10QSB 1 bestnet10qsb053105.txt PERIOD ENDED 05-31-05 ================================================================================ 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 May 31, 2005. [ ] 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 June 30, 2005 there were 43,652,298 shares of common stock, par value $.001 per share, outstanding. Transitional Small Business Disclosure Format (Check One): Yes [ ] No [X] ================================================================================ 1 BESTNET COMMUNICATIONS CORP. INDEX TO QUARTERLY REPORT ON FORM 10-QSB FOR THE QUARTERLY PERIOD ENDED MAY 31, 2005 AND MAY 31, 2004 PAGE ---- PART I. FINANCIAL INFORMATION ITEM 1. Financial Statements CONDENSED CONSOLIDATED BALANCE SHEETS -- May 31, 2005(unaudited) and August 31, 2004 3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MAY 31, 2005 AND MAY 31, 2004 4 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE NINE MONTHS ENDED MAY 31, 2005 AND MAY 31, 2004 5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED MAY 31, 2005 AND MAY 31, 2004 6 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 7 ITEM 2. Management's Discussion and Analysis or Plan of Operation OVERVIEW 11 RESULTS OF OPERATIONS 11 LIQUIDITY AND CAPITAL RESOURCES 13 CRITICAL ACCOUNTING POLICIES 13 INFLATION 14 ITEM 3. Controls and Procedures 14 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings 15 ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds 15 ITEM 3. Defaults upon Senior Securities 15 ITEM 4. Submission of Matters to a Vote of Security Holders 15 ITEM 5. Other Information 15 ITEM 6. Exhibits and Reports on Form 8-K 16 2
PART I: FINANCIAL INFORMATION ITEM 1. Financial Statements BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS May 31, August 31, ASSETS 2005 2004 ------ ---- ---- (UNAUDITED) Current Assets: Cash and cash equivalents $ 60,649 $ 405,299 Accounts receivable, less allowance of $7,999 and $9,606 73,880 78,080 Prepaid expenses and other current assets 55,444 38,407 ------------ ------------ Total current assets 189,973 349,999 Property and equipment, net of accumulated depreciation of $3,567,578 and $3,783,695 252,534 351,298 Deposits and other assets 84,636 50,607 ------------ ------------ Total assets $ 527,143 $ 923,691 ============ ============ LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ LIABILITIES Current Liabilities: Capital lease obligations, current portion $ 4,025 $ 5,006 Accounts payable and accrued expenses 155,695 239,934 Convertible notes payable, net of discount of $0 and $17,760 -- 35,556 Notes payable 10,506 943 Notes payable - related parties 160,000 160,000 Deferred revenue 11,342 11,559 ------------ ------------ Total current liabilities 341,568 452,998 Long-Term Liabilities: Capital lease obligations, long-term portion -- 2,721 ------------ ------------ Total long-term liabilities -- 2,721 ------------ ------------ Total liabilities 341,568 455,719 ------------ ------------ STOCKHOLDERS EQUITY Preferred stock, par value $.001 per share; 10,000,000 shares authorized; 443,162 and 1,413,544 shares issued and outstanding at May 31, 2005 and August 31, 2004 443 1,413 Common stock, par value $.001 per share; 100,000,000 shares authorized; 45,552,298 issued and 43,652,298 outstanding at May 31, 2005; and 42,435,026 shares issued and 40,535,026 shares outstanding at August 31, 2004 45,552 42,435 Additional paid-in capital 37,081,968 36,738,292 Accumulated deficit (36,030,388) (35,402,168) ------------ ------------ 1,097,575 1,379,972 Less treasury stock, 1,900,000 common shares, at cost (912,000) (912,000) ------------ ------------ Total stockholders' equity 185,575 467,972 ------------ ------------ Total liabilities and stockholders' equity $ 527,143 $ 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 MAY 31, 2005 AND MAY 31, 2004 2005 2004 ---- ---- (UNAUDITED) (UNAUDITED) Revenues $ 403,096 $ 557,322 ------------ ------------ Expenses: Cost of revenues (exclusive of depreciation and amortization shown separately below) 273,315 348,478 General and administrative expenses 200,473 259,703 Depreciation and amortization 44,242 506,058 ------------ ------------ Total expenses 518,030 1,114,239 ------------ ------------ Loss from operations (114,934) (556,917) ------------ ------------ Other income (expense): Interest income 137 2 Interest and finance charges (4,256) (213,266) Loss on disposal of assets (1,663) -- Other income (expense) (252) (3,292) ------------ ------------ Total other expense (6,034) (216,556) ------------ ------------ Loss from operations (120,968) (773,473) ------------ ------------ Preferred stock dividends -- (15,245) ------------ ------------ Loss available to common shareholders $ (120,968) $ (788,718) ============ ============ Loss per common share, basic and diluted $ (.00) $ (.03) ------------ ------------ Weighted average number of shares outstanding, basic and diluted 43,652,298 30,937,984 ============ ============ See accompanying notes to condensed consolidated financial statements. 4
BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE NINE MONTHS ENDED MAY 31, 2005 AND MAY 31, 2004 2005 2004 ---- ---- (UNAUDITED) (UNAUDITED) Revenues $ 1,186,602 $ 1,654,826 ------------ ------------ Expenses: Cost of revenues (exclusive of depreciation and amortization shown separately below) 781,906 1,089,569 General and administrative expenses 862,072 1,012,128 Depreciation and amortization 132,705 1,516,909 ------------ ------------ Total expenses 1,776,683 3,618,606 ------------ ------------ Loss from operations (590,081) (1,963,780) ------------ ------------ Other income (expense): Interest income 829 387 Interest and finance charges (31,928) (519,054) Conversion expense (See Note 5) -- (541,182) Other income (expense) (7,040) (3,543) ------------ ------------ Total other expense (38,139) (1,063,392) ------------ ------------ Loss from operations (628,220) (3,027,172) ------------ ------------ Preferred stock dividends -- (15,245) ------------ ------------ Loss available to common shareholders $ (628,220) $ (3,042,417) ============ ============ Loss per common share, basic and diluted $ (.01) $ (.10) ------------ ------------ Weighted average number of shares outstanding, basic and diluted 42,388,616 30,579,882 ============ ============ See accompanying notes to condensed consolidated financial statements. 5
BESTNET COMMUNICATIONS CORP. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED MAY 31, 2005 AND MAY 31, 2004 2005 2004 ---- ---- (UNAUDITED) (UNAUDITED) Operating activities: Net loss $ (628,220) $(3,027,172) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 132,705 1,516,909 Non-cash transactions 97,873 1,094,598 Changes in assets and liabilities: Accounts receivable 4,200 (11,548) Prepaid expenses and other current assets 54,964 78,459 Deposits and other assets (34,029) 43,329 Accounts payable and accrued expenses (84,239) (12,805) Deferred revenue (217) (4,721) ----------- ----------- Net cash used in operating activities (456,963) (322,951) ----------- ----------- Investing activities: Purchase of property and equipment (33,941) (55,559) ----------- ----------- Net cash used in investing activities (33,941) (55,559) ----------- ----------- Financing activities: Proceeds from issuance of notes payable 50,000 235,000 Proceeds from conversion of units 230,393 60,000 Repayment of notes payable (130,437) (72,470) Principal payments on capital lease obligation (3,702) (4,052) ----------- ----------- Net cash provided by financing activities 146,254 218,478 ----------- ----------- Net increase (decrease) in cash 344,650 (160,032) Cash and cash equivalents, beginning of period 405,299 226,559 ----------- ----------- Cash and cash equivalents, end of period $ 60,649 $ 66,527 =========== =========== See accompanying notes to condensed consolidated financial statements. 6
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 nine-month period ended May 31, 2005, are not necessarily indicative of the results that may be expected for the fiscal year ending August 31, 2005. 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 and nine-month periods ended May 31, 2005 include current shares outstanding and those included in the Unit offering completed on March 30, 2003 (See Note 3). As of May 31, 2005 and May 31, 2004, there were 10,316,786 and 22,071,458 potentially dilutive shares, respectively. NOTE 3 -- UNIT OFFERING In January 2005, the Company's Board of Directors approved the splitting of its outstanding Units into their underlying securities. As a condition to this Unit split, the Board required that the unit holders convert their Series A Convertible Preferred Stock at the time of the split. During January and February 2005, 1,151,967 units were split into their underlying securities. 1,151,967 shares of Series A Convertible Preferred stock were converted into 2,303,934 shares of common stock. In addition, 1,151,967 warrants were also delivered to those investors who converted their units. We received proceeds of approximately $230,000 from this transaction due to the conversion of the Series A Convertible Preferred Stock into common stock at the rate of $0.20 per share of preferred stock. NOTE 4 -- NOTES PAYABLE Note Payable On February 13, 2004, the Company entered into a Note Purchase Agreement with Anthony Silverman, a member of the Company's Board of Directors and Executive Committee, 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 March 23, 2005, this note was paid in full as a result of the issuance of our Convertible Promissory Notes. 7 On May 3, 2004, the Company entered into a Note Purchase Agreement with Anthony Silverman a member of the Company's Board of Directors and Executive Committee, 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. On March 23, 2005, this note was paid in full as a result of the issuance of our Convertible Promissory Notes. 