<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 May 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 1080, 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 12,071,324
--------------------------
Outstanding at July 18, 1996
Reflects one-for-two reverse stock split
effective May 1, 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 Registrant and its Subsidiary are found
after the signature page.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
RESULTS OF OPERATIONS
Three Months Ended May 31, 1996 as Compared with Three Months ended May 31,
1995.
During the quarter ended May 31, 1996, the Company had gross sales of
$1,183,116, an increase of $915,663, or 342% over gross sales of $267,453
during the three months ended May 31, 1995. The increase 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.
The Company's gross sales during the quarter ended May 31, 1996 were offset
by returns and allowances of $58,705. During the quarter ended May 31, 1995,
returns and allowances were $76,142. In addition, during the quarter ended May
31, 1996, the Company set aside a reserve of $400,000 in connection with
possible bad debts associated with accounts receivable which is included in the
financial statements under selling, general and administrative expenses. The
allowances and returns resulted from Company's strategy of distributing products
on a promotional and trial basis. While the Company intends to aggressively
market its products, management believes that the current market awareness of
its products and the implementation of new sales and marketing strategies will
result in a decrease in the percentage of allowances and reserves in future
periods. Management is also in the process of implementing 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 $46,872 during the quarter ended May 31, 1996, an increase of
$21,517, or approximately 85%, from costs of sales of $25,355 incurred in the
previous period. As a percentage of gross sales, costs of sales decreased in
the quarter ended May 31, 1996 to 4% from 10% in the prior period, primarily as
a result of greater efficiencies from the higher level of sales.
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Selling, general and administrative expenses for the quarter ended May 31,
1996 were $1,441,073, an increase of $1,048,714, or 267%, over selling, general
and administrative expenses during the quarter ended May 31, 1995. Such expenses
increased as a result of a $400,000 reserve relating to possible bad debts
associated with accounts receivable, $175,845 relating to promotional product
marketing expenses, and the addition of sales and marketing, development, and
administrative personnel in connection with the Company's increasing operations,
trade show and marketing expenses, expenses related to its status as a publicly
traded company, its continued efforts to expand core facilities and the opening
of its Dallas and Houston offices. 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 expects to continue increases in selling,
general and administrative expenses in future periods as a result of expansion
of its core business.
In addition to the research and development costs of $48,723 reflected in
the Company's statement of operations for the quarter ended May 31, 1996, the
Company has also capitalized $70,265 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 $164,648 in the quarter ended May 31, 1996
from $35,269, or 367% 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
acquisitions.
Interest expense for the quarter ended May 31, 1996 increased to $34,652,
an increase of $24,907, or 256%, over interest expense during the same period in
the prior year, primarily due to increased debt 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 or Plan of Operation," are forward looking statements
and 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,
costs related to 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 May 31, 1996 were $68,860.
2
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Cash flows from operations were a negative $1,380,980 for the quarter
ended May 31, 1996 compared to negative $309,529 for the quarter ended May 31,
1995. The increase was due principally to the increased expenses relating to
the Company's expansion and development, selling and marketing efforts, and
increases in receivables.
Cash used in investing activities was $195,535 in the quarter ended May 31,
1996 compared to $23,346 in the same period of the prior year. This increase
was due to an increase of capital expenditures.
Cash flows provided by financing activities were $1,519,810 in the quarter
ended May 31, 1996 compared to $397,180 in the quarter ended May 31, 1995. This
increase was due primarily to the proceeds of issuances of shares of the
Company's common stock, notes payable, offset by payments on notes payable, and
net proceeds from factoring of accounts receivable.
As a result of the aforementioned factors, cash and cash equivalents
decreased by $56,705 in the quarter ended May 31, 1996.
Beginning March 1, 1996, the Company entered into a series of financing
transactions, which resulted in: the conversion of $714,000 of notes payable
outstanding at February 29, 1996 to warrants to purchase common stock; proceeds
of $425,000 from the exercise of stock options; warrant exercises and
conversions of debt incurred after February 29, 1996 which increased equity by
$957,500 before associated costs; and an increase in debt of approximately
$415,000 as a result of the sale of warrants and debentures.
Subsequent to the end of the quarter ended May 31, 1996, the Company has
realized an aggregate total of $144,904 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. As of
July 22, 1996, the Company has raised net proceeds of $5,837,476 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 will be able to refinance
approximately $1,250,000 of outstanding indebtedness and will be able to draw up
to $500,000 for working capital.
As of March 1, 1996, the Company consummated the sale of certain restaurant
assets and related development rights to Miami Subs Corporation ("Miami Subs").
