e10qsb

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-QSB

(Mark One)


[X]		QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2004


[ ]		TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

For the transition period from _________________ to _________________

Commission file number 001-15363

AdStar, Inc.

(Exact name of small business issuer as specified in its charter)


Delaware		22-3666899

(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

4553 Glencoe Avenue, Suite 325, Marina del Rey, California 90292
(Address of principal executive offices)

(310) 577-8255
(Issuer’s telephone number)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes[X] No [ ]

State the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: As of November 15, 2004 the Issuer had outstanding 14,508,772 shares of its common stock, including 58,740 shares issuable to various vendors.

Transitional Small Business Disclosure Format (Check one): Yes [ ] No [X]

AdStar, Inc. and Subsidiary
Consolidated Balance Sheet
September 30, 2004 (unaudited)


Assets
Current assets:
Cash and cash equivalents	$	2,449,277
Accounts receivable, net of allowance for doubtful accounts of $59,000		547,733
Notes receivable from officers — current portion		7,911
Prepaid and other current assets		410,070

Total current assets		3,414,991
Notes receivable from officers, net of current portion		226,381
Property and equipment, net		109,270
Capitalized and purchased software, net		1,890,101
Intangible assets, net		1,422,852
Goodwill		2,246,454
Other assets		133,838

Total assets	$	9,443,887

Liabilities and Stockholders’ Equity
Current liabilities:
Due to publications	$	1,743,022
Accounts payable and accrued expenses		844,588
Deferred revenue and customer deposits — current portion		184,149
Loans from Stockholders, current portion		21,000
Capital lease obligations — current portion		24,862
Convertible Note — current portion		248,784

Total current liabilities		3,066,405
Deferred revenue — net of current portion		162,538
Capital lease obligations, net of current portion		305
Loans from Stockholders, net of current portion		31,500
Convertible Note, net of current portion		452,013

Total liabilities		3,712,761
Commitments and contingencies
Stockholders’ equity:
Convertible Preferred stock, par value $0.0001; authorized 5,000,000 shares; Series B-2, 2,000,000 issued and outstanding; liquidation preference of $1,679,039		1,342,404
Common stock, par value $0.0001; authorized 20,000,000 shares; 14,499,473 shares issued and outstanding		1,450
Additional paid-in capital		20,072,891
Treasury stock, par value $0.0001; 67,796 shares		(67,796	)
Accumulated deficit		(15,617,824	)

Total stockholders’ equity		5,731,125

Total liabilities and stockholders’ equity	$	9,443,887

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

AdStar, Inc. and Subsidiary
Statements of Operations
For the three month and nine month periods
ended September 30, 2003 and 2004 (unaudited)


	Three months ended						Nine months ended
	September 30,						September 30,
	2003			2004			2003			2004
ASP, net	$	404,233		$	440,282		$	1,106,706		$	1,264,486
Licensing and software		209,304			551,118			637,344			1,664,972
Customization and other		52,750			272,437			147,417			770,890

Net Revenues		666,287			1,263,837			1,891,467			3,700,348
Cost of revenues, including depreciation and amortization of $142,548, $151,980, $378,161 and $477,707		297,600			549,105			923,737			1,484,288

Gross profit		368,687			714,732			967,730			2,216,060
General and administrative expense		317,811			479,498			930,753			1,384,194
Selling and marketing expense		146,926			322,417			504,300			977,881
Product maintenance and development expenses		310,184			331,068			887,712			972,026
Amortization		—			22,059			—			66,172

Loss from operations		(406,234	)		(440,310	)		(1,355,035	)		(1,184,213	)
Beneficial interest and amortization of financing fees on Convertible Note		(10,000	)		(67,451	)		(10,000	)		(231,122	)
Interest income (expense), net		2,717			(10,170	)		4,998			(21,507	)

Loss before taxes		(413,517	)		(517,931	)		(1,360,037	)		(1,436,842	)
Provision for income taxes		963			3,463			2,888			14,544

Net loss	$	(414,480	)	$	(521,394	)	$	(1,362,925	)	$	(1,451,386	)

Loss per share — basic and										$
diluted	$	(0.05	)	$	(0.04	)	$	(0.16	)		(0.11	)
Weighted average number of shares — basic and diluted		8,423,387			14,491,204			8,296,130			13,889,859

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

AdStar, Inc. and Subsidiary
Statements of Cash Flows
For the nine month periods ended
September 30, 2003 and 2004 (unaudited)


	2003			2004
Cash flows from operating activities:
Net loss	$	(1,362,925	)	$	(1,451,386	)
Adjustments to reconcile net loss to net cash used in operating activities
Depreciation and amortization		592,764			595,180
Beneficial interest and amortization of financing fees on Convertible Note		—			228,121
Allowance for doubtful accounts		(3,327	)		25,000
Stock based vendor payments		46,250			80,057
Changes in assets and liabilities:
Accounts receivable		(130,712	)		(232,861	)
Prepaid and other assets		50,319			(223,668	)
Due to publications		805,398			659,049
Accounts payable and accrued expenses		111,901			(348,839	)
Deferred revenue and customer deposits		(3,761	)		156,914

Net cash provided by (used in) operating activities		105,907			(512,433	)

Cash flows from investing activities:
Purchase of Edgil Associates, Inc.		—			(85,000	)
Purchase of property and equipment		(38,628	)		(26,578	)
Additions to capitalized and purchased software		(514,971	)		(423,964	)
Additions to intangible assets		—			(6,003	)
Principal repayments of shareholder notes receivable		5,347			5,653

Net cash used in investing activities		(548,252	)		(535,892	)

Cash flows from financing activities:
Increase to restricted cash		(1,957,582	)		—
Proceeds from issuance of convertible note payable		—			1,348,514
Repayment of note payable		—			(45,454	)
Proceeds from sale of common stock in private placement		1,741,714			—
Proceeds from issuance of note payable		200,000			—
Repayment of note payable		(200,000	)		—
Proceeds from issuance of Series B-2 preferred stock		528,683			—
Proceeds from exercises of options and warrants		251,574			167,579
Costs of conversion of Series A preferred stock		—			(30,181	)
Principal repayments on loans from shareholders		—			(10,500	)
Principal repayments on capital leases		(20,932	)		(24,833	)

Net cash provided by financing activities		543,457			1,405,125

Net increase in cash and cash equivalents		101,112			356,800
Cash and cash equivalents at beginning of period		940,378			2,092,477

Cash and cash equivalents at end of period	$	1,041,490		$	2,449,277

Supplemental cash flow disclosure:
Taxes paid	$	7,543		$	3,548
Interest paid	$	11,161		$	32,008
Non cash investing and financing activities
Conversion of 1,443,457 shares of convertible preferred stock into equivalent shares of common stock — Note 5	$	—		$	1,697,840
Conversion of $225,000 of convertible note into 100,000				$
shares of common stock — Note 6	$	—			225,000
Conversion of accrued legal fees to common stock	$	50,000		$	--
Issuance of common stock to financial consultants	$	15,000		$	—
Issuance of common stock to technical consultants	$	11,250		$	80,087
Issuance of common stock — finder’s fee associated with convertible note				$	32,000

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

AdStar, Inc. and Subsidiary
Notes To Interim Financial Statements
(Unaudited)

1. General

The interim financial statements for AdStar, Inc. (the “Company”) have been prepared in accordance with accounting principals generally accepted in the United States of America for interim financial information and with instructions to Form 10-QSB and Item 10 of Regulation S-B. Accordingly they do not include all of the information and footnotes required by accounting principals generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2003.

For the nine-month period ended September 30, 2004, the Company had incurred a cash outflow from operations of $512,000. Although there can be no assurance, we believe that the additional $1,500,000 in proceeds from a private placement of a 3-year secured convertible note funded in April 2004, our available funds, combined with cash generated from existing operations, new customers and the flexibility to cut back our work-force upon completion or delay of significant customization projects, will be sufficient to meet our anticipated working capital needs through September 30, 2005. In addition the Company continues to seek additional financings. There is no assurance that management will be successful with these plans. However, if events and circumstances occur such that the Company does not meet its current operating plan as expected, and the Company is unable to raise additional financing, the Company may be required to further reduce certain spending, which could have a material adverse effect on the Company’s ability to achieve its intended business objectives.

2. Summary of Significant Accounting Policies

Concentration of Credit Risk and Major Customers

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of trade accounts receivable.

For the nine months ended September 30, 2004 and 2003, one customer accounted for 10.1% and one customer accounted for 11.3% of the Company’s revenues. At September 30, 2004, seven customers in the aggregate accounted for 51.7% of the Company’s accounts receivable. The majority of the Company’s customers have historically consisted of newspapers and publishers of classified advertisements.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of AdStar, Inc. and its wholly owned subsidiary Edgil Associates, Inc. All intercompany transactions and balances have been eliminated in consolidation.

Computation of Earnings Per Share

Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to common stockholders’ by the weighted average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is computed by dividing the net income (loss) applicable to common stockholders’ by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued, using the treasury stock method. Potential common shares are excluded from the computation when their effect is antidilutive.

For the three and nine months ended September 30, 2004 diluted loss per share does not include 1,355,374 and 2,416,270 respectively, of options and warrants to purchase common stock and 2,000,000 shares of common stock issuable upon the conversion of B-2 preferred stock to common stock, as their inclusion would be antidilutive.

Reclassifications

Certain reclassifications have been made to prior period balances in order to conform to the current period presentation.

New accounting pronouncements

On December 17, 2003, the SEC’s Office of the Chief Accountant and Division of Corporation Finance issued Staff Accounting Bulletin (SAB) 104, Revenue Recognition. The SAB updates portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins (SAB 103 codification) in order to make the guidance consistent with current authoritative accounting literature. The principal revisions relate to the incorporation of certain sections of the staffs FAQ document on revenue recognition into Topic 13. The Company does not expect the adoption of SAB 104 to have a material effect on our financial statements.