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 May 31, 2005, the principal balance of the note is $8,680. On December 29, 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 13.00% per annum and is due in nine monthly installments of $469, including principal and interest, beginning on January 21, 2005. As of May 31, 2005, the principal balance of the note is $1,826. On December 13, 2004, the Company issued a promissory note to Richard Bourke in the principal amount of $12,000 and another note to Marco Messina in the principal amount of $6,000. Both Mr. Bourke and Mr. Messina are members of our Board of Directors and each note was issued in consideration of services rendered. These notes were paid in full on April 5, 2005. On May 26, 2005, we issued a promissory note to Stanley Schloz, a member of our Board of Directors and Executive Committee, in the principal amount of $25,000. The note bears interest at a rate of 10% and is due by August 25, 2005. This note was paid in full on July 8, 2005. On May 26, 2005, we issued a promissory note to Anthony Silverman, a member of our Board of Directors and Executive Committee, in the principal amount of $25,000. The note bears interest at a rate of 10% and is due by August 25, 2005. This note was paid in full on July 8, 2005. Convertible Promissory Notes On March 23, 2005, we issued our Convertible Promissory Note in the principal amount of $110,000 to Anthony Silverman. Mr. Silverman is a member of our Board of Directors and Executive Committee. The Note is due on March 31, 2006 and bears interest at the rate of 10% per annum, payable monthly. The principal of and any accrued interest under Note is convertible at the option of the Holder into shares of the Registrant's common stock at a conversion price of $0.12 per share. If the Note is converted, the Holder may participate in any registration of securities (with certain exceptions) effected by the Registrant under the Securities Act of 1933 (so-called "piggy-back" rights). The Note is convertible into 916,667 shares of the Company's common stock. The consideration for the Note is the discharge of two existing promissory notes issued by the Registrant to Mr. Silverman, in the aggregate principal amount of $110,000, which notes had been due and payable on March 13, 2005 and May 3, 2005 respectively. NOTE 5 -- 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 6 -- 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 8
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: Nine Months Ended May 31, Three Months Ended May 31, 2005 2004 2005 2004 ---- ---- ---- ---- Net Loss $ (628,220) $ (3,042,417) $ (120,968) $ (788,718) Pro forma compensation expense for stock options (101,444) (521,496) (7,697) (139,158) ------------ ------------ ------------ ------------ Pro forma net loss $ (729,664) $ (3,563,913) $ (128,665) $ (927,876) ============ ============ ============ ============ Pro forma loss per share available to common shareholders $ (.02) $ (.12) $ (.00) $ (.02) ============ ============ ============ ============ Weighted average number of shares outstanding, basic and diluted 42,388,616 30,579,882 43,652,298 30,937,984 ============ ============ ============ ============ NOTE 7 -- SUBSEQUENT EVENTS On June 10, 2005, the Company's Executive Committee temporarily reduced the exercise price on its trading warrants. The original exercise price of these warrants was $0.30. For a period of June 10, 2005 through June 30, 2005, the exercise price on these warrants was reduced to $0.15. As of June 30, 2005, 1,270,356 warrants were exercised and 1,270,356 shares of common stock was issued as a result of these warrants being exercised. This resulted in gross proceeds to the Company of approximately $190,500. On June 30, 2005, in lieu of a cash payment, Mr. Anthony Silverman, one of our directors, credited $29,550 against the $110,000 principal amount convertible note (See Note 4 - Notes Payable) in payment for the exercise of warrants held by him for the purchase of 197,000 shares of common stock. Effective July 6, 2005, Richard Bourke, a member of the Company's Board of Directors, tendered his resignation from the Board of Directors. NOTE 8 -- 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 from members of our Board of Directors, and additional financing was raised from the exercise of our trading warrants. The Company requires and continues to pursue additional capital for revenue growth and strategic plan implementation. NOTE 9 - 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. 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 9
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. 