Miami Subs assumed the Company's indebtedness of $1,500,000 to a lender and 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 during the six
months following the closing, during which the Company cannot sell the shares
without Miami Subs' consent. Miami Subs has the right to acquire the stock for
$2.50 per share. The Company will thereafter 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. All sales are subject to
a right of first refusal by Miami Subs. The Company has issued a nonrecourse
non-interest bearing promissory note to Miami Subs in the original principal
amount
3
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of $1,500,000, which has been reduced by payments of $250,000. The Note is
secured by a pledge of the Miami Subs stock. The maturity date has been extended
to July 23, 1996. The Company is currently in negotiations with Miami Subs with
respect to the Note and the Miami Subs stock. Based on recent events, the
Company has concluded that it can no longer recover its investment in the Miami
Subs stock and has written down the investment to its market value as of July
19, 1996.
Officers and directors of the Company advanced funds to the Company to meet
various short-term obligations during the quarter ended May 31, 1996.
The Company believes the funds available from the sources described above
will be sufficient to fund its current operations through the end of 1996, but
that it will 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 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
ITEM 1. LEGAL PROCEEDINGS
The Company is 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 2. CHANGES IN SECURITIES
On May 1, 1996, the Company filed with the Secretary of State of Delaware a
Certificate of Amendment that (a) effected a one-for-two reverse split of its
common stock and (b) changed the name of the Company from LoneStar Hospitality
Corporation to Citadel Computer Systems Incorporated. Under the terms of the
Certificate of Amendment, all fractional shares resulting from the reverse stock
split were rounded to the nearest whole share.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
4
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
As of May 1, 1996, the holders of a majority of the common stock of the
Company executed a written consent to approve the amendment of the Certificate
of Incorporation of the Company. The Certificate of Amendment (a) effected a
one-for-two reverse split of its common stock and (b) changed the name of the
Company from LoneStar Hospitality Corporation to Citadel Computer Systems
Incorporated. See "Item 2-Changes in Securities."
ITEM 5. OTHER INFORMATION
PROPOSED ACQUISITION
In May 1996, the Company entered into a letter of intent to acquire two
companies, Astonishing Developments Inc. ("ADI") and Kent-Marsh Ltd., Inc., that
develop security software for stand alone personal computers, for a total
consideration of approximately $2,800,000, consisting of $1,800,000 in common
stock (subject to sales limitations for two years) and $1,000,000 in cash over
six months following execution of a definitive purchase agreement. The Company
paid $200,000 to the selling shareholders of ADI in June 1996 pursuant to
promissory notes by the selling stockholders which notes must be repaid over
twelve months if the acquisition is not consummated. The Company anticipates
that the transaction will be consummated in August 1996 upon satisfactory
completion of its due diligence review.
EXPANSION OF BOARD OF DIRECTORS
Since May 31, 1996, the Company has expanded the number of 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.
5
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(A) EXHIBITS
4. Certificate of Designations of Series A Convertible Preferred
Stock
27. Financial Data Schedule
(B) REPORTS ON FORM 8-K.
On March 13, 1996, the Company filed a Form 8-K pursuant to which it
reported the merger of LoneStar Hospitality Corporation and Citadel
Computer Systems Incorporated, the acquisition of Circuit Masters
Software, Inc., the sale of certain assets, and the change of the
Company's fiscal year.
On June 11, 1996, subsequent to the end of the fiscal quarter, 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.