Software Development Costs

Costs to establish the technological feasibility of software applications developed by us are charged to expense as incurred. Certain costs incurred subsequent to achieving technological feasibility are capitalized. Accordingly, we capitalize a portion of the internal labor costs and external consulting costs associated with essential Web site development and enhancement activities. Costs associated with conceptual design and feasibility assessments as well as maintenance and routine changes are expensed as incurred. Capitalized costs are amortized based on current or future revenue for each product with an annual minimum equal to the straight-line basis over the estimated economic lives of the applications, not to exceed 5 years. During the nine months ended September 30, 2004 we capitalized $424,000 and amortized $462,00 in capitalized software costs and expensed $972,000 in software development and maintenance costs. Based on historical results and the current business plan the Company is examining the carrying value of certain previously capitalized software costs. Conclusions emanating from the examination could result in the elimination or reduction of the carrying value of these assets.

3. Goodwill

In accordance with SFAS No. 142, the Company recorded goodwill of $2,246,454 from the purchase of Edgil Associates, Inc. (Edgil). The Company does not amortize goodwill in accordance with SFAS 142. However the Company will evaluate goodwill at least on an annual basis for impairment or when there are indications of impairment. In future periods if goodwill is determined to be impaired, the Company will recognize a non-cash charge equal to the excess of the carrying value over the fair value. There can be no assurance that future evaluations of goodwill will not result in impairment and a charge to earnings.

The Company completed its annual impairment analysis including obtaining an independent outside appraisal and such analysis indicated that the amount of goodwill is fairly stated.

4. Significant Contracts

On March 18, 2002, the Company entered into a series of agreements with Tribune Company (“Tribune”) and sold 1,443,457 shares of Series A convertible preferred stock to for approximately $1.8 million. The Series A convertible preferred stock at cost which approximated fair value. The Company converted the Series A

convertible preferred stock into an equivalent number of the Company’s common stock on April 1, 2004, see note 5.

As of September 30, 2004, $294,063 in development and customization costs associated with the FlexAds application have been capitalized net of a write down of $316,462 in December 31, 2003.

In December 2002 the Company entered into an agreement with Tribune Company for an additional investment by Tribune of $1,500,000. As part of the transaction, AdStar developed additional features that expand the capabilities of its generic service and the customized services that were launched in August 2002. The investment is in the form of an initial purchase by Tribune of 1,200,000 shares of Series B-1 preferred stock for $900,000 which funded in December 2002 and a subsequent purchase, of 800,000 shares of Series B-2 preferred stock for $600,000. In addition, on the second closing the series B-1 shares, plus additional shares issued for accrued dividends on Series B-1 converted to series B-2. The purchase price for each share of the Series B-1 and Series B-2 preferred stock was $0.75 at or below the fair market value of AdStar common stock at the time of the respective closing. These shares carry a liquidation preference that includes a dividend of 7% per year available only upon liquidation and currently convert on a 1:1 basis. Shareholders of Series B Preferred Stock are entitled to vote on all matters submitted to the stockholders for vote and vote as a single class with the shareholders of our Common Stock. The holders of Series B preferred stock are entitled to one vote for each share of common issuable upon conversion.

5. Convertible preferred stock

The Company has authorized 5,000,000 shares of preferred stock, par value $0.0001 per share, of which 1,443,457 shares have been designated as Series A, convertible preferred stock (“Series A preferred stock”), 1,200,000 shares have been designated as Series B-1, convertible preferred stock and 2,000,000 shares have been designated as Series B-2, convertible preferred stock (“Series B preferred stock”). The remaining authorized shares have not been designated.

Pursuant to automatic conversion provisions in the Tribune Company agreement, all 1,443,457 shares of Series A preferred stock automatically converted to an equivalent number of shares of common stock on April 1, 2004.

At September 30, 2004, the Company has reserved 2,000,000 shares of common stock for issuance upon the conversion of the Series B preferred stock.

6. Convertible Note

On April 12, 2004, the Company closed a $1.5 million private placement of a 3-year secured convertible note (the “Note”) and 7-year warrants to purchase 200,000 shares (the “Warrants”) of our common stock (the “Common Stock”) with Laurus Master Fund, Ltd., a New York City based institutional fund and an accredited investor (“Laurus Master Fund”).

The Note bears interest at the prime rate minus one percentage point and is convertible into Common Stock at an initial fixed conversion price of $2.25 per share (the “Fixed Conversion Price”), 105% of the average closing price of the Common Stock (“Average Closing Price”) during the 22 trading days preceding the closing date. The Note has limited anti-dilution protection for capital changes and, on a

weighted average basis, for issuance of Common Stock below the Fixed Conversion Price, excluding shares issued in mergers, acquisition or strategic relationships, shares underlying compensatory options, shares issued on conversion or exercise of outstanding securities and other exceptions.

The shares underlying the Note are covered by an effective registration statement and subject to certain limitations based on market volume for the Common Stock and Laurus Master Fund’s aggregate holdings, Laurus Master Fund is required to convert all monthly installments of principal and interest into Common Stock if the Average Closing Price for the 5 trading days immediately preceding each monthly installment payment date is more than 10 percent above the Fixed Conversion Price. Additionally, we may redeem the Note by paying 125 percent of the then outstanding principal balance plus accrued interest. The Note is secured by a first lien on all of our assets.

Of the Warrants, 120,000 are exercisable at $2.58 and 80,000 are exercisable at $2.80 (120% and 130% of the Average Closing Price during the 22 trading days preceding the closing).

Pursuant to the terms of the Note and the Warrants, Laurus Master Fund may not receive shares of Common Stock on conversion of the Note or exercise of the Warrants to the extent such conversion or exercise would result in Laurus Master Fund beneficially owning in excess of 4.99% of the issued and outstanding shares of Common Stock.

During May 2004, pursuant to the terms of the Note, Laurus Master Fund elected to convert $225,000 of the Note into 100,000 shares of Common Stock. At a conversion price of $2.25 per share.

The Company recorded a debt discount of approximately $734,000 consisting of the intrinsic value of the beneficial conversion of approximately $467,000 and the portion of the proceeds allocated to the warrants issued to the lenders of approximately $267,000, using the Black-Scholes option pricing model, based on the relative fair values of the warrants and the notes. The debt discount is being amortized as interest expense over the three-year term of the notes using the interest method.

During the three and nine month periods ending September 30, 2004, approximately $67,000 and $231,000 of prepaid financing fees and debt discount was amortized as interest expense, including a non-cash portion of approximately $55,000 and $208,000. The non-cash portion was comprised of approximately $52,000 and $98,000 debt discount amortization for the period and an accelerated debt amortization of approximately $0 and $107,000, respectively, as a result of the conversion of $225,000 in debt to equity. The future non-cash debt discount and prepaid finder fees to be amortized as interest expense over the remaining 33 months of the note are approximately $68,000 for the remainder of 2004, $270,000 in 2005, $270,000 in 2006 and $79,000 in 2007. In the event the investors convert additional amounts of the debt or exercise all or part of the warrants, the Company will be required to amortize the remaining debt discount in the period in which the conversion or exercise occurs. In addition, the Company is exploring the possibility of refinancing this debt. Certain of the refinancing alternatives, if concluded prior to the end of the fiscal year, could require the accelerated amortization of the prepaid financing fees and debt discount.

The net proceeds from the financing will be used for working capital. We believe that with this added working capital we can more quickly achieve the goals of our business plan and accelerate our strategic acquisition program.

7. Loans from shareholders

Pursuant to the Merger agreement the notes payable to the two former stockholders of Edgil were restated whereby each stockholder received $51,500 in principal payments upon the closing and the remaining $31,500 note balance, for each Stockholder, is to be repaid in six equal payments of principal along with all interest at a rate of 8% per annum, with the first payment to be made on the six month anniversary of the Effective Date (October 21, 2003) and each of the next five payments to be paid each six months thereafter, with the final payment to be made on the third anniversary of the Closing Date. Accordingly $21,000 in minimum principal pay downs are due during each of the years ending December 31, 2004, 2005, and 2006.

8. Officers notes receivable

In July 2002, AdStar entered into a loan transaction with Leslie Bernhard, President and Chief Executive Officer and Eli Rousso, Executive Vice President and Chief Technical Officer for $110,434 and $100,000, respectively. As part of the transaction, Ms. Bernhard and Mr. Rousso each issued to AdStar an unsecured, non-negotiable promissory note bearing interest at 5.56% with monthly principal and interest payments of $763 and $691, respectively. The note is payable on a monthly basis, with all remaining outstanding principal and interest amounts due on July 31, 2022. Concurrently, an outstanding note from Ms. Bernhard in the amount of $39,566 was restructured under the same terms and conditions as the aforementioned new note. The loans are forgiven if there is a change in control in AdStar or if the loan maker is dismissed for other than cause as defined by the loan and employment agreements. At September 30, 2004 the outstanding notes receivable was $234,292.

9. Due to publications

The Company processes credit cards on behalf of certain of its customers as part of ASP services provided. The Company receives net proceeds daily on behalf of these customers for third party ads placed via credit card. These transactions are reconciled monthly and submitted to the publication, net of processing fees, generally within 35 days from the month end.

