 641 38,355
64 NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA 1. PERIODS COMBINED The Star Telecommunications Inc. (STAR) consolidated balance sheet as of March 31, 1998 has been combined with the United Digital Network Inc. (UDN) consolidated balance sheet as of March 31, 1998. The Star consolidated statements of operations for the years ended December 31, 1995, 1996 and 1997 have been combined with the UDN consolidated statements of operations for the years ended January 31, 1996, 1997 and 1998, respectively. The Star consolidated statement of operations for the three month period ended March 31, 1998 has been combined with the UDN consolidated statement of operations for the three month period ended March 31, 1998. The unaudited pro forma condensed statements of operations for the years ended December 31, 1995, 1996 and 1997 do not include the results of operations of T-One, which merged with STAR on March 10, 1998, since it is immaterial to the consolidated results of operations of STAR. 2. MERGER COSTS STAR and UDN estimate that they will incur direct transaction costs of approximately $800,000 associated with the Merger, consisting of fees for investment banking, legal, accounting, financial printing and other related charges. Fees incurred by STAR will be charged to operations in the fiscal quarter in which the Merger is consummated. No significant merger related costs were incurred by STAR through December 31, 1997. UDN expensed $160,000 of merger related costs in the year ended January 31, 1998. Merger expenses for the three months ended March 31, 1998 for STAR and UDN amounted to $378,000 and $14,000, respectively. 3. INTERCOMPANY BALANCES At March 31, 1998, STAR had amounts due from UDN as follows (amounts in thousands): Note receivable............................................. $ 4,500 Trade receivables........................................... 1,188 Interest receivable......................................... 120 --------- Total....................................................... $ 5,808 --------- ---------
4. INTERCOMPANY TRANSACTIONS For the years ended December 31, 1995, 1996 and 1997, intercompany sales and related costs of sales amounted to $43,000, $259,000 and $1,153,000, respectively. Intercompany sales for the three months ended March 31, 1998 amounted to $1,385,000. Intercompany interest for the year ended December 31, 1997 and for the three month period ended March 31, 1998 related to the note and amounted to $28,000 and $92,000, respectively. 5. PRO FORMA INCOME TAXES The pro forma provision for income taxes, pro forma net income (loss) and pro forma net income (loss) per common share of STAR for the years ended December 31, 1995, 1996 and 1997 reflect a pro forma tax adjustment, which assumes that both STAR as well as LDS, which was acquired by STAR in a pooling of interest transaction on November 30, 1997, were C-Corporations for all periods presented (see Note 9 of Notes to STAR Telecommunications, Inc. Consolidated Financial Statements). 65 NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL DATA 5. PRO FORMA INCOME TAXES (CONTINUED) The Merger adjustment in the provision for income taxes for the years ended December 31, 1995, 1996 and 1997 as well as for the three months ended March 31, 1998 are an adjustment to reflect STAR's effective tax rate in the statements of income for the combined entity. 6. EXCHANGE OF STOCK Eliminates UDN's common stock balance less the par value of 636,025 shares to be issued in the Merger. 7. CONVERTIBLE DEBENTURE To record the conversion of a debenture in the amount of $550,000 at March 31, 1998 which is convertible into 275,000 shares of UDN Common Stock which in turn will be converted into an equivalent number of STAR Common Stock based on the Exchange Ratio. 8. PRO FORMA EARNINGS PER SHARE The unaudited pro forma combined basic earnings per share and diluted earnings per share are based on the weighted average number of common and dilutive equivalent shares, for each period at the Exchange Ratio of 0.086772 shares of STAR Common Stock for each share of UDN Common Stock outstanding during the period. 66 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF STAR THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF STAR SHOULD BE READ IN CONJUNCTION WITH "SELECTED CONSOLIDATED FINANCIAL DATA OF STAR" AND THE STAR CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO, EACH OF WHICH IS INCLUDED ELSEWHERE IN THIS PROXY STATEMENT/PROSPECTUS. THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS, AS DEFINED IN SECTION 27A OF THE SECURITIES ACT, THAT INVOLVE RISKS AND UNCERTAINTIES. STAR'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING, BUT NOT LIMITED TO THOSE DISCUSSED IN "RISK FACTORS" AND ELSEWHERE IN THIS PROXY STATEMENT/PROSPECTUS. SEE "DESCRIPTION OF FORWARD-LOOKING STATEMENTS." OVERVIEW STAR is an emerging multinational carrier focused primarily on the international long distance market. STAR offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 countries through its flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with other long distance providers. STAR installed its first international gateway switch in Los Angeles in June 1995 and initially recognized wholesale revenues in August 1995. A significant portion of STAR's revenues in 1994 and 1995 were generated by the commercial operations of LDS. REVENUES. Most of STAR's revenues are generated by the sale of international long distance services on a wholesale basis to other, primarily domestic, long distance providers. STAR records revenues from the sale of long distance services at the time of customer usage. STAR's agreements with its wholesale customers are short-term in duration and the rates charged to customers are subject to change from time to time, generally with five days notice to the customer. COSTS OF SERVICES. STAR has pursued a strategy of attracting customers and building calling volume and revenue by offering favorable rates compared to other long distance providers. STAR continues to lower its cost of services by (i) expanding STAR's owned network facilities, (ii) continuing to utilize STAR's sophisticated information systems to route calls over the most cost-effective routes and (iii) leveraging STAR's traffic volumes and information systems to negotiate lower variable usage-based costs with domestic and foreign providers of transmission capacity. Costs of services include those costs associated with the transmission and termination of international long distance services. Currently, a majority of transmission capacity used by STAR is obtained on a variable, per minute basis. As a result, some of STAR's current costs of services is variable. STAR's contracts with its vendors provide that rates may fluctuate, with rate change notice periods varying from five days to one year, with certain of STAR's longer term arrangements requiring STAR to meet minimum usage commitments in order to avoid penalties. Such variability and the short-term nature of many of the contracts subject STAR to the possibility of unanticipated cost increases and the loss of cost-effective routing alternatives. Included in STAR's costs of services are accruals for rate and minute disputes and unreconciled billing differences between STAR and its vendors. Each quarter management reviews the cost of services accrual and adjusts the balance for resolved items. Costs of services also include fixed costs associated with the leasing of network facilities. STAR intends to begin providing international long distance services to commercial customers in certain European countries in the second half of 1998. STAR began providing long distance service to commercial markets in the U.S. with its acquisition of LDS in November 1997. STAR believes that traffic from commercial customers has the potential to generate higher gross margins than wholesale traffic. STAR also expects, however, that an expansion into this market will also increase the risk of bad debt 67 exposure and lead to higher overhead costs. Information related to wholesale and commercial revenues and operations will be reported in future Exchange Act filings made by STAR in accordance with Financial Accounting Standards Board Statement No. 131. Prices in the international long distance market have declined in recent years and, as competition continues to increase, STAR believes that prices are likely to continue to decline. Additionally, STAR believes that the increasing trend of deregulation of international long distance telecommunications will result in greater competition, which could adversely affect STAR's revenue per minute and gross margin. STAR believes, however, that the effect of such decreases in prices will be offset by increased calling volumes and decreased costs. OPERATING EXPENSES. Selling, general and administrative expenses consist primarily of personnel costs, depreciation and amortization, tradeshow and travel expenses and commissions and consulting fees, as well as an accrual for bad debt expense. These expenses have been increasing over the past year, which is consistent with STAR's recent growth, accelerated expansion into Europe, and investment in systems and facilities. STAR expects this trend to continue, and to include, among other things, a significant increase in depreciation and amortization. Management believes that additional selling, general and administrative expenses will be necessary to support the expansion of STAR's network facilities, its sales and marketing efforts and STAR's expansion into commercial markets. FOREIGN EXCHANGE. STAR's revenues and cost of long distance services are sensitive to foreign currency fluctuations. STAR expects that an increasing portion of STAR's revenues and expenses will be denominated in currencies other than U.S. dollars, and changes in exchange rates may have a significant effect on STAR's results of operations. FACTORS AFFECTING FUTURE OPERATING RESULTS. STAR's quarterly operating results are difficult to forecast with any degree of accuracy because a number of factors subject these results to significant fluctuations. As a result, STAR believes that period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indications of future performance. STAR's revenues, costs and expenses have fluctuated significantly in the past and are likely to continue to fluctuate significantly in the future as a result of numerous factors. STAR's revenues in any given period can vary due to factors such as call volume fluctuations, particularly in regions with relatively high per-minute rates; the addition or loss of major customers, whether through competition, merger, consolidation or otherwise; the loss of economically beneficial routing options for the termination of STAR's traffic; financial difficulties of major customers; pricing pressure resulting from increased competition; and technical difficulties with or failures of portions of STAR's network that impact STAR's ability to provide service to or bill its customers. STAR's cost of services and operating expenses in any given period can vary due to factors such as fluctuations in rates charged by carriers to terminate STAR's traffic; increases in bad debt expense and reserves; the timing of capital expenditures, and other costs associated with acquiring or obtaining other rights to switching and other transmission facilities; changes in STAR's sales incentive plans; and costs associated with changes in staffing levels of sales, marketing, technical support and administrative personnel. In addition, STAR's operating results can vary due to factors such as changes in routing due to variations in the quality of vendor transmission capability; loss of favorable routing options; the amount of, and the accounting policy for, return traffic under operating agreements; actions by domestic or foreign regulatory entities; the level, timing and pace of STAR's expansion in international and commercial markets; and general domestic and international economic and political conditions. Further, a substantial portion of transmission capacity used by STAR is obtained on a variable, per minute and short-term basis, subjecting STAR to the possibility of unanticipated price increases and service cancellations. Since STAR does not generally have long term arrangements for the purchase or resale of long distance services, and since rates fluctuate significantly over short periods of time, STAR's gross margins are subject to significant fluctuations over short periods of time. STAR's gross margins also may be negatively impacted in the longer term by competitive pricing pressures. 68 RECENT ACQUISITIONS AND DEVELOPMENTS STAR has recently acquired or entered into agreements to acquire the following companies and has taken the following actions: - L.D. SERVICES, INC. On November 30, 1997, STAR acquired LDS, certain non-operating entities and majority ownership in another entity for approximately 849,000 shares of Common Stock in a transaction accounted for as a pooling of interests. STAR's audited financial statements have been restated to include LDS' historical performance for all relevant periods. The commercial business of LDS has historically had higher gross margins and higher selling, general and administrative expenses and operating costs than STAR's wholesale operations. As STAR integrates and expands the commercial accounts of LDS, such increase in operations may affect STAR's future operating margins. In 1997, LDS settled disputes with the California PUC and with the District Attorney of Monterey, California. The resulting payments and restrictions on LDS' activities adversely affected its 1997 operating results. See "Business of STAR--Government Regulation--Actions Against LDS." - T-ONE CORP. On March 10, 1998, STAR acquired T-One for 1,353,000 shares of Common Stock in a transaction accounted for as a pooling of interests. For the fiscal year ended December 31, 1997, T-One had revenues of $30.4 million, gross profit of $1.8 million, selling, general and administrative expenses of $1.5 million and net income of $0.2 million. See Note 14 of Notes to STAR Consolidated Financial Statements. - STOCK SPLIT. On March 31, 1998, STAR effected the Stock Split with payment to the holders of the shares of Common Stock outstanding on February 20, 1998 of a stock dividend equal to 1.05 shares of Common Stock for each such outstanding share. - PUBLIC OFFERING. On May 4, 1998, STAR consummated a firmly underwritten public offering of 6,000,000 shares of STAR Common Stock, of which 5,685,000 shares were sold by STAR and 315,000 shares were sold by a certain stockholder of STAR. STAR and certain STAR stockholders have granted the underwriters a 30-day option to purchase up to 900,000 additional shares of STAR Common Stock solely to cover over-allotments, if any. RESULTS OF OPERATIONS The following table sets forth certain selected items in STAR's statements of operations as a percentage of total revenues for the periods indicated:
THREE MONTHS YEARS ENDED DECEMBER 31, ENDED MARCH 31, ----------------------------- ----------------- 1995 1996 1997 1997 1998 ------ ------- ------ ------ ------ (UNAUDITED) Revenues................................ 100.0% 100.0% 100.0% 100.0% 100.0% Costs of services....................... 68.9 86.4 86.5 86.9 86.3 ------ ------- ------ ------ ------ Gross profit............................ 31.1 13.6 13.5 13.1 13.7 Operating Expenses: Selling, general and administrative expenses............................ 21.8 14.4 9.4 9.1 9.1 Depreciation and amortization......... 0.4 0.5 1.1 1.0 1.5 ------ ------- ------ ------ ------ Total operating expenses.............. 22.2 14.9 10.6 10.1 10.6 Income (loss) from operations........... 8.9 (1.3) 2.9 3.0 3.0 ------ ------- ------ ------ ------ Income (loss) before provision for income taxes.......................... 8.7 (1.5) 2.3 2.6 2.7 Provision for income taxes.............. 0.1 0.3 0.8 0.4 1.2 ------ ------- ------ ------ ------ Net income (loss)....................... 8.6% (1.8)% 1.5% 2.2% 1.5% ------ ------- ------ ------ ------ ------ ------- ------ ------ ------
69 THREE MONTHS ENDED MARCH 31, 1998 COMPARED TO THREE MONTHS ENDED MARCH 31, 1997 (UNAUDITED) REVENUES. Revenues increased 52.4% to $129.3 million in the first quarter of 1998 from $84.8 million in the first quarter of 1997. Wholesale revenues increased to $121.2 million (including $11.4 million of revenue from T-One) from $76.5 million (including $5.4 million of revenue from T-One). Wholesale minutes of use increased 73.2% to 324.4 million in the first quarter of 1998, as compared to 187.3 million minutes of use in the comparable quarter of the year prior. This increase reflects growth in the number of wholesale customers from 100 in March of 1997 to 131 at the end of March 1998, as well as an increase in usage by existing customers. The average rate per minute of use declined to $0.37 for the current quarter as compared to $0.40 for the quarter ended March 31, 1997 reflecting the change in country mix to include a larger proportion of lower rate per minute countries as well as lower prices on competitive routes. Commercial revenues decreased to $8.1 million in the first quarter of 1998 from $8.4 million in the first quarter of 1997 reflecting the termination of the LDS customer base in California due to the 1997 settlement entered into by LDS with each of the California PUC and the District Attorney of Monterey, California. GROSS PROFIT. On a consolidated basis gross profit increased 59.2% to $17.7 million in the first quarter of 1998 from $11.1 million in the first quarter of 1997. Wholesale gross profit increased to $14.3 million in 1998 from $7.6 million for 1997 and wholesale gross margin increased to 11.8% from 9.9%, respectively. Wholesale gross profit expanded during the first quarter of 1998 as traffic was increasingly routed over the Company's proprietary international network. Without the inclusion of T-One in the Company's wholesale results the gross margin would have been 12.5% and 10.2% for the quarters ending March 31, 1998 and 1997, respectively. SELLING, GENERAL AND ADMINISTRATIVE. For the first quarter of 1998, selling, general and administrative expenses increased 49.8% to $11.6 million, from $7.7 million in the first quarter of 1997. Wholesale selling, general and administrative expenses increased to $8.1 million in the first quarter of 1998 from $4.7 million in the first quarter of 1997, and increased as a percentage of wholesale revenues to 6.7% from 6.1% over the comparable periods. Total expenses increased year to year in absolute dollars as STAR expended its proprietary international network and employee base. Commercial selling, general and administrative expenses increased to $3.5 million in the first quarter of 1998 from $3.0 million in the first quarter of 1997 and increased as a percentage of commercial revenues to 42.4% from 36.3%, respectively, as LD Services increased its telemarketing sales force to focus on new ethnic marketing programs. The Company expects selling, general and administrative expenses to expand in absolute dollars and as a percentage of revenues throughout fiscal year 1998, as the Company expands its network and employee base and in connection with the Company's development of the commercial market. DEPRECIATION. Depreciation increased to $1.9 million for the first quarter of 1998 from $820,000 for the first quarter of 1997, and increased as a percentage of revenues to 1.5% from 1.0% in the prior period. Depreciation increased as a result of STAR's continuing expansion of its proprietary international network which includes purchases of switches, undersea cable and leasehold improvements associated with switch sites. STAR expects depreciation expense to increase as the Company continues to expand its global telecommunications network. OTHER INCOME (EXPENSE). Other expense, net, increased to $495,000 in the first quarter of 1998 from $326,000 in the first quarter of 1997. This increase is primarily due to interest expense of $618,000 incurred under various capital leases and bank lines of credit. Interest income earned on short-term investments increased to $283,000 in the first quarter of 1998 from $21,000 in the first quarter of 1997 reflecting interest earned on cash generated by operations. Also included in other expense is $171,000 in foreign currency losses related to the intercompany account between STAR and its German subsidiary. 70 PROVISION FOR INCOME TAXES. The provision for income taxes increased to $1.5 million in the first quarter of 1998 from $341,000 in the first quarter of 1997 ($888,000 pro forma), primarily due to the increase in profitability of the Company. YEARS ENDED DECEMBER 31, 1997 AND 1996 REVENUES. Revenues increased 58.1% to $376.2 million in 1997 from $238.0 million in 1996. Wholesale revenues increased to $348.7 million from $208.1 million, with minutes of use increasing to 863.3 million minutes in 1997, as compared to 479.7 million minutes of use in the prior year. This increase reflects an increase in the number of wholesale customers from 84 in 1996 to 105 at the end of 1997, as well as an increase in usage by existing customers. The average rate per minute of usage for wholesale customers declined from $0.43 cents per minute in 1996 to $0.40 cents per minute in 1997, reflecting the change in country mix to include a larger proportion of lower rate per minute countries as well as lower prices on competitive routes. Taking into account the acquisition of T-One, on a pro forma basis, revenues in 1997 would have been $406.6 million, an increase of 56.1% from $260.4 million in 1996. Commercial revenues decreased to $27.5 million in 1997 from $29.9 million in 1996 reflecting the termination of the LDS customer base in California due to the 1997 settlement entered into by LDS with each of the California PUC and the District Attorney of Monterey, California. See "Business of STAR-- Governmental Regulation--Actions Against LDS." GROSS PROFIT. Gross profit increased 57.3% to $51.0 million in 1997 from $32.4 million in 1996. Wholesale gross profit increased to $39.8 million in 1997 from $19.7 million for 1996 and wholesale gross margin increased to 11.4% from 9.4%, respectively. Wholesale gross profit expanded during 1997 as traffic was increasingly routed over STAR's proprietary international network. Commercial gross profit decreased 11.8% to $11.2 million in 1997 from $12.7 million in 1996 and commercial gross margin declined to 40.7% from 42.6% over such periods, reflecting declining prices in the competitive long distance market. As STAR migrates the LDS commercial customer base onto STAR's network, LDS's cost of commercial long distance services is expected to decline. Taking into account the acquisition of T-One, on a pro forma basis, gross profit in 1997 would have been $52.8 million, an increase of 56.4% over gross profit of $33.7 million in 1996. SELLING, GENERAL AND ADMINISTRATIVE. In 1997, selling, general and administrative expenses increased 3.1% to $35.4 million, from $34.3 million in 1996. Wholesale selling, general and administrative expenses increased to $26.0 million in 1997 from $24.1 million in 1996, but decreased as a percentage of wholesale revenues to 7.5% from 11.6% over the comparable periods. Total expenses increased year to year in absolute dollars as STAR expanded its proprietary international network and employee base. Included in the 1996 selling, general and administrative expense was $11.6 million in reserves and write-offs against deposits and accounts receivable related to bad debts from two customers. Commercial selling, general and administrative expenses decreased to $9.4 million in 1997 from $10.2 million in 1996 and remained flat as a percentage of commercial revenues at approximately 34.1%. STAR expects selling, general and administrative expenses to expand in absolute dollars and as a percentage of revenues in fiscal year 1998, as STAR expands its network and employee base and in connection with STAR's entry into the commercial market. DEPRECIATION. Depreciation increased to $4.2 million for 1997 from $1.2 million for 1996, and increased as a percentage of revenues to 1.1% from 0.5% in the prior period. Depreciation increased as a result of STAR's continuing expansion of its proprietary international network which includes purchases of switches, submarine cable and leasehold improvements associated with switch sites. STAR expects depreciation expense to increase as STAR continues to expand its global telecommunications network. OTHER INCOME (EXPENSE). Other expense, net, increased to $2.6 million in 1997 from $552,000 in 1996. This increase is primarily due to interest expense of $1.6 million incurred under various capital leases and bank lines of credit and a legal settlement and associated expenses of $1.7 million. The legal settlement 71 relates to the dispute settled by LDS with the California PUC and the District Attorney of Monterey County. See "Business of STAR--Governmental Regulation--Actions Against LDS." Interest income earned on short-term investments increased to $492,000 in 1997 from $110,000 in 1996 due to interest earned on the proceeds of STAR's June 1997 initial public offering. PROVISION FOR INCOME TAXES. The historical provision for income taxes increased to $2.9 million in 1997 from $592,000 in 1996 primarily due to the increase in profitability of STAR. YEARS ENDED DECEMBER 31, 1996 AND 1995 REVENUES. Revenues increased 414.2% to $238.0 million in 1996 from $46.3 million 1995. Wholesale revenues increased to $208.1 million in 1996 from $16.1 million in 1995, with minutes of use increasing to 479.7 million in 1996, as compared to 38.1 million minutes of use in the prior year. The increase in wholesale revenue resulted from STAR's commencement of operations as an international long distance carrier, an increase in the number of customers as compared to the prior year and an increase in minutes of wholesale traffic from new and existing customers. The increase in traffic is also attributable to an increase in the number of routes with favorable rates that STAR was able to offer to customers. Commercial revenues decreased to $29.9 million in 1996 from $30.2 million in 1995 due to a decrease in the rate per minute charged, which was partially offset by an increase in the number of minutes sold. Taking into account the acquisition of T-One, on a pro forma basis revenues would have been $260.4 million in 1996, an increase of 341.9% from $58.9 million in 1995. GROSS PROFIT. Gross profit increased 125.3% to $32.4 million for 1996 from $14.4 million in 1995. Wholesale gross profit increased to $19.7 million in 1996 from $1.8 million for 1995. Wholesale gross margin decreased to 9.4% in 1996 from 11.0% in 1995, reflecting the change from STAR's prior consulting business to operating as an international long distance carrier. Gross profit was positively impacted during 1996 by the negotiation of lower rates on routes with significant traffic, and negatively impacted by increases in traffic on routes with lower margins. Commercial gross profit increased to $12.7 million in 1996 from $12.6 million in 1995 with gross margin increasing to 42.6% from 41.8%, respectively. The gross profit from commercial services expanded as costs associated with the local exchange carriers declined. Taking into account the acquisition of T-One, on a pro forma basis, gross profit in 1996 would have been $33.7 million, an increase of 130.0% from $14.7 million in 1995. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 240.4% to $34.3 million in 1996 from $10.1 million in 1995. Wholesale selling, general and administrative expenses increased to $24.1 million in 1996 from $2.1 million in 1995, and decreased as a percentage of revenues to 11.6% from 12.8% in the prior period. Selling, general and administrative expenses increased between periods as STAR increased its employee base and incurred payroll, employee benefits, commission and related expenses. STAR also established a reserve for doubtful accounts to reflect its significantly higher revenue levels and invested in sales and marketing activities, including tradeshows and travel. Hi-Rim and CCI, two of STAR's major customers in 1996, informed STAR that they were experiencing financial difficulties and would be unable to pay in full outstanding accounts receivable. As a result, the full amount of the approximately $10.8 million owed to STAR by Hi-Rim and CCI as of December 31, 1996 which was not subsequently collected or for which no offsetting value was received, was written off or reserved in 1996. In addition, STAR wrote-off $820,000 of intangible assets relating to CCI. Commercial selling, general and administrative expenses increased to $10.2 million in 1996 from $8.0 million in 1995 reflecting higher operating costs. DEPRECIATION. Depreciation increased to $1.2 million for 1996 from $186,000 for 1995, an increase as a percentage of revenues to 0.5% from 0.4% in the prior period. Depreciation increased as a result of STAR's purchase of switches and of the operating equipment and leasehold improvements associated with its Los Angeles and New York switching facilities. Depreciation expense will increase as STAR expands its ownership of switching and transmission facilities through purchase or use of capital leases. 72 OTHER INCOME (EXPENSE). Other expense, net, increased to $552,000 in 1996 from $75,000 in 1995. This increase is primarily due to a $100,000 legal settlement in the second quarter of 1996 as well as $601,000 in interest expense incurred under various bank and stockholder lines of credit. This increase was offset by $110,000 in interest income on short-term investments and cash equivalents primarily from funds raised in private placements of equity securities during the first three quarters of 1996. PROVISION FOR INCOME TAXES. Through December 31, 1995 STAR had elected to be taxed as an S-Corporation for both federal and state income tax purposes and thus was only subject to 1.5% tax on taxable income for state purposes. LDS was an S-Corporation through the date of the merger on November 30, 1997. The pro forma provision for income taxes, assumes that both STAR and LDS were C-Corporations for all periods presented. During 1996, the historical provision for income taxes increased to $592,000 as a result of the reserve of $2.9 million of the net deferred tax asset. LIQUIDITY AND CAPITAL RESOURCES As of March 31, 1998, STAR had cash and cash equivalents of approximately $5.3 million, short-term investments of $3.0 million, and a working capital surplus of $8.3 million. In June 1997, STAR completed an initial public offering of 9.4 million shares of Common Stock of which approximately 8.1 million shares were sold by STAR and approximately 1.3 million shares were sold by certain selling stockholders. The net proceeds to STAR (after deducting, underwriting, discounts and offering expenses) from the sale of such shares of Common Stock were approximately $30.9 million. As of December 31, 1997, STAR had used the proceeds from the offering to repay indebtedness of $14.2 million, to purchase switching and transmission related equipment and to finance STAR's operations in the U.K. On May 4, 1998, STAR completed a secondary offering of 6,000,000 shares of Common Stock of which 5,685,000 shares were sold by STAR and 315,000 shares were sold by a selling stockholder. The net proceeds to STAR (after deducting underwriting discounts and offering expenses) from the sale of such shares of Common Stock were aproximately $145.0 million. As of March 31, 1998, STAR had no funds outstanding on its $25 million revolving line of credit, which bears interest at the bank's cost of funds plus 175 basis points and expires on July 1, 1999. However, the line of credit is reduced by outstanding letters of credit in the amount of $4.7 million. STAR generated net cash from operating activities of $10.1 million in 1997, primarily from net income plus depreciation and amortization, while using $3.4 million in 1996. STAR's investing activities used cash of approximately $29.6 million during 1997 primarily resulting from capital expenditures and the investment of the proceeds from the initial public offering in marketable securities, while using $9.8 million in 1996. STAR's financing activities provided cash of approximately $19.3 million during 1997 primarily from the sale of Common Stock and borrowings under lines of credit, offset by repayments under various lines of credit, while providing $14.7 million in 1996. STAR generated net cash from operating activities of $3.7 million in the first quarter of 1998. The Company's investing activities provided cash of approximately $17,000 during the first quarter of 1998 primarily from the sale of marketable securities offset by investments made in additional undersea cables and switching equipment. STAR's financing activities used cash of approximately $335,000 during the first quarter of 1998 primarily from repayments under capital lease agreements offset by the exercise of employee stock options. At March 31, 1998, STAR had capital lease obligations of $30.1 million, and $2.1 million in term loans, relating to its switching facilities and operating equipment. STAR anticipates making capital expenditures of approximately $80.0 million during 1998 to expand its global network. STAR believes that the proceeds from the offering and cash generated from operations, as well as funding under its bank line of credit, will satisfy STAR's current liquidity needs. Nevertheless, as STAR continues to expand its network facilities and pursues its strategy of growth through acquisition, STAR's liquidity needs may increase, perhaps 73 significantly, which could require STAR to seek such additional financing or the expansion of its borrowing capacity under current or new lines of credit. As appropriate, STAR will use capital lease financing or raise additional debt or equity capital to finance new projects or acquisitions. STAR had foreign currency contracts outstanding at December 31, 1997 in the notional amount of $6.3 million. STAR had no foreign currency contracts outstanding at March 31, 1998. YEAR 2000 COMPLIANCE. STAR has made a concerted effort to ensure that the software components of its information and billing systems are Year 2000 compliant. As such, management believes that, after January 1, 2000, STAR will be able to continue to accurately track and bill calls. At the same time, it is likely that the operations of a number of STAR's customers and vendors rely on software that is not Year 2000 compliant. 74 BUSINESS OF STAR OVERVIEW STAR is an emerging multinational carrier focused primarily on the international long distance market. STAR offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 foreign countries through a flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with long distance providers. STAR has grown its revenues rapidly by capitalizing on the deregulation of international telecommunications markets, combining sophisticated information systems with flexible routing and leveraging management's industry expertise. STAR has increased its revenues from $46.3 million in 1995 to $376.2 million in 1997. INDUSTRY BACKGROUND The international long distance telecommunications services industry consists of all transmissions of voice and data that originate in one country and terminate in another. This industry is undergoing a period of fundamental change which has resulted in substantial growth in international telecommunications traffic. According to industry sources, worldwide gross revenues for providers of international telephone service were over $60 billion in 1996 and the volume of international traffic on the public telephone network is expected to grow at a compound annual growth rate of approximately 13% from 1996 through the year 2000. From the standpoint of U.S.-based long distance providers, the industry can be divided into two major segments: the U.S. international market, consisting of all international calls billed in the U.S., and the overseas market, consisting of all international calls billed in countries other than the U.S. The U.S. international market has experienced substantial growth in recent years, with gross revenues from international long distance services rising from approximately $8.5 billion in 1990 to approximately $14.9 billion in 1996, according to FCC data. STAR believes that a number of trends in the international telecommunications market will continue to drive growth in international traffic, including: - continuing deregulation and privatization of telecommunications markets; - pressure to reduce international outbound long distance rates paid by end users driven by increased competition in newly deregulated global markets; - the dramatic increase in the availability of telephones and the number of access lines in service around the world; - the increasing globalization of commerce, trade and travel; - the proliferation of communications devices such as faxes, cellular telephones, pagers and data communications devices; - increasing demand for data transmission services, including the Internet; and - the increased utilization of high quality digital undersea cable and resulting expansion of bandwidth availability. THE DEVELOPMENT OF THE U.S. AND OVERSEAS MARKETS The 1984 deregulation of the U.S. telecommunications industry enabled the emergence of a number of new long distance companies in the U.S. Today, there are over 500 U.S. long distance companies, most of which are small or medium-sized companies. In order to be successful, these small and medium-sized 75 companies need to offer their customers a full range of services, including international long distance. However, most of these carriers do not have the critical mass to receive volume discounts on international traffic from the larger facilities-based carriers such as AT&T, MCI and Sprint. In addition, these small and medium sized companies generally have only limited capital resources to invest in international facilities. New international carriers such as STAR emerged to take advantage of this demand for less expensive international bandwidth. These emerging multinational carriers acted as aggregators of international traffic for smaller carriers, taking advantage of larger volumes to obtain volume discounts on international routes (resale traffic), or investing in facilities when volume on particular routes justify such investments. Over time, as these emerging international carriers became established and created a high quality networks, they began to carry overflow traffic from the larger long distance providers seeking lower rates on certain routes. Deregulation and privatization have also allowed new long distance providers to emerge in foreign markets. By eroding the traditional monopolies held by single national providers, many of which are wholly or partially government owned, such as Post Telegraph & Telephone operators ("PTTs"), deregulation is providing U.S.-based providers the opportunity to negotiate more favorable agreements with PTTs and emerging foreign providers. In addition, deregulation in certain foreign countries is enabling U.S.-based providers to establish local switching and transmission facilities in order to terminate their own traffic and begin to carry international long distance traffic originated in that country. STAR believes that growth of traffic originated in markets outside of the U.S. will be higher than the growth in traffic originated within the U.S. due to recent deregulation in many foreign markets, relative economic growth rates and increasing access to telecommunications facilities in emerging markets. INTERNATIONAL SWITCHED LONG DISTANCE SERVICES International switched long distance services are provided through switching and transmission facilities that automatically route calls to circuits based upon a predetermined set of routing criteria. The call typically originates on a local exchange carrier's network and is transported to the caller's domestic long distance carrier. The domestic long distance provider then carries the call to an international gateway switch. An international long distance provider picks up the call at its gateway and sends it directly or through one or more other long distance providers to a corresponding gateway switch operated in the country of destination. Once the traffic reaches the country of destination, it is then routed to the party being called though that country's domestic telephone network. International long distance providers can generally be categorized by their ownership and use of switches and transmission facilities. The largest U.S. carriers, such as AT&T, MCI and Sprint, primarily utilize owned transmission facilities and generally use other long distance providers to carry their overflow traffic. Since only very large carriers have transmission facilities that cover the over 200 countries to which major long distance providers generally offer service, a significantly larger group of long distance providers own and operate their own switches but either rely solely on resale agreements with other long distance 76 carriers to terminate their traffic or use a combination of resale agreements and owned facilities in order to terminate their traffic as shown below: [GRAPH] OPERATING AGREEMENTS. Under traditional operating agreements, international long distance traffic is exchanged under bilateral agreements between international long distance providers in two countries. Operating agreements provide for the termination of traffic in, and return traffic to, the international long distance providers' respective countries at a standard "accounting rate" with that international provider. Under a traditional operating agreement, the international long distance provider that originates more traffic compensates the long distance provider in the other country by paying a net amount based on the difference between minutes sent and minutes received and the settlement rate, which is generally one-half of the accounting rate. Under a typical operating agreement both carriers jointly own the transmission facilities between two countries. A carrier gains ownership rights in a digital fiber optic cable by purchasing direct ownership in a particular cable prior to the time the cable is placed in service, acquiring an "Indefeasible Right of Use" ("IRU") in a previously installed cable, or by leasing or obtaining capacity from another long distance provider that either has direct ownership or IRUs in the cable. In situations where a long distance provider has sufficiently high traffic volume, routing calls across directly owned or IRU cable is generally more cost-effective on a per call basis than the use of short-term variable capacity arrangements with other long distance providers or leased cable. However, direct ownership and acquisition of IRUs require a company to make an initial investment of its capital based on anticipated usage. TRANSIT ARRANGEMENTS. In addition to utilizing an operating agreement to terminate traffic delivered from one country directly to another, an international long distance provider may enter into transit arrangements pursuant to which a long distance provider in an intermediate country carries the traffic to a country of destination. Such transit arrangements involve agreement among the providers in all the countries involved and are generally used for overflow traffic or where a direct circuit is unavailable or not volume justified. RESALE ARRANGEMENTS. Resale arrangements typically involve the wholesale purchase and sale of transmission and termination services between two long distance providers on a variable, per minute basis. The resale of capacity, which was first permitted in the U.S. market in the 1980s enabled the emergence of new international long distance providers that rely at least in part on capacity acquired on a wholesale basis from other long distance providers. International long distance calls may be routed through a facilities-based carrier with excess capacity, or through multiple long distance resellers between the originating long 77 distance provider and the facilities-based carrier that ultimately terminates the traffic. Resale arrangements set per minute prices for different routes, which may be guaranteed for a set time period or subject to fluctuation following notice. The resale market for international capacity is constantly changing, as new long distance resellers emerge and existing providers respond to fluctuating costs and competitive pressures. In order to be able to effectively manage costs when utilizing resale arrangements, long distance providers need timely access to changing market data and must quickly react to changes in costs through pricing adjustments or routing decisions. ALTERNATIVE TERMINATION ARRANGEMENTS. As the international telecommunications market has become deregulated, service providers have developed alternative arrangements to reduce their termination costs by, for example, routing traffic via third countries to obtain lower settlement rates or using international private line facilities to bypass the settlement rates applicable to traffic routed over the PSTN. These arrangements include ISR, traffic refiling and the acquisition of transmission and switching facilities in foreign countries so as to self-correspond. Refiling of traffic takes advantage of disparities in settlement rates between different countries. An originating operator typically refiles traffic by sending it first to a third country that enjoys lower settlement rates with the destination country where upon it is forwarded or refiled to the destination country thereby resulting in a lower overall termination cost. The difference between transit and refiling is that, with respect to transit, the operator in the destination country typically has a direct relationship with the originating operator and is aware of the arrangement, while with refiling, the operator in the destination country typically is not aware that it is terminating refiled traffic originated in another country. While the United States has taken no position with respect to whether refile comports with international regulation, refile is illegal in many countries. With ISR, a long distance provider completely bypasses the settlement system by connecting an IPL to the PSTN on one or both ends. While ISR currently is only sanctioned by U.S. and other regulatory authorities on some routes, ISR services are increasing and are expected to expand significantly as deregulation of the international telecommunications market continues. In addition, new market access agreements, such as the WTO Agreement, have made it possible for many international service providers to establish their own transmission and switching facilities in certain foreign countries, enabling them to self-correspond and directly terminate traffic. See "--Government Regulation." The highly competitive and rapidly changing international telecommunications market has created a significant opportunity for carriers that can offer high quality, low cost international long distance service. Deregulation, privatization, the expansion of the resale market and other trends influencing the international telecommunications market are driving decreased termination costs, a proliferation of routing options, and increased competition. Successful companies among both the emerging and established international long distance companies will need to aggregate enough traffic to lower costs of both facilities-based or resale opportunities, maintain systems which enable analysis of multiple routing options, invest in facilities and switches and remain flexible enough to locate and route traffic through the most advantageous routes. THE STAR APPROACH STAR is an emerging multinational carrier focused primarily on the international long distance market. STAR offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 foreign countries through a flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with long distance providers. STAR has grown its revenues rapidly by capitalizing on the deregulation of international telecommunications markets, combining sophisticated information systems with flexible routing and leveraging management's industry expertise. STAR markets its services to large global carriers seeking lower rates and high quality overflow capacity, as well as to small and medium-sized long distance companies that do not have the critical mass to invest in their own international transmission facilities or to obtain volume discounts from the larger 78 facilities-based carriers. During the fourth quarter of 1997, STAR provided switched international long distance services to 105 customers and currently provides these services to nine of the top forty global carriers. STAR has also recently focused on building a customer base overseas, particularly in Europe, and has opened offices in Dusseldorf, Frankfurt, Hamburg and Munich, Germany and London, England. In addition, STAR has begun to market its international long distance services directly to certain commercial customers in the U.S. and overseas. STRATEGY STAR's objective is to be a leading provider of highly reliable, low-cost switched international long distance services on a wholesale basis to U.S. and foreign-based telecommunications companies, as well as on a retail basis to commercial customers. Key elements of STAR's strategy include the following: EXPAND SWITCHING AND TRANSMISSION FACILITIES. STAR is continuing to pursue a flexible approach to expanding and enhancing its network facilities by investing in both switching and transmission facilities where traffic volumes justify such investments. STAR has expanded its international gateway switching facilities through the addition of a facility in Dallas and plans to put into service in 1998 switches in Atlanta, Chicago, Miami and Seattle; Dusseldorf, Frankfurt, Hamburg and Munich, Germany; Paris, France; and Tokyo, Japan. STAR's international gateway switch in London, England went into service in April 1997 and four switches in Germany are expected to be operational in the second quarter of 1998. In addition, STAR is planning to install a network of switches in selected other European and Asian cities. CAPITALIZE ON PROJECTED INTERNATIONAL LONG DISTANCE GROWTH. STAR believes that the international long distance market provides attractive opportunities due to its higher revenue and profit per minute, and greater projected growth rate as compared to the domestic long distance market. STAR targets international markets with high volumes of traffic, relatively high rates per minute and prospects for deregulation and privatization. STAR believes that the ongoing trend toward deregulation and privatization will create new opportunities for STAR in international markets. Although STAR has focused to date primarily on providing services for U.S.-based long distance providers, STAR also intends to expand the international long distance services it offers to foreign-based long distance providers. LEVERAGE TRAFFIC VOLUME TO REDUCE COSTS. STAR continues to focus on building its volume of international long distance traffic. Higher traffic volumes strengthen STAR's negotiating position with vendors, customers and potential foreign partners, which allows STAR to lower its costs of service. In addition, higher traffic volumes on particular routes allow STAR to lower its cost of services on these routes by transitioning from acquiring capacity on a variable cost per minute basis to fixed cost arrangements such as longer-term capacity agreements with major carriers, long-term leases and ownership of facilities. LEVERAGE INFORMATION SYSTEMS AND SWITCHING CAPABILITIES. STAR leverages its sophisticated information systems to analyze its routing alternatives, and select the most cost-effective routing from among STAR owned facilities, network of resale arrangements with other long distance providers, operating agreements and alternative termination relationships. STAR has invested significant resources in the development of software to track specific usage information by customer and revenue and cost information on specific routes on a daily basis. STAR's information systems are critical components in managing its customer and vendor relationships, routing traffic to the most cost-effective alternative, and targeting its marketing efforts. MAINTAIN HIGH QUALITY. STAR believes that reliability, call completion rates, voice quality, rapid set up time and a high level of customer and technical support are key factors evaluated by U.S. and foreign-based telecommunications companies and large corporate customers in selecting a carrier for their international traffic. STAR's state-of-the-art switching equipment is fully compliant with international C-7 and domestic SS-7 signaling standards. STAR strives to provide a consistently high level of customer and technical support and has technical support personnel at its switching facilities 24 hours per day, seven days per week to assist its customers and to continually monitor network operations. 79 EXPAND INTO COMMERCIAL MARKET. STAR plans to expand into niche commercial markets in the U.S. and in other deregulating countries where it believes it can leverage its international network and where the customer base has a significant international calling pattern. As an example of this strategy, STAR is using the LDS telemarketing sales force to target small commercial customers in ethnic markets to increase traffic to Mexico and Latin America. Additionally, STAR intends to use UDN's network of independent sales agents to target medium-sized commercial customers with a demand for international calling services at competitive rates. Finally, STAR plans to use its direct sales forces to target larger commercial customers, concentrating at first on potential customers in Los Angeles and New York. With respect to the offering of commercial services abroad, STAR initially intends to focus on Germany, the U.K. and selected European cities where competition for commercial customers is less mature. GROWTH THROUGH ACQUISITIONS. STAR actively pursues opportunities to enhance its business through strategic and synergistic acquisitions. These acquisitions may focus on entering new territories, enlarging STAR's presence in an existing territory, adding capacity or expanding into new market segments, such as the commercial market. In addition to expanding its revenue base, STAR plans to realize operating efficiencies by integrating newly-acquired operations into STAR's billing, tracking and other systems. On November 30, 1997, STAR acquired LDS, a long-distance provider focusing on small commercial customers throughout the United States, for approximately 849,000 shares of Common Stock. On March 10, 1998, STAR acquired T-One, an international wholesale long distance provider, for 1,353,000 shares of Common Stock. On November 19, 1997, STAR entered into an agreement to acquire UDN, a commercial long distance provider. The acquisition of UDN is subject to approval by UDN's stockholders and to various regulatory approvals. Each of these transactions has been, or will be, accounted for as a pooling of interests. NETWORK STAR provides international long distance services to approximately 220 foreign countries through a flexible, switched-based network consisting of resale arrangements with other long distance providers, various foreign termination relationships, international gateway switches and leased and owned transmission facilities. STAR's network employs state-of-the-art digital switching and transmission technologies and is supported by comprehensive monitoring and technical support personnel. STAR's switching facilities are staffed 24 hours per day, seven days per week. TERMINATION ARRANGEMENTS STAR seeks to retain flexibility and maximize its termination opportunities by utilizing a continuously changing mix of routing alternatives, including resale arrangements, operating agreements and other advantageous termination arrangements. This diversified approach is intended to enable STAR to take advantage of the rapidly evolving international telecommunications market in order to provide low-cost international long distance service to its customers. STAR utilizes resale arrangements to provide it with multiple options for routing traffic through its switches to each destination country. Traffic under resale arrangements typically terminates pursuant to a third party's correspondent relationships. STAR purchased capacity from 57 vendors in 1997. A substantial portion of this capacity is obtained on a variable, per minute and short-term basis, subjecting STAR to the possibility of unanticipated price increases and service cancellations. STAR's contracts with its vendors provide that rates may fluctuate, with rate change notice periods varying from five days to one year, with certain of STAR's longer term arrangements requiring STAR to make minimum usage commitments in order to achieve additional volume discounts. As a result of deregulation and competition in the international telecommunications market, the pricing of termination services varies by carrier depending on such factors as call traffic and time of day. Since STAR does not typically enter into long-term contracts with these providers, pricing can change significantly over short periods of time. STAR's proprietary information systems enable STAR to track the pricing variations in the international telecommunications 80 market on a daily basis, allowing STAR's management to locate and reroute traffic to the most cost-effective alternatives. See "Risk Factors--Operating Results Subject to Significant Fluctuations." STAR currently has operating agreements with carriers in a number of countries and is in the process of negotiating additional operating agreements for other countries. STAR has been and will continue to be selective in entering into operating agreements. STAR also has agreements with international providers of long distance services for termination of traffic that STAR routes over a its network to such countries. STAR currently has such termination arrangements with several carriers in a number of countries, and STAR is in the process of expanding its coverage of such countries and entering into similar arrangements in additional countries. The FCC or foreign regulatory agencies may take the view that certain of STAR's termination arrangements do not comply with current rules and policies applicable to international settlements, such as current ISR rules. To the extent that the revenue generated under such arrangements becomes a significant portion of overall revenue, the loss of such arrangements, whether as a result of regulatory actions or otherwise, could have a material adverse effect on STAR's business, operating results and financial condition. In addition, the FCC could impose sanctions on STAR, including forfeitures, if certain of STAR's arrangements are found to be inconsistent with FCC rules. See "--Government Regulation," "Risk Factors--Risks of International Telecommunications Business," and "--Potential Adverse Effects of Government Regulation." SWITCHES AND TRANSMISSION FACILITIES International long distance traffic to and from the U.S. is generally transmitted through an international gateway switching facility across undersea digital fiber optic cable or via satellite to a termination point. International gateway switches are digital computerized routing facilities that receive calls, route calls through transmission lines to their destination and record information about the source, destination and duration of calls. STAR's global network facilities include both international gateway switches and undersea digital fiber optic cable. STAR currently operates international gateway switches in New York, Los Angeles, Dallas and London, England. In 1998, STAR plans to put into service international gateway switches in Atlanta, Chicago, Miami and Seattle; Dusseldorf, Frankfurt, Hamburg, and Munich, Germany; Paris, France; and Tokyo, Japan. STAR considers any of its switches to be international gateway switches if STAR can route international calls across such switch. STAR's switching facilities are linked to a proprietary reporting system, which STAR believes provides it with a competitive advantage by permitting management on a real-time basis to determine the most cost-effective termination alternatives, monitor customer usage and manage gross margins by route. STAR has installed multiple redundancies into its switching facilities to decrease the risk of a network failure. For example, STAR employs both battery and generator power back-up and has installed hardware that automatically shifts the system to auxiliary power during a power outage, rather than relying on manual override. STAR is in the process of adding a network control center in its Los Angeles facility, which is expected to be completed in 1998. STAR currently holds ownership positions in a number of digital undersea fiber optic cables, and has recently added capacity on the TPC-5 undersea fiber optic cable system and has entered into commitments to acquire transmission capacity on three additional undersea fiber optic cable systems, Gemini, AC-1 and China-U.S. STAR plans to increase its investment in direct and IRU ownership of cable in situations where STAR enters into operating agreements and in other situations in which it determines that such an investment would enhance operating efficiency or reduce transmission costs. Through its acquisitions of T-One and UDN, STAR has acquired, or will acquire, additional switching and transmission facilities. By acquiring T-One, STAR has added a switch located in the same building as STAR's New York international gateway switch and has added a number of operating agreements to countries in Africa and the Middle East, among other locations. In addition, T-One owns capacity on 81 certain cable and satellite systems. Upon consummation of the acquisition of UDN, STAR will acquire a switch located in the same building as STAR's Dallas switch. STAR plans to integrate these facilities into its existing network. SALES AND MARKETING STAR markets its services on a wholesale basis to other telecommunications companies through its experienced direct sales force and marketing/account management team who leverage the long-term industry relationships of STAR's senior management. STAR reaches its customers primarily through domestic and international trade shows and through relationships gained from years of experience in the telecommunications industry. STAR had 20 direct sales and marketing employees and over 145 telemarketing representatives as of March 1, 1998. In the wholesale market, STAR's sales and marketing employees utilize the extensive, customer specific usage reports and network utilization data generated by STAR's sophisticated information systems to effectively negotiate agreements with customers and prospective customers and to rapidly respond to changing market conditions. STAR believes that it has been able to compete more effectively as a result of the personalized service and ongoing senior management-level attention that is given to each customer. In connection with STAR's expansion into the commercial market, STAR expects to target small commercial customers through LDS' existing telemarketing operation, deliver services to medium-sized commercial customers through UDN's network of independent sales agents and utilize a direct sales force to approach larger commercial accounts. Establishment of a sales force capable of effectively expanding STAR's services into the commercial market can be expected to require substantial efforts and management and financial resources and may increase STAR's operating costs. See "Risk Factors--Risks Associated with Growth of Telecommunications Network and Customer Base." INFORMATION AND BILLING SYSTEMS STAR's operations use advanced information systems including call data collection and call data storage linked to a proprietary reporting system. STAR also maintains redundant billing systems for rapid and accurate customer billing. STAR's switching facilities are linked to a proprietary reporting system, which STAR believes provides it with a competitive advantage by permitting management on a real-time basis to determine the most cost-effective termination alternatives, monitor customer usage and manage gross margins by route. STAR's systems also enable it to ensure accurate and timely billing and to reduce routing errors. As STAR's systems were designed for the wholesale marketplace, STAR is currently in the process of modifying its systems in anticipation of its entrance into the commercial marketplace. STAR's proprietary reporting software compiles call, price and cost data into a variety of reports which STAR can use to re-program its routes on a real-time basis. STAR's reporting software can generate the following reports as needed: - customer usage, detailing usage by country and by time period within country, in order to track sales and rapidly respond to any loss of traffic from a particular customer; - country usage, subtotaled by vendor or customer, which assists STAR with route and network planning; - vendor rates, through an audit report that allows management to determine at a glance which vendors have the lowest rates for a particular country in a particular time period; - vendor usage by minute, enabling STAR to verify and audit vendor bills; - dollarized vendor usage to calculate the monetary value of minutes passed to STAR's vendors, which assists with calculating operating margin when used in connection with the customer reports; 82 - loss reports used to rapidly highlight routing alternatives that are operating at a loss as well as identifying routes experiencing substantial overflow; and - LATA (Domestic Call Area) reporting by originating and terminating LATA, allowing for accurate Local Exchange charge audits, and protecting from Local Exchange overcharging. STAR has built multiple redundancies into its billing and call data collections systems. Nine call collector computers receive call information in real-time, immediately duplicating data, sending one copy to billing, while the other copy is used for customer service internally and for traffic analysis. STAR maintains two independent and redundant billing systems in order to both verify billing internally and to ensure that bills are sent out on a timely basis. All of the call data, and resulting billing data, are continuously backed up on tape drives and redundant storage devices, and are regularly transported to an off-site safe location. COMPETITION The international telecommunications industry is intensely competitive and subject to rapid change. STAR's competitors in the international wholesale switched long distance market include large, facilities-based multinational corporations and PTTs, smaller facilities-based providers in the U.S. and overseas that have emerged as a result of deregulation, switched-based resellers of international long distance services and international joint ventures and alliances among such companies. International wholesale switched long distance providers compete on the basis of price, customer service, transmission quality, breadth of service offerings and value-added services. STAR also competes abroad with a number of dominant telecommunications operators that previously held various monopolies established by law over the telecommunications traffic in their countries. See "Risk Factors--Significant Competition." Additionally, the telecommunications industry is in a period of rapid technological evolution, marked by the introduction of competitive new product and service offerings, such as the utilization of the Internet for international voice and data communications. STAR is unable to predict which of many possible future product and service offerings will be important to maintain its competitive position or what expenditures will be required to develop and provide such products and services. STAR believes that it competes favorably on the basis of price, transmission quality and customer service. The number of STAR's competitors is likely to increase as a result of the new competitive opportunities created by the WTO Agreement. Further, under the terms of the WTO Agreement, the United States and the other 68 countries participating in the Agreement have committed to open their telecommunications markets to competition, and foreign ownership and adopt measures to protect against anticompetitive behavior, effective starting on February 5, 1998. As a result, STAR believes that competition will continue to increase, placing downward pressure on prices. Such pressure could adversely affect STAR's gross margins if STAR is not able to reduce its costs commensurate with such price reductions. COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES AND ALLIANCES. A majority of the U.S.