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: July 22, 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
FINANCIAL STATEMENT
MAY 31, 1996
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED BALANCE SHEETS
MAY 31, FEBRUARY 29,
1996 1996
--------- -----------
(UNAUDITED)
ASSETS
<TABLE>
<CAPTION>
Current assets
<S> <C> <C>
Cash $ 68,860 $ 125,565
Accounts receivable - net 963,825 484,336
Marketable securitieS 1,567,186 -
Assets under contract of sale - 2,605,772
Prepaid expenses and other current assets 155,613 82,405
---------- ----------
Total current assets 2,755,484 3,298,078
Property and equipment-net 125,365 110,327
Software - net 2,773,261 2,757,412
Other assets 124,012 249,046
---------- ----------
$5,778,122 $6,414,863
========== ==========
</TABLE>
LIABILITIES AND STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Current liabilities
<S> <C> <C>
Notes payable $ 3,697,392 $ 4,034,214
Accounts payable and accrued expenses 1,558,752 2,030,800
----------- -----------
Total current liabilities 5,256,144 6,065,014
Long-term liabilites - 34,360
Stockholders' equity
Common stock 119,843 115,091
Additional paid-in capital 4,218,438 2,405,144
Accumulated deficit (3,816,303) (2,204,746)
----------- -----------
521,978 315,489
----------- -----------
$ 5,778,122 $ 6,414,863
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
<PAGE>
CITADEL COMPUTER SYSTEMS INCORPORATED
CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED MAY 31,
(UNAUDITED)
<TABLE>
<CAPTION>
1996 1995
------------- ------------
<S> <C> <C>
Revenues
Sales $ 1,183,116 $ 267,453
Less returns and allowances (58,705) ( 76,142)
------------ ----------
Net sales 1,124,411 191,311
Cost of sales (46,872) (25,355)
------------ ----------
Gross profit 1,077,539 165,956
Operating expenses
Selling, general and administrative expenses 1,441,073 392,359
Depreciation and amortization 164,648 35,269
Research and development costs 48,723 -
------------ ----------
1,654,444 427,628
------------ ----------
Operating loss ( 576,905) ( 261,672)
Unrealized loss on marketable securities 1,000,000 -
Other income (expense)
Interest expense ( 34,652) ( 9,745)
Other - ( 1,888)
------------ ----------
( 34,652) ( 11,633)
------------ -----------
Net (loss) $( 1,611,557) $( 273,305)
============ ==========
Per share data
Net loss $( .14) $( .04)
============ ==========
Weighted average shares outstanding 11,746,709 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 THREE MONTHS ENDED MAY 31,
(UNAUDITED)
<TABLE>
<CAPTION>
1996 1995
-------------- ----------------
<S> <C> <C>
Cash flows from operating
activities
Net loss $(1,611,557) $( 273,305)
Adjustments to reconcile
net loss to net cash
provided by (used in)
operating activities
Depreciation and
amortization 164,648 35,269
Unrealized loss on
marketable securities 1,000,000 -
Change in operating assets
and liabilities
Accounts receivable ( 479,489) ( 64,436)
Prepaid expenses ( 73,208) 17,642)
Other assets 125,034 ( 875)
Other liabilites ( 34,360) -
Accounts payable ( 472,048) 11,460
Net cash provided by
(used in) operations (1,380,980) ( 309,529)
----------- ----------
Cash flows from investing
activities
Purchase of equipment
and software ( 195,535) ( 23,346)
----------- ----------
Net cash used in
investing activities ( 195,535) ( 23,346)
Cash flows from financing
activities
Proceeds from sale of
common stock 1,104,046 -
Debt proceeds 415,000 397,180
Debt payments ( 37,822) -
Decrease in assets under
contract for sale - net 38,586 -
----------- ----------
Net cash provided by
financing activities 1,519,810 397,180
Net increase
(decrease) in cash ( 56,705) 64,305
Cash at beginning of period 125,565 24,037
----------- ----------
Cash at end of period $ 68,860 $ 88,342
=========== ==========
</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) 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 recent events, the Compnay has concluded that it can no longer recover
its investment in the Miami Subs stock and has written down the investment to
its market value as of July 19, 1996.
NOTE C - STOCKHOLDERS' EQUITY
During the period from March 1, 1996 through July 22, 1996 the Company's
stockholders' equity reflects the following changes.
<TABLE>
<CAPTION>
STOCKHOLDERS' EQUITY
----------------------
<S> <C>
Balance at February 29, 1996 $ 315,489
Exercise of stock options 425,000
Securities issued pursuant to private placement 679,046
Conversion of debt to equity 714,000
Net (loss) from operations (1,611,557)
----------
Balance at May 31, 1996 521,978
Exercise of stock options 144,904
Securities issued pursuant to private placement 5,837,476
---------
Pro forma balance at July 22, 1996 $6,504,358
=========
</TABLE>
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EXHIBIT 4
CERTIFICATE OF THE POWERS, DESIGNATIONS, PREFERENCES, AND
RELATIVE, PARTICIPATING, OPTIONAL, AND OTHER RIGHTS AND
THE QUALIFICATIONS, LIMITATIONS, AND RESTRICTIONS
OF THE SERIES A CONVERTIBLE PREFERRED STOCK
OF
CITADEL COMPUTER SYSTEMS INCORPORATED
(Pursuant to Section 151(g) of the
Delaware General Corporation Law)
The undersigned, Steven B. Solomon, 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 July 11, 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 of the
Board of Directors;
WHEREAS, the Company has not previously filed with the Secretary of
State of the State of Delaware a Certificate of Designation with respect to any
shares of the Company's authorized but unissued 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;
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WHEREAS, the Company proposes to make an offering of up to 