10. Stock based compensation

The Company has adopted the disclosure only provisions of SFAS No. 123. If compensation cost associated with the Company’s stock-based compensation plan had been determined using the fair value prescribed by SFAS No. 123, the Company’s net loss for the nine months ended September 30, 2003 and 2004 would have increased to the pro forma amounts indicated below:


		Nine months ended
		September 30,
		2003			2004
Net loss — applicable to common stockholders	As reported	$	(1,362,925	)	$	(1,451,386	)
	Add: Stock based
	employee compensation
	included in reported
	loss		-0-			-0-
	Deduct: Employee
	compensation expense		(215,233	)		(225,615	)
	pro forma		(1,578,158	)		(1,677,001	)
Loss per share -	As reported	$	(0.16	)	$	(0.11	)
	pro forma	$	(0.19	)	$	(0.12	)

Because additional stock options are expected to be granted each year, the above pro forma disclosures are not representative of pro forma effects on reported financial results for future years.

11. Related party transactions

During the nine months ended September 30, 2003 and 2004 the Company’s total revenues derived from related parties were $387,944 and $556,890 respectively.

12. Restructuring costs

During 2002, the Company contemplated a restructuring plan which among other things, contemplated the closure of the New York office within approximately nine months, a related reduction in force of the 4 technology staff as of December 31, 2002 and the abandonment of an externally created customized billing software module. During December 2002 the Company hired a seasoned industry executive to transfer the software programs and intellectual knowledge from the New York office to the corporate office, identify and begin training existing personnel in anticipation of the reduction-in-force, and abandoned the billing software system. The corporate office will assume full revenue responsibilities concurrently with the closing of the New York office.

During 2003 the Company completed the major enhancement of is products and the major requirements under the terms of the Tribune Agreements. In addition the Company acquired Edgil Associates, Inc., and immediately commenced an overall product line evaluation as part of the integration. As described in prior quarter financials, management approved a reduction-in-force during the fourth quarter, evaluated excess computer equipment and paid a bonus associated with the successful transfer of various functions of the New York office to the Los Angeles office.

The following table summarizes the restructuring activity for the nine months ended September 30, 2004; these costs are included in accrued expenses on the balance sheet:


Accrued restructuring	Bonus and Severance			Office Lease			Legal and Other		Total
Balance December 31, 2003	$	25,311		$	58,608		$	15,653	$	99,572
Charges for the period		(25,311	)		(11,789	)		—		(37,100	)

Balance September 30, 2004	$	—		$	46,819		$	15,653	$	62,472

13. Acquisition of Edgil Associates, Inc.

On October 21, 2003 the Company acquired Edgil Associates, Inc. (Edgil) through a forward triangular merger pursuant to an Agreement and Plan of Merger, dated as of the Effective Date, by and among AdStar, Edgil, EDG, and Edward P. Hopey and Gilbert Wolsky, the stockholders of Edgil (collectively, the “Edgil Stockholders”).

Pursuant to the Merger Agreement, the Company paid $1,520,000 cash and issued 1,311,530 shares of common stock, in exchange for the business and assets of Edgil. Based upon the average closing price of the Common Stock on the Nasdaq SmallCap Market for the 10 trading day period beginning October 14, 2003 the value of the Edgil Shares was $2,111,563. In addition, the Company issued 63,397 AdStar options valued at $68,926 using the Black-Scholes method as replacement options for fully vested Edgil employee options and recorded an estimated $285,000 in Legal, Accounting and other fees as part of the cost of the acquisition.

The acquisition of Edgil adds to AdStar’s suite of e-commerce services, Edgil’s EdgCapture, an integrated payment processing solution that interfaces directly with publishers’ classified and circulation systems; and EdgFlow, a content processing solution that allows publishers to deliver media content such as articles, technical documents, advertisements, wire stories, etc., to multiple channels in a variety of formats. Edgil’s products and services will continue to be offered under the Edgil brand, and AdStar will maintain Edgil’s Massachusetts-based headquarters.

The acquisition of Edgil is accounted for as a purchase business combination in accordance with the Statement of Financial Accounting Standards (SFAS) no. 141, “Business Combinations.” The total purchase price related to the acquisition of Edgil was $3,985,489. Edgil will operate as a wholly owned subsidiary of AdStar and the Company’s financial statements will include the results of Edgil from the closing date of the acquisition (October 21, 2003).

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The allocation of the purchase price is based in part on independent third-party valuation of certain intangible assets. The excess purchase price over the estimated fair value of the assets acquired and liabilities assumed is recorded as goodwill. The estimated cost of the acquisition, and accordingly the recorded amount of goodwill, was increased by $85,000 since December 31, 2003 as a result of underestimating professional costs associated with NASDAQ and SEC requirements.


At October 21, 2003
Current assets	$	430,887
Purchased software		311,000
Customer list		1,500,000
Goodwill		2,934,634

Total assets acquired		5,176,521
Current liabilities		439,852
Deferred tax liability		688,180
Notes payable Shareholders		63,000

Total liabilities assumed		1,191,032

Net assets acquired	$	3,985,489

The purchased software is comprised of internally created software which was valued by the independent third-party who assigned an expected useful life of 5 years.

The customer list of $1,500,000 is primarily comprised of value of the recurring revenue stream associated with long-term customers, valued by the independent third-party who assigned an expected life of 17 years.

The excess of the purchase price over the estimated fair value of the assets acquired and the liabilities assumed was recorded as goodwill. There is no step up in basis of the assets for tax purposes therefore the goodwill is not deductible for tax purposes.

Since there is no step up in basis of the acquired Edgil assets for tax purposes, amortization of purchased software and customer list is not deductible for tax purposes. The $688,180 deferred tax liability is calculated at Edgil’s 38% blended tax rate assigned by the independent third-party appraiser and applied to the $311,000 purchased software and $1,500,000 customer list. At December 31, 2003 in accordance with SFAS 141, the deferred tax liability is expected to be realized over the term as the deferred tax asset, therefore the deferred tax liability was offset against the deferred tax asset on AdStar, Inc. (AdStar) as part of the consolidated income tax provision. As a result of this transaction, AdStar’s deferred tax asset valuation allowance was reduced. In accordance with SFAS 109, the change in the valuation allowance was offset against goodwill. Accordingly, the deferred tax assets and liabilities of the Company has a 100% valuation allowance recorded.

The following summarized pro forma consolidated results of operations are presented as if the acquisition of Edgil had occurred on January 1, 2003. The unaudited pro forma results are not necessarily indicative of future earnings or earnings that would have been reported had the acquisition been completed as presented.


	The three months ended			The nine months ended
	September 30, 2003			September 30, 2003
Revenue	$	1,341,887		$	3,918,267
Net Loss		(332,766	)		(1,117,783	)
Loss per share — basic and diluted	$	(0.02	)	$	(0.07	)

14. Subsequent event

On October 8, 2004, AdStar, Inc. (“AdStar”) placed approximately $125,000 into an escrow account in connection with the possible establishment of a new business relationship (outside of the marketing arrangement for short messages and related services announced on October 11, 2004.) AdStar may, at its option, make additional deposits of up to approximately $250,000 if the new relationship is not established before December 2004. If the relationship is established before the end of the year, or later if agreed to by the parties, the deposits will be applied against the cost of establishing the relationship. If the relationship is not established, AdStar will forfeit all deposits.

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

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and related notes to the financial statements included elsewhere in this quarterly report. Certain statements in this discussion and elsewhere in this report constitute forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934 and are subject to the “Risk Factors” included in our Annual Report on Form 10-KSB for our fiscal year ended December 31, 2003. Because this discussion involves risk and uncertainties, our actual results may differ materially from those anticipated in these forward-looking statements.

Overview

In 2001 we repositioned our products, moving away from the idea of the Internet as a stand-alone business category, and moving towards the idea of the Internet as an extremely efficient and flexible communication channel. We recognized that this technology can be utilized to greatly enhance the functionality of the software we licensed to our existing customer base, as well as expand into new areas where our technology can be used to connect advertising outlets with advertisers. During 2002, we began to execute our business plan and spent virtually the entire year on successfully enhancing and integrating our existing technology and new products into the existing and new customers. While some of our historical business has migrated to our new transaction based model, it continues to be used by hundreds of recruitment agencies and volume advertisers. During 2003 we continued customer requested enhancements to our existing applications and expect to monetize the rollouts to a greater extent in 2004 as more publications adapt the new robust applications available to them.

In working with our customers, we recognized there was a great demand for our Web-based technology within the newspaper industry to run the online classified ad-taking abilities at our customer’s Web sites under a private label branded site concept. Therefore, we revised our business model to embrace these concepts, and we focused on the immediate needs of our customers. While doing this, we also made sure that our technology remained flexible to allow for changes as the needs of our customers change and as we develop product extensions and new lines of business based on our existing technology and expertise.

We adopted our marketing and sales strategies to our new Web-based ad-taking ASP product, and began marketing the product in September 2001 and found that it was well received by our customers. During 2001, we implemented our Web-based classified ad-taking ASP product at 14 new metropolitan newspapers. Given the severe downturn in advertising revenue in 2001, we were told by many potential customers that implementing our ASP product will need to wait until their advertising revenue has returned to more normal levels. In 2002, despite a slow economy we contracted with an additional 16 newspapers to use our Web-based classified ad-taking ASP product.

In 2003 we formalized our marketing effort behind our XML Gateway. (Application Programming Interface) With third parties and publishers alike looking to incorporate classified print advertising into their applications, the Gateway proved to be an easy way to accomplish it.

Publishers are beginning to realize the revenue potential of offering print in combination with online advertising. Being able to accomplish it has been problematic due to old legacy systems that cannot accommodate this offering. Referred to as reverse publishing, it addresses the users who currently go online to buy an online ad for a reasonable up-charge they can include a print ad in their advertising package. The strength of a combination print and online ad assures the advertiser of maximum exposure. Publishers now receive classified advertising from a myriad

of sources transmitted in a myriad of ways, each offering their own challenges to process in a quick and efficient way. The XML Gateway allows a newspaper to provide a common, single point of entry to whoever wants to send ads and easily drive them directly into their publishing systems.