-based international telecommunications services revenue is currently generated by AT&T, MCI and Sprint. STAR also competes with WorldCom, Pacific Gateway Exchange, Inc. and other U.S.-based and foreign long distance providers, including the RBOCs, which presently have FCC authority to resell and terminate international telecommunication services. Many of these companies have considerably greater financial and other resources and more extensive domestic and international communications networks than STAR. STAR's business would be materially adversely affected to the extent that a significant number of such customers limit or cease doing business with STAR for competitive or other reasons. Consolidation in the telecommunications industry could not only create even larger competitors with greater financial and other resources, but could also adversely affect STAR by reducing the number of potential customers for STAR's services. EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began providing long distance service to the commercial market, a market that is subject to intense competition from a number 83 of well capitalized companies. The commercial market is also characterized by the lack of customer loyalty, with commercial customers regularly changing service providers. There can be no assurance that STAR will be able to compete successfully in the commercial market. GOVERNMENT REGULATION STAR's U.S. interstate and international telecommunications service offerings generally are subject to the regulatory jurisdiction of the FCC. Certain telecommunication services offered by STAR in the U.S. may also be subject to the jurisdiction of state regulatory authorities, commonly known as public utility commissions ("PUCs"). STAR's telecommunications service offerings outside the U.S. are also generally subject to regulation by national regulatory authorities. In addition, U.S. and foreign regulatory authorities may affect STAR's international service offerings as a result of the termination or transit arrangements associated therewith. U.S. or foreign regulatory authorities may take actions or adopt regulatory requirements which could adversely affect STAR. See "Risk Factors--Potential Adverse Effect of Government Regulation." U.S. REGULATION STAR's business is subject to various U.S. and foreign laws, regulations, agency actions and court decisions. STAR's U.S. international telecommunications service offerings are subject to regulation by the FCC. The FCC requires international carriers to obtain authorization under Section 214 of the Communications Act prior to acquiring international facilities by purchase or lease, or providing international service to the public. Prior FCC approval is also required to transfer control of a certificated carrier. STAR is also subject to FCC policies and rules that regulate the manner in which international telecommunication services may be provided, including, for instance, the circumstances under which a carrier may provide international switched services using IPL facilities and under which it may route traffic through third countries to or from its final destination. The Communications Act and the FCC's rules and policies also impose certain other obligations on carriers providing international telecommunication services. These include the obligation to file at the FCC and to maintain tariffs containing the rates, terms, and conditions applicable to their services; to file certain reports regarding international traffic and facilities; to file certain contracts with correspondent carriers; to disclose affiliations with foreign carriers and significant foreign ownership interests; to pay certain regulatory fees based, among other things, upon the carrier's revenues and ownership of international transmission capacity. INTERNATIONAL SERVICES. FCC rules require STAR to obtain prior FCC authorization to acquire and operate international communication circuits in satellites and undersea fiber optic cables; similar FCC authority is required for STAR to resell such capacity. STAR holds both facilities-based and resale international authorizations, including a "global" authorization that provides broad authority to offer switched and private line international services. STAR has filed tariffs for international services with the FCC. FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's IPL resale policy limits the conditions under which a carrier may connect IPLs to the PSTN at one or both ends to provide switched services, commonly known as ISR. A carrier generally may only offer ISR services to a foreign country if the FCC has found (a) the country is a member of the WTO and at least 50% of the U.S. billed and settled traffic to that country is settled at or below the benchmark settlement rate adopted by the FCC in IB Docket No. 96-261; or (b) the country is not a WTO member, but it offers U.S. carriers equivalent opportunities to engage in ISR and at least 50% of the U.S. billed and settled traffic is settled at or below the applicable benchmark. Settled traffic refers to traffic subject to an accounting rate agreement between U.S. and foreign carriers. An accounting rate is a per minute wholesale charge negotiated by international carriers for terminating traffic in either direction. Each carrier is paid a settlement rate for terminating traffic on its own network 84 which ordinarily is one-half of the accounting rate. STAR's FCC authority currently permit it to provide ISR service to Canada, the U.K., Sweden, New Zealand, Australia and the Netherlands. The FCC is currently reviewing U.S. carrier applications to provide ISR to Belgium, Chile, Denmark, Finland, France, Germany, Hong Kong, Norway and Luxembourg, among other routes, and upon grant of any such ISR application to a given country, the FCC's rules also would permit STAR to provide ISR service to that country. Certain of STAR's termination arrangements with foreign operators involve IPL arrangements which may be inconsistent with the foregoing FCC IPL resale policy and STAR's existing ISR authorization. If the FCC were to determine, by its own actions or in response to the filing of a third party that any of STAR's IPL arrangements violate its ISR policy or STAR's ISR authorization, the FCC could order STAR to terminate any non-conforming arrangements. In addition, STAR could be subject to a monetary forfeiture and to other penalties, including the revocation of STAR's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect upon STAR's business, operating results and financial condition. FCC INTERNATIONAL SETTLEMENTS POLICY. The FCC's ISP places limits on the arrangements which U.S. international carriers may enter into with foreign carriers for exchanging public switched telecommunications traffic, which the FCC terms International Message Telephone Service. The policy does not apply to ISR services. The ISP is primarily intended to deter dominant foreign carriers from discriminating amongst competing U.S. carriers by, for example, favoring the foreign carrier's U.S. affiliate. Absent FCC consent, the ISP requires that U.S. carriers receive an equal share of the accounting rate (i.e., that settlement rates be equivalent) and receive inbound traffic in proportion to the volume of U.S. outbound traffic which they generate. The ISP and other FCC policies also prohibit a U.S. carrier from offering or accepting a "special concession" from a foreign carrier where the foreign carrier possess sufficient market power on the foreign end of the route to affect competition adversely in the U.S. market." A "special concession" is defined by the FCC as an exclusive arrangement involving services, facilities or functions on the foreign end of a U.S. international route which are necessary for providing basic telecommunications, and which are not offered to similarly situated U.S. carriers authorized to serve that route. U.S. international carriers wishing to establish settlement arrangements for IMTS which do not comply with the ISP must obtain a waiver of the FCC's rules or a declaratory ruling from the FCC under the FCC's "flexibility" policy that the non-standard arrangement is in the public interest. FCC policy provides that a request by a U.S. international carrier to establish a non-standard settlement arrangement with a foreign carrier in a WTO member country is presumptively in the public interest, and that said presumption generally may be overcome only by a demonstration that the foreign carrier is not subject to competition in its home market from more than one facilities-based international carrier. Notwithstanding the FCC's ISP waiver and flexibility policies, it is possible that the FCC could find that certain of STAR's arrangements with foreign operators were or are inconsistent with the ISP and that STAR has not requested prior FCC authority therefore. If the FCC were to determine by its own actions or in response to the filing of a third party that STAR has violated the ISP, the FCC could order STAR to terminate any non-conforming arrangement. In addition, STAR could be subject to a monetary forfeiture and to other penalties, including revocation of STAR's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect upon STAR's business, operating results and financial condition. The FCC's policies also require U.S. international carriers providing IMTS to negotiate and adopt settlement rates with foreign correspondents for IMTS which are at or below certain benchmark rates beginning January 1, 1999 for high income countries. U.S. international carriers must establish IMTS settlement rates at or below the benchmark rate with any foreign affiliate beginning April 1, 1998. STAR expects that any IMTS operating agreement which it has or may have with a foreign affiliate will satisfy the foregoing benchmarks requirement. STAR currently has IMTS operating agreements with certain foreign correspondents which provide for settlement rates above the FCC's prescribed benchmarks. STAR will negotiate in good faith to establish IMTS settlement rates with its foreign correspondents which satisfy the FCC's benchmarks but 85 there can be no assurance that such negotiations will succeed. The FCC's order adopting the foregoing settlement benchmarks and the timetable therefor is currently being reconsidered by the FCC. Several foreign telecommunications carriers also have petitioned the U.S. Court of Appeals to vacate the FCC's benchmarks order arguing that, among other things, the FCC lacks the jurisdiction to prescribe the settlement rates which foreign carriers may collect from U.S. carriers. However, subject to FCC reconsideration and action by the Court of Appeals, if STAR is unable to negotiate benchmark settlement rates with certain foreign correspondents, the FCC may intervene on its own action or in response to a filing by a third party. STAR is unable to predict the form which such intervention may take but it could disrupt STAR's arrangement for transmitting traffic to certain countries require STAR to suspend direct service to certain countries or require STAR to make alternative termination arrangements with certain countries all of which could have a material adverse effect on STAR's business, operating results and financial condition. FCC POLICIES ON TRANSIT AND REFILE. International switched telecommunication traffic is frequently routed indirectly via one or more third countries to its final destination. When such arrangements are mutually agreed, they are commonly based on a transit agreement under which settlement payments are made to all parties. In other cases, traffic may be sent to a third country and then forwarded or refiled for delivery to its final destination without the knowledge or consent of the destination carrier. STAR uses both transit and refile arrangements to terminate its international traffic. The FCC routinely approves transit arrangements by U.S. international carriers. The FCC's rules also permit carriers to use ISR facilities in many cases to route traffic via a third country for refile through the public switched network. However, the extent to which U.S. carriers may enter into refile arrangements consistent with the ISP is currently under review by the FCC. In 1997, the FCC stated that above-cost accounting rates had led an increasing amount of international traffic to migrate to least cost routes through the use of practices such as hubbing, refile and reorigination. The FCC stated that such practices are an economically rational response to inflated settlement rates. Notwithstanding the FCC's past rules, policies and statements regarding the scope of permissible transit and refile arrangements, the FCC could find by its own actions or in response to the filing of a third party, that certain of STAR's transit or refile arrangements violate the ISP or other FCC policies. In that event, the FCC could order STAR to terminate any non-conforming transit or refile arrangements. In addition, STAR could be subject to a monetary forfeiture and to other penalties, including revocation of STAR's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect on STAR's business, operating results and financial condition. REPORTING REQUIREMENTS. International telecommunication carriers also are required by the FCC's rules timely to file certain reports regarding international traffic and revenues, the ownership and use of international facilities; and their affiliates with foreign carriers. The FCC considers a U.S. carrier to be affiliated with a foreign carrier if it has a 25% interest in the capital stock of the carrier or it controls the foreign carrier or is under common ownership or control. The FCC requires these reports so that, among other things, it may monitor the development of industry competition and the potential for a dominant foreign carrier to discriminate amongst U.S. carriers. STAR generally has filed said traffic, facilities and foreign affiliation reports. The FCC's rules require international telecommunication carriers to file at the FCC copies of their contracts with other carriers, including operating agreements, within 30 days of execution. STAR has filed copies of its operating agreements with the FCC. Competitive U.S. international carriers do not routinely file other carrier-to-carrier contracts with the FCC and, consistent with industry practice, STAR has not filed certain other carrier contracts. Notwithstanding, the foregoing FCC filings by STAR, the FCC by its own action or in response to the filing of a third party could determine that STAR has failed to meet certain of the foregoing filing and reporting requirements or that certain Company filings are deficient. In that event, STAR could be directed to remedy any asserted non-compliance; STAR could also be subject to a monetary forfeiture and to other penalties, and, although STAR believes that it would be largely unprecedented in such circumstances, and hence unlikely, the FCC could revoke STAR's 86 authorizations to operate as an international carrier. Any such FCC action could have a material adverse affect on STAR's business, results and financial condition. REGULATORY FEES. The Communications Act, and FCC rules and policies, impose certain fees upon carriers providing interstate and international telecommunication services. These fees are levied, among other things, to defray the FCC's operating expenses, to underwrite universal telecommunication service (e.g., by subsidizing certain services used by schools and libraries), such as Internet access, and by other telecommunications users in areas of the U.S. where service costs are significantly above average), to fund the Telecommunications Relay Service ("TRS"), which provides special options for hearing-impaired users, and to support the administration of telephone numbering plans. Carriers that provide domestic interstate services must pay an annual regulatory fee based on their interstate revenues; the fee is currently 0.12% of revenue. The bulk of STAR's revenue, which is derived from international services, is not subject to this fee. Carriers that provide domestic interstate services to end users must pay a universal telecommunications service fee each month based upon the total estimated demand for U.S. universal service funding. If applicable, each carrier's share is approximately four percent of the carrier's annual end user revenues. STAR generally offers its services only to other carriers which in turn provide services to end-users. Such carrier-to-carrier revenues are not subject to universal service fees, and thus STAR generally is not liable to pay universal service fees. Carriers that only offer international service (i.e., service between the United States and a foreign country or service between two foreign carriers) also are not subject to the universal service fee. However, if an international carrier has an affiliate that provides domestic interstate services, then the carrier's international revenues are subject to said fee. Until its acquisition of LDS, STAR did not offer domestic interstate services. As a result of the operations of LDS, any revenue STAR receives from end users for international services may be subject to universal service fees. U.S. interstate and international carriers must pay a percentage of their total revenue each year to support the North American Numbering Plan Administrator. For the 1998 filing year, the contribution rate is less than .003 percent of net telecommunications revenue. U.S. carriers must pay a certain percentage of their domestic interstate revenues to support the TRS Fund. For the 1998 filing year, the contribution rate is less than .04 percent of gross domestic interstate revenue. STAR has routinely paid the foregoing regulatory fees and, with regard to the annual regulatory fees owed by interstate carriers, STAR is currently owed approximately $20,000 by the FCC due to the inadvertent overpayment of said fee for a prior year. The foregoing regulatory fees typically change annually. STAR cannot predict the future regulatory fees for which it may be liable. Said fees could rise significantly for STAR and amount to four percent or more of STAR's gross international and interstate revenues if STAR is no longer exempt from paying universal service fees as a result of an affiliate's provision of domestic interstate services, or because STAR provides service directly to end users, or because amendments to the Communications Act repeal the universal service fee exemption for carriers which only offer international service or services provided to connecting carriers. Because the international telecommunication services business is highly competitive, an increase in the regulatory fees which STAR must pay could impair its market position and have a material adverse effect on STAR's business, operating results and financial condition. RECENT AND POTENTIAL FCC ACTIONS. Recent FCC rulemaking orders and other actions have lowered the entry barriers for new facilities-based and resale international carriers by streamlining the processing of new applications and granting non-dominant carriers greater flexibility in establishing non-standard settlement arrangements with non-dominant foreign carriers, including the non-dominant U.S. affiliates of such carriers. In addition, the FCC's rules implementing the WTO Agreement presume that competition will be advanced by the U.S. entry of facilities-based and resale carriers from WTO member countries, thus further increasing the number of potential competitors in the U.S. market and the number of carriers which may also offer end-to-end services. The FCC is reviewing the proposed merger of WorldCom and MCI, and is expected soon to review the proposed merger of LCI International, Inc. and Qwest Communications International Inc. FCC approval and consummation of these mergers would increase concentration in the international telecommunications service industry and the potential market power of 87 STAR's competitors. The FCC also recently has sought to reduce the foreign termination costs of U.S. international carriers by prescribing maximum or benchmark settlement rates which foreign carriers may charge U.S. carriers for terminating switched telecommunications traffic and, if the FCC's benchmarks order survives judicial review, the FCC's action may reduce STAR's settlement costs, although the costs of other U.S. international carriers also may be reduced in a similar fashion. The FCC has not stated how it will enforce the new settlement benchmarks if U.S. carriers are unsuccessful in negotiating settlement rates at or below the prescribed benchmarks, but any future FCC intervention could disrupt STAR's transmission arrangements to certain countries or require STAR to modify its existing arrangements; other U.S. international carriers might be similarly affected. The 1996 amendment to the Communications Act permits the FCC to forbear enforcement of the tariff provisions in the Act, which apply to all interstate and international carriers, and the U.S. Court of Appeals is currently reviewing an FCC order directing all domestic interstate carriers to detariff their offerings. Subject to the Court's decision, the FCC may forbear its current tariff rules for U.S. international carriers, such as STAR, or order such carriers to detariff their services. In that event, STAR would have greater flexibility in pricing its service offerings and to compete, although any such FCC action likely would grant other non-dominant international carriers equivalent freedom. The FCC routinely reviews the contribution rate for various levels of regulatory fees, including the rate for fees levied to support universal service, which fees may be increased in the future for various reasons, including the need to support the universal service programs mandated by the Communications Act, the total costs for which are still under review by the FCC. The FCC also is reviewing the extent to which international carriers may refile traffic using international private line facilities or otherwise. Future FCC actions regarding refile could affect STAR by, for example, requiring it to discontinue certain termination arrangements which it now has or to implement alternative routing arrangements for certain countries; on the other hand, the FCC may further liberalize its existing rules and policies regarding refile in which case STAR is likely to be well positioned to expand certain refile operations even though new opportunities may become available to its competitors. STAR can not predict the net effect of these or other possible future FCC actions on its business, operating results and financial condition, although the net effect could be material. STATE REGULATION STATE. The intrastate long distance telecommunications operations of STAR and its subsidiaries are subject to various state laws and regulations, including prior certification, notification, registration and/or tariff requirements. In certain states, prior regulatory approval is required for changes in control of telecommunications services. The vast majority of states require STAR and its subsidiaries to apply for certification to provide intrastate telecommunications services, or at a minimum to register or to be found to be exempt from regulation, prior to commencing sale of intrastate services. Additionally, the vast majority of states require STAR or its subsidiaries to file and maintain detailed tariffs setting forth rates charged by STAR to its end-users for intrastate services. Many states also impose various reporting requirements and/or require prior approval for transfers of control of certificated carriers and assignments of carrier assets, including customer bases, carrier stock offerings, and incurrence by carriers of significant debt. Certificates of authority can generally be conditioned, modified, canceled, terminated or revoked by state regulatory authorities for failure to comply with state laws and/or rules, regulations and policies of the state regulatory authorities. Fines and other penalties, including, for example, the return of all monies received for intrastate traffic from residents of a state in which a violation has occurred may be imposed. STAR, along with its regulated subsidiaries, believes it has made the filings and taken the actions it believes are necessary to provide the intrastate services it currently provides to end users throughout the U.S. STAR and/or its subsidiaries are qualified to do business as foreign corporations, and have received certification to provide intrastate telecommunications services in all states where certification is required, and have received approval for changes of control where such approvals are necessary. STAR and its subsidiaries are required to make periodic filings in order to maintain certificated status and remain qualified as foreign corporations. 88 In early 1997, the FCC instituted significant changes to the current incumbent local exchange carrier access charge structure. These changes were meant, in part, to bring access charges closer to their actual costs. While there has been a general trend towards access charge reductions, new primary interexchange carrier charges (PICCs) were authorized by the FCC to be imposed on interexchange carriers serving presubscribed access charges closer to their actual costs. PICCs are a flat-rated, per presubscribed line, per month access charge imposed upon all facilities-based carriers (although they may be passed through to resellers). Facilities-based carriers were assessed interstate PICCs effective January 1, 1998. Intrastate PICCs have also been adopted in the five state Ameritech region (Michigan, Wisconsin, Illinois, Indiana, and Ohio), and may be adopted elsewhere. At the same time, STAR may pursue underlying carriers for pass throughs of any access charge reductions they may realize from incumbent local exchange carriers. ACTIONS AGAINST LDS. In 1997, prior to STAR's acquisition of LDS, LDS settled disputes with the California PUC and with the District Attorney of Monterey, California regarding LDS' alleged unauthorized switching of long distance customers. As part of the Settlements, LDS was subject to fines and restrictions on its business operations in California. In addition, the FCC has received numerous informal complaints against LDS regarding the alleged unauthorized switching of long distance customers, which complaints currently remain under review. Following STAR's acquisition of LDS and in order to comply with the Settlements, STAR has imposed strict restrictions on certain former LDS employees, restricting these employees with respect to California intrastate telecommunications operations. Additionally, STAR has taken a number of steps to reduce the risk of a repeat occurrence regarding the alleged unauthorized switching of commercial customers in California. There can, however, be no assurance that LDS or STAR will not be subject to further regulatory review by the California PUC or the FCC. FOREIGN REGULATION UNITED KINGDOM. In the U.K., telecommunications services offered by STAR and through its affiliate, STAR Europe Ltd. ("STAR Europe"), are subject to regulation by various U.K. regulatory agencies. The U.K. generally permits competition in all sectors of the telecommunications market, subject to licensing requirements and license conditions. STAR has been granted a license to provide international services on a resale basis and STAR Europe has been granted a license to provide international services over its own facilities, which licenses are subject to a number of restrictions. Implementation of these licenses have permitted STAR to engage in cost-effective routing of traffic between the U.S. and the U.K. and beyond. GERMANY. In Germany, telecommunications services offered by STAR through its affiliate, STAR Telecommunications Deutschland GmbH ("STAR Germany"), are subject to regulation by the Regulierungsbehorde fur Telekommunikation und Post (which is under the jurisdiction of the Ministry of Economy). Germany permits the competitive provision of international facilities-based and resale services. STAR Germany was granted a license for the provision of voice telephony on the basis of self-operated telecommunications networks on December 4, 1997. Under this license, STAR Germany is presently installing telecommunications switching facilities in Dusseldorf, Frankfurt, Hamburg and Munich and is leasing connection transmission facilities between these switches and additional facilities. The network of STAR Germany will be used primarily for routing international telecommunications traffic between the U.S., the U.K., Germany and beyond. There can be no assurance that future changes in regulation of the services provided by STAR Germany will not have a material adverse effect on STAR's business, operating results and financial condition. OTHER COUNTRIES. STAR plans to initiate a variety of services in certain European countries including France and Belgium. These services will include value-added services to closed user groups and other voice services as regulatory liberalization in those countries permits. These and other countries have announced plans or adopted laws to permit varying levels of competition in the telecommunications market. Under 89 the terms of the WTO Agreement, each of the signatories has committed to opening its telecommunications market to competition, foreign ownership and to adopt measures to protect against anticompetitive behavior, effective starting on January 1, 1998. Although STAR plans to obtain authority to provide service under current and future laws of those countries, or, where permitted, provide service without government authorization, there can be no assurance that foreign laws will be adopted and implemented providing STAR with effective practical opportunities to compete in these countries. Moreover, there can be no assurance of the nature and pace of liberalization in any of these markets. STAR's inability to take advantage of such liberalization could have a material adverse affect on STAR's ability to expand its services as planned. EMPLOYEES As of April 30, 1998, STAR employed 507 full-time employees. STAR is not subject to any collective bargaining agreement and it believes that its relationships with its employees are good. PROPERTIES STAR's principal offices are located in Santa Barbara, California in four facilities providing an aggregate of approximately 24,972 square feet of office space. Approximately 5,332 square feet of this office space is leased pursuant to two leases that both expire in July 1999. The remaining approximately 12,327 square feet of office space is located in two buildings and is rented by STAR pursuant to a lease that expires in June 2003. STAR also leases approximately 16,595 square feet of space for its switching facility in Los Angeles, California under a sublease and a lease expiring in April 2006, an aggregate of approximately 33,445 square feet of space for its switching facilities in New York, New York under three leases which expire in December 31, 2001, July 31, 2003 and April 2008, respectively, approximately 6,167 square feet of space for its switching facility in Dallas, Texas under a lease expiring in April 2007, and approximately 8,000 square feet of space for its switching facility in London, England under a lease expiring in July 2006. STAR leases approximately 14,628 square feet in Dusseldorf, approximately 27,835 square feet in Frankfurt, approximately 12,002 square feet in Hamburg and approximately 12,408 square feet in Munich, Germany under four leases expiring on or about January 1, 2008. The aggregate facility lease payments made by STAR in 1997 were approximately $2.2 million. STAR believes that all other material terms of its leases are commercially reasonable terms that are typically found in commercial leases in each of the respective areas in which STAR leases space. STAR believes that its facilities are adequate to support its current needs and that additional facilities will be available at competitive rates as needed. LITIGATION STAR is not presently a party to any material pending litigation. From time to time, however, STAR is party to various legal proceedings, including billing disputes and collection matters, that arise in the ordinary course of business. 90 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF UDN RESULTS OF OPERATIONS The following table sets forth certain selected items in UDN's statements of operations as a percentage of total revenues for the periods indicated:
NINE MONTHS ENDED YEARS ENDED APRIL 30, JANUARY 31, ------------------------------- ------------------- 1995 1996 1997 1997 1998 ------- ------- ------- ------- ------- Revenues................................ 100.0% 100.0% 100.0% 100.0% 100.0% Costs of services....................... 82.0 75.1 76.9 76.7 79.6 ------- ------- ------- ------- ------- Gross profit............................ 18.0 24.9 23.1 23.3 20.4 Operating Expenses: Selling, general and administrative expenses............................ 83.0 33.3 21.5 20.6 26.5 Provision for doubtful accounts....... 3.2 2.9 2.8 1.5 12.7 Depreciation and amortization expense............................. 11.7 7.3 3.8 4.0 3.3 ------- ------- ------- ------- ------- Total Operating Expenses.............. 97.9 43.5 28.1 26.1 42.5 ------- ------- ------- ------- ------- Loss from operations.................... (79.9) (18.6) (5.0) (2.8) (22.1) Other income (expense): Other gains and losses................ (5.1) (0.8) 0.4 0.3 (2.0) ------- ------- ------- ------- ------- Interest expense, net................. (3.6) (1.3) (2.6) (2.6) (2.9) ------- ------- ------- ------- ------- Total other income (expense).......... (8.7) (2.1) (2.2) (2.3) (4.9) Income tax benefit...................... 0.2 0.2 ------- ------- ------- ------- ------- Net loss................................ (88.6)% (20.7)% (7.0)% (4.9)% (27.0)% ------- ------- ------- ------- ------- ------- ------- ------- ------- -------
NINE MONTHS ENDED JANUARY 31, 1998 AND 1997 REVENUES. UDN's revenues increased 42.7% to $23.9 million for the nine months ended January 31, 1998 as compared to $16.8 million for the nine months ended January 31, 1997. The acquisition of CTN on January 1, 1997 contributed $2.8 million of this increase. Growth in agent/affinity revenue accounted for an additional $1.8 million of new revenue, while a new international calling program that began in October 1997 produced $0.9 million in increased revenue. GROSS PROFIT. In the nine month periods ended January 31, 1998 and January 31, 1997, gross profits were $4.9 million (20.4% of revenue) and $3.9 million (23.3% of revenue), respectively. The decline in gross profit in the nine months ended January 31, 1998 was caused by a number of factors. The start-up of UDN's California network and switching operations resulted in significant network underutilization and unbillable call records. UDN's Arizona switch also experienced operating problems that caused increased costs in certain types of calls. UDN believes that these were one-time factors that have been rectified, although network inefficiencies may continue to impact gross profits as UDN's California network continues to grow at a rapid pace. Another factor affecting gross profit is the increase during the nine months ended January 31, 1998 in international and wholesale revenues as a percentage of UDN's total revenue mix. International and wholesale products have lower gross margins than UDN's other products. SELLING, GENERAL AND ADMINISTRATIVE. For the nine months ended January 31, 1998 and January 31, 1997, UDN's selling, general and administrative ("SG&A") expenses were $6.3 million (26.5% of revenue) and $3.5 million (20.6% of revenue), respectively. The most recent nine month period was negatively impacted by several factors. First, UDN is incurring costs related to transitioning to new billing and order-entry systems. UDN has outgrown its existing systems, has temporarily added significant new staff in order 91 to manually process the order entry flow, and is expending resources in order to consolidate the separate billing processes. Additionally, UDN expanded its sales and marketing efforts through increases in personnel and through agent commission and incentive plans. Significant growth in UDN's agent/affinity revenue has caused a corresponding increase in monthly commission expenses. The combination of the above factors has caused the most recent nine month SG&A expenses to increase substantially as a percentage of revenues. As a part of the Merger Agreement, UDN is in the process of converting to STAR's billing and order-entry systems. The completion of the conversion by mid-1998 should cause a major reduction in billing and order-entry expenses. This will, in the view of UDN management, cause SG&A expenses to decrease and to compare more favorably as a percentage of revenue. PROVISION FOR DOUBTFUL ACCOUNTS. UDN's provision for doubtful accounts increased from $245,000 (1.5% of revenue) in the nine months ended January 31, 1997 to $3.1 million (12.7% of revenue) in the nine months ended January 31, 1998. The most recent nine month period was negatively impacted by the bankruptcies of two major wholesale customers and an approximate $1.3 million write-off due to a fraud situation that arose in December 1997. DEPRECIATION. UDN's depreciation and amortization expenses for the nine months ended January 31, 1998 increased to $0.8 million from $0.7 million in the nine months ended January 31, 1997. The increase in the most recent nine month period results from amortization of the goodwill and customer base costs associated with the January 1997 CTN acquisition. INTEREST EXPENSE. UDN's interest expense in the nine month period ended January 31, 1998 increased to $0.7 million from $0.4 million in the nine month period ended January 31, 1997. Three factors contributed to this increase. First, UDN has accrued interest of $48,000 on the $2.5 million promissory note dated November 19, 1997 with STAR. Second, $1.0 million of the purchase price related to the January 1, 1997 CTN acquisition was financed through the issuance of notes payable to the sellers. UDN had interest expense from the CTN notes of $48,000 in the nine month period ended January 31, 1998 and only $6,000 in the comparable nine month period ended January 31, 1997. Third, borrowings under UDN's accounts receivable financing arrangement began for DNI in July 1996 and in September 1996 for AMS. UDN was financing its accounts receivable for the full nine month period ended January 31, 1998, but for only a portion of the nine months ended January 31, 1997. Interest expense under the accounts receivable financing was $0.3 million and $0.1 million in the nine months ended January 31, 1998 and 1997, respectively. OTHER INCOME (EXPENSE). Other expenses of $0.4 million were recorded by UDN in the nine months ended January 31, 1998. These expenses result from the November 19, 1997 Merger Agreement. As a result of this agreement, UDN incurred a $0.1 million penalty for terminating an underwriting agreement with Madison Securities, Inc., expensed legal and other costs related to that offering and UDN's Form 10-SB filing with the Securities and Exchange Commission, and additionally expended $0.1 million for a fairness opinion with respect to the Merger Agreement. Finally, certain costs incurred for the development of and conversion to a new billing system were expensed since UDN is now proceeding with moving to the STAR billing system. In the nine months ended January 31, 1997, an extraordinary gain of $45,000, net of tax, was recognized on the settlement of amounts owed under a switching equipment lease. YEARS ENDED APRIL 30, 1997, 1996 AND 1995 REVENUES. UDN's revenues increased 199% to $24.0 million in the year ended April 30, 1997 from $8.0 million in the 1996 period, and 1996 revenues were up 243% from $2.3 million in the 1995 period. This increase resulted from a growth strategy combining significant internal growth with three acquisitions. On April 27, 1995, UDN acquired DNI. On March 26, 1996, UDN acquired AMS. On January 1, 1997, UDN acquired CTN. Internal growth in the period ended April 30, 1997 was primarily through UDN's agent/affinity programs and through a recently initiated international calling program, while the 1996 92 comparable period revenue growth was through agent/affinity programs and prepaid calling card programs. The 1995 revenues were derived through direct sales efforts primarily in the Dallas/Ft. Worth metropolitan area. GROSS PROFIT. In the year ended April 30, 1997, UDN's gross profit was $5.6 million (23.1%). This compares to a gross profit of $2.0 million (24.9%) in the year ended April 30, 1996 and to a gross profit of $0.4 million (18.0%) in the year ended April 30, 1995. The 1995 gross profit percentage was smaller than in 1996 and 1997 due to initial over-capacity in UDN's newly expanded network. The acquisition of DNI in April 1995 caused a significant increase in the 1996 gross profit and in the gross profit percentage. This resulted from consolidation of UDN's network into the DNI network, consolidation of switching platforms and more efficient usage of the network as a result of the significant growth in revenue. Gross profit in 1997 ($5.6 million) increased by 178% as compared to 1996 gross profit ($2.0 million), which resulted from a 199% growth in revenue. Gross profit as a percentage of revenue declined in 1997 to 23.1% as compared to 24.9% in 1996. The acquisition of AMS in March 1996 contributed to the 1997 decline. AMS is a switchless reseller with significantly lower margins than UDN's switched customer base. Gross profit as a percentage of revenue in UDN's switched base actually increased in 1997 to 31.3%, as compared to 24.9% in 1996, but UDN's total gross profit percentage was reduced by the addition of the AMS switchless base which had a gross profit percentage of 14.1% in 1997. SELLING, GENERAL AND ADMINISTRATIVE. UDN's selling, general and administrative expenses were $5.2 million in the year ended April 30, 1997, a 86% increase over SG&A expenses of $2.8 million in the year ended April 30, 1996, which in turn was up 47% over SG&A expenses of $1.9 million in the year ended April 30, 1995. SG&A expenses as a percentage of revenue declined significantly as UDN grew during the last three years. SG&A expenses were 21.5% of revenue in the year ended April 30, 1997, while they were 33.3% in 1996 and 83.0% in 1995. This improvement was the result of the economies realized as the operations of the DNI, AMS and CTN acquisitions were consolidated and as revenue growth in the year ended April 30, 1997 increased rapidly. PROVISION FOR DOUBTFUL ACCOUNTS. In the year ended April 30, 1995, UDN's provision for doubtful accounts was $75,000 (3.2% of revenue), while in the year ended April 30, 1996 the provision for doubtful accounts was $229,000 (2.9% of revenue) and in the year ended April 30, 1997 was $693,000 (2.8% of revenue). While the total provision for doubtful accounts has increased each year, its percentage as compared to total revenue has declined in each of the last two years, indicating an improvement in the quality of the Company's customer base and in its management of the accounts receivable. DEPRECIATION. UDN's depreciation and amortization expense grew to $0.9 million in the year ended April 30, 1997 from $0.6 million in the year ended April 30, 1996, which was an increase from $0.3 million in the year ended April 30, 1995. Amortization of the customer base and goodwill associated with the acquisition of DNI comprise the majority of the increase for the year ended April 30, 1996. Amortization of the AMS and CTN acquisitions caused the increase in the year ended April 30, 1997. INTEREST EXPENSE. UDN's interest expense in the year ended April 30, 1995 was $85,000 which was primarily related to the financing of switching, computer and other equipment. In the year ended April 30, 1996, interest expense increased to $0.1 million due to interest on the notes issued as part of the DNI acquisition price and also to interest expense on the acquired DNI switch. In the year ended April 30, 1997, interest expense increased to $0.6 million as a result of the notes and convertible debentures issued as part of the AMS and CTN acquisitions. In addition, in July 1996, UDN began incurring interest expense under an accounts receivable financing arrangement on the DNI receivables, which was expanded in September 1996 to include financing on the AMS receivables. Interest expense of $200,000 was realized from the financing of receivables during the year ended April 30, 1997. OTHER INCOME (EXPENSE). In the year ended April 30, 1997, UDN realized an extraordinary gain of $97,000, net of income taxes, which was related to the settlement of amounts owed under a switching 93 equipment lease. In the year ended April 30, 1996, a loss on impairment of assets was recorded to reflect the write down of certain excess switching equipment to reflect fair market value. In the year ended April 30, 1995, UDN recorded a $0.1 million loss on the sale of assets, which resulted from the March 1995 sale of UDN's answering service business. LIQUIDITY, CAPITAL RESOURCES AND OTHER At January 31, 1998, UDN had $1.0 million cash on hand and a working capital deficit of $10.3 million, which compares to working capital deficits $3.2 million at April 30, 1997 and $2.0 million at April 30, 1996. The $7.1 million decrease in working capital during the most recent nine month period related primarily to UDN's net loss of $6.5 million and also to an increase in the current portion of notes and debentures payable. UDN has historically operated with small cash balances and negative working capital. Funds have been raised, as needed, generally through private placements of UDN Common Stock. In their audit report on the April 30, 1997 financial statements, UDN's independent accountants raise substantial doubt about UDN's ability to continue as a going concern due to UDN's significant working capital deficiency and current cash flows that are not sufficient to repay debts on the scheduled due dates. At the time that the Merger Agreement was executed in November 1997, UDN was in the process of raising $3.0 million in a private placement through Madison Securities, Inc. In the nine months ended January 31, 1998, $0.8 million had been raised through the issuance of UDN Common Stock. In the previous fiscal year ended April 30, 1997, $1.4 million was raised through the issuance of UDN Common Stock. As a part of the Merger Agreement, UDN terminated the $3.0 million Madison private placement and received from STAR a loan in the amount of $2.5 million. In December 1997, UDN discovered the extent of a fraud situation and certain other uncollectible amounts out of its Phoenix location. On January 30, 1998, the original Merger Agreement was amended and on February 2, 1998 UDN received a second loan in the amount of $2.0 million. UDN believes it has sufficient funds on hand to be able to meet its obligations as they become due through the closing date of the Merger. In September 1997, UDN began expending funds to expand its operations by installing a California statewide network utilizing a new switch lease agreement. Also, in the latter months of 1997, UDN began expending significant funds on the development of a new billing system. This effort was terminated upon the signing of the Merger Agreement and UDN is now proceeding with integrating its three different billing systems into the STAR billing platform. These efforts combined with the unexpected losses realized in the fraud situation, the other bad debt write-offs, debt repayments, the cost of manually processing high numbers of new orders and the cost of the sales and marketing and incentive plans have caused UDN to experience a severe lack of liquidity. The STAR loans have temporarily cured that situation. However, should the Merger terminate without completion, UDN will be in the position of finding another billing alternative and of raising sufficient capital to repay the STAR loans and to meet its other obligations. There can be no assurance that UDN would be successful in raising such funds in that eventuality or that UDN will have sufficient liquidity to continue operations as a going concern. The company is reviewing its computer programs and systems to ensure that the programs and systems will function properly and be Year 2000 compliant. In this process, the Company expects to replace some existing systems and upgrade others. The Company presently believes that, with modifications to existing software and conversions to new software, the year 2000 problem will not pose significant operational problems for the Company's computer systems. The estimated cost of these efforts are not expected to be material to the Company's financial position or any year's results of operations. 94 BUSINESS OF UDN UDN is a provider of voice and data long distance services, travelcard services, international long distance, prepaid calling cards and various other telecommunication services to residential, small to medium-sized commercial customers, switchless resellers, agents and wholesale purchasers. The principal market for its long distance services is the central and southwest United States. UDN has customers in over 40 states. UDN operates primarily through its wholly-owned subsidiaries, Advanced Management Services, Inc. ("AMS"), CTN-Custom Telecommunications Network of Arizona, Inc. ("CTN") and United Digital Network of Texas, Inc. ("DNI"). UDN offers an array of services designed to afford its customers an integrated telecommunications solution to their telecommunication needs. UDN was incorporated in Canada under the British Columbia Company Act on June 2, 1980 under the name Stag Explorations Ltd. and, on November 30, 1990, UDN changed its name to Stag Holdings Ltd. and, on February 8, 1993, UDN changed its name to Unidex Communications Corp. On April 25, 1995, UDN reincorporated in the United States by filing Articles of Continuance with the Secretary of State of Wyoming, which allowed UDN to continue its existence as a Wyoming corporation. Subsequently, UDN merged into its wholly-owned subsidiary, a Delaware corporation, and continued its existence as Unidex Communications Corp, a Delaware corporation. Effective August 9, 1996, UDN changed its name from Unidex Communications Corp. to United Digital Network, Inc., consolidated its share capital on the basis of four old shares for one new share, and increased its authorized capital to 100 million shares of common stock, par value, $0.01 per share. UDN's growth has resulted from a two-pronged growth strategy. First, a plan of acquiring selected types of long distance companies has produced four major acquisitions that have been successfully integrated into UDN's operations. Second, a direct sales force, complemented by a small but rapidly growing agent network, has produced significant internal growth during the last two years. ACQUISITIONS In March 1993, for a purchase price of $747,000, UDN acquired ANI, a Texas based company. ANI was a small start-up long distance company in Texas that also provided various "live-operator" functions such as answering services and third party customer service to business customers. In April 1995, for a purchase price of $827,665, UDN acquired DNI, a Dallas, Texas based company which provides telecommunications services to small and medium sized commercial customers in Texas and Oklahoma. DNI's operations were integrated into UDN's existing Dallas base of business. This acquisition brought to UDN a more sophisticated switching platform, a more efficient and flexible customer-billing system and its own leased network facilities in the south central United States. In March 1996, for a purchase price of $5.0 million UDN, subject to adjustment based on various revenue performance criteria, acquired AMS, a Phoenix, Arizona based long distance switchless reseller which has in the past specialized in marketing long distance services to the motor freight industry. The $5.0 million purchase price consisted of $1.0 million in cash and $4.0 million in convertible debentures and promissory notes; as a result of discounts applied to the convertible debentures and promissory notes under generally accepted accounting principles, the purchase price has been recorded by UDN at $3.5 million for financial reporting purposes. The acquisition of AMS gave UDN an expanded agent program, a nationwide retail customer base and a long distance provider in the trucking industry market. AMS provides services to customers in Arizona and over 40 other states. Prior to the AMS acquisition, most of UDN's revenue came from Texas and Oklahoma. In January 1997, UDN entered into a capital lease agreement with RealSource, Inc. to lease, with the option to purchase for a nominal amount, the WorldDial Prepaid Calling Platform, the WorldDial Point- 95 of-Sale Activation Platform and all equipment necessary for the operation thereof ("WorldDial Platforms"). UDN has commenced providing services to certain prepaid card marketers and anticipates that this activity will provide increasing revenues during the next 12 months. In January 1997, for a purchase price of $1.4 million, UDN acquired CTN, a switch-based reseller located in Phoenix, Arizona. CTN has a commercial customer base and a complete originating and terminating network in Arizona and New Mexico. With the acquisition of CTN, UDN's network extends through Arizona, California, New Mexico, Oklahoma and Texas. INTERNAL GROWTH From fiscal year ending April 30, 1995 through December 31, 1997, UDN's customer base increased from approximately 2,000 customers to over 22,000 customers nationwide. As a part of UDN's two-pronged growth strategy, besides acquisitions, UDN's internal growth contributed significantly to this increase in customers and total revenue. During the fiscal year ended April 30, 1997, internal growth contributed nearly $750,000 in new monthly revenues. Approximately one-fourth of this growth came from UDN's pre-paid calling card product line, with the remainder coming from revenue increases in agent, affinity group and direct sales customers. PRODUCT OFFERINGS UDN provides long-distance voice and data services primarily in the south-central and southwestern United States. UDN offers a broad array of services designed to afford small and medium-sized commercial clients, and on a limited basis residential customers, integrated telecommunications solutions to their telecommunication needs. UDN operates in Texas, Oklahoma and California under the name DNI in Arizona and in over 40 other states under the name AMS, and also in Arizona and New Mexico under the name CTN. UDN's direct sales force targets businesses with monthly telecommunication expenses within a range of $250 to $10,000. UDN provides these clients with basic inbound and outbound long distance service as well as travelcard, prepaid calling cards and international long distance services. To complement these offerings and to be viewed by its clients as a provider of "bundled" products, UDN also provides on a limited basis the following services: Conference Calling, Fax Mail-Box, FAX Broadcast, FAX-on-Demand, voice mail and Dedicated and Switched Data Services. UDN's strategy is to provide a broad product line so that its clients will view UDN as a one-stop provider of telecommunication services. UDN believes that the more services a client obtains from UDN, the less susceptible a client will be to switch to one of UDN's competitors. One of UDN's strengths is its ability to customize products to fit a customer's needs. Like many other resellers, UDN buys bulk long distance services from various wholesale carriers. Unlike many resellers, however, UDN also originates and terminates a majority of its traffic on its own network throughout Texas, Oklahoma, Arizona and New Mexico. With significant volumes, this constitutes a lower cost method of routing long distance traffic. With the CTN acquisition, UDN obtained an Arizona and New Mexico network and a switch-sharing lease arrangement on a switch located in Phoenix, Arizona. UDN's network is built around its DEX-400 switch located in Dallas. During 1997, UDN entered into a switch-sharing arrangement with STAR for the use of a switch in southern California. A statewide California network is being implemented. UDN's business plan contemplates continuing growth by marketing its services through four separate channels: 1. DIRECT SALES. UDN currently employs direct-sales representatives in both the Dallas and Phoenix offices. These representatives each carry a monthly quota for generating new business, and focus on selling to small and medium-sized commercial accounts. 96 2. AGENT SALES. UDN uses a nationwide force of over 75 independent agents to sell UDN's services to both residential and commercial accounts. The independent agents are paid on the basis of a percentage of revenue that is billed by the clients that they have brought to UDN. In addition to the existing agent development group, a director of third party marketing was hired in May 1996 who is focusing on developing agents primarily through affinity marketing. 3. WHOLESALE SERVICES--SWITCHLESS RESELLERS AND CARRIER SALES. A switchless reseller is a non-facilities based long distance company for whom UDN acts as a wholesale provider of long distance services. The switchless reseller's clients are connected directly to UDN's network. Call detail records are sent to the reseller at the end of each month, which allows the reseller to utilize his own billing system in order to bill his clients. Alternatively, UDN may provide billing services to the switchless reseller and, for a fee, will bill the switchless reseller's customers for him. "Carrier sales" are those minutes other long distance carriers send to UDN to be terminated by UDN on its own network which presently covers Texas, Oklahoma, Arizona, New Mexico and portions of southern California. Although carrier sales constitute lower margin revenue, UDN's strategy is to have a base of wholesale clients for expanding its network geographically, which in turn should provide additional markets for higher margin direct sales and may ultimately increase margins in the agent base. 4. PREPAID CALLING CARDS. The agreement with RealSource, Inc. with respect to the WorldDial Platforms has made prepaid calling cards a recent addition to UDN's product line. Prepaid calling cards constitute a rapidly growing market. In addition to continuing to expand the above channels to market, UDN intends to focus on several other key areas to ensure the future growth of UDN. First, UDN must retain its customer base. The replacement of lost clients is a major expense to UDN and results in lost revenues. Second, UDN will continue to explore opportunities for expanding its product line. Just as the acquisition of the WorldDial Platforms has expanded UDN's product lines, UDN intends to continue to acquire, develop and market products and services that meet the expanding needs of its clients. These products may include, among others, local service, cellular service, paging and personal communications services. UDN currently serves over 22,000 customers nationwide, primarily located in Texas, Oklahoma, Arizona and California. Current monthly long distance revenue is approximately $3.0 million, which has grown as follows from UDN's entrance into the market in 1992:
LONG DISTANCE REVENUES ------------- Fiscal Year Ended April 30, 1993............................................... $ 13,000 Fiscal Year Ended April 30, 1994............................................... $ 152,000 Fiscal Year Ended April 30, 1995............................................... $ 1,378,000 Fiscal Year Ended April 30, 1996............................................... $ 8,027,000 Fiscal Year Ended April 30, 1997............................................... $24,012,000 For the Nine Months Ended January 31, 1998..................................... $23,942,000
EMPLOYEES UDN has 67 employees, of which 7 are full-time direct-sales representatives. DESCRIPTION OF PROPERTY UDN and its subsidiaries lease each of their principal executive offices. UDN does not own all of the transmission facilities needed to complete long distance telephone calls. Other than the switching facility in Dallas, UDN leases ports on switching facilities in Los Angeles and Phoenix. Therefore, UDN's operator services, direct dial long distance, "800" service, wholesale long distance service and international business 97 are largely dependent upon the contractual arrangement with facilities-based carriers for the transmission of calls on a cost-effective basis. UDN has contractual arrangements with a carrier for the use of its switch and transmission facilities in Los Angeles and Phoenix. These contracts are on a month-to-month basis. LEGAL PROCEEDINGS Except as set forth below, UDN is not engaged in any material litigation, and the officers and directors presently know of no threatened or pending material litigation in which it is contemplated that UDN will be made a party, except for proceedings involving AMS with respect to AMS operating in certain states without certification. In January 1998, AMS filed an action in Maricopa County Court of the State of Arizona against The Software Group, LLC, d/b/a Global Software Group, LLC ("Global") seeking $1.3 million in damages for an alleged breach of service contracts with AMS. AMS claims that Global failed to pay amounts due to AMS for services provided to Global under the service contracts. Global has filed a counterclaim against UDN and Messrs. Snedegar and Christensen. AMS intends to vigorously pursue its claim against Global. There can be no assurance, however, that AMS will prevail in its collection of damages. In addition, whether or not AMS is ever able to collect its damages, such collection process could be time consuming and costly. 98 MANAGEMENT OF STAR AND UDN OFFICERS AND DIRECTORS OF STAR The officers and directors of STAR and their ages as of May 18, 1998, are as follows:
NAME AGE POSITION - ---------------------------------------- --- ------------------------------------------------------------------ Christopher E. Edgecomb(1).............. 39 Chief Executive Officer, Chairman of the Board and Director Mary A. Casey(1)(2)..................... 35 President, Secretary and Director David Vaun Crumly....................... 34 Executive Vice President--Sales and Marketing James E. Kolsrud........................ 53 Executive Vice President--Operations and Engineering Kelly D. Enos........................... 39 Chief Financial Officer, Treasurer and Assistant Secretary Mark Gershien........................... 46 Director Gordon Hutchins, Jr.(3)................. 49 Director John R. Snedegar(2)(3).................. 49 Director Arunas A. Chesonis...................... 36 Director
