-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, SQuq4R6jUjEqRERJjMO7l583A1kZ9gtMdmaCdEcskFJcgFOAJEnnDig6V9kxCtxs xclF7rloBeC49N3dQ0m9iQ== 0001108890-05-000044.txt : 20050114 0001108890-05-000044.hdr.sgml : 20050114 20050114140642 ACCESSION NUMBER: 0001108890-05-000044 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 20041130 FILED AS OF DATE: 20050114 DATE AS OF CHANGE: 20050114 FILER: COMPANY DATA: COMPANY CONFORMED NAME: BESTNET COMMUNICATIONS CORP CENTRAL INDEX KEY: 0000799694 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 861006416 STATE OF INCORPORATION: NV FISCAL YEAR END: 0831 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-15482 FILM NUMBER: 05530234 BUSINESS ADDRESS: STREET 1: 5075 CASCADE ROAD SE STREET 2: SUITE A CITY: GRAND RAPIDS STATE: MI ZIP: 49546 BUSINESS PHONE: 616-977-9933 MAIL ADDRESS: STREET 1: 5075 CASCADE ROAD SE STREET 2: SUITE A CITY: GRAND RAPIDS STATE: MI ZIP: 49546 FORMER COMPANY: FORMER CONFORMED NAME: WAVETECH INTERNATIONAL INC DATE OF NAME CHANGE: 19980225 FORMER COMPANY: FORMER CONFORMED NAME: WAVETECH INC DATE OF NAME CHANGE: 19920703 10QSB 1 bestnet10qsb113004.txt PERIOD ENDED 11-30-04 ================================================================================ U.S. 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 November 30, 2004 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from to . -------------------- ------------------- Commission File Number 0-15482 BESTNET COMMUNICATIONS CORP. --------------------------------------------------------- (Name of Small Business Issuer as Specified in Its Charter) Nevada 86-1006416 ------------------------------ ----------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 5075 Cascade Road SE, Suite A, Grand Rapids, Michigan 49546 -------------------------------------- (Address of principal executive offices) (616) 977-9933 ------------------------- (Issuer's telephone number) Check whether the issuer (1) filed all report required to be filed by Section 13 or 15(d) of the Exchange Act during the past twelve 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 [ ] As of December 28, 2004 there were 41,316,364 shares of common stock, par value $.001 per share, outstanding. Transitional Small Business Disclosure Format (Check One): Yes [ ] No [X] ================================================================================ BESTNET COMMUNICATIONS CORP. INDEX TO QUARTERLY REPORT ON FORM 10-QSB FOR THE QUARTERLY PERIOD ENDED NOVEMBER 30, 2004 AND 2003 PAGE ---- PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements CONDENSED CONSOLIDATED BALANCE SHEETS -- November 30, 2004(unaudited) and August 31, 2004 3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED NOVEMBER 30, 2004 AND 2003 4 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED NOVEMBER 30, 2004 AND 2003 5 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 6 ITEM 2. Management's Discussion and Analysis or Plan of Operation OPERATIONS OVERVIEW 12 BUSINESS OF BESTNET AND SUBSIDIARIES 14 LIQUIDITY AND CAPITAL RESOURCES 18 CRITICAL ACCOUNTING POLICIES 19 RESULTS OF OPERATIONS 20 INFLATION 21 ITEM 3. Controls and Procedures 21 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings 22 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds 22 ITEM 3. Defaults upon Senior Securities 23 ITEM 4. Submission of Matters to a Vote of Security Holders 23 ITEM 5. Other Information 23 ITEM 6. Exhibits and Reports on Form 8-K 23 2
PART I: FINANCIAL INFORMATION ITEM 1. Financial Statements BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS November 30, August 31, ASSETS 2004 2004 ------ ---- ---- (UNAUDITED) Current Assets: Cash and cash equivalents $ 136,755 $ 405,299 Accounts receivable, less allowance of $8,484 and $9,606 75,176 78,080 Prepaid expenses and other current assets 92,689 38,407 ------------ ------------ Total current assets 304,620 349,999 Property and equipment, net of accumulated depreciation of $3,479,789 and $3,783,695 330,818 351,298 Deposits and other assets 51,581 50,607 ------------ ------------ Total assets $ 687,019 $ 923,691 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ LIABILITIES Current Liabilities: Capital lease obligations, current portion $ 5,148 $ 5,006 Accounts payable and accrued expenses 193,864 239,934 Convertible notes payable, net of discount of $0 and $17,760 59,678 36,499 Notes payable - related parties 138,000 160,000 Deferred revenue 12,249 11,559 ------------ ------------ Total current liabilities 408,939 452,998 Long-Term Liabilities: Capital lease obligations, long-term portion 1,379 2,721 ------------ ------------ Total long-term liabilities 1,379 2,721 ------------ ------------ Total liabilities 410,318 455,719 ------------ ------------ STOCKHOLDERS EQUITY Preferred stock, par value $.001 per share; 10,000,000 shares authorized; 1,595,129 and 1,413,544 shares issued and outstanding at November 30, 2004 and August 31, 2004 1,595 1,413 Common stock, par value $.001 per share; 100,000,000 shares authorized; 43,091,686 issued and 41,191,686 outstanding at November 30, 2004; and 42,435,026 shares issued and 40,535,026 shares outstanding at August 31, 2004 43,092 42,435 Additional paid-in capital 36,816,928 36,738,292 Accumulated deficit (35,702,469) (35,402,168) Common stock subscribed, underlying common shares of 124,678 29,555 -- ------------ ------------ 1,188,701 1,379,972 Less treasury stock, 1,900,000 common shares, at cost (912,000) (912,000) ------------ ------------ Total stockholders' equity 276,701 467,972 ------------ ------------ Total liabilities and stockholders' equity $ 687,019 $ 923,691 ============ ============ See accompanying notes to condensed consolidated financial statements. 3
BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED NOVEMBER 30, 2004 AND 2003 2004 2003 ---- ---- (UNAUDITED) (UNAUDITED) Revenues $ 400,304 $ 545,027 ------------ ------------ Expenses: Cost of revenues (exclusive of depreciation and amortization shown separately below) 253,583 377,697 General and administrative expenses 376,108 341,494 Depreciation and amortization 43,733 504,379 ------------ ------------ Total expenses 673,424 1,223,570 ------------ ------------ Loss from operations (273,120) (678,543) ------------ ------------ Other income (expense): Interest income 636 330 Interest and finance charges (23,440) (146,772) Conversion expense (See Note 5) -- (541,182) Other income (expense) (4,377) 1,214 ------------ ------------ Total other expense (27,181) (686,410) ------------ ------------ Loss available to common shareholders $ (300,301) $ (1,364,953) ============ ============ Loss per common share, basic and diluted $ (.01) $ (.05) ------------ ------------ Weighted average number of shares outstanding, basic and diluted 40,674,424 28,408,756 ============ ============ See accompanying notes to condensed consolidated financial statements. 4
BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED NOVEMBER 30, 2004 AND 2003 2004 2003 ---- ---- (UNAUDITED) (UNAUDITED) Operating activities: Net loss $ (300,301) $(1,364,953) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 43,733 504,379 Non-cash transactions 91,474 677,526 Changes in assets and liabilities: Accounts receivable 2,904 (5,763) Prepaid expenses and other current assets 13,718 32,439 Deposits and other assets (974) 43,256 Accounts payable and accrued expenses (46,070) 46,877 Deferred revenue 690 235 ----------- ----------- Net cash used in operating activities (194,826) (66,004) ----------- ----------- Investing activities: Purchase of property and equipment (23,253) (18,001) ----------- ----------- Net cash used in investing activities (23,253) (18,001) ----------- ----------- Financing activities: Repayment of notes payable (49,265) (16,696) Principal payments on capital lease obligation (1,200) (1,439) ----------- ----------- Net cash provided by (used in) financing activities (50,465) (18,135) ----------- ----------- Net decrease in cash (268,544) (102,140) Cash and cash equivalents, beginning of period 405,299 226,559 ----------- ----------- Cash and cash equivalents, end of period $ 136,755 $ 124,419 =========== =========== See accompanying notes to condensed consolidated financial statements. 5
BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-QSB. Accordingly, certain information and footnote disclosures normally included in financial statements have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the unaudited condensed consolidated financial statements for the periods presented include all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation. The balance sheet at August 31, 2004, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. For further information, refer to the Company's financial statements, and footnotes thereto, for the fiscal year ended August 31, 2004, included in its Form 10-KSB for such fiscal period. Operating results for the three-month period ended November 30, 2004, are not necessarily indicative of the results that may be expected for the fiscal year ending August 31, 2004. The condensed consolidated financial statements include the accounts of BestNet Communications Corp. and its wholly owned subsidiaries, Interpretel, Inc., and Telplex International Communications, Inc. (collectively the "Company", "BestNet", "we", "us", or "ours"). All material intercompany balances and transactions have been eliminated. Bestnetcall and, ClicktoPhone are registered trademarks of BestNet Communications Corp. All other trademarks, service marks and trade names referred to in this report are the property of their respective owners. NOTE 2 -- PER SHARE DATA Basic loss per common share equals diluted loss per common share for all periods presented as the effect of all potentially dilutive securities (convertible preferred stock, stock options and warrants) are anti-dilutive (decreases the loss per share amount). Per share calculations, for the three-month period ended November 30, 2004 include current shares outstanding and those included in the Unit offering completed on March 30, 2003 (See Note 4). NOTE 3 -- TRANSACTIONS WITH SOFTALK, INC. The Company