In 2003 we also saw the release our new USER INTERFACE for Web-based ad taking. This new interface accommodates a variety of customized up-sells for an advertiser. Including our bold headlines, borders, background shading, pictures and graphic attention getters. The user is able to create in real time an ad with a unique look and feel.

As important as up-sells are to newspapers for additional revenue, what is more important is the platform we have created that can expand to offer new and unique capabilities. The future of classifieds rests with the online side of the industry. While print classifieds are two-dimensional online classifieds will offer all that technology can provide. In the future we will be able to provide sound, text messaging, voice recognition, auction function and order fulfillment for items sold etc. All these capabilities will ultimately be provided by our ever-expanding suite of products. We will partner with these technologies or we will acquire to ensure our leadership role as the E-Commerce provider to the newspaper industry.

In October of 2003 we acquired Edgil Associates, Inc. Edgil provides credit card processing to the newspaper industry. Key to their service is providing seamless integration of these transactions into billing systems and circulation systems alike. Historically operating in a license model we look forward to offering this service in a hosted environment with monthly fees and transaction fees in line with AdStar’s current model. Edgil’s principal product lines include EdgCapture, a complete payment processing solution and EdgFlow, a content processing and routing needs solution.

EdgeCapture -Processing credit card payments has become a way of life for newspapers. Advertising, circulation, and new media departments need to automate payment processing and integrate e-commerce programs into day-to-day operations. Using EdgCapture, newspapers have seen a dramatic improvement in their bottom line. Offering prepayment alternatives to advertisers and subscribers reduces labor and the costs associated with taking ads and subscriptions over the phone or Internet. More than just a piece of software, EdgCapture is an innovative service that allows newspapers and groups of newspapers to establish their own private payment processing interfaces. With a consistent track record, EdgCapture effortlessly processes millions of transactions per year.

EdgFlow — Data is at the heart of every corporate operation. Managing the distribution of data among a variety of systems has become an extremely complex task.

The EdgFlow system was designed to help organizations cope with their changing data requirements. The diversity of client/server environments and open database solutions gives a whole new meaning to the phrase ‘data delivery’. Its flexibility is particularly attractive for data management applications running in a heterogeneous environment encompassing various desktop and legacy systems.

EdgFlow allows organizations to deliver timely information in a format that they need. With the increasing distribution of information to the Internet, intranets, and a variety of databases, corporations must be equipped with the high performance tools necessary to meet the information-specific demands of their customers and their staff.

Edgil’s customer account base offers fertile ground for cross selling opportunities for Web-based ad taking.

In addition to transitioning to a recurring revenue model and expanding our newspaper customers, we are now in a position to reduce our operating costs on a going forward basis. There can be no assurance that our new product offerings or the arrangement with Tribune Company will be successful in generating revenues sufficient to support our operating expenses.

Prior to the development of our Web business, revenues had been generally sufficient to support our historic business. In developing our Web-based system we began to incur significant losses that could not be offset by the revenues generated by our historic business. These expenses caused us to incur significant losses from 1998 through 2003. Our future success is dependent upon our ability to substantially grow revenues and control costs to the point where we can fund the level of operations necessary to serve the anticipated customer base. To this end, our plans have included expanding the products and services offered to our customers by building on our proprietary software processes and unique position within the industry. We feel that there is significant opportunity to increase revenues by offering the Web software and services that we had initially developed for ourselves to print publications as an application service provider (“ASP”). In addition we have already taken steps to control or in some cases reduce costs on an ongoing basis.

Results of Operations

The following table sets forth the results of operations expressed as a percentage of revenues:


	Three months ended						Nine months ended
	September 30,						September 30,
	2003			2004			2003			2004
ASP, net		61	%		35	%		58	%		34	%
Licensing and software		31	%		44	%		34	%		45	%
Customization and other		8	%		22	%		8	%		21	%

Net revenues		100	%		100	%		100	%		100	%
Cost of revenues		45	%		43	%		49	%		40	%

Gross profit		55	%		57	%		51	%		60	%
General and administrative expense		48	%		38	%		49	%		37	%
Selling and marketing expense		22	%		26	%		27	%		26	%
Product maintenance and Development expenses		46	%		26	%		47	%		26	%
Amortization		—			2	%		—			2	%

Loss from operations		-61	%		-35	%		-72	%		-32	%
Beneficial interest and amortization of financing fees on Convertible Note Other income (expense)		-1	%		-5	%		—			-6	%
Interest income (expense)		—			-1	%		—			-1	%

Loss before taxes		-62	%		-41	%		-72	%		-39	%
Provision for income taxes		—			—			—			—

Net loss		-62	%		-41	%		-72	%		-39	%

Three and nine month periods ended September 30, 2004 and 2003

Revenues - Net revenues for the three months ended September 30, 2004 increased to $1,264,000 in 2004 from $666,000 in 2003, an increase of $598,000 or 90%. The increase in net revenue for 2004 is primarily comprised of a net increase of $342,000 or 164% in Licensing and software revenues and a net increase of $220,000 or 417% in Customization and other revenues. The increase in Licensing and Software revenues is primarily related to the addition to our suite of e-commerce services for the newspaper publishing industry of EdgCapture, an integrated payment processing solution that interfaces directly with publishers’ classified and circulation

systems; and EdgFlow, a content processing solution that allows publishers to deliver media content such as articles, technical documents, advertisements, wire stories, etc., to multiple channels in a variety of formats. The net increase in these revenues reflects a partial offset for a decrease of $7,000 from the termination of one licensing and software customer and $6,000 as a result of termination by 2 customers of the use of our outmoded licensed fax technology as the industry continues to move toward a web-based product. We now have only 2 remaining licenses for this technology. The increase in Customization and other revenue relates primarily to customization services associated with our new EdgCapture and EdgFlow software lines and to a $111,000 increase due to customization services to power a classified web order entry for the four online vertical classified advertising products, Recruitment, Autos, Real Estate and Merchandise, for The Atlanta Journal-Constitution (AJC). These ads will flow through AdStar’s XML Gateway. The AJC contract is expected to continue into the fourth quarter of 2004. The increase of $36,000 or 9% in ASP Revenue is primarily comprised of an increase in revenues of $16,000 and $6,000, from an increase in transaction volumes from existing customers and from the addition of a new customer, respectively, partially offset by a $3,000 decrease in revenues due to the termination of an existing customer. No revenues from EdgCapture or EdgeFlow and related customization services were reflected in our 2003 results since these services for our newspaper customer base were added through our acquisition of Edgil Associates in October 2003.

Net revenues for the nine months ended September 30, 2004 increased to $3,700,000 from $1,891,000 for 2003, a net increase of $1,809,000 or 96%. The increase in net revenue for 2004 is primarily comprised of a net increase of $1,028,000 or 161% in Licensing and software revenues and a net increase of $623,000 or 423% in Customization and other revenues. The increase in Licensing and Software revenues is primarily related to the addition EdgCapture and EdgFlow software lines. The net increase in these revenues reflects a partial offset for a decrease of $15,000 from the termination by a licensing and software customer and $27,000 as a result of termination by 2 customers of the use of our licensed fax technology. The increase in Customization and other revenue relates primarily to customization services associated with our new EdgCapture and EdgFlow software lines and to a $265,000 increase due to customization services to power a new online recruitment service with The Washington Post (TWP) and to power a classified web order entry for the four online vertical classified advertising products for The Atlanta Journal-Constitution (AJC). These ads, for both papers, will flow through AdStar’s XML Gateway. The TWP contract was essentially completed during the second quarter and the AJC contract is expected to continue into the fourth quarter of 2004. The increase of $158,000 or 14% in ASP Revenue is primarily comprised of an increase in revenues of $111,000 and $6,000, from an increase in transaction volumes from existing customers and from the addition of a new customer, respectively, partially offset by a decrease of $14,000 in revenues due to the termination of three customers.

We expect that revenues from our ASP Product will continue to increase as we sign on new and continue to convert existing customers to adopt our XML Gateway (such as TWP and AJC) along with the expected related increase in transaction volume we process on behalf of those customers.

Cost of revenues - Cost of revenues consists primarily of the costs to customize and install software applications, configure end-user software, install Web-based ad-taking software, provide technical customer training and end-user support, amortization of internally developed application modules, depreciation of production servers and related software, royalties, and co-location costs. These costs increased 84% to $549,000 for the three months ended September 30, 2004 compared with $298,000 for the three months ended September 30, 2003. Our gross profit margin increased slightly to 57% for the three months ended September 30, 2004 from 55% for the three months ended September 30, 2003. The $251,000 increase in cost of revenues during 2004 is primarily comprised of a net increase of $151,000 or 60% for the cost underlying our new EdgCapture and EdgFlow services which were not part of our service offerings to publishers in the comparable period last year and an $115,000 increase in direct labor and overhead associated

with the AJC service contracts described above, offset by a $34,000 reduction in amortization as a result of the write-down of capitalized software in the fourth quarter 2003 and an additional $11,000 reduction in amortization due to the full amortization of a portion of capitalized software.

Cost of revenues for the nine months ended September 30, 2004 increased to $1,484,000 from $924,000 for the nine months ended September 30, 2003. Our gross profit margin for the nine months ended September 30, 2004 increased to 60% from 51% for the nine months ended September 30, 2003. The $561,000 increase in cost of revenues during 2004 is primarily comprised of a net increase of $428,000 or 76% for the cost underlying our new EdgCapture and EdgFlow services which were not part of our service offerings to publishers in the comparable period last year and an $165,000 increase in direct labor and overhead associated with the TWP and AJC service contracts, offset by a $46,000 reduction in amortization as a result of the write-down of capitalized software in the fourth quarter 2003 and a additional $11,000 reduction in amortization due to the full amortization of a portion of capitalized software.