- ------------------------ (1) Member of Non-Executive Stock Option Committee (2) Member of Audit Committee (3) Member of Compensation Committee CHRISTOPHER E. EDGECOMB co-founded STAR in September 1993, served as President of STAR until January 1996 and has served as STAR's Chief Executive Officer and Chairman of the Board since January 1996. Mr. Edgecomb has been a Director of STAR since its inception. Prior to that time, Mr. Edgecomb was a founder and the Executive Vice President of West Coast Telecommunications ("WCT"), a nation-wide long distance carrier, from August 1989 to December 1994. Prior to founding WCT, Mr. Edgecomb was President of Telco Planning, a telecommunications consulting firm, from January 1986 to July 1989. Prior to that time, Mr. Edgecomb held senior level sales and marketing positions with TMC Communications, American Network and Bay Area Teleport. MARY A. CASEY has been a Director and Secretary of STAR since co-founding STAR in September 1993, and has served as STAR's President since January 1996. Prior to that time, Ms. Casey was Director of Customer Service at WCT from December 1991 to June 1993, and served as Director of Operator Services at Call America, a long distance telecommunications company, from May 1988 to December 1991. DAVID VAUN CRUMLY has served as STAR's Executive Vice President--Sales and Marketing since January 1996. Prior to that time, Mr. Crumly served as a consultant to the Company from November 1995 to January 1996, was Vice President of Carrier Sales of Digital Network, Inc. from June 1995 to November 1995 and was Director of Carrier Sales of WCT from June 1992 to June 1995. Prior to joining WCT, Mr. Crumly served in various sales and marketing capacities with Metromedia, a long-distance company, from September 1990 to June 1992 and with Claydesta, a long-distance company, from May 1987 to September 1989. JAMES E. KOLSRUD has served as STAR's Executive Vice President--Operations and Engineering since September 1996. Prior to joining STAR, Mr. Kolsrud was an international telecommunications consultant from March 1995 to September 1996. Prior to that time, he was a Vice President, Corporate Engineering and Administration of IDB Communications Group, Inc. ("IDB"), an international communications company, from October 1989 to March 1995, and prior to that time, he was President of the International Division of IDB. 99 KELLY D. ENOS has served as STAR's Chief Financial Officer since December 1996 and as Treasurer and Assistant Secretary since April 1997. Prior to that time, Ms. Enos was an independent consultant in the merchant banking field from February 1996 to November 1996 and a Vice President of Fortune Financial, a merchant banking firm, from April 1995 to January 1996. Ms. Enos served as a Vice President of Oppenheimer & Co., Inc., an investment bank, from July 1994 to March 1995 and a Vice President of Sutro & Co., an investment bank, from January 1991 to June 1994. MARK GERSHIEN has served as a Director of STAR since March 1998. Mr. Gershien has been the Senior Vice President of Sales and Marketing for Level 3 Communications, a telecommunications and information services company, since January 1998. Prior to that time, Mr. Gershien was the Senior Vice President of National Accounts for WorldCom, Inc., an international telecommunications company, and President and Chief Executive Officer of MFS Telecom, a division of MFS Communications, Inc. prior to its merger with WorldCom, Inc. GORDON HUTCHINS, JR. has served as a Director of STAR since January 1996. Mr. Hutchins has been President of GH Associates, a telecommunications consulting firm, since July 1989. Prior to founding GH Associates, Mr. Hutchins served as President and Chief Executive Officer of ICC Telecommunications, a competitive access provider, and held senior management positions with several other companies in the telecommunications industry. JOHN R. SNEDEGAR has served as a Director of STAR since January 1996. Mr. Snedegar has been the President of UDN since June 1990. See "--Officers and Directors of UDN." ARUNAS A. CHESONIS has served as a Director of STAR since May 1998. From May 1987 to April 1998, Mr. Chesonis served in various executive positions with ACC Corp. and its subsidiaries, including most recently President of ACC Corp. and President and Chief Operating Officer of ACC Global Corp. STAR BOARD COMPOSITION In accordance with the terms of STAR's Certificate of Incorporation, the terms of office of the Board of Directors are divided into three classes: Class I, whose term will expire at the annual meeting of stockholders to be held in 1998; Class II, whose term will expire at the annual meeting of stockholders to be held in 1999; and Class III, whose term will expire at the annual meeting of stockholders to be held in 2000. The Class I directors are Gordon Hutchins, Jr. and John R. Snedegar, the Class II directors are Mark Gershien and Mary A. Casey, and the Class III directors are Christopher E. Edgecomb and Arunas A. Chesonis. At each annual meeting of stockholders after the initial classification, the successors to directors whose term will then expire will be elected to serve from the time of election and qualification until the third annual meeting following election. This classification of the Board of Directors may have the effect of delaying or preventing changes in control or changes in management of STAR. See "Risk Factors--Anti-takeover Effects of Certificate of Incorporation, Bylaws and Delaware Law" and "Description of STAR Capital Stock--Anti-takeover Effects of Provisions of the Certificate of Incorporation, Bylaws and Delaware Law." Each officer is elected by and serves at the discretion of the STAR Board. Each of STAR's officers and directors, other than nonemployee directors, devotes substantially full time to the affairs of STAR. STAR's nonemployee directors devote such time to the affairs of STAR as is necessary to discharge their duties. There are no family relationships among any of the directors, officers or key employees of STAR. STAR DIRECTOR COMPENSATION STAR's non-employee directors receive $2,000 for each Board meeting attended and $1,000 for each telephonic Board meeting. In addition, each non-employee director is reimbursed for out-of-pocket expenses incurred in connection with attendance at meetings of the Board of Directors and its committees. In 1996, Messrs. Hutchins and Snedegar were each granted stock options to purchase 20,500 shares of 100 STAR's Common Stock. In 1997, Messrs. Hutchins and Snedegar and Roland Van der Meer, a former director, were each granted stock options to purchase 10,250 shares of STAR's Common Stock. In 1998, Messrs. Hutchins, Snedegar and Gershien were each granted stock options to purchase 10,250 shares of STAR Common Stock, and Mr. Chesonis was granted stock options to purchase 10,000 shares of STAR Common Stock. See "Certain Transactions--Transactions with STAR Outside Directors." STAR EXECUTIVE COMPENSATION The following Summary Compensation Table sets forth the compensation earned by STAR's Chief Executive Officer and four other executive officers who earned (or would have earned) salary and bonus in excess of $100,000 for services rendered in all capacities to STAR and its subsidiaries (the "STAR Named Officers") for each of the fiscal years in the two year period ended December 31, 1997. SUMMARY COMPENSATION TABLE
LONG TERM COMPENSATION ------------- SECURITIES UNDERLYING ALL OTHER NAME AND PRINCIPAL POSITION FISCAL YEAR SALARY ($) BONUS ($) OPTIONS (#) COMPENSATION ($) - ------------------------------------------------- ----------- ----------- ----------- ------------- ----------------- Christopher E. Edgecomb ......................... 1997 360,000 -- -- 3,202(1) Chief Executive Officer and Chairman of the 1996 360,000 -- -- 9,223(1) Board Mary A. Casey ................................... 1997 217,500 -- -- 13,615(2) President and Secretary 1996 156,042 -- -- 15,028(2) David Vaun Crumly ............................... 1997 380,779 1,014 -- 6,202(2) Executive Vice President--Sales and Marketing 1996 298,002 -- 410,000 3,202(2) James E. Kolsrud ................................ 1997 177,083 1,014 -- 5,528(3) Executive Vice President--Operations and 1996 25,000 -- 205,000 -- Engineering Kelly D. Enos(4) ................................ 1997 150,000 1,014 20,500 25,924(5) Chief Financial Officer and Treasurer 1996 12,500 -- 153,750 --
- ------------------------ (1) Consists of life and health insurance premiums paid by STAR. (2) Consists of life and health insurance premiums and a car allowance paid by STAR. (3) Consists of health insurance premiums paid by STAR. (4) Ms. Enos joined STAR in December 1996. (5) Consists of a moving allowance of $22,721 and life and health insurance premiums paid by STAR. 101 The following table contains information concerning the stock option grants made to each of the STAR Named Officers named below for the year ended December 31, 1997. OPTION GRANTS IN LAST FISCAL YEAR
POTENTIAL REALIZABLE VALUE OF ASSUMED NUMBER OF ANNUAL RATES OF STOCK SECURITIES PERCENT OF TOTAL PRICE APPRECIATION UNDERLYING OPTIONS GRANTED EXERCISE FOR OPTION TERM(1) OPTIONS TO EMPLOYEES IN PRICE PER EXPIRATION --------------------- NAME GRANTED (#) FISCAL YEAR SHARE ($/SH) DATE 5% ($) 10% ($) - ------------------------------------ ----------- ----------------- ------------- ----------- --------- ---------- Kelly D. Enos....................... 20,500(2) 2.3% $ 6.83 06/27/07 $ 88,045 $ 223,124
- ------------------------ (1) The 5% and 10% assumed annual rates of compounded stock price appreciation are mandated by rules of the Securities and Exchange Commission. There can be no assurance provided to any executive officer or any other holder of STAR's securities that the actual stock price appreciation over the 10-year option term will be at the assumed 5% and 10% levels or at any other defined level. Unless the market price of the STAR Common Stock appreciates over the option term, no value will be realized from the option grants made to the executive officer. (2) The option becomes exercisable in four equal annual installments on June 26, 1998, 1999, 2000 and 2001, respectively. AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES No options were exercised by the STAR Named Officers for the fiscal year ended December 31, 1997. No stock appreciation rights were exercised during such year or were outstanding at the end of that year. STAR COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION The Compensation Committee of STAR's Board (the "Compensation Committee") was formed in May 1996, and, in 1997, the members of the Compensation Committee were Gordon Hutchins, Jr., John R. Snedegar and Roland A. Van der Meer. None of these individuals was at any time during the year ended December 31, 1997, or at any other time, an officer or employee of STAR. Mr. Van der Meer resigned from the Board and the Compensation Committee, effective as of February 1, 1998. The Non-Executive Compensation Committee of STAR's Board (the "Non-Executive Compensation Committee") was formed in 1997, and the members are Christopher E. Edgecomb and Mary A. Casey. No member of the Compensation Committee or the Non-Executive Compensation Committee served at any time during the year ended December 31, 1997 as a member of the board of directors or compensation committee of any entity that has one or more executive officers serving as a member of STAR's Board, Compensation Committee or Non-Executive Compensation Committee, except that Mr. Hutchins was a director of UDN for a portion of 1997. The Compensation Committee and the Non-Executive Compensation Committee shall collectively be referred to hereafter as the "Compensation Committees." STAR 1997 OMNIBUS STOCK INCENTIVE PLAN STAR's 1997 Omnibus Stock Incentive Plan (the "Omnibus Plan") was adopted by the Board of Directors on January 30, 1997 as the successor to STAR's 1996 Supplemental Option Plan (the "Supplemental Plan"). STAR has reserved 3,075,000 shares for issuance under the Omnibus Plan. This share reserve is comprised of (i) the 2,050,000 shares that were available for issuance under the Supplemental Plan, plus (ii) an increase of 1,025,000 shares. As of May 15, 1998, 32,060 shares had been issued under the Supplemental and Omnibus Plans, options for approximately 2,142,314 shares were outstanding (873,686 of which were granted under the Supplemental Plan) and approximately 915,330 shares remained available for future grant. Shares of STAR Common Stock subject to outstanding options, including options granted 102 under the Supplemental Plan, which expire or terminate prior to exercise, will be available for future issuance under the Omnibus Plan. In addition, if stock appreciation rights ("SARs") and stock units are settled under the Omnibus Plan, then only the number of shares actually issued in settlement will reduce the number of shares available for future issuance under this plan. Under the Omnibus Plan, employees, outside directors and consultants may be awarded options to purchase shares of STAR Common Stock, SARs, restricted shares and stock units. Options may be incentive stock options designed to satisfy Section 422 of the Internal Revenue Code or nonstatutory stock options not designed to meet such requirements. SARs may be awarded in combination with options, restricted shares or stock units, and such an award may provide that the SARs will not be exercisable unless the related options, restricted shares or stock units are forfeited. The Omnibus Plan is administered by the Board or the Compensation Committees (the "Administrator"). The Administrator has the complete discretion to determine which eligible individuals are to receive awards; determine the award type, number of shares subject to an award, vesting requirements and other features and conditions of such awards; interpret the Omnibus Plan; and make all other decisions relating to the operation of the Omnibus Plan. The exercise price for options granted under the Omnibus Plan may be paid in cash or in outstanding shares of STAR Common Stock. Options may also be exercised on a cashless basis, by a pledge of shares to a broker or by promissory note. The payment for the award of newly issued restricted shares will be made in cash. If an award of SARs, stock units or restricted shares from STAR's treasury is granted, no cash consideration is required. The Administrator has the authority to modify, extend or assume outstanding options and SARs or may accept the cancellation of outstanding options and SARs in return for the grant of new options or SARs for the same or a different number of shares and at the same or a different exercise price. The Board may determine that an outside director may elect to receive his or her annual retainer payments and meeting fees from STAR in the form of cash, options, restricted shares, stock units or a combination thereof. The Board will decide how to determine the number and terms of the options, restricted shares or stock units to be granted to outside directors in lieu of annual retainers and meeting fees. Upon a change in control, the Administrator may determine that an option or SAR will become fully exercisable as to all shares subject to such option or SAR. A change in control includes a merger or consolidation of STAR, certain changes in the composition of the Board and acquisition of 50% or more of the combined voting power of STAR's outstanding stock. In the event of a merger or other reorganization, outstanding options, SARs, restricted shares and stock units will be subject to the agreement of merger or reorganization, which may provide for the assumption of outstanding awards by the surviving corporation or its parent, their continuation by STAR (if STAR is the surviving corporation), accelerated vesting and accelerated expiration, or settlement in cash. The Board may amend or terminate the Omnibus Plan at any time. Amendments may be subject to stockholder approval to the extent required by applicable laws. In any event, the Omnibus Plan will terminate on January 22, 2007, unless sooner terminated by the Board. STAR 1996 OUTSIDE DIRECTOR NONSTATUTORY STOCK OPTION PLAN STAR's 1996 Outside Director Nonstatutory Stock Option Plan (the "Director Plan") was ratified and approved by the Board of Directors as of May 14, 1996. STAR has reserved 410,000 shares of STAR Common Stock for issuance under the Director Plan. As of May 15, 1998, 71,750 shares had been issued under the Director Plan, options for 81,750 shares were outstanding and 256,500 shares remained available for future grant. If an outstanding option expires or terminates unexercised, then the shares subject to such option will again be available for issuance under the Director Plan. 103 Under the Director Plan, outside directors of STAR may receive nonstatutory options to purchase shares of STAR Common Stock. The Director Plan is administered by the Board or the Compensation Committee (the "Administrator"). The Administrator has the discretion to determine which eligible individuals will receive options, the number of shares subject to each option, vesting requirements and any other terms and conditions of such options. The exercise price for options granted under the Director Plan will be at least 85% of the fair market value of the STAR Common Stock on the option grant date, shall be 110% of the fair market value of the STAR Common Stock on the option grant date if the option is granted to a holder of more than 10% of the STAR Common Stock outstanding and may be paid in cash, check or shares of STAR Common Stock. The exercise price may also be paid by cashless exercise or pledge of shares to a broker. The Administrator may modify, extend or renew outstanding options or accept the surrender of such options in exchange for the grant of new options, subject to the consent of the affected optionee. Upon a change in control, the Board may accelerate the exercisability of outstanding options and provide an exercise period during which such accelerated options may be exercised. The Board also has the discretion to terminate any outstanding options that had been accelerated and had not been exercised during such exercise period. In the event of a merger of STAR into another corporation in which holders of STAR Common Stock receive cash for their shares, the Board may settle the option with a cash payment equal to the difference between the exercise price and the amount paid to holders of STAR Common Stock pursuant to the merger. The Board may amend or terminate the Director Plan at any time. In any event, the Director Plan will terminate on May 14, 2006, unless sooner terminated by the Board. STAR EMPLOYMENT AGREEMENTS AND CHANGE OF CONTROL ARRANGEMENTS STAR has an employment agreement with Mary A. Casey, pursuant to which Ms. Casey holds the position of President of STAR, is paid an annual salary of $20,000 per month, subject to adjustment to reflect increases in the Consumer Price Index, was entitled to purchase 1,677,273 shares of STAR Common Stock, and is eligible to receive a bonus, as determined by the Chief Executive Officer and Board of Directors. The agreement also provides that Ms. Casey will receive a severance payment equal to $7,000 per month for the first six months after termination of employment, and an additional payment of $7,000 per month for the next six months, minus any amounts earned by her from other employment during such period. In addition, the agreement provides that if Ms. Casey's employment is terminated (other than for cause) within four months after a Sale Transaction (as defined below), she will continue to receive the compensation provided in the agreement until the expiration of the agreement on December 31, 2000, instead of the severance payments described above. A Sale Transaction is an acquisition of more than 75% of the voting securities of STAR, pursuant to a tender offer or exchange offer approved in advance by the Board of Directors. In January 1996, STAR entered into an employment agreement with David Vaun Crumly pursuant to which Mr. Crumly became Executive Vice President of STAR. The agreement provides for an annual salary of $10,000 per month with an annual increase, plus incentive bonuses tied to gross revenues of STAR. The agreement also provides for a commission on certain accounts of STAR and an option to purchase 369,000 shares of STAR Common Stock at an exercise price of $0.73 per share. In addition, in the event of a Sale Transaction, Mr. Crumly will receive a bonus payment equal to the lesser of $1,500,000 or a percentage of the monthly gross sales of accounts relating to customers introduced to STAR by Mr. Crumly. If his employment is terminated in certain circumstances, without cause, within four months after a Sale Transaction, Mr. Crumly is entitled to receive the compensation provided in this agreement, minus any compensation earned by other employment, until the expiration of the agreement on December 31, 2000. 104 In December 1996, STAR entered into an employment agreement with Kelly D. Enos, pursuant to which Ms. Enos became Chief Financial Officer of STAR. The agreement provides for an annual salary of $150,000 (which has been increased to $160,000) and an option to purchase 153,750 shares of STAR Common Stock at an exercise price of $4.00 per share. The agreement also provides that Ms. Enos will receive a severance payment equal to the compensation which she would have received under the remaining term of the agreement if she terminates the agreement as a result of STAR's default of its material obligations and duties under the agreement or if she is terminated by STAR without cause within four months after a Sale Transaction. In September 1996, STAR entered into an employment agreement with James E. Kolsrud, pursuant to which Mr. Kolsrud became Executive Vice President--Operations and Engineering of STAR. The agreement provides for a monthly salary of $16,667, an option to purchase 205,000 shares of STAR Common Stock pursuant to STAR's 1996 Supplemental Stock Option Plan at a price of $4.00 per share, reimbursement of reasonable out-of-pocket expenses incurred in connection with Company business, and fringe benefits accorded to executives of STAR as determined by the Board of Directors. In the event of termination pursuant to the agreement, Mr. Kolsrud shall be entitled to receive compensation accrued and payable to him as of the date of his termination or death, and all other amounts payable to him under the agreement shall thereupon cease. If his employment is terminated in certain circumstances within four months after a Sale Transaction, then Mr. Kolsrud shall continue to receive the compensation provided in the agreement until the expiration of the agreement on December 31, 2000. OFFICERS AND DIRECTORS OF UDN After the Merger, the officers and directors of UDN are expected to be and their ages as of December 31, 1997 are, as follows:
NAME AGE POSITION - ----------------------------------- --- --------------------------------------------------- John R. Snedegar .................. 49 President Laguna Hills, CA 92653 Dale W. Christensen ............... 45 Chief Operating Officer and Chief Financial Officer Carrollton, TX 75007 Christopher E. Edgecomb ........... 38 Director Santa Barbara, CA 93101 Mary A. Casey ..................... 34 Director Santa Barbara, CA 93101 Kelly D. Enos ..................... 38 Director Santa Barbara, CA 93101
JOHN R. SNEDEGAR has been the President and a Director of UDN since June 1990. From June 1980 to February 1992, Mr. Snedegar was the President and CEO of AmeriTel Management, Inc., a provider of long distance telecommunications and management services. Mr. Snedegar is also a director for StarBase Corporation, a software development company, and of STAR. Mr. Snedegar also serves as President of Kendall Venture Funding, Ltd., a reporting company in Alberta, Canada. DALE W. CHRISTENSEN co-founded ANI Communications in February 1992, and joined UDN as Chief Operating Officer and Chief Financial Officer upon UDN's acquisition of ANI later that same year. From 1989 to 1992, Mr. Christensen was the Controller of International Telecharge, Inc. ("ITI"), a telecommunications company that provided alternative operator services primarily to the pay phone and hospitality markets. For biographies of Mr. Edgecomb, Ms. Casey and Ms. Enos, see "--Officers and Directors of STAR." All directors hold office until the next annual meeting of stockholders or until their successors have been duly elected or qualified or until his earlier death, resignation or removal. Executive officers of UDN are appointed by and serve at the discretion of the UDN Board. 105 UDN DIRECTOR COMPENSATION The members of the UDN Board of Directors are not compensated in such capacity. However, the UDN Board of Directors may, by resolution, reimburse directors for out-of-pocket expenses incurred in their capacity as directors of UDN. UDN EXECUTIVE COMPENSATION The following Summary Compensation Table sets forth the compensation earned by UDN's President and one other executive officer who earned (or would have earned) salary and bonus in excess of $100,000 for services rendered in all capacities to UDN and its subsidiaries (the "UDN Named Officers") for each of the fiscal years in the three year period ended April 30, 1998. SUMMARY COMPENSATION TABLE
LONG TERM COMPENSATION ------------ SECURITIES FISCAL UNDERLYING ALL OTHER NAME AND PRINCIPAL POSITION YEAR SALARY ($) BONUS OPTIONS (#) COMPENSATION - ----------------------------------- ------ -------------- -------- ------------ ------------ John R. Snedegar, ................. 1998 $ 125,587 $ 50,000 -- $7,200 President/Chief Executive Officer 1997 118,019 25,000 -- 6,000 1996 -- -- -- -- Dale W. Christensen, .............. 1998 $ 101,443 $ 23,750 37,500 $2,400 Chief Operating Officer and Vice 1997 104,877 20,000 -- -- President Finance 1996 90,930 6,500 37,500 --
The following table contains information concerning the stock option grants made to each of the UDN Named Officers named below for the year ended April 30, 1998. OPTION GRANTS IN LAST FISCAL YEAR
MARKET VALUE OF NUMBER OF PERCENT OF SECURITIES SECURITIES TOTAL OPTIONS EXERCISE UNDERLYING UNDERLYING GRANTED TO PRICE PER OPTIONS ON THE OPTIONS GRANTED EMPLOYEES IN SHARE DATE OF GRANT EXPIRATION NAME (#)(1) FISCAL YEAR (CDN $/SH) (CDN $/SECURITY) DATE - ---------------------------------------- --------------- --------------- ------------- ----------------- ----------- Dale W. Christensen..................... 37,500 49.0% $ 2.28 $ 2.28 6/11/02
- ------------------------ (1) These options are fully vested. AGGREGATE OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES No options were exercised by the UDN Named Officers for the fiscal year ended April 30, 1998. No stock appreciation rights were exercised during such year or were outstanding at the end of that year.
UNEXERCISED OPTIONS @ APRIL VALUE OF UNEXERCISED 30, IN-THE-MONEY 1997 OPTIONS AT APRIL 30, 1997 NAME EXERCISABLE/UNEXERCISABLE (#) EXERCISABLE/UNEXERCISABLE ($$) - ------------------------------------------------- ------------------------------ ------------------------------- Dale Christensen................................. 37,500/0 nil
106 OUTSTANDING STOCK OPTIONS
NUMBER OF UDN EXERCISE PRICE EXPIRY DATE OF CLASS OF OPTIONEE SHARES UNDER OPTION PER SHARE OPTION - ------------------------------------------------ ------------------- -------------------- -------------------- Executive Officers, as a group (1 person)....... 37,500 US$ 1.64/CD$2.80 May 2, 2000 37,500 US$ 2.04/CD$2.28 June 11, 2002 Directors who are not executive officers, as a 25,000 US$ 2.16/CD$2.92 May 11, 2000 group (3 persons)............................. 75,000 US$ 2.14/CD$2.92 January 15, 2001 50,000 US$ 1.97/CD$2.68 March 26, 2001 Other employees of UDN, or its subsidiaries, as 16,250 US$ 1.64/CD$2.80 May 2, 2000 a group (21 persons).......................... 39,375 US$ 1.77/CD$2.40 August 21, 2000 98,750 US$ 2.02/CD$2.76 June 6, 2001 40,000 US$ 1.84/CD$2.50 October 4, 2001 36,250 US$ 1.59/CD$2.22 April 4, 2002 13,750 US$ 2.04/CD$2.28 June 11, 2002
UDN EMPLOYMENT AGREEMENTS EMPLOYMENT CONTRACT WITH MR. SNEDEGAR. UDN entered into an Employment Agreement, dated June 1, 1996, with its President, John R. Snedegar, pursuant to which Mr. Snedegar is employed for a four-year term from June 1, 1996, at a base salary of $125,000 per annum. The agreement also provides for typical perquisites such as reimbursement of expenses, paid vacation, automobile allowance and medical, disability and life insurance. Mr. Snedegar can earn a bonus of up to $50,000 per fiscal year at the discretion of the Board of Directors or based on revenue and profitability targets to be established by the Board (the "Bonus"). Mr. Snedegar may terminate the agreement for any reason upon ninety days' prior written notice. In the event that Mr. Snedegar's employment is terminated without cause, Mr. Snedegar will be entitled to a severance payment equal to his monthly base salary times the number of months remaining in the term of the agreement up to a maximum of 24 months, in addition to two times the amount of the Bonus earned during the fiscal year prior to termination. In the event that there is a change in control of UDN, Mr. Snedegar may elect to terminate the agreement. In that event, Mr. Snedegar will be entitled to a severance payment equal to his monthly base salary times the number of months remaining in the term of the contract, up to a maximum of 24 months, in addition to two times the amount of the Bonus earned during the fiscal year prior to termination and will continue to receive life insurance, health insurance and disability insurance benefits for a period of two years from the date of termination. In the event that the agreement is otherwise terminated, Mr. Snedegar will be entitled to receive an amount equivalent to the Bonus for the fiscal year in which termination occurs multiplied by a fraction, the numerator of which is the number of days in that year prior to termination and the denominator is 365. EMPLOYMENT CONTRACT WITH MR. CHRISTENSEN. UDN entered into an Employment Agreement dated May 1, 1997, with its Chief Financial Officer and Chief Operating Officer, Dale W. Christensen, pursuant to which Mr. Christensen is employed for a two-year term from May 1, 1997, at a base salary of $100,000 per annum. The agreement also provides for typical perquisites such as reimbursement of expenses, paid vacation, automobile allowance and medical and disability insurance. Mr. Christensen can earn a bonus of up to $25,000 per fiscal year based on revenue and profitability targets to be agreed upon between UDN's President and Mr. Christensen (the "Bonus"). Mr. Christensen may terminate the agreement for any reason upon thirty days' prior written notice. In the event that Mr. Christensen's employment is terminated by UDN without cause, Mr. Christensen will be 107 entitled to a severance payment equal to his monthly base salary times the number of months remaining in the term of the agreement up to a maximum of six months, in addition to the amount of the Bonus which would have been earned in the fiscal year of termination, multiplied by a fraction of which the numerator is the number of days in that year prior to termination and the denominator is 365. In the event that there is a change in control of UDN, Mr. Christensen may elect to terminate the agreement. In that event, Mr. Christensen will be entitled to a severance payment equal to his monthly base salary times the number of months remaining in the term of the contract, up to a maximum of six months and will continue to receive medical and disability insurance benefits for a period of six (6) months from the date of termination. 108 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS TRANSACTIONS WITH STAR OUTSIDE DIRECTORS STAR provides services to Digital Network, Inc. ("DNI"), a wholly owned subsidiary of UDN. John R. Snedegar, a Director of STAR, is President of UDN. For the year ended December 31, 1997 and the four months ended April 30, 1998, DNI made payments to STAR in the amount of approximately $1,141,000 and $1,877,000, respectively for such services. On November 19, 1997, STAR entered into the Merger Agreement. Messrs. Snedegar and Edgecomb beneficially own 11.4% and 2%, respectively, of the outstanding common stock of UDN. In connection with the Merger, STAR has loaned $4.5 million to UDN at market rates of interest. See "The Merger-- The Merger Agreement--Promissory Notes." GH Associates, an affiliate of Gordon Hutchins, Jr., a Director of STAR, provides consulting services to STAR. For the years ended December 31, 1995, 1996 and 1997 and for the four months ended April 30, 1998, STAR made payments of approximately $60,000, $154,000, $72,000 and $31,000, respectively, to GH Associates for general business consulting services relating to the telecommunications industry and for the performance of other tasks requested by STAR's Chief Executive Officer, President and Board of Directors. In addition, in connection with these services, STAR granted to Mr. Hutchins a nonstatutory option to purchase 205,000 shares of STAR Common Stock at an exercise price of $1.46 per share. STAR's Outside Directors have been granted nonstatutory stock options under the Director Plan. See "Management of STAR and UDN--STAR Director Compensation." TRANSACTIONS WITH STAR EXECUTIVE OFFICERS Each of Kelly D. Enos, David Vaun Crumly and James E. Kolsrud received incentive stock options to purchase 4,100 shares of STAR Common Stock at an exercise price of $16.31 in January 1998, and incentive stock options to purchase 100 shares of STAR Common Stock at an exercise price of $27.00 in May 1998. On October 4, 1996, STAR entered into a $12.0 million line of credit with Comerica Bank. This line of credit was guaranteed by Christopher E. Edgecomb, STAR's Chief Executive Officer. STAR has entered into a new revolving credit facility since that time and Mr. Edgecomb's guarantee of the Comerica Bank line has been terminated. Mr. Edgecomb did not receive any additional compensation in connection with such guarantee. STAR has entered into lines of credit with Mr. Edgecomb in the aggregate amount of $1,448,000. Borrowings under the lines of credit bear interest at a rate of 9.0% and there was $82,000 outstanding under these lines of credit as of March 31, 1998. In addition, on November 27, 1997 STAR provided a short-term loan to Mr. Edgecomb for $8.0 million. The loan carried interest of 7% per annum and was repaid in seven days. Mr. Edgecomb owns Star Aero Services, Inc. ("Star Aero"), which has ownership interests in five airplanes that STAR utilizes for business travel from time to time. For the years ended December 31, 1995, 1996 and 1997 and the four months ended April 30, 1998, STAR paid $144,000, $68,000, $171,000 and $10,000, respectively, in costs related to the use of Star Aero services. Mr. Crumly had controlling ownership of three companies that resold transmission capacity to STAR during 1996 for a total of approximately $240,000. No fees were paid to Mr. Crumly during 1997 with respect to such transmission capacity. In addition, STAR reimbursed approximately $131,000 in legal fees incurred by such companies in connection with a dispute with the provider of the capacity that was resold to STAR. Mr. Kolsrud has a 12.5% interest in Interpacket Group, Inc. ("Interpacket") which has direct termination arrangements with STAR for certain countries in Central and South America. For the years ended December 31, 1996 and 1997 and the four months ended April 30, 1998, STAR paid $37,000, 109 $256,000 and $1,146,000, respectively, for services rendered by Interpacket. In addition, STAR purchased satellite transmission equipment and services from Interpacket during 1997 in the amount of $1,114,000. INDEMNIFICATION OF STAR DIRECTORS AND OFFICERS STAR's Amended and Restated Certificate of Incorporation limits the liability of its directors for monetary damages arising from a breach of their fiduciary duty as directors, except to the extent otherwise required by the Delaware General Corporation Law. Such limitation of liability does not affect the availability of equitable remedies such as injunctive relief or rescission. STAR's Bylaws provide that STAR shall indemnify its directors and officers to the fullest extent permitted by Delaware law, including in circumstances in which indemnification is otherwise discretionary under Delaware law. STAR's has also entered into or will enter into indemnification agreements with its officers and directors containing provisions that may require STAR, among other things, to indemnify such officers and directors against certain liabilities that may arise by reason of their status or service as directors or officers (other than liabilities arising from willful misconduct of a culpable nature), to advance their expenses incurred as a result of any proceeding against them as to which they could be indemnified, and to obtain directors' and officers' insurance if available on reasonable terms. STAR believes that all of the transactions set forth above were made on terms no less favorable to STAR than could have been obtained from unaffiliated third parties. All future transactions, including loans between STAR and its officers, directors, principal stockholders and their affiliates will be approved by a majority of the Board of Directors, including a majority of the independent and disinterested outside directors on the Board of Directors, and will continue to be on terms no less favorable to STAR than could be obtained from unaffiliated third parties. TRANSACTIONS WITH UDN DIRECTORS AND OFFICERS Donald Sledge is covered by UDN's health and dental insurance plan, and UDN reimburses the annual costs of his life insurance policy. In March 1996, UDN acquired all of the outstanding common stock of AMS for consideration totaling $5.0 million, consisting of $1.0 million in cash, $3.0 million in convertible debentures and $1.0 million in notes payable. Ninety-three percent of the outstanding shares of AMS were owned by Ennis Rushton and Cindy Rushton, his wife. Immediately following this transaction, Mr. Rushton became a director of UDN. Under the AMS acquisition agreement, UDN was entitled to reduce the outstanding amount of the convertible debentures and notes payable issued in the transaction by the amounts by which (a) the net worth of AMS at closing was less than an agreed upon amount and (b) revenue in several specified post-closing periods was less than an agreed upon amount. Pursuant to these provisions, UDN reduced the outstanding debentures by approximately $1.1 million as a result of the closing-date equity level of AMS, and by approximately $368,000 as a result of the post-closing revenue of AMS. Ennis and Cindy Rushton disputed the amount of the reduction relating to post-closing revenue. In addition, subsequent to the AMS acquisition, $500,000 of the convertible debentures were converted by the holders into 250,000 shares of UDN Common Stock. In March 1998, UDN settled the dispute with Ennis and Cindy Rushton by a reduction of $200,000 in the amount outstanding under the Convertible Debenture. All amounts due under the notes payable to the AMS sellers have been paid and the net amount outstanding under the Convertible Debenture is $550,000. In each of fiscal 1998 and fiscal 1996, Dale Christensen was granted options to acquire 37,500 shares of UDN Common Stock. 110 PRINCIPAL STOCKHOLDERS OF STAR The following table sets forth certain information known to STAR regarding beneficial ownership of STAR Common Stock as of May 15, 1998, as adjusted to reflect the issuance of shares in the Merger by (i) each person who is known by STAR to own beneficially more than five percent of STAR's Common Stock, (ii) each of STAR's directors, (iii) each of the Named Officers, and (iv) all current officers and directors as a group.
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED BEFORE THE MERGER(1) AFTER THE MERGER(1) --------------------------- --------------------------- NAME AND ADDRESS OF BENEFICIAL OWNER NUMBER PERCENT(2) NUMBER PERCENT(2) - ------------------------------------------------------------ ------------ ------------- ------------ ------------- Entities affiliated with the Hunt Family Trusts(3) ......... 2,099,182 5.0% 2,099,182 5.0% 3900 Thanksgiving Tower Dallas, Texas 75201 Gordon Hutchins, Jr.(4) .................................... 178,350 * 178,350 * John R. Snedegar(5) ........................................ 30,750 * 102,912 * Mark Gershien .............................................. -- * -- * Arunas A. Chesonis ......................................... -- * -- * Christopher E. Edgecomb .................................... 13,353,707 32.0 13,365,507 31.5 Mary A. Casey .............................................. 1,646,613 3.9 1,646,613 3.9 David Vaun Crumly(6) ....................................... 594,500 1.4 596,342 1.4 James E. Kolsrud(7) ........................................ 71,747 * 71,747 * Kelly D. Enos(8) ........................................... 55,307 * 55,307 * All directors and executive officers as a group (9 persons)(9) .............................................. 15,930,974 37.8 16,016,778 37.4
- ------------------------ * Represents beneficial ownership of less than 1% of the outstanding shares of Common Stock. (1) Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting or investment power with respect to securities. The address for each listed director and officer is c/o STAR Telecommunications, Inc., 223 East De La Guerra Street, Santa Barbara, California 93101. To STAR's knowledge, except as indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of STAR Common Stock. (2) Percentage of beneficial ownership is based on 41,755,594 shares of STAR Common Stock outstanding as of May 15, 1998 and 42,391,619 shares of STAR Common Stock after the completion of the Merger. The number of shares of STAR Common Stock beneficially owned includes the shares issuable pursuant to stock options and warrants that are exercisable within sixty days of May 15, 1998. Shares issuable pursuant to stock options are deemed outstanding for computing the percentage of the person holding such options but are not outstanding for computing the percentage of any other person. (3) Consists of 692,895 shares held by Lyda Hunt--Herbert Trusts--David Shelton Hunt, 346,447 shares held by Lyda Hunt--Herbert Trusts--Bruce William Hunt, 346,447 shares held by Lyda Hunt-- Herbert Trusts--Douglas Herbert Hunt, 346,447 shares held by Lyda Hunt--Herbert Trusts--Barbara Ann Hunt, 346,447 shares held by Lyda Hunt--Herbert Trusts--Lyda Bunker Hunt and 20,500 shares held by David Shelton Hunt. The co-trustees of each of the Hunt Family Trusts hold voting and investment power for all shares of STAR's Common Stock held by the respective trusts. Walter P. Roach and Gage A. Prichard are the co-trustees of each such trust. (4) Consists of 178,350 shares issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. 111 (5) Prior to the Merger, consists of 20,500 shares of Common Stock, and 10,250 shares issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. After completion of the Merger, consists of 2,804 shares of STAR Common Stock owned by a trust for the benefit of Mr. Snedegar's children, under which Mr. Snedegar is a potential beneficiary and the sole trustee. In addition, Mr. Snedegar is a potential beneficiary and the sole trustee under the Snedegar Revocable Living Trust ("SRLT"). SRLT, in turn, owns 100% of the issued shares of Norexco Petroleum Company ("Norexco"), which in turn owns 100% of the issued shares of Avalon Management Corp. ("Avalon"). Avalon is the general partner of and owns 25% of a limited partnership, Access Financial, L.P. ("Access"), which owns 21,555 shares of STAR Common Stock. The post-merger number also includes 5,423 shares held pursuant to an Escrow Agreement dated October 21, 1993 among Montreal Trust Company of Canada, UDN and the shareholders named therein, 2,576 shares of STAR Common Stock subject to share purchase warrants owned by Access and exercisable within sixty days of May 15, 1998, and 10,250 shares issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998 (6) Prior to the Merger, consists of 451,000 shares of Common Stock, and 143,500 shares of Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998, and after the completion of the Merger, consists of 451,193 shares of Common Stock and 145,126 shares of Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. (7) Consists of 20,497 shares of Common Stock held in joint tenancy and 51,250 shares of Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. (8) Consists of 16,870 shares of Common Stock and 39,718 shares of Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. (9) Prior to the Merger, consists of 421,787 shares of Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998, and after completion of the Merger, includes 427,270 shares of STAR Common Stock issuable upon the exercise of stock options and warrants exercisable within sixty days of May 15, 1998. 112 PRINCIPAL STOCKHOLDERS OF UDN The following table sets forth the number of and percentage of outstanding shares of Common Stock owned by officers, directors and principal stockholders of UDN as of May 15, 1998.
SHARES OF COMMON STOCK BENEFICIALLY OWNED(1) ------------------------- NAMES AND ADDRESS OF BENEFICIAL OWNER NUMBER PERCENT(2) - ---------------------------------------- ------------- ------ John R. Snedegar ....................... 831,647(3) 11.8% 18872 MacArthur Boulevard, Suite 300 Irvine, California 92612 Dale W. Christensen .................... 236,817(4) 3.3% 1431 Greenway Drive, Suite 640 Irving, Texas 75038 Ennis Rushton .......................... 507,500(5) 7.2% 660 Bird Lane Litchfield, Arizona Donald Sledge .......................... 112,500(6) 1.6% 27 Cherry Hill Court Alamo, California 94507 Janine Thomas .......................... 25,000(7) 0.4% 109 Stevens Drive W. Vancouver, BC V751C2 All Directors and Executive Officers as a Group (5 persons) .................. 1,713,464 24.3%
- ------------------------ (1) Beneficial ownership is determined in accordance with the rules of the Securities and Exchange Commission and includes voting or investment power with respect to securities. To UDN's knowledge, except as indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table have sole voting and investment power with respect to all shares of UDN Common Stock. (2) Percentage of beneficial ownership is based on 7,054,844 shares of UDN Common Stock outstanding as of May 15, 1998. (3) Includes 36,250 shares of UDN Common Stock owned by a trust for the benefit of Mr. Snedegar's children, under which Mr. Snedegar is a potential beneficiary and the sole trustee. In addition, Mr. Snedegar is a potential beneficiary and the sole trustee under SRLT. SRLT, in turn, owns 100% of the issued shares of Norexco which in turn owns 100% of the issued shares of Avalon. Avalon is the general partner of and owns 25% of Access which owns 278,650 shares of UDN. Includes share purchase warrants to purchase 29,688 shares of UDN Common Stock owned by Access, which warrants are currently exercisable and expire on February 10, 1999. Includes 62,500 shares of UDN Common Stock held pursuant to an Escrow Agreement dated October 21, 1993 among Montreal Trust Company of Canada, UDN and the shareholders named therein. (4) Includes 37,500 shares of UDN Common Stock held pursuant to an Escrow Agreement dated October 21, 1993 among Montreal Trust Company of Canada, UDN and the stockholders named therein. Includes 7,500 shares of UDN Common Stock issuable upon exercise of share purchase warrants, which warrants are currently exercisable and expire of February 10, 1999. Also includes 75,000 shares of UDN Common Stock issuable upon exercise of stock options exercisable within sixty days of May 15, 1998. (5) Consists of the shares issued to Ennis Rushton, a director of UDN, and Cindy Rushton, his wife, upon conversion of $500,000 in principal amount of UDN's convertible debentures and 275,000 shares of UDN Common Stock issuable upon conversion of the remaining $550,000 of convertible debentures 113 held by Mr. and Mrs. Rushton. See "Business of UDN--Acquisitions" and "Certain Relationships and Related Transactions." (6) Includes 75,000 shares of UDN Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. (7) Includes 25,000 shares of UDN Common Stock issuable upon the exercise of stock options exercisable within sixty days of May 15, 1998. SHARES HELD IN ESCROW ON BEHALF OF CERTAIN STOCKHOLDERS. Pursuant to an escrow agreement dated October 21, 1993, among Montreal Trust Company of Canada, UDN and certain stockholders of UDN, including John Snedegar, Dale Christensen and three non-related parties, 187,500 shares of UDN Common Stock were placed in escrow in accordance with the Securities Act of British Columbia. These shares may be released from escrow if UDN achieves certain cumulative cash flow levels. If the terms for the release of the shares are not achieved by December 13, 1998, the shares will be canceled. 114 DESCRIPTION OF STAR CAPITAL STOCK The authorized capital stock of STAR consists of 50,000,000 shares of Common Stock, $0.001 par value, and 5,000,000 shares of Preferred Stock, $0.001 par value. COMMON STOCK As of May 15, 1998, there were approximately 41,755,594 shares of STAR Common Stock outstanding that were held of record by approximately 170 stockholders. There will be approximately 42,391,619 shares of Common Stock outstanding (assuming no exercise after May 15, 1998 of outstanding options) after giving effect to the issuance of shares of STAR Common Stock in the Merger. The holders of STAR Common Stock are entitled to one vote per share on all matters to be voted upon by the stockholders. Subject to preferences that may be applicable to any outstanding Preferred Stock, the holders of STAR Common Stock are entitled to receive ratably such dividends, if any, as may be declared from time to time by STAR's Board of Directors out of funds legally available therefor. In the event of the liquidation, dissolution, or winding up of STAR, the holders of STAR Common Stock are entitled to share ratably in all assets remaining after payment of liabilities, subject to prior distribution rights of Preferred Stock, if any, then outstanding. The STAR Common Stock has no preemptive or conversion rights or other subscription rights. There are no redemption or sinking fund provisions applicable to the STAR Common Stock. All outstanding shares of STAR Common Stock are fully paid and nonassessable, and the shares of STAR Common Stock to be issued upon completion of this offering will be fully paid and nonassessable. PREFERRED STOCK Pursuant to STAR's Amended and Restated Certificate of Incorporation, the Board of Directors has the authority to issue up to 5,000,000 shares of Preferred Stock in one or more series and to fix the rights, preferences, privileges and restrictions thereof, including dividend rights, dividend rates, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences and the number of shares constituting any series or the designation of such series, without further vote or action by the stockholders. The issuance of Preferred Stock may have the effect of delaying, deferring or preventing a change in control of STAR without further action by the stockholders and may adversely affect the voting and other rights of the holders of STAR Common Stock. The issuance of Preferred Stock with voting and conversion rights may adversely affect the voting power of the holders of STAR Common Stock, including the loss of voting control to others. At present, STAR has no plans to issue any of the Preferred Stock. ANTI-TAKEOVER EFFECTS OF PROVISIONS OF THE CERTIFICATE OF INCORPORATION, BYLAWS AND DELAWARE LAW CERTIFICATE OF INCORPORATION AND BYLAWS. STAR's Amended and Restated Certificate of Incorporation provides that the Board of Directors be divided into three classes of directors, with each class serving a staggered three-year term. The classification system of electing directors may tend to discourage a third party from making a tender offer or otherwise attempting to obtain control of STAR and may maintain the incumbency of the Board of Directors, as the classification of the Board of Directors generally increases the difficulty of replacing a majority of the directors. The Amended and Restated Certificate of Incorporation also provides that all stockholder actions must be effected at a duly called meeting and not by a consent in writing. Further, provisions of the Bylaws and the Amended and Restated Certificate of Incorporation provide that the stockholders may amend the Bylaws or certain provisions of the Amended and Restated Certificate of Incorporation only with the affirmative vote of 75% of STAR's capital stock. These provisions of the Amended and Restated Certificate of Incorporation and Bylaws could discourage potential acquisition proposals and could delay or prevent a change in control of STAR. These provisions are intended to enhance the likelihood of continuity and stability in the composition of the Board of Directors and in the policies formulated by the Board of Directors and to discourage certain types of 115 transactions that may involve an actual or threatened change of control of STAR. These provisions are designed to reduce the vulnerability of STAR to an unsolicited acquisition proposal. The provisions also are intended to discourage certain tactics that may be used in proxy fights. However, such provisions could have the effect of discouraging others from making tender offers for STAR's shares and, as a consequence, they also may inhibit fluctuations in the market price of STAR's shares that could result from actual or rumored takeover attempts. Such provisions also may have the effect of preventing changes in the management of STAR. See "Risk Factors--Effect of Certain Charter Provisions; Anti-takeover Effects of Certificate of Incorporation, Bylaws and Delaware Law." DELAWARE TAKEOVER STATUTE. STAR is subject to Section 203 of the Delaware General Corporation Law ("Section 203"), which, subject to certain exceptions, prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years following the date that such stockholder became an interested stockholder, unless: (i) prior to such date, the board of directors of the corporation approved either the business combination or the transaction that resulted in the stockholder becoming an interested stockholder; (ii) upon consummation of the transaction that resulted in the stockholder becoming an interested stockholder, the interested stockholder owned at least 85% of the voting stock of the corporation outstanding at the time the transaction commenced, excluding for purposes of determining the number of shares outstanding those shares owned (x) by persons who are directors and also officers and (y) by employee stock plans in which employee participants do not have the right to determine confidentially whether shares held subject to the plan will be tendered in a tender or exchange offer; or (iii) on or subsequent to such date, the business combination is approved by the board of directors and authorized at an annual or special meeting of stockholders, and not by written consent, by the affirmative vote of at least 66 2/3% of the outstanding voting stock that is not owned by the interested stockholder. Section 203 defines business combination to include: (i) any merger or consolidation involving the corporation and the interested stockholder; (ii) any sale, transfer, pledge or other disposition of 10% or more of the assets of the corporation involving the interested stockholder; (iii) subject to certain exceptions, any transaction that results in the issuance or transfer by the corporation of any stock of the corporation to the interested stockholder; (iv) any transaction involving the corporation that has the effect of increasing the proportionate share of the stock of any class or series of the corporation beneficially owned by the interested stockholder; or (v) the receipt by the interested stockholder of the benefit of any loans, advances, guarantees, pledges or other financial benefits provided by or through the corporation. In general, Section 203 defines an interested stockholder as any entity or person beneficially owning 15% or more of the outstanding voting stock of the corporation and any entity or person affiliated with or controlling or controlled by such entity or person. REGISTRATION RIGHTS Holders of approximately 7,153,000 shares of STAR Common Stock are entitled to certain rights with respect to the registration of such shares under the Securities Act. Under the terms of the agreement between STAR and the holders of such registrable securities, if STAR proposes to register any of its securities under the Securities Act, either for its own account or for the account of other security holders exercising registration rights, such holders are entitled to notice of such registration and are entitled to include shares of such Common Stock therein. Additionally, certain holders are also entitled to demand registration rights pursuant to which they may require STAR to file a registration statement under the Securities Act at its expense with respect to their shares of Common Stock, and STAR is required to use its best efforts to effect such registration. Further, holders may require STAR to file additional registration statements on Form S-3 at STAR's expense. All of these registration rights are subject to certain conditions and limitations, among them the right of the underwriters of an offering to limit the number of shares included in such registration and the right of STAR not to effect a requested registration within six months following an offering of STAR's securities, including the offering made hereby. 116 TRANSFER AGENT AND REGISTRAR The Transfer Agent and Registrar for the STAR Common Stock is U.S. Stock Transfer Corporation, 1745 Gardena Avenue, Glendale, California 91204, and its telephone number is (818) 502-1404. CERTAIN INCOME TAX CONSEQUENCES CERTAIN UNITED STATES FEDERAL INCOME TAX CONSEQUENCES The following discussion addresses certain material federal income tax consequences of the Merger to stockholders of UDN Common Stock who hold their shares as capital assets (within the meaning of Section 1221 of the Internal Revenue Code of 1986, as amended (the "Code")). The discussion is based on the current provisions of the Code, applicable Treasury Regulations, judicial authority and administrative rulings and practice. It does not address all aspects of federal income taxation that may be relevant to particular UDN stockholders in light of their specific circumstances, or to certain types of stockholders subject to special treatment under the federal income tax laws, including without limitation, insurance companies, tax-exempt organizations, foreign persons, financial institutions or broker-dealers, and stockholders who acquired their UDN Common Stock pursuant to the exercise of employee stock options or in other compensatory transactions. This discussion also does not address the state, local, foreign or other federal tax consequences of the Merger. There can be no assurance that the Internal Revenue Service will not take a contrary view to any expressed herein. No rulings have been or will be requested from the Internal Revenue Service with respect to the tax consequences of the Merger. Moreover, legislative, judicial or administrative changes or interpretations may be forthcoming that could alter or modify the statements and conclusions set forth herein, possibly with retroactive effect. ALL UDN STOCKHOLDERS ARE URGED TO CONSULT THEIR OWN TAX ADVISORS AS TO THE SPECIFIC TAX CONSEQUENCES TO THEM OR THE MERGER, INCLUDING THE APPLICABILITY AND EFFECT OF ANY FEDERAL, STATE, LOCAL AND FOREIGN TAX LAWS, AND POSSIBLE CHANGES IN APPLICABLE TAX LAWS. Based on the assumptions set forth below, the Merger should qualify as a tax-free reorganization under Section 368(a)(1) of the Code. As a result, no gain or loss will be recognized by a stockholder whose shares of UDN Common Stock are converted into shares of STAR Common Stock, except to the extent of any cash received in lieu of fractional shares of STAR Common Stock. Each stockholder receiving cash in lieu of a fractional share of STAR Common Stock will be treated as having received such fractional share interest and as having sold it for the cash received, recognizing gain or loss equal to the difference between the amount of cash received and the portion of that stockholder's basis in the shares of UDN Common Stock allocable to the fractional share interest. Such gain or loss will generally be treated as capital gain or loss (long-term or short-term depending on the stockholder's holding period), unless the payment transaction is essentially equivalent to a dividend within the meaning of Section 302 of the Code (a "Dividend Transaction"). The tax basis of the STAR Common Stock exchanged therefor (except for the basis attributable to any fractional share interest in STAR Common Stock), and the holding period of the STAR Common Stock will include the holding period of the UDN Common Stock surrendered in the Merger. A stockholder who exercises his appraisal rights with respect to a share of UDN Common Stock and receives payment for such stock in cash will recognize capital gain or loss (long-term or short-term depending on the the stockholder's holding period) measured by the difference between the amount of cash received and the stockholder's basis in such share, provided the appraisal transaction is not a Dividend Transaction. A transaction is not a Dividend Transaction with respect to a UDN stockholder if, after taking into account shares owned actually and constructively within the meaning of Section 318 of the Code, there is a meaningful reduction in the stockholder's proportionate interest in the corporation. Under this rule, the 117 Internal Revenue Service has ruled that a redemption of a fractional share for cash in the context of a reorganization transaction (such as the Merger) is generally not a Dividend Transaction. In addition, the Internal Revenue Service has ruled that any reduction in the percentage interest of a small minority shareholder in a publicly held corporation who exercises no control over corporate affairs should constitute a meaningful reduction. The tax discussion set forth herein is based on the accuracy of certain representations made by STAR and UDN, including the following: (i) the Merger will be consummated in accordance with the Merger Agreement; (ii) following the Merger, UDN will hold substantially all (i.e., 90% of net asset value and 70% of gross asset value) of its own properties and substantially all of Newco's properties, and will continue its historic business or use a significant portion of its historic business assets in a business; (iii) UDN has not redeemed, and persons related to UDN have not acquired (other than in exchange for STAR or UDN stock), an amount of UDN stock, and UDN has not made any extraordinary distributions with respect to its stock, prior to and connection with the Merger, that would in the aggregate, reduce the value of all outstanding UDN stock immediately prior to the Merger (after giving effect to such redemptions, acquisitions, and distributions) to a value of less than 50 percent of the value of all of the outstanding stock of UDN stock immediately prior to the Merger determined without regard to such redemptions, acquisitions and distributions; and (iv) in connection with the Merger, neither STAR nor any person related to STAR, will acquire any UDN Common Stock for consideration other than STAR Common Stock (other cash paid for fractional share and dissenters' shares) or redeem any of the STAR Common Stock issued in the Merger. If the Merger were not to constitute a reorganization under Section 368(a)(1) of the Code, each UDN stockholder would recognize gain or loss equal to the difference between the fair market value of the STAR Common Stock received and cash received in lieu of fractional share and such stockholder's basis in the shares of UDN Common Stock exchanged therefor. Such gain or loss would be long-term or short-term capital gain or loss, depending upon the stockholder's holding period with respect to the UDN Stock. Because the former UDN stockholders will own less than 50 percent of STAR after the Merger, the Merger will be treated as an "ownership change" with respect to UDN for purposes of Section 382 of the Code. As a result, the ability of STAR to use any net operating losses of UDN from periods prior to the Effective Time will generally be limited to an annual amount equal to the total value (determined immediately prior to the Merger) of the stock of UDN multiplied by a long-term tax-exempt interest rate factor (as published by the Internal Revenue Service on a monthly basis). CERTAIN CANADIAN AND FOREIGN TAX CONSEQUENCES Stockholders of UDN and dissenting stockholders of UDN who are residents in, or citizens of, Canada or another foreign jurisdiction should be aware that the Merger (or the exercise of appraisal rights in respect of the Merger) may result in the holder realizing or being required to record a gain or loss on the exchange of shares under the Merger (or upon the exercise of, or any payment being made in connection with, appraisal rights) or result in other tax consequences to such holders. Such tax consequences, if any, are not described herein. Such stockholders are urged to consult their own Canadian or foreign tax, legal or other financial advisors, as applicable, as to the implications of the Merger to them under such income tax laws. LEGAL MATTERS The validity of the STAR Common Stock offered hereby will be passed upon for STAR by Riordan & McKinzie, a Professional Corporation, Los Angeles, California. Certain legal matters will be passed on for UDN by Parker Chapin Flattau & Klimpl, LLP, New York, New York. 118 EXPERTS The Consolidated Financial Statements of STAR Telecommunications, Inc. as of December 31, 1996 and 1997 and for each of the years in the three year period ended December 31, 1997, included in this Proxy Statement/Prospectus and elsewhere in this Registration Statement have been audited by Arthur Andersen LLP, independent public accountants, as set forth in their reports with respect thereto, and are included herein in reliance upon the authority of said firm as experts in accounting and auditing in giving said reports. The Consolidated Financial Statements of United Digital Network, Inc. as of April 30, 1996 and 1997 and for each of the years in the two year period ended April 30, 1997, included in this Proxy Statement/ Prospectus and elsewhere in this Registration Statement have been audited by Price Waterhouse LLP, independent accountants, as set forth in their reports with respect thereto, and are included herein in reliance upon the authority of said firm as experts in accounting and auditing in giving said reports. The Consolidated Financial Statements of United Digital Network, Inc. as of April 30, 1995 and for the one-year period ended April 30, 1995, included in this Proxy Statement/Prospectus and elsewhere in this Registration Statement have been audited by Weaver & Tidwell, L.L.P., independent accountants, as set forth in their report with respect thereto, and are included herein in reliance upon the authority of said firm as experts in accounting and auditing in giving said reports. FUTURE STOCKHOLDER PROPOSALS UDN expects to hold an annual meeting of stockholders in 1998 unless the Merger is completed prior thereto. Any UDN stockholder who intends to submit a proposal for inclusion in the proxy materials for the 1998 annual meeting of UDN must submit such proposal to the Secretary of UDN by September 21, 1998. 119 INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE ----- Report of Independent Public Accountants................................................................... F-2 Consolidated Balance Sheets as of December 31, 1996 and 1997............................................... F-3 Consolidated Statements of Operations for the years ended December 31, 1995, 1996 and 1997................. F-4 Consolidated Statements of Stockholders' Equity for the years ended December 31, 1995, 1996 and 1997....... F-5 Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1996 and 1997................. F-6 Notes to Consolidated Financial Statements................................................................. F-8
