<PAGE>
U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-QSB
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended August 31, 1996
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
--------- ----------
Commission file number: 0-08718
CITADEL COMPUTER SYSTEMS INCORPORATED
(Exact name of small business issuer
as specified in its charter)
DELAWARE 75-2432011
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3811 TURTLE CREEK BLVD., SUITE 330, DALLAS, TX 75219
(Address of principal executive offices)
(214) 520-9292
(Issuer's telephone number)
-------------------------------------------
(Former name, former address and former fiscal
year, if changed since last report)
Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
Yes X No
----- -----
State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date.
Common Stock, par value $.01 14,363,101
-----------------------------------
Outstanding at October 10, 1996
Transitional Small Business Disclosure Format Yes [ ] No [X]
<PAGE>
Unless otherwise indicated, share and per share information contained in
this Report reflect the Company's one-for-five reverse stock split, effective as
of December 11, 1995, the one-for-two stock dividend paid on February 2, 1996
and the one-for-two reverse stock split, effective as of May 1, 1996. The
Company changed its fiscal year end to the last day in February from March 31,
commencing February 29, 1996.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The Financial Statements of the Company are found after the signature page.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
RESULTS OF OPERATIONS
During the three months ended August 31, 1996, the Company had net sales of
$1,762,000, an increase of $1,369,000, or 348% over net sales of $394,000 during
the three months ended August 31, 1995. During the six months ended August 31,
1996, the Company had net sales of $2,889,000, an increase of $2,256,000, or
356% over net sales of $632,000 during the six months ended August 31, 1995.
The increases occurred primarily as a result of an increase in the Company's
marketing and sales efforts. The Company realized additional sales as a result
of increased market awareness of its NetOFF, Server Sentry and Phantom of the
Console products, as well as the addition of new vertical marketing channels and
the increase in its sales and marketing efforts through the expansion of the
Company's sales and marketing department and approximately $200,000 of net sales
resulting from acquisitions.
During the quarter ended August 31, 1996, the Company set aside a reserve
of $500,000 in connection with possible bad debts associated with accounts
receivable which is included in the financial statements under selling, general
and administrative expenses. During the six month period ended August 31, 1996,
the Company set aside reserves of $900,000 in connection with possible bad debts
associated with accounts receivable, which is included in the financial
statements under selling, general and administrative expenses. Management is
continuing its efforts to implement procedures that they believe will result in
a decrease in the percentage of reserves in future periods.
The costs and expenses incurred in connection with producing the Company's
products were $108,000 during the three months ended August 31, 1996, an
increase of $59,000, or approximately 120%, from costs of sales of $49,000
incurred in the previous period. As a percentage of gross sales, costs of sales
decreased in the three months ended August 31, 1996, to 6.2% from 12.5% in the
prior period. The costs and expenses incurred in connection with producing the
Company's products were $155,000 during the six months ended August 31, 1996, an
increase of $77,000, or approximately 98%, from costs of sales of $78,000
incurred in the previous period. As a percentage of gross sales, costs of sales
decreased in the six months ended
1
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August 31, 1996, to 5.4% from 12.4% in the prior period. The decreases in cost
of sales on a percentage basis were primarily the result of greater efficiencies
from the higher level of sales.
Selling, general and administrative expenses for the three months ended
August 31, 1996, were $1,749,000, an increase of $1,471,000, or 528%, over
selling, general and administrative expenses during the three months ended
August 31, 1995. Such expenses increased primarily due to the Company's growth
which included the addition of key management and implementation of corporate
infrastructure, the hiring of sales and marketing, development, and
administrative personnel, trade show and marketing expenses, expenses related to
its status as a publicly traded company, its continued efforts to expand its
product offerings and the opening of its Dallas office and expansion of its
Houston office, and as a result of a $500,000 reserve relating to possible bad
debts associated with accounts receivable, and $140,000 relating to promotional
product marketing expenses. Selling, general and administrative expenses for
the six months ended August 31, 1996, were $3,202,000, an increase of
$2,368,000, or 284%, over selling, general and administrative expenses during
the six months ended August 31, 1995. Such expenses increased as a result of
the factors discussed above relating to the Company's growth, including reserves
relating to possible bad debts associated with accounts receivable, and
promotional product marketing expenses. The Company's priority during the early
stage of its development was to devote its primary efforts to increasing the
awareness of its products in the marketplace, to refine existing products
through feedback from customers, and to establish a market for upgrades of its
existing products and for new products. The Company may continue this strategy
in connection with new technologies it developes or acquires. The Company
expects to continue increases in selling, general and administrative expenses in
future periods as a result of expansion of its core business and acquired
technologies.