Given our current level of Web automation, we will be able to manage significantly greater transaction volumes with limited increases to our current staffing and equipment levels, once we have completed the enhancements necessary to fully transition the EdgCapture payment processing software to an ASP model. Accordingly, we expect a corresponding increase in cash to be generated from our gross profits as transaction volume increases in our ASP products.

General and administrative expenses - General and administrative expense consists primarily of the cost of executive, administrative, accounting, finance, and personnel along with professional fees and public company related expenses. General and administrative expenses increased 51% during the three months ended September 30, 2004 to $480,000 from $318,000 during the comparable period in 2003. The $162,000 increase during 2004 is primarily comprised of a net increase of $36,000 to support our new EdgCapture and EdgFlow services and $72,000 in temporary and permanent increases in salaries and benefits primarily as a result of shifting of executive responsibilities, and salary increases in accounting and administrative personnel. An increase in consulting fees of $50,000 primarily associated with Sarbanes-Oxley compliance matters and contractual obligations to obtain Statement on Accounting Standards number 70 (“SAS 70”) certification as part of our customers compliance with Sarbanes-Oxley requirements and an increase in legal and accounting fees of $12,000 primarily associated with research and consultation on potential acquisitions and related matters.

General and administrative expenses increased 49% during the nine months ended September 30, 2004 to $1,384,000 from $931,000 during the comparable period in 2003. The $453,000 increase during 2004 is primarily comprised of a net increase of $231,000 to support our new EdgCapture and EdgFlow services and $128,000 in temporary and permanent increases in salaries and benefits primarily as a result of shifting executive responsibilities, and salary increases in accounting and administrative personnel; an increase in consulting fees of $50,000 primarily associated with Sarbanes-Oxley compliance matters and contractual obligations to obtain SAS 70 certification as part of our customers compliance with Sarbanes-Oxley requirements and an increase in legal and accounting fees of $39,000 primarily associated with research and consultation on potential acquisitions and related matters.

Management believes that our existing executive staffing levels are sufficient to allow for significant growth without the need to add personnel and related costs for the foreseeable future. However, the impact of complying with Sarbanes-Oxley and SAS 70 has not been fully analyzed at this time and may require the addition of personnel and/or systems to adequately meet the requirements.

Selling and marketing expense - Selling and marketing expense consists primarily of direct charges for advertising, sales promotion, marketing, trade shows, customer service and business development. Selling expense increased 119% during the three months ended September 30, 2004 to $322,000 from $147,000 during the comparable period in 2003. The $175,000 increase during 2004 is primarily comprised of a net increase of $128,000 or 73% attributable to selling and marketing expenses for our new EdgCapture and EdgFlow services, a $24,000 commission expense related to a newly created commission plan, a $12,000 consulting expense related to a new product distribution agreement and a $9,000 net increase in advertising and publicity, tradeshows and business promotion related to our increased focus on selling and marketing our products.

Selling expense increased 94% during the nine months ended September 30, 2004 to $978,000 from $504,000 during the nine months ended September 30, 2003. The $474,000 increase during 2004 is primarily comprised of a net increase of $320,000 or 68% attributable to selling and marketing expenses for our new EdgCapture and EdgFlow services, a $56,000 net increase in salary, moving and related expenses, primarily related to the hiring of a senior vice president of sales, a $46,000 commission expense related to a newly created commission plan and a $65,000 increase in advertising and publicity, tradeshows and business promotion as anticipated with the increased focus on selling and marketing our products, offset by a $13,000 reduction in outside consulting fees and other costs.

In 2004 we expect an increase in selling and marketing expenses as compared to the related periods of 2003 as we continue the development and implementation of our strategic marketing plan and continue to build upon our existing relationships with Tribune Company, Knight-Ridder, Inc., CareerBuilder, L.L.C., Manheim Interactive, Inc. and other potential strategic partners.

Product maintenance and development expenses - Product maintenance and development expenses consist of expenses to identify functional requirements, to plan, identify and conceptually design and test the required technical infrastructure, and to perform software and Web-site maintenance, and other general routine fixes. The costs consist primarily of personnel related expenses for technical and design personnel, equipment maintenance and outside consultants. Product maintenance and development expenses increased 7% for the three months ended September 30, 2004 to $331,000 from $310,000 for the comparable period in 2003. The $21,000 increase during 2004 is primarily comprised of a net increase of $45,000, due to our new EdgCapture and EdgFlow services, offset by a net decrease of $24,000 due to reductions in our technical staffing levels.

Product maintenance and development expenses increased 9% for the nine months ended September 30, 2004 to $972,000 from $888,000 for the comparable period in 2003. The $84,000 increase during 2004 is primarily comprised of a net increase of $248,000, attributable to our new EdgCapture and EdgFlow services, offset by a net decrease of $164,000 due to reductions in our technical staffing levels.

We monitor technical staffing levels closely and believe that our current level of technical staffing will be sufficient for the near future. Conversely, we may need to increase technical staffing in the short term if we obtain additional customers more quickly than currently expected or an unexpected increase in customer demand for customization projects occurs. However, an increase in customer demand requiring an increase in technical staffing costs are generally offset by increased revenues for such services.

Beneficial interest and amortization of financing fees on Convertible Note - On April 12, 2004, we closed a $1.5 million private placement of a 3-year secured convertible note and 7-year warrants to purchase 200,000 shares of our common stock with Laurus Master Fund, Ltd., a New York City based institutional fund and an accredited investor.

We recorded a debt discount of approximately $734,000 consisting of the intrinsic value of the beneficial conversion of approximately $467,000 and the portion of the proceeds allocated to the warrants issued to the lenders of approximately $267,000, using the Black-Scholes option pricing model, based on the relative fair values of the warrants and the notes. The debt discount is being amortized as interest expense over the three-year term of the notes using the interest method.

During the three and nine month periods ending September 30, 2004, approximately $67,000 and $231,000 of prepaid financing fees and debt discount were amortized as interest expense, including a non-cash portions of approximately $55,000 and $208,000, respectively. The non-cash portion was comprised of approximately $52,000 and $98,000 debt discount amortization and an accelerated debt amortization of approximately $0 and $107,000, respectively, as a result of the conversion of $225,000 in debt to equity.

Liquidity and Capital Resources

Prior to 1999 we financed our business primarily from cash generated by operations. Subsequently, we have financed our business through a combination of cash generated from operations and debt and equity financings. For the years ending December 31, 2003 and 2002, we raised net proceeds of $2,622,000 and $3,831,000, respectively, in equity and debt financings, including the acquisition of Edgil in October 2003. In April 2004 we raised an additional $1,500,000 from a convertible debt financing to fund operations and enhance and expand the product line we provide our customers.

As of September 30, 2004, we had cash of approximately $2,449,000 compared to $2,092,000, as of December 31, 2003 a combined net increase of $357,000. The net increase in cash and cash equivalents was a result of $512,000 in net cash used in operating activities, $535,000 in net cash used in investing activities, offset by net proceeds of $1,405,000 provided by financing activities. In addition, at September 30, 2004 we had positive working capital of $323,000 compared to $149,000 at December 31, 2003, a net improvement of $174,000 primarily as a result of the cash remaining from the Laurus financing.

Net cash used in operations during the nine months ended September 30, 2004 was approximately $512,000. Net cash used in operating activities was primarily the result of a net loss of $1,463,000 less non-cash charges of $595,000 in Depreciation and amortization, $228,000 in Beneficial interest and amortization of financing fees on the convertible note, $25,000 in Allowance for doubtful accounts and $80,000 in Stock based vendor payments, net of a $659,000 increase in Due to publications, a $156,000 increase in Deferred revenue and customer deposits, offset by a $233,000 increase in Accounts receivable, $224,000 in Prepaids and other assets and a $349,000 decrease in Accounts payable and accrued expenses. The increase in Due to publications is a by-product of the seasonal nature of the classified advertising industry whereby a greater volume of newspaper ads are placed in the first three quarters of the calendar year with a material drop-off in the fourth quarter. The increase in Accounts receivable is primarily due to the increase in revenues from major service contracts such as The Atlanta Journal-Constitution and the Los Angeles Times whereby we perform on the contracts until certain milestones are met, the increase in Prepaids and other assets is primarily attributable to costs associated with potential acquisition targets which is primarily comprised of legal and other professional fees, and the reduction in Accounts payable and accrued expenses is primarily related to paying legal, accounting and financing fees associated with the Laurus Financing and ongoing legal and accounting matters and payment of accrued severance and bonus’ related to restructurings.

Net cash used in investing activities during the nine months ended September 30, 2004 was approximately $536,000. Net cash used in investing activities was primarily comprised of $424,000 in ongoing enhancements to our proprietary software, the purchase of $27,000 in property and equipment as well as an additional $85,000 increase in the cost of the acquisition of

Edgil. The software enhancements primarily relate to the conversion of Edgil’s EdgeCapture payment processing software from a stand-alone server based application to a web-based application available to all AdStar and Edgil customers, as well as new customers and the conversion of the existing of the EdgeCapture application to support running on additional end-user specific platforms. The addition to the cost of Edgil is primarily related to additional legal and accounting fees required to satisfy NASDAQ technical requirements.

Net cash provided by financing activities during the nine months ended September 30, 2004 was approximately $1,405,000, which primarily consisted of approximately, $1,350,000 in net proceeds from issuance of a convertible note and $168,000 from the exercise of employee options and vendor warrants, offset by approximately, $30,000 in costs to convert the Series A convertible preferred stock, $11,000 in repayments of principal on loans to shareholders and $25,000 in repayments of principal on the capital leases.