F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of STAR Telecommunications, Inc. and Subsidiaries: We have audited the accompanying consolidated balance sheets of STAR TELECOMMUNICATIONS, INC. (a Delaware corporation) AND SUBSIDIARIES, as of December 31, 1996 and 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of STAR Telecommunications, Inc. and Subsidiaries as of December 31, 1996 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN LLP Los Angeles, California February 12, 1998 (except with respect to the stock split discussed in Note 14 as to which the date is March 31, 1998) F-2 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS ASSETS
DECEMBER 31, ------------------------------ 1996 1997 ------------- -------------- CURRENT ASSETS: Cash and cash equivalents............. $ 1,726,000 $ 1,458,000 Short-term investments................ 1,630,000 18,579,000 Accounts receivable, net of allowance of $6,202,000 and $7,745,000 at December 31, 1996 and 1997, respectively......... 27,660,000 42,407,000 Receivable from related parties....... 115,000 -- Other receivables..................... 284,000 2,198,000 Prepaid expenses...................... 960,000 4,712,000 Prepaid taxes......................... 677,000 -- Deferred income taxes................. -- 3,699,000 Other current assets.................. 825,000 61,000 ------------- -------------- Total current assets................ 33,877,000 73,114,000 ------------- -------------- PROPERTY AND EQUIPMENT: Operating equipment................... 8,653,000 29,142,000 Leasehold improvements................ 4,248,000 6,289,000 Furniture, fixtures and equipment..... 2,418,000 4,564,000 ------------- -------------- 15,319,000 39,995,000 Less-Accumulated depreciation and amortization........................ (1,407,000) (5,638,000) ------------- -------------- 13,912,000 34,357,000 ------------- -------------- OTHER ASSETS: Investments........................... 153,000 27,000 Deposits.............................. 5,630,000 6,055,000 Other................................. 428,000 -- ------------- -------------- 6,211,000 6,082,000 ------------- -------------- Total assets........................ $ 54,000,000 $ 113,553,000 ------------- -------------- ------------- -------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Revolving lines of credit............. $ 7,814,000 $ -- Revolving lines of credit with stockholder......................... 26,000 138,000 Current portion of long-term debt..... 267,000 480,000 Current portion of obligations under capital leases...................... 872,000 2,495,000 Accounts payable...................... 9,391,000 7,987,000 Taxes payable......................... -- 2,156,000 Related party payable................. 269,000 -- Accrued line costs.................... 19,494,000 38,403,000 Accrued expenses...................... 2,086,000 5,609,000 ------------- -------------- Total current liabilities........... 40,219,000 57,268,000 ------------- -------------- LONG-TERM LIABILITIES: Long-term debt, net of current portion............................. 466,000 348,000 Capital lease obligations, net of current portion..................... 4,936,000 11,139,000 Deferred compensation................. 116,000 57,000 Deposits.............................. -- 164,000 Other long-term liabilities........... 352,000 563,000 ------------- -------------- Total long-term liabilities......... 5,870,000 12,271,000 ------------- -------------- STOCKHOLDERS' EQUITY: Series A Preferred Stock, $.001 par value, authorized-- 5,000,000 shares Issued and outstanding-- 2,802,446 at December 31, 1996 and none at December 31, 1997................... 3,000 -- Common Stock, $.001 par value, authorized - 50,000,000 shares Issued and outstanding-- 23,223,810 and 33,678,519 at December 31, 1996 and 1997, respectively.............. 23,000 34,000 Additional paid-in capital............ 13,971,000 45,407,000 Deferred compensation................. (118,000) (30,000) Retained earnings (deficit)........... (5,968,000) (1,397,000) ------------- -------------- Stockholders' equity................ 7,911,000 44,014,000 ------------- -------------- Total liabilities and stockholders' equity............. $ 54,000,000 $ 113,553,000 ------------- -------------- ------------- --------------
The accompanying notes are an integral part of these consolidated balance sheets. F-3 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, --------------------------------------------- 1995 1996 1997 ------------- -------------- -------------- REVENUES......................................................... $ 46,283,000 $ 237,991,000 $ 376,198,000 COSTS OF SERVICES................................................ 31,897,000 205,585,000 325,237,000 ------------- -------------- -------------- Gross Profit................................................... 14,386,000 32,406,000 50,961,000 ------------- -------------- -------------- OPERATING EXPENSES: Selling, general and administrative expenses................... 10,086,000 34,331,000 35,381,000 Depreciation and amortization.................................. 186,000 1,151,000 4,245,000 Merger expense................................................. -- -- 286,000 ------------- -------------- -------------- 10,272,000 35,482,000 39,912,000 ------------- -------------- -------------- Income (loss) from operations................................ 4,114,000 (3,076,000) 11,049,000 ------------- -------------- -------------- OTHER INCOME (EXPENSES): Interest income................................................ 22,000 110,000 492,000 Interest expense............................................... (64,000) (601,000) (1,633,000) Legal settlement and expenses.................................. -- (100,000) (1,653,000) Other income (expense)......................................... (33,000) 39,000 208,000 ------------- -------------- -------------- (75,000) (552,000) (2,586,000) ------------- -------------- -------------- Income (loss) before provision for income taxes.............. 4,039,000 (3,628,000) 8,463,000 PROVISION FOR INCOME TAXES....................................... 66,000 592,000 2,895,000 ------------- -------------- -------------- NET INCOME (LOSS)................................................ $ 3,973,000 $ (4,220,000) $ 5,568,000 ------------- -------------- -------------- ------------- -------------- -------------- Income (loss) before provision for income taxes.............. 4,039,000 (3,628,000) 8,463,000 PRO FORMA INCOME TAXES (UNAUDITED)............................... 1,632,000 1,535,000 3,090,000 ------------- -------------- -------------- PRO FORMA NET INCOME (LOSS) (UNAUDITED).......................... $ 2,407,000 $ (5,163,000) $ 5,373,000 ------------- -------------- -------------- ------------- -------------- -------------- Pro forma basic income (loss) per common share (unaudited)....... $ 0.13 $ (0.24) $ 0.19 ------------- -------------- -------------- ------------- -------------- -------------- Pro forma diluted income (loss) per common share (unaudited)..... $ 0.13 $ (0.24) $ 0.17 ------------- -------------- -------------- ------------- -------------- --------------
The accompanying notes are an integral part of these consolidated statements. F-4 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
PREFERRED STOCK COMMON STOCK ADDITIONAL ---------------------- ---------------------- PAID-IN SHARES AMOUNT SHARES AMOUNT CAPITAL ----------- -------- ----------- -------- ------------ Balance, December 31, 1994................... -- $ -- 17,455,959 $17,000 $ 341,000 Issuance of common stock..................... -- -- 1,843,339 2,000 101,000 Conversion of debt to equity................. -- -- -- -- 990,000 Net income................................... -- -- -- -- -- Cash distributions to stockholders........... -- -- -- -- -- ----------- -------- ----------- -------- ------------ Balance, December 31, 1995................... -- -- 19,299,298 19,000 1,432,000 Effect of terminating the S-corporation election................................... -- -- -- -- (690,000) Compensation expense relating to stock options.................................... -- -- -- -- 168,000 Issuance of common stock..................... -- -- 3,924,512 4,000 5,564,000 Issuance of preferred stock.................. 2,802,446 3,000 -- -- 7,497,000 Net loss..................................... -- -- -- -- -- Cash distributions to stockholders........... -- -- -- -- -- ----------- -------- ----------- -------- ------------ Balance, December 31, 1996................... 2,802,446 3,000 23,223,810 23,000 13,971,000 Effect of L.D. Services terminating the S-corporation election..................... -- -- -- -- (61,000) Conversion of redeemable preferred stock to common stock............................... (2,802,446) (3,000) 1,868,284 3,000 -- Initial public offering of common stock...... -- -- 8,097,500 8,000 30,936,000 Exercise of stock options.................... -- -- 488,925 -- 447,000 Compensation expense relating to stock options.................................... -- -- -- -- -- Tax benefit from non-qualified stock options.................................... -- -- -- -- 114,000 Cash distributions to stockholders........... -- -- -- -- -- Net income................................... -- -- -- -- -- ----------- -------- ----------- -------- ------------ Balance, December 31, 1997................... -- $ -- 33,678,519 $34,000 $ 45,407,000 ----------- -------- ----------- -------- ------------ ----------- -------- ----------- -------- ------------ RETAINED DEFERRED EARNINGS COMPENSATION (DEFICIT) TOTAL ------------ ------------ ------------ Balance, December 31, 1994................... $ -- $ 1,839,000 $ 2,197,000 Issuance of common stock..................... -- -- 103,000 Conversion of debt to equity................. -- -- 990,000 Net income................................... -- 3,973,000 3,973,000 Cash distributions to stockholders........... -- (4,216,000) (4,216,000) ------------ ------------ ------------ Balance, December 31, 1995................... -- 1,596,000 3,047,000 Effect of terminating the S-corporation election................................... -- 690,000 -- Compensation expense relating to stock options.................................... (118,000) -- 50,000 Issuance of common stock..................... -- -- 5,568,000 Issuance of preferred stock.................. -- -- 7,500,000 Net loss..................................... -- (4,220,000) (4,220,000) Cash distributions to stockholders........... -- (4,034,000) (4,034,000) ------------ ------------ ------------ Balance, December 31, 1996................... (118,000) (5,968,000) 7,911,000 Effect of L.D. Services terminating the S-corporation election..................... -- 61,000 -- Conversion of redeemable preferred stock to common stock............................... -- -- -- Initial public offering of common stock...... -- -- 30,944,000 Exercise of stock options.................... -- -- 447,000 Compensation expense relating to stock options.................................... 88,000 -- 88,000 Tax benefit from non-qualified stock options.................................... -- -- 114,000 Cash distributions to stockholders........... -- (1,058,000) (1,058,000) Net income................................... -- 5,568,000 5,568,000 ------------ ------------ ------------ Balance, December 31, 1997................... $ (30,000) $ (1,397,000) $ 44,014,000 ------------ ------------ ------------ ------------ ------------ ------------
The accompanying notes are an integral part of these consolidated statements. F-5 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, -------------------------------------------- 1995 1996 1997 -------------- ------------- ------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)................................................ $ 3,973,000 $ (4,220,000) $ 5,568,000 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization.................................. 186,000 1,151,000 4,245,000 Loss on investment............................................. 80,000 -- -- Loss on disposal of equipment.................................. -- -- 42,000 Compensation expense relating to stock options................. -- 50,000 88,000 Provision for doubtful accounts................................ 217,000 15,753,000 7,695,000 Deferred income taxes.......................................... -- -- (3,699,000) Deferred compensation.......................................... -- 116,000 (59,000) Decrease (increase) in assets: Accounts receivable.............................................. (10,522,000) (28,476,000) (22,442,000) Receivable from related parties.................................. 129,000 (65,000) 115,000 Other receivables................................................ (268,000) -- (1,914,000) Prepaid expenses................................................. (114,000) (830,000) (3,752,000) Deposits......................................................... (630,000) (4,948,000) (425,000) Prepaid taxes.................................................... -- (677,000) 677,000 Other current assets............................................. -- (825,000) 764,000 Increase (decrease) in liabilities: Accounts payable................................................. 8,035,000 (1,269,000) (1,404,000) Taxes payable.................................................... -- -- 2,270,000 Related party payables........................................... 320,000 (51,000) (269,000) Accrued line costs............................................... 476,000 19,018,000 18,909,000 Accrued expenses................................................. 194,000 1,865,000 3,523,000 Deposits......................................................... -- -- 164,000 -------------- ------------- ------------- Net cash provided by (used in) operating activities........ 2,076,000 (3,408,000) 10,096,000 -------------- ------------- ------------- CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures............................................. (1,123,000) (7,852,000) (13,436,000) Investments...................................................... -- (153,000) 126,000 Short-term investments........................................... -- (1,630,000) (16,949,000) Other............................................................ -- (139,000) 639,000 -------------- ------------- ------------- Net cash used in investing activities...................... (1,123,000) (9,774,000) (29,620,000) -------------- ------------- -------------
F-6 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, -------------------------------------------- 1995 1996 1997 ------------- ------------- -------------- CASH FLOWS FROM FINANCING ACTIVITIES: Stockholders' distributions...................................... $ (4,216,000) $ (4,034,000) $ (1,058,000) Borrowings under lines of credit................................. 1,460,000 14,746,000 34,211,000 Repayments under lines of credit................................. (130,000) (8,262,000) (42,025,000) Borrowings under lines of credit with stockholder................ 3,418,000 701,000 583,000 Repayments under lines of credit with stockholder................ (1,319,000) (1,873,000) (471,000) Borrowings under long-term debt.................................. -- 800,000 193,000 Payments under long-term debt.................................... -- (67,000) (1,622,000) Payments under capital lease obligations......................... (52,000) (358,000) (1,946,000) Issuance of common stock......................................... -- 5,568,000 30,944,000 Stock options exercised.......................................... -- -- 447,000 Issuance of preferred stock...................................... -- 7,500,000 -- ------------- ------------- -------------- Net cash (used in) provided by financing activities.......... (839,000) 14,721,000 19,256,000 ------------- ------------- -------------- INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................... 114,000 1,539,000 (268,000) CASH AND CASH EQUIVALENTS, beginning of year....................... 73,000 187,000 1,726,000 ------------- ------------- -------------- CASH AND CASH EQUIVALENTS, end of year............................. $ 187,000 $ 1,726,000 $ 1,458,000 ------------- ------------- -------------- ------------- ------------- --------------
The accompanying notes are an integral part of these consolidated statements F-7 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1997 1. NATURE OF BUSINESS STAR Telecommunications, Inc., a Delaware corporation, and Subsidiaries (the "Company" or "STAR"), is an emerging multinational carrier focused primarily on the international long distance market. The Company offers highly reliable, low-cost switched voice services on a wholesale basis primarily to U.S.-based long distance carriers. STAR provides international long distance service through a flexible network comprised of foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with other long distance providers. While the Company was incorporated in 1993, it did not commence its current business as a provider of long distance services until the second half of 1995. During the six months ended June 1995, the Company primarily acted as an agent for, and provided various consulting services to, companies in the telecommunications industry. During 1996 and 1997, the Company established several wholly-owned foreign subsidiaries to further expand its international network. The Company made substantial investments to install switch facilities in two of these subsidiaries, Star Europe Limited (SEL) which is located in London, England, and Star Telecommunications Deutschland (GmbH) which is located in Frankfurt, Germany. The Company plans to use these switch facilities to decrease international traffic termination costs and to initiate outbound calls from these local markets. In December 1997, the Company entered into the domestic commercial long-distance market through the acquisition of L.D. Services, Inc., also known as LCCR Inc. ("LDS"). LDS is a retail long-distance service provider throughout the United States. The merger constituted a tax-free reorganization and has been accounted for as a pooling of interests under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have been restated to include the results of operations, financial position and cash flows of LDS as though it had always been a part of STAR (see Note 8). The pro forma results of operations and pro forma income or loss per common share for 1995, 1996 and 1997 assumes that both STAR and LDS had been C-Corporations for all periods presented. The Company is subject to various risks in connection with the operation of its business. These risks include, but are not limited to, regulations (both domestic and foreign), dependence on transmission facilities-based carriers and suppliers, price competition and competition from larger industry participants. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The accompanying consolidated financial statements include the accounts of STAR Telecommunications, Inc. and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated. REVENUE RECOGNITION The Company records revenues for telecommunications sales at the time of customer usage. Finance charges for customer late payments are included in revenues and amount to $32,000, $1,467,000 and $2,747,000 for the years ended December 31, 1995, 1996 and 1997, respectively. F-8 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) COST OF SERVICES Cost of services for wholesale long distance services represents direct charges from vendors that the Company incurs to deliver service to its customers. These include leasing costs for the dedicated phone lines, which form the Company's network, and rate-per-minute charges from other carriers that terminate traffic on behalf of the Company. In addition, retail long distance service cost includes billing and collection service fees from local exchange carriers and call rating services. ACCOUNTING FOR INTERNATIONAL LONG DISTANCE TRAFFIC The Company has carrier service agreements with telecommunication carriers in foreign countries under which international long distance traffic is both originated and terminated on the Company's network. The Company records revenues and related costs as the traffic is recorded in the switch. Revenue from foreign customers equaled $178,000 and $6,577,000 for the years ended December 31, 1996 and 1997, respectively. The Company had no revenues from foreign customers during 1995. CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of demand deposits and money market funds, which are highly liquid short-term instruments with original maturities of three months or less from the date of purchase. Cash and cash equivalents are stated at cost, which approximates market. FINANCIAL INSTRUMENTS The carrying amounts of notes payable and capital lease obligations approximate their fair value because interest rates approximate market rates for similar instruments. Off balance sheet derivative financial instruments at December 31, 1997 consist of foreign currency exchange agreements. The Company enters into foreign currency exchange contracts to manage foreign currency exposures. The principle objective of such contracts is to minimize the risks and/or costs associated with financial and global operating activities. The Company does not utilize financial instruments for trading or other speculative purposes. The counterparty to these contractual arrangements is a multinational financial institution with which the Company also has other financial relationships. The Company enters into forward currency exchange contracts in the normal course of business to manage its exposure against foreign currency fluctuations on payable positions resulting from fixed asset purchases and other contractual expenditures denominated in foreign currencies. At December 31, 1997, gains and losses on foreign exchange contracts are not material to the consolidated financial statements. The fair values of foreign currency contracts are estimated by obtaining quotes from brokers. At December 31, 1997, the Company has foreign currency contracts outstanding with the notional value of $6,305,000 which had an estimated fair value to receive $6,218,000 worth of German marks and British pounds, the difference of which has been recognized in operations. F-9 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The following table summarizes outstanding commitments to purchase foreign currency at December 31, 1997:
MATURITY NOTIONAL DATE AMOUNT FAIR VALUE DIFFERENCE -------------------------- ------------ ------------ ---------- British Pounds..................... 1/29/98 through 3/27/98 $ 364,000 $ 373,000 $ 9,000 Deutsche Mark...................... 1/05/98 through 1/26/98 5,941,000 5,845,000 (96,000) ------------ ------------ ---------- $ 6,305,000 $ 6,218,000 $ (87,000) ------------ ------------ ---------- ------------ ------------ ----------
MARKETABLE SECURITIES Marketable securities consists of interest bearing securities with original maturities in excess of three months. At December 31, 1997, the fair market value of temporary investments, classified as "available for sale securities", approximated cost, thus no unrealized holding gains or losses were reported in the accompanying balance sheets. During fiscal year 1997, the Company realized gains from the sale of securities of approximately $48,000. PROPERTY AND EQUIPMENT Property and equipment are carried at cost. Depreciation and amortization of property and equipment are computed using the straight-line method over the following estimated useful lives: Operating equipment....................................... 5-25 years Leasehold improvements.................................... Life of lease Computer equipment........................................ 3-7 years Furniture and fixtures.................................... 5-7 years
Operating equipment includes assets financed under capital lease obligations of $6,218,000 and $15,921,000 at December 31, 1996 and 1997, respectively. Accumulated amortization related to assets financed under capital leases was $391,000 and $2,123,000 at December 31, 1996 and 1997, respectively. In addition, operating equipment includes seven Indefeasible Rights of Use (IRU) in cable systems amounting to $110,000 and $2,303,000 and four ownership interests in an international cable amounting to $148,000 and $1,534,000 at December 31, 1996 and 1997, respectively. These assets are amortized over the life of the agreements of 14 to 25 years (see Note 5). Replacements and betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed. The cost and accumulated depreciation applicable to assets sold or retired are removed from the accounts and the gain or loss on disposition is recognized in other income or expense. DEPOSITS AND OTHER ASSETS Deposits represent payments made to long distance providers to secure lower rates. These deposits are refunded or applied against future services. Other assets at December 31, 1996 represent initial public offering expenses, which were subsequently charged to additional paid in capital during 1997 at the time of the initial public offering. F-10 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CONSOLIDATED STATEMENTS OF CASH FLOWS During the years ended December 31, 1995, 1996 and 1997 cash paid for interest was $45,000, $534,000 and $1,359,000, respectively. For the same periods, cash paid for income taxes amounted to $51,000, $1,262,000 and $3,761,000, respectively. Non-cash investing and financing activities are as follows:
YEARS ENDED DECEMBER 31, ------------------------------------------- 1995 1996 1997 ------------- ------------- ------------- Equipment purchased through capital leases.......................... $ 1,052,000 $ 5,166,000 $ 9,772,000 Notes issued for asset purchases.................................... -- -- 1,524,000 Debt converted to equity............................................ 1,093,000 -- -- Tax benefits related to stock options............................... -- -- 114,000
These non-cash transactions are excluded from the consolidated statements of cash flows. NET INCOME (LOSS) PER COMMON SHARE The following schedule summarizes the information used to compute pro forma net income or loss per common share for the years ended December 31, 1995, 1996 and 1997:
1995 1996 1997 ------------- ------------- ------------- Pro forma net income (loss)......................................... $ 2,407,000 $ (5,163,000) $ 5,373,000 ------------- ------------- ------------- ------------- ------------- ------------- Weighted average number of common shares used to compute basic earnings (loss) per share.......................................... 18,020,000 21,939,000 28,868,000 Weighted average common share equivalents........................... -- -- 2,757,000 ------------- ------------- ------------- Weighted average number of common shares and common share equivalents used to compute diluted net income (loss) per common share.............................................................. 18,020,000 21,939,000 31,625,000 ------------- ------------- ------------- ------------- ------------- ------------- Basic pro forma net income (loss) per common share (unaudited)...... $ 0.13 $ (0.24) $ 0.19 Diluted pro forma net income (loss) per common share (unaudited).... $ 0.13 $ (0.24) $ 0.17
CONCENTRATIONS OF RISK The Company's two largest customers account for approximately 25 percent and 7 percent of gross accounts receivable at December 31, 1996 and 1997, respectively. The Company's largest customer and second largest customer in 1997 represent 3 percent and 4 percent of accounts receivable as of December 31, 1997, respectively. The Company's largest customer in 1996 was Cherry Communications, Inc. The second largest customer in 1996 was Hi-Rim Communications, Inc. Only one customer, Cherry Communications had a receivable balance exceeding 10 percent of gross accounts receivable at December 31, 1996 and no individual customer has an account receivable balance greater than 10 percent of gross accounts receivable at December 31, 1997. F-11 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The two largest customers represent approximately 16 percent, 26 percent and 17 percent of revenues during the years ended December 31, 1995, 1996 and 1997, respectively. During 1995 and 1996, only sales to Cherry Communications exceeded 10 percent of total sales. For the year ended December 31, 1997, only one customer equaled 10 percent of consolidated sales. The Company performs ongoing credit evaluations of its customers. The Company analyzes daily traffic patterns and concludes whether or not the customer's credit status justifies the traffic volume. If the customer is deemed to carry too large a volume in relation to its credit history, the traffic received by the Company's switch is reduced to prevent further build up of the receivable from this customer. The Company's allowance for doubtful accounts is based on current market conditions. Purchases from the four largest vendors for the years ended December 31, 1995 and 1996 amounted to 57 percent and 45 percent of total purchases, respectively. Purchases from the four largest vendors for the year ended December 31, 1997 amounted to 36 percent of total purchases. Included in the Company's balance sheets at December 31, 1996 and 1997 are approximately $179,000 and $6,367,000 of equipment which is located in foreign countries. USE OF ESTIMATES The preparation of consolidated 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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. RECENTLY ISSUED ACCOUNTING STANDARDS In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share". The statement replaces primary EPS with basic EPS, which is computed by dividing reported earnings available to common stockholders by weighted average shares outstanding. The provision requires the calculation of diluted EPS. The Company adopted this statement in 1997 and all prior year earnings per share amounts have been recalculated based on the provisions of SFAS No. 128. F-12 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) TRANSLATION OF FOREIGN CURRENCY Management determined that the functional currency of its foreign subsidiaries is still the U.S. dollar. Thus all foreign translation gains or losses are reflected in the results of operations in other income (expense). The foreign subsidiary balance sheets are translated into U.S. dollars using the year-end exchange rates except for prepayments, property, other long-term assets, and stockholders' equity accounts, which are translated at rates in effect when these balances were originally recorded. Revenues and expenses are translated at average rates during the year except for depreciation and amortization, which are translated at historical rates. 3. ACCRUED EXPENSES Accrued expenses at December 31, 1996 and 1997 consist of the following:
1996 1997 ------------ ------------ Payroll and related......................................................... $ 783,000 $ 943,000 Management bonuses.......................................................... 25,000 152,000 Professional services....................................................... 640,000 384,000 Sales and other taxes....................................................... 10,000 295,000 Line and billing cost....................................................... 324,000 2,592,000 Other....................................................................... 304,000 1,243,000 ------------ ------------ $ 2,086,000 $ 5,609,000 ------------ ------------ ------------ ------------
4. LINES OF CREDIT BANK LINE OF CREDIT Effective as of September 30, 1997, the Company executed an agreement with Sanwa Bank, California for a $25 million line of credit, which expires on July 1, 1999. The facility has certain financial and non-financial covenants that include, among other restrictions, the maintenance of minimum levels of tangible net worth. Borrowings on the facility are limited to 75 percent of eligible accounts receivable and are secured by substantially all of the assets of the Company. The credit facility provides for borrowings at an interest rate based upon the bank's cost of funds plus 1.75 percent (7.47 percent at December 31, 1997). The Company plans to use the credit facility to support letters of credit and for working capital or other general corporate purposes. At December 31, 1997, no amounts were outstanding, however the Company's availability under this credit facility was reduced to $20.1 million due to $4.9 million in letters of credit which were outstanding at December 31, 1997. The weighted average interest rate on short term debt during the years ended December 31, 1995, 1996 and 1997 was 10.21 percent, 9.68 percent and 9.12 percent, respectively. LINES OF CREDIT WITH STOCKHOLDER At December 31, 1996 and 1997, the Company's revolving lines of credit with the founder and chief executive officer of the Company totaled $1,448,000. The debt matures on March 30, 1998 with interest F-13 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 4. LINES OF CREDIT (CONTINUED) payable at maturity at a rate of 9 percent. There was $1,422,000 and $1,310,000 available to be borrowed against these lines of credit at December 31, 1996 and 1997, respectively. The Company recognized interest expense related to this debt of $11,000, $34,000 and $9,000 for the years ended December 31, 1995, 1996 and 1997, respectively. 5. LONG-TERM DEBT The Company finances some of its telecommunication equipment under capital lease arrangements or through notes payable as follows:
DECEMBER 31, --------------------------- 1996 1997 ------------ ------------- Bank debt at prime plus 1.5 percent........................................ $ 733,000 $ -- Notes payable for Indefeasible Rights of Use on submarine cable, payable in quarterly installments of principal plus interest at LIBOR plus 6 percent (11.72 percent at December 31, 1997) through September 1999............... -- 762,000 Note payable for Indefeasible Right of Use, payable in quarterly installments of $9,000 plus interest at LIBOR plus 6 percent through September 1999............................................................ -- 66,000 Obligations under capital leases........................................... 5,808,000 13,634,000 ------------ ------------- $ 6,541,000 $ 14,462,000 ------------ ------------- ------------ -------------
Minimum future lease payments under capital leases at December 31, 1997 are as follows:
YEAR ENDING DECEMBER 31, - ----------------------------------------------------------------------------------------- 1998................................................................................. $ 3,944,000 1999................................................................................. 3,943,000 2000................................................................................. 3,614,000 2001................................................................................. 2,927,000 2002................................................................................. 2,505,000 Thereafter........................................................................... 814,000 ------------- 17,747,000 Less: Amount representing interest....................................................... (4,113,000) ------------- 13,634,000 Less: Current portion.................................................................... (2,495,000) ------------- $ 11,139,000 ------------- -------------
F-14 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 6. COMMITMENTS AND CONTINGENCIES OPERATING LEASES The Company leases office space, dedicated private telephone lines, equipment and other items under various agreements expiring through 2006. At December 31, 1997, the minimum aggregate payments under non-cancelable operating leases are summarized as follows:
FACILITIES AND DEDICATED YEAR ENDING DECEMBER 31, EQUIPMENT PRIVATE LINES TOTAL - --------------------------------------------------------- -------------- ------------- ------------- 1998................................................. $ 3,375,000 $ 4,969,000 $ 8,344,000 1999................................................. 3,318,000 1,906,000 5,224,000 2000................................................. 3,283,000 372,000 3,655,000 2001................................................. 2,946,000 -- 2,946,000 2002................................................. 2,739,000 -- 2,739,000 Thereafter........................................... 8,423,000 -- 8,423,000 -------------- ------------- ------------- $ 24,084,000 $ 7,247,000 $ 31,331,000 -------------- ------------- ------------- -------------- ------------- -------------
Facility and equipment rent expense for the years ended December 31, 1995, 1996 and 1997 was approximately $195,000, $1,076,000 and $3,199,000, respectively. Dedicated private line expense was approximately $604,000, $7,045,000 and $9,414,000, for those same periods and is included in cost of services in the accompanying consolidated statements of operations. EMPLOYMENT AGREEMENTS The Company has employment agreements through December 31, 2000 with several employees and executives. Some of these agreements provide for a continuation of salaries in the event of a termination, with or without cause, following a change in control of the Company. One agreement provides for a payment of at least $1,500,000 in the event of a change in control of the Company. The Company expensed $116,000 and $64,000 of deferred compensation relating to these agreements for the years ended December 31, 1996 and 1997, respectively. PURCHASE COMMITMENTS The Company is obligated under various service agreements with long distance carriers to pay minimum usage charges. The Company anticipates exceeding the minimum usage volume with these vendors. Minimum future usage charges at December 31, 1997 are as follows:
YEAR ENDING DECEMBER 31, - ----------------------------------------------------------------------------------------- 1998..................................................................................... $ 44,053,000 1999..................................................................................... 8,356,000 2000..................................................................................... 2,949,000 2001..................................................................................... 65,000 2002..................................................................................... 65,000 Thereafter............................................................................... 774,000 ------------- $ 56,262,000 ------------- -------------
F-15 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 6. COMMITMENTS AND CONTINGENCIES (CONTINUED) The Company has entered into six fixed asset purchase agreements. These commitments are to purchase IRU's, switches, and leasehold improvements for switch sites. The total commitment approximates $63 million. The Company plans to finance the majority of these costs through capital lease arrangements. LEGAL MATTERS The Company is subject to litigation from time to time in the normal course of business. Although it is not possible to predict the outcome of such litigation, based on the facts known to the Company and after consultation with counsel, management believes that such litigation will not have a material adverse effect on its financial position or results of operations. On September 4, 1997, prior to the merger between LDS and the Company, LDS entered into a settlement agreement with the Consumer Services Division of the California Public Utilities Commission (PUC). The agreement settles the alleged unauthorized switching of long-distance customers to LDS between the years 1995 and 1996. It includes a payment of $760,000 to the PUC for restitution to affected customers as defined in the agreement. Additionally, LDS agreed to a voluntary revocation of its operating authority in the State of California. Under the agreement, service to all California customers has to be terminated within 120 days after approval of the agreement by the PUC. On November 19, 1997, the PUC approved the agreement along with a transfer of control to STAR. On November 15, 1997, LDS settled a civil suit with the District Attorney of Monterey, California for a monetary payment of $700,000 and various non-monetary concessions as defined in the agreement. This suit was of the same nature as the above action of the PUC and covers complaints from the years 1994 through 1997. LETTERS OF CREDIT At December 31, 1997, the Company has nine standby letters of credit outstanding, which expire between January 20, 1998 and December 19, 1998. These letters of credit, all of which are secured by the bank line of credit, total $4,900,000. 7. RELATED PARTY TRANSACTIONS The founder and chief executive officer of the Company owns Star Aero Services, Inc. (Star Aero). Star Aero's principal assets represent airplanes which it provides to the Company for business travel on an as needed basis. In return, the Company pays for costs related to the airplanes. Star Aero reimburses the Company for certain costs relating to the maintenance of the planes. For the years ended December 31, 1995, 1996 and 1997, the Company paid $144,000, $68,000 and $171,000, respectively, in costs related to the use of Star Aero services. As of December 31, 1995 and 1996, the Company had receivables from Star Aero of $50,000 and $115,000, respectively. The Company had no receivables from Star Aero at December 31, 1997. During 1997, the Company provided a short-term loan to the chief executive officer for $8,000,000. The loan carried interest of 7 percent per annum, was secured by $30,000,000 of the stockholder's stock in the Company, and was repaid in seven days. F-16 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 7. RELATED PARTY TRANSACTIONS (CONTINUED) During 1995, the Company invested $128,000 in a company related to an employee of STAR. During 1996 and 1997, the Company provided services to this company in the amounts of $167,000 and $926,000. As of December 31, 1996 and 1997, accounts receivable from this related party amounted to $57,000 and $41,000, respectively. During 1995, 1996 and 1997, the Company purchased consulting services from a company owned by a board member in the amount of $60,000, $154,000 and $72,000, respectively. During 1996 and 1997, the Company purchased consulting services from a company owned in part by an employee and a significant stockholder for $37,000 and $256,000, respectively. In addition, the Company purchased equipment and services from this company in the amount of $1,114,000 in 1997. This significant stockholder is also a 30 percent investor in a company, whose subsidiary provided consulting services to the Company in the amount of $12,000 in 1996 and $213,000 in 1997. In addition, the Company purchased telecommunication services from three related companies for $240,000 during 1996 and paid legal fees on behalf of these companies in the amount of $131,000. During the years ended December 31, 1995, 1996 and 1997, the Company also provided long distance telephone service to a company controlled by another board member in the amount of $43,000, $250,000 and $1,141,000, respectively. Accounts receivable for these services total $721,000 as of December 31, 1997. In addition, the Company loaned $2,500,000 to this related party. The Company has announced its intention to merge the two companies (see Note 14). 8. BUSINESS COMBINATIONS In November 1997, the Company acquired LDS, a domestic commercial long distance telecommunications provider, in a transaction that was accounted for as a pooling of interests. The Company issued 849,298 shares of its common stock to LDS' shareholders in exchange for all outstanding LDS shares plus shares of certain non-operating entities owned by LDS' shareholders and majority ownership in an affiliated telephone retailer controlled by LDS. The accompanying consolidated financial statements have been restated to include the financial position and results of operations of LDS for all periods presented. Net sales and historical net income (loss) of the combining companies for the last three years are as follows:
1995 1996 1997 ------------- -------------- -------------- Net Sales: STAR................................................. $ 16,125,000 $ 208,086,000 $ 348,738,000 LDS.................................................. 30,158,000 29,905,000 27,460,000 ------------- -------------- -------------- Total................................................ $ 46,283,000 $ 237,991,000 $ 376,198,000 ------------- -------------- -------------- ------------- -------------- -------------- Net Income (Loss): STAR................................................. $ (568,000) $ (6,644,000) $ 5,605,000 LDS.................................................. 4,541,000 2,424,000 (37,000) ------------- -------------- -------------- Total................................................ $ 3,973,000 $ (4,220,000) $ 5,568,000 ------------- -------------- -------------- ------------- -------------- --------------
F-17 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 9. INCOME TAXES Through December 31, 1995, the Company had elected to be taxed as an S-Corporation for both federal and state income tax purposes. While the election was in effect, all taxable income, deductions, losses and credits of the Company were included in the tax returns of the shareholders. Accordingly, for federal income tax purposes, no tax benefit, liability or provision has been reflected in the accompanying historical consolidated financial statements for the year ended December 31, 1995. For state tax purposes, an S-Corporation is subject to a 1.5 percent tax on taxable income, with a minimum tax of approximately $1,000 annually. Effective January 1, 1996, the Company terminated its S-Corporation election and is now taxable as a C-Corporation. In addition, the results of operations and provision for income taxes for LDS through November 30, 1997 reflects LDS' status as an S-Corporation. The unaudited pro forma income taxes, pro forma net income (loss), and pro forma earnings per share information reflected in the consolidated statements of operations assumes that both STAR and LDS were taxed as C-Corporations for all periods presented. The Company accounts for income taxes in accordance with SFAS No. 109, "Accounting for Income Taxes," under which deferred assets and liabilities are provided on differences between financial reporting and taxable income using enacted tax rates. Deferred income tax expenses or credits are based on the changes in deferred income tax assets or liabilities from period to period. Under SFAS No. 109, deferred tax assets may be recognized for temporary differences that will result in deductible amounts in future periods. A valuation allowance is recognized if, on the weight of available evidence, it is more likely than not that some portion or all of the deferred tax asset will not be realized. The Company has recorded a net deferred tax asset of $3,699,000 at December 31, 1997. Realization is dependent on generating sufficient taxable income in the future. Although realization is not assured, management believes it is more likely than not that the net deferred tax asset recorded will be realized. The components of the net deferred tax assets at December 31, 1996 and 1997 are as follows:
1996 1997 ------------- ------------- Deferred tax asset: Reserve for accounts and note receivable................................ $ 3,104,000 $ 4,169,000 Accrued line cost....................................................... 201,000 798,000 Vacation accrual........................................................ 24,000 138,000 Deferred compensation................................................... 47,000 38,000 Accrued bonuses......................................................... 25,000 -- Accrued services........................................................ -- 183,000 Foreign net operating losses............................................ -- 468,000 State income taxes...................................................... 48,000 392,000 ------------- ------------- 3,449,000 6,186,000 Deferred tax liability: Depreciation............................................................ (565,000) (804,000) ------------- ------------- Subtotal.................................................................. 2,884,000 5,382,000 Valuation reserve......................................................... (2,884,000) (1,683,000) ------------- ------------- Net deferred tax asset.................................................... $ -- $ 3,699,000 ------------- ------------- ------------- -------------
F-18 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 9. INCOME TAXES (CONTINUED) The provision for income taxes for the years ended December 31, 1995, 1996 and 1997 are as follows:
PRO FORMA HISTORICAL (UNAUDITED) -------------------------------- ---------------------------------- 1995 1996 1997 1995 1996 1997 --------- --------- ---------- --------- ----------- ---------- Current Federal taxes............................. $ -- $ 393,000 $4,899,000 $1,365,000 $1,231,000 $5,281,000 State taxes............................... 66,000 199,000 1,138,000 416,000 394,000 1,261,000 --------- --------- ---------- --------- ----------- ---------- 66,000 592,000 6,037,000 1,781,000 1,625,000 6,542,000 --------- --------- ---------- --------- ----------- ---------- Deferred Federal taxes............................. -- -- (2,273,000) (121,000) (70,000) (2,512,000) State taxes............................... -- -- (869,000) (28,000) (20,000) (940,000) --------- --------- ---------- --------- ----------- ---------- -- -- (3,142,000) (149,000) (90,000) (3,452,000) --------- --------- ---------- --------- ----------- ---------- Provision for income taxes.................. $ 66,000 $ 592,000 $2,895,000 $1,632,000 $1,535,000 $3,090,000 --------- --------- ---------- --------- ----------- ---------- --------- --------- ---------- --------- ----------- ----------
Differences between the provision for income taxes and income taxes at the statutory federal income tax rate for the years ended December 31, 1995, 1996 and 1997 are as follows:
PRO FORMA HISTORICAL (UNAUDITED) ---------------------------------- ---------------------------------- 1995 1996 1997 1995 1996 1997 ---------- ---------- ---------- --------- ----------- ---------- Income taxes at the statutory federal rate................................ $1,373,000 $(1,234,000) $2,962,000 $1,373,000 ($1,234,000) $2,962,000 State income taxes, net of federal income tax effect................... 246,000 (221,000) 486,000 246,000 (221,000) 486,000 Foreign taxes at rates different than U.S. taxes.......................... -- -- 187,000 -- -- 187,000 Change in valuation reserve........... -- 2,884,000 (1,201,000) -- 2,884,000 (1,201,000) Permanent differences................. -- 104,000 33,000 13,000 108,000 307,000 Effect of STAR S-Corp status until December 31, 1995................... 223,000 -- -- -- -- -- Effects of LDS S-Corp status until November 30, 1997................... (1,808,000) (958,000) 152,000 -- -- -- Other................................. 32,000 17,000 276,000 -- (2,000) 349,000 ---------- ---------- ---------- --------- ----------- ---------- $ 66,000 $ 592,000 $2,895,000 $1,632,000 $1,535,000 $3,090,000 ---------- ---------- ---------- --------- ----------- ---------- ---------- ---------- ---------- --------- ----------- ----------
10. STOCK OPTIONS On January 22, 1996, the Company adopted the 1996 Stock Incentive Plan (the "Plan"). The Plan, which was amended on March 31, 1996, provides for the granting of stock options to purchase up to 1,476,000 shares of common stock and terminates January 22, 2006. Options granted become exercisable at a rate of not less than 20 percent per year for five years. During 1996, the Company entered into three separate stock option agreements outside the Plan. The first agreement, dated March 1, 1996, provided for 410,000 non-incentive stock options exercisable immediately. The options were exercisable at fair market value at the date of issuance, which was $0.98 per share, to expire in 10 years. The second stock option agreement was entered into on May 1, 1996 for an F-19 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 10. STOCK OPTIONS (CONTINUED) additional 410,000 shares to also be issued at $0.98 per share. Of these options half vested on March 1, 1997 and half expired. On May 15, 1996, the Company granted 205,000 options, valued at $1.46 per share at the date of issuance to a director. Of these options 34 percent were exercisable immediately. The remaining options are exercisable equally on May 15, 1997 and 1998. At December 31, 1996 and 1997, 1,025,000 and 820,000 options, respectively, issued outside a plan were outstanding. On September 23, 1996, the Company adopted the 1996 Supplemental Stock Option Plan. This plan which expires on August 31, 2006, replaces the Plan and has essentially the same features. The Company can issue options or other rights to purchase up to 2,050,000 shares of stock which expire up to 10 years after the date of grant, except for incentive options issued to a holder of more than 10 percent of the common stock outstanding, which expire five years after the date of grant. In December 1996, the Company issued 174,000 options at $4.00 per share. The Board of Directors determined the market value of the December options to be $4.68 per share. The Company is recognizing the difference between the market value at the date of grant and the exercise price as compensation expense over the vesting period. At December 31, 1996 and 1997, 2,358,000 and 1,873,000 options, respectively, were outstanding under the aggregate of the 1996 Stock Incentive Plan and the Supplemental Stock Option Plan. On May 14, 1996, the Company adopted the 1996 Outside Director Nonstatutory Stock Option Plan (the "Director Plan"). The number of shares which may be issued under this plan upon exercise of options may not exceed 410,000 shares. The exercise price of an option is determined by the Board of Directors and may not be less than 85 percent of the fair market value of the common stock at the time of grant and has to be 110 percent of the fair market value of the common stock at the time of grant if the option is granted to a holder of more than 10 percent of the common stock outstanding. At the discretion of the administrator, the options vest at a rate of not less than 20 percent per year, which may accelerate upon a change in control, as defined. The plan expires on May 14, 2006. At December 31, 1996 and 1997, 82,000 and 41,000 options, respectively, were outstanding under the Director Plan. On January 30, 1997, the Board of Directors approved the 1997 Omnibus Stock Incentive Plan (the "Omnibus Plan") to replace the existing 1996 supplemental plan upon the effective date of the initial public offering. The plan provides for awards to employees, outside directors and consultants in the form of restricted shares, stock units, stock options and stock appreciation rights and terminates on January 22, 2007. The maximum number of shares available for issuance under this plan may not exceed 1,025,000 shares plus the number of shares still unissued under the supplemental option plan. Options granted to any one optionee may not exceed more than 1,025,000 common shares per year subject to certain adjustments. Incentive stock options may not have a term of more than 10 years from the date of grant. At December 31, 1997, 763,000 options, were outstanding under the Omnibus Plan. F-20 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 10. STOCK OPTIONS (CONTINUED) Information regarding the Company's stock option plans and nonqualified stock options as of December 31, 1995, 1996 and 1997, and changes during the years ended on those dates is summarized as follows:
WEIGHTED-AVERAGE SHARES EXERCISE PRICE --------------- ----------------- December 31, 1995.......................................... -- $ -- Granted.................................................... 3,491,355 1.89 Exercised.................................................. -- -- Forfeited.................................................. (26,855) 1.95 --------------- ------ December 31, 1996.......................................... 3,464,500 1.89 --------------- ------ Granted.................................................... 914,296 7.91 Exercised.................................................. (488,925) 0.89 Forfeited.................................................. (392,774) 2.40 --------------- ------ December 31, 1997.......................................... 3,497,097 $ 3.54 --------------- ------ --------------- ------
At December 31, 1996, 912,425 options were exercisable at a weighted average exercise price of $1.10 per share. At December 31, 1997, 1,275,645 options were exercisable at a weighted average exercise price of $1.51 per share. The options outstanding at December 31, 1997 expire in various years through 2007. Information about stock options outstanding at December 31, 1997 is summarized as follows:
OPTIONS OUTSTANDING ------------------------------------------------------------------- WEIGHTED- AVERAGE WEIGHTED- WEIGHTED- NUMBER REMAINING AVERAGE NUMBER AVERAGE OUTSTANDING CONTRACTED EXERCISE EXERCISABLE EXERCISE RANGE OF EXERCISE PRICES AT 12/31/97 LIFE PRICE AT 12/31/97 PRICE - ---------------------------------------------------- ----------- ------------- ----------- ----------- ------------- $0.73 to $1.46...................................... 1,807,126 8.28 $ 1.17 1,113,695 $ 1.14 $4.00 to $6.83...................................... 1,146,721 8.96 $ 4.68 161,950 $ 4.07 $8.11 to $11.10..................................... 543,250 9.66 $ 9.06 -- $ -- ----------- ----- ----------- ----------- ----- 3,497,097 8.72 $ 3.54 1,275,645 $ 1.51 ----------- ----- ----------- ----------- ----- ----------- ----- ----------- ----------- -----
The Company has elected to adopt FASB No. 123 for disclosure purposes only and applies Accounting Principle Board (APB) Opinion No. 25 and related interpretations in accounting for its employee stock options. Approximately $50,000 and $88,000 in compensation cost was recognized relating to consultant options for the years ended December 31, 1996 and 1997, respectively. Had compensation cost for stock options awarded under these plans been determined based on the fair value at the dates of grant consistent with the methodology of FASB No. 123, the Company's net income or loss and basic and diluted income or loss per share for the years ended December 31, 1996 and 1997 would have reflected the following pro forma amounts: F-21 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 10. STOCK OPTIONS (CONTINUED) Pro forma Net Income (Loss) Per Share
1996 1997 ------------- ------------ Pro forma Net Income (Loss)...................................... $ (5,536,000) $ 4,756,000 Pro forma Basic Net Income (Loss) per share...................... $ (0.25) $ 0.16 Pro forma Diluted Net Income (Loss) per share.................... $ (0.25) $ 0.15
The fair value of each option grant is estimated on the date of grant using the minimum value method of option pricing with the following assumptions used for the grants; weighted average risk-free interest rate of 6.4 and 6.2 percent and an expected life of ten years and six years for the years ended December 31, 1996 and 1997, respectively. Expected volatility for 1997 was 31.05 percent and it is assumed that no dividends would be issued during the option term. Because the Company did not have a stock option program prior to 1996, the resulting pro forma compensation cost may not be representative of that to be expected in future years. 11. CAPITAL STOCK During 1994, the Company issued 16,606,661 shares of stock to the Company's founder for $10,000. During 1995, this stockholder converted $990,000 of debt into capital for no additional shares. During 1995, the Company also issued 1,843,339 shares to another executive of the Company on conversion of a loan. On February 23, 1996, the Company sold 2,049,980 shares of common stock to various investors for $1,500,000. On July 12, 1996, the Company sold 1,874,532 shares of common stock to an investor for $4,068,000. On July 25, 1996, the Company sold 2,802,446 shares of Series A preferred stock to a group of investors for $7,500,000. In connection with this transaction, the Company and buyers of the preferred shares entered into an investor's rights agreement which obligated the Company to file up to two registration statements to register such shares. These preferred shares converted to common stock at a ratio of 3-for-2 as a result of the public offering in accordance with the investors rights agreement. In June 1997, the Company completed its Initial Public Offering ("IPO") of 9,430,000 shares of common stock of which 8,097,500 shares were sold by the Company and 1,332,500 shares were sold by certain selling shareholders. The net proceeds to the Company (after deducting underwriting discounts and offering expenses of approximately $4.6 million) from the sale of shares was approximately $30.9 million. On November 30, 1997, the Company completed the acquisition of LDS pursuant to the terms of the agreement and 849,298 shares were issued for all of the outstanding shares to LDS. 12. BUSINESS SEGMENTS At December 31, 1997, Star has two business segments, wholesale long distance and commercial long distance telecommunications. The wholesale segment provides long distance services to U.S. and foreign based telecommunications companies and the commercial segment, obtained by acquisition of LDS, provides commercial long distance services to small retailers throughout the United States. F-22 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 12. BUSINESS SEGMENTS (CONTINUED) The accounting policies of the segments are the same as those described in the significant accounting policies, however, the Company evaluates performance based on profit or loss from operations before income taxes and non-recurring gains or losses. There are no intercompany sales among the wholesale and commercial segments and both segments are managed separately. Reportable segment information for the years ended December 31, 1995, 1996 and 1997 are as follows:
WHOLESALE COMMERCIAL ALL OTHER TOTAL -------------- ------------- ---------- -------------- 1995 Revenues from external customers..................... $ 16,125,000 $ 30,158,000 $ -- $ 46,283,000 Interest income...................................... -- 22,000 -- 22,000 Interest expense..................................... (64,000) -- -- (64,000) Depreciation and amortization........................ (128,000) (58,000) -- (186,000) Segment profit (loss)................................ (568,000) 4,541,000 -- 3,973,000 Other significant non-cash items: Capital lease additions............................ 888,000 164,000 -- 1,052,000 Property additions financed by notes payable....... -- -- -- -- Debt converted to equity........................... 1,093,000 -- -- 1,093,000 Segment assets....................................... 12,869,000 5,447,000 -- 18,316,000 Expenditures for segment assets...................... 1,062,000 61,000 -- 1,123,000 1996 Revenues from external customers..................... $ 208,086,000 $ 29,905,000 $ -- $ 237,991,000 Interest income...................................... 83,000 27,000 -- 110,000 Interest expense..................................... (589,000) (12,000) -- (601,000) Depreciation and amortization........................ (1,073,000) (78,000) -- (1,151,000) Segment profit (loss)................................ (6,644,000) 2,424,000 -- (4,220,000) Other significant non-cash items: Capital lease additions............................ 5,097,000 69,000 -- 5,166,000 Property additions financed by notes payable....... -- -- -- -- Segment assets....................................... 48,674,000 5,326,000 -- 54,000,000 Expenditures for segment assets...................... 7,838,000 14,000 -- 7,852,000 1997 Revenues from external customers..................... $ 348,738,000 $ 27,460,000 $ -- $ 376,198,000 Interest income...................................... 519,000 -- (27,000) 492,000 Interest expense..................................... (1,633,000) (27,000) 27,000 (1,633,000) Depreciation and amortization........................ (4,189,000) (56,000) -- (4,245,000) Segment profit (loss)................................ 5,605,000 (37,000) -- 5,568,000 Other significant non-cash items: Capital lease additions............................ 9,772,000 -- -- 9,772,000 Property additions financed by notes payable....... 1,524,000 -- -- 1,524,000 Segment assets....................................... 106,709,000 6,844,000 -- 113,553,000 Expenditures for segment assets...................... 13,419,000 17,000 -- 13,436,000
F-23 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 12. BUSINESS SEGMENTS (CONTINUED) The Company had no customers, collectively, representing more than 10 percent of consolidated revenue in any foreign country. 13. QUARTERLY CONSOLIDATED INFORMATION (UNAUDITED) The following table presents unaudited quarterly operating results, including the results of LDS, for each of the Company's eight quarters in the two-year period ended December 31, 1997 (amounts in thousands):
QUARTER ENDED --------------------------------------------- MARCH 31, JUNE 30, SEPT. 30, DEC. 31, ----------- --------- --------- ---------- 1996 Net sales............................................... $ 42,926 $ 50,064 $ 68,433 $ 76,568 Gross profit............................................ 6,689 7,206 7,714 10,797 Operating income (loss)................................. 2,100 1,961 1,219 (8,356) Net income (loss)....................................... 1,477 1,294 870 (7,861) 1997 Net sales............................................... $ 79,382 $ 89,167 $ 94,867 $ 112,782 Gross profit............................................ 10,789 11,730 12,913 15,529 Operating income........................................ 2,495 2,633 3,100 2,821 Net income.............................................. 1,907 656 1,014 1,991
14. SUBSEQUENT EVENTS ACQUISITIONS In November 1997, the Company signed a merger agreement with United Digital Network, Inc. ("UDN"). The Company intends to account for the transaction as a pooling of interests. At December 31, 1997, the Company has accounts receivable from UDN in the amount of $721,000 and a note receivable of $2.5 million plus accrued interest of $28,000. Both the accounts receivable and the note have been fully reserved at December 31, 1997. Subsequent to year end, the Company loaned an additional $2 million to UDN. On March 10, 1998, the Company consummated a merger with T-One Corp. ("T-One") to be accounted for as a pooling of interests. In connection with this merger, the Company issued 1,353,000 shares of its common stock for all outstanding shares of T-One. The following unaudited pro forma data F-24 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) DECEMBER 31, 1997 14. SUBSEQUENT EVENTS (CONTINUED) summarizes the combined operating results of the Company and T-One as if the merger had occurred at the beginning of the periods presented.