is in the business of providing communication solutions to its customers using the network infrastructure, proprietary technology and applications it owns. Softalk, Inc. ("Softalk"), is a privately-owned Ontario, Canada corporation, who was a significant shareholder of the Company and owns the patented methodology currently used in some of our solutions. We have an exclusive license to Softalk's patented methodology for commercial accounts. The arbitration proceedings with Softalk that we have previously reported was compromised and settled by an agreement made on October 9, 2003 and made final on December 3, 2003. Pursuant to that agreement: o We released our claim against Softalk for a loan repayment in the amount of $1,589,768.21 plus $211,048 in interest that had accrued on that amount o We paid over to Softalk $27,709 for royalties that had accrued under the Softalk License and Softalk released us from all obligations to pay royalties thereafter; o We released our claim against Softalk for rights to the source code for the licensed technology and our rights to any future communications software developed by Softalk; 6 o We agreed to release all rights to the SMS calling program developed by Softalk; o Softalk released us from a claim in the amount of $481,465; o Warrants for the purchase of 5,276,753 shares of our common stock were returned to us by Softalk. Warrants for 3,276,753 shares were exercisable at $3.25 per share; warrants for 1,000,000 shares were exercisable at $5.00 and warrants for an additional 1,000,000 shares were exercisable at $10.00; o 1,900,000 shares of our common stock held by Softalk, were returned to us as treasury stock at a time when the bid and ask prices on the OTC BULLETIN BOARD were $.26 and $.29 respectively; and o Softalk agreed that 1,900,000 additional shares of our common stock that it continued to hold would be sold at a rate no greater than 100,000 shares per month over a period of 19 months from the settlement date, with the right to carry over to future periods any unsold portion of such 100,000 shares per month. We believe that as of December 28, 2004, Softalk had sold 1,500,000 shares in the market. We understand that Softalk wishes to sell its remaining 400,000 shares at the rate of 100,000 shares per month, subject to our prior written consent, as is provided in the settlement agreement described above. On March 26, 2004, we received a notice from Softalk alleging a breach of the confidentiality and change of control provisions of the Softalk License and of that portion of the settlement agreement (described above) providing for the release for sale of BestNet Communications common shares held by Softalk, and stating that Softalk wished to terminate the License and demanding arbitration of the issues. After discussions between respective counsels for the parties, it was agreed to stay all proceedings pending further negotiations. After consultation with counsel, we do not believe that we are in default under the Softalk License or the settlement agreement. We have advised Softalk, however, that we believe that Softalk is in breach of the Softalk License in that it is competing with us for commercial customers notwithstanding that the Softalk License grants us exclusive rights in that market. On or about November 22, 2004, we were notified that Softalk had renewed its demand to arbitrate the issues and terminate the Softalk License. We intend to contest Softalk's claims vigorously and to assert counterclaims against Softalk for, among other things, breaching its agreement not to compete with us for commercial customers through the use of the technology that is subject to the Softalk License. NOTE 4 -- UNIT OFFERING On March 30, 2003, the Company completed the private placement of Units pursuant to the terms of a Unit Purchase Agreement (the "Units") with accredited investors, resulting in gross proceeds to the Company of approximately $917,000. In conjunction with this offering, the Company incurred approximately $104,000 in costs directly associated with the private placement. The Company issued an aggregate of 3,055,399 Units at a per Unit purchase price of $0.30 under this private placement. Each Unit consists of the following underlying securities: (a) three shares of the Company's common stock; (b) one share of Series A Convertible Preferred Stock, par value $.001 per share; and (c) one three-year warrant to purchase one share of common stock at a per share price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of the Company's common stock in exchange for $0.10 per common share ($.20 for each Series A Convertible Preferred share converted). The securities underlying the Units are not to be separately tradable or transferable apart from the Units until such time as determined by the Company's Board of Directors. The Company has accounted for this transaction as though the securities underlying the Units have been issued. Accordingly, the accompanying financial statements reflect 9,166,197 shares of common stock, 3,055,399 shares of Series A Preferred Stock and an increase in additional paid-in capital to reflect the warrants issued in conjunction with the Unit offering. The Company allocated approximately $556,000 to the common stock, approximately $265,000 to the Series A Preferred Stock and approximately $96,000 to the warrants. This allocation is 7 based on the relative fair values of the various securities underlying the Units. As a result of the beneficial conversion feature associated with the Series A Preferred Stock, the Company recorded a deemed dividend in the amount of approximately $265,000, which is reflected in the Statement of Operations as a preferred stock dividend. As is discussed in Note 5, the Company also issued $150,000 in aggregate principal of Senior Secured Notes that, along with any unpaid accrued interest, are convertible to Units at a conversion rate of $.30 per Unit. During fiscal 2003, the Senior Secured Notes and unpaid accrued interest of approximately $2,000 were converted to 508,194 Units. As discussed in the preceding paragraph, the underlying securities related to the Units are reflected in the financial statements. Accordingly, the accompanying financial statements reflect 1,524,582 shares of common stock, 508,194 shares of Series A Preferred Stock and an increase in additional paid-in capital to reflect the warrants issued in conjunction with the conversion of the Senior Secured Notes into Units. The Company allocated approximately $92,000 to the common stock, approximately $44,000 to the Series A Preferred Stock and approximately $16,000 to the warrants. This allocation is based on the relative fair values of the various securities underlying the Units. March 12, 2004 - On March 12, 2004, the Company completed the private placement of units pursuant to the terms of a Unit Purchase Agreement (the "Units") with an accredited investor and related party, resulting in gross proceeds to the Company of approximately $60,000. The Company issued an aggregate of 200,000 Units at a per Unit purchase price of $0.30. Each Unit consists of the following underlying securities: (a) three shares of the Company's common stock; (b) one share of Series A Convertible Preferred Stock, par value $.001 per share; and (c) one three-year warrant to purchase one share of common stock at a per share price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of the Company's common stock in exchange for $0.10 per common share ($.20 for each Series A Convertible Preferred share converted). In August 2004, these units were split into their underlying securities. In July 2004, the Company's Board of Directors approved the splitting of its Units into their underlying securities. As part of this Unit split, the Board required that the unit holders convert their Series A Convertible Preferred Stock at the time of the split. During July and August 2004, 2,347,614 units were split into their underlying securities. 2,347,614 shares of Series A Convertible Preferred stock were converted into 4,875,228 shares of common stock. In addition, 2,347,614 warrants were also delivered to those investors who converted their units. NOTE 5 -- NOTES PAYABLE Convertible Notes Payable On September 26, 2002, the Company entered into a Note and Warrant Purchase Agreement with several accredited investors. This convertible debt financing, which was completed on October 30, 2002, yielded $665,000 in gross proceeds to the Company. The convertible notes have a term of 1-year and bear interest at a rate of 6% per annum. The principal amount outstanding under each convertible note, together with accrued interest is convertible into shares of common stock of the Company at the election of the holder at a conversion price equal to one share of common stock for each $1.00 of principal and interest converted. In addition, a warrant to purchase one additional share of the Company's common stock at a per share exercise price of $1.50 was issued for each $2.00 invested. During the first quarter of fiscal 2004, we defaulted in the payment of amounts due under the 6% Convertible Promissory Notes. As an incentive to convert, accredited investors were offered a new conversion proposal. Under the terms of this proposal, the Note would be convertible into the Company's common stock at a conversion price of $.15 per share. In addition, the warrants associated with this Note and Warrant Purchase Agreement would be cancelled. On or before November 30, 2003, four investors elected to convert their principal and accrued interest into common stock. The principal of $220,000 and accrued interest of approximately $2,600 was converted into 1,484,311 shares of common stock. In conjunction with this induced conversion, $541,182 was recorded as conversion expense and is presented in the other income and expense section of the accompanying condensed consolidated statement of operations. Also during the first quarter of fiscal 2004, the maturity date remaining $445,000 in aggregate principal amount of Convertible Promissory Notes, was extended for one year. Such Notes now bear interest at a rate of 8% per annum and are convertible into the Company's common stock at a conversion rate of $.10 per common share. The beneficial conversion feature associated with the note extensions resulted in an additional discount to the notes of $445,000, which is being amortized over the lives of the extended notes. 