In addition to the research and development costs of $3,959,000 reflected
in the Company's statement of operations for the three months ended August 31,
1996 (which reflected research and development costs written-off by the Company
in connection with the acquisitions of the ADI Group and MicroVault and the
purchase of technology from Xerox discussed in Item 5 and footnotes D and E to
the Consolidated Financial Statements), the Company has also capitalized $90,000
of development costs, which increase was due to increased development staff and
new product development activities and which are being amortized over the
expected lives of the products. Depreciation and amortization expense increased
to $176,000 in the three months ended August 31, 1996, from $38,000, or an
increase of 362% over the prior period, due to the acquisition of certain
companies and products. In addition to the research and development costs of
$4,008,000 reflected in the Company's statement of operations for the six months
ended August 31, 1996 (which reflected research and development costs of
$3,959,000 written-off by the Company as discused above), the Company has also
capitalized $160,000 of development costs, which increase was due to increased
development staff and new product development activities and which are being
amortized over the expected lives of the products. Depreciation and
amortization expense increased to $341,000 in the six months ended August 31,
1996, from $102,000, or 233% during the prior period, due to the acquisition of
certain companies and products. The Company expects to continue to increase
development staff and to enhance its product line through internal development
and possible acquisitions.
2
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Interest expense for the three months ended August 31, 1996 increased to
$144,000, an increase of $18,000, or 14%, over interest expense during the same
period in the prior year. Interest expense for the six months ended August 31,
1996 increased to $179,000, an increase of $33,000, or 22%, over interest
expense during the same period in the prior year. Such increases were primarily
due to increased indebtedness associated with the recent financing activities
described under "Liquidity and Capital Resources" below.
The statements contained in this Report that are not historical facts,
including, but not limited to, statements found in this Item 2 - "Management's
Discussion and Analysis," are forward looking statements and as such involve a
number of risks and uncertainties. The actual results of the future events
described in such forward-looking statements in this Report could differ
materially from those stated in such forward looking statements. Among the
factors that could cause actual results to differ materially are: general
economic conditions, competition, the market for network software products,
seasonality of product sales, costs and risks related to integration of
acquisitions, software development costs and possible future litigation, as well
as the risks and uncertainties discussed in this Report, including, without
limitation, the portions referenced above, and the uncertainties set forth from
time to time in the Company's other public reports and filings and public
statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash and cash equivalents at August 31, 1996 were $594,000.
Cash flows from operations were a negative $2,834,000 for the six months
ended August 31, 1996, compared to negative $626,000 for the six months ended
August 31, 1995. The increase was due principally to the increased expenses
relating to the Company's expansion and development, selling and marketing
efforts, decreases in accounts payable and accrued expenses, and increases in
receivables.
Cash used in investing activities was $3,614,000 in the six months ended
August 31, 1996, compared to $176,000 in the same period of the prior year.
This increase was due to an increase in net purchases of securities and
businesses and an increase in capital expenditures.
In addition, on August 27, 1996, the Company announced a share
repurchase program whereby the Company is authorized to repurchase up to 500,000
shares of its outstanding common stock in the open market through February 1998.
During the quarter ended August 31, 1996, the Company had not repurchased any
shares.
Cash flows provided by financing activities were $6,917,000 in the six
months ended August 31, 1996, compared to $802,000 in the six months ended
August 31, 1995. This increase was due primarily to the proceeds of issuances
of shares of the Company's common stock, preferred stock and notes payable, net
of payments against debt.
As a result of the aforementioned factors, cash and cash equivalents
increased by $469,000 in the six months ended August 31, 1996.
3
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During the three months ended August 31, 1996, the Company has realized an
aggregate total of $216,000 from the exercise of outstanding options and
warrants.
In June and July 1996, the Company conducted private placements of notes
and preferred stock that are mandatorily convertible into common stock. The
Company raised net proceeds of $5,970,000 in these offerings.
The Company has signed a nonbinding letter of intent with respect to a line
of credit with a bank under which the Company may refinance approximately
$1,250,000 of outstanding indebtedness and will be able to draw up to $500,000
for working capital.
In March 1996, the Company consummated the sale of certain restaurant
assets and related development rights to Miami Subs Corporation ("Miami Subs").
The Company received 1,325,000 shares of Miami Subs common stock, which are held
in escrow by Miami Subs and are subject to restrictions on transfer. Miami Subs
has the right to acquire the stock for $2.50 per share. The Company will be
able to sell the stock in private transactions, or in open market transactions
not to exceed 240,000 shares per calendar quarter or 20,000 shares per week,
with sales subject to a right of first refusal by Miami Subs. The Company
issued a nonrecourse non-interest bearing promissory note to Miami Subs with a
remaining principal amount of $1,250,000, secured by a pledge of the stock. The
maturity date has been extended to October 31, 1996 and the Company is in
negotiations with Miami Subs with respect to the Note and the stock. The
Company determined that it could not recover its investment in the
Miami Subs stock and wrote down the investment during the quarter ended
May 31, 1996, to its market value as of July 19, 1996.
The Company believes the funds available from the sources described above
will be sufficient to fund its current operations through the end of its 1997
fiscal year, but that it may need additional funds to expand its operations and
to pursue acquisitions that will permit it to expand its line of products and to
complement its internal software development efforts. The Company expects to
engage in additional capital raising efforts during fiscal 1997 and is engaged
in discussions with investment banking from time to time firms about such
efforts, but has not entered into any letter of intent with an investment
banking firm or determined the structure or amount of any such efforts. There
is no assurance that the Company will be successful in identifying or engaging
an investment banking firm or that, if it does so, it will be successful in
raising capital in any such offering.