At September 30, 2004, we have an accumulated deficit of $15,630,000. We have incurred significant recurring net losses for the years ended December 2002, 2003 and the nine months ended September 30, 2004 of $2,160,000 and $2,842,000 and $1,463,000. Our 2002 and 2003 and first nine months 2004 net losses were principally attributable to our shift in focus from an on-line business to an ASP business with and expanded suite of products. We expect to continue to incur losses until we are able to increase revenues significantly from fees based on the number of purchases transacted through our ASP product. We believe cash on hand of $2,449,000 at September 30, 2004, and expected increase in the cash flows we are currently generating from operations from contemplated cost cutting strategies, including a contemplated reduction-in-force as well as other cost saving measures, our reduction in personnel at the beginning of January 2004 and an expected increase in revenues from our continued success in growing our business will generate sufficient capital to meet our cash needs through the next twelve months. In addition we believe the cash on hand coupled with positive working capital will allow us to further enhance our ability to grow organically and positions us to take advantage of additional strategic acquisitions and revenue sharing arrangements should they present themselves. In May 2004, $225,000 of the debt was converted into equity which is expected to have a positive impact on our cash flow into the third and fourth quarters of 2004. We expect our cash balance to continue to decline through the fourth quarter 2004 due to the seasonality of our industry and begin to increase again in the first quarter 2005.

We are optimistic that our growing ASP business will continue to be accepted in the marketplace. However, our ability to sell ASP business products and service offerings during the current year may be hampered by the current unstable climate in the advertising market, the geo-political climate, including the war in Iraq, and state of the economy in general. These factors, coupled with the unproven ability of our newly acquired subsidiary, Edgil, to continue to generate positive cash flow, possible competition from other vendors, the extended selling cycle in our industry, and customer delays in customization and implementations, could delay our ability to increase revenue to a level sufficient to cover our expenses.

We currently have no additional borrowings available to us under any credit arrangement, and we are continuing to look for additional financing. To conserve cash and to more rapidly achieve at least break-even cash flow from operations, we have begun to implement a new program of salary reductions, the further elimination of excess personnel and other reductions of operating expenses, the full impact of which will be realized in the first quarter of next year. However, adequate funds may not be available or may not be available on terms favorable to us or at all. If additional funds are raised through the issuance of equity securities, dilution to existing stockholders may result. If funding is insufficient at any time in the future, we may be unable to develop or enhance our products or services, take advantage of business opportunities or respond to competitive pressures, any of which could have a material adverse effect on our financial position, results of operations and cash flows.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements require that we make estimates and judgments that affect the reported amounts of assets, liabilities, revenues, expenses, and related disclosure. On an on-going basis, we re-evaluate our estimates, including those relating to revenue recognition, uncollectible accounts receivable, intangible assets and contingent expenses and revise reported amounts prospectively. We base our estimates on historical experiences, combined with anticipated activity and various other assumptions that we believe to be reasonable under the circumstances. When combined, this body of knowledge forms the basis for making judgments about the carrying value of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

Financial Reporting Release No. 60, which was recently issued by the Securities and Exchange Commission, requires all companies to include a discussion of critical accounting policies or methods used in preparation of financial statements. The following is a brief discussion of our most critical accounting policies, including those methods affected by our more complex judgments and estimates.

Revenue Recognition

We derive revenue from several products and services as follows:

ASP revenue — We receive revenue by providing an application service provider (“ASP”) product that allows customers to use our software applications on a “shared system” over the Internet. This technology is a publisher-specific ad-taking Web site service that offers visitors to a newspaper’s Web page the opportunity to buy classified ads, for both the print and/or on-line editions of the newspaper, in real-time, on a 24/7 basis. We receive monthly fees for hosting the transactions and providing customer support, and recognize the fees ratably over the contract period.

Web site revenue — The Company receives revenue from fees charged to customers who transact business on the Advertise123.com Web site. This site permits the general public to plan, schedule, compose and purchase advertising from many print and on-line publishers. Under the guidance provided by the Securities Exchange Commission Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition” and the Emerging Issues Task Force (“EITF”) Abstract No. 99-19 “Reporting Revenue Gross as a Principal versus Net as an Agent” (“EITF 99-19”), we are, in substance, acting as an agent for the publishers and therefore recognize as revenue only the net fees realized on the transactions. We recognize revenue on a per-transaction basis when the ad is placed through their system and collection from the customer is probable.

Licensing and Software; Customization and other revenues — We generate revenue from technology service contracts that generally contain multiple elements such as software customization services, monthly fees and post-contract customer support (PCS). Revenue from these arrangements is recognized in accordance with Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, and SOP 98-9, “Software Revenue Recognition with Respect to Certain Transactions”. Accordingly, revenue is allocated to each element within the contract based on the relative fair values of those elements using vendor specific objective evidence. Revenue from monthly fees and PCS under software maintenance arrangements is based upon renewal rates and is recognized ratably over the term of the arrangement. Revenue from software customization services is recognized as the services are performed, using a percentage of completion methodology based on labor hours. We also provide customization services at the

customers’ request and recognize revenue as the services are performed, using a percentage of completion methodology based on labor hours.

Deferred revenue consists primarily of deferred revenues from long-term License and Software contracts, PCS maintenance arrangements prepaid annually and customization and other revenues billed and paid in advance. Revenue from upfront license fees, monthly fees and PCS under software maintenance arrangements is based upon renewal rates and is recognized ratably over the term of the arrangement, licenses and maintenance generally range from month-to-month up to 10 years on historical AdStar and 25 years and 1 to 5 years on historical Edgil, respectively. Since AdStar acquired Edgil all newly signed license and software contracts are generally 1 to 3 years in duration. Deferred revenue on the 25-year license arrangements are approximately $72,000, PCS contracts paid in advance and prepaid customer deposits are $147,000 as of September 30, 2004. Revenue from software customization services is recognized upon the completion of services. As part of the integration of Edgil into AdStar’s business model we are currently offering new Edgil contracts on terms and conditions similar to AdStar, generally one year or less in duration.

Areas requiring management’s judgment includes revenue recognition and cost estimation on the fixed fee software customization element of the contracts. Revenue is recognized on these contracts using a percentage-of-completion methodology, based upon labor input measures and an estimate of time to completion. Monthly, technical and operations management review the estimates of labor hours required to complete the customizations and the effect of any change in estimate is reflected in the period in which the change is first known. Such changes in estimates have not been material to our results of operation. The corresponding cost of revenue charge is derived based upon the same labor input measurements and our existing cost structure. If we do not accurately estimate the resources required under the contract or the scope of the work to be performed, or if we do not manage our projects properly within the prescribed timeframe, future margins may be significantly and adversely affected. If increases in projected costs-to-complete are sufficient to create a loss contract, the entire estimated loss is charged to operations in the period the loss first becomes known. The complexity of the estimation process and uncertainties inherent in software customization activities may affect the percentages derived under the percentage-of-completion accounting method, which in turn may affect the amounts reported in the financial statements.

Software Development Costs

Costs to establish the technological feasibility of software applications developed by us are charged to expense as incurred. Certain costs incurred subsequent to achieving technological feasibility are capitalized. Accordingly, we capitalize a portion of the internal labor costs and external consulting costs associated with essential Web site development and enhancement activities. Costs associated with conceptual design and feasibility assessments as well as maintenance and routine changes are expensed as incurred. Capitalized costs are amortized based on current or future revenue for each product with an annual minimum equal to the straight-line basis over the estimated economic lives of the applications, not to exceed 5 years. During the nine months ended September 30, 2004 we capitalized $424,000 and amortized $462,000 in capitalized software costs and expensed $972,000 in software development and maintenance costs. Based on historical results and the current business plan we are examining the carrying value of certain previously capitalized software costs. Conclusions emanating from the examination could result in the elimination or reduction of the carrying value of these assets.

Warranties and Product liability

We warrant that our products conform to their respective functional specifications. Our customized software products, ASP application products and Software License Agreements are warranted to perform as designed. Such warranties are extended throughout the term of extended

service agreements that clients enter into with us. Direct costs associated with the initial period of service have been insignificant and are generally covered by upfront fees.

We currently carry product liability insurance. We believe the amount of insurance is adequate to cover its risks. To further mitigate its risks, our standard service agreement expressly limits its liabilities and warranties of its products and services in accordance with accepted provisions of the Uniform Commercial Code as adopted in most states.

Allowance for doubtful accounts

We maintain an allowance for doubtful accounts using estimates that we make based on factors we believe appropriate such as the composition of the accounts receivable aging, historical bad debts, changes in payment patterns, customer creditworthiness and current economic trends. If we used different assumptions, or if the financial condition of the customers were to deteriorate, resulting in an impairment of their ability to make payments, additional provisions for doubtful accounts would be required and would increase our bad debt expense.

Contractual Obligations, Commitments and Contingencies

We have contractual obligations and commitments primarily with regards to employment agreements for 4 of our executives, a convertible note due in equal monthly principal installments payable over a 33 month period commencing July, 2004, certain non-cancelable operating lease obligations for office space and equipment, and capital lease obligations for computer equipment and office furniture.

The following table aggregates our expected contractual obligations and commitments subsequent to September 30, 2004:


	Payments due by Period for the 1 year ending September 30,
Contractual obligations	2005		2006		2007		2008		2009		Thereafter		Total
Employment agreements	$	611,025	$	278,500	$	53,200							$	942,725
Convertible Note (1)		502,271		545,453		227,276								1,275,000
Operating lease commitments (2)		279,856		218,309		134,332		137,389		140,450		11,725		922,061
Loans from stockholders		21,000		21,000		10,500								52,500
Capital Lease commitments		28,407		316		—		—		—				28,722

	$	1,442,559	$	1,063,578	$	425,308	$	137,389	$	140,450	$	11,725	$	3,221,009

(1) Accounts for prepayment of approximately 4 months principal payments based on repayment provisions of the note whereby the $225,000 converted in May 2004 is applied against the $45,456 monthly principal payments until fully applied.