8 During the second quarter of fiscal 2004, certain investors elected to convert $22,000 of their aggregate principal into 220,000 shares of common stock. During the third quarter of fiscal 2004, an investor elected to convert $2,500 in aggregate principal into 25,000 shares of common stock. Effective May 19, 2004, an investor holding $200,000 in aggregate principal of notes issued by the Company, plus accrued interest of $10,187, elected to convert the note into 2,101,865 common shares. These shares were issued in June 2004, During the fourth quarter of fiscal 2004, investors holding $220,500 in aggregate principal of notes issued by the Company, plus accrued interest of $13,296, elected to convert the notes into 2,512,960 common shares. Bridge Financing On January 8, 2004, the Company entered into a Note Purchase Agreement with two accredited investors. This convertible debt financing yielded $75,000 in bridge financing to the Company. The notes have a term of 1-year and bear an interest rate of 10%. The principal amount of each note, plus accrued interest, are convertible into Units of the Company at a conversion price of $0.30 per Unit share. Each Unit consists of the following underlying securities: (a) three shares of the Company's common stock; (b) one share of Series A Convertible Preferred Stock, par value $.001 per share; and (c) one three-year warrant to purchase one share of common stock at a per share price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of the Company's common stock in exchange for $0.10 per common share ($.20 for each Series A Convertible Preferred share converted). The securities underlying the Units are not to be separately tradable or transferable apart from the Units until such time as determined by the Company's Board of Directors. The beneficial conversion feature associated with these notes resulted in a discount to the notes of $75,000 which is being amortized over the one year life of the note. Interest is accrued monthly. On July 8, 2004, one accredited investor, a related party, elected to convert $25,000 face value plus $1,270 of accrued interest into 87,565 of the Company's units. As of August 31, 2004, approximately $3,300 of interest was accrued as payable to the remaining investor. On November 18, 2004, the remaining note holder elected to convert $50,000 face value plus $4,475 of accrued interest into 181,585 shares of the Company's units. On February 13, 2004, the Company entered into a Note Purchase Agreement with an accredited investor, a related party, which yielded $60,000 in bridge financing to the Company. The promissory note has a term of 1-year and bears an interest rate of 10% per annum. Interest is payable quarterly on this note. On April 15, 2004, the Company entered into a Note Purchase Agreement with an accredited investor and a related party, resulting in proceeds to the Company of $40,000. The promissory note has a term of two months and bears interest at a rate of 8% per annum. Interest is payable monthly on this note. This note was paid in full on November 9, 2004. On May 3, 2004, the Company entered into a Note Purchase Agreement with an accredited investor and a related party, resulting in proceeds to the Company of $60,000. The promissory note has a term of one year and bears an interest rate of 10% per annum. Interest is payable monthly on this note. Note Payable On October 1, 2004, the Company entered into a note payable agreement to finance $68,000 of directors and officer's insurance premiums. The note bears interest at a rate of 7.25% per annum and is due in eight monthly installments of $8,733, including principal and interest, beginning on November 1, 2004. As of November 30, 2004, the principal balance of the note is $59,678. 9
NOTE 6 -- RECLASSIFICATIONS AND RESTATEMENTS Certain reclassifications have been made to conform fiscal 2004 information to the presentation of fiscal 2005 information. The reclassifications have no effect on net income. NOTE 7 -- STOCK BASED COMPENSATION In December 2002, the Financial Accounting Standards Board ("FASB") issued Statements of Financial Accounting Standards ("SFAS") No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation" in that it requires additional disclosures about our stock-based compensation plans. SFAS No. 148 is effective for periods beginning after December 15, 2002. We account for our stock-based compensation plans using the intrinsic value method of recognition and measurement principles under APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. We have adopted the disclosure-only provisions of SFAS No. 123. Assuming that we had accounted for our stock-based compensation programs using the fair value method promulgated by SFAS no. 123, pro forma net income (loss) and net income (loss) per share would have been as follows: Three Months Ended November 30 2004 2003 ----------- ----------- Net loss $ (300,301) $(1,364,953) Pro forma compensation expense for stock options (72,312) (127,063) ----------- ----------- Pro forma net loss $ (372,613) $(1,492,016) =========== =========== Pro forma loss per share available to common stockholders $ (.01) $ (.05) =========== =========== NOTE 8 -- SUBSEQUENT EVENTS On December 21, 2004, the Company entered into a note payable agreement to finance $4,001 of general and liability insurance premiums. The note bears interest at a rate of 13% per annum and is due in nine monthly installments of $469, including principal and interest, beginning on January 21, 2005. On January 4, 2005, the Company announced the execution of a Letter of Intent between BestNet Communications Corp. and Pacific Biometrics, Inc. Under the terms and conditions of the Letter, the companies agree to negotiate the terms of (a) a Stock Purchase Agreement and (b) an Asset Purchase and Management Agreement. Under the proposed Stock Purchase Agreement, PBI agrees to issue series A convertible preferred stock, representing 25% of the voting power, in PBI Technology, Inc. (PBI Tech), a wholly owned subsidiary of PBI, to BestNet at an aggregate purchase price of $1,000,000. Under the proposed Asset Purchase and Management Agreement, Dharma, Inc., a wholly owned subsidiary of BestNet, will (i) purchase all assets relating to PBI's proprietary Osteopatch(TM) and SalivaSac(TM) technologies, subject to certain restrictions, and (ii) engage PBI Tech to manage the further development and application of the Osteopatch(TM) and SalivaSac(TM) technologies, in consideration for which BestNet will (i) issue to PBI shares and warrants up to a total of 25% of the outstanding shares (fully diluted) of BestNet, and (ii) fund operations of Dharma in the amount of $500,000. On January 10, 2005, the Company announced approval by its Board of Director to split the Company's outstanding units into the securities comprising such units. The units are currently traded under the symbol BESCU. Each unit presently consists of: three shares of common stock; one share of Series A Convertible Preferred Stock; and one warrant to purchase a share of common stock at a per share exercise price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of common stock at a conversion price of $.10 per common share. An aggregate of 3,190,258 shares of common stock are issuable upon conversion of the shares of Series A Convertible Preferred Stock underlying the units. The Company will receive net proceeds of approximately $319,000 assuming all of the shares of Series A Convertible Preferred Stock are converted into shares of common stock. Each holder's right to split the units into the underlying securities is contingent upon the conversion of the underlying shares of Series A Convertible Preferred Stock into common stock on or prior to February 24, 2005. All units that have not been split by such date will continue to trade as units on the Pink Sheets. 10
NOTE 9 -- GOING CONCERN The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. The Company has incurred losses from operations over the years and anticipates additional losses in fiscal year 2005. Management has been successful in obtaining financing and has implemented a number of cost-cutting initiatives to reduce its working capital needs. The Company requires and continues to pursue additional capital for growth and strategic plan implementation. NOTE 10 - PENDING ACCOUNTING PRONOUNCEMENTS In November 2004, the FASB issued Statement No. 151 ("SFAS 151"), "Inventory Cost - An Amendment of ARB No. 43, Chapter 4." SFAS 151 clarifies accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. It requires that those items be recognized as current-period charges regardless of whether they meet the criterion of abnormal. Currently, we do not have any inventory, accordingly, adoption of SFAS 151 does not have a significant impact on our financial statements. In December 2004, the FASB issued Statement No. 152 ("SFAS 152"), "Accounting for Real Estate Time-Sharing Transactions - An Amendment of Statements 66 and 67." SFAS 152 amends SFAS 66 and 67 to reference the financial accounting and reporting guidance for real estate time-sharing transactions and to state that the guidance for incidental operations and costs incurred to sell real estate projects does not apply to real estate time-sharing transactions. SFAS 152 is effective for financial statements for fiscal years beginning after June 15, 2005. Currently, the Company does not have any real estate transactions. Accordingly, adoption of SFAS 152 does not have a significant impact on our financial statements. In December 2004, the FASB issued Statement No. 153 ("SFAS 153"), "Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29." SFAS 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Adoption of SFAS 153 does not have a significant impact on our financial statements. In December 2004, the FASB issued Statement No. 123R ("SFAS 123R"), "Share-Based Payment". This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. It requires that the fair-value-based method be used to account for these transactions for all public entities. This Statement is effective for small business issuers for the first reporting period after December 15, 2005 and will effect any stock based compensation issued after that date. 11 ITEM 2. Management's Discussion And Analysis Or Plan Of Operation THIS QUARTERLY REPORT ON FORM 10-QSB CONTAINS CERTAIN STATEMENTS WHICH ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE SAFE HARBOR PROVISIONS OF SECTION 27A OF THE SECURITIES ACT OF 1993, AS AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. THESE STATEMENTS RELATE TO FUTURE EVENTS, INCLUDING THE FUTURE FINANCIAL PERFORMANCE OF BESTNET. IN SOME CASES, YOU CAN IDENTIFY FORWARD-LOOKING STATEMENTS BY TERMINOLOGY SUCH AS "MAY," "WILL," "SHOULD," "EXPECTS," "PLANS," "ANTICIPATES," "BELIEVES," "ESTIMATES," "PREDICTS," "POTENTIAL," OR "CONTINUE" OR THE NEGATIVE OF SUCH TERMS AND OTHER COMPARABLE TERMINOLOGY. THESE STATEMENTS ONLY REFLECT MANAGEMENT'S EXPECTATIONS AND ESTIMATES AS OF THE DATE OF THIS REPORT. ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY FROM THESE EXPECTATIONS. IN EVALUATING THOSE STATEMENTS, YOU SHOULD SPECIFICALLY CONSIDER VARIOUS FACTORS, INCLUDING THE RISKS INCLUDED IN THE REPORTS FILED BY BESTNET WITH THE SEC. THESE FACTORS MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM ANY FORWARD-LOOKING STATEMENTS. BESTNET IS NOT UNDERTAKING ANY OBLIGATION TO UPDATE ANY FORWARD-LOOKING STATEMENTS CONTAINED IN THIS REPORT. All references to "we," "our," "us," or "BestNet refer to BestNet Communications Corp. and its subsidiaries. This report should be read in conjunction with our Annual report on Form 10-KSB for the fiscal year ended August 31, 2004. OPERATIONS OVERVIEW Revenues for the three-month period ended November 30, 2004 decreased by 26% over the comparable period in fiscal 2004. Prior to the September Caribbean hurricanes, approximately 28% of our revenue is normally derived from the Cayman Islands in the Caribbean. The recent hurricanes in the Caribbean area disrupted telephone communications and caused our revenue to decline by approximately 21% beginning during the second week of September 2004. Although we are beginning to regain that revenue, we cannot predict whether or when it will be completely restored or whether such a natural or other disaster will occur in the future. Our revenue usually declines during the month of December because of the effect of the holidays during that period. Cost of revenues, as a percent of revenues, decreased by 6% for the three-month period ended November 30, 2004, as compared to the same period in fiscal 2004. The decrease in this percentage was due principally to the routing of calls on our network through the highest quality, most cost effective carriers. Our most significant costs of providing services include fees paid to wholesalers for telephone line access, connectivity to our wholesalers, "merchant fees" paid to credit card companies for processing customer payments, and sales commissions paid to agents. For the three-month period ended November 30, 2004, contribution margin increased to 37% as compared to 31% for the same period in fiscal 2004. We believe we can maintain this contribution margin while concentrating on our revenue growth. General and administrative costs increased by 6% for the three-month period ended November 30, 2004, as compared to the same period in fiscal 2004. This increase was due principally to the issuance of stock for consulting services of approximately $54,000. We continue to focus our efforts on reducing the monthly amount of cash consumed by current operations, while still investing to grow the business. We continue to work to surpass breakeven as quickly as possible. Depreciation and amortization expenses decreased to $43,733 for the three-month period ended November 30, 2004, from $504,379 for the comparable period in fiscal 2004. Our Board of Directors has concluded that the value of the Softalk License, which has historically been shown as an intangible asset on our balance sheet, has been reduced to zero, as reported on our Form 10-KSB for the fiscal year ended August 31, 2004, because of our history of losses doing business with the licensed technology and the low probability of achieving positive cash flow in that business within a reasonable period of time. 12 Interest income increased to $636 for the three-month period ended November 30, 2004, from $330 for the comparable period in fiscal 2004 due primarily to a larger average cash balance in the Company's money market account. Interest and finance charges decreased to $146,772 for the three-month period ended November 30, 2003, from $188,188 for the comparable period in fiscal 2003. The interest and finance charges are primarily attributable to the Company's issuance and conversion of convertible notes in connection with its financing transactions. Conversion expense increased to $541,182 for the three-month period ended November 30, 2003 from $0 in the comparable period in fiscal 2003. During the first quarter of fiscal 2004, the Company's 6% convertible Notes Payable went into default as they were past due. The Company, as an incentive to convert, offered holders of the Convertible Notes Payable a conversion price of $0.15 per share, with the stipulation that all outstanding warrants that were issued in conjunction with the Convertible Notes Payable would be returned to the Company. This modified conversion rate represents a significant decline from the original conversion rate that was provided for in the original Convertible Note Agreements. Of the $665,000 principal outstanding, holders of $220,000 aggregate principal elected to convert, at the modified conversion rate of $0.15 per share. The Company recognized a conversion expense of $541,182 related to these conversions. The remaining Convertible Notes Payable have been extended for an additional year with modified conversion terms. As a result of the beneficial conversion terms inherent in the extended Convertible Notes Payable, the Company recorded a discount to the notes payable, which is being amortized over the extended term to interest and finance charges. First quarter 2005 loss per common share, basic and diluted, decreased to $(.01) from $(.05) in the first quarter 2004, with 40,674,424 and 28,408,756 common shares outstanding, respectively. 13 BUSINESS OF BESTNET AND SUBSIDIARIES GENERAL We were formed in 1995 as a New Jersey corporation, under the name "Wavetech, Inc.", through the merger of two predecessor corporations. We changed our corporate domicile to Nevada in December 1997, by merging into a Nevada corporation named, "Interpretel International, Inc." and subsequently changed our name to, "Wavetech International, Inc." Our business at the time was to develop and market software for customized telephone calling card services. In 1999 we changed our business to take advantage of technological advances making it possible to provide improved telephone services through the use of the Internet. Since then, our business has been to apply Internet technology to provide worldwide long distance telephone communication and teleconferencing services to commercial and residential consumers at prices lower than those generally available from conventional telephone companies. In 2000, reflecting that business change, we changed our name to "BestNet Communications Corp". The Internet technology we use is patented by Softalk, Inc., an Ontario, Canada corporation ("Softalk"). We have a license from Softalk (the "Softalk License") to use that technology in specific applications. The patent will expire in 2021. See Part II, ITEM 1, "LEGAL PROCEEDINGS", below, for a description of disputes between us and Softalk. We have never achieved a positive cash flow or profitability in our present business because we have not yet generated a volume of business sufficient to cover our overhead costs. In October 2003, we made changes to management, reduced overhead expenses, initiated product development efforts and adopted a new marketing plan in an effort to achieve positive cash flow from operations. Success in these efforts and plans will depend on our ability to obtain funding, as our cash flow is insufficient to cover our operating expenses or to acquire additional equipment or other assets that may be required. See "CUSTOMERS AND MARKETING" below in this section. NEW FIELD OF BUSINESS As an alternative method of realizing value for our shareholders, we are exploring whether to enter a new field of business by seeking to participate in the bio-tech industry. We are in the process of establishing a new subsidiary for this purpose. On January 4, 2005, the Company announced the execution of a Letter of Intent between BestNet Communications Corp. and Pacific Biometrics, Inc. Under the terms and conditions of the Letter, the companies agree to negotiate the terms of (a) a Stock Purchase Agreement and (b) an Asset Purchase and Management Agreement. Under the proposed Stock Purchase Agreement, PBI agrees to issue series A convertible preferred stock, representing 25% of the voting power, in PBI Technology, Inc. (PBI Tech), a wholly owned subsidiary of PBI, to BestNet at an aggregate purchase price of $1,000,000. Under the proposed Asset Purchase and Management Agreement, Dharma, Inc., a wholly owned subsidiary of BestNet, will (i) purchase all assets relating to PBI's proprietary Osteopatch(TM) and SalivaSac(TM) technologies, subject to certain restrictions, and (ii) engage PBI Tech to manage the further development and application of the Osteopatch(TM) and SalivaSac(TM) technologies, in consideration for which BestNet will (i) issue to PBI shares and warrants up to a total of 25% of the outstanding shares (fully diluted) of BestNet, and (ii) fund operations of Dharma in the amount of $500,000. We consider this a high risk business but one in which the potential rewards for success can be substantial. Our ability to enter the new business will be dependent on our ability to obtain sufficient financing for the purpose and there is no assurance of any success in this regard. SERVICES Generally, we apply the rights granted to us under the Softalk License to connect telephone users directly to ordinary worldwide telephone circuits (called the "Public Switched Telephone Network" or "PSTN") operated by "wholesalers", who are generally large, well known telecommunications companies. Customers initiate long distance calls on our system by dialing a specified number on their telephone instruments or accessing a specified Internet location through a browser, desktop application, personal digital assistant (PDA), email, or cellular text messaging. In accordance with our procedures, information identifying them as our customers and their method of payment, we then connect the customer to the person or people they wish to dial. We also provide a service whereby our customers can, at their expense, establish a similar method for receiving incoming calls from others whom they permit to use the system. 