PART II. OTHER INFORMATION
Except as listed below, all information required by Part II is omitted
because the items are inapplicable or the answer is negative.
ITEM 1. LEGAL PROCEEDINGS
A former employee of Old LoneStar filed a lawsuit against the Company and
one of its
4
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officers and directors alleging that the Company and/or the individual owe the
plaintiff additional stock options and seeking damages in excess of $2,600,000.
The Company and the individual believe such claims are without merit and intends
to vigorously defend against the claim and is considering filing counterclaims.
The Company has filed an answer in the case, styled Heredia v. Citadel, et al.,
--------------------------
in the 298th Court of Dallas County, Texas.
The Company is also involved in routine litigation from time to time. Such
litigation, including other litigation in which the Company is currently
involved, is not material to the Company's consolidated financial condition or
results of operations.
ITEM 5. OTHER INFORMATION
ACQUISITIONS
In August 1996, the Company completed the acquisition of two affiliated
companies, Astonishing Developments Inc. and KentMarsh Ltd., Inc. (the
"ADI Group"), which develop security software for stand alone personal
computers, for a total consideration of approximately $2,200,000, consisting of
$1,200,000 in common stock (subject to sales limitations for two years) and
$1,000,000 in cash over six months ($600,000 of which has already been paid).
In August 1996, the Company completed the acquisition of DanaSoft, Inc.,
which develops and markets software for internet and intranet applications, for
100,000 shares of Citadel common stock. In August 1996, the Company also
completed the acquisition of MicroVault Corporation, a data security software
provider, for 150,000 shares of Citadel common stock and $75,000.
In August 1996, the Company completed the purchase of the TabWorks and
Cougar technology and product lines from the XSoft Division of Xerox
Corporation, headquartered at the Xerox Palo Alto Research Center (PARC). Total
consideration consists of $750,000 in cash, a non-interest bearing $1,350,000
senior note ($1,206,560 after discount for inputed interest) payable over two
years, and royalty payments of up to $1,250,000 over four years. The Company
has the right to pay an aggregate of $2,500,000 during the first year following
the purchase in exchange for the release of its obligations under the note and
royalty terms. In August 1996, the Company and XSoft announced their strategic
partnership pursuant to which XSoft's Summarizer Technology was licensed to the
Company.
See Notes D and E to the Notes to Consolidated Financial Statements for a
discussion of the accounting treatment of such acquisitions and purchases.
EXPANSION OF BOARD OF DIRECTORS
During the quarter ended August 31, 1996, the Company expanded the number
of
5
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directors comprising the board of directors from six to eight. The board
appointed Victor K. Kiam II, chairman of Remington Products LLC, a leading
consumer products firm, and Mark Rogers, managing director of NFT Ventures, a
venture capital fund controlled by Ray Noorda, founder of Novell, Inc. Each new
director was granted options to purchase 400,000 shares of the Company's common
stock.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
4.1 Certificate of Designations of Series A Convertible Preferred
Stock (incorporated by reference from Exhibit 4 to the Company's Form 10-
QSB for the fiscal quarter ended May 31, 1996).
4.2 Certificate of Designations of Series B Convertible Preferred
Stock.
27. Financial Data Schedule
(b) REPORTS ON FORM 8-K.
On June 11, 1996, the Company filed a Form 8-K/A amending the March
13, 1996 Form 8-K to include audited financial statements of Citadel
Computer Systems Incorporated and Circuit Masters Software Inc.
On September 5, 1996, the Company filed a Form 8-K relating to the
acquisition of KentMarsh Ltd., Inc. and Astonishing Developments, Inc.
6
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.
CITADEL COMPUTER SYSTEMS INCORPORATED
(REGISTRANT)
Date: October 15, 1996 By: /s/ Steven B. Solomon
----------------------------------------
Steven B. Solomon, Chief Operating Officer and
Secretary (Principal Financial and Accounting
Officer and Duly Authorized Signatory)
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
AUGUST 31, 1996 FEBRUARY 29, 1996
--------------- -----------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets
Cash $ 594,493 $ 125,565
Accounts receivable - net 2,083,999 484,336
Marketable securities - trading 2,000,000 -
Marketable securities - available for
sale 1,462,500 -
Assets under contract of sale - 2,605,772
Prepaid expenses and other current
assets 313,264 82,405
----------- -----------
Total current assets 6,454,256 3,298,078
Property and equipment - net 307,374 110,327
Software - net 4,374,886 2,757,412
Other assets 340,966 249,046
----------- -----------
$11,477,482 $ 6,414,863
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Notes payable $ 2,564,438 $ 4,034,214
Debentures 515,100 -
Current portion of long-term notes
payable 420,000 -
Accounts payable and accrued expenses 1,543,296 2,030,800
Other current liabilities 1,180,000 -
----------- -----------
Total current liabilities $ 6,222,834 $ 6,065,014
Notes payable 981,560 -
Other long-term liabilities 227,770 34,360
Stockholders' equity
Common stock 131,782 115,091
Preferred stock 1,870,000 -
Mandatorily convertible debt 3,223,700 -
Unrealized loss on securities
available for sale (104,687) -
Additional paid-in capital 7,105,397 2,405,144
Accumulated deficit (8,180,874) (2,204,746)
----------- -----------
4,045,318 315,489
----------- -----------
$11,477,482 $ 6,414,863
=========== ===========
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
THESE FINANCIAL STATEMENTS.