10 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. OVERVIEW BestNet is a long distance phone carrier providing domestic and international long distance, international dialing, teleconferencing services, ClicktoPhone and custom Internet-based communications services based on proprietary technology. Our services are accessed via web browsers, text messaging, standard phones, mobile phones, wireless devices, e-mail and soft-phones. Services are delivered using standard phone lines and equipment. Our suite of communications products will allow customers to save up to 70% on your existing phone costs, with no contracts. RESULTS OF OPERATIONS COMPARISON OF THE THREE AND NINE MONTH PERIODS ENDED MAY 31, 2005, TO THE THREE AND NINE MONTH PERIODS ENDED MAY 31, 2004. Revenues Revenues decreased to $403,096 during the three-month period ended May 31, 2005, compared to $557,322 during the comparable period in fiscal 2004. Revenues decreased to $1,186,602 during the nine-month period ended May 31, 2005, from $1,654,826 during the comparable period in fiscal 2004. Prior to the Caribbean hurricanes in September 2004, approximately 28% of our revenue was normally derived from the Cayman Islands in the Caribbean. The hurricanes disrupted telephone communications and caused our revenue to decline by approximately 21% beginning during the second week of September 2004. Current Caribbean area minutes used by customers are down approximately 39% from pre-hurricane periods. We cannot predict whether or when it will be completely restored or whether such a natural or other disaster will occur in the future. Current period revenues were derived from customer usage of Bestnetcall service including international long distance, conference calling as well as the Company's product, ClicktoPhone. Cost of Revenues Cost of revenues decreased to $273,315 during the three-month period ended May 31, 2005, from $348,478 during the comparable period in fiscal 2004. Cost of revenues decreased to $781,906 during the nine-month period ended May 31, 2005, 11 from $1,089,569 during the comparable period in fiscal 2004. The decrease was directly related to the decrease in minutes used by customers on our network resulting from the Caribbean hurricanes. Cost of revenues include primarily carrier expenses and connectivity to our carriers. General and Administrative Expenses General and administrative expenses decreased to $200,473 during the three-month period ended May 31, 2005, from $259,703 during the comparable period in fiscal 2004. Payroll and related expenses decreased to $67,130 during the three-month period ended May 31, 2005, from $126,385 during the comparable period in fiscal 2004. This decrease was in direct relation to a decrease in salary payments to the Company's officers. In addition, our Chief Operating Officer went to part time status beginning February 1, 2005 resulting in monthly salary savings of approximately $7,000. General and administrative expenses decreased to $862,072 during the nine-month period ended May 31, 2005, from $1,012,128 during the comparable period in fiscal 2004. Payroll and related expenses decreased to $247,177 during the nine-month period ended May 31, 2005, from $512,081 during the comparable period in fiscal 2004. This decrease was in direct relation to a decrease in salary payments to the Company's officers. In addition, our COO went to part time status beginning February 1, 2005 resulting in monthly salary savings of approximately $7,000. Shares of stock were also issued to certain members of our Board of Directors during the second quarter of fiscal 2004 resulting in a non-cash expense of approximately $64,000. Compensation paid to our President, principally due to electing a new President, decreased to $14,500 during the 3rd quarter of fiscal 2005 from $65,000 during the first quarter of 2005. Of the $65,000, $35,000 was non-cash expense related to the issuance of shares of common stock. We have also reduced director compensation cash payments to $0 beginning in February 2005, saving $3,000 per month. Legal and professional fees increased to $39,639 during the nine-month period ended May 31, 2005, from $7,529 during the comparable period in fiscal 2004, reflecting additional legal fees surrounding the potential partnership with Pacific Biometrics, Inc. The Company has decided not to pursue this partnership. Marketing and consulting fees increased to $89,584 during the nine-month period ended May 31, 2005, from $14,745 during the comparable period in fiscal 2004. During the first six months of fiscal 2005, the Company engaged a firm providing search engine optimization efforts and entered into consulting contracts with one of our directors. These contracts were cancelled during the 2nd quarter of fiscal 2005. Investor relations expenses decreased to $7,949 during the nine-month period ended May 31, 2005, from $30,407 during the comparable period in fiscal 2004, the latter amount reflecting the annual meeting costs incurred during fiscal 2004. Accounting fees decreased to $61,738 during the nine-month period ended May 31, 2005, from $81,278 during the comparable period in fiscal 2004 due principally to lower audit fees. Sales, excise and commodity taxes increased to $26,373 during the nine-month period ended May 31, 2005, from $15,846 during the comparable period in fiscal 2004 reflecting the results of an IRS Excise tax audit where it was determined that the Company was to collect and remit excise taxes. Depreciation and Amortization Expenses Depreciation and amortization expenses decreased to $44,242 for the three-month period ended May 31, 2005, from $506,058 for the comparable period in fiscal 2004. Depreciation and amortization expenses decreased to $132,705 for the nine-month period ended May 31, 2005, from $1,516,909 for the comparable period during 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. Interest Income Interest income was not material during the period. Interest and Finance Charges and Conversion Expenses Interest and finance charges decreased to $4,256 for the three-month period ended May 31, 2005, from $213,266 for the comparable period in fiscal 2004. Interest and finance charges decreased to $31,928 for the nine-month period 12 ended May 31, 2005, from $519,054 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. The majority of these convertible notes were converted into the Company's securities during the 4th Quarter of fiscal 2004. There was no conversion expense during the nine-month period ended May 31, 2005 as compared with $541,182 during 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. 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. During the second quarter of fiscal 2005, we implemented further cost cutting measures. See general and administrative expenses under "RESULTS OF OPERATIONS" within this document. 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. At May 31, 2005, we had cash of $60,649, which is expected to finance operations for approximately 3 months. The Company does not generate income sufficient to offset the costs of its operations. During June 2005, we obtained additional financing of approximately $190,500 due to the exercise of the Company's warrants. As a result, we have historically relied upon the issuance of debt or equity in order to finance our operations. 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. Unless we achieve profitable operations in future periods, obtain additional capital through asset sales, securing a revolving credit facility, debt or equity offerings, or a combination of the foregoing, we will encounter liquidity difficulties and be unable to continue in business. 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 13 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. INFLATION The Company's operations are influenced by general economic trends and technology advances in the telecommunications industry as well as the changing value of the United States Dollar due to much of our customer base being located outside the United States. 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 May 31, 2005, 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. 14 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings Our involvement in legal proceedings is described in our Annual Report on Form 10-KSB filed with the SEC as of August 31, 2004 and our Quarterly Report on Form 10-QSB filed with the SEC as of May 31, 2005. There have been no changes since then. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds On March 23, 2005, we issued our Convertible Promissory Note in the principal amount of $110,000 to Anthony Silverman. Mr. Silverman is a member of our Board of Directors and Executive Committee. The Note is due on March 31, 2006 and bears interest at the rate of 10% per annum, payable monthly. The principal of and any accrued interest under Note is convertible at the option of the Holder into shares of the Registrant's common stock at a conversion price of $0.12 per share. If the Note is converted, the Holder may participate in any registration of securities (with certain exceptions) effected by the Registrant under the Securities Act of 1933 (so-called "piggy-back" rights). The Note is convertible into 916,667 shares of the Company's common stock. The consideration for the Note is the discharge of two existing promissory notes issued by the Registrant to Mr. Silverman, in the aggregate principal amount of $110,000, which notes had been due and payable on March 13, 2005 and May 3, 2005 respectively. On June 30, 2005, Anthony Silverman, a member of the Company's Board of Directors, elected to exercise 197,000 warrants at the temporary exercise price of $0.15. Mr. Silverman authorized to reduce his convertible note of $110,000 by $29,550 as a result of this exercise. 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 On March 21, 2005, our Board of Directors established an Executive Committee to exercise all of the powers of the Board of Directors when the full Board of Directors is not in session. The members are Stanley Schloz, Anthony Silverman and Barry Griffith. The Committee may be terminated or its powers limited by future action of the Board of Directors. Effective July 6, 2005, Richard Bourke, a member of the Company's Board of Directors, tendered his resignation from the Board of Directors. We are engaged in discussions with various parties with respect to a possible disposition of our telephone business. There are no firm agreements with any such party. 15 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. 16 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: July 15, 2005 BESTNET COMMUNICATIONS CORP. By: /s/ Stanley L. Schloz -------------------------------- Stanley L. Schloz, President By: /s/ Michael A. Kramarz -------------------------------- Michael A. Kramarz, Chief Financial Officer 17