14 The connections are made through hardware and network equipment we maintain on leased premises at co-location facilities which connect us to our wholesalers in Toronto, Ontario, Canada and at New York, New York. This system enables telephone users to place regular, point-to-point, calls as well as conference calls anywhere in the world. The Softalk License grants us the right to use and sell the following services based on the Softalk patent: "WebCall" is a method whereby the customer accesses our website through his or her own computer and initiates a call by placing a request for a call between his or her own telephone and a specified destination, or receiver, to be established by our switch on the PSTN. The destination or receiving telephone site can also include ships at sea, off shore oil rigs or other sites reached via satellite transmission. This is the basic technology that supports all of our services. "WebConferenceCall" is a method whereby the customer utilizes "Web Call" to place conference calls. "DesktopCall" is a method for initiating calls through the customer's computer by means of a downloaded, desktop application and therefore without using the customer's web browser. "PDACall" enables the customer to place calls through our system using a mobile, wireless device. "Callme" enables the customer to permit other persons (friends, relatives, etc.) to use our system to place a call to the customer at the customer's expense. A variation of this service, called, "ClicktoPhone" permits an unlimited number of calls. The Softalk License is exclusive as to commercial customers and non-exclusive as to individual customers. Approximately 80% of our revenue is derived from individual customers and 20% from commercial customers "Commercial" customers are defined in the Softalk License as corporations (with one or more shareholders), limited liability companies, partnerships, associations or other entities or organizations, but do not include any such organization using the technology as charitable gift from Softalk. We offer two additional services, developed by us that we believe are not subject to the Softalk License: "SMS Call", a method of initiating calls through mobile telephones, via a text message, without the use of the Internet, and "DialCall", a method of initiating calls, by dialing a specified North American toll free number, without the use of the Internet. A variation permits a party to join in a conference call already in progress by dialing into a specified North American toll free number. We also developed and apply a program called OpenCall which is an Application Program Interface or "API", which permits an independent distributor or agent to offer our services under its own name but which in fact connects its customers to our system. The concept underlying our business is that we are able to charge customers less for long distance calls than would be charged by conventional telephone companies. Since both halves of call are inbound, we are able to pass along wholesale long distance rates to our customers We are in the process of applying for a United States patent on a technological improvement that reduces the amount of information that needs to be entered by customers who can transmit text messages through such devices as cellular telephones. When applied, this improvement is expected to reduce the time and expense involved in placing and processing the call. There is no assurance that a patent will be issued or that if issued, such a patent will be upheld. Furthermore, our legal right to use this improvement if the Softalk License is terminated is uncertain. The patent on the licensed Softalk technology will expire in October 2021. We have plans, subject to the availability of the necessary funding, to develop an alternative personal computer based method (called "Voice over Internet Protocol" or "VoIP") for placing calls and to be able to use VoIP wholesale carriers. If this development were successful, it would be outside, and therefore not limited by, the scope of the Softalk License. 15 During the 2004 fiscal year our development efforts included the development of the "OpenCall" and "DialCall" programs described above, enhancing various features of our system and improving our website. We are engaged in a number of research and development efforts to improve and enhance our existing services and to develop new ones, including VoIP, which, if successful, will enable us to offer services with greater efficiency and at lower prices. All of our research and development efforts are subject to our ability to obtain sufficient funding. We do not know whether or not Softalk has licensed others to use its patented technology for services to individual customers or, if it has, whether any other licensee is actually using it. The License originally provided for our payment of "commissions" or royalties to Softalk, but subsequent amendments eliminated further payments to Softalk by us, except that if we sue infringers of the patent and collect money damages from any of them, we would be obligated to pay to Softalk 25% of the amounts received after first deducting the costs and expenses of litigation, including attorney fees. We may lose our rights under the Softalk License under the following circumstances: 1. If Softalk reasonably determines that we have failed to maintain a specified quality of service as to the Softalk Products, Softalk may terminate the License if we have not remedied the failure to Softalk's satisfaction within sixty days of Softalk's notice to us of the alleged failure. 2. If we fail to comply in any material respect with any term or condition of the License Agreement, and such failure to comply is not corrected within a thirty-day notice period. 3. If we become bankrupt or insolvent, make an assignment for the benefit of our creditors or if a receiver is appointed for our assets or business. 4. If we have a change of control Softalk shall have the right to terminate the License upon sixty days written notice. For purposes of this provision, there is a "change of control" if: a. Any person is or becomes the beneficial owner (as such terms are defined under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) directly or indirectly, of our securities representing fifty-one percent (51%) or more of the combined voting power of our then outstanding securities, other than (i) an employee benefit plan established or maintained by us or a subsidiary of ours, or (ii) any person who owned such quantity of securities as of the original date of the Softalk License, or b. Our stockholders approve of (i) a merger or consolidation of our company with or into another corporation (other than a merger or consolidation in which at least a majority of the directors of the surviving or resulting corporation immediately after the transaction have been our directors, (ii) a sale or disposition of all or substantially all of our assets, or (iii) a plan of liquidation or dissolution of our company, or c. The individuals who constituted our Board of Directors as of the date of the License, or persons approved by a vote of at least 80% of the other directors (other than a person or persons elected to the Board in an actual or threatened election contest) cease for any reason to constitute at least 80% of the Board. The present Board was elected in October 2003 as the result of such an election contest. We may not assign our rights under the Softalk License and that provision of the License, as well as the default provisions summarized above, would prevent us from selling our present business to any other party or hinder us in entering into any other business combination, even if to do so might be in the best interests of our shareholders. If we were to lose our rights under the License, we could no longer continue to offer our present services to new customers although we could continue with our present customers. As previously reported, Softalk has alleged that we are in default under the License. We do not believe that any event of default has occurred and have denied the allegation. We have had a number of discussions with Softalk in an effort to resolve the matter. As of the date of this Report, Softalk has demanded arbitration of the issues as provided in the Softalk License. If the dispute is not resolved, we intend to assert counterclaims as described under "LEGAL PROCEEDINGS", Item 3 of this Report, below. 