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENT OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
AUGUST 31, AUGUST 31,
1996 1995 1996 1995
----------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Net sales $ 1,762,407 $ 393,586 $ 2,888,938 $ 632,968
Cost of sales 108,318 49,244 155,190 78,413
----------- ---------- ----------- ----------
Gross profit 1,654,089 344,342 2,733,748 554,555
Operating expenses
Selling, general and administrative
expenses 1,748,967 278,420 3,201,698 833,221
Depreciation and amortization 175,856 38,087 340,505 102,212
Research and development costs 3,959,069 27,271 4,007,792 27,271
----------- ---------- ----------- ----------
5,883,892 343,778 7,549,995 962,704
----------- ---------- ----------- ----------
Operating income (loss) (4,229,803) 564 (4,816,247) (408,149)
Other income (expense)
Interest expense (144,256) (126,480) (178,909) (146,405)
Other - (15,587) - (18,499)
Loss on marketable securities (238,175) - (1,238,175) -
----------- ---------- ----------- ----------
(382,431) (142,067) (1,417,084) (164,904)
----------- ---------- ----------- ----------
Net loss before extraordinary items (4,612,234) (141,503) (6,233,331) (573,053)
Extraordinary item - gain on debt
settlement 259,422 - 257,303 -
----------- ---------- ----------- ----------
Net loss $(4,352,812) $ (141,503) $(5,976,028) $ (573,053)
=========== ========== =========== ==========
Per share data
Net loss before extraordinary item $ (.38) $(.02) $ (.52) $(.09)
Extraordinary item .02 - .02 -
----------- ---------- ----------- ----------
Net loss $ (.36) $(.02) $ (.50) $(.09)
=========== ========== =========== ==========
Weighted average shares outstanding 12,030,060 6,514,000 11,888,385 6,514,000
=========== ========== =========== ==========
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
THESE FINANCIAL STATEMENTS.
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE SIX MONTHS ENDED AUGUST 31,
(UNAUDITED)
<TABLE>
<CAPTION>
1996 1995
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<S> <C> <C>
Cash flows from operating activities
Net loss $(5,976,028) $(573,053)
Adjustments to reconcile net loss to
net cash (used in) operating activities
Depreciation and amortization 338,681 102,212
Net loss on marketable securities 1,238,414 -
Research and development expenses
acquired with stock 3,959,069 -
Change in operating assets and
liabilities
Accounts receivable (1,367,237) (253,589)
Prepaid expenses and other current
assets (172,140) (13,594)
Other assets 132,492 (875)
Other liabiliites (34,460) -
Accounts payable and accrued expenses (952,686) 112,858
----------- ---------
Net cash (used in) operations (2,833,895) (626,041)
Cash flows from investing activities
Purchase of equipment and software (804,487) (175,877)
Purchase of trading securities (4,818,841) -
Sales of trading securities 2,580,427 -
Purchase of businesses (571,043) -
----------- ----------
Net cash used in investing
activities (3,613,944) (175,877)
Cash flows from financing activities
Proceeds from sale of stock and
convertible debt 7,157,443 -
Net change in notes payable (755,776) 643,434
Proceeds from sale of debentures 515,100 -
Other - 158,245
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Net cash provided by financing
activities 6,916,767 801,679
Net increase (decrease) in cash 468,928 (239)
Cash at beginning of period 125,565 24,037
----------- ---------
Cash at end of period $ 594,493 $ 23,798
=========== =========
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF
THESE FINANCIAL STATEMENTS.
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note A - Basis of Presentation
The financial information presented herein should be read in conjunction with
the financial statements and footnotes included in the Company's Annual Report
on Form 10-KSB for the period ended February 29, 1996. The balance sheet as of
February 29, 1996, has been derived from the audited financial statement at that
date.
The accompanying unaudited financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial information.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all adjustments considered necessary for a fair
presentation, consisting of those of a normal recurring nature, are reflected in
the accompanying financial statements.
Note B - Marketable Securities
The Company received 1,325,000 shares of Miami Subs U.S.A., Inc. (Miami Subs)
common stock as consideration for the sale of its restaurants on March 1, 1996.
The carrying value of the stock at the date of sale of $2,567,186 has been
reduced by $1,000,000 and has been charged to income for the quarter ended May
31, 1996. Based on events occurring after the sale of the restaurants, the
Company concluded that it could no longer recover its investment in the Miami
Subs stock and wrote down the investment to its market value as of July 19,
1996.
Note C - Stockholders' Equity
During the period from March 1, 1996, through August 31, 1996, the Company's
stockholders' equity reflects the following changes.