1995 1996 1997 ------------- -------------- -------------- Revenue.......................................................... $ 58,937,000 $ 260,423,000 $ 406,636,000 Gross profit..................................................... 14,667,000 33,739,000 52,784,000 Income (loss) from operations.................................... 3,847,000 (3,658,000) 11,365,000 Net income (loss) (1)............................................ 2,140,000 (5,738,000) 5,574,000 Diluted income (loss) per common share (2)....................... $ 0.11 $ (0.25) $ 0.17
- ------------------------ (1) Includes pro forma income (loss) of STAR plus net income (loss) of T-One assuming STAR and LDS C-Corporation status. (2) The diluted pro forma income (loss) per common share is based on the sum of the historical average common shares outstanding, as reported by STAR, and the historical average common shares outstanding for T-One (adjusted to reflect non-dilutive common stock equivalents) converted to STAR shares at the exchange ratio of 13,530 STAR shares per T-One share. EQUITY TRANSACTIONS On February 3, 1998 the Company announced a 2.05 for 1 stock split in the nature of a stock dividend. The stock split is effective March 31, 1998 and has been retroactively reflected in the accompanying consolidated financial statements for all periods presented. Subsequent to year end, the Company granted 219,350 additional stock options to employees and directors. LINE OF CREDIT On March 18, 1998, the Company amended the line of credit agreement with Sanwa Bank by adjusting the borrowing base to 55% of aggregate eligible accounts receivable, revising certain covenants and releasing all pledged collateral. F-25 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES TABLE OF CONTENTS
PAGE --------- Condensed Consolidated Balance Sheets As Of December 31, 1997 And March 31, 1998........................... F-27 Condensed Consolidated Statements Of Income For the Three Month Periods Ended March 31, 1997 and 1998.................................................................................. F-28 Condensed Consolidated Statements of Cash Flows For The Three Month Periods Ended March 31, 1997 And 1998..................................................................................................... F-29 Notes To Condensed Consolidated Financial Statements....................................................... F-30
F-26 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31, 1997 ------------ MARCH 31, 1998 ----------- (UNAUDITED) Current Assets: Cash and cash equivalents......................................................... $ 1,903 $ 5,285 Short-term investments............................................................ 18,631 2,978 Accounts receivable, net.......................................................... 46,675 51,024 Receivable from related parties................................................... -- 303 Other current assets.............................................................. 10,695 16,057 ------------ ----------- Total current assets............................................................ 77,904 75,647 ------------ ----------- Property and equipment, net........................................................... 35,959 67,814 Other assets.......................................................................... 6,453 851 ------------ ----------- Total assets.................................................................... $ 120,316 $ 144,312 ------------ ----------- ------------ ----------- Current Liabilities: Revolving lines of credit with stockholder........................................ $ 138 $ 82 Current portion of long-term obligations.......................................... 2,975 6,314 Accounts payable and other accrued expenses....................................... 22,344 23,242 Accrued network cost.............................................................. 38,403 37,667 ------------ ----------- Total current liabilities....................................................... 63,860 67,305 ------------ ----------- Long-Term Liabilities: Long-term obligations, net of current portion..................................... 12,391 25,902 Other long-term liabilities....................................................... 863 378 ------------ ----------- Total long-term liabilities..................................................... 13,254 26,280 ------------ ----------- Stockholders' Equity: Common Stock $.001 par value: Authorized--50,000,000 shares................................................... 35 36 Additional paid-in capital........................................................ 45,697 51,308 Deferred compensation............................................................. (30) (10) Retained deficit.................................................................. (2,500) (607) ------------ ----------- Total stockholders' equity...................................................... 43,202 50,727 ------------ ----------- Total liabilities and stockholders' equity...................................... $ 120,316 $ 144,312 ------------ ----------- ------------ -----------
See accompanying notes to the condensed consolidated financial statements. F-27 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF INCOME (IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED MARCH 31, ---------------------- 1997 1998 --------- ----------- (UNAUDITED) Revenue................................................................................... $ 84,827 $ 129,269 Cost of services.......................................................................... 73,726 111,593 --------- ----------- Gross profit.......................................................................... 11,101 17,676 Operating expenses Selling, general and administrative expenses.......................................... 7,720 11,561 Depreciation and amortization......................................................... 820 1,879 Merger expense........................................................................ -- 314 --------- ----------- 8,540 13,754 --------- ----------- Income from operations.................................................................. 2,561 3,922 --------- ----------- Other income (expense): Interest income....................................................................... 21 283 Interest expense...................................................................... (398) (618) Other................................................................................. 51 (160) --------- ----------- (326) (495) --------- ----------- Income before provision for income taxes.............................................. 2,235 3,427 Provision for income taxes................................................................ 341 1,534 --------- ----------- Net income................................................................................ $ 1,894 $ 1,893 --------- ----------- --------- ----------- Income before provision for income taxes.............................................. 2,235 Pro forma income taxes.................................................................... 888 --------- Pro forma net income...................................................................... $ 1,347 --------- --------- Basic income per share.................................................................... $ 0.05 ----------- ----------- Diluted income per share.................................................................. $ 0.05 ----------- ----------- Pro forma basic income per share.......................................................... $ 0.05 --------- --------- Pro forma diluted income per share........................................................ $ 0.05 --------- ---------
See accompanying notes to the condensed consolidated financial statements. F-28 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
THREE MONTHS ENDED MARCH 31, --------------------- 1997 1998 --------- ---------- (UNAUDITED) Cash Flows From Operating Activities: Net income.............................................................................. $ 1,894 $ 1,893 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization....................................................... 820 1,879 Loss on disposal of equipment....................................................... 42 -- Compensation expense relating to stock options...................................... 20 20 Provision for doubtful accounts..................................................... 1,128 1,017 Deferred income taxes............................................................... -- (1,411) Deferred compensation............................................................... (81) 50 Decrease (increase) in assets: Accounts receivable............................................................. (6,315) (5,366) Receivable from related parties................................................. (14) (303) Other assets.................................................................... (207) 6,294 Increase (decrease) in liabilities: Accounts payable and accrued expenses........................................... 9,169 898 Accrued network cost............................................................ (3,599) (736) Other liabilities............................................................... 287 (535) --------- ---------- Net cash provided by operating activities................................... 3,144 3,700 --------- ---------- Cash Flows From Investing Activities: Capital expenditures.................................................................... (2,324) (15,636) Investments............................................................................. (93) -- Short-term investments, net............................................................. 1,656 15,653 Proceeds from the sale of assets........................................................ 18 -- --------- ---------- Net cash provided (used) by investing activities............................ (743) 17 --------- ----------
Cash Flows From Financing Activities: Repayments under lines of credit..................................... (2,472) -- Repayments under lines of credit with stockholder.................... (26) (56) Payments under long-term debt........................................ (101) (187) Payments under capital lease obligations............................. (67) (1,061) Other financing activities........................................... (467) -- Stock options exercised.............................................. -- 969 --------- --------- Net cash used in financing activities (3,133) (335) --------- --------- Increase (decrease) in cash and cash equivalents......................... (732) 3,382 Cash and cash equivalents, beginning of period........................... 1,844 1,903 --------- --------- Cash and cash equivalents, end of period................................. $ 1,112 $ 5,285 --------- --------- --------- ---------
See accompanying notes to the condensed consolidated financial statements. F-29 STAR TELECOMMUNICATIONS, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (1) GENERAL The financial statements included herein are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial reporting and Securities Exchange Commission ("SEC") regulations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In management's opinion, the financial statements reflect all adjustments (of a normal and recurring nature) which are necessary to present fairly the financial position, results of operations, stockholders' equity and cash flows for the interim periods. These financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 1997, as set forth in the Registration Statement on Form S-1 of STAR Telecommunications, Inc. ("STAR" or the "Company") Registration No. 333-48559, as amended, which was filed with the SEC on March 24, 1998. The results for the three month period ended March 31, 1998, are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. In March 1998, the company consummated a merger with T-One Corp. ("T-One"). The merger constituted a tax-free reorganization and has been accounted for as pooling of interests under Accounting Principles Board Opinion No. 16. Accordingly, all prior period consolidated financial statements presented have been restated to include the results of operations, financial position, and cash flows of T-One. On March 31, 1998, the Company effected a 2.05 for 1 stock split in the nature of a stock dividend with payment to the holders of the shares of common stock outstanding on February 20, 1998. The stock split has been retroactively reflected in the condensed consolidated financial statements for all periods presented. (2) BUSINESS AND PURPOSE Star is an international long distance service provider offering low cost switched voice services on a wholesale basis primarily to U. S.-based long distance carriers. In addition, STAR provides domestic commercial long-distance services through its subsidiary, LD Services, Inc. ("LDS"). (3) NET INCOME PER COMMON SHARE In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share". The statement replaces primary EPS with basic EPS, which is computed by dividing reported earnings available to common stockholders by weighted average shares outstanding. The provision requires the calculation of diluted EPS. The Company adopted this statement in 1997. F-30 The following schedule summarizes the information used to compute net income per common share for the three months ended March 31, 1997 and 1998 (in thousands):
THREE MONTHS ENDED MARCH 31, -------------------- 1997 1998 --------- --------- Weighted number of common shares used to compute basic earnings per share...................... 24,577 35,629 Weighted common share equivalents.............................................................. 3,917 2,085 --------- --------- Weighted number of common share and share equivalents used to compute diluted earnings per share......................................................................................... 28,494 37,714 --------- --------- --------- ---------
(4) PRO FORMA INCOME TAXES The results of operations and provision for income taxes for the three months ended March 31, 1997 reflects LDS status as an S-Corporation prior to the merger with STAR. The pro forma income taxes, pro forma net income, and pro forma earnings per share information reflected in the condensed consolidated statements of income assumes that both STAR and LDS were taxed as C-Corporations for all periods presented. (5) COMPREHENSIVE INCOME On January 1, 1998, the Company adopted SFAS No. 130, "Reporting Comprehensive Income". For year end financial statements SFAS 130 requires that comprehensive income, which is the total of net income and all other non-owner changes in equity, be displayed in a financial statement with the same prominence as other consolidated financial statements. In addition, the standard encourages companies to display the components of other comprehensive income below the total for net income. During the quarters ended March 31, 1997 and 1998, comprehensive income equaled net income. (6) SIGNIFICANT EVENTS In March 1998, the Company acquired T-One, an international wholesale long distance telecommunications provider based in New York, in a transaction that was accounted for as a pooling of interests. The Company issued 1,353,000 shares of its common stock to T-One's shareholders in exchange for all outstanding T-One shares. The accompanying consolidated financial statements are restated to include the financial position and result of operations of T-One for all periods presented. Net sales and historical net income (loss) of the combining companies for the three months ended March 31, 1997 and 1998, are as follows (in thousands): F-31
THREE MONTHS ENDED MARCH 31, --------------------- 1997 1998 --------- ---------- Net Sales: STAR............................................................... $ 79,382 $ 117,899 T-One.............................................................. 5,528 11,788 Elimination........................................................ (83) (418) --------- ---------- Total.............................................................. $ 84,827 $ 129,269 --------- ---------- --------- ---------- Net Income (Loss): STAR............................................................... $ 1,907 $ 1,981 T-One.............................................................. (13) (88) --------- ---------- Total.................................................................. $ 1,894 $ 1,893 --------- ---------- --------- ----------
In November 1997, the Company signed a merger agreement with United Digital Network, Inc. ("UDN"). The Company intends to account for the transaction as a pooling of interests. On February 3, 1998, the Company announced a 2.05 for 1 stock split in the nature of a stock dividend. The Company effected the stock split on March 31, 1998, which has been retroactively reflected in the accompanying consolidated financial statements for all periods presented. (7) STATEMENTS OF CASH FLOWS During the three month periods ended March 31, 1997 and 1998, cash paid for interest was $357,000 and $585,000 respectively. For the same periods, cash paid for income taxes amounted to $212,000 and $1,575,000, respectively. Non-cash investing and financing activities are as follows (in thousands):
THREE MONTHS ENDED MARCH 31, -------------------- 1997 1998 --------- --------- Equipment purchased through notes and capital leases....................... $ 913 $ 18,098 Tax benefits related to stock options...................................... - 4,643 --------- --------- $ 913 $ 22,741 --------- --------- --------- ---------
(8) SUBSEQUENT EVENTS On May 4, 1998, the Company completed a public offering of 6,000,000 shares of Common Stock of which 5,685,000 shares were sold by the Company and 315,000 shares were sold by a selling stockholder. The net proceeds to the Company (after deducting underwriting discounts and offering expenses) from the sale of such shares of Common Stock were approximately $145 million. (9) SEGMENT INFORMATION At March 31, 1998, Star has two business segments, wholesale long distance and commercial long distance telecommunications. The wholesale segment provides long distance services to U.S. and foreign based telecommunications companies and the commercial segment provides commercial long distance services to small retailers throughout the United States. F-32 Both segments are accounted for in accordance with Generally Accepted Accounting Principles or "GAAP". Reportable segment information for the periods ended March 31, 1997 and 1998 are as follows:
MARCH 31, 1997 WHOLESALE COMMERCIAL TOTAL Revenue from external customers............................................. $ 76,454 $ 8,373 $ 84,827 Interest income............................................................. 21 -- 21 Interest expense............................................................ 397 1 398 Depreciation and amortization............................................... 814 6 820 Segment profit.............................................................. 1,419 475 1,894 Segment assets.............................................................. 63,546 5,181 68,727
MARCH 31, 1998 WHOLESALE COMMERCIAL TOTAL Revenue from external customers............................................. $ 121,193 $ 8,076 $ 129,269 Interest income............................................................. 281 2 283 Interest expense............................................................ 618 -- 618 Depreciation and amortization............................................... 1,876 3 1,879 Segment profit (loss)....................................................... 1,978 (85) 1,893 Segment assets.............................................................. 137,678 6,634 144,312
F-33 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) INDEX TO FINANCIAL STATEMENTS
PAGE --------- Report of Independent Accountants for the years ended April 30, 1996 and 1997.............................. F-35 Report of Independent Accountants for the year ended April 30, 1995........................................ F-36 Consolidated Financial Statements: Consolidated Balance Sheets as of April 30, 1996 and 1997................................................ F-37 Consolidated Statements of Operations for the years ended April 30, 1995, 1996 and 1997.................. F-38 Consolidated Statements of Shareholders' Equity for the years ended April 30, 1995, 1996 and 1997.......................................................................................... F-39 Consolidated Statements of Cash Flows for the years ended April 30, 1995, 1996 and 1997.................. F-40 Notes to Consolidated Financial Statements................................................................. F-41
F-34 REPORT OF INDEPENDENT ACCOUNTANTS September 5, 1997, except as to Notes 2, 9 and 15, which are as of May 18, 1998 To the Board of Directors and Shareholders of United Digital Network, Inc. and Subsidiaries (formerly Unidex Communications Corp.) In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, shareholders' equity and of cash flows present fairly, in all material respects, the financial position of United Digital Network, Inc. and its subsidiaries (formerly Unidex Communications Corp.) at April 30, 1996 and 1997, and the results of their operations and their cash flows for the years then ended, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As described in Note 14 to the consolidated financial statements, the Company has a significant working capital deficiency and its current cash flow from operations is not sufficient to permit the Company to repay debts on the scheduled due dates. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to this matter are also described in Note 14. The financial statements do not include any adjustment that might result from the outcome of this uncertainty. /s/ PRICE WATERHOUSE LLP F-35 INDEPENDENT AUDITOR'S REPORT To the Shareholders UNIDEX COMMUNICATIONS CORP. We have audited the consolidated statements of operations, shareholders' equity and cash flows of Unidex Communications Corp. and Subsidiaries for the year ended April 30, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our previously issued report dated July 21, 1995, we expressed an opinion that the 1995 consolidated financial statements presented fairly the results of operation, changes in shareholders' equity and cash flows of Unidex Communications Corp. and Subsidiaries for the year ended April 30, 1995 in conformity with generally accepted accounting principles, except for the omission of the disclosure of proforma results of operations relating to a business acquisition. The Company has included the omitted proforma information in Note 3. Accordingly, our present opinion on the 1995 financial statements is different from that presented in our previous report. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the results of operations, changes in shareholders' equity and cash flows of the Unidex Communications Corp. for the year ended April 30, 1995 in accordance with generally accepted accounting principles. WEAVER AND TIDWELL, L.L.P. Dallas, Texas July 21, 1995, except for the proforma information relating to the business acquisition, as to which the date is May 20, 1997. F-36 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED BALANCE SHEETS
AS OF APRIL 30, ---------------------------- 1996 1997 ------------- ------------- ASSETS Current assets: Cash and cash equivalents........................................................ $ 1,073,649 $ 556,366 Accounts and notes receivable, net (Note 5)...................................... 2,452,336 3,918,905 Receivable from employee......................................................... 12,010 -- Prepaid expenses and other....................................................... 140,991 453,247 ------------- ------------- Total current assets........................................................... 3,678,986 4,928,518 Property and equipment, net (Note 6)............................................... 1,369,576 1,947,234 Intangible assets, net (Note 7).................................................... 5,367,809 6,158,354 Other assets....................................................................... 170,791 162,067 ------------- ------------- Total assets................................................................... $ 10,587,162 $ 13,196,173 ------------- ------------- ------------- ------------- LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Trade accounts payable........................................................... $ 3,407,351 $ 5,628,664 Other accrued liabilities........................................................ 220,834 330,640 Notes and accounts payable to shareholders, net (Note 12)........................ 1,143,650 896,470 Current maturities of long-term obligations (Note 8)............................. 559,596 689,712 Accrued taxes, other than income taxes........................................... 388,881 567,352 ------------- ------------- Total current liabilities...................................................... 5,720,312 8,112,838 ------------- ------------- Long-term obligations (Note 8)..................................................... 436,700 1,309,792 Long-term obligations to shareholders, net (Note 12)............................... 1,624,586 684,990 Commitments and contingencies (Note 13) Shareholders' equity: Common stock, $.01 par value 100,000,000 shares authorized; 5,250,340 and 6,378,442 issued at April 30, 1996 and 1997, respectively (Notes 2 and 9)................................................... 52,503 63,784 Additional paid-in capital....................................................... 9,913,694 11,863,723 Retained deficit................................................................. (7,160,633) (8,838,954) ------------- ------------- Total shareholders' equity..................................................... 2,805,564 3,088,553 ------------- ------------- Total liabilities and shareholders' equity................................... $ 10,587,162 $ 13,196,173 ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-37 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED APRIL 30, ------------------------------------------- 1995 1996 1997 ------------- ------------- ------------- Telecommunications revenues.......................................... $ 2,338,467 $ 8,026,587 $ 24,012,368 Cost of revenues..................................................... 1,917,734 6,029,796 18,455,095 ------------- ------------- ------------- Gross profit..................................................... 420,733 1,996,791 5,557,273 ------------- ------------- ------------- Operating expenses: Selling, general and administrative................................ 1,941,624 2,675,265 5,154,901 Provision for doubtful accounts.................................... 74,662 228,827 693,164 Depreciation and amortization...................................... 273,053 583,530 900,545 ------------- ------------- ------------- Total operating expenses......................................... 2,289,339 3,487,622 6,748,610 ------------- ------------- ------------- Loss from operations before other expenses........................... (1,868,606) (1,490,831) (1,191,337) Other expenses: Interest expense, net.............................................. (85,431) (107,474) (634,103) Loss on sale of assets............................................. (118,680) -- -- Loss on impairment of assets....................................... -- (63,997) -- ------------- ------------- ------------- Total other expenses............................................. (204,111) (171,471) (634,103) ------------- ------------- ------------- Loss before income tax benefit and extraordinary gain................ (2,072,717) (1,662,302) (1,825,440) ------------- ------------- ------------- Income tax benefit (Note 10)......................................... -- -- 50,000 ------------- ------------- ------------- Loss before extraordinary gain....................................... (2,072,717) (1,662,302) (1,775,440) ------------- ------------- ------------- Extraordinary gain on debt restructuring (net of income taxes of $50,000)........................................... -- -- 97,119 ------------- ------------- ------------- Net loss............................................................. $ (2,072,717) $ (1,662,302) $ (1,678,321) ------------- ------------- ------------- ------------- ------------- ------------- Loss per weighted average common shares outstanding (basic and diluted): Loss before extraordinary gain on debt restructuring............... $ (0.92) $ (0.45) $ (0.33) Extraordinary gain................................................. -- -- 0.02 ------------- ------------- ------------- Net loss per share................................................. $ (0.92) $ (0.45) $ (0.31) Weighted average number of common shares outstanding (basic and diluted)......................................................... 2,252,953 3,706,993 5,359,156 ------------- ------------- ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-38 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED APRIL 30, 1995, 1996 AND 1997 ------------------------------------------------------------------ COMMON STOCK ADDITIONAL --------------------- PAID-IN RETAINED SHARES AMOUNT CAPITAL DEFICIT TOTAL ---------- --------- ------------- ------------- ------------- Balance at April 30, 1994................... 1,854,002 $ -- $ 4,074,620 $ (3,425,614) $ 649,006 Net loss.................................... -- -- -- (2,072,717) (2,072,717) Issuance of common stock for: Private placements........................ 1,205,625 -- 2,015,722 -- 2,015,722 Exercise of warrants...................... 43,405 -- 167,113 -- 167,113 Acquisition of DNI........................ 250,000 -- 407,006 -- 407,006 Consideration for finder's fees........... 1,984 -- -- Issuance costs.............................. -- -- (49,915) -- (49,915) ---------- --------- ------------- ------------- ------------- Balance at April 30, 1995................... 3,355,016 -- 6,614,546 (5,498,331) 1,116,215 ---------- --------- ------------- ------------- ------------- Net loss.................................... -- -- -- (1,662,302) (1,662,302) Increase in par value to $.01/share......... -- 33,550 (33,550) -- -- Issuance of common stock for: Private placements........................ 1,444,432 14,444 2,674,593 -- 2,689,037 Exercise of warrants...................... 450,892 4,509 714,644 -- 719,153 Compensation expense........................ -- -- 47,000 -- 47,000 Issuance costs.............................. -- -- (103,539) -- (103,539) ---------- --------- ------------- ------------- ------------- Balance at April 30, 1996................... 5,250,340 $ 52,503 $ 9,913,694 $ (7,160,633) $ 2,805,564 ---------- --------- ------------- ------------- ------------- ---------- --------- ------------- ------------- ------------- Net loss.................................... -- -- -- (1,678,321) (1,678,321) Issuance of common stock for: Private placements........................ 722,250 7,222 1,143,272 -- 1,150,494 Exercise of warrants...................... 155,852 1,559 264,259 -- 265,818 Conversion of 11% debentures.............. 250,000 2,500 497,498 -- 499,998 Compensation expense........................ -- -- 45,000 -- 45,000 ---------- --------- ------------- ------------- ------------- Balance at April 30, 1997................... 6,378,442 $ 63,784 $ 11,863,723 $ (8,838,954) $ 3,088,553 ---------- --------- ------------- ------------- ------------- ---------- --------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-39 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED APRIL 30, ------------------------------------------- 1995 1996 1997 ------------- ------------- ------------- Cash flows from operating activities: Net loss........................................................... $ (2,072,717) $ (1,662,302) $ (1,678,321) Adjustments to reconcile net loss to net cash used by operating activities: Depreciation and amortization.................................... 276,026 583,530 900,545 Gain on debt restructure......................................... -- -- (147,119) Loss on disposal of assets....................................... 118,680 -- -- Loss on impairment............................................... -- 63,997 -- Compensation recognized for stock options........................ -- 47,000 45,000 Interest amortization of notes discount.......................... -- -- 263,307 Other............................................................ (14,914) (3,494) 7,990 (Increase) decrease, net of effect of acquisition: Unfactored accounts and notes receivable....................... (203,307) 179,016 (3,750,778) Prepaid expenses and other assets.............................. 47,751 152,385 (631,734) Increase (decrease), net of effect of acquisition: Accounts and notes payable and accrued expenses................ 29,143 (705,416) 1,666,637 ------------- ------------- ------------- Net cash provided by (used in) operating activities.......... (1,819,338) (1,345,284) (3,324,473) ------------- ------------- ------------- Cash flows from investing activities: Additions to property and equipment................................ (193,745) (186,439) (673,714) Purchase of CTN, net of cash acquired.............................. -- -- (350,000) Purchase of AMS, net of cash acquired.............................. -- (542,980) -- Purchase of DNI, net of cash acquired.............................. (200,000) -- -- Sale of assets..................................................... 150,000 -- -- Receipts on notes.................................................. 5,128 71,375 75,752 ------------- ------------- ------------- Net cash used in investing activities........................ (238,617) (658,044) (947,962) ------------- ------------- ------------- Cash flows from financing activities: Proceeds from issuance of common stock............................. 2,132,920 3,236,725 1,350,309 Proceeds from factoring of trade receivables, net.................. -- -- 3,562,230 Principal payments on obligations.................................. (303,080) (280,825) (1,157,387) Advances from shareholders......................................... 233,329 -- -- ------------- ------------- ------------- Net cash provided by financing activities.................... 2,063,169 2,955,900 3,755,152 ------------- ------------- ------------- Increase (decrease) in cash.......................................... 5,214 952,572 (517,283) Cash at beginning of year............................................ 115,863 121,077 1,073,649 ------------- ------------- ------------- Cash at end of year.................................................. $ 121,077 $ 1,073,649 $ 556,366 ------------- ------------- ------------- ------------- ------------- ------------- Supplemental disclosure of cash flow information: Interest paid...................................................... $ 93,105 $ 113,815 $ 719,758 ------------- ------------- ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-40 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS United Digital Network, Inc. (the "Company"), formerly Unidex Communications Corp. was incorporated in 1980 under the British Columbia Company Act in British Columbia, Canada, and its shares are publicly traded on the Vancouver Stock Exchange. In April 1995, the Company's continuance was authorized to the jurisdiction of Wyoming under the Wyoming Business Corporation Act from the Registrar of Companies for the Province of British Colombia. The Company then merged with a wholly-owned subsidiary domiciled in the state of Delaware, thereafter becoming a Delaware Corporation. The Company operates through its principal subsidiaries, Answer-Net, Inc. (ANI), Digital Network, Inc. (DNI), Advanced Management Services, Inc. (AMS) and CTN-Custom Telecommunications Network of Arizona, Inc. (CTN). The Company's principal business activity is providing basic long distance services, travelcard services, prepaid calling card services, and various other telecommunication services to residential and small to medium sized commercial customers. The majority of the Company's customers are located in the states of Texas, Oklahoma, Arizona, New Mexico and California, as well as customers located nationwide in the motor freight industry. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries ANI, DNI, AMS and CTN. The financial statements and related footnotes are presented in U.S. dollars, unless otherwise indicated, and all significant intercompany accounts and transactions are eliminated in consolidation. Certain previously reported amounts have been reclassified to conform to the current year presentation. FINANCIAL INSTRUMENTS The fair market value of financial instruments is determined by reference to various market data and other valuation techniques as appropriate. The Company believes that the fair values of financial instruments approximate their recorded values. BUSINESS AND CREDIT CONCENTRATIONS In the normal course of business, the Company extends unsecured credit to its customers. Management has provided an allowance for doubtful accounts to provide for amounts which may eventually become uncollectible and to provide for any disputed charges. Sales to one customer for the period ended April 30, 1997 represents approximately 12% of telecommunications revenues. REVENUE RECOGNITION The Company recognizes revenue from its direct dial long distance and operator services as such services are performed. F-41 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) PROPERTY AND EQUIPMENT Property and equipment are stated at cost. Depreciation for financial statement purposes, which includes amortization of assets under capital leases, is provided utilizing the straight-line method over the estimated useful lives of the depreciable assets or the lease terms. Expenditures for major renewals and betterments, which significantly extend the useful lives of existing property and equipment, are capitalized and depreciated. Upon retirement or disposition of property and equipment, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is recognized in income. Expenditures for repair and maintenance are charged to expense as incurred. In March 1995, the FASB issued Statement of Financial Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121"), which requires that an entity review long-lived assets for impairment, and any impairment loss for assets to be held and used shall be reported as a component of income from continuing operations before income taxes. The impairment loss recognized shall be measured as the amount by which the carrying amount of the asset exceeds the fair value of the asset. In November 1995, the Company adopted SFAS 121. The application of SFAS 121 resulted in a charge to income for the 1996 fiscal year and a decrease in the value of two long-lived assets. FOREIGN CURRENCY TRANSACTIONS Foreign currency transaction gains and losses are included in determining net income and are not significant. INTANGIBLE ASSETS Intangible assets consist of the acquired cost of goodwill and customer lists. These intangibles are amortized utilizing the straight-line method over their estimated useful lives. The realizability of goodwill and customer lists is evaluated periodically as events or circumstances indicate a possible inability to recover their carrying amount. Such evaluation is based on various analyses, including cash flow and profitability projections that incorporate, as applicable, the impact on existing company businesses. The analyses necessarily involve significant management judgment to evaluate the capacity of an acquired business to perform within projections. Historically, the Company has generated sufficient returns from acquired businesses to recover the cost of their intangible assets. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. F-42 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) SHAREHOLDERS' EQUITY Loss per share is computed by dividing the net loss by the weighted average number of shares of common stock outstanding during the periods. The effect of outstanding options and warrants on the computation of net loss per share is antidilutive and, therefore, is not included in the computation for the years ended April 30, 1995, 1996 and 1997. On June 5, 1996, the Company's board of directors declared a four-for-one reverse common stock split. As a result, effective August 9, 1996, all of the Company's 50,000,000 shares of common stock, both issued and unissued, were consolidated into 12,500,000 shares. The Company's par value of $.01 per share remained unchanged. All share and per share amounts appearing in the consolidated financial statements and notes thereto have been retroactively adjusted for the stock split. On June 5, 1996, the Company's board of directors also approved an increase in the authorized shares of the Company from 12,500,000 to 100,000,000 shares effective August 9, 1996. Concurrent with this change, the Company's name was changed to United Digital Network, Inc. FEDERAL INCOME TAXES During fiscal 1994, the Company adopted Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Deferred income taxes are calculated utilizing an asset and liability approach, whereby deferred taxes are provided for tax effects of basis differences for assets and liabilities arising from differing treatments for financial and income tax reporting purposes. Valuation allowances against deferred tax assets are provided where appropriate. There was no impact on the consolidated financial statements upon adoption of SFAS 109. NEW ACCOUNTING STANDARDS In February 1997, the FASB issued Financial Statement of Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 specifies the computation, presentation and disclosure requirements for earnings per share ("EPS") for entities with publicly held common stock or potential common stock. The Company adopted SFAS 128 in the third quarter of fiscal 1998 and has restated all prior period EPS amounts pursuant to SFAS 128. SFAS 128 simplifies the standards for computing EPS previously found in Accounting Principles Board Opinion No. 15, "Earnings per Share" and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the statement of operations for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes the effect of potentially dilutive securities while diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised, converted into or resulted in the issuance of common stock. Common stock equivalents consist of common stock issuable under the assumed exercise of stock options and warrants, computed based on the treasury stock method and the assumed conversion of the Company's issued and outstanding preferred stock. Common stock equivalents are not included in diluted EPS calculations to the extent their inclusion would have an anti-dilutive effect. F-43 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) In June 1997, the FASB issued SFAS 130 "Reporting Comprehensive Income." This statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. This statement is effective for fiscal years beginning after December 15, 1997. The Company believes that the adoption of this standard will not have a material effect on the Company's consolidated results of operations or financial position. 3. ACQUISITIONS DIGITAL NETWORK, INC. Effective April 27, 1995, the Company acquired all of the outstanding shares of Digital Network, Inc. (DNI). DNI provides telecommunication services to customers in Texas and southern Oklahoma. The acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price was allocated to the assets purchased and the liabilities assumed based upon fair values at the date of acquisition. The excess of the purchase price over the fair values of the net assets acquired was $679,241, and was reflected as goodwill. A summary of the DNI excess of cost over the net assets acquired is as follows: Assets, including identified intangible assets of $360,000.............. $1,331,363 Property and equipment.................................................. 1,261,674 Current liabilities..................................................... (1,906,894) Long-term debt, net..................................................... (537,719) ---------- Net liabilities acquired................................................ 148,424 Goodwill................................................................ 679,241 ---------- Purchase price.......................................................... $ 827,665 ---------- ----------
The following unaudited pro forma combined results of operations for the Company assume that the acquisition of CTN was completed at May 1, 1995, the acquisition of AMS was completed at May 1, 1994 and the acquisition of DNI was completed at May 1, 1993. These pro forma amounts represent the historical operating results of DNI combined with those of the Company with appropriate adjustments which give effect to interest expense and amortization. These pro forma amounts are not necessarily indicative of consolidated operating results which would have occurred had AMS and DNI been included in the operations of the Company during the periods presented, or which may result in the future, because these amounts do not reflect full transmission and switched service cost optimization, and the synergistic effect on operating, selling, and general and administrative expenses.
FOR THE YEARS ENDED APRIL 30, ------------------------------------------- 1995 1996 1997 ------------- ------------- ------------- Revenues.................................................. $ 17,429,712 $ 21,647,023 $ 26,966,853 Net loss.................................................. (3,190,433) (2,722,749) (2,104,696) Net loss per share outstanding (basic and diluted)........ (1.42) (.73) (.39)
F-44 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. ACQUISITIONS (CONTINUED) ADVANCED MANAGEMENT SERVICES, INC. Effective March 26, 1996, the Company acquired all of the outstanding common stock of AMS, a long distance carrier based in Phoenix, Arizona. The acquisition was accomplished through the payment of $1,100,000 in cash and the issuance of a series of convertible debentures and a note payable totaling $2,381,947, net of discount. The Company has recorded adjustments to the purchase price and reductions to the notes and debentures payable to the sellers based on management's best estimate of allowable adjustments defined in the stock purchase agreement. The present value of the notes and debentures was imputed using an interest rate of 11%. Future payments are contingent upon, and may be reduced, if various revenue and equity targets through March 1998 as outlined in the purchase agreement are not met. The acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price was allocated to the assets purchased and the liabilities assumed based upon fair values at the date of acquisition. The excess of the purchase price over the fair values of the net liabilities acquired was $3,541,050 and was reflected as goodwill. A summary of the AMS excess of cost over net liabilities acquired is as follows: Assets, including identified intangible assets of $820,000.............. $2,994,730 Property and equipment.................................................. 24,295 Liabilities............................................................. (3,078,128) ---------- Net liabilities acquired................................................ (59,103) Goodwill................................................................ 3,541,050 ---------- Purchase price.......................................................... $3,481,947 ---------- ----------
The Company's consolidated statement of operations includes the results of operations of AMS since March 26, 1996. The Company will also include AMS in its 1996 consolidated federal income tax return for the period it was owned in 1996. CTN-CUSTOM TELECOMMUNICATIONS NETWORK OF ARIZONA, INC. Effective January 1, 1997, the Company acquired all of the outstanding common stock of CTN, a long distance carrier based in Phoenix, Arizona. The acquisition was accomplished through the payment of $350,000 in cash and the issuance of a convertible debenture and a note payable totaling $1,050,000, accumulating interest at 7% per annum. Future payments are contingent upon, and may be reduced, if various revenue targets through November 1997, as outlined in the purchase agreement, are not met. The acquisition was accounted for using the purchase method of accounting, and accordingly, the purchase price was allocated to the assets purchased and the liabilities assumed based upon fair values at the date of acquisition. The excess of the purchase price over the fair values of the net assets acquired was F-45 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 3. ACQUISITIONS (CONTINUED) $975,956 and was reflected as goodwill. A summary of the CTN excess of cost over net assets acquired is as follows: Assets, including identified intangible assets of $290,000.................... $ 1,298,495 Property and equipment.................. 18,369 Liabilities............................. (842,950) ------------- Net assets acquired..................... 473,914 Goodwill................................ 975,956 ------------- Purchase price.......................... $ 1,449,870 ------------- -------------
The Company's consolidated statement of operations includes the results of operations of CTN since January 1, 1997. The Company will also include CTN in its 1997 consolidated federal income tax return for the period it was owned in 1997. 4. NONCASH INVESTING AND FINANCING ACTIVITIES During the year ended April 30, 1996, the Company purchased all of the capital stock of AMS for $1,100,000 in cash and the issuance of a series of convertible debentures and a note payable totaling $2,381,947. During the year ended April 30, 1995, the Company purchased all of the capital stock of DNI for $200,000 in cash and the issuance of a $200,000 note payable and the issuance of 250,000 shares of common stock at $1.628 a share. Additionally, during fiscal 1995, the Company sold net assets with a carrying value of $578,876 in exchange for $150,000 cash and a $295,000 note receivable. The Company recorded capital lease obligations of $87,465, $19,949 and $489,802 during the years ended April 30, 1995, 1996 and 1997, respectively. During the year ended April 30, 1996, accounts payable to shareholders of $17,926 and notes payable of $50,000 were relieved through the exercise of warrants. During the year ended April 30, 1997, an accrued liability of $66,000 was relieved through the issuance of common stock. During the year ended April 30, 1997 the Company purchased all of the capital stock of CTN for $350,000 in cash and the issuance of a convertible debenture and a note payable totaling $1,050,000. F-46 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 5. ACCOUNTS AND NOTES RECEIVABLE Accounts and notes receivable consist of the following:
FOR THE YEARS ENDED APRIL 30, --------------------------- 1996 1997 ------------- ------------ Trade receivables:......................................................... $ 1,262,617 $ 3,420,941 Billed................................................................... 1,337,640 3,213,712 Unbilled................................................................. Receivable from Freshstart Communications.................................. -- 614,858 Credit reserve due from factor............................................. -- 330,695 Other...................................................................... 74,790 332,468 ------------- ------------ Total notes and unfactored accounts receivable............................. 2,675,047 7,912,674 Total receivables assigned to factor....................................... -- (3,562,230) ------------- ------------ Total notes and accounts receivables....................................... 2,675,047 4,350,444 Allowance for doubtful accounts............................................ (222,711) (431,539) ------------- ------------ Total accounts and notes receivable, net................................... $ 2,452,336 $ 3,918,905 ------------- ------------ ------------- ------------
The Company's monthly billing cycle is such that certain services performed in the last month of one fiscal year will not be billed until the first month of the subsequent fiscal year. These services are recognized as revenue and recorded as unbilled receivables when earned. In May 1996, the Company entered into a receivables purchase facility with Receivables Funding Corporation (RFC). Under this facility, the Company transfers receivables with recourse to RFC subject to the conditions of the facility. The transfers are recorded in the period in which they occur. DNI and AMS began transferring approximately 90% of eligible receivables to RFC beginning in July and September, respectively. In June 1996, the FASB issued Statement of Financial Accounting Standards No. 125, "Accounting for Transfer and Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 125"). SFAS 125 requires that a transfer of financial assets be accounted for as either a sale of these assets or as a secured borrowing with a pledge of collateral. There are certain criteria which must be met to classify the transfer as a sale. The Company adopted SFAS 125 for the 1997 fiscal year. Under the provisions of SFAS 125, the Company's transfers of receivables to RFC meet the criteria for classification as sales. In 1997, the Company received $14,307,392 in proceeds from the factoring of trade receivables. F-47 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 6. PROPERTY AND EQUIPMENT Property and equipment consist of:
APRIL 30, ---------------------------- 1996 1997 LIFE ------------- ------------- ---------- Communications equipment..................................... $ 3,281,643 $ 4,153,300 2-8 years Office equipment............................................. 321,250 569,705 5 years Leasehold improvements....................................... 20,053 43,894 5 years ------------- ------------- 3,622,946 4,766,899 Accumulated depreciation..................................... (2,253,370) (2,819,665) ------------- ------------- Total property and equipment, net............................ $ 1,369,576 $ 1,947,234 ------------- ------------- ------------- -------------
Total depreciation expense, including amortization of equipment under capital leases, charged to operations for the years ended April 30, 1995, 1996 and 1997 was $245,768, $436,688 and $498,701, respectively. 7. INTANGIBLE ASSETS Intangible assets consist of:
APRIL 30, -------------------------- 1996 1997 LIFE ------------ ------------ ---------- Goodwill....................................................... $ 4,193,143 $ 5,094,387 25 years Customer lists................................................. 1,316,832 1,606,832 7 years ------------ ------------ 5,509,975 6,701,219 Accumulated amortization....................................... (142,166) (542,865) ------------ ------------ Total intangible assets, net................................... $ 5,367,809 $ 6,158,354 ------------ ------------ ------------ ------------
Additions to goodwill and customer lists were recorded during fiscal years 1995, 1996 and 1997 as a result of the Company's acquisitions (Note 3). 8. LONG-TERM OBLIGATIONS Long-term obligations consist of:
APRIL 30, --------------------------- 1996 1997 ------------- ------------ Convertible debenture with interest of 7% per annum due January 1999. Amounts contingent on certain factors discussed in Note 3................ $ -- $ 500,000 Notes payable Repayable in monthly installment amounts of $24,625 including interest at 7% per annum, commencing in February 1997, due January 1999............ -- 463,581
F-48 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 8. LONG-TERM OBLIGATIONS (CONTINUED)
APRIL 30, --------------------------- 1996 1997 ------------- ------------ Repayable in monthly installments of $7,395 including interest at 16.9% per annum. Final payment due November 1998............................. -- 116,828 Repayable to a bank in monthly installments of $2,042 including interest at the WALL STREET JOURNAL prime rate plus 2% per annum, fully retired................................................................ 50,117 -- Repayable in monthly installment amounts of $3,678 plus interest at 8%, final payment due June 1995. This note is currently in default......... 41,098 41,098 Repayable to a bank in monthly installments of $1,825 including interest at the WALL STREET JOURNAL prime rate plus 2% per annum, fully retired................................................................ 63,743 -- Repayable in monthly installments of $4,894 including interest at 8%, fully retired.......................................................... 36,800 -- Capital lease obligations................................................ 804,538 877,997 ------------- ------------ Total long-term obligations................................................ 996,296 1,999,504 Less current maturities: Long-term debt........................................................... 191,758 387,322 Capital lease obligations................................................ 367,838 302,390 ------------- ------------ Long-term portion.......................................................... $ 436,700 $ 1,309,792 ------------- ------------ ------------- ------------
Principal repayments of long-term debt are due approximately as follows:
YEARS ENDING APRIL 30, ------------ 1998...................................................................................... $ 689,712 1999...................................................................................... 1,059,059 2000...................................................................................... 234,244 2001...................................................................................... 16,489 2002...................................................................................... -- ------------ Total long-term debt...................................................................... $1,999,504 ------------ ------------
In September 1996, the Company recorded an extraordinary gain of $68,258 from the restructuring of a capital lease to a note payable. In February 1997, the Company recorded an extraordinary gain of $78,861 from the full settlement of two notes payable. F-49 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS, WARRANTS, AND OTHER ACCOUNTING FOR STOCK-BASED COMPENSATION In October 1995, Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation" ("SFAS No. 123"), was issued by the Financial Accounting Standards Board. The statement requires the fair value of stock options and other stock-based compensation issued to employees to either be included as compensation expense in the income statements of companies or the pro forma effect on net income and earnings per share of such compensation expense to be disclosed in the footnotes to the Company's financial statements beginning in 1996. The Company has elected to adopt SFAS No. 123 on a disclosure basis only. Had compensation cost for the Company's stock option plan been determined based on the fair market value at the grant dates for awards consistent with the method provided by SFAS No. 123, the Company's net loss and net loss per share would have been reflected by the following pro forma amounts for the years ended April 30, 1995, 1996, and 1997.
YEARS ENDED APRIL 30, ---------------------------------------- 1995 1996 1997 ------------ ------------ ------------ Net loss As reported........................ $ 2,072,717 $ 1,662,302 $ 1,678,321 Pro forma.......................... $ 2,097,861 $ 1,969,630 $ 1,878,190 Primary net loss per share (basic As reported........................ $ .92 $ .45 $ .31 and diluted) Pro forma.......................... $ .93 $ .53 $ .35
The fair value of each grant is estimated on the date of grant using the Black-Scholes Option Pricing Model with the following weighted-average assumptions used for grants during the years ended April 30, 1995, 1996 and 1997.