16 CUSTOMERS AND MARKETING Approximately 12,000 customers have open accounts with us that permit them to place calls through our system. Of these, approximately 8,300 customers actually used our system during the last fiscal year. Approximately 90% of these customers are individuals, contributing approximately 80% of our revenue, and the remaining 10% are business entities, contributing approximately 20% of our revenue. Less than 3% of calls placed through our system originate and terminate (intrastate and interstate calls) within the United States. During the 2004 fiscal year, calls originated from approximately 183 countries and terminated in (that is, are placed to) approximately 221 countries. The most frequently used telephone routes (amounting to approximately 70% of our revenue) are in the Americas, including the Caribbean area. Prior to the September Caribbean hurricanes, approximately 28% of our revenue is normally derived from the Cayman Islands in the Caribbean. The recent hurricanes in the Caribbean area disrupted telephone communications and caused our revenue to decline by approximately 21% beginning during the second week of September 2004. Although we are beginning to regain that revenue, we cannot predict whether or when it will be completely restored or whether such a natural or other disaster will occur in the future. Generally, there is a trend to increasing use of the Internet to place telephone calls. However, increased worldwide usage and technological improvements have brought additional competition to the market and this has resulted in a downward pressure on prices that we and our competitors are able to charge our customers. This, in turn, adversely affects profits margins in our industry. We plan to counter this trend and generate a positive cash flow by attempting to increase the volume of our business without a significant increase in overhead expense. We have plans, subject to the availability of the necessary funding, to develop an alternative personal computer based method (usually called "VoIP") for placing calls and to be able to use VoIP wholesale carriers. Our new marketing plan is directed at increasing the volume of calls placed through our system, thereby increasing revenue relative to overhead expense and achieving a positive cash flow. Under this plan we have improved our website and begun a search engine optimization effort or "SEO". The SEO involves engaging a consultant and placing key words within our website that will assure that when members of the public search on the internet for discount telephone providers, a link to our "BestNet" service will appear at or near the top of the resulting list. In addition, members of our management, including some of our Directors, are engaged in an effort to increase the number of "agents" selling our services. Agents use their private labeled websites to solicit customers, thus connecting their customers to our system. Some agents maintain websites that have a link to our website, thereby directing customers to us. Other agents contract to provide call services to their customers but fulfill their obligations by connecting their customers to our system. We pay both types of agent a commission based on the amount of revenue they produce for us. As of the date of this Report, there are ten agents who, in the aggregate, presently generate approximately 14% of our revenue. These agents are located in Brazil, Peru, Mexico, Costa Rica, Venezuela, Spain, Australia, South Africa, United States and Lebanon. COMPETITION Our industry is characterized by intense competition among numerous participants. There is a relative ease of entry into this industry because of factors such as surplus capacity and rapid technological advancements that have increased the alternatives that are available to users and put downward pressure on prices. Competitors include calling card providers, teleconferencing providers, dial-around services and Internet calling companies. They range from large, well-established telephone companies to new start-ups. The larger competitors have well-standing customer bases, and financial and marketing resources substantially greater than ours. Our possible use of VoIP technology, even if successful, would also face wide competition. We have been able to remain in this business because, in contrast to some of our competitors, our technology does not require customers to purchase any special equipment or software and because in certain markets our prices to our customers are generally not higher than those charged by others. Furthermore, we have been able to date to fund our operating losses by obtaining investment capital from private investors, including present members of our Board of Directors. Our continued ability to compete will depend on our ability to continue to raise investment capital until we are able to achieve positive cash flow and on our ability to apply the additional capital to expand our customer base and to maintain our ability to compete from a technical point of view. 17 OPERATIONS Technical. We connect our customers to telephone lines by the use of hardware and network switching equipment. We maintain that equipment in Toronto and in New York City on the premises of co-locations facilities that connect us to the worldwide telephone circuits. When a customer initiates a call, he or she connects to our web server, located in Grand Rapids, Michigan, which is connected to our customer database and then to our PSTN switches. One of these two switches (in Toronto or New York) places the calls through to the wholesale circuits. Technical operations are conducted at our location in Toronto, Canada, by a group of three contractors under the direction of our Chief Operating Officer, who is located there. That group monitors the system to assure continuous uninterrupted operations and quality control, maintains an anti-virus effort to prevent willful interference with our system, assists in customer support, and also carries out our research, development and implementation efforts, including continuous enhancements and improvements to our system. Administrative and Financial. Our administrative and financial functions and customer service operations are performed at our Grand Rapids, Michigan, office, where we have four employees including our Chief Financial Officer. Our President works from his home in Scottsdale, Arizona, traveling to Toronto and Grand Rapids as deemed advisable. We collect approximately 90% of our revenue by charging customer credit cards. Some larger accounts are invoiced on a monthly basis. Credit losses have not been significant. Wholesaler Agreements. Our customers use telephone lines that are owned by various telecommunications companies with whom we have wholesale services agreements. Under these wholesale agreements, we receive the right to use certain telephone lines and circuits around the world and in turn pay those wholesalers, a fee (usually per minute of usage) determined from time to time by the wholesaler. The rates charged by the wholesalers are typically lower than those charged by conventional telephone companies. The wholesale agreements provide for continuous, monthly renewals unless the Company or the wholesaler gives at least thirty (30) days notice of termination. The Company believes that if its wholesale agreements were to be terminated, that there are numerous telecommunications companies to provide similar services at comparable rates. GOVERNMENT REGULATION Our industry is generally subject to federal, state, provincial and local regulation. In the United States, the Federal Communications Commission (FCC) exercises jurisdiction over all facilities and services of telecommunications common carriers to the extent those facilities are used to provide, originate, or terminate interstate or international communications. Internationally and within the United States, we operate under a Section 214 License issued to us by the FCC. We operate in Canada under a Class "A" Operating License issued to us by the Canadian Radio-television and Telecommunications Commission (CRTC). Currently we believe these licenses are sufficient for the services we provide. We continue to monitor changes in regulations and plan to fully comply in areas we operate around the world. LIQUIDITY AND CAPITAL RESOURCES We have never achieved a positive cash flow or profitability in our present business because we have not yet generated a volume of business sufficient to cover our overhead costs. In October 2003, we made changes to management, reduced overhead expenses, initiated product development efforts and adopted a new marketing plan in an effort to achieve positive cash flow from operations. Success in these efforts and plans, and even our ability to remain in business, will depend on our ability to obtain funding, as our cash flow is insufficient to cover our operating expenses or to acquire additional equipment or other assets that may be required. Our auditors have qualified their opinion on our financial statements reflecting uncertainty as to our ability to continue in business. Our Board of Directors has concluded that the value of the Softalk License, which has historically been shown as an intangible asset on our balance sheet, has been reduced to zero, as reported on our Form 10-KSB for the fiscal year ended August 31, 2004, because of our history of losses doing business with the licensed technology and the low probability of achieving positive cash flow in that business within a reasonable period of time. Our operating losses to date have been covered by equity and debt financing obtained from private investors, including certain present members of our Board of Directors. 18 At November 30, 2004, the Company had cash of $136,755. The Company does not generate income sufficient to offset the costs of its operations. As a result, it has historically relied upon the issuance of debt or equity in order to raise capital. In the absence of achieving profitable operations in future periods, obtaining additional capital through asset sales, securing a revolving credit facility, debt or equity offerings, or a combination of the foregoing, we may encounter liquidity difficulties. No assurance can be given that the Company will be able to raise additional capital when needed, or at all, or that such capital, if available, will be on terms acceptable to the Company. CRITICAL ACCOUNTING POLICIES "Managements Discussion and Analysis or Plan of Operation" discusses our condensed consolidated unaudited financial statements that have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities at the date of the financial statements, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, we evaluate our estimates and judgments, including those related to revenue recognition, valuation allowances for accounts receivable and impairment of long-lived assets. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. The result of these estimates and judgments form the basis for making conclusions about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. The SEC suggests that all registrants list their most "critical accounting policies" in Management's Discussion and Analysis. A critical accounting policy is one which is both important to the portrayal of the Company's financial condition and results and requires management's most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management believes the following critical accounting policies affect its more significant judgments and estimates in the preparation of its consolidated financial statements. Our Board of Directors has concluded that the value of the Softalk License, which has historically been shown as an intangible asset on our balance sheet, has been reduced to zero, as reported on our Form 10-KSB for the fiscal year ended August 31, 2004, because of our history of losses doing business with the licensed technology and the low probability of achieving positive cash flow in that business within a reasonable period of time. 19 RESULTS OF OPERATIONS COMPARISON OF THE THREE-MONTH PERIOD ENDED NOVEMBER 30, 2004, TO THE THREE-MONTH PERIOD ENDED NOVEMEBER 30, 2003. Revenues Revenues decreased to $400,304 for the three-month period ended November 30, 2004, compared to $545,027 for the comparable period in fiscal 2004. Prior to the September Caribbean hurricanes, approximately 28% of our revenue is normally derived from the Cayman Islands in the Caribbean. The recent hurricanes in the Caribbean area disrupted telephone communications and caused our revenue to decline by approximately 21% beginning during the second week of September 2004. Although we are beginning to regain that revenue, we cannot predict whether or when it will be completely restored or whether such a natural or other disaster will occur in the future. Our revenue usually declines during the month of December because of the effect of the holidays during that period. Current period revenues were derived from customer usage of Bestnetcall service including international long distance, conference calling as well as the Company's new product, ClicktoPhone. Cost of Revenues Cost of revenues decreased to $253,583 for the three-month period ended November 30, 2004, from $377,697 for the comparable period in fiscal 2004. The decrease in cost of revenues was related to decreased usage of our network and the increase of our contribution margin to 37% from 31% in fiscal 2004. We are taking further steps to maintain these contribution margins. General and Administrative Expenses General and administrative expenses increased to $362,165 for the three-month period ended November 30, 2004, from $341,494 for the comparable period in fiscal 2004. Payroll and related expenses decreased to $91,005 for the three-month period ended November 30, 2004, from $163,873 for the comparable period in fiscal 2004 reflecting our reduction in executive personnel. Legal and professional fees decreased to $4,594 for the three-month period ended November 30, 2004, from $9,929 for the comparable period in fiscal 2004, reflecting a settlement in charges owed to our law firm. Sales and commodity taxes decreased to $2,738 for the three-month period ended November 30, 2004, from $5,481 for the comparable period in fiscal 2004 due to the decrease in revenue for the first quarter of fiscal 2005. Marketing/Consulting expense increased to $147,512 for the three-month period ended November 30, 2004, from $5,748 for the comparable period in fiscal 2004 due principally to marketing and consulting contracts with an outside vendor and our directors. Approximately $54,000 of this increase was expenses related to the issuance of stock for services. Accounting fees increased to $22,775 for the three-month period ended November 30, 2004, from $21,086 for the comparable period in fiscal 2004. Outside services expense decreased to $20,458 for the three-month period ended November 30, 2004, from $22,215 for the comparable period in fiscal 2004, due to expenses incurred with improvements made to our network operations. Investor Relations expense decreased to $4,395 for the three-month period ended November 30, 2004, from $21,775 for the comparable period in fiscal 2003, due principally from the cost of our annual shareholder meeting held during the first quarter of fiscal 2004. Continued select cost reductions are having a positive impact on general and administrative expenses bringing us closer to breakeven. Depreciation and Amortization Expenses Depreciation and amortization expenses decreased to $43,733 for the three-month period ended November 30, 2004, from $504,379 for the comparable period in fiscal 2004. Our Board of Directors has concluded that the value of the Softalk License, which has historically been shown as an intangible asset on our balance sheet, has been reduced to zero, as reported on our Form 10-KSB for the fiscal year ended August 31, 2004, because of our history of losses doing business with the licensed technology and the low probability of achieving positive cash flow in that business within a reasonable period of time. 20 Interest Income Interest income increased to $636 for the three-month period ended November 30, 2004, from $330 for the comparable period in fiscal 2004 due primarily to a larger average cash balance in the Company's money market account. Interest and Finance Charges and Conversion Expenses Interest and finance charges decreased to $24,948 for the three-month period ended November 30, 2004, from $146,772 for the comparable period in fiscal 2004. The interest and finance charges are primarily attributable to the Company's issuance and conversion of convertible notes in connection with its financing transactions. Most of these convertible notes were converted into common stock by the end of fiscal 2004. Conversion expense decreased to $0 for the three-month period ended November 30, 2004 from $541,182 in the comparable period in fiscal 2004. During the first quarter of fiscal 2004, the Company defaulted in the payment of its 6% convertible Notes Payable. The Company, as an incentive to convert, offered holders of the Convertible Notes a conversion price of $0.15 per share, with the stipulation that all outstanding warrants that were issued in conjunction with the Convertible Notes would be returned to the Company. This modified conversion rate represents a significant decrease from the original conversion rate that was provided for in the original Convertible Note Agreements. Of the $665,000 principal outstanding, holders of $220,000 aggregate principal elected to convert, at the modified conversion rate of $0.15 per share. The Company recognized a conversion expense of $541,182 related to these conversions. The remaining Convertible Notes have been extended for an additional year with modified conversion terms. As a result of the beneficial conversion terms inherent in the extended Convertible Notes, the Company recorded a discount to the notes payable, which is being amortized over the extended term to interest and finance charges. Preferred Declared and Deemed Dividends None. INFLATION Although the Company's operations are influenced by general economic trends and technology advances in the telecommunications industry, the Company does not believe that inflation has had a material effect on its operations. ITEM 3. Controls and Procedures Evaluation of Disclosure Controls and Procedures Our management, including our chief executive officer and principal accounting officer, have carried out an evaluation of the effectiveness of our disclosure controls and procedures as of November 30, 2004, pursuant to Exchange Act Rules 13a - 15(e) and 15(d) - 15 (e). Based upon that evaluation, our chief executive officer and principal accounting officer have concluded that as of such date, our disclosure controls and procedures in place are adequate to ensure material information and other information requiring disclosure is identified and communicated on a timely basis. Changes in Internal Control Over Financial Reporting During the period covered by this Report, there have been no significant changes in our internal control over financial reporting that have materially affected or are reasonably likely to material affect our internal control over financial reporting. 