<TABLE>
<CAPTION>
<S> <C>
Stockholders' equity at February 29, $ 315,489
1996
Exercise of stock options 425,000
Securities issued pursuant to private
placement 679,046
Conversion of debt to equity 714,000
Net loss (1,611,557)
-----------
Stockholders' equity at May 31, 1996 521,978
Exercise of stock options and warrants 216,000
Securities issued pursuant to private
placement 5,845,261
Equity issued in acquisitions 1,919,578
Unrealized loss on securities (104,687)
Net loss (4,352,812)
-----------
Stockholders' equity at August 31, 1996 4,045,318
Securities issued pursuant to private
placement 1,440,000
-----------
Stockholders' equity at October 14, 1996 $ 5,485,318
===========
</TABLE>
<PAGE>
Note D - Acquisitions
In August 1996, the Company completed the acquisition of the ADI Group,
which develops security software for stand alone personal computers, for a total
consideration of approximately $2,200,000, consisting of $1,200,000 in common
stock (subject to sales limitations for two years) and $1,000,000 in cash over
six months ($600,000 of which has already been paid).
In August 1996, the Company completed the acquisition of DanaSoft, Inc.,
which develops and markets software for internet and intranet applications, for
$264,000 in Citadel common stock and $30,000 in cash. In August 1996, the
Company also completed the acquisition of MicroVault Corporation, a data
security software provider, for $475,200 in Citadel common stock and $75,000 in
cash.
All of such acquisitions have been accounted for by the purchase method.
In connection with the acquisition of the ADI Group and MicroVault Corporation,
the Company wrote off $2,402,000 of purchased research and development
technology that had not reached the working model stage and for which there is
not alternate use. The following pro forma operating data has been prepared as
though the acquisitions had been made as of the beginning of the previous fiscal
year (March 1, 1995):
<TABLE>
<CAPTION>
Three months ended August 31, Six months ended August 31,
1996 1995 1996 1995
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues $ 2,052,976 $ 779,527 $ 3,549,319 $ 1,364,076
Net loss before
extraordinary item (2,550,293) N/A (4,246,688) N/A
Net loss $(2,290,871) $(2,603,731) $ (4,005,752) $(3,120,951)
Net loss per share
before extraordinary item $ (.20) N/A $ (.34) N/A
Net loss per share $ (.18) $ (.36) $ (.32) $ (.44)
</TABLE>
The write-off of purchased research and development costs of $2,402,000 is
reflected in the pro form net loss only for the 1995 periods.
The pro forma operating results are not necessarily indicative of the actual
results that would have occurred had the acquisitions been made on March 1, 1995
or of the future operations of the combined companies.
Note E - Purchase and License of Technology
In August 1996, the Company purchased the TabWorks and Cougar technology
and product lines from the XSoft Division of Xerox Corporation, headquartered at
the Xerox Palo Alto Research Center (PARC). Total consideration consists of
$750,000 in cash, a non-interest bearing $1,350,000 senior note ($1,206,560
after discount for imputed interest) payable over two years, and royalty
payments of up to $1,250,000 over four years. The Company has the right to pay
an aggregate of $2,500,000 during the first year following the acquisition in
exchange for the release of its obligations under the note and royalty terms.
In August 1996, the Company and XSoft announced their strategic partnership
pursuant to which XSoft's Summarizer Technology was licensed to the Company.
In connection with this purchase of technology, the Company wrote off
approximately $1,557,000 of purchased research and development technology that
had not reached the working model stage and for which there is not alternate
use.
<PAGE>
EXHIBIT 4.2
CERTIFICATE OF DESIGNATIONS, PREFERENCES AND RIGHTS
OF SERIES B CONVERTIBLE PREFERRED STOCK OF
CITADEL COMPUTER SYSTEMS INCORPORATED
(Pursuant to Section 151(g) of the
Delaware General Corporation Law)
The undersigned does hereby certify:
(a) that he is, and at all times mentioned herein was, the duly elected and
acting Chief Operating Officer and Secretary of Citadel Computer Systems
Incorporated, a Delaware corporation (the "Company");
(b) that the Company's Certificate of Incorporation, as amended (the
"Certificate of Incorporation"), authorizes the Company's board of directors
(the "Board of Directors") to adopt resolutions fixing the voting powers,
designations, preferences, rights and qualifications, limitations or
restrictions of any series of Preferred Stock, and the Board of Directors has
delegated such authority to its executive committee (the "Executive Committee");
and
(c) the Executive Committee adopted the following resolutions at a meeting held
on September 24, 1996:
WHEREAS, the Certificate of Incorporation authorizes a class of stock
designated Preferred Stock (the "Preferred Stock"), comprising 1,000,000 shares,
par value $0.01 per share, provides that such Preferred Stock may be issued from
time to time in one or more series, and vests authority in the Board of
Directors of the Company to fix or alter the voting powers, designations,
preferences and relative, participating, optional or other special rights,
rights and terms of redemption, the redemption price or prices and the
liquidation preferences of any wholly unissued series of Preferred Stock within
the limitations set forth in the Delaware General Corporation Law, and the Board
of Directors has delegated such authority to the Executive Committee;
WHEREAS, the Company has no outstanding shares of the Company's authorized
Preferred Stock;
WHEREAS, there remains 1,000,000 shares of the Company's authorized but
unissued Preferred Stock eligible for designation by the Company with respect to
new series thereof;
1
<PAGE>
WHEREAS, the Company proposes to make an offering of up to 1,620 shares of
a new series of Preferred Stock (the "Offering"); and
WHEREAS, it is the desire of the Company to designate a series of Preferred
Stock and to fix the powers, preferences and rights, and the qualifications,
limitations or restrictions thereof in connection with the Offering;
NOW, THEREFORE, BE IT RESOLVED, that the Company, does hereby designate
1,620 shares of authorized but unissued Preferred Stock as Series B Convertible
Preferred Stock (the "Series B Preferred Stock"), and does hereby fix the voting
powers, preferences, and relative, participating, optional, or other special
rights and qualifications, limitations, or restrictions thereof as follows:
Part 1. General.