YEARS ENDED APRIL 30, ------------------------------- 1995 1996 1997 --------- --------- --------- Dividend yield............................................................ -- -- -- Expected volatility....................................................... 60.31% 57.65% 56.23% Risk free interest rate................................................... 7.60% 7.23% 6.16% Option term............................................................... 3 years 5 years 5 years
The Company granted stock options entitling the holders to purchase 61,250, 386,250 and 296,250 common shares during the fiscal years ended April 30, 1995, 1996 and 1997, respectively. Outstanding stock options to certain directors, officers, employees, and others entitle the holders to purchase totals of 143,250, 411,250 and 605,625 common shares at prices ranging from $2.40 to $6.40, $2.40 to $2.92, and $2.22 to $2.92 (Canadian) per share as of April 30, 1995, 1996 and 1997, respectively. These options are exercisable subject to vesting schedules, and in the case of options granted to others, the achievement of certain performance targets. The options expire on various dates between January 1998 and April 2002. During the years ended April 30, 1996 and 1997, respectively, the Company recorded compensation expense and an increase in additional paid-in-capital in the amount of $47,000 and $45,000, respectively, for options granted to outsiders. F-50 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS, WARRANTS, AND OTHER (CONTINUED) Additional information regarding options granted and outstanding is summarized below:
WEIGHTED AVERAGE NUMBER OF OPTION PRICE OPTIONS (CANADIAN) ----------- --------------- Outstanding at April 30, 1994................................................. 153,250 $ 4.49 Granted..................................................................... 61,250 $ 2.73 Canceled/Expired............................................................ (71,250) $ 3.68 ----------- Outstanding at April 30, 1995................................................. 143,250 $ 4.14 Granted..................................................................... 386,250 $ 2.74 Canceled/Expired............................................................ (118,250) $ 4.34 ----------- Outstanding at April 30, 1996................................................. 411,250 $ 2.77 Granted..................................................................... 296,250 $ 2.49 Canceled/Expired............................................................ (101,875) $ 2.75 ----------- Outstanding at April 30, 1997................................................. 605,625 $ 2.64 ----------- Exercisable at April 30, 1997................................................. 438,125 $ 2.65 -----------
The following table summarizes information about the fixed-price stock options outstanding at April 30, 1997.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE --------------------------------------- -------------------------- WEIGHTED- WEIGHTED- WEIGHTED- RANGE OF AVERAGE AVERAGE SHARES AVERAGE EXERCISE SHARES REMAINING EXERCISE EXERCISABLE EXERCISE PRICES OUTSTANDING CONTRACTUAL PRICE AT PRICE (CANADIAN) AT 4/30/97 LIFE (CANADIAN) 4/30/97 (CANADIAN) - ------------- ----------- ----------- ------------- ----------- ------------- $2.22 36,250 4.9 years $ 2.22 10,000 $ 2.22 $2.24 75,000 4.6 years $ 2.24 75,000 $ 2.24 $2.40 37,500 3.3 years $ 2.40 37,500 $ 2.40 $2.50 77,500 4.4 years $ 2.50 25,000 $ 2.50 $2.68 50,000 3.9 years $ 2.68 50,000 $ 2.68 $2.76 98,750 4.1 years $ 2.76 10,000 $ 2.76 $2.80 130,625 2.1 years $ 2.80 130,625 $ 2.80 $2.92 100,000 3.6 years $ 2.92 100,000 $ 2.92 ----------- ----------- $2.22-$2.92 605,625 3.7 years $ 2.64 438,125 $ 2.65 ----------- -----------
WARRANTS The Company issued warrants attached to certain shares issued for cash entitling the holders to purchase an additional 1,205,625, 797,216 and 361,125 common shares during the years ended April 30, 1995, 1996 and 1997, respectively. Total outstanding warrants entitle the holders to purchase up to 1,475,792, 1,551,949 and 1,757,222 shares as of April 30, 1995, 1996 and 1997, respectively, at prices F-51 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. STOCK OPTIONS, WARRANTS, AND OTHER (CONTINUED) ranging from $2.00 to $6.00, $2.00 to $4.40, and $2.22 to $4.00 (Canadian) per share for 1995, 1996 and 1997, respectively, exercisable at any time and expiring on various dates through March 1999. Pursuant to an agreement, the Company issued additional warrants to certain warrant holders entitling them to purchase an additional 647,216 common shares as the Company did not file with various securities regulatory authorities as defined in the agreement by December 22, 1996. The additional warrants issued expire in March 1998. ESCROW SHARES The Company issued 187,500 common shares to certain shareholders subject to an escrow agreement dated May 19, 1988 and amended October 21, 1993, concurrent with its initial public offering on the Vancouver Stock Exchange. Under the terms of the escrow agreement, shares are to be released from escrow on the basis of one share for each $1.52 (Canadian) of cumulative cash flow, as defined by the agreement. Any shares released from escrow and issued to employees will be treated as compensation. No shares had been released as of April 30, 1997. In December 1998, any shares not released from escrow will be canceled. 10. FEDERAL INCOME TAXES The components of the net deferred tax asset were as follows:
APRIL 30, ---------------------------- 1996 1997 ------------- ------------- Deferred tax assets: Allowance for doubtful accounts........................................... $ 76,000 $ 158,057 Depreciation.............................................................. 23,000 92,943 Net operating loss carryforwards.......................................... 1,669,000 1,813,844 ------------- ------------- Gross deferred tax asset................................................ 1,768,000 2,064,844 Deferred tax liability: Basis difference arising from purchase accounting......................... 279,000 416,433 ------------- ------------- Gross deferred tax liability.............................................. 279,000 416,433 ------------- ------------- Valuation allowance......................................................... (1,489,000) (1,648,411) ------------- ------------- Net deferred tax asset...................................................... $ -- $ -- ------------- ------------- ------------- -------------
F-52 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. FEDERAL INCOME TAXES (CONTINUED) The following is a reconciliation of the provision for income taxes at the U.S. federal income tax rate to the income taxes reflected in the consolidated statements of operations:
FOR THE YEARS ENDED APRIL 30, ------------------------------------- 1995 1996 1997 ----------- ----------- ----------- Income tax benefit at federal statutory rate............................... $ (705,000) $ (565,000) $ (450,920) Operating losses not benefited............................................. 750,000 407,000 144,610 Nondeductible amortization arising from purchase accounting................ -- 57,000 70,693 Change in valuation reserve and other...................................... (45,000) 101,000 235,617 ----------- ----------- ----------- Income tax benefit provided................................................ $ -- $ -- $ -- ----------- ----------- ----------- ----------- ----------- -----------
The net deferred tax asset is fully reserved because of management's uncertainty regarding the Company's ability to recognize the benefit of the asset in future years. A portion of the deferred tax asset at April 30, 1997, has been recognized as a tax benefit, the result of an extraordinary gain from debt restructuring. At April 30, 1996 and 1997, the Company had net operating loss carryforwards of approximately $4,909,511 and $5,334,835, respectively. Utilization of the net operating loss carryforwards may be limited by the separate return loss year rules and by ownership changes which have occurred or could occur in the future. 11. LEASES The Company leases certain office facilities and equipment under capital leases and noncancellable operating leases expiring through January 2001. At the end of the capital lease terms, the Company has the option to purchase the leased equipment. Minimum annual rentals under these leases are as follows:
CAPITAL OPERATING YEARS ENDING APRIL 30, LEASES LEASES - -------------------------------------------------------------------------------- ------------ ---------- 1998............................................................................ $ 374,427 $ 258,884 1999............................................................................ 367,026 251,499 2000............................................................................ 246,305 191,170 2001............................................................................ 17,537 68,700 2002............................................................................ -- -- ------------ ---------- Total minimum lease payments.................................................... 1,005,295 $ 770,253 ---------- Amounts representing interest................................................... (127,298) ------------ Present value of net minimum lease payments..................................... 877,997 Current portion................................................................. (302,390) ------------ Long-term capitalized lease obligations......................................... $ 575,607 ------------ ------------
F-53 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. LEASES (CONTINUED) Assets recorded under capital leases are included in property and equipment as follows:
APRIL 30, ------------------------- 1996 1997 ----------- ------------ Communications equipment....................................................... $ 948,733 $ 1,322,695 Office equipment............................................................... 64,106 53,432 ----------- ------------ 1,012,839 1,376,127 Accumulated amortization....................................................... (202,852) (497,816) ----------- ------------ $ 809,987 $ 878,311 ----------- ------------ ----------- ------------
The total rent expense incurred during the years ended April 30, 1995, 1996 and 1997 was $126,660, $186,470 and $300,662, respectively. In addition to minimum rentals, one lease provides for the Company to pay contingent rentals based on usage. Contingent rentals under this lease were not significant in fiscal 1997. The Company was in default on certain lease obligations totaling $211,110 at April 30, 1996 due to nonpayment. The Company successfully restructured the lease agreement and recorded an extraordinary gain during fiscal 1997. 12. RELATED PARTY TRANSACTIONS The Company has the following obligations to shareholders:
APRIL 30, -------------------------- 1996 1997 ------------ ------------ Convertible debenture with interest imputed at 11% per annum (Amounts contingent on certain factors discussed in Note 3) Due February 1997................................................................. $ 838,056 $ -- Due December 1997................................................................. 250,000 250,000 Due July 1998..................................................................... 750,000 750,000 Notes payable Repayable in four quarterly installments of $250,000 from June 1997 to June 1998, with interest imputed at 11%. (Amount contingent on certain factors discussed in Note 3)........................................................................... 1,000,000 725,341 Notes repayable in monthly installment amounts of $9,202 each including interest at 6% per annum, refinanced in July 1996, due June 1997.................................... 200,000 36,532 Notes repayable in monthly installment amounts of $3,144 each including interest at 12% per annum, refinanced in July 1996, due June 1997................................ 150,000 12,388 Other................................................................................. 36,289 -- ------------ ------------ 3,224,345 1,774,261 Less: Discount on convertible debentures and note payable imputed at 11%.................................................................... (456,109) (192,801) ------------ ------------ Total long-term notes payable to shareholders....................................... 2,768,236 1,581,460 Less current maturities: Long-term debt, net of discount on convertible debenture imputed at 11% of $80,695 and $51,144, respectively............................. 1,143,650 896,470 ------------ ------------ $ 1,624,586 $ 684,990 ------------ ------------ ------------ ------------
F-54 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 12. RELATED PARTY TRANSACTIONS (CONTINUED) In March 1996, in order to finance the acquisition of AMS, the Company issued a series of convertible debentures with scheduled maturities through July 1998. The debentures are convertible at the option of the holder into a maximum of 875,000 shares of the Company's common stock at a conversion rate of .5 shares for each $1 of outstanding debentures. In February 1997, the holder of the convertible debentures converted $500,000 of the outstanding debentures into 250,000 shares of the Company's common stock. In January 1997, as part of the financing of the acquisition of CTN, the Company issued a convertible debenture with scheduled maturity in January 1999. This debenture is convertible at the option of the holder into a maximum of 150,000 shares of the Company's common stock at a conversion rate of 3 shares for each $10 of the outstanding debenture. The Company is provided executive office space by another company of which a Company executive is a director. Interest of $1,587 and $12,706 was paid to directors of the Company for the years ended April 30, 1996 and 1997, respectively. No interest was paid to related parties during 1995. 13. COMMITMENTS AND CONTINGENCIES The Company has entered into various long-term commitments for the purchase of network usage. Total payments under these agreements were $1,613,863 and $8,801,941 for the years ended April 30, 1996 and 1997. The aggregate amount of minimum purchases of network usage under these various agreements are $12,450,000 and $12,100,000, for 1998 and 1999, none thereafter, respectively. The Company is involved in various claims and legal actions arising in the ordinary course of business. Management believes it is unlikely that the final outcome of any of the claims or proceedings to which the Company is a party would have a materially adverse effect on the Company's financial position or results of operations. On February 8, 1996, the federal government signed legislation that will, without limitation, permit the Regional Bell Operating Companies ("RBOC") to provide domestic and international long distance services upon a finding by the FCC that the petitioning RBOC has satisfied certain criteria for opening up its local exchange network to competition and that its provision of long distance services would further the public interest; removes existing barriers to entry into local service markets; significantly changes the manner in which carrier-to-carrier arrangements are regulated at the federal and state level; establishes procedures to revise universal service standards; and, establishes penalties for unauthorized switching of customers. The Company cannot predict the effect such legislation will have on the Company or the industry. However, the Company believes that it is positioned to take advantage of business opportunities in the rapidly changing telecommunications market. 14. FINANCING OF OPERATIONS At April 30, 1997, the Company's current liabilities exceeded its current assets by $3,184,320 and the Company was experiencing losses from operations. The financial stability of the Company depends on its ability to raise additional capital until operations reach a profitable level. The Company's plans are to F-55 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 14. FINANCING OF OPERATIONS (CONTINUED) continue funding the growth of the Company through additional private placements, as it has done in the past, and by discounting receivables. The Company has entered into an agreement with a brokerage firm whereby the brokerage firm has committed to raise $2-3 million through an equity offering of the Company's shares on a best efforts basis. Also, on September 3, 1997, the Company received proceeds of $540,015 in a private placement of the Company's common stock, which is subject to the approval of the Vancouver Stock Exchange before the shares can be issued. 15. SUBSEQUENT EVENT On November 19, 1997, the Company entered into an Agreement and Plan of Merger (the "Merger") whereby IIWII Corp., a wholly-owned subsidiary of STAR Telecommunications, Inc. ("STAR"), will be merged with and into the Company. Under the terms of amendments to the Merger dated January 30, 1998 and April 6, 1998 (the "Amendments"), UDN's stockholders will receive for each share of UDN Common Stock a portion of a share (the "Exchange Ratio") of STAR Common Stock determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price. STAR will also assume all outstanding options, warrants, and other rights to acquire the Company's stock. The Merger is subject to approval by the stockholders of both companies and certain other conditions, including the receipt of an opinion that the Merger may be accounted for as a pooling of interests. The Amendments to the Merger contain provisions whereby STAR and the Company executed promissory notes totaling $4.5 million as a financial accommodation to fund the Company's working capital needs. F-56 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) INDEX TO FINANCIAL STATEMENTS
PAGE --------- Consolidated Financial Statements: Consolidated Balance Sheets as of January 31, 1997 and January 31, 1998.................................. F-58 Consolidated Statements of Operations for the nine months ended January 31, 1997 and January 31, 1998 ... F-59 Consolidated Statements of Shareholders' Equity as of January 31, 1997 and January 31, 1998....................................................................................... F-60 Consolidated Statements of Cash Flows for the nine months ended January 31, 1997 and January 31, 1998.... F-61 Notes to Consolidated Financial Statements................................................................. F-62
F-57 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED BALANCE SHEETS
JANUARY 31, ---------------------------- 1997 1998 ------------- ------------- (UNAUDITED) ASSETS Current assets: Cash and cash equivalents........................................................ $ 263,178 $ 964,077 Accounts and notes receivable, net of allowance of $375,406 and $2,451,877, respectively................................................................... 3,584,353 4,381,550 Receivable from employee......................................................... 12,010 -- Prepaid expenses and other....................................................... 433,176 335,655 ------------- ------------- Total current assets........................................................... 4,292,717 5,681,282 ------------- ------------- Property and equipment, net of accumulated depreciation of $2,705,910 and $3,211,500, respectively.......................................................... 1,974,026 2,042,779 Intangible assets, net of accumulated amortization of $429,945 and $875,314, respectively...................................................................... 6,484,063 5,920,447 Other assets....................................................................... 132,201 199,976 ------------- ------------- Total assets................................................................... $ 12,883,007 $ 13,844,484 ------------- ------------- LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) Current liabilities: Trade accounts payable........................................................... $ 5,054,441 $ 10,224,885 Other accrued liabilities........................................................ 345,724 412,109 Notes and accounts payable to shareholders, net.................................. 1,700,864 957,978 Note payable to STAR Telecommunications, Inc..................................... -- 2,500,000 Current maturities of long-term obligations...................................... 784,057 1,254,615 Accrued taxes, other than income taxes........................................... 640,926 628,945 ------------- ------------- Total current liabilities...................................................... 8,526,012 15,978,532 ------------- ------------- Long-term obligations.............................................................. 1,424,391 493,325 Long-term obligations to shareholders, net......................................... 913,604 -- Shareholders' equity (deficit): Common stock $.01 par value, 100,000,000 shares and authorized; 5,250,340 and 6,808,594 issued at January 31, 1997 and 1998, respectively.................... 52,503 68,086 Additional paid-in capital....................................................... 9,958,694 12,617,072 Retained deficit................................................................. (7,992,197) (15,312,531) ------------- ------------- Total shareholders' equity (deficit)........................................... 2,019,000 (2,627,373) ------------- ------------- ------------- ------------- Total liabilities and shareholders' equity (deficit)......................... $ 12,883,007 $ 13,844,484 ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-58 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE NINE MONTHS ENDED JANUARY 31, ---------------------------- 1997 1998 ------------- ------------- (UNAUDITED) Telecommunications revenues........................................................ $ 16,774,044 $ 23,941,796 Cost of revenues................................................................. 12,869,586 19,047,419 ------------- ------------- Gross profit................................................................... 3,904,458 4,894,377 ------------- ------------- Operating expenses: Selling, general and administrative.............................................. 3,458,440 6,344,242 Provision for doubtful accounts.................................................. 245,055 3,055,433 Depreciation and amortization.................................................... 674,023 783,186 ------------- ------------- Total operating expenses....................................................... 4,377,518 10,182,861 ------------- ------------- Loss from operations before other expenses......................................... (473,060) (5,288,484) Other expenses: Interest expense, net............................................................ (426,762) (699,907) Other............................................................................ -- (485,186) ------------- ------------- Total other expenses........................................................... (426,762) (1,185,093) ------------- ------------- Loss before income tax benefit and extraordinary gain.............................. (899,822) (6,473,577) Income tax benefit................................................................. 23,208 -- ------------- ------------- Loss before extraordinary gain................................................... (876,614) (6,473,577) ------------- ------------- Extraordinary gain on debt restructuring (net of income taxes of $23,208).......... 45,050 -- ------------- ------------- Net loss......................................................................... $ (831,564) $ (6,473,577) ------------- ------------- ------------- ------------- Loss per weighted average common shares outstanding (basic and diluted): Loss before extraordinary gain on debt restructuring............................. $ (.17) $ (.99) Extraordinary gain............................................................... .01 -- ------------- ------------- Net loss per share............................................................... (.16) (0.99) ------------- ------------- ------------- ------------- Weighted average number of common shares outstanding (basic and diluted)......... 5,250,340 6,541,734 ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-59 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
(UNAUDITED) -------------------------------------------------------------------- ADDITIONAL PAID-IN RETAINED SHARES AMOUNT CAPITAL DEFICIT TOTAL ---------- ---------- ------------- -------------- ------------- Balance at April 30, 1996................. 5,250,340 $ 52,503 $ 9,913,694 $ (7,160,633) $ 2,805,564 Net loss.................................. -- -- -- (831,564) (831,564) Compensation expenses..................... -- -- 45,000 -- 45,000 ---------- ---------- ------------- -------------- ------------- Balance at January 31, 1997............... 5,250,340 $ 52,503 $ 9,958,694 $ (7,992,197) $ 2,019,000 ---------- ---------- ------------- -------------- ------------- ---------- ---------- ------------- -------------- -------------
(UNAUDITED) -------------------------------------------------------------------- ADDITIONAL PAID-IN RETAINED SHARES AMOUNT CAPITAL DEFICIT TOTAL ---------- ---------- ------------- -------------- ------------- Balance at April 30, 1997................. 6,378,442 $ 63,784 $ 11,863,723 $ (8,838,954) $ 3,088,553 Net loss.................................. -- -- -- (6,473,577) (6,473,577) Issuance of common stock for: Private placements...................... 337,152 3,372 586,644 -- 590,016 Exercise of warrants.................... 93,000 930 166,705 -- 167,635 ---------- ---------- ------------- -------------- ------------- Balance at January 31, 1998............... 6,808,594 $ 68,086 $ 12,617,072 $ (15,312,531) $ (2,627,373) ---------- ---------- ------------- -------------- ------------- ---------- ---------- ------------- -------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. F-60 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED JANAURY 31, --------------------------- 1997 1998 ------------ ------------- (UNAUDITED) Cash flows from operating activities: Net loss........................................................................... $ (831,564) $ (6,473,577) Adjustments to reconcile net loss to net cash used by operating activities: Depreciation and amortization.................................................... 674,023 783,096 Extraordinary gain on debt restructuring......................................... (68,258) -- Interest amortization of note discounts.......................................... 137,118 148,680 Compensation recognized for stock options........................................ 45,000 -- Other, net....................................................................... 78,795 (3,409) (Increase) decrease, net of effects of acquisitions: Accounts and notes receivable.................................................... (47,915) (457,259) Prepaid expenses and other assets................................................ (381,622) 15,016 Increase (decrease), net of effects of acquisitions: Accounts and notes payable and accrued expenses.................................. 1,181,076 4,739,294 ------------ ------------- Net cash provided by (used in) operating activities.......................... 786,653 (1,248,159) ------------ ------------- Cash flows from investing activities: Additions to property and equipment................................................ (577,329) (411,787) Purchase of CTN.................................................................... (350,000) -- Proceeds from notes................................................................ 52,419 59,280 ------------ ------------- Net cash used in investing activities........................................ (874,910) (352,507) Cash flows from financing activities: Proceeds from issuance of common stock............................................. -- 757,652 Proceeds from issuance of short-term debt.......................................... -- 2,500,000 Principal payments on obligations.................................................. (722,214) (1,249,275) ------------ ------------- Net cash used in provided by financing activities............................ (722,214) 2,008,377 ------------ ------------- Increase (Decrease) in cash.......................................................... (810,471) 407,711 Cash at beginning of period.......................................................... 1,073,649 556,366 ------------ ------------- Cash at end of period................................................................ $ 263,178 $ 964,077 ------------ ------------- ------------ ------------- Supplemental disclosure of cash flow information: Interest paid...................................................................... $ 494,360 $ 669,129 ------------ ------------- ------------ -------------
The accompanying notes are integral part of these consolidated financial statements. F-61 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. DESCRIPTION OF BUSINESS United Digital Network (the "Company"), formerly Unidex Communications Corp., operates through its principal subsidiaries, United Digital Network of Texas, Inc. ("DNI"), Advanced Management Services, Inc. (AMS) and Custom Telecom Network (CTN). In September 1997, the Company formed DNI with the merger of two wholly-owned subsidiaries, Answer-Net, Inc. and Digital Network, Inc. The Company's principal business activity is providing basic long distance services, travelcard service, international long-distance, and various other telecommunication services to residential and small to medium sized commercial customers. The principal markets for its long distance services are the central and southwest United States as well as customers located nationwide in the motor freight industry. The Company has suffered recurring losses from operations that raise substantial doubt about its ability to continue as a going concern. At January 31, 1998, the Company's current liabilities exceeded its current assets by $10,297,250. The Company is actively pursuing opportunities for a business combination in order to achieve financial stability. On November 19, 1997, the Company entered into a merger agreement with STAR Telecommunications, Inc. See further discussion in Note 4. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries DNI, AMS and CTN. The financial statements and related footnotes are presented in U.S. dollars, unless otherwise indicated, and all significant intercompany accounts and transactions are eliminated in consolidation. The interim financial data as of January 31, 1997 and 1998 and for the nine month periods then ended is unaudited; however, in the opinion of the Company, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows for the interim periods. The interim consolidated financial statements and the notes thereto should be read in conjunction with the consolidated financial statements and notes included in the Company's consolidated financial statements for the year ended April 30, 1997. LOSS PER SHARE Loss per share is computed by dividing the net loss by the weighted average number of shares of common stock outstanding during the periods. The effect of outstanding options and warrants on the computation of net loss per share is antidilutive and, therefore, is not included in the computation of loss per share amounts for the nine month periods ended January 31, 1997 and 1998. NEW ACCOUNTING STANDARDS In February 1997, the FASB issued Financial Statement of Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS 128 specifies the computation, presentation, and disclosure requirements for earnings per share ("EPS") for entities with publicly held common stock or potential common stock. The Company adopted SFAS 128 in the third quarter of fiscal 1998 and has restated all prior period EPS amounts pursuant to SFAS 128. SFAS 128 simplifies the standards for computing EPS previously found in Accounting Principles Board Opinion No. 15, "Earnings per Share" and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the statement of operations for F-62 UNITED DIGITAL NETWORK, INC. AND SUBSIDIARIES (FORMERLY UNIDEX COMMUNICATIONS CORP.) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic EPS excludes the effect of potentially dilutive securities while diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised, converted into or resulted in the issuance of common stock. Common stock equivalents consist of common stock issuable under the assumed exercise of stock options and warrants, computed based on the treasury stock method and the assumed conversion of the Company's issued and outstanding preferred stock. Common stock equivalents are not included in diluted EPS calculations to the extent their inclusion would have an anti-dilutive effect. 3. ACCOUNTS RECEIVABLE During the nine months ended January 31, 1998, bad debt expense of $3.1 million was recorded by the Company. Included in this amount was the write-off of receivables from two major wholesale customers as a result of the customer's bankruptcy, and the write-off of $1.3 million receivable resulting from customer fraud. 4. SUBSEQUENT EVENTS On November 19, 1997, the Company entered into an Agreement and Plan of Merger (the "Merger") whereby IIWII Corp., a wholly-owned subsidiary of STAR Telecommunications, Inc. ("STAR"), will be merged with and into the Company. Under the terms of amendments to the Merger dated January 30, 1998 and April 6, 1998 (the "Amendments"), UDN's stockholders will receive for each share of UDN Common Stock a portion of a share (the "Exchange Ratio") of STAR Common Stock determined by dividing $2.05 by the average closing price of STAR Common Stock on the Nasdaq National Market for the five trading days prior to the Effective Time (the "Average Price"), provided that if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price. STAR will also assume all outstanding options, warrants, and other rights to acquire the Company's stock. The Merger is subject to approval by the stockholders of both companies and certain other conditions, including the receipt of an opinion that the Merger may be accounted for as a pooling of interests. The Amendments to the Merger contain provisions whereby STAR and the Company executed promissory notes totaling $4.5 million as a financial accommodation to fund the Company's working capital needs. In the third quarter of fiscal 1998, the Company entered into an Agreement of Compromise, Settlement and Release (the "Agreement") related to disputes arising under the AMS stock purchase agreement dated March 5, 1996. Under the Agreement, the convertible debenture in the amount of $750,000 due in July 1998 was reduced to $550,000 as a result of allowable adjustments defined in the stock purchase agreement. F-63 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- ANNEX A AGREEMENT AND PLAN OF MERGER BY AND AMONG STAR TELECOMMUNICATIONS, INC., IIWII CORP. AND UNITED DIGITAL NETWORK, INC. Dated as of November 19, 1997 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- TABLE OF CONTENTS
PAGE --------- ARTICLE I THE MERGER....................................................................................... A-1 1.1 The Merger...................................................................................... A-1 1.2 Filing.......................................................................................... A-1 1.3 Effective Time of the Merger.................................................................... A-1 1.4 Certificate of Incorporation and By-Laws........................................................ A-1 1.5 Directors and Officers.......................................................................... A-1 1.6 Warrants and Options............................................................................ A-2 ARTICLE II CONVERSION OF AND SURRENDER AND A-2 PAYMENT FOR COMMON STOCK....................................................................... 2.1 Conversion...................................................................................... A-2 2.2 Closing of Transfer Books....................................................................... A-3 2.3 Surrender of Certificates....................................................................... A-3 ARTICLE III CERTAIN EFFECTS OF MERGER...................................................................... A-3 3.1 Effect of Merger................................................................................ A-3 3.2 Further Assurances.............................................................................. A-4 ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE A-4 ACQUIROR AND NEWCO............................................................................ 4.1 Organization.................................................................................... A-4 4.2 Capital Stock................................................................................... A-4 4.3 Authority Relative to Agreement................................................................. A-4 4.4 Acquiror Common Stock........................................................................... A-4 4.5 No Violations or Consents....................................................................... A-4 4.6 Litigation...................................................................................... A-5 4.7 Financial Statements and Reports................................................................ A-5 4.8 Registration Statement; Blue Sky Filings; Proxy Statement; Other Information.................... A-5 4.9 Brokers......................................................................................... A-6 ARTICLE V REPRESENTATIONS AND WARRANTIES OF THE COMPANY.................................................... A-6 5.1 Corporate Organization.......................................................................... A-6 5.2 Capital Stock................................................................................... A-6 5.3 Options, Warrants or Other Rights............................................................... A-6 5.4 Authority Relative to Agreement................................................................. A-6 5.5 No Violations or Consents....................................................................... A-7 5.6 Governmental Authorizations and Regulations..................................................... A-7 5.7 Litigation...................................................................................... A-8 5.8 Financial Statements and Reports; Material Liabilities.......................................... A-8 5.9 Absence of Certain Changes or Events............................................................ A-8 5.10 Benefit Plans................................................................................... A-8 5.11 ERISA........................................................................................... A-9 5.12 Environmental Matters........................................................................... A-10 5.13 Real Estate Leases.............................................................................. A-10 5.14 Title to Properties; Absence of Liens and Encumbrances.......................................... A-10 5.15 Tax Matters..................................................................................... A-11 5.16 Intellectual Property........................................................................... A-12 5.17 Labor Matters................................................................................... A-12 5.18 Insurance....................................................................................... A-12
i
PAGE --------- 5.19 Contracts....................................................................................... A-12 5.20 Registration Statement; Blue Sky Filings; Proxy Statement; Other Information.................... A-13 5.21 Brokers......................................................................................... A-13 5.22 Continuity of Interest.......................................................................... A-13 5.23 Transactions with Affiliated Parties............................................................ A-13 ARTICLE VI COVENANTS AND AGREEMENTS........................................................................ A-13 6.1 Registration Statement; Proxy Statement; Stockholder Meeting; Vancouver Exchange................ A-13 6.2 Conduct of the Business of the Company Prior to the Effective Time.............................. A-14 6.3 Access to Properties and Record; Acquiror Notice................................................ A-16 6.4 Negotiations.................................................................................... A-16 6.5 Indemnification................................................................................. A-16 6.6 Confidentiality................................................................................. A-17 6.7 Reasonable Best Efforts......................................................................... A-17 6.8 Certification of Stockholder Vote............................................................... A-17 6.9 Loan to Company................................................................................. A-17 6.10 Outsourcing Agreement........................................................................... A-18 6.11 Affiliate Agreements............................................................................ A-18 6.12 Proxy Agreement................................................................................. A-18 6.13 Disclosure Schedules............................................................................ A-18 ARTICLE VII CONDITIONS PRECEDENT........................................................................... A-18 7.1 Conditions to Each Party's Obligation to Effect the Merger...................................... A-18 7.2 Conditions to the Obligation of the Company to Effect the Merger................................ A-19 7.3 Conditions to Obligations of the Acquiror and Newco to Effect the Merger........................ A-19 7.4 Closing Conditions Deemed Satisfied............................................................. A-20 ARTICLE VIII TERMINATION, AMENDMENT AND WAIVER............................................................. A-20 8.1 Termination..................................................................................... A-20 8.2 Fees and Expenses............................................................................... A-21 8.3 Amendment....................................................................................... A-21 8.4 Waiver.......................................................................................... A-21 ARTICLE IX MISCELLANEOUS................................................................................... A-22 9.1 Survival........................................................................................ A-22 9.2 Expenses and Fees............................................................................... A-22 9.3 Notices......................................................................................... A-22 9.4 Headings........................................................................................ A-23 9.5 Publicity....................................................................................... A-23 9.6 Entire Agreement; Knowledge..................................................................... A-23 9.7 Assignment...................................................................................... A-23 9.8 Counterparts.................................................................................... A-23 9.9 Invalidity, Etc................................................................................. A-23 9.10 Specific Performance............................................................................ A-23 9.11 Governing Law................................................................................... A-23
ii EXHIBITS
Exhibit A Certificate of Merger Exhibit B Promissory Note Exhibit C Affiliate Agreements Exhibit D Proxy Agreement
iii ANNEX A AGREEMENT AND PLAN OF MERGER AGREEMENT AND PLAN OF MERGER dated as of November 19, 1997 (this "Agreement"), by and among STAR Telecommunications, Inc., a Delaware corporation (the "Acquiror"), IIWII Corp., a Delaware corporation and wholly-owned subsidiary of the Acquiror ("Newco"), and United Digital Network, Inc., a Delaware corporation (the "Company"). R E C I T A L S: A. The Boards of Directors of Newco, the Acquiror and the Company deem it advisable and in the best interests of their respective stockholders to merge Newco with and into the Company (the "Merger") upon the terms and conditions set forth herein and in accordance with the General Corporation Law of the State of Delaware (the "General Corporation Law") (the Company and Newco being hereinafter sometimes referred to as the "Constituent Corporations" and the Company, following the effectiveness of the Merger, being hereinafter sometimes referred to as the "Surviving Corporation"); and B. The Boards of Directors of the Acquiror, Newco and the Company have approved the Merger upon the terms and subject to the conditions set forth herein and, in the case of the Company, on the receipt of a "fairness opinion" from its financial advisor in form, substance, and scope that is satisfactory to the Board of Directors of the Company. A G R E E M E N T NOW, THEREFORE, in consideration of the mutual representations, warranties, covenants, agreements and conditions contained herein, and in order to set forth the terms and conditions of the Merger and the mode of carrying the same into effect, the parties hereby agree as follows: ARTICLE I THE MERGER 1.1 THE MERGER. Upon the terms and conditions hereinafter set forth and in accordance with the General Corporation Law, at the Effective Time, as defined below, Newco shall be merged with and into the Company and thereupon the separate existence of Newco shall cease, and the Company, as the Surviving Corporation, shall continue to exist under and be governed by the General Corporation Law. 1.2 FILING. Upon the satisfaction or waiver of the conditions set forth in Section 7 hereof (other than the condition set forth in Section 7.1(b) which may not be waived), Newco and the Company will cause a Certificate of Merger, in substantially the form of EXHIBIT A attached hereto (the "Certificate of Merger"), to be executed and filed with the Secretary of State of the State of Delaware as provided in Section 251 of the General Corporation Law. 1.3 EFFECTIVE TIME OF THE MERGER. The Merger shall become effective immediately upon the filing, in accordance with Section 251 of the General Corporation Law, of the Certificate of Merger with the Secretary of State of the State of Delaware in accordance with Section 251. The date and time of such filing is herein sometimes referred to as the "Effective Time." 1.4 CERTIFICATE OF INCORPORATION AND BY-LAWS. Upon the effectiveness of the Merger, the Certificate of Incorporation of Newco shall be the certificate of incorporation of the Surviving Corporation and the By-Laws of Newco as in effect on the date hereof shall be the By-Laws of the Surviving Corporation. 1.5 DIRECTORS AND OFFICERS. The persons who are directors of Newco immediately prior to the Effective Time and the officers of the Company shall, after the Effective Time and in accordance with the A-1 Certificate of Merger, serve as the directors and officers, respectively, of the Surviving Corporation, in each case such directors and officers to serve until their successors have been duly elected and qualified in accordance with the Certificate of Incorporation and By-Laws of the Surviving Corporation. 1.6 WARRANTS AND OPTIONS. On the Effective Time, the Acquiror shall assume the duties and obligations of the Company, and the Acquiror shall be vested with the powers, rights and privileges of the Company, under (a) the warrants of the Company that remain outstanding at the Effective Time (the "Warrants") and (b) the options of the Company that remain outstanding at the Effective Time (the "Options"), as such warrants and options are listed on Schedule 5.3. As of the Effective Time, the Acquiror shall have reserved for issuance and continue to maintain sufficient shares of Acquiror Common Stock, as defined below, to issue the required shares of Acquiror Common Stock pursuant to the exercise of Warrants and Options after the Effective Time, subject to appropriate adjustment in the exercise price thereof, based on the Exchange Ratio, as defined below. ARTICLE II CONVERSION OF AND SURRENDER AND PAYMENT FOR COMMON STOCK 2.1 CONVERSION. At the Effective Time, by virtue of the Merger and without any action on the part of the holders thereof: (a) Each of the issued and outstanding shares of the Common Stock, $.01 par value, of the Company ("Common Stock"), other than (i) Dissenting Stock, as defined below, or (ii) shares of Common Stock held in the treasury of the Company, shall be automatically converted into the right to receive consideration per share (the "Merger Consideration") consisting of that portion of a share (the "Exchange Ratio") of the Acquiror's common stock, $0.001 per share ("Acquiror Common Stock"), determined by dividing $2.75 by the average closing price of Acquiror's Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that, if the Average Price is equal to or greater than $32.73, then the Exchange Ratio shall be determined by dividing $3.00 by the Average Price, provided, further, that, if the Average Price is less than or equal to $26.78, then the Exchange Ratio shall be determined by dividing $2.50 by the Average Price. The Exchange Ratio shall be adjusted as may be necessary and appropriate to reflect any and all stock splits, reverse stock splits, reclassifications and similar capital events that affect Acquiror Common Stock. (b) Each issued and outstanding share of the Common Stock of Newco shall be converted into approximately Seven Thousand Five Hundred Sixty-Four (7,564) validly issued, fully paid and non-assessable shares of common stock, $.01 par value (the "New Common Stock"), of the Surviving Corporation. (c) All shares of Common Stock which are held by the Company as treasury shares shall be canceled and retired and cease to exist, without any conversion thereof or payment with respect thereto. (d) No fraction of a share of Acquiror Common Stock will be issued in the Merger, but, in lieu thereof, each holder of Common Stock who would otherwise be entitled to a fraction of a share of Acquiror Common Stock (after aggregating all fractional shares of Acquiror Common Stock to be received by such holder) will be entitled to receive from the Acquiror an amount of cash (rounded to the nearest whole US $0.01) equal to the product of (i) such fraction of a share multiplied by (ii) the Average Price. Notwithstanding any provision of this Agreement to the contrary, shares of the Common Stock with respect to which appraisal rights have been demanded and perfected in accordance with Section 262(d) of the General Corporation Law (the "Dissenting Stock") shall not be converted into the right to receive the Merger Consideration at or after the Effective Time, and the holder thereof shall be entitled only to such A-2 rights as are granted by the General Corporation Law. Notwithstanding the preceding sentence, if any holder of shares of Common Stock who demands appraisal of such shares under the General Corporation Law shall effectively withdraw his demand for such appraisal (in accordance with Section 262(k) of the General Corporation Law) or becomes ineligible for such appraisal (through failure to perfect or otherwise) then, as of the Effective Time or the occurrence of such event, whichever is the last to occur, such holder's Dissenting Stock shall cease to be Dissenting Stock and shall be converted into and represent the right to receive the Merger Consideration, without interest thereon, as provided in this Section 2.1. The Company shall give Acquiror (i) prompt notice of any written demands for appraisal, withdrawals of demands for appraisal and any other instrument served pursuant to Section 262 of the General Corporation Law received by the Company and (ii) the opportunity to participate in all negotiations and proceedings with respect to demands for appraisal under such Section. 2.2 CLOSING OF TRANSFER BOOKS. At the Effective Time, the stock transfer books of the Company shall be closed, and no transfer of shares of Common Stock of the Company shall thereafter be made. If, after the Effective Time, certificates previously representing shares of Common Stock are presented to the Surviving Corporation or the Exchange Agent, as defined below, such certificates shall be canceled and exchanged for the Merger Consideration as provided in Section 2.1, subject to applicable law in the case of Dissenting Stock. 2.3 SURRENDER OF CERTIFICATES. At least five days prior to the mailing of the Proxy Statement, as defined below, Newco shall, subject to the reasonable approval of the Company, designate an exchange agent (the "Exchange Agent") to effect the exchange for Acquiror Common Stock of certificates that, prior to the Effective Time, represented shares of Common Stock entitled to the Merger Consideration. As soon as practicable after the Effective Time, the Exchange Agent shall send a notice and transmittal form to each holder of record of Common Stock immediately prior to the Effective Time advising such holder of the effectiveness of the Merger and the procedure for surrendering to the Exchange Agent (who may appoint forwarding agents with the approval of Newco) the certificate or certificates to be exchanged pursuant to the Merger. Upon the surrender for exchange of such a certificate, together with such letter of transmittal duly completed and properly executed in accordance with instructions thereto and such other documents as may be required pursuant to such instructions, the holder shall receive the Merger Consideration. After the Effective Time, until so surrendered and exchanged, each certificate which immediately prior to the Effective Time represented outstanding shares of the Common Stock (other than Dissenting Stock) shall represent solely the right to receive the Merger Consideration. ARTICLE III CERTAIN EFFECTS OF MERGER 3.1 EFFECT OF MERGER. On and after the Effective Time, the Surviving Corporation shall possess all the rights, privileges, powers and franchises, and be subject to all the restrictions, disabilities and duties of each of the Constituent Corporations; and all and singular rights, privileges, powers and franchises of each of the Constituent Corporations, and all property, real, personal and mixed, and all debts due to either of the Constituent Corporations on whatever account, as well for stock subscriptions as all other things in action or belonging to each of the Constituent Corporations, shall be vested in the Surviving Corporation; and all property, rights, privileges, powers and franchises, and all and every other interest shall be thereafter the property of the Surviving Corporation as they were of the Constituent Corporations, and the title to any real estate vested by deed or otherwise, in either of the Constituent Corporations shall not revert or be in any way impaired; but all rights of creditors and all liens upon any property of either of the Constituent Corporations shall be preserved unimpaired, and all debts, liabilities and duties of the Constituent Corporations shall thenceforth attach to and be the sole responsibility of the Surviving Corporation and may be enforced against the Surviving Corporation to the same extent as if said debts, liabilities and duties had been incurred or contracted by it. A-3 3.2 FURTHER ASSURANCES. If at any time after the Effective Time the Surviving Corporation shall consider or be advised that any further deeds, assignments or assurances in law or any other acts are necessary, desirable or proper to vest, perfect or confirm, of record or otherwise, in the Surviving Corporation, the title to any property or right of the Constituent Corporations acquired or to be acquired by reason of, or as a result of, the Merger, the Constituent Corporations agree that the Surviving Corporation and its proper officers and directors shall and will execute and deliver all such deeds, assignments and assurances in law and do all acts necessary, desirable or proper to vest, perfect or confirm title to such property or right in the Surviving Corporation and otherwise to carry out the purposes of this Agreement, and that the proper officers and directors of the Constituent Corporations and the proper officers and directors of the Surviving Corporation are fully authorized in the name of the Constituent Corporations or otherwise to take any and all such action. ARTICLE IV REPRESENTATIONS AND WARRANTIES OF THE ACQUIROR AND NEWCO The Acquiror and Newco jointly and severally represent and warrant to the Company as follows: 4.1 ORGANIZATION. Each of Acquiror and Newco is a corporation duly organized, validly existing and in good standing under the laws of the State of Delaware, and each has the requisite corporate power and authority to own, lease and operate its assets and to conduct its business in the manner in which it is presently conducted. 4.2 CAPITAL STOCK. The authorized capital stock of the Acquiror consists in its entirety of 50,000,000 shares of Common Stock, $0.001 par value, of which, as of September 30, 1997, 15,798,254 are issued and outstanding, and 5,000,000 shares of Preferred Stock, $0.001 par value per share, none of which is issued and outstanding. The authorized capital stock of Newco consists in its entirety of 1,000 shares of common stock, $.01 par value, all of which are issued and outstanding. All of the outstanding shares of Newco common stock are owned beneficially and of record by the Acquiror. 4.3 AUTHORITY RELATIVE TO AGREEMENT. Each of the Acquiror and Newco has full corporate power and authority to execute and deliver this Agreement and to consummate the Merger and the other transactions contemplated on its part hereby. The execution, delivery and performance by each of the Acquiror and Newco of this Agreement and the consummation of the transactions contemplated hereby have been duly authorized by all necessary corporate action on the part of the Acquiror and Newco. This Agreement has been duly executed and delivered by each of the Acquiror and Newco, and is a legal, valid and binding obligation of each of the Acquiror and Newco, enforceable against each of the Acquiror and Newco in accordance with its terms, except to the extent that its enforceability may be limited by applicable bankruptcy, insolvency, reorganization or other laws affecting the enforcement of creditors' rights generally or by general equitable principles. 4.4 ACQUIROR COMMON STOCK. The shares of Acquiror Common Stock to be issued in connection with the Merger have been duly authorized and, when issued as contemplated hereby at the Effective Time, will be validly issued, fully paid and non-assessable, and not subject to any preemptive rights or other rights or interests of third parties. 4.5 NO VIOLATIONS OR CONSENTS. The execution, delivery and performance of this Agreement by each of the Acquiror and Newco and the consummation by each of them of the transactions contemplated hereby, will not (i) violate or conflict with any provision of any charter or by-laws of the Acquiror or Newco, (ii) require the consent, waiver, approval, license or authorization of or any filing by the Acquiror or Newco with any public authority, other than (a) the filing of a pre-merger notification report under The Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the rules and regulations promulgated thereunder (the "HSR Act"), (b) in connection with or in compliance with the provisions of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the Securities Act of 1933, as amended (the "Securities Act"), the Communications Act of 1934, as amended (the "Communications A-4 Act"), the General Corporation Law or the "takeover" or "blue sky" laws of various states and (c) any other filings and approvals expressly contemplated by this Agreement, (iii) violate, conflict with or result in a breach of or the acceleration of any obligation under, or constitute a default (or an event which with notice or the lapse of time or both would become a default) under, or give to others any right of termination, amendment, acceleration or cancellation of, or result in the creation of a lien or other encumbrance on any property or asset of the Acquiror or Newco pursuant to any provision of any indenture, mortgage, lien, lease, agreement, instrument, order, judgment or decree to which the Acquiror or Newco is subject or by which the Acquiror or Newco or any of their property or assets is bound, or (iv) violate or conflict with any law, rule, regulation, permit, ordinance or decree applicable to the Acquiror or Newco or by which any property or asset of either of them is bound or affected except, in each of the instances set forth in items (i) through (iv) above, where failure to give such notice, make such filings, or obtain such authorizations, consents or approvals, or where such violations, conflicts, breaches or defaults, in the aggregate, would not have an Acquiror Material Adverse Effect, as defined below. 4.6 LITIGATION. Except as may be disclosed in the Acquiror SEC Filings, as defined below, there are no suits, arbitrations, actions or proceedings pending or, to the best of the Acquiror's knowledge, threatened or, to the best of the Acquiror's knowledge, investigations pending or threatened against the Acquiror or with respect to any property or asset of it before any court, arbitrator, administrator or governmental or regulatory authority or body which, in the aggregate, are likely to have a material adverse effect on the business, operations or financial condition of the Acquiror (an "Acquiror Material Adverse Effect"). 4.7 FINANCIAL STATEMENTS AND REPORTS. The Acquiror heretofore has delivered to the Company true and complete copies of (a) its Registration Statement on Form S-1 dated June 12, 1997, Registration No. 333-21325, and (b) its Quarterly Reports on Form 10-Q for the quarters ended June 30, 1997 and September 30, 1997 (collectively,"Acquiror SEC Filings"). As of the respective times such documents were filed or, as applicable, became effective, the Acquiror SEC Filings complied as to form and content, in all material respects, with the requirements of the Securities Act and the Exchange Act, as the case may be, and the rules and regulations promulgated thereunder, and did not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. The financial statements of the Acquiror included in the Acquiror SEC Filings were prepared in accordance with generally accepted accounting principles ("GAAP") applied on a consistent basis and (except as may be indicated therein or in the notes thereto) present fairly the consolidated financial position, results of operations and cash flows of the Acquiror and its consolidated subsidiaries as of the dates and for the periods indicated subject, in the case of unaudited interim consolidated financial statements, to normal recurring year-end adjustments. 4.8 REGISTRATION STATEMENT; BLUE SKY FILINGS; PROXY STATEMENT; OTHER INFORMATION. The Registration Statement, as defined below, and the information supplied or to be supplied in writing by either the Acquiror or Newco for inclusion in the Proxy Statement, as defined below, and any other documents to be filed with the Securities and Exchange Commission (the "SEC"), including, without limitation, the British Columbia Securities Commission ("BCSC"), the Vancouver Stock Exchange (the "VSE") or any regulatory agency in connection with the transactions contemplated hereby, will not be, at the respective times such documents are filed or declared effective by the SEC and on the Effective Time, and, with respect to the Proxy Statement, when first published, sent or given to stockholders of the Company, false or misleading with respect to any material fact, or omit to state any material fact necessary in order to make the statements therein not misleading or, in the case of the Proxy Statement or any amendment thereof or supplement thereto, at the time of the special meeting of the Company's stockholders provided for in Section 6.1, be false or misleading with respect to any material fact, or omit to state any material fact necessary to correct any statement in any earlier communication with respect to the solicitation of any proxy for such meeting. All documents which the Acquiror or Newco files or is responsible for filing with A-5 the SEC and any regulatory agency in connection with the Merger (including, without limitation, the Registration Statement) will comply as to form and content in all material respects with the provisions of applicable law and regulations. Notwithstanding the foregoing, the Acquiror and Newco make no representations or warranties with respect to any information that has been supplied in writing by the Company or its auditors, attorneys or financial advisors specifically for use in the Registration Statement or in any other documents to be filed by the Acquiror with the SEC or any other regulatory agency in connection with the transactions contemplated hereby. 4.9 BROKERS. Neither the Acquiror nor Newco has paid or become obligated to pay any fee or commission to any broker, finder, investment banker or other intermediary in connection with this Agreement, except that the Acquiror has retained Lehman Brothers as its financial advisor in connection with the transactions contemplated by this Agreement. ARTICLE V REPRESENTATIONS AND WARRANTIES OF THE COMPANY Except as set forth in the disclosure schedules to be delivered to the Acquiror by the Company (the "Disclosure Schedules") pursuant to Section 6.13, the Company represents and warrants to the Acquiror and Newco as follows: 5.1 CORPORATE ORGANIZATION. Each of the Company and each of its subsidiaries Advanced Management Services, Inc. CTN-- Custom Telecommunications Network of Arizona, Inc. and United Digital Network of Texas, Inc. (formerly known as AnswerNet, Inc., which includes, pursuant to a merger, Digital Network, Inc.) (each a "Subsidiary" and collectively, the "Subsidiaries"), is a corporation duly organized, validly existing and in good standing under the laws of its state of incorporation with all requisite corporate power and authority to own, operate and lease its properties and to carry on its business as it is now being conducted, and is qualified or licensed to do business and is in good standing in each jurisdiction in which the failure to be so qualified or licensed, in the aggregate, would have a material adverse effect on the financial condition, operations or business of the Company and the Subsidiaries taken as a whole (a "Company Material Adverse Effect"). The Certificates of Incorporation and By-Laws of the Company and the Subsidiaries are in full force and effect. The Company is not in violation of or in default under any provision of its Certificate of Incorporation or By-Laws. The Subsidiaries are the only subsidiaries, direct or indirect, of the Company. 5.2 CAPITAL STOCK. The authorized capital stock of the Company consists in its entirety of 100,000,000 shares of Common Stock, $.01 par value, of which, as of the date hereof, 7,564,103 are issued and outstanding and none are held in the Company's treasury. Except as set forth on SCHEDULE 5.2, all of the outstanding shares of capital stock of each of the Subsidiaries are owned beneficially and of record by the Company free and clear of all liens, charges, encumbrances, options, rights of first refusal or limitations or agreements regarding voting rights of any nature, other than the Proxy Agreement, as defined below. All of the outstanding shares of capital stock of the Company and the Subsidiaries have been duly authorized, validly issued and are fully paid and nonassessable. 5.3 OPTIONS, WARRANTS OR OTHER RIGHTS. Except as set forth on SCHEDULE 5.3 or as contemplated by this Agreement, there is no outstanding right, subscription, warrant, call, unsatisfied preemptive right, option or other agreement or arrangement of any kind to purchase or otherwise to receive from the Company or any Subsidiary any of the outstanding, authorized but unissued, unauthorized or treasury shares of the capital stock or any other equity security of the Company or any Subsidiary and there is no outstanding security of any kind convertible into or exchangeable for such capital stock. 