21 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings The arbitration proceedings with Softalk that we have previously reported was compromised and settled by an agreement made on October 9, 2003 and made final on December 3, 2003. Pursuant to that agreement: o We released our claim against Softalk for a loan repayment in the amount of $1,589,768.21 plus $211,048 in interest that had accrued on that amount o We paid over to Softalk $27,709 for royalties that had accrued under the Softalk License and Softalk released us from all obligations to pay royalties thereafter; o We released our claim against Softalk for rights to the source code for the licensed technology and our rights to any future communications software developed by Softalk; o We agreed to release all rights to the SMS calling program developed by Softalk; o Softalk released us from a claim in the amount of $481,465; o Warrants for the purchase of 5,276,753 shares of our common stock were returned to us by Softalk. Warrants for 3,276,753 shares were exercisable at $3.25 per share; warrants for 1,000,000 shares were exercisable at $5.00 and warrants for an additional 1,000,000 shares were exercisable at $10.00; o 1,900,000 shares of our common stock held by Softalk, were returned to us as treasury stock at a time when the bid and ask prices on the OTC BULLETIN BOARD were $.26 and $.29 respectively.; and o Softalk agreed that 1,900,000 additional shares of our common stock that it continued to hold would be sold at a rate no greater than 100,000 shares per month over a period of 19 months from the settlement date, with the right to carry over to future periods any unsold portion of such 100,000 shares per month. We believe that as of December 6, 2004, Softalk had sold 1,400,000 shares in the market. We understand that Softalk wishes to sell its remaining 500,000 shares at the rate of 100,000 shares per month, subject to our prior written consent, as is provided in the settlement agreement described above. On March 26, 2004, we received a notice from Softalk alleging a breach of the confidentiality and change of control provisions of the Softalk License and of that portion of the settlement agreement (described above) providing for the release for sale of BestNet Communications common shares held by Softalk, and stating that Softalk wished to terminate the License and demanding arbitration of the issues. After discussions between respective counsel for the parties, it was agreed to stay all proceedings pending further negotiations. After consultation with counsel, we do not believe that we are in default under the Softalk License or the settlement agreement. We have advised Softalk, however, that we believe that Softalk is in breach of the Softalk License in that it is competing with us for commercial customers notwithstanding that the Softalk License grants us exclusive rights in that market. On or about November 22, 2004, we were notified that Softalk had renewed its demand to arbitrate the issues and terminate the Softalk License. We intend to contest Softalk's claims vigorously and to assert counterclaims against Softalk for, among other things, breaching its agreement not to compete with us for commercial customers through the use of the technology that is subject to the Softalk License. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds On January 8, 2004, we obtained $75,000 from the sale and issuance of Convertible Notes to two accredited investors, one of which was a trust whose beneficiaries are our President, Stanley L. Schloz, and his wife. The Notes have 22 a one-year term and bear interest at a rate of 10% per annum. Interest is accrued monthly. The principal amount of and accrued interest under each Note are convertible into Units of the Company at the election of the holder at a conversion price equal to one Unit for each $0.30 of principal and interest converted. Each Unit consists of the following underlying securities: (a) three shares of the Company's common stock; (b) one share of Series A Convertible Preferred Stock, par value $.001 per share; and (c) one three-year warrant to purchase one share of common stock at a per share price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of the Company's common stock in exchange for $0.10 per common share ($.20 for each Series A Convertible Preferred share converted). The securities underlying the Units are not to be separately tradable or transferable apart from the Units until such time as determined by the Company's Board of Directors. We agreed to register with the SEC for resale the shares of common stock underlying the Units that are issuable upon conversion of the Note. On July 8, 2004, one of the investors, Mr. Schloz, through his trust, converted $25,000 of principal plus $1,270 of accrued interest under the Convertible Note into 87,565 Units. On March 12, 2004, we received approximately $60,000 from the sale of an aggregate 200,000 Units at a per Unit purchase price of $0.30 to an accredited investor, Katsinam Partners, LP, which is an affiliate of two of our directors, Messrs Anthony Silverman and Richard Bourke. Each Unit consists of: (a) three shares of the Company's common stock; (b) one share of Series A Convertible Preferred Stock, par value $.001 per share; and (c) one three-year warrant to purchase one share of common stock at a per share price of $0.30. Each share of Series A Convertible Preferred Stock is convertible into two shares of the Company's common stock in exchange for a payment $0.10 per common share ($.20 for each Series A Convertible Preferred share converted). We agreed to register with the SEC for resale the shares of common stock underlying the Units that are issuable upon conversion of the Note. In August 2004, these Units were separated into the underlying securities. The issuance of the Company's securities described in the paragraphs above were made in reliance upon the exemption from the registration provisions of the Securities Act of 1933 as set forth in Section 4(2) thereof. ITEM 3. Defaults Upon Senior Notes None. ITEM 4. Submission of Matters to a Vote of Security Holders None. ITEM 5. Other Information None. ITEM 6. Exhibits and Reports on Form 8K a) Exhibits. Description 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Dated: January 14, 2005 BESTNET COMMUNICATIONS CORP. By: /s/ Stanley L. Schloz -------------------------------- Stanley L. Schloz, President and Director By: /s/ Michael A. Kramarz -------------------------------- Michael A. Kramarz, Chief Financial Officer By: /s/ Kelvin Wilbore -------------------------------- Kelvin Wilbore, Chief Operations Officer By: /s/ Marco Messina -------------------------------- Marco Messina, Director By: /s/ Anthony Silverman -------------------------------- Anthony Silverman, Director By: /s/ Barry K. Griffith -------------------------------- Barry K. Griffith, Director By: /s/ Richard Bourke -------------------------------- Richard Bourke, Director 24 EX-31.1 2 bestnetexhib311-113004.txt CERTIFICATION OF CEO PER SECTION 302 Exhibit 31.1 Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Stanley L. Schloz, President of BestNet Communications Corp. (the "Company"), certify that: (1) I have reviewed this Quarterly Report on Form 10-QSB of the Company for the quarterly period ended November 30, 2004 (the "Report"); (2) Based on my knowledge, the Report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report; (3) Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition and results of operations of the Company as of, and for, the periods represented in the Report; (4) The Company's other certifying officers and I are responsible for establishing and maintaining "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the Company and we have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others with these entities, particularly during the period in which this Report is being prepared; (b) Evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this Report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this Report based on such evaluation; and (c) Disclosed in this Report any change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter (i.e., the quarter ended November 30, 2004) that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. (5) The Company's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. Dated: January 14, 2005 By: /s/ Stanley L. Schloz ------------------------------- Stanley L. Schloz President EX-31.2 3 bestnetexhib312-113004.txt CERTIFICATION OF CFO PER SECTION 302 Exhibit 31.2 Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 I, Michael A. Kramarz, Chief Financial Officer of BestNet Communications Corp. (the "Company"), certify that: (1) I have reviewed this Quarterly Report on Form 10-QSB of the Company for the quarterly period ended November 30, 2004 (the "Report"); (2) Based on my knowledge, the Report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by the Report; (3) Based on my knowledge, the financial statements, and other financial information included in the Report, fairly present in all material respects the financial condition and results of operations of the Company as of, and for, the periods represented in the Report; (4) The Company's other certifying officers and I are responsible for establishing and maintaining "disclosure controls and procedures" (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e) for the Company and we have: (b) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others with these entities, particularly during the period in which this Report is being prepared; (b) Evaluated the effectiveness of the Company's disclosure controls and procedures and presented in this Report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this Report based on such evaluation; and (c) Disclosed in this Report any change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter (i.e., the quarter ended November 30, 2004) that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. (5) The Company's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Company's auditors and the audit committee of the Company's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Company's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Company's internal control over financial reporting. Dated: January 14, 2005 By: /s/ Michael A. Kramarz ------------------------------- Michael A. Kramarz Chief Financial Officer EX-32.1 4 bestnetexhib321-113004.txt CERTIFICATION OF CEO PER SECTION 906 EXHIBIT 32.1 BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report on Form 10-QSB of BestNet Communications CORP. (the "Company") for the quarterly period ended November 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I Stanley L. Schloz, President of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Stanley L. Schloz - ----------------------------- Stanley L. Schloz President January 14, 2005 EX-32.2 5 bestnetexhib322-113004.txt CERTIFICATION OF CFO PER SECTION 906 EXHIBIT 32.2 BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report on Form 10-QSB of BestNet Communications CORP. (the "Company") for the quarterly period ended November 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I Michael A. Kramarz, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that: (1) The report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Michael A. Kramarz - ----------------------------- Michael A. Kramarz Chief Financial Officer January 14, 2005 -----END PRIVACY-ENHANCED MESSAGE-----