-------
All shares of Series B Preferred Stock will be identical with each other in
all respects. All of the shares of Series B Preferred Stock will be of such
rank as to any other outstanding series of Preferred Stock of the Company as to
dividends and distributions upon liquidation, dissolution or winding up, as
shall be provided in the resolutions of the Board of Directors or the Executive
Committee of the Company creating such other series, subject in each case to the
conditions contained herein.
Part 2. Dividends.
---------
The holder of each issued and outstanding share of Series B Preferred Stock
shall be entitled to receive dividends at a rate of $50.00 per share per annum,
when and as declared by the Board of Directors of the Company. No dividends
(other than those payable solely in shares of Common Stock of the Company) shall
be paid on or declared and set apart for any Common Stock or series of Preferred
Stock that is subordinate to the Series B Preferred Stock so long as any shares
of Series B Preferred Stock are outstanding, unless, at the same time, an
equivalent or greater dividend or distribution is declared or paid or set apart,
as the case may be, on the Series B Preferred Stock, payable on the same day as
if fully converted into Common Stock pursuant to Part 4. At the sole option of
the Company, dividends on each share of Series B Preferred Stock may be paid in
either (a) cash out of the assets at the time legally available for such
purposes, or (b) shares of Common Stock in an amount determined by dividing (x)
the amount of the dividend payable thereon, by (y) the Conversion Price (as
defined in Part 4 hereof) in effect on the dividend declaration date. No
dividends shall be paid on the Series B Preferred Stock at such time as such
payment would violate the laws of the State of Delaware.
2
<PAGE>
Part 3. Liquidation Preference (a) In the event of any liquidation,
----------------------
dissolution or winding up of the Company, either voluntary or involuntary, the
holders of the Series B Preferred Stock then issued and outstanding shall be
entitled to receive out of the assets of the Company available for distribution
to its stockholders, whether from capital, surplus or earnings, prior and in
preference to any payment or distribution and setting apart for payment or
distribution of any of the net assets or surplus funds of the Company to the
holders of the Common Stock or any series of Preferred Stock with a liquidation
preference subordinate to the Series B Preferred Stock, an amount (the
"Liquidation Preference") for each share of Series B Preferred Stock then held
by them equal to $1,000 per share (the "Stated Value") plus accrued dividends.
If upon the occurrence of such event, the assets and funds thus distributed
among the holders of the Series B Preferred Stock shall be insufficient to
permit the payment to such holders of the full Liquidation Preference, then the
entire assets and funds of the Company legally available for distribution shall
be distributed among the holders of the Series B Preferred Stock and the holders
of any other series of Preferred Stock with a liquidation preference equal to
that of the Series B Preferred Stock, in proportion to the shares of Series B
Preferred Stock or other such series of Preferred Stock then held by them.
(b) If the assets and funds of the Company available for distribution to
the Company's stockholders exceed the aggregate Liquidation Preferences payable
to the holders of Series B Preferred Stock pursuant to paragraph 3(a) above,
then after the payments required by paragraph 3(a) shall have been made or
irrevocably set apart for payment, such assets or funds shall be distributed
among the holders of Common Stock and subordinate Preferred Stock.
(c) (i) A consolidation or merger (within the meaning of Section 368(a) of
the Internal Revenue Code of 1986, as amended) of the Company with or into one
or more other corporations or other business organizations, (ii) the sale, lease
or transfer of all or substantially all of the assets of the Company, or (iii)
any other form of corporate reorganization in which outstanding shares of the
Company are exchanged for or converted into cash, securities of another
corporation or business organization or other property, which in any such case
shall not in fact result in a liquidation (in whole or in part) of the Company
and the distribution of its assets to its stockholders shall not be deemed or
treated as a liquidation, dissolution or winding up of the Company within the
meaning of Part 3.
Part 4. Conversion. The holders of Series B Preferred Stock will have the
----------
following conversion rights:
(a) Right to Convert. Each share of Series B Preferred Stock shall be
----------------
convertible,
3
<PAGE>
on and after the Conversion Dates and at the Conversion Ratio set forth below,
into fully paid and non-assessable shares of Common Stock.
(b) Method of Conversion. Subject to paragraph (c) below, each holder of
--------------------
Series B Preferred Stock who desires to convert the same into shares of Common
Stock shall provide notice to the Company by the execution and delivery to it of
a Notice of Conversion in substantially the form attached as Annex A hereto.
Notice may be given by telecopy to the Company at 512.520.9293. The date on
which a Notice of Conversion is received by the Company shall be a "Notice
Date". The Company shall use its reasonable best efforts to issue and deliver
within five business days after receipt of the Notice of Conversion and the
certificate or certificates for the shares of Series B Preferred Stock, with
proper endorsement if necessary, from the holder electing conversion, a
certificate or certificates representing the number of shares of Common Stock to
which the holder shall be entitled to upon the conversion.