(2) Excludes sublet office agreement of $2,400 per month through April 2005.

Item 3. Controls And Procedures

Evaluation of Disclosure Controls and Procedures. AdStar’s management, with the participation of the chief executive officer and the chief financial officer, carried out an evaluation of the effectiveness of the AdStar’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15-d-15(e)) as of the end of the period covered by this quarterly report (the “Evaluation Date”). Based upon that evaluation, the chief executive officer and the chief financial officer concluded that, as of the Evaluation Date, AdStar’s disclosure controls and procedures are effective, providing them with material information relating to AdStar as required to be disclosed in the reports AdStar files or submits under the Exchange Act on a timely basis.

Changes in Internal Control over Financial Reporting. There were no changes in AdStar’s internal controls over financial reporting, known to the chief executive officer or the chief financial officer, that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, AdStar’s internal control over financial reporting.

PART II

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

Recent Sales of Unregistered Securities.

AdStar established a vendor payment plan whereby it may compensate vendors in shares of its common stock in lieu of cash. Under the plan, 400,000 shares are available for issuance. In the nine month period ended September 30, 2004, 64,644 shares were issued to vendors under the plan relying upon the exemption under sections 4(2) and 4(6) of the Securities Act of 1933 and which represented compensation for the period of $112,057. The vendors have taken the shares for investment.

On April 12, 2004, we closed on a $1.5 million private placement of a 3-year secured convertible note (the “Note”) and 7-year warrants to purchase 200,000 shares (the “Warrants”) of our common stock (the “Common Stock”) with Laurus Master Fund, Ltd., a New York City based institutional fund and an accredited investor (“Laurus Master Fund”).

The Note bears interest at the prime rate minus one percentage point and is convertible into Common Stock at an initial fixed conversion price of $2.25 per share (the “Fixed Conversion Price”), 105% of the average closing price of the Common Stock (“Average Closing Price”) during the 22 trading days preceding the closing date. The Note has limited anti-dilution protection for capital changes and, on a weighted average basis, for issuance of Common Stock below the Fixed Conversion Price, excluding shares issued in mergers, acquisition or strategic relationships, shares underlying compensatory options, shares issued on conversion or exercise of outstanding securities and other exceptions.

The shares underlying the Note are covered by an effective registration statement and subject to certain limitations based on market volume for the Common Stock and Laurus Master Fund’s aggregate holdings, Laurus Master Fund is required to convert all monthly installments of principal and interest into Common Stock if the Average Closing Price for the 5 trading days immediately preceding each monthly installment payment date is more than 10 percent above the Fixed Conversion Price. Additionally, we may redeem the Note by paying 125 percent of the then outstanding principal balance plus accrued interest. The Note is secured by a first lien on all of our assets.

Of the Warrants, 120,000 are exercisable at $2.58 and 80,000 are exercisable at $2.80 (120% and 130% of the Average Closing Price during the 22 trading days preceding the closing).

Pursuant to the terms of the Note and the Warrants, Laurus Master Fund may not receive shares of Common Stock on conversion of the Note or exercise of the Warrants to the extent such conversion or exercise would result in Laurus Master Fund beneficially owning in excess of 4.99% of the issued and outstanding shares of Common Stock.

Item 6. Exhibits

a. Exhibits:


Exhibit No.		Description
31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

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

32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



Date November 15, 2004	/s/ Anthony J. Fidaleo
	Chief Financial Officer
	(Principal Financial Officer)

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				PAGE
	PART I — FINANCIAL INFORMATION
		Item 1.	Interim condensed financial statements
			(unaudited)
			Balance Sheet — September 30, 2004		3
			Statements of Operations		4
			For the three month periods and nine month periods ended September 30, 2003 and 2004
			Statements of Cash Flows		5
			For the nine month periods ended September 30, 2003 and 2004
			Notes to Interim Financial Statements		6
		Item 2.	Management’s discussion and analysis or plan of operation		15
		Item 3.	Controls and Procedures		26
	PART II — OTHER INFORMATION
		Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		26
		Item 6.	Exhibits		27
	SIGNATURES				28
Exhibit 31.1
Exhibit 31.2
Exhibit 32.1
Exhibit 32.2

1.		General

		The interim financial statements for AdStar, Inc. (the “Company”) have been prepared in accordance with accounting principals generally accepted in the United States of America for interim financial information and with instructions to Form 10-QSB and Item 10 of Regulation S-B. Accordingly they do not include all of the information and footnotes required by accounting principals generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the nine-month period ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. These financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the year ended December 31, 2003.

		For the nine-month period ended September 30, 2004, the Company had incurred a cash outflow from operations of $512,000. Although there can be no assurance, we believe that the additional $1,500,000 in proceeds from a private placement of a 3-year secured convertible note funded in April 2004, our available funds, combined with cash generated from existing operations, new customers and the flexibility to cut back our work-force upon completion or delay of significant customization projects, will be sufficient to meet our anticipated working capital needs through September 30, 2005. In addition the Company continues to seek additional financings. There is no assurance that management will be successful with these plans. However, if events and circumstances occur such that the Company does not meet its current operating plan as expected, and the Company is unable to raise additional financing, the Company may be required to further reduce certain spending, which could have a material adverse effect on the Company’s ability to achieve its intended business objectives.

2.		Summary of Significant Accounting Policies

		Concentration of Credit Risk and Major Customers

		Financial instruments that potentially subject the Company to significant concentrations of credit risk consist principally of trade accounts receivable.

		For the nine months ended September 30, 2004 and 2003, one customer accounted for 10.1% and one customer accounted for 11.3% of the Company’s revenues. At September 30, 2004, seven customers in the aggregate accounted for 51.7% of the Company’s accounts receivable. The majority of the Company’s customers have historically consisted of newspapers and publishers of classified advertisements.

		Principles of Consolidation

		The accompanying consolidated financial statements include the accounts of AdStar, Inc. and its wholly owned subsidiary Edgil Associates, Inc. All intercompany transactions and balances have been eliminated in consolidation.

		Computation of Earnings Per Share

		Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to common stockholders’ by the weighted average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is computed by dividing the net income (loss) applicable to common stockholders’ by the weighted average number of common shares outstanding plus the number of additional common shares that would have been outstanding if all dilutive potential common shares had been issued, using the treasury stock method. Potential common shares are excluded from the computation when their effect is antidilutive.

		For the three and nine months ended September 30, 2004 diluted loss per share does not include 1,355,374 and 2,416,270 respectively, of options and warrants to purchase common stock and 2,000,000 shares of common stock issuable upon the conversion of B-2 preferred stock to common stock, as their inclusion would be antidilutive.

		Reclassifications

		Certain reclassifications have been made to prior period balances in order to conform to the current period presentation.

		New accounting pronouncements

		On December 17, 2003, the SEC’s Office of the Chief Accountant and Division of Corporation Finance issued Staff Accounting Bulletin (SAB) 104, Revenue Recognition. The SAB updates portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins (SAB 103 codification) in order to make the guidance consistent with current authoritative accounting literature. The principal revisions relate to the incorporation of certain sections of the staffs FAQ document on revenue recognition into Topic 13. The Company does not expect the adoption of SAB 104 to have a material effect on our financial statements.

		Software Development Costs

		Costs to establish the technological feasibility of software applications developed by us are charged to expense as incurred. Certain costs incurred subsequent to achieving technological feasibility are capitalized. Accordingly, we capitalize a portion of the internal labor costs and external consulting costs associated with essential Web site development and enhancement activities. Costs associated with conceptual design and feasibility assessments as well as maintenance and routine changes are expensed as incurred. Capitalized costs are amortized based on current or future revenue for each product with an annual minimum equal to the straight-line basis over the estimated economic lives of the applications, not to exceed 5 years. During the nine months ended September 30, 2004 we capitalized $424,000 and amortized $462,00 in capitalized software costs and expensed $972,000 in software development and maintenance costs. Based on historical results and the current business plan the Company is examining the carrying value of certain previously capitalized software costs. Conclusions emanating from the examination could result in the elimination or reduction of the carrying value of these assets.

3.		Goodwill

		In accordance with SFAS No. 142, the Company recorded goodwill of $2,246,454 from the purchase of Edgil Associates, Inc. (Edgil). The Company does not amortize goodwill in accordance with SFAS 142. However the Company will evaluate goodwill at least on an annual basis for impairment or when there are indications of impairment. In future periods if goodwill is determined to be impaired, the Company will recognize a non-cash charge equal to the excess of the carrying value over the fair value. There can be no assurance that future evaluations of goodwill will not result in impairment and a charge to earnings.

		The Company completed its annual impairment analysis including obtaining an independent outside appraisal and such analysis indicated that the amount of goodwill is fairly stated.

4.		Significant Contracts

		On March 18, 2002, the Company entered into a series of agreements with Tribune Company (“Tribune”) and sold 1,443,457 shares of Series A convertible preferred stock to for approximately $1.8 million. The Series A convertible preferred stock at cost which approximated fair value. The Company converted the Series A

		convertible preferred stock into an equivalent number of the Company’s common stock on April 1, 2004, see note 5.
		As of September 30, 2004, $294,063 in development and customization costs associated with the FlexAds application have been capitalized net of a write down of $316,462 in December 31, 2003.