5.4 AUTHORITY RELATIVE TO AGREEMENT. The Company has full corporate power and authority to execute and deliver this Agreement and to consummate the Merger and the other transactions contemplated on its part hereby. The execution and delivery by the Company of this Agreement and the consummation of the transactions contemplated on its part hereby have been duly authorized by its Board A-6 of Directors, and (other than the approval and adoption of this Agreement by the holders of a majority of the then outstanding shares of Common Stock, as provided in Section 6.1 hereof, the filing and recordation of appropriate merger documents as required by the General Corporation Law and the receipt of a satisfactory fairness opinion from its financial advisor) no other corporate proceedings on the part of the Company or its stockholders are necessary to authorize the execution and delivery of this Agreement by the Company or the consummation of the transactions contemplated on its part hereby. In that regard, the Company hereby represents that its Board of Directors has (i) determined that the Merger is fair to and in the best interests of the Company's stockholders, (ii) approved the Merger and (iii) resolved to recommend in the Proxy Statement adoption of this Agreement and authorization of the Merger by the stockholders of the Company, such matters to be subject to the fiduciary duties of such directors and to the receipt of a satisfactory fairness opinion from its financial advisor. This Agreement has been duly executed and delivered by the Company, and constitutes a legal, valid and binding obligation of the Company, enforceable against the Company in accordance with its terms, except to the extent that its enforceability may be limited by applicable bankruptcy, insolvency, reorganization or other laws affecting the enforcement of creditors' rights generally or by general equitable principles. 5.5 NO VIOLATIONS OR CONSENTS. Except as set forth on SCHEDULE 5.5, the execution, delivery and performance of this Agreement by the Company and the consummation by it of the transactions contemplated hereby will not (i) violate or conflict with any provision of any charter or by-laws of the Company or any Subsidiary, (ii) require the consent, waiver, approval, license or authorization of or any filing by the Company or any Subsidiary with any third party or public authority (other than (a) the filing of a premerger notification report under the HSR Act, (b) in connection with or in compliance with the provisions of the Exchange Act, the Securities Act, the General Corporation Law, the Communications Act or the "takeover" or "blue sky" or "public utility" laws of various states, and (c) and any other filings and approvals expressly contemplated by this Agreement, including, without limitation, those with the BCSC and the VSE), (iii) violate, conflict with or result in a breach of or the acceleration of any obligation under, or constitute a default (or an event which with notice or the lapse of time or both would become a default) under, or give to others any right of termination, amendment, acceleration or cancellation of, or result in the creation of a lien or other encumbrance on any property or asset of the Company or any Subsidiary pursuant to any provision of any indenture, mortgage, lien, lease, agreement, instrument, order, judgment or decree to which the Company or any Subsidiary is subject or by which the Company or any Subsidiary or any of their property or assets is bound, or (iv) violate or conflict with any law, rule, regulation, permit, ordinance, regulation or decree applicable to the Company or any Subsidiary or by which any property or asset of either of them is bound or affected except, in each of the instances set forth in items (i) through (iv) above, where failure to give such notice, make such filings, or obtain such authorizations, consents or approvals, or where such violations, conflicts, breaches or defaults, in the aggregate, would not have a Company Material Adverse Effect. 5.6 GOVERNMENTAL AUTHORIZATIONS AND REGULATIONS. SCHEDULE 5.6 is a true and complete list of all material governmental licenses, franchises, permits and other authorizations ("Permits") held by the Company and/or the Subsidiaries. Such Permits are all governmental licenses, franchises, permits and other authorizations necessary to the conduct of the business of the Company and the Subsidiaries, except where the failure to hold such Permits, in the aggregate, would not have a Company Material Adverse Effect. Such Permits are valid and in full force and effect and the Company knows of no threatened suspension, cancellation or invalidation of any such Permit except where any such action would not result in a Company Material Adverse Effect. Neither the Company nor any Subsidiary is in conflict with, or is in default or violation of, any law, rule, regulation, order, judgment, Permit, ordinance, regulation or decree applicable to the Company or any Subsidiary or by which any property or asset of either of them is bound or affected, except where such conflicts, defaults or violations, in the aggregate, would not have a Company Material Adverse Effect. A-7 5.7 LITIGATION. Except as may be disclosed in the PPM, as defined below, or on SCHEDULE 5.7, there are no suits, arbitrations, actions or proceedings, pending or, to the best of the Company's or any Subsidiary's knowledge, threatened or, to the best of the Company's or any Subsidiary's knowledge, investigations pending or threatened against the Company or any Subsidiary or with respect to any property or asset of any of them before any court, arbitrator, administrator or governmental or regulatory authority or body which, in the aggregate, are likely to have a Company Material Adverse Effect. 5.8 FINANCIAL STATEMENTS AND REPORTS; MATERIAL LIABILITIES. (a) The Company has delivered to the Acquiror true and complete copies of its Confidential Private Placement Memorandum dated October 28, 1997 (the "PPM") As of the date thereof, the PPM did not contain any untrue statement of a material fact or omit to state any material fact required to be stated therein or necessary to make the statements therein, in light of the circumstances under which they were made, not misleading. The financial statements in the PPM were prepared in accordance with GAAP applied on a consistent basis and (except as may be indicated therein or in the notes thereto) present fairly the consolidated financial position, results of operations and cash flows of the Company and its consolidated subsidiaries as of the dates and for the periods indicated subject, in the case of un-audited interim consolidated financial statements, to normal recurring year-end adjustments and subject to the "going concern" opinion of the Company's independent accountants. (The audited consolidated balance sheet of the Company and the Subsidiaries as of April 30, 1997 included in the PPM is hereinafter called the "Company Balance Sheet," and April 30, 1997 is hereinafter called the "Company Balance Sheet Date," and the Company's balance sheet for the three month period ended July 31, 1997 included in the PPM is hereafter called the "Interim Balance Sheet"). (b) Except as set forth on SCHEDULE 5.8(b), the Company and its Subsidiaries, considered as a whole, have no material liabilities or obligations (whether fixed, accrued, contingent or otherwise) that are not fully reflected or provided for on, or disclosed in the notes to, the Company Balance Sheet or the Company Interim Balance Sheet, except for (i) liabilities in the ordinary course of business that could not be reasonably expected to have a Company Material Adverse Effect or (ii) liabilities incurred in the ordinary course of business that are not required by GAAP to be reflected thereon and which are not material. 5.9 ABSENCE OF CERTAIN CHANGES OR EVENTS. Since the Company Balance Sheet Date and except as disclosed on SCHEDULE 5.9, the business of the Company and the Subsidiaries have been conducted in the ordinary course consistent with past practice, and (i) there has not been any material adverse change in the financial condition, results of operations, properties, or business of the Company or any Subsidiary, nor, to the Company's knowledge, has there occurred any event or development that could be reasonably foreseen to result in a Company Material Adverse Effect. 5.10 BENEFIT PLANS. Except as disclosed on SCHEDULE 5.10, neither the Company nor any Subsidiary has outstanding any employment agreement with any officer or employee of the Company or any Subsidiary or any bonus, incentive compensation, deferred compensation, profit sharing, stock option, stock bonus, stock purchase, savings, severance, salary continuation, consulting, retirement (including health and life insurance benefits provided after retirement) or pension plan (including Company Employee Benefit Plans as defined in Section 5.11 hereof) or arrangement with or for the benefit of any officer, employee or other person, or for the benefit of any group of officers, employees or other persons that provides for payment of more than $100,000 in annual benefits. Neither the Company nor any Subsidiary has made, or entered into any agreement to make, any payment that becomes payable as a result of the consummation of this transaction which would be treated as an "excess parachute payment" as defined in Section 280G of the Internal Revenue Code of 1986, as amended (the "IRC"). There are no such agreements, plans or other arrangements entered into with or provided for any independent contractors with whom the Company or any Subsidiary has a business relationship. A-8 5.11 ERISA. Set forth on SCHEDULE 5.10 are all of the employee benefit plans, as defined in Section 3(3) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), but without regard to whether any such plan is in fact subject to ERISA, that is sponsored, or is being maintained or contributed to, by the Company or any Subsidiary that provides for payment of more than $25,000 in annual benefits (the "Company Employee Benefit Plans"). None of the Company Employee Benefit Plans are "multiemployer plans" as defined in Section 3(37) of ERISA. The Company has furnished or made available or will promptly after the date hereof make available to Newco and the Acquiror (a) a true and complete copy of the plan document and summary plan description for each Company Employee Benefit Plan, (b) a true and complete copy of the most recently filed Form 5500 (including the related schedules) with respect to each Company Employee Benefit Plan for which such form is required to be filed, (c) a true and complete copy of any trust agreement, insurance contract or other agreement or arrangement serving as source of funding any benefits payable under any Company Employee Benefit Plan, and (d) the most recently issued financial statement and actuarial report, if any, for each Company Employee Benefit Plan. No "prohibited transactions" (as such term is defined in Section 4975 of the IRC, or in Part 4 of Subtitle B of Title I of ERISA) have occurred with respect to any Company Employee Benefit Plan that could result in the imposition of taxes or penalties that, in the aggregate, could have a Company Material Adverse Effect. With respect to each of the Company Employee Benefit Plans that is intended to qualify for favorable income tax treatment under Section 401(a) of the IRC, (i) the Internal Revenue Service ("IRS") has issued a favorable determination letter with respect to such plan; (ii) except as set forth on SCHEDULE 5.10, the Company has furnished Newco and Acquiror with a copy of the determination letter most recently issued by the IRS with respect to such plan and the application filed with the IRS for such determination letter; and (iii) to the best knowledge of the Company, no event has occurred from the date of each such favorable determination letter that would adversely affect the tax-qualified status of the plan in question. Each Company Employee Benefit Plan has been administered in compliance with the applicable requirements of ERISA and the IRC, and in compliance with all other applicable provisions of law, except for such noncompliance, if any, that, in the aggregate, would not have a Company Material Adverse Effect. With respect to each Company Employee Benefit Plan, neither the Company nor any Subsidiary has incurred liabilities which, in the aggregate, could have a Company Material Adverse Effect as a result of the violation of or the failure to comply with any applicable provision of ERISA, the IRC, any other applicable provision of law, or any provision of such plan. None of the Company Employee Benefit Plans which is an "employee pension benefit plan", as that term is defined in Section 3(2) of ERISA (a "Company Employee Pension Benefit Plan"), has incurred an "accumulated funding deficiency," within the meaning of Section 302 of ERISA or Section 412 of the IRC which, in the aggregate, could have a Company Material Adverse Effect. Neither the Company nor any Subsidiary has failed to make any contribution to, or to make any payment under, any Company Employee Benefit Plan that it was required to make pursuant to the terms of the plan or pursuant to applicable law in any amount which, in the aggregate, could have a Company Material Adverse Effect. To the best knowledge of the Company, no "reportable events," with respect to which a notice must be filed with the Pension Benefit Guaranty Corporation ("PBGC"), has occurred with respect to any Company Employee Pension Benefit Plan subject to Title IV of the ERISA which events, in the aggregate, could have a Company Material Adverse Effect. No proceedings by the PBGC to terminate any Company Employee Pension Benefit Plan pursuant to Subtitle C of Title IV of ERISA have to the best of the Company's knowledge, been instituted or threatened which, in the aggregate, could have a Company Material Adverse Effect. Except for any liabilities in an amount which, in the aggregate, would not have a Company Material Adverse Effect, neither the Company nor any Subsidiary (1) has incurred any liability to the PBGC in connection with any Company Employee Pension Benefit Plan, including any liability under Section 4069 of ERISA and any penalty imposed under Section 4071 of ERISA, (2) has terminated any Company Employee Pension Benefit Plan, or ceased operations at any facility or withdrawn from any Company Employee Pension Benefit Plan, in a manner that could subject it to liability or any liens under Section 4062, 4063, 4064 or 4068 of ERISA or (3) has any knowledge as to the existence of any state of facts, or as to the occurrence of any transactions, that might reasonably be anticipated to result in any A-9 liability of the Company or any Subsidiary to the PBGC under any other provision of Title IV of ERISA. There is no pending or, to the best knowledge of the Company, threatened legal action, proceeding or investigation against or involving any Company Employee Benefit Plan which could result in liabilities to the Plan, the Company or any Subsidiary that, in the aggregate, could have a Company Material Adverse Effect. Except as disclosed on SCHEDULE 5.10, the present value of accrued benefits of each Company Employee Benefit Plan that is a defined benefit plan as defined in Section 3(35) of ERISA does not exceed the value of the assets of such plan available to pay such benefits by an amount that, in the aggregate for all such plans, could have a Company Material Adverse Effect. All representations made by the Company in this Section 5.11 are likewise true with respect to each Subsidiary. 5.12 ENVIRONMENTAL MATTERS. "Company Real Properties" shall mean all real property now or previously owned, operated or leased by the Company, any Subsidiary or any predecessor-in-interest. Except as set forth on SCHEDULE 5.12: (i) the Company, each of the Subsidiaries, and to the best of the Company's knowledge, each of the Company Real Properties is in compliance with, and has no liability under any or all applicable Environmental Laws, except where the failure to comply or such liability would not have a Company Material Adverse Effect; (ii) none of the Company, any Subsidiary or any of the Company Real Properties has been alleged in writing by any governmental agency or third party to be in violation of, to be liable under, or to be subject to any administrative or judicial proceeding pursuant to, any Environmental Law, the violation of which would have a Company Material Adverse Effect; and (iii) to the best knowledge of the Company and each Subsidiary, there are no facts or circumstances which could reasonably form the basis for the assertion of any claims against the Company or any Subsidiary relating to environmental matters which, in the aggregate, would have a Company Material Adverse Effect. As used herein, Environmental Law means any federal, state, or local law, statute, rule or regulation, or the common law governing or relating to the environment or to occupational health and safety. 5.13 REAL ESTATE LEASES. SCHEDULE 5.13 sets forth a complete and accurate list, a copy of which has been delivered to the Acquiror of (i) all leases and subleases under which the Company or any Subsidiary is lessor or lessee of any real property, together with all amendments, supplements, nondisturbance agreements and other agreements pertaining thereto; (ii) all material options held by the Company or any Subsidiary or contractual obligations on the part of the Company or any Subsidiary to purchase or acquire any interest in real property; and (iii) all options granted by the Company or any Subsidiary or contractual obligations on the part of the Company or any Subsidiary to sell or dispose of any material interest in real property (except for sale-leaseback transactions) in each such instance in items (i) through (iii) above, which provides for a payment of more than $25,000. Such leases, subleases and other agreements are in full force and constitute binding obligations of the Company and, to the best of its knowledge, the other parties thereto, and (i) there are no defaults thereunder by the Company or any Subsidiary or, to the best of Company's knowledge, by any other party thereto; and (ii) no event has occurred which (with notice, lapse of time or both or occurrence of any other event) would constitute a default by the Company or any Subsidiary or, to the best of the Company's knowledge, by any other party thereto, other than defaults or events which, in the aggregate, would not have a Company Material Adverse Effect. The Company or a Subsidiary has good, valid and insurable leasehold title to all such leased property, free and clear of all encumbrances, liens, charges or other restrictions of any kind or character, except for Permitted Liens, as defined below. 5.14 TITLE TO PROPERTIES; ABSENCE OF LIENS AND ENCUMBRANCES. SCHEDULE 5.14 lists all real property owned by the Company or any Subsidiary as of the date of this Agreement. The Company and/or a Subsidiary has good, valid and insurable title in fee simple to all of the real property listed on SCHEDULE 5.14, free and clear of all encumbrances, liens, charges or other restrictions of any character whatsoever, except for (i) statutory liens for current taxes or assessments not due or delinquent or the validity of which is being contested in good faith, (ii) mechanics, workers, repairmen's and other similar liens arising or incurred in the ordinary course of business, (iii) such other liens, imperfections in title, A-10 charges, easements, restrictions and other encumbrances, if any, which in the aggregate do not have a Company Material Adverse Effect, and (iv) except as set forth on SCHEDULE 5.14 (collectively "Permitted Liens"). Except for leased assets, the Company and the Subsidiaries have good and insurable title to all of their material tangible personal property used in their businesses, including, without limitation, those reflected in the Company Balance Sheet (other than assets disposed of in the ordinary course of business since the Company Balance Sheet Date), free and clear of all liens, charges, pledges, security interests or other encumbrances, except liens for taxes not yet due and payable and such liens or other imperfections of title of the type and nature described as "Permitted Liens" above to the extent applicable, if any, as would not, in the aggregate, have a Company Material Adverse Effect on the operation of the business of the Company or any Subsidiary, and except as reflected or disclosed in the Company Balance Sheet, or on SCHEDULE 5.14. 5.15 TAX MATTERS. Except as set forth on SCHEDULE 5.15, the Company has paid, or the Company Balance Sheet contains adequate provision for, all federal, state, local, foreign or other governmental income, franchise, payroll, F.I.C.A., unemployment, withholding, real property, personal property, sales, payroll, disability and all other taxes imposed on the Company or any Subsidiary or with respect to any of their respective properties, or otherwise payable by them, including interest and penalties, if any, in respect thereof (collectively, "Company Taxes"), for the Company taxable period ended on the date of the Company Balance Sheet and all fiscal periods of the Company prior thereto, except such nonpayment, or failure to make adequate provision, which, in the aggregate, would not have a Company Material Adverse Effect. Company Taxes paid and/or incurred from the date of the Company Balance Sheet until the Effective Time include only Company Taxes incurred in the ordinary course of business determined in the same manner as in the taxable period ending on the date of the Company Balance Sheet. Except as disclosed on SCHEDULE 5.15, the Company and its Subsidiary have timely filed all income tax, excise tax, sales tax, use tax, gross receipts tax, franchise tax, employment and payroll related tax, property tax, and all other tax returns which the Company and/or each Subsidiary (as the case may be) are required to file ("Tax Returns"), and have paid or provided for all the amounts shown to be due thereon, except where such failure to make such timely filings, in the aggregate, would not have a Company Material Adverse Effect, and except for the nonpayment of such amounts which, in the aggregate, would not have a Company Material Adverse Effect. Except as set forth on SCHEDULE 5.15, (i) neither the Company nor any Subsidiary has filed or entered into, or is otherwise bound by, any election, consent or extension agreement that extends any applicable statute of limitations with respect to taxable periods of the Company, (ii) the Company is not a party to any contractual obligation requiring the indemnification or reimbursement of any person with respect to the payment of any Tax, (iii) no claim has ever been made or threatened by an authority in a jurisdiction where the Company or any Subsidiary do not file Tax Returns that they are or may be subject to Taxes by that jurisdiction, except for any such claims as, in the aggregate, would not have a Company Material Adverse Effect, (iv) no issues have been raised by the relevant taxing authorities on audit that are of a recurring nature and that would have an effect upon the Taxes of the Company or any Subsidiary, except for any issue which, in the aggregate, would not have a Company Material Adverse Effect. Except as set forth on SCHEDULE 5.15, to the best of the Company's and each Subsidiary's knowledge, no action or proceeding is pending or threatened by any governmental authority for any audit, examination, deficiency, assessment or collection from the Company or any Subsidiary of any Company Taxes, no unresolved claim for any deficiency, assessment or collection of any Company Taxes has been asserted against the Company or any Subsidiary, and all resolved assessments of Company Taxes have been paid or are reflected in the Company Balance Sheet, except for any of the foregoing which, in the aggregate, would not have a Company Material Adverse Effect. A-11 5.16 INTELLECTUAL PROPERTY. SCHEDULE 5.16 lists all the registered patents, trademarks, service marks, copyrights, trade names and applications for any of the foregoing owned by the Company or any Subsidiary as of the date of this Agreement (the "Registered Intellectual Property"). The Company and/or the Subsidiaries have good title to the Registered Intellectual Property and have good title to, or valid licenses or rights to use, all patents, copyrights, trademarks, trade names, brand names, proprietary and other technical information, technology and software (collectively "Intellectual Property") which are used in the operation of their businesses as presently conducted, except for such title, license or use imperfections as, in the aggregate, would not have a Company Material Adverse Effect. There are no claims or proceedings pending or, to the Company's and each Subsidiary's knowledge, threatened against the Company or any Subsidiary asserting that the Company or any Subsidiary is infringing or engaging in the unauthorized use of any Intellectual Property of any other person or entity, except such claims or proceedings which, in the aggregate, would not have a Company Material Adverse Effect. 5.17 LABOR MATTERS. Neither the Company nor any Subsidiary is a party to any collective bargaining agreement with respect to any of their employees. None of the employees of the Company or any Subsidiary are represented by any labor union and, as of the date hereof, neither the Company nor any Subsidiary has any knowledge of any union organizational efforts involving the Company's employees during the past five years. Except as set forth on SCHEDULE 5.17, neither the Company nor any Subsidiary has received written notice of any claim, or has knowledge of any facts which are likely to give rise to any claim, that they have not complied in any respect with any laws relating to the employment of labor, including, without limitation, any provisions thereof relating to wages, hours, collective bargaining, the payment of social security and similar taxes, equal employment opportunity, employment discrimination or employment safety, except such claims which, in the aggregate, would not have a Company Material Adverse Effect. 5.18 INSURANCE. SCHEDULE 5.18 lists, as of the date of this Agreement, all material policies of fire, products liability, general liability, vehicle, worker's compensation, directors' and officers' liability, title and other insurance owned or held by or covering the Company or any Subsidiary or any of their property or assets which are material to the business of the Company and any Subsidiary, taken as a whole. As of the date hereof, all of such policies are in full force and effect, except as to matters or defaults which, in the aggregate, would not have a Company Material Adverse Effect, and no written notice of cancellation or termination has been received with respect to any such policy which has not been replaced or cannot be replaced on substantially similar terms prior to the date of such cancellation or termination. 5.19 CONTRACTS. SCHEDULE 5.19 contains a complete and correct list of all material agreements, contracts and commitments (collectively, the "Contracts"), (a) to which the Company is a party or by which it is bound, or (b) by which any of the assets, properties or the business is bound, and in either case, which constitute (i) mortgages, indentures, security agreements, and other agreements and instruments relating to the borrowing of money by or from, or any extension or credit to or from, the Company; (ii) sales agency or marketing agreements; (iii) agreements or commitments for capital expenditures; (iv) brokerage or finder's agreements; (v) partnership, joint venture or other arrangements or agreements involving a sharing of profits or expenses; (vi) contracts or commitments to sell, lease or otherwise dispose of any assets, properties or business other than in the ordinary course of business; (vii) contracts or commitments limiting the freedom of the Company to compete in any line of business or in any geographic area or with any person, and any nondisclosure or nonsolicitation agreements which limit the Company; (viii) any other agreements, contracts and commitments material to the business, operations or financial condition of the Company in each instance under items (i) through (viii) above which Contract relates to an aggregate amount of more than $75,000. All of the Contracts are valid and in full force and effect and the Company has performed all of its obligations under each Contract and no default, violation or breach by the Company or, to the Company's knowledge, any other party, under any Contract has occurred which affects the enforceability of such Contract or any party's rights thereunder, except for such defaults, violations and breaches which would not, in the aggregate, have a Company Material Adverse Effect. A-12 5.20 REGISTRATION STATEMENT; BLUE SKY FILINGS; PROXY STATEMENT; OTHER INFORMATION. The Proxy Statement and the information supplied or to be supplied in writing by the Company for inclusion in the Registration Statement and any other documents to be filed with the SEC, the BCSC, the VSE or any other regulatory agency in connection with the transactions contemplated hereby will, at the respective times such documents are filed, or, as applicable, declared effective, and on the Effective Time, and, with respect to the Proxy Statement, when first published, sent or given to stockholders of the Company, be false or misleading with respect to any material fact, or omit to state any material fact necessary in order to make the statements therein not misleading or, in the case of the Proxy Statement or any amendment thereof or supplement thereto, at the time of the special meeting of the Company's stockholders provided for in Section 6.1, be false or misleading with respect to any material fact, or omit to state any material fact necessary to correct any statement in any earlier communication with respect to the solicitation of any proxy for such meeting. If, at any time prior to the Effective Time, any event relating to the Company or any of its affiliates, officers or directors is discovered by the Company that should be set forth in an amendment to the Registration Statement or a supplement to the Proxy Statement, the Company will promptly inform the Acquiror, and such amendment or supplement will be promptly filed with the VSE and disseminated to the stockholders of the Company, to the extent required by applicable securities laws. All documents which the Company files or is responsible for filing with the VSE and any other regulatory agency in connection with the Merger (including, without limitation, the Proxy Statement) will comply as to form and content in all material respects with the provisions of applicable law. Notwithstanding the foregoing, neither the Company nor the Subsidiary make any representations or warranties with respect to any information that has been supplied in writing by the Acquiror or Newco, or their auditors, attorneys, financial advisors, specifically for use in the Proxy Statement, or in any other documents to be filed with the VSE or any other regulatory agency in connection with the transactions contemplated hereby. 5.21 BROKERS. Except as set forth in Schedule 5.21, neither the Company nor any Subsidiary has paid or become obligated to pay any fee or commission to any broker, finder, investment banker or other intermediary in connection with this Agreement. 5.22 CONTINUITY OF INTEREST. The Company has caused each person who is an affiliate, as defined in Rule 12b-2 under the Exchange Act (an "Affiliate"), to deliver to the Acquiror and each Affiliate has, concurrently with the signing of this Agreement, signed an affiliate agreement in the form attached hereto as EXHIBIT C (an "Affiliate Agreement") providing, among other things, that such person has no plan or intention and will not sell, pledge, transfer or otherwise dispose of shares of Acquiror Common Stock or in any way reduce their risk relative to any such shares, until such time as financial results covering at least 30 days of combined operations of the Acquiror and the Company have been published within the meaning of Section 201.01 of the Codification of Financial Reporting Policies of the SEC and except in compliance with the applicable provisions of the Securities Act, and the rules and regulations thereunder. 5.23 TRANSACTIONS WITH AFFILIATED PARTIES. SCHEDULE 5.23 sets forth a true and complete list and description of all transactions engaged in between the Company and any director, officer, employee, stockholder, partner or agent of the Company, or any of their respective spouses or children, any trust of which any such person is the grantor, trustee or beneficiary, any corporation of which any such person or party is a stockholder, employee, officer or director, or any partnership or other person in which any such person or party owns an interest (all such persons, trusts, corporations and partnerships being herein referred to collectively as "Affiliated Parties" and individually as an "Affiliated Party"). No Affiliated Party is a party to any agreement, contract or commitment with the Company except as set forth in SCHEDULE 5.24. ARTICLE VI COVENANTS AND AGREEMENTS 6.1 REGISTRATION STATEMENT; PROXY STATEMENT; STOCKHOLDER MEETING; VANCOUVER EXCHANGE. A-13 (a) As promptly as practicable after the execution of this Agreement, the Acquiror and Newco will file with the SEC a registration statement on Form S-4 (as amended or supplemented, the "Registration Statement") relating to the registration under the Securities Act of the Acquiror Common Stock to be received in the Merger, and file with state securities administrators such registration statements or other documents as may be required under applicable blue sky laws to qualify or register such Acquiror Common Stock in such states as are designated by the Company (the "Blue Sky Filings"). The Acquiror and Newco will use their reasonable best efforts to cause the Registration Statement to become effective as soon as practicable. In the process of its preparation of the Registration Statement, the Acquiror will provide the Company and its advisors drafts of the Registration Statement and will provide the Company and its advisors a reasonable opportunity to participate in such drafting process. The Acquiror will notify the Company promptly of the receipt of any comments from the SEC or its staff or from any state securities administrators and of any request by the SEC or its staff or by any state securities administrators for amendments or supplements to the Registration Statement or any Blue Sky Filings or for additional information, and will supply the Company and its legal counsel with copies of all correspondence between the Acquiror or any of its representatives, on the one hand, and the SEC, its staff or any state securities administrators, on the other hand, with respect to the Registration Statement. (b) As promptly as practicable following the execution of this Agreement, and after receipt by the Company of a fairness opinion from its financial advisor, the Company agrees that this Agreement shall be submitted at a meeting (the "Meeting") of its stockholders duly called and held pursuant to Section 251(c) of the General Corporation Law. As soon as practicable after the date of this Agreement, the Company shall take all action, to the extent necessary in accordance with applicable law, its Certificate of Incorporation and By-Laws, to convene a meeting of its stockholders promptly to consider and vote upon the approval of the Merger, and the Company shall prepare and file with the VSE, subject to the prior approval of the Acquiror, which approval the Acquiror shall not unreasonably withhold, such information as may be necessary to allow the VSE to approve the merger (the "VSE Approval"), preliminary and final versions of a proxy statement and proxy and other filings relating to the Meeting as required by the VSE and the applicable regulations thereof. The term "Proxy Statement" shall mean such proxy statement at the time it initially is mailed to stockholders and all duly filed amendments or revisions made thereto, if any, similarly mailed. Notice of the Meeting shall be mailed to the Company's stockholders of the Company along with the Proxy Statement. The Company will notify the Acquiror promptly of the receipt of any comments from the VSE with respect to the Proxy Statement and will supply the Acquiror and its legal counsel with copies of all correspondence from or to the VSE and any other applicable regulatory authority. The Company, after consultation with the Acquiror and its legal counsel, shall respond promptly to any comments made by the VSE with respect to the VSE Approval and the Proxy Statement and cause the Proxy Statement and proxy to be mailed to its stockholders at the earliest practicable time following the execution hereof. 6.2 CONDUCT OF THE BUSINESS OF THE COMPANY PRIOR TO THE EFFECTIVE TIME. Except as set forth on SCHEDULE 6.2, the Company agrees that prior to the Effective Time, except as otherwise consented to or approved in writing by the Acquiror or expressly permitted by this Agreement: (a) the business of the Company and the Subsidiaries shall be conducted only in the ordinary course and consistent with past practice; (b) each of the Company and each Subsidiary shall not (i) amend its Certificate of Incorporation or By-Laws, (ii) change the number of authorized, issued or outstanding shares of its capital stock, except upon the exercise of stock options or warrants outstanding on the date hereof, (iii) declare, set aside or pay any dividend or other distribution or payment in cash, stock or property in respect of shares of its capital stock, (iv) make any direct or indirect redemption, retirement, purchase or other acquisition of any of its capital stock (except for repurchases of Common Stock from employees A-14 pursuant to existing stock subscription agreements between the Company and certain of its employees) or (v) split, combine or reclassify its outstanding shares of capital stock; (c) neither the Company nor any Subsidiary shall, directly or indirectly, (i) issue, grant, sell or pledge or agree or propose to issue, grant, sell or pledge any shares of, or rights of any kind to acquire any shares of the capital stock of the Company or any Subsidiary, except that the Company may issue shares of Common Stock upon the exercise of stock options or warrants outstanding on the date hereof, (ii) other than in the ordinary course of business and consistent with past practice and other than with respect to the Promissory Note, incur any material indebtedness for borrowed money, except material indebtedness for borrowed money incurred under credit facilities existing as of the date hereof, (iii) waive, release, grant or transfer any rights of material value, except in the ordinary course of business consistent with past practices or (iv) transfer, lease, license, sell, mortgage, pledge, dispose of or encumber any material assets of the Company or any Subsidiary other than in the ordinary course of business and consistent with past practice; (d) the Company and the Subsidiaries shall use their reasonable commercial efforts to preserve intact the business organization of the Company and the Subsidiaries, to keep available the services of its operating personnel and to preserve the goodwill of those having business relationships with each of them, including, without limitation, suppliers and customers; (e) neither the Company nor any Subsidiary will, directly or indirectly, (i) increase the compensation payable or to become payable by it to any of its employees, officers or directors, except in accordance with employment agreements, welfare and benefit plans set forth on SCHEDULE 5.10, and except, with respect to employees who are not directors or officers, for increases in the ordinary course of business, consistent with past practice, (ii) adopt additional, or make any payment or provision, other than as required by existing plans or agreements, including provisions and actions under existing stock option plans in connection with the Merger, in the ordinary course of business and consistent with prior practice, with respect to any stock option, bonus, profit sharing, pension, retirement, deferred compensation, employment or other payment or employee compensation plan, agreement or arrangement for the benefit of employees of the Company or any Subsidiary, (iii) grant any stock options or stock appreciation rights or issue any warrants, (iv) enter into or amend any employment or severance agreement or arrangement or (v) make any loan or advance to, or enter into any written contract, lease or commitment with, any officer or director of the Company or its Subsidiary; (f) neither the Company nor any Subsidiary shall, directly or indirectly, assume, guarantee, endorse or otherwise become responsible for the obligations of any other individual, firm or corporation other than a Subsidiary or make any loans or advances to any individual, firm or corporation except in the ordinary course of its business and consistent with past practices; (g) neither the Company nor any Subsidiary shall make any investment of a capital nature either by purchase of stock or securities, contributions to capital, property transfers, acquisition or financing of equipment or otherwise, or other than in the ordinary course of business, by the purchase of any property or assets of any other individual, firm or corporation; (h) neither the Company nor any Subsidiary shall enter into modify or amend in any material respect or take any action to terminate their respective material contracts, except in the ordinary course of business; (i) neither the Company nor any Subsidiary shall take any action, other than reasonable and usual actions in the ordinary course of business and consistent with past practice, with respect to accounting policies or procedures, except for changes required by GAAP; (j) neither the Company nor any Subsidiary shall, without the consent of the Acquiror, settle or compromise any material federal, state, local or foreign income tax proceeding or audit; A-15 (k) the Company and the Subsidiaries will promptly advise the Acquiror in writing of any Company Material Adverse Effect or any breach of the Company's representations or warranties, or any material breach of a covenant contained herein of which the Company or any Subsidiary has knowledge; and (l) neither the Company nor any Subsidiary shall enter into an agreement to do any of the things described in clauses (a) through (k). 6.3 ACCESS TO PROPERTIES AND RECORD; ACQUIROR NOTICE. The Company and the Subsidiaries shall afford to the Acquiror and Newco and their respective accountants, counsel and representatives, reasonable access during normal business hours throughout the period prior to the Effective Time to all of their properties, books, contracts, commitments and written records (including, but not limited to, tax returns for the preceding six years), and shall make reasonably available their officers and employees to answer fully and promptly questions put to them thereby; provided that no investigation pursuant to this Section 6.3 shall alter any representation or warranties of any party hereto or conditions to the obligation of the parties hereto; provided, further, that such access shall not unreasonably interfere with the normal business operations of any of the parties hereto. In connection with the preparation of its fairness opinion, the Company's financial advisor shall be provided with the reasonable level of access to the Acquiror and its books and records that may be necessary with respect thereto. The Acquiror will provide the Company written notice of any Acquiror Material Adverse Effect. 6.4 NEGOTIATIONS. Following the execution of this Agreement by the Company, neither the Company nor any Subsidiary, nor the directors, officers, attorneys, financial advisors, or other authorized persons of any of them, shall, directly or indirectly, solicit, initiate or participate in discussions or negotiations with or the submission of any offer or proposal by or provide any information to, any corporation, partnership, person, or other entity or group (other than Newco or the Acquiror or any officer or other authorized representative of Newco or the Acquiror) concerning any Third Party Transaction, as defined below, or, except as provided in Section 8.1(b) or as may be consistent with fiduciary responsibilities under applicable law as advised in writing by outside counsel, participate in any negotiation regarding any Third Party Transaction or otherwise cooperate in any way with any effort or attempt by any other person to effectuate a Third Party Transaction. Notwithstanding the foregoing, the Board of Directors of the Company may furnish such information to or enter into discussions and/or negotiations with any corporation, partnership, person or other entity or group that makes an unsolicited offer to engage in a Third Party Transaction with the Company that the Board of Directors of the Company in good faith determines, with the assistance of its financial advisor, may represent a transaction more favorable to the Company's stockholders when compared to the Merger and the Merger Consideration if, and only to the extent that, the Board determines after consultation with outside legal counsel that the failure to take such action would be inconsistent with the compliance by the Board of Directors with its fiduciary duties to the stockholders of the Company under applicable law, provided that such party shall enter into a confidentiality agreement on substantially the terms contained in Section 6.6 of this Agreement, the Company shall notify the Acquiror as to the contents of information being provided and the Company shall diligently enforce its rights under such confidentiality agreement. The Company represents and warrants that the Company is not currently involved in discussions or negotiations with any third party with respect to a Third Party Transaction. The Company will promptly communicate to the Acquiror the identity of any potential third party purchaser making any such proposal or contact and, prior to the execution of any agreement relating to any such Third Party Transaction, shall also communicate the proposed terms and conditions thereof. The Company agrees not to release any third party from, or waive any provision of, any confidentiality or standstill agreement to which the Company is a party. 6.5 INDEMNIFICATION. The Acquiror agrees that all provisions with respect to indemnification by the Company and the Subsidiaries or with respect to liability to the Company or any Subsidiary now existing in favor of any present or former director, officer, employee or agent (and their respective heirs and assigns) of the Company or any Subsidiary, respectively (the "Indemnified Parties"), as set forth in their respective A-16 Certificates of Incorporation, as amended, or By-Laws or pursuant to other agreements in effect on the date hereof, shall survive the Merger, shall not be amended, repealed or modified and shall continue in full force and effect for a period of at least six years from the Effective Time. 6.6 CONFIDENTIALITY. (a) Subject to applicable law and to subpoena, the Acquiror and Newco will hold, and will cause each of their affiliates, employees, officers, directors and other representatives to hold, in strict confidence, and to not use to the detriment of the Company or the Subsidiaries, any information or data concerning the Company or the Subsidiaries furnished to them in connection with the transactions contemplated by this Agreement, except for information or data generally known or available to the public; and if the transactions contemplated by this Agreement are not consummated, such confidence shall be maintained and the Acquiror and Newco will return to the Company or the Subsidiaries all such information and data as the Company or the Subsidiaries may request. (b) Subject to applicable law and to subpoena, each of the Company and the Subsidiaries will hold, and will cause each of the Company's and each Subsidiary's employees, officers, directors and other representatives to hold, in strict confidence, and to not use to the detriment of the Acquiror or Newco, any information or data concerning the Acquiror or Newco furnished to them in connection with the transactions contemplated by this Agreement, except for information or data generally known or available to the public; and if the transactions contemplated by this Agreement are not consummated, such confidence shall be maintained and the Company and the Subsidiaries will return to the Acquiror or Newco all such information and data as the Acquiror or Newco may request. 6.7 REASONABLE BEST EFFORTS. Subject to the terms and conditions hereof and the fiduciary obligations of the directors of the Company, each of the parties hereto agrees to use their reasonable best efforts to take, or cause to be taken, all action and to do, or cause to be done, all things necessary to satisfy the conditions set forth herein as soon as practicable, including, without limitation, reasonable best efforts necessary to list on the Nasdaq National Market the shares of the Acquiror Common Stock issuable pursuant to the Merger or thereafter, reasonable best efforts necessary to have removed or rescinded any temporary, preliminary or permanent injunction, including the injunctions or other orders described in Section 7.1(c), and reasonable best efforts necessary to defend against any and all litigation, including the proceedings described in Section 7.1(f) brought against either of the parties hereto. The Acquiror and the Company each agree to take, or cause to be taken, all action, and to do, or cause to be done, all things necessary or required by the United States Federal Trade Commission or the United States Department of Justice in connection with the expiration or termination of the waiting period under the HSR Act; provided that neither party will be required to take any action or to do anything in connection with the foregoing which would materially impair the Acquiror's or the Surviving Corporation's ownership or operation of all or a material portion of the business and assets of the Company and its Subsidiary taken as a whole, or compel the Acquiror to dispose of all or a material portion of the business or assets of the Acquiror and its subsidiaries, taken as a whole. No party hereto will take any action for the purpose of delaying, impairing or impeding the receipt of any required consent, authorization, order or approval or the making of any required filing or registration. 6.8 CERTIFICATION OF STOCKHOLDER VOTE. At or prior to the closing of the transactions contemplated by this Agreement, the Company shall deliver to Acquiror a certificate of the Company's Secretary setting forth (i) the number of shares of Common Stock voted in favor of adoption of this Agreement and consummation of the Merger and the number of shares of Common Stock voted against adoption of this Agreement and consummation of the Merger; and (ii) the number of shares of Dissenting Stock. 6.9 LOAN TO COMPANY. On the execution of this Agreement, the Acquiror shall loan to the Company $2.5 million pursuant to the terms and conditions set forth in that certain promissory note attached hereto as Exhibit B (the "Promissory Note"). A-17 6.10 OUTSOURCING AGREEMENT. The Company and the Acquiror shall use reasonable efforts to negotiate the terms and conditions of and enter into a billing outsourcing agreement, which shall provide, among other things, for the management by Acquiror of the Company's customer billings and which shall be on terms at least as favorable as the terms of the Company's present outsourcing agreement. 6.11 AFFILIATE AGREEMENTS. To ensure that the Merger is accounted for as a "pooling of interests," the Company will deliver to Newco from such affiliates of the Company as deemed necessary by the Acquiror's independent auditors a written agreement in the form attached hereto as Exhibit C (the "Affiliate Agreements") relating to the disposition of the shares of the Acquiror's Common Stock received thereby in the Merger. 6.12 PROXY AGREEMENT. On the execution of this Agreement, John R. Snedegar shall deliver to the Acquiror a proxy agreement substantially in the form attached hereto as Exhibit D (the "Proxy Agreement"). 6.13 DISCLOSURE SCHEDULES. The Company shall use its reasonable best efforts to deliver the Disclosure Schedules to the Acquiror promptly following the execution of this Agreement. ARTICLE VII CONDITIONS PRECEDENT 7.1 CONDITIONS TO EACH PARTY'S OBLIGATION TO EFFECT THE MERGER. The respective obligations of each party to effect the Merger shall be subject to the fulfillment at or prior to the Effective Time of the following conditions: (a) The Registration Statement shall have been declared effective, and no stop order suspending the effectiveness of the Registration Statement shall have been issued by the SEC or shall be continuing to be in effect, and no proceedings for that purpose shall have been initiated or threatened by the SEC. (b) This Agreement and the Merger contemplated hereby shall have been approved and adopted by the requisite vote of the holders of the outstanding shares of Common Stock of the Company entitled to vote thereon at the Meeting. (c) No United States, Canadian or state governmental authority or other agency or commission or United States, Canadian or state court of competent jurisdiction shall have enacted, issued, promulgated, enforced or entered any statute, rule, regulation, injunction or other order (whether temporary, preliminary or permanent) which is in effect and has the effect of making the acquisition of Common Stock by Newco illegal or otherwise prohibiting consummation of the transactions contemplated by this Agreement. (d) Any waiting period applicable to the Merger under the HSR Act shall have expired or been terminated. (e) All filings with the FCC required under the Communications Act and with state agencies under state public utility statutes, if necessary, shall have been made. (f) The shares of Acquiror Common Stock issuable in the Merger or thereafter shall have been authorized for listing on the Nasdaq National Market, upon official notice of issuance. (g) There shall not have been instituted or pending any action or proceeding by or before any court or governmental authority or other regulatory or administrative agency or commission, domestic or foreign, by any government or governmental authority, nor shall there be any determination by any government, governmental authority, regulatory or administrative agency or commission which, in either case, would require either party to take any action or do anything in connection with the foregoing which would result in a material adverse effect to their respective businesses or materially impair Acquiror's or the Surviving Corporation's ownership or operation of all or a material portion of the business or assets of the Company and the Subsidiary, taken as a whole, or compel Acquiror to A-18 dispose of all or a material portion of the business or assets of Acquiror and the Subsidiaries, taken as a whole. 7.2 CONDITIONS TO THE OBLIGATION OF THE COMPANY TO EFFECT THE MERGER. The obligation of the Company to effect the Merger shall be subject to the fulfillment at or prior to the Effective Time of the following additional conditions: (a) Each of the Acquiror and Newco shall have performed in all material respects its obligations under this Agreement required to be performed by it on or prior to the Effective Time pursuant to the terms hereof. (b) All representations or warranties of the Acquiror and Newco in this Agreement which are qualified with respect to an Acquiror Material Adverse Effect or materiality shall be true and correct, and all such representations or warranties that are not so qualified shall be true and correct in all material respects, in each case as if such representation or warranty was made as of the Effective Time, except to the extent that any such representation or warranty is made as of a specified date, in which case such representation or warranty shall have been true and correct as of such specified date. (c) Since the date of this Agreement, there shall not have been any material adverse change in the financial condition, results of operations, properties or business of the Acquiror and its Subsidiaries, taken as a whole, excluding any such change caused by a general change in the economy or in the telecommunications industry served by the Acquiror and its Subsidiaries. (d) Each of the Acquiror and Newco shall have delivered a certificate of its President or Vice President to the effect set forth in paragraphs (a), (b) and (c) of this Section 7.2. (e) The Company shall have received from Riordan & McKinzie, counsel to the Acquiror and Newco, an opinion dated the Effective Time in the form reasonably agreed to by the parties hereto. (f) The Company shall have received the opinion of its financial advisors that the Merger and other transactions contemplated by this Agreement are fair, from a financial point of view, to the stockholders of the Company. 7.3 CONDITIONS TO OBLIGATIONS OF THE ACQUIROR AND NEWCO TO EFFECT THE MERGER. The obligations of Acquiror and Newco to effect the Merger shall be subject to the fulfillment at or prior to the Effective Time of the following additional conditions: (a) Each of the Company and its Subsidiaries shall have performed in all material respects each of its obligations under this Agreement required to be performed by it on or prior to the Effective Time pursuant to the terms hereof. (b) All representations or warranties of the Company in this Agreement which are qualified with respect to a Company Material Adverse Effect or materiality shall be true and correct, and all such representations or warranties that are not so qualified shall be true and correct in all material respects, in each case as if such representation or warranty were made as of the Effective Time except to the extent that any such representation or warranty is made as of a specified date, in which case such representation or warranty shall have been true and correct as of such specified date. (c) Since the date of this Agreement, there shall not have been any material adverse change in the financial condition, results of operations, properties or business of the Company and its Subsidiaries, taken as a whole, excluding any such change caused by a general change in the economy or in the telecommunications industry served by the Company and its Subsidiaries and other than any such change approved by the Acquiror. (d) The Company shall have delivered a certificate of its President or Vice President to the effect set forth in paragraphs (a), (b) and (c) to this Section 7.3. (e) Newco shall have received letters of resignation addressed to the Company from those members of the Company's board of directors as listed on SCHEDULE 7.3(e), which resignations shall be effective as of the Effective Time. A-19 (f) The Acquiror shall have received from Parker Chapin Flattau & Klimpl, LLP, counsel to the Company, an opinion dated the Effective Time in the form reasonably agreed to by the parties hereto. (g) Holders of no more than 5% of the outstanding shares of Common Stock shall not have caused such shares to become Dissenting Stock. (h) Newco shall have received executed Affiliate Agreements from designated Company affiliates. (i) The Acquiror shall have received letters (i) from Arthur Andersen LLP approving the accounting treatment of the Merger as a "pooling of interests" and (ii) from Price Waterhouse LLP that the Company has taken no action in the past two years that would prevent the application of a "pooling of interests" accounting treatment to the Merger, and the SEC shall not have objected to such accounting treatment. 7.4 CLOSING CONDITIONS DEEMED SATISFIED. If the Meeting has been completed and has resulted in a vote sufficient to approve the Merger in accordance with applicable law, and if all other conditions precedent to the consummation of the Merger contained in this Article VII (other than the conditions set forth in Sections 7.1(c) and (d)) have been satisfied or have otherwise been waived as of the date of such Meeting, such conditions precedent to the consummation of the Merger (except as provided in the next succeeding sentence) shall terminate, and the parties to this Agreement agree to consummate the Merger as soon as practicable thereafter; provided, however, that in no event shall any party be required to consummate the Merger or any other transactions contemplated by this Agreement to the extent that such consummation would violate any applicable laws or regulations. In such event, the Acquiror, on the one hand, and the Company, on the other hand, shall cooperate to deliver, as soon as practicable after the satisfaction or waiver of such conditions precedent, the officer's certificates and opinions required of the Acquiror by Section 7.2(d) and 7.2(f), and required of the Company by Section 7.3(d) and 7.3(f), respectively, and, upon the Effective Time, the Acquiror shall deliver the certificate required of the Exchange Agent by Section 7.2(e) and the Company will deliver to Newco the letters of resignation required by Section 7.3(e). ARTICLE VIII TERMINATION, AMENDMENT AND WAIVER 8.1 TERMINATION. This Agreement may be terminated and the Merger contemplated herein may be abandoned at any time prior to the Effective Time and before approval by the stockholders of the Company: (a) by the mutual consent of Newco and the Company; (b) by Newco or the Company, if (i) the Board of Directors of the Company shall have failed to recommend, or withdrawn, modified or amended in any respect its approval or recommendation of the Merger and of the transactions contemplated hereby or the Board of Directors of the Company shall have resolved to do any of the foregoing or (ii) the stockholders shall have failed to vote in favor of this Agreement and the Merger and, in the case of the Company seeking termination pursuant to Section 8.1(b)(i), the Company having paid to Newco the Termination Fee, as defined below, in accordance with the terms of Section 8.2. (c) by Newco if (i) there has occurred a material adverse change in the financial condition, operations, or business of the Company and its Subsidiaries taken as a whole, or (ii) there is a breach of any of the representations and warranties of the Company which are qualified with respect to a Company Material Adverse Effect or materiality or if the Company shall have breached in any material respect any of such representations or warranties which are not so qualified, or if the Company fails to comply in any material respect with any of its covenants or agreements contained herein, which breaches or failures, as the case may be, are, in the aggregate, material in the context of the transactions contemplated by this Agreement; A-20 (d) by the Company (i) if there has occurred a material adverse change in the financial condition, operations, or business of the Acquiror or (ii) there is a breach of any of the representations and warranties of the Acquiror or Newco which are qualified with respect to an Acquiror Material Adverse Effect or materiality or if the Acquiror or Newco shall have breached in any material respect any of such representations or warranties which are not so qualified, or if the Acquiror or Newco fails to comply in any material respect with any of its covenants or agreements contained herein, which breaches or failures, as the case may be, are, in the aggregate, material in the context of the transactions contemplated by this Agreement; and (e) by either Newco or the Company, if on or before May 1, 1998 the Merger shall not have been consummated; provided that neither party may terminate under this Section 8.1(e) if such failure has been caused by that party's material breach of this Agreement; provided further that if any condition to this Agreement shall fail to be satisfied by reason of the existence of an injunction or order of any court or governmental or regulatory body resulting from an action or proceeding commenced by any party which is not a government or governmental authority, then at the request of either party the deadline date referred to above shall be extended for a reasonable period of time, not in excess of 120 days, to permit the parties to have such injunction vacated or order reversed. (f) by the Acquiror by the later to occur of December 3, 1997, or the date that is three business days after delivery by the Company of the final version of the Disclosure Schedules. (g) by the Company if it has not satisfied the condition set forth in Section 7.2 (f). In the event of such termination and abandonment, no party hereto (or any of its directors or officers) shall have any liability or further obligation to any other party to this Agreement except as provided in Section 8.2, and except that nothing herein will relieve any party from liability for any wilful breach of this Agreement prior to such termination or abandonment. 8.2 FEES AND EXPENSES. If this Agreement is terminated by Newco or the Company pursuant to Section 8.1(b)(i), (a) after receipt of a bona fide proposal to acquire (by means of a tender or exchange offer, merger, consolidation, business combination or otherwise) all or a substantial portion of the outstanding shares of Common Stock or of the assets of the Company and the Subsidiaries (all such transactions being referred to herein as "Third Party Transactions"), or (b) prior to the satisfaction of the condition set forth in Section 7.2(f), then the Company shall, simultaneously with such termination, pay to Newco by wire transfer of immediately available funds, $2,000,000.00 (the "Termination Fee"). 8.3 AMENDMENT. Subject to the applicable provisions of the General Corporation Law, this Agreement may be amended by the parties hereto solely by action taken by their respective Boards of Directors. This Agreement may not be amended except by an instrument in writing signed on behalf of each of the parties hereto. 8.4 WAIVER. At any time prior to the Effective Time, the parties hereto, by action taken by their respective Boards of Directors, may (i) extend the time for the performance of any of the obligations or other acts of the other parties hereto, (ii) waive any inaccuracies in the representations and warranties of the other party contained herein or in any documents delivered pursuant hereto, and (iii) waive compliance by the other party with any of the agreements or conditions herein. Any agreement on the part of a party hereto to any such extension or waiver shall be valid only if set forth in an instrument in writing signed on behalf of such party. A-21 ARTICLE IX MISCELLANEOUS 9.1 SURVIVAL. All representations, warranties and agreements contained in this Agreement or in any instrument delivered pursuant to this Agreement shall terminate and be extinguished at the Effective Time or the earlier date of termination of this Agreement pursuant to Section 8.1, as the case may be, except that the agreements set forth in Article I and in Sections 6.5, 6.6, 6.7, 6.9, 6.10 and 9.5 will survive the Effective Time indefinitely and those set forth in Sections 8.2 and 9.5 will survive the termination of this Agreement indefinitely, and other than any covenant the breach of which has resulted in the termination of this Agreement. 9.2 EXPENSES AND FEES. If the Merger is consummated, all reasonable fees and expenses incurred in connection with the Merger and the transactions contemplated thereby will be paid by the Surviving Corporation. If the Merger is not consummated, each party hereto shall, subject to the provision of Section 8.2 above, bear their respective fees and expenses. 9.3 NOTICES. All notices and other communications given or made pursuant hereto shall be in writing and shall be deemed to have been given or made if in writing and delivered personally or sent by registered or certified mail (postage prepaid, return receipt requested) or by telecopier to the parties at the following addresses and facsimile numbers: (a) if to Newco or the Acquiror to: STAR Telecommunications, Inc. 223 E. De La Guerra St. Santa Barbara, CA 93101 Attention: Chris Edgecomb Fax: (805) 884-1137 with copies to: Riordan & McKinzie 300 South Grand Avenue, Ste. 2900 Los Angeles, CA 90071 Attention: Timothy F. Sylvester, Esq. Fax: (213) 229-8550 (b) if to the Company, to: United Digital Network, Inc. 18872 MacArthur Blvd., Suite 300 Irvine, CA 92612 Attention: John R. Snedegar Fax: (714) 833-8679 with copies to: Parker Chapin Flattau & Klimpl, LLP 1211 Avenue of the Americas New York, NY 10036 Attention: Martin E. Weisberg, Esq. Fax: (212) 704-6288 or at such other addresses as shall be furnished by the parties by like notice, and such notice or communication shall be deemed to have been given or made as of the date so delivered or mailed or confirmation of transmission. A-22 9.4 HEADINGS. The headings contained in this Agreement are inserted for convenience only and do not constitute a part of this Agreement. 9.5 PUBLICITY. The parties hereto shall not, and shall cause their affiliates not to, issue or cause the publication of any press release or other announcement with respect to the Merger or this Agreement without consulting with all other parties and their respective counsel and without delivering a draft of any such press release to such parties. 9.6 ENTIRE AGREEMENT; KNOWLEDGE. This Agreement constitutes the entire agreement among the parties and supersedes all other prior agreements and understandings, both written and oral, among the parties, or any of them, with respect to the subject matter hereof. For purposes of this Agreement, "knowledge" of any party shall mean the knowledge of the executive officers of that party after such officers shall have made all reasonable inquiries. 9.7 ASSIGNMENT. This Agreement and all of the provisions hereof shall be binding upon and inure to the benefits of the parties hereto and their respective successors and permitted assigns. Neither this Agreement nor any of the rights, interests or obligations shall be assigned by any of the parties hereto without the prior written consent of the other parties, provided that Newco's rights and duties hereunder may be assigned to a wholly owned subsidiary of the Acquiror, which assumes all of Newco's duties and obligations. This Agreement is not intended to confer upon any other person any rights or remedies hereunder. 9.8 COUNTERPARTS. This Agreement may be executed in one or more counterparts, all of which shall be considered one and the same agreement and each of which shall be deemed an original. 9.9 INVALIDITY, ETC. In the event that any provision of this Agreement shall be deemed contrary to law or invalid or unenforceable in any respect by a court of competent jurisdiction, the remaining provisions shall remain in full force and effect to the extent that such provisions can still reasonably be given effect in accordance with the intentions of the parties, and the invalid and unenforceable provisions shall be deemed, without further action on the part of the parties, modified, amended and limited solely to the extent necessary to render the same valid and enforceable. 9.10 SPECIFIC PERFORMANCE. Each of the parties hereto acknowledges and agrees that the other parties hereto would be irreparably damaged in the event any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached. Accordingly, each of the parties hereto agrees that they each shall be entitled to an injunction or injunctions to prevent breaches of the provisions of this Agreement and to enforce specifically this Agreement and the terms and conditions hereof in any action instituted in any court of the United States or any state having competent jurisdiction, in addition to any other remedy to which such party may be entitled, at law or in equity. 9.11 GOVERNING LAW. The validity and interpretation of this Agreement shall be governed by the laws of the State of Delaware, without reference to the conflict of laws principles thereof. [THE REMAINDER OF THIS PAGE IS INTENTIONALLY LEFT BLANK] A-23 IN WITNESS WHEREOF, the Acquiror, Newco and the Company have caused this Agreement to be signed by their respective officers thereunto duly authorized, all as of the date first written above. ACQUIROR: STAR TELECOMMUNICATIONS, INC. By: /s/ CHRIS EDGECOMB ----------------------------------------- Chris Edgecomb CHIEF EXECUTIVE OFFICER