(c) Conversion Date. The Series B Preferred Stock shall become convertible
---------------
into shares of Common Stock at any time commencing forty (40) days after the
closing date for the original issuance of the Series B Preferred Stock (the
"Conversion Date").
(d) Conversion Ratio. In addition to such shares of Common Stock as may be
----------------
issued upon the election of the Company pursuant to Part 2 above as dividends,
each share of Series B Preferred Stock shall be convertible into the number of
shares of Common Stock according to the following formula:
N x 1,000
----------------------
Conversion Price
where:
N = the number of shares of Series B Preferred Stock for which conversion is
elected.
Conversion Price = the product of (x) the average closing bid price as reported
on the Nasdaq system (or on such other national securities exchange or automated
quotation system on which the Common Stock is then primarily traded) of the
Common Stock for the five consecutive trading days immediately preceding the
Notice Date and (y) .83.
(e) Automatic Conversion. Each share of Series B Preferred Stock
--------------------
outstanding on September 24, 1998 automatically shall be converted into Common
Stock on such date at the Conversion Ratio then in effect, and September 24,
1998 shall be deemed to be the Notice Date with respect to such conversion;
provided however, if September 24, 1998 is not a day on which the Nasdaq system
is open for trading or quotation, the deemed Notice
4
<PAGE>
Date shall be the next succeeding day on which the Nasdaq system is open for
trading or quotation.
(f) Fractional Shares. No fractional share will be issued upon the
-----------------
conversion of any shares of Series B Preferred Stock. All shares of Common
Stock (including fractions thereof) issuable on conversion of Series B Preferred
Stock by a holder thereof shall be aggregated for purposes of determining
whether the conversion would result in the issuance of any fractional share.
If, after the aggregation, the conversion would result in the issuance of a
fractional share, the Company shall, in lieu of issuing any fractional share,
round up or down any fractional share to the nearest whole share of Common
Stock.
(g) Adjustment to Conversion Price.
------------------------------
(i) If, prior to the conversion of all shares of Series B Preferred
Stock, the number of shares of Common Stock or Series B Preferred Stock is
increased by a stock split, stock dividend, or similar event, or if the number
of shares of Common Stock or Series B Preferred Stock is decreased by a
combination, reclassification, reverse stock split, or similar event, the Board
of Directors of the Company shall make an equitable adjustment in the Conversion
Ratio, if necessary, to reflect such event in order to preserve substantially
the initial Conversion Ratio. The Company will send to each holder of Series B
Preferred Stock written notice of each change in the Conversion Ratio.
(ii) If, prior to conversion of all shares of Series B Preferred
Stock, there shall be any merger, consolidation, exchange of shares,
recapitalization, reorganization or similar event, as a result of which shares
of Common Stock will be ch anged into the same or a different number of shares
of the same or different class or classes of stock or other securities of the
Company or another entity, then holders of Series B Preferred Stock will
thereafter have the right to purchase and receive upon conversion of shares of
Series B Preferred Stock, on the basis and on the terms and conditions specified
herein, and in lieu of shares of Common Stock immediately theretofore issuable
upon conversion, such shares of stock or securities as may be issued or payable
with respect to or in exchange for the number of shares of Common Stock
immediately theretofore purchasable and receivable upon conversion of shares of
Series B Preferred Stock had such event not taken place. In any case subject
hereto, appropriate provision shall be made with respect to the rights and
interests of the holders of Series B Preferred Stock to the end that the
provisions hereof (including without limitation provisions for adjustment of the
Conversion Price and the number or type of shares issuable upon conversion of
the Series B Preferred Stock) shall thereafter be applicable, as nearly as may
be practicable in relation to any shares of stock or securities thereafter
deliverable upon the exercise hereof. The Company shall not effect any
transaction described in this subsection (ii) unless the successor or acquiring
entity (if not the Company) assumes by written instrument the obligation to
deliver to the holders of
5
<PAGE>
Series B Preferred Stock shares of stock or securities, as in accordance with
the foregoing, the holders of the Series B Preferred Stock may be entitled to
purchase upon conversion.
(h) Reservation of Stock Issuable Upon Conversion. The Company shall at
---------------------------------------------
all times reserve and keep available out of its authorized but unissued shares
of Common Stock, solely for the purpose of effecting the conversion of the
shares of Series B Preferred Stock, such number of shares of Common Stock as
shall from time to time be sufficient to effect the conversion of all then
outstanding shares of Series B Preferred Stock. If at any time the number of
authorized but unissued shares of Common Stock shall not be sufficient to effect
the conversion of all then outstanding shares of Series B Preferred Stock, the
Company will take such corporate action as may be necessary to increase its
authorized but unissued shares of Common Stock to such number of shares as shall
be sufficient for such purposes.