		In December 2002 the Company entered into an agreement with Tribune Company for an additional investment by Tribune of $1,500,000. As part of the transaction, AdStar developed additional features that expand the capabilities of its generic service and the customized services that were launched in August 2002. The investment is in the form of an initial purchase by Tribune of 1,200,000 shares of Series B-1 preferred stock for $900,000 which funded in December 2002 and a subsequent purchase, of 800,000 shares of Series B-2 preferred stock for $600,000. In addition, on the second closing the series B-1 shares, plus additional shares issued for accrued dividends on Series B-1 converted to series B-2. The purchase price for each share of the Series B-1 and Series B-2 preferred stock was $0.75 at or below the fair market value of AdStar common stock at the time of the respective closing. These shares carry a liquidation preference that includes a dividend of 7% per year available only upon liquidation and currently convert on a 1:1 basis. Shareholders of Series B Preferred Stock are entitled to vote on all matters submitted to the stockholders for vote and vote as a single class with the shareholders of our Common Stock. The holders of Series B preferred stock are entitled to one vote for each share of common issuable upon conversion.

5.		Convertible preferred stock

		The Company has authorized 5,000,000 shares of preferred stock, par value $0.0001 per share, of which 1,443,457 shares have been designated as Series A, convertible preferred stock (“Series A preferred stock”), 1,200,000 shares have been designated as Series B-1, convertible preferred stock and 2,000,000 shares have been designated as Series B-2, convertible preferred stock (“Series B preferred stock”). The remaining authorized shares have not been designated.

		Pursuant to automatic conversion provisions in the Tribune Company agreement, all 1,443,457 shares of Series A preferred stock automatically converted to an equivalent number of shares of common stock on April 1, 2004.

		At September 30, 2004, the Company has reserved 2,000,000 shares of common stock for issuance upon the conversion of the Series B preferred stock.

6.		Convertible Note

		On April 12, 2004, the Company closed a $1.5 million private placement of a 3-year secured convertible note (the “Note”) and 7-year warrants to purchase 200,000 shares (the “Warrants”) of our common stock (the “Common Stock”) with Laurus Master Fund, Ltd., a New York City based institutional fund and an accredited investor (“Laurus Master Fund”).

		The Note bears interest at the prime rate minus one percentage point and is convertible into Common Stock at an initial fixed conversion price of $2.25 per share (the “Fixed Conversion Price”), 105% of the average closing price of the Common Stock (“Average Closing Price”) during the 22 trading days preceding the closing date. The Note has limited anti-dilution protection for capital changes and, on a

7.		Loans from shareholders

		Pursuant to the Merger agreement the notes payable to the two former stockholders of Edgil were restated whereby each stockholder received $51,500 in principal payments upon the closing and the remaining $31,500 note balance, for each Stockholder, is to be repaid in six equal payments of principal along with all interest at a rate of 8% per annum, with the first payment to be made on the six month anniversary of the Effective Date (October 21, 2003) and each of the next five payments to be paid each six months thereafter, with the final payment to be made on the third anniversary of the Closing Date. Accordingly $21,000 in minimum principal pay downs are due during each of the years ending December 31, 2004, 2005, and 2006.

8.		Officers notes receivable

		In July 2002, AdStar entered into a loan transaction with Leslie Bernhard, President and Chief Executive Officer and Eli Rousso, Executive Vice President and Chief Technical Officer for $110,434 and $100,000, respectively. As part of the transaction, Ms. Bernhard and Mr. Rousso each issued to AdStar an unsecured, non-negotiable promissory note bearing interest at 5.56% with monthly principal and interest payments of $763 and $691, respectively. The note is payable on a monthly basis, with all remaining outstanding principal and interest amounts due on July 31, 2022. Concurrently, an outstanding note from Ms. Bernhard in the amount of $39,566 was restructured under the same terms and conditions as the aforementioned new note. The loans are forgiven if there is a change in control in AdStar or if the loan maker is dismissed for other than cause as defined by the loan and employment agreements. At September 30, 2004 the outstanding notes receivable was $234,292.

9.		Due to publications

		The Company processes credit cards on behalf of certain of its customers as part of ASP services provided. The Company receives net proceeds daily on behalf of these customers for third party ads placed via credit card. These transactions are reconciled monthly and submitted to the publication, net of processing fees, generally within 35 days from the month end.

10.		Stock based compensation

		The Company has adopted the disclosure only provisions of SFAS No. 123. If compensation cost associated with the Company’s stock-based compensation plan had been determined using the fair value prescribed by SFAS No. 123, the Company’s net loss for the nine months ended September 30, 2003 and 2004 would have increased to the pro forma amounts indicated below:

		Because additional stock options are expected to be granted each year, the above pro forma disclosures are not representative of pro forma effects on reported financial results for future years.

11.		Related party transactions

		During the nine months ended September 30, 2003 and 2004 the Company’s total revenues derived from related parties were $387,944 and $556,890 respectively.

12.		Restructuring costs

		During 2002, the Company contemplated a restructuring plan which among other things, contemplated the closure of the New York office within approximately nine months, a related reduction in force of the 4 technology staff as of December 31, 2002 and the abandonment of an externally created customized billing software module. During December 2002 the Company hired a seasoned industry executive to transfer the software programs and intellectual knowledge from the New York office to the corporate office, identify and begin training existing personnel in anticipation of the reduction-in-force, and abandoned the billing software system. The corporate office will assume full revenue responsibilities concurrently with the closing of the New York office.

		During 2003 the Company completed the major enhancement of is products and the major requirements under the terms of the Tribune Agreements. In addition the Company acquired Edgil Associates, Inc., and immediately commenced an overall product line evaluation as part of the integration. As described in prior quarter financials, management approved a reduction-in-force during the fourth quarter, evaluated excess computer equipment and paid a bonus associated with the successful transfer of various functions of the New York office to the Los Angeles office.

13.		Acquisition of Edgil Associates, Inc.

		On October 21, 2003 the Company acquired Edgil Associates, Inc. (Edgil) through a forward triangular merger pursuant to an Agreement and Plan of Merger, dated as of the Effective Date, by and among AdStar, Edgil, EDG, and Edward P. Hopey and Gilbert Wolsky, the stockholders of Edgil (collectively, the “Edgil Stockholders”).

		Pursuant to the Merger Agreement, the Company paid $1,520,000 cash and issued 1,311,530 shares of common stock, in exchange for the business and assets of Edgil. Based upon the average closing price of the Common Stock on the Nasdaq SmallCap Market for the 10 trading day period beginning October 14, 2003 the value of the Edgil Shares was $2,111,563. In addition, the Company issued 63,397 AdStar options valued at $68,926 using the Black-Scholes method as replacement options for fully vested Edgil employee options and recorded an estimated $285,000 in Legal, Accounting and other fees as part of the cost of the acquisition.

		The acquisition of Edgil adds to AdStar’s suite of e-commerce services, Edgil’s EdgCapture, an integrated payment processing solution that interfaces directly with publishers’ classified and circulation systems; and EdgFlow, a content processing solution that allows publishers to deliver media content such as articles, technical documents, advertisements, wire stories, etc., to multiple channels in a variety of formats. Edgil’s products and services will continue to be offered under the Edgil brand, and AdStar will maintain Edgil’s Massachusetts-based headquarters.

		The acquisition of Edgil is accounted for as a purchase business combination in accordance with the Statement of Financial Accounting Standards (SFAS) no. 141, “Business Combinations.” The total purchase price related to the acquisition of Edgil was $3,985,489. Edgil will operate as a wholly owned subsidiary of AdStar and the Company’s financial statements will include the results of Edgil from the closing date of the acquisition (October 21, 2003).

		The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The allocation of the purchase price is based in part on independent third-party valuation of certain intangible assets. The excess purchase price over the estimated fair value of the assets acquired and liabilities assumed is recorded as goodwill. The estimated cost of the acquisition, and accordingly the recorded amount of goodwill, was increased by $85,000 since December 31, 2003 as a result of underestimating professional costs associated with NASDAQ and SEC requirements.

		The purchased software is comprised of internally created software which was valued by the independent third-party who assigned an expected useful life of 5 years.

		The customer list of $1,500,000 is primarily comprised of value of the recurring revenue stream associated with long-term customers, valued by the independent third-party who assigned an expected life of 17 years.

		The excess of the purchase price over the estimated fair value of the assets acquired and the liabilities assumed was recorded as goodwill. There is no step up in basis of the assets for tax purposes therefore the goodwill is not deductible for tax purposes.

		Since there is no step up in basis of the acquired Edgil assets for tax purposes, amortization of purchased software and customer list is not deductible for tax purposes. The $688,180 deferred tax liability is calculated at Edgil’s 38% blended tax rate assigned by the independent third-party appraiser and applied to the $311,000 purchased software and $1,500,000 customer list. At December 31, 2003 in accordance with SFAS 141, the deferred tax liability is expected to be realized over the term as the deferred tax asset, therefore the deferred tax liability was offset against the deferred tax asset on AdStar, Inc. (AdStar) as part of the consolidated income tax provision. As a result of this transaction, AdStar’s deferred tax asset valuation allowance was reduced. In accordance with SFAS 109, the change in the valuation allowance was offset against goodwill. Accordingly, the deferred tax assets and liabilities of the Company has a 100% valuation allowance recorded.

14.		Subsequent event

		On October 8, 2004, AdStar, Inc. (“AdStar”) placed approximately $125,000 into an escrow account in connection with the possible establishment of a new business relationship (outside of the marketing arrangement for short messages and related services announced on October 11, 2004.) AdStar may, at its option, make additional deposits of up to approximately $250,000 if the new relationship is not established before December 2004. If the relationship is established before the end of the year, or later if agreed to by the parties, the deposits will be applied against the cost of establishing the relationship. If the relationship is not established, AdStar will forfeit all deposits.


	AdStar, Inc
	(Registrant)