NEWCO: IIWII CORP. By: /s/ KELLY ENOS ----------------------------------------- Kelly Enos CHIEF FINANCIAL OFFICER
COMPANY: UNITED DIGITAL NETWORK, INC. By: /s/ JOHN R. SNEDEGAR ----------------------------------------- John R. Snedegar CHIEF EXECUTIVE OFFICER
A-24 FIRST AMENDMENT TO AGREEMENT AND PLAN OF MERGER FIRST AMENDMENT TO AGREEMENT AND PLAN OF MERGER dated as of January 30, 1998 (this "Amendment"), by and among STAR Telecommunications, Inc., a Delaware corporation (the "Acquiror"), IIWII Corp., a Delaware corporation and wholly-owned subsidiary of the Acquiror ("Newco"), and United Digital Network, Inc., a Delaware corporation (the "Company"). R E C I T A L S: A. The parties to this Amendment entered into that certain Agreement and Plan of Merger dated as of November 19, 1997 (the "Merger Agreement"), which set forth the terms and conditions pursuant to which the Merger would be consummated. B. The parties to this Amendment hereby wish to amend the Merger Agreement on the terms set forth below. C. Capitalized terms not otherwise defined herein shall have the meanings therefor in the Merger Agreement. A G R E E M E N T NOW, THEREFORE, in consideration of the mutual representations, warranties, covenants, agreements and conditions contained herein, and in order to set forth the terms and conditions of the Merger and the mode of carrying the same into effect, the parties hereby agree as follows: ARTICLE I THE MERGER 1. CONVERSION. Section 2.1(a) of the Agreement shall be deleted in its entirety and replaced with the following: (a) Each of the issued and outstanding shares of the Common Stock, $.01 par value, of the Company ("Common Stock"), other than (i) Dissenting Stock, as defined below, or (ii) shares of Common Stock held in the treasury of the Company, shall be automatically converted into the right to receive consideration per share (the "Merger Consideration") consisting of that portion of a share (the "Exchange Ratio") of the Acquiror's common stock, $0.001 per share ("Acquiror Common Stock"), determined by dividing US$2.05 by the average closing price of Acquiror's Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"). 2. SECOND LOAN TO COMPANY. Promptly following the execution of this Amendment, the Acquiror shall loan to the Company $2 million pursuant to the terms and conditions set forth in that certain promissory note attached hereto as Exhibit B-1. Following the receipt of such funds, the Company shall immediately apply at least $700,000 to balances due by the Company to the Acquiror. 3. WAIVER OF SECTION 8.1(F). STAR hereby waives Section 8.1(f) of the Merger Agreement. In that regard, the Acquiror acknowledges that, subject to Sections 6.2(k) and 7.3(b) of the Merger Agreement, it has completed its due diligence investigation of the Company. 4. NO FURTHER AMENDMENT. Except as otherwise set forth in this Amendment, the Merger Agreement shall remain in full force and effect without further amendment, modification or alteration. A-25 IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be signed by their respective officers thereunto duly authorized, all as of the date first written above. ACQUIROR: STAR TELECOMMUNICATIONS, INC. By: /s/ KELLY ENOS ----------------------------------------- Kelly Enos CHIEF EXECUTIVE OFFICER
NEWCO: IIWII CORP. By: /s/ KELLY ENOS ----------------------------------------- Kelly Enos CHIEF FINANCIAL OFFICER
COMPANY: UNITED DIGITAL NETWORK, INC. By: /s/ JOHN R. SNEDEGAR ----------------------------------------- John R. Snedegar CHIEF EXECUTIVE OFFICER
A-26 SECOND AMENDMENT TO AGREEMENT AND PLAN OF MERGER SECOND AMENDMENT TO AGREEMENT AND PLAN OF MERGER dated as of April 6, 1998 (this "Second Amendment"), by and among STAR Telecommunications, Inc., a Delaware corporation (the "Acquiror"), IIWII Corp., a Delaware corporation and wholly-owned subsidiary of the Acquiror ("Newco"), and United Digital Network, Inc., a Delaware corporation (the "Company"). R E C I T A L S: A. The parties to this Second Amendment entered into that certain Agreement and Plan of Merger dated as of November 19, 1997, as amended to date (the "Merger Agreement"), which set forth the terms and conditions pursuant to which the Merger would be consummated. B. The parties to this Second Amendment hereby wish to amend the Merger Agreement on the terms set forth below. C. Capitalized terms not otherwise defined herein shall have the meanings therefor in the Merger Agreement. A G R E E M E N T NOW, THEREFORE, in consideration of the mutual representations, warranties, covenants, agreements and conditions contained herein, and in order to set forth the terms and conditions of the Merger and the mode of carrying the same into effect, the parties hereby agree as follows: 1. CONVERSION. Section 2.1(a) of the Agreement shall be deleted in its entirety and replaced with the following: "(a) Each of the issued and outstanding shares of the Common Stock, $.01 par value, of the Company ("Common Stock"), other than (i) Dissenting Stock, as defined below, or (ii) shares of Common Stock held in the treasury of the Company, shall be automatically converted into the right to receive consideration per share (the "Merger Consideration") consisting of that portion of a share (the "Exchange Ratio") of the Acquiror's Common Stock, $0.001 par value per share ("Acquiror Common Stock"), determined by dividing US$2.05 by the average closing price of Acquiror's Common Stock on the Nasdaq National Market for the five (5) trading days prior to the Effective Time (the "Average Price"), provided that, if the Average Price is equal to or greater than $27.50, the Exchange Ratio shall be determined by using $27.50 as the Average Price." 2. COVENANTS AND AGREEMENTS. The following Section should be added to "Article VI Covenants and Agreements," as follows: "6.14 REGULATORY APPROVALS. (a) The Company agrees to utilize all reasonable efforts and to cooperate with Acquiror in every way as may be necessary, reasonable or advisable to consummate and make effective the transactions contemplated by this Agreement and will use all reasonable efforts to assist Acquiror in obtaining all Regulatory Approvals, waivers, permits, consents, other approvals, authorizations and clearances and to effect all registrations, filings and notices with or to third parties or governmental, regulatory or public bodies or authorities which are, in the reasonable opinion of Acquiror, necessary or desirable in connection with the transactions contemplated by this Agreement. Until such time as the Regulatory Approvals have been obtained, there shall be no change in the ownership or management of the Company and no transfer of control whatsoever over the Company's certificates of public convenience and necessity and daily operations. Pending receipt of the Regulatory Approvals, the Company, its current shareholders, officers, directors and employees shall remain directly and solely responsible for the operation of the Company's telecommunications services and for compliance with all applicable provisions of federal telecommunications law, state public service commission laws and all applicable A-27 regulations and policies thereunder. Further, pending receipt of the Regulatory Approvals, the Company, its current shareholders, officers, directors and employees shall manage and operate the Company's telecommunications services in a manner that is fully consistent with the terms and conditions of the Company's certificates of public convenience and necessity, the public interest and the best interest of the Company's shareholders. As used herein, "Regulatory Approvals" shall mean all necessary regulatory approvals from the FCC and from any and all state public service commissions required for the transfer of ownership or control over the Company. (b) Acquiror agrees to use its reasonable efforts to take, as promptly as possible, or cause to be taken, all action and do, or cause to be done, all things necessary, proper or advisable to consummate and make effective the transactions contemplated by this Agreement, and Acquiror specifically agrees to use all reasonable efforts to obtain all Regulatory Approvals, waivers, permits, consents, other approvals, authorizations and clearances and to effect all registrations, filings and notices with or to third parties or governmental, regulatory or public bodies or authorities which are, in the reasonable opinion of Acquiror, necessary or desirable in connection with the transactions contemplated by this Agreement. Until such time as the Regulatory Approvals have been obtained, there shall be no change in the ownership or management of the Company and no transfer of control whatsoever over the Company's certificates of public convenience and necessity and daily operations. Pending receipt of the Regulatory Approvals, the Company, its current shareholders, officers, directors and employees shall remain directly and solely responsible for the operation of the Company's telecommunications services and for compliance with all applicable provisions of federal telecommunications law, state public service commission laws and all applicable regulations and policies thereunder. Further, pending receipt of the Regulatory Approvals, the Company, its current shareholders, officers, directors and employees shall manage and operate the Company's telecommunications services in a manner that is fully consistent with the terms and conditions of the Company's certificates of public convenience and necessity, the public interest and the best interest of the Company's shareholders." 3. CONDITIONS PRECEDENT. (a) Section 7.1(e) of the Agreement is hereby amended by adding the following sentence: "The Regulatory Approvals, all licenses, permits, authorizations, consents and other approvals of and filing with any governmental or regulatory agency required to be obtained or made in connection with the consummation of the transactions contemplated by this Agreement shall have been duly obtained or made by or on behalf of Acquiror." (b) The introductory language of Section 7.2 shall be modified by adding the following clause after the word "conditions": "each of which may be waived by the Company, in its sole discretion:" (c) The introductory language of Section 7.3 shall be modified by adding the following clause after the word "conditions": "each of which may be waived by the Acquiror and Newco, in their sole discretion:" 4. TERMINATION, AMENDMENT AND WAIVER. Section 8.1(e) of the Agreement is hereby amended by deleting the date "May 1, 1998" in the first line and replacing such date with "July 15, 1998". 5. NO FURTHER AMENDMENT. Except as otherwise set forth in this Amendment, the Merger Agreement shall remain in full force and effect without further amendment, modification or alteration. A-28 IN WITNESS WHEREOF, the parties hereto have caused this Second Amendment to be signed by their respective officers thereunto duly authorized, all as of the date first written above. ACQUIROR: STAR TELECOMMUNICATIONS, INC. By: /s/ KELLY ENOS ----------------------------------------- Kelly Enos CHIEF EXECUTIVE OFFICER
NEWCO: IIWII CORP. By: /s/ KELLY ENOS ----------------------------------------- Kelly Enos CHIEF FINANCIAL OFFICER
COMPANY: UNITED DIGITAL NETWORK, INC. By: /s/ JOHN R. SNEDEGAR ----------------------------------------- John R. Snedegar CHIEF EXECUTIVE OFFICER
A-29 ANNEX B May 7, 1998 Board of Directors United Digital 18872 Macarthur Blvd. Suite 300 Irvine, CA 92612 Members of the Board: We understand that Star Telecommunications, Inc. ("Star"), United Digital Network, Inc. ("United Digital") and IIWII Corp. ("Merger Sub"), a wholly-owned subsidiary of Star, have entered into an Agreement and Plan of Merger, dated as of November 19, 1997 (the "Merger Agreement"), which provides, among other things, for the merger (the "Merger") of Merger Sub with and into United Digital. Pursuant to the Merger, United Digital will become a wholly-owned subsidiary of Star and each issued and outstanding share of common stock, par value $0.01 per share, of United Digital (the "United Digital Common Stock"), other than shares held in treasury or held by United Digital or any subsidiary of United Digital, shall be converted into the right to receive a fraction of a share of common stock, par value $0.001 per share, of Star (the "Star Common Stock"). This conversion is subject to terms and conditions which are more fully set forth in the Merger Agreement. Capitalized terms used herein without definition shall have the same meanings herein as are ascribed to those terms in the Merger Agreement. You have asked for our opinion as to whether the Exchange Ratio pursuant to the Merger Agreement is fair from a financial point of view to the holders of shares of United Digital Common Stock. For purposes of the opinion set forth herein, we have: (i) reviewed certain publicly available financial statements and other information of Star and United Digital, respectively; (ii) reviewed certain internal financial statements and other financial and operating data concerning United Digital and Star prepared by the management of United Digital and Star, respectively; (iii) discussed the past and current operations and financial condition and the prospects of Star, including information relating to certain strategic, financial and operational benefits anticipated from the Merger, with senior executives of Star; (iv) discussed the past and current operations and financial condition and the prospects of United Digital, including information relating to certain strategic, financial and operational benefits anticipated from the Merger, with senior executives of United Digital; (v) reviewed the pro forma impact of the Merger on the earnings per share and consolidated capitalization of Star and United Digital, respectively; (vi) reviewed the reported prices and trading activity for the Star Common Stock; (vii) compared the financial performance of United Digital and Star and the prices and trading activity of the United Digital Common Stock and the Star Common Stock with that of certain other publicly-traded companies and their securities; (viii) reviewed the financial terms, to the extent publicly available, of certain comparable acquisition transactions; (ix) reviewed and discussed with the senior managements of United Digital and Star the strategic rationale for the Merger and certain alternatives to the Merger; B-1 (x) reviewed the Merger Agreement and the agreements to be entered in connection therein; and (xi) considered such other factors as we have deemed appropriate. We have assumed and relied upon, without independent verification, the accuracy and completeness of the information furnished to us by United Digital, Star and other publicly available sources and reviewed by us for the purposes of this opinion. With respect to the internal financial statements and other financial and operating data including estimates of the strategic, financial and operational benefits anticipated from the Merger provided by United Digital and Star, we have assumed that they have been reasonably prepared on a basis reflecting the best currently available estimates and judgments of the prospects of Star and United Digital, respectively. We have relied upon the assessment by the managements of Star and United Digital of their ability to retain key employees of both Star and United Digital. We have also relied upon, without independent verification, the assessment by managements of United Digital and Star of the strategic and other benefits expected to result from the Merger. We have also relied upon, without independent verification, the assessment by mangements of United Digital and Star of the timing and risks associated with the integration of United Digital with Star. We have not made any independent valuation or appraisal of the assets, liabilities or technology of Star or United Digital, respectively, nor have we been furnished with any such appraisals. We have assumed that the Merger will be accounted for as a "pooling-of-interests" business combination in accordance with U.S. Generally Accepted Accounting Principles and the Merger will be treated as a tax-free reorganization and/or exchange pursuant to the Internal Revenue Code of 1986 and will be consummated in accordance with the terms set forth in the Merger Agreement. Our opinion is necessarily based on economic, market and other conditions as in effect on, and the information made available to us as of, the date hereof. In arriving at our opinion, we were not authorized to solicit, and did not solicit, interest from any third party with respect to an acquisition, business combination or other extraordinary transaction involving United Digital, nor did we discuss the acquisition with any parties other than Star. We have acted as financial advisor to the Board of Directors of United Digital in connection with this transaction and will receive a fee for our services. In the past, Madison Securities, Inc. has provided financial advisory and financing services for United Digital and have received fees for the rendering of these services. In addition, in the ordinary course of our business we may actively trade the securities of Star for our own account and for the accounts of our customers and, accordingly, may at any time hold a long or short position in such securities. It is understood that this letter is for the information of the Board of Directors of United Digital and may not be used for any other purpose without our prior written consent, except that this opinion may be included in its entirety in any filing made by Star and/or United Digital with the Securities and Exchange Commission with respect to the transactions contemplated by the Merger Agreement. In addition, this opinion does not in any manner address the prices at which the Star Common Stock will actually trade at any time and we express no recommendation or opinion as to how the holders of United Digital Common Stock should vote at the shareholders' meeting held in connection with the Merger. Based upon and subject to the foregoing, we are of the opinion on the date hereof that the Exchange Ratio pursuant to the Merger Agreement is fair from a financial point of view to the holders of shares of United Digital Common Stock. Very truly yours, /s/Madison Securities, Inc. ---------------------------------------------------------------------- MADISON SECURITIES, INC. B-2 ANNEX C SECTION 262 OF THE GENERAL CORPORATION LAW OF THE STATE OF DELAWARE Section 262 APPRAISAL RIGHTS. (a) Any stockholder of a corporation of this State who holds shares of stock on the date of the making of a demand pursuant to subsection (d) of this section with respect to such shares, who continuously holds such shares through the effective date of the merger or consolidation, who has otherwise complied with subsection (d) of this section and who has neither voted in favor of the merger or consolidation nor consented thereto in writing pursuant to Section 228 of this title shall be entitled to an appraisal by the Court of Chancery of the fair value of his shares of stock under the circumstances described in subsections (b) and (c) of this section. As used in this section, the word "stockholder" means a holder of record of stock in a stock corporation and also a member of record of a nonstock corporation; the words "stock" and "share" mean and include what is ordinarily meant by those words and also membership or membership interest of a member of a nonstock corporation; and the words "depository receipt" mean a receipt or other instrument issued by a depository representing an interest in one or more shares, or fractions thereof, solely of stock of a corporation, which stock is deposited with the depository. (b) Appraisal rights shall be available for the shares of any class or series of stock of a constituent corporation in a merger or consolidation to be effected pursuant to Section Section 251, 252, 254, 257, 258, 263 or 264 of this title: (1) Provided, however, that no appraisal rights under this section shall be available for the shares of any class or series of stock, which stock, or depository receipts in respect thereof at the record date fixed to determine the stockholders entitled to receive notice of and to vote at the meeting of stockholders to act upon the agreement of merger or consolidation, were either (i) listed on a national securities exchange or designated as a national market system security on an interdealer quotation system by the National Association of Securities Dealers, Inc. or (ii) held of record by more than 2,000 holders; and further provided that no appraisal rights shall be available for any shares of stock of the constituent corporation surviving a merger if the merger did not require for its approval the vote of the stockholders of the surviving corporation as provided in subsection (f) of Section 251 of this title. (2) Notwithstanding paragraph (1) of this subsection, appraisal rights under this section shall be available for the shares of any class or series of stock of a constituent corporation if the holders thereof are required by the terms of an agreement of merger or consolidation pursuant to Section Section 251, 252, 254, 257, 258, 263 and 264 of this title to accept for such stock anything except: a. Shares of stock of the corporation surviving or resulting from such merger or consolidation, or depository receipts in respect thereof; b. Shares of stock of any other corporation, or depository receipts in respect thereof, which shares of stock or depository receipts at the effective date of the merger or consolidation will be either listed on a national securities exchange or designated as a national market system security on an interdealer quotation system by the National Association of Securities Dealers, Inc. or held of record by more than 2,000 holders; c. Cash in lieu of fractional shares or fractional depository receipts described in the foregoing subparagraphs a. and b. of this paragraph; or d. Any combination of the shares of stock and cash in lieu of fractional shares or fractional depository receipts described in the foregoing subparagraphs a., b. and c. of this paragraph. C-1 (3) In the event all of the stock of a subsidiary Delaware corporation party to a merger effected under Section 253 of this title is not owned by the parent corporation immediately prior to the merger, appraisal rights shall be available for the shares of the subsidiary Delaware corporation. (c) Any corporation may provide in its certificate of incorporation that appraisal rights under this section shall be available for the shares of any class or series of its stock as a result of an amendment to its certificate of incorporation, any merger or consolidation in which the corporation is a constituent corporation or the sale of all or substantially all of the assets of the corporation. If the certificate of incorporation contains such a provision, the procedures of this section, including those set forth in subsections (d) and (e) of this section, shall apply as nearly as is practicable. (d) Appraisal rights shall be perfected as follows: (1) If a proposed merger or consolidation for which appraisal rights are provided under this section is to be submitted for approval at a meeting of stockholders, the corporation, not less than 20 days prior to the meeting, shall notify each of its stockholders who was such on the record date for such meeting with respect to shares for which appraisal rights are available pursuant to subsections (b) or (c) hereof that appraisal rights are available for any or all of the shares of the constituent corporations, and shall include in such notice a copy of this section. Each stockholder electing to demand the appraisal of his shares shall deliver to the corporation, before the taking of the vote on the merger or consolidation, a written demand for appraisal of his shares. Such demand will be sufficient if it reasonably informs the corporation of the identity of the stockholder and that the stockholder intends thereby to demand the appraisal of his shares. A proxy or vote against the merger or consolidation shall not constitute such a demand. A stockholder electing to take such action must do so by a separate written demand as herein provided. Within 10 days after the effective date of such merger or consolidation, the surviving or resulting corporation shall notify each stockholder of each constituent corporation who has complied with this subsection and has not voted in favor of or consented to the merger or consolidation of the date that the merger or consolidation has become effective; or (2) If the merger or consolidation was approved pursuant to Section Section 228 or 253 of this title, the surviving or resulting corporation, either before the effective date of the merger or consolidation or within 10 days thereafter, shall notify each of the stockholders entitled to appraisal rights of the effective date of the merger or consolidation and that appraisal rights are available for any or all of the shares of the constituent corporation, and shall include in such notice a copy of this section. The notice shall be sent by certified or registered mail, return receipt requested, addressed to the stockholder at his address as it appears on the records of the corporation. Any stockholder entitled to appraisal rights may, within 20 days after the date of mailing of the notice, demand in writing from the surviving or resulting corporation the appraisal of his shares. Such demand will be sufficient if it reasonably informs the corporation of the identity of the stockholder and that the stockholder intends thereby to demand the appraisal of his shares. (e) Within 120 days after the effective date of the merger or consolidation, the surviving or resulting corporation or any stockholder who has complied with subsections (a) and (d) hereof and who is otherwise entitled to appraisal rights, may file a petition in the Court of Chancery demanding a determination of the value of the stock of all such stockholders. Notwithstanding the foregoing, at any time within 60 days after the effective date of the merger or consolidation, any stockholder shall have the right to withdraw his demand for appraisal and to accept the terms offered upon the merger or consolidation. Within 120 days after the effective date of the merger or consolidation, any stockholder who has complied with the requirements of subsections (a) and (d) hereof, upon written request, shall be entitled to receive from the corporation surviving the merger or resulting from the consolidation a statement setting forth the aggregate number of shares not voted in favor of the merger or consolidation and with respect to which demands for appraisal have been received and the aggregate number of holders of such shares. Such C-2 written statement shall be mailed to the stockholder within 10 days after his written request for such a statement is received by the surviving or resulting corporation or within 10 days after expiration of the period for delivery of demands for appraisal under subsection (d) hereof, whichever is later. (f) Upon the filing of any such petition by a stockholder, service of a copy thereof shall be made upon the surviving or resulting corporation, which shall within 20 days after such service file in the office of the Register in Chancery in which the petition was filed a duly verified list containing the names and addresses of all stockholders who have demanded payment for their shares and with whom agreements as to the value of their shares have not been reached by the surviving or resulting corporation. If the petition shall be filed by the surviving or resulting corporation, the petition shall be accompanied by such a duly verified list. The Register in Chancery, if so ordered by the Court, shall give notice of the time and place fixed for the hearing of such petition by registered or certified mail to the surviving or resulting corporation and to the stockholders shown on the list at the addresses therein stated. Such notice shall also be given by one or more publications at least one week before the day of the hearing, in a newspaper of general circulation published in the City of Wilmington, Delaware or such publication as the Court deems advisable. The forms of the notices by mail and by publication shall be approved by the Court, and the costs thereof shall be borne by the surviving or resulting corporation. (g) At the hearing on such petition, the Court shall determine the stockholders who have complied with this section and who have become entitled to appraisal rights. The Court may require the stockholders who have demanded an appraisal for their shares and who hold stock represented by certificates to submit their certificates of stock to the Register in Chancery for notation thereon of the pendency of the appraisal proceedings; and if any stockholder fails to comply with such direction, the Court may dismiss the proceedings as to such stockholder. (h) After determining the stockholders entitled to an appraisal, the Court shall appraise the shares, determining their fair value exclusive of any element of value arising from the accomplishment or expectation of the merger or consolidation, together with a fair rate of interest, if any, to be paid upon the amount determined to be the fair value. In determining such fair value, the Court shall take into account all relevant factors. In determining the fair rate of interest, the Court may consider all relevant factors, including the rate of interest which the surviving or resulting corporation would have had to pay to borrow money during the pendency of the proceeding. Upon application by the surviving or resulting corporation or by any stockholder entitled to participate in the appraisal proceeding, the Court may, in its discretion, permit discovery or other pretrial proceedings and may proceed to trial upon the appraisal prior to the final determination of the stockholder entitled to an appraisal. Any stockholder whose name appears on the list filed by the surviving or resulting corporation pursuant to subsection (f) of this section and who has submitted his certificates of stock to the Register in Chancery, if such is required, may participate fully in all proceedings until it is finally determined that he is not entitled to appraisal rights under this section. (i) The Court shall direct the payment of the fair value of the shares, together with interest, if any, by the surviving or resulting corporation to the stockholders entitled thereto. Interest may be simple or compound, as the Court may direct. Payment shall be so made to each such stockholder, in the case of holders of uncertificated stock forthwith, and the case of holders of shares represented by certificates upon the surrender to the corporation of the certificates representing such stock. The Court's decree may be enforced as other decrees in the Court of Chancery may be enforced, whether such surviving or resulting corporation be a corporation of this State or of any state. (j) The costs of the proceeding may be determined by the Court and taxed upon the parties as the Court deems equitable in the circumstances. Upon application of a stockholder, the Court may order all or a portion of the expenses incurred by any stockholder in connection with the appraisal proceeding, including, without limitation, reasonable attorney's fees and the fees and expenses of experts, to be charged pro rata against the value of all the shares entitled to an appraisal. C-3 (k) From and after the effective date of the merger or consolidation, no stockholder who has demanded his appraisal rights as provided in subsection (d) of this section shall be entitled to vote such stock for any purpose or to receive payment of dividends or other distributions on the stock (except dividends or other distributions payable to stockholders of record at a date which is prior to the effective date of the merger or consolidation); provided, however, that if no petition for an appraisal shall be filed within the time provided in subsection (e) of this section, or if such stockholder shall deliver to the surviving or resulting corporation a written withdrawal of his demand for an appraisal and an acceptance of the merger or consolidation, either within 60 days after the effective date of the merger or consolidation as provided in subsection (e) of this section or thereafter with the written approval of the corporation, then the right of such stockholder to an appraisal shall cease. Notwithstanding the foregoing, no appraisal proceeding in the Court of Chancery shall be dismissed as to any stockholder without the approval of the Court, and such approval may be conditioned upon such terms as the Court deems just. (l) The shares of the surviving or resulting corporation to which the shares of such objecting stockholders would have been converted had they assented to the merger or consolidation shall have the status of authorized and unissued shares of the surviving or resulting corporation. C-4 PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 20. INDEMNIFICATION OF DIRECTORS AND OFFICERS Section 145 of the Delaware General Corporation Law authorizes a court to award or a corporation's Board of Directors to grant indemnification to directors and officers in terms sufficiently broad to permit such indemnification under certain circumstances for liabilities (including reimbursement for expenses incurred) arising under the Securities Act of 1933, as amended (the "Securities Act"). Article VII, Section 6, of the Registrant's Bylaws provides for mandatory indemnification of its directors and officers and permissible indemnification of employees and other agents to the maximum extent permitted by the Delaware General Corporation Law. The Registrant's Amended and Restated Certificate of Incorporation provides that, pursuant to Delaware law, its directors shall not be liable for monetary damages for breach of the directors' fiduciary duty as directors to the Company and its stockholders. This provision in the Amended and Restated Certificate of Incorporation does not eliminate the directors' fiduciary duty, and in appropriate circumstances equitable remedies such as injunctive or other forms of non-monetary relief will remain available under Delaware law. In addition, each director will continue to be subject to liability for breach of the director's duty of loyalty to the Company for acts or omissions not in good faith or involving intentional misconduct, for knowing violations of law, for actions leading to improper personal benefit to the director, and for payment of dividends or approval of stock repurchases or redemptions that are unlawful under Delaware law. The provision also does not affect a director's responsibilities under any other law, such as the federal securities laws or state or federal environmental laws. The Registrant has entered or will enter into Indemnification Agreements with its officers and directors that provide the Registrant's officers and directors with further indemnification to the maximum extent permitted by the Delaware General Corporation Law. ITEM 21. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (A) EXHIBITS. The following Exhibits are attached hereto and incorporated herein by reference.
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------- ----------------------------------------------------------------------------------------------------- 2.1* Amended and Restated Stock Acquisition Agreement and Plan of Merger dated as of November 30, 1997 by and among the Registrant, Big Dave's Acquisition Corp., LCCR, Inc., and the shareholders listed on the signature page thereto. 2.2 Agreement and Plan of Merger dated as of November 19, 1997 by and among the Registrant, IIWII Corp. and United Digital Network, Inc. (the "UDN Merger Agreement"), as amended (incorporated by reference from ANNEX A to the Proxy Statement/Prospectus constituting Part I of this Registration Statement). 2.3** Stock Purchase Agreement dated as of January 26, 1998 by and among the Registrant, T-One Corp. and Taha Mikati, as amended. 3.1** Amended and Restated Certificate of Incorporation of the Registrant. 3.2** Bylaws of the Registrant. 4.1+++ Specimen Common Stock certificate. 4.2+ Registration Rights Agreement, dated September 24, 1996, between the Registrant and the investors named therein. 4.3+ Registration Rights Agreement, dated July 12, 1996, between the Registrant and the investor named therein. 4.4+ Investor Rights Agreement dated July 25, 1996, between the Registrant and the investors named therein.
II-1
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------- ----------------------------------------------------------------------------------------------------- 4.5* Registration Rights Agreement dated as of November 30, 1997 by and among the Company and the shareholders listed on the signature page thereto. 4.6** Registration Rights Agreement dated as of March 10, 1998 between the Registrant and Taha Mikati. 5.1 Opinion of Riordan & McKinzie, a Professional Law Corporation. 10.1+ Form of Indemnification Agreement. 10.2+ 1996 Amended and Restated Stock Incentive Plan. 10.3+ 1996 Outside Director Nonstatutory Stock Option Plan. 10.4++ 1997 Omnibus Stock Incentive Plan. 10.5+ Employment Agreement between the Registrant and Mary Casey dated July 14, 1995, as amended. 10.6+ Employment Agreement between the Registrant and Kelly Enos dated December 2, 1996. 10.7+ Employment Agreement between the Registrant and David Vaun Crumly dated January 1, 1996. 10.8+ Employment Agreement between the Registrant and James Kolsrud dated December 18, 1996. 10.9+ Consulting Agreement between the Registrant and Gordon Hutchins, Jr. dated May 1, 1996. 10.10+ Nonstatutory Stock Option Agreement between the Registrant and Gordon Hutchins, Jr. dated May 15, 1996. 10.11+ Free Standing Commercial Building Lease between the Registrant and Thomas M. Spear, as receiver for De La Guerra Court Investments, dated for reference purposes as of March 1, 1996. 10.12+ Standard Office Lease--Gross between the Registrant and De La Guerra Partners, L.P. dated for reference purposes as of July 9, 1996. 10.13+ Office Lease between the Registrant and WHUB Real Estate Limited Partnership dated June 28, 1996, as amended. 10.14+ Standard Form of Office Lease between the Registrant and Hudson Telegraph Associates dated February 28, 1996. 10.15+ Agreement for Lease between the Registrant and Telehouse International Corporation of Europe Limited dated July 16, 1996. 10.16+ Sublease between the Registrant and Borton, Petrini & Conron dated March 20, 1994, as amended. 10.17+ Office Lease between the Registrant and One Wilshire Arcade Imperial, Ltd. dated June 28, 1996. 10.18+ Lease Agreement between the Registrant and Telecommunications Finance Group dated April 6, 1995. 10.19+ Lease Agreement between the Registrant and Telecommunications Finance Group dated January 3, 1996, as amended. 10.20++ Master Lease Agreement between the Registrant and NTFC Capital Corporation dated December 20, 1996. 10.21+ Variable Rate Installment Note between the Registrant and Metrobank dated October 4, 1996. 10.22+ Assignment of Purchase Order and Security Interest between the Registrant and DSC Finance Corporation dated January 1, 1996. 10.23++ Line of Credit Promissory Note between the Registrant and Christopher E. Edgecomb dated November 7, 1996, as amended. 10.24++ Office Lease Agreement between the Registrant and Beverly Hills Center LLC effective as of April 1, 1997.
II-2
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------- ----------------------------------------------------------------------------------------------------- 10.25** Credit Agreement dated as of September 30, 1997 among the Registrant, the financial institutions party thereto and Sanwa Bank California, as amended. 10.26** Office Lease between the Registrant, Hudson Telegraph Associates and American Communications Corp., as amended. 10.27** Amendment Number Three to Employment Agreement between the Registrant and Mary A. Casey dated as of July 1, 1997. 10.28** Amendment Number One to Employment Agreement between the Registrant and Kelly D. Enos dated as of November 12, 1997. 10.29** Amendment Number One to First Restatement of Employment Agreement between the Registrant and James Kolsrud dated as of June 16, 1997. 10.30** Amendment Number One to Employment Agreement between the Registrant and David Vaun Crumly dated as of November 11, 1997. 10.31** First Amendment to Amended and Restated 1996 Stock Incentive Plan. 10.32*** Agreement dated as of December 1, 1997 between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.33** Leasing Agreement between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.34** Guarantee Agreement between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.35** Note and Security Agreement dated as of December 18, 1997 between the Registrant and NationsBanc Leasing Corporation. 10.36** Amendment of Lease dated as of September 30, 1997 between the Registrant and Hudson Telegraph (reference is hereby made to Exhibit 10.14). 10.37 Intentionally omitted. 10.38** Lease Agreement dated July 29, 1996 between the Registrant and Telecommunications Finance Group. 10.39** Promissory Note issued by Christopher E. Edgecomb in favor of the Registrant dated November 26, 1997. 10.40** Stock Pledge Agreement dated November 26, 1997 between the Registrant and Christopher E. Edgecomb. 10.41** Commercial Lease dated October 31, 1997 between the Registrant and Prinzenpark GbR. 10.42** Commercial Lease dated October 9, 1997 between the Registrant and WSL Weststadt Liegenschafts GmbH. 10.43** Office Lease between the Registrant and Airport-Center KGHP Gewerbeban GmbH & Cie. 10.44** Lease dated November 19, 1997 between the Registrant and DIFA Deutsche Immobilien Fonds Aktiengesellschaft. 21.1*** Subsidiaries of the Registrant. 23.1 Consent of Arthur Andersen LLP, Independent Public Accountants. 23.2 Consent of Riordan & McKinzie (contained in Exhibit 5.1). 23.3 Consent of Madison Securities, Inc. 23.4 Consent of Price Waterhouse LLP, Independent Public Accountants. 23.5 Consent of Weaver and Tidwell, Independent Public Accountants.
II-3
EXHIBIT NUMBER DESCRIPTION OF DOCUMENT - ----------- ----------------------------------------------------------------------------------------------------- 24.1** Power of Attorney. 27.1** Financial Data Schedule. 99.1 Form of UDN Proxy. 99.2 Opinion of Madison Securities, Inc. (incorporated by reference from ANNEX B to the Proxy Statement/Prospectus constituting Part I of this Registration Statement).
- ------------------------ + Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on February 7, 1997 and incorporated by reference herein. ++ Filed as an exhibit to Amendment No. 1 to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on May 16, 1997 and incorporated by reference herein. +++ Filed as an exhibit to Amendment No. 2 to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on May 29, 1997 and incorporated by reference herein. * Filed on December 15, 1997 as an exhibit to the Company's Current Report on Form 8-K (File No. 000-22581) and incorporated by reference herein. ** Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-48559) on March 24, 1998 and incorporated by reference herein. ***Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 000-22581) on March 31, 1998 and incorporated by reference herein. (B) FINANCIAL STATEMENT SCHEDULES Not Applicable ITEM 22. UNDERTAKINGS The undersigned registrant hereby undertakes: (1) That prior to any public reoffering of the securities registered hereunder through use of a prospectus which is a part of this registration statement, by any person or party who is deemed to be an underwriter within the meaning of Rule 145(c), the issuer undertakes that such reoffering prospectus will contain the information called for by the applicable registration form with respect to reofferings by persons who may be deemed underwriters, in addition to the information called for by the other Items of the applicable form. (2) That every prospectus (i) that is filed pursuant to paragraph (2) immediately preceding, or (ii) that purports to meet the requirements of section 10(a)(3) of the Securities Act and is used in connection with an offering of securities subject to Rule 415, will be filed as a part of an amendment to the registration statement and will not be used until such amendment is effective, and that, for purposes of determining any liability under the Securities Act, each such post-effective amendment shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (3) To respond to requests for information that is incorporated by reference into the prospectus pursuant to Items 4, 10(b), 11, or 13 of this Form, within one business day of receipt of such request, and to send the incorporated documents by first class mail or other equally prompt means. This includes information contained in documents filed subsequent to the effective date of the registration statement through the date of responding to the request. (4) To supply by means of post-effective amendment all information concerning a transaction, and the company being acquired involved therein, that was not the subject of and included in the registration statement when it became effective. II-4 (5) Insofar as indemnification for liabilities arising under the Securities Act may be permitted to directors, officers and controlling persons of the registrant pursuant to the foregoing provisions, or otherwise, the registrant has been advised that in the opinion of the Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue. (6) To file, during any period in which offers or sales are being made, a post-effective amendment to this registration statement: (i) To include any prospectus required by section 10(a)(3) of the Securities Act. (ii) To reflect in the prospectus any facts or events arising after the effective date of the registration statement (or the most recent post-effective amendment thereof) which, individually or in the aggregate, represent a fundamental change in the information set forth in the registration statement. Notwithstanding the foregoing, any increase or decrease in volume of securities offered (if the total dollar value of securities offered would not exceed that which was registered) and any deviation from the low or high end of the estimated maximum offering range may be reflected in the form of prospectus filed with the Commission pursuant to Rule 424(b) if, in the aggregate, the changes in volume and price represent no more than a 20% change in the maximum aggregate offering price set forth in the "Calculation of Registration Fee" table in the effective registration statement. (iii) To include any material information with respect to the plan of distribution not previously disclosed in the registration statement or any material change to such information in the registration statement. (7) That, for the purpose of determining any liability under the Securities Act, each such post-effective amendment that contains a form of prospectus shall be deemed to be a new registration statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. (8) To remove from registration by means of a post-effective amendment any of the securities being registered which remain unsold at the termination of the offering. II-5 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant has duly caused this Amendment No. 1 to the Registration Statement on Form S-4 to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of Santa Barbara, State of California, on this 28th day of May, 1998. STAR TELECOMMUNICATIONS, INC. By: /s/ CHRISTOPHER E. EDGECOMB ----------------------------------------- Christopher E. Edgecomb Chief Executive Officer
KNOW MEN BY ALL THESE PRESENTS, that each person whose signature appears below constitutes and appoints Christopher E. Edgecomb, Mary A. Casey and Kelly D. Enos, and each of them, his true and lawful attorneys-in-fact and agents, each with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments, including post-effective amendments, to this Registration Statement, and any registration statement relating to the offering covered by this Registration Statement and filed pursuant to Rule 462(b) under the Securities Act of 1933, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that each of said attorneys-in-fact and agents or their substitute or substitutes may lawfully do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Act of 1933, this Amendment No. 1 to the Registration Statement has been signed below by the following persons in the capacities and on the dates indicated. /s/ CHRISTOPHER E. EDGECOMB Chief Executive Officer - ------------------------------ and Director (Principal May 28, 1998 Christopher E. Edgecomb Executive Officer) * - ------------------------------ President and Director May 28, 1998 Mary A. Casey * Chief Financial Officer - ------------------------------ (Principal Financial and May 28, 1998 Kelly D. Enos Accounting Officer) * - ------------------------------ Director May 28, 1998 Gordon Hutchins, Jr. * - ------------------------------ Director May 28, 1998 John R. Snedegar II-6 * - ------------------------------ Director May 28, 1998 Mark Gershien * - ------------------------------ Director May 28, 1998 Arunas Chesonis *By: /s/ CHRISTOPHER E. EDGECOMB ------------------------- Christopher E. Edgecomb ATTORNEY-IN-FACT II-7 EXHIBIT INDEX
EXHIBIT SEQUENTIALLY NUMBER DESCRIPTION OF DOCUMENT NUMBERED PAGE - ----------- ---------------------------------------------------------------------------------------- ----------------- 2.1* Amended and Restated Stock Acquisition Agreement and Plan of Merger dated as of November 30, 1997 by and among the Registrant, Big Dave's Acquisition Corp., LCCR, Inc., and the shareholders listed on the signature page thereto. 2.2 Agreement and Plan of Merger dated as of November 19, 1997 by and among the Registrant, IIWII Corp. and United Digital Network, Inc. (the "UDN Merger Agreement"), as amended (incorporated by reference from ANNEX A to the Proxy Statement/Prospectus constituting Part I of this Registration Statement). 2.3** Stock Purchase Agreement dated as of January 26, 1998 by and among the Registrant, T-One Corp. and Taha Mikati, as amended. 3.1** Amended and Restated Certificate of Incorporation of the Registrant. 3.2** Bylaws of the Registrant. 4.1+++ Specimen Common Stock certificate. 4.2+ Registration Rights Agreement, dated September 24, 1996, between the Registrant and the investors named therein. 4.3+ Registration Rights Agreement, dated July 12, 1996, between the Registrant and the investor named therein. 4.4+ Investor Rights Agreement dated July 25, 1996, between the Registrant and the investors named therein. 4.5* Registration Rights Agreement dated as of November 30, 1997 by and among the Company and the shareholders listed on the signature page thereto. 4.6** Registration Rights Agreement dated as of March 10, 1998 between the Registrant and Taha Mikati. 5.1 Opinion of Riordan & McKinzie, a Professional Law Corporation. 10.l+ Form of Indemnification Agreement. 10.2+ 1996 Amended and Restated Stock Incentive Plan. 10.3+ 1996 Outside Director Nonstatutory Stock Option Plan. 10.4++ 1997 Omnibus Stock Incentive Plan. 10.5+ Employment Agreement between the Registrant and Mary Casey dated July 14, 1995, as amended. 10.6+ Employment Agreement between the Registrant and Kelly Enos dated December 2, 1996. 10.7+ Employment Agreement between the Registrant and David Vaun Crumly dated January 1, 1996. 10.8+ Employment Agreement between the Registrant and James Kolsrud dated December 18, 1996. 10.9+ Consulting Agreement between the Registrant and Gordon Hutchins, Jr. dated May 1, 1996. 10.10+ Nonstatutory Stock Option Agreement between the Registrant and Gordon Hutchins, Jr. dated May 15, 1996. 10.11+ Free Standing Commercial Building Lease between the Registrant and Thomas M. Spear, as receiver for De La Guerra Court Investments, dated for reference purposes as of March 1, 1996. 10.12+ Standard Office Lease--Gross between the Registrant and De La Guerra Partners, L.P. dated for reference purposes as of July 9, 1996.
EXHIBIT SEQUENTIALLY NUMBER DESCRIPTION OF DOCUMENT NUMBERED PAGE - ----------- ---------------------------------------------------------------------------------------- ----------------- 10.13+ Office Lease between the Registrant and WHUB Real Estate Limited Partnership dated June 28, 1996, as amended. 10.14+ Standard Form of Office Lease between the Registrant and Hudson Telegraph Associates dated February 28, 1996. 10.15+ Agreement for Lease between the Registrant and Telehouse International Corporation of Europe Limited dated July 16, 1996. 10.16+ Sublease between the Registrant and Borton, Petrini & Conron dated March 20, 1994, as amended. 10.17+ Office Lease between the Registrant and One Wilshire Arcade Imperial, Ltd. dated June 28, 1996. 10.18+ Lease Agreement between the Registrant and Telecommunications Finance Group dated April 6, 1995. 10.19+ Lease Agreement between the Registrant and Telecommunications Finance Group dated January 3, 1996, as amended. 10.20++ Master Lease Agreement between the Registrant and NTFC Capital Corporation dated December 20, 1996. 10.21+ Variable Rate Installment Note between the Registrant and Metrobank dated October 4, 1996. 10.22+ Assignment of Purchase Order and Security Interest between the Registrant and DSC Finance Corporation dated January 1, 1996. 10.23++ Line of Credit Promissory Note between the Registrant and Christopher E. Edgecomb dated November 7, 1996, as amended. 10.24++ Office Lease Agreement between the Registrant and Beverly Hills Center LLC effective as of April 1, 1997. 10.25** Credit Agreement dated as of September 30, 1997 among the Registrant, the financial institutions party thereto and Sanwa Bank California, as amended. 10.26** Office Lease between the Registrant, Hudson Telegraph Associates and American Communications Corp., as amended. 10.27** Amendment Number Three to Employment Agreement between the Registrant and Mary A. Casey dated as of July 1, 1997. 10.28** Amendment Number One to Employment Agreement between the Registrant and Kelly D. Enos dated as of November 12, 1997. 10.29** Amendment Number One to First Restatement of Employment Agreement between the Registrant and James Kolsrud dated as of June 16, 1997. 10.30** Amendment Number One to Employment Agreement between the Registrant and David Vaun Crumly dated as of November 11, 1997. 10.31** First Amendment to Amended and Restated 1996 Stock Incentive Plan. 10.32*** Agreement dated as of December 1, 1997 between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.33** Leasing Agreement between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.34** Guarantee Agreement between the Registrant and Nortel Dasa Network Systems GmbH & Co. KG. 10.35** Note and Security Agreement dated as of December 18, 1997 between the Registrant and NationsBanc Leasing Corporation.
EXHIBIT SEQUENTIALLY NUMBER DESCRIPTION OF DOCUMENT NUMBERED PAGE - ----------- ---------------------------------------------------------------------------------------- ----------------- 10.36** Amendment of Lease dated as of September 30, 1997 between the Registrant and Hudson Telegraph (reference is hereby made to Exhibit 10.14). 10.37 Intentionally omitted. 10.38** Lease Agreement dated July 29, 1996 between the Registrant and Telecommunications Finance Group. 10.39** Promissory Note issued by Christopher E. Edgecomb in favor of the Registrant dated November 26, 1997. 10.40** Stock Pledge Agreement dated November 26, 1997 between the Registrant and Christopher E. Edgecomb. 10.41** Commercial Lease dated October 31, 1997 between the Registrant and Prinzenpark GbR. 10.42** Commercial Lease dated October 9, 1997 between the Registrant and WSL Weststadt Liegenschafts GmbH. 10.43** Office Lease between the Registrant and Airport-Center KGHP Gewerbeban GmbH & Cie. 10.44** Lease dated November 19, 1997 between the Registrant and DIFA Deutsche Immobilien Fonds Aktiengesellschaft. 21.1*** Subsidiaries of the Registrant. 23.1 Consent of Arthur Andersen LLP, Independent Public Accountants. 23.2 Consent of Riordan & McKinzie (contained in Exhibit 5.1). 23.3 Consent of Madison Securities, Inc. 23.4 Consent of Price Waterhouse LLP, Independent Public Accountants. 23.5 Consent of Weaver and Tidwell, Independent Public Accountants. 24.1** Power of Attorney. 27.1** Financial Data Schedule. 99.1 Form of UDN Proxy. 99.2 Opinion of Madison Securities, Inc. (incorporated by reference from ANNEX B to the Proxy Statement/Prospectus constituting Part I of this Registration Statement).
- ------------------------ + Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on February 7, 1997 and incorporated by reference herein. ++ Filed as an exhibit to Amendment No. 1 to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on May 16, 1997 and incorporated by reference herein. +++ Filed as an exhibit to Amendment No. 2 to the Company's Registration Statement on Form S-1 (Registration No. 333-21325) on May 29, 1997 and incorporated by reference herein. * Filed on December 15, 1997 as an exhibit to the Company's Current Report on Form 8-K (File No. 000-22581) and incorporated by reference herein. ** Filed as an exhibit to the Company's Registration Statement on Form S-1 (Registration No. 333-48559) on March 24, 1998 and incoroporated by reference herein. ***Filed as an exhibit to the Company's Annual Report on Form 10-K (File No. 000-22581) on March 31, 1998 and incorporated by reference herein. EX-5.1 2 EXHIBIT 5.1 EXHIBIT 5 May 28, 1998 Ladies and Gentlemen: We have acted as counsel to STAR Telecommunications, Inc., a Delaware corporation (the "Company"), in connection with the registration under the Securities Act of 1933, as amended (the "1993 Act"), of the issuance of up to 830,401 shares of the common stock, $0.001 par value per share (the "Common Stock") of the Company (the "Shares"), in accordance with the terms of the Agreement and Plan of Merger, dated as of November 19, 1997, as amended on January 30, 1998 and April 8, 1998, by and among the Company, IIWII Corp., a Delaware corporation and wholly owned subsidiary of the Company and United Digital Network, Inc., a Delaware corporation. This opinion is delivered to you in connection with the Registration Statement on Form S-4, Registration No. 333-53335, as amended to date (the "Registration Statement"), for the aforementioned sale, filed with the Securities and Exchange Commission (the "Commission") under the 1933 Act. In rendering the opinion set forth herein, we have made such investigations of fact and law, and examined such documents and instruments, or copies thereof established to our satisfaction to be true and correct copies thereof, as we have deemed necessary under the circumstances. Based upon the foregoing and such other examinations of law and fact as we have deemed necessary, and in reliance thereon, we are of the opinion that, subject to the issuance of an appropriate order by the Commission declaring the Registration Statement effective, and the compliance with applicable state securities and "blue sky" laws, the Shares have been duly authorized and will be upon delivery thereof validly issued, fully paid and nonassessable. We hereby consent to the filing of this opinion as an exhibit to the Registration Statement and to the reference to this firm under the caption "Legal Matters" in the Prospectus which is a part of the Registration Statement. Very truly yours, /s/ Riordan & McKinzie EX-23.1 3 EXHIBIT 23.1 EXHIBIT 23.1 CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS As independent public accountants, we hereby consent to the use of our reports dated February 12, 1998 (except with respect to the stock split discussed in Note 14 of the Notes to Consolidated Financial Statements as to which the date is March 31, 1998) and to all references to our firm included in or made a part of this registration statement on Form S-4. ARTHUR ANDERSEN LLP Los Angeles, California May 28, 1998 EX-23.3 4 EXHIBIT 23.3 EXHIBIT 23.3 CONSENT OF MADISON SECURITIES, INC. We hereby consent to the use of our opinion letter dated May 7, 1998 to the Board of Directors of United Digital Network, Inc. (the "Company") attached as Annex B to the Company's Proxy Statement/ Prospectus on Form S-4 (the "Prospectus") and to the references to our firm in the Prospectus under the headings of "Summary" and "The Merger." In giving such consent, we do not admit that we come within the category of persons whose consent is required under Section 7 of the Securities Act of 1933, as amended, or the rules and regulations of the Securities and Exchange Commission thereunder and we do not thereby admit that we are experts with respect to any part of the Regulations Statement under the meaning of the term "expert" as used in the Securities Act. Madison Securities, Inc. Chicago, Illinois May 28, 1998 EX-23.4 5 EXHIBIT 23.4 EXHIBIT 23.4 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the use in the Prospectus constituting part of this Registration Statement on Form S-4 of STAR Telecommunications, Inc. of our report dated September 5, 1997, except as to Notes 2, 9 and 15, which are as of May 18, 1998, relating to the financial statements of United Digital Network, Inc., which appears in such Prospectus. We also consent to the reference to us under the heading "Experts" in such Prospectus. PRICE WATERHOUSE LLP Dallas, Texas May 28, 1998 EX-23.5 6 EXHIBIT 23.5 EXHIBIT 23.5 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the use in this registration statement of Star Telecommunications, Inc. on Form S-4 of our report on Unidex Communication Corp. dated July 21, 1995, except for the proforma information relating to the business acquisition, as to which the date is May 20, 1997, appearing in the Prospectus, which is part of this registration statement. /s/ WEAVER AND TIDWELL, L.L.P. Weaver and Tidwell, L.L.P. Dallas, Texas May 28, 1998 EX-99.1 7 EXHIBIT 99.1 UNITED DIGITAL NETWORK, INC. INSTRUMENT OF PROXY THIS INSTRUMENT OF PROXY IS SOLICITED BY THE BOARD OF DIRECTORS OF THE COMPANY The undersigned, being a stockholder of UNITED DIGITAL NETWORK, INC. (the 'Company'), hereby appoints JOHN SNEDEGAR, or failing him, JANINE THOMAS, with full power of substitution of each of them, both directors of the Company, or ____________ , as proxyholder for the undersigned, to vote for the undersigned at the Special Meeting of the Company, to be held at McCarthy Tetrault, Main Board Room, 13th Floor, 777 Dunsmuir Street, Vancouver, British Columbia Canada on Tuesday, the 30th day of June, 1998, at 10:00 a.m., local time, and at any adjournment thereof and to vote the shares in the capital stock of the Company registered in the name of the undersigned. The undersigned hereby acknowledges receipt of the Notice of Special Meeting and the Proxy Statement relating to the Special Meeting and hereby revokes any proxy or proxies heretofore given. THE BOARD OF DIRECTORS RECOMMENDS A VOTE FOR THE AGREEMENT AND THE PLAN OF MERGER. 1. To approve and adopt the Agreement and Plan of Merger, dated as of November 19, 1997, as amended January 30, 1998 and April 6, 1998, by and among the Company, STAR Telecommunications, Inc., a Delaware corporation ('STAR'), and IIWII Corp., a Delaware corporation and a wholly-owned subsidiary of STAR ('Newco'), and the transactions contemplated thereby, including, among other things, the merger of Newco with and into the Company. / / FOR / / AGAINST / / ABSTAIN 2. Upon such other matters as may properly come before the Special Meeting and any adjournments or postponements thereof. In their discretion, the proxyholders are authorized to vote upon such other business as may properly come before the Special Meeting and any adjournments or postponements thereof. THE SHARES REPRESENTED BY THIS INSTRUMENT OF PROXY WILL BE VOTED OR WITHHELD FROM VOTING IN ACCORDANCE WITH THE INSTRUCTIONS GIVEN AND, IF A CHOICE IS SPECIFIED WITH RESPECT TO ANY MATTER TO BE ACTED UPON, THE SHARES WILL BE VOTED ACCORDINGLY. IF NO CHOICE IS SPECIFIED IN THIS INSTRUMENT OF PROXY AND ONE OF THE PERSONS NAMED IN THIS INSTRUMENT OF PROXY IS APPOINTED AS PROXYHOLDER, THE SHARES REPRESENTED BY THIS INSTRUMENT OF PROXY WILL BE VOTED IN FAVOR OF SUCH MATTERS. THIS INSTRUMENT OF PROXY CONFERS UPON THE PERSON NAMED HEREIN AS PROXYHOLDER DISCRETIONARY AUTHORITY WITH RESPECT TO AMENDMENTS OR VARIATIONS TO MATTERS IDENTIFIED IN THE NOTICE OF SPECIAL MEETING AND OTHER MATTERS WHICH MAY PROPERLY COME BEFORE THE MEETING. NOTES TO INSTRUMENT OF PROXY 1. If the stockholder does not want to appoint any of the persons named in the instrument of proxy, he should strike out their names and insert, in the blank space provided, the name of the person he wishes to act as his proxyholder. Such other person need not be a stockholder of the Company. 2. The instrument of proxy will not be valid unless it is dated and signed by stockholder or by his attorney duly authorized by him in writing, or, in the case of a corporation, is executed under its corporate seal or by an officer or officers or attorney for the Company duly authorized. 3. The instrument of proxy to be effective must be deposited at the Company's transfer agent, Montreal Trust Company, 4th Floor, 510 Burrard Street, Vancouver, B.C., V6C 3B9, prior to the time of the Meeting or any adjournment thereof. 4. Please sign exactly as your name appears on your account. If the shares are registered in the names of two or more persons, each should sign. If acting as attorney, executor, trustee or in another representative capacity, sign name and title. WITNESS my hand this _____ day of ___________________________ , 1998. ___________________________________ Name (Please Print) ___________________________________ (Signature of Stockholder) Address: __________________________ -----END PRIVACY-ENHANCED MESSAGE-----