(i) Status of Converted Stock. Upon the Company receiving a Notice of
-------------------------
Conversion for any shares of Series B Preferred Stock pursuant to this section,
the shares covered by such Notice of Conversion shall no longer be deemed
outstanding and all rights with respect to such shares shall cease and be
canceled and such shares shall be returned to the status of authorized but
unissued Preferred Stock of no designated class or series and shall not be
issuable by the Company as Series B Preferred Stock.
Part 5. Voting Rights.
-------------
Except as otherwise expressly required by the Delaware General Corporation
Law or as to any repeal, modification, or amendment to this Certificate of
Designation, which repeal, modification, or amendment shall require the
affirmative vote of the holders of at least a majority of the shares of Series B
Preferred Stock outstanding, voting separately as a class, the holders of Series
B Preferred Stock shall have no voting power whatsoever, and no holder of Series
B Preferred Stock shall vote or otherwise participate in any proceeding in which
actions shall be taken by the Company or the stockholders thereof, or be
entitled to notification of any meeting of the Board of Directors or the
stockholders.
Part 6. Replacement.
-----------
Upon receipt of evidence reasonably satisfactory to the Company (an
affidavit of the registered holder with indemnification provisions will be
satisfactory) of the ownership and the loss, theft, destruction or mutilation of
any certificate evidencing shares of Series B Preferred Stock, and in the case
of any such loss, theft or destruction, upon receipt of indemnity reasonably
satisfactory to the Company or, in the case of any mutilation, upon surrender of
such certificate, the Company will (at the holder's expense) execute and deliver
in lieu of such certificate a new certificate of like kind representing the
number of
6
<PAGE>
shares of Series B Preferred Stock represented by such lost, stolen, destroyed
or mutilated certificate, and dividends will accrue on the shares of Series B
Preferred Stock represented by such new certificate from the date to which
dividends have been fully paid on such lost, stolen, destroyed or mutilated
certificate.
FURTHER RESOLVED, that the statements contained in the foregoing
resolutions creating and designating the Series B Preferred Stock and fixing the
number, powers, preferences and relative, optional, participating and other
special rights and the qualifications, limitations, restrictions, and other
distinguishing characteristics thereof shall, upon the effective date of such
series, be deemed to be included in the Certificate of Incorporation of the
Company pursuant to Sections 104 and 151 of the Delaware General Corporation
Law.
The undersigned further certifies that the authorized number of shares of
Preferred Stock is 1,000,000 and that the number of shares of this series of
Preferred Stock, the Series B Convertible Preferred Stock, none of which has
been issued, is 1,620.
IN WITNESS WHEREOF, Citadel Computer Systems Incorporated has caused this
Certificate to be executed by its duly authorized representative as of September
24, 1996.
CITADEL COMPUTER SYSTEMS INCORPORATED
By:
-------------------------------------------
Steven B. Solomon, Chief Operating Officer
7
<PAGE>
NOTICE OF CONVERSION
(To be Executed by the Registered Holder to Convert Series B Preferred Stock)
The undersigned hereby irrevocably elects to convert $____________ or
____________ shares of Series B Preferred Stock into shares of Common Stock of
Citadel Computer Systems Incorporated (the "Company") according to the
conditions hereof, as of the date written below. The undersigned represents and
warrants that (i) all of the requirements of Regulation S promulgated under the
Securities Act of 1933, as amended (the "Securities Act"), applicable to the
undersigned have been complied with by the undersigned and (ii) the undersigned
has not engaged in any transaction or series of transactions that is a part of
or a plan or scheme to evade the registration requirements of the Securities
Act.
-----------------------------------------
Date of Conversion*
-----------------------------------------
Applicable Conversion Price
-----------------------------------------
Dollar amount or Shares
-----------------------------------------
Signature
Name and Address:
-----------------------------------------
-----------------------------------------
-----------------------------------------
*The original certificate representing shares of Series B Preferred Stock and
this Notice of Conversion must be received by the Company by the fifth business
day following the Date of Conversion.
8
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FINANCIAL
STATEMENTS OF CITADEL COMPUTER SYSTEMS INCORPORATED FOR THE QUARTERS ENDED
AUGUST 31, 1996 AND 1995 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> FEB-28-1997
<PERIOD-START> JUN-01-1996
<PERIOD-END> AUG-31-1996
<CASH> 594,493
<SECURITIES> 3,462,500
<RECEIVABLES> 2,083,999
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 6,454,256
<PP&E> 307,374
<DEPRECIATION> 0
<TOTAL-ASSETS> 11,477,482
<CURRENT-LIABILITIES> 6,222,834
<BONDS> 0
0
1,870,000
<COMMON> 131,782
<OTHER-SE> 2,043,536
<TOTAL-LIABILITY-AND-EQUITY> 11,477,482
<SALES> 1,762,407
<TOTAL-REVENUES> 1,762,407
<CGS> 108,318
<TOTAL-COSTS> 5,883,892
<OTHER-EXPENSES> 238,175
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 144,256
<INCOME-PRETAX> (4,612,234)
<INCOME-TAX> 0
<INCOME-CONTINUING> (4,612,234)
<DISCONTINUED> 0
<EXTRAORDINARY> 259,422
<CHANGES> 0
<NET-INCOME> (4,352,812)
<EPS-PRIMARY> (.36)
<EPS-DILUTED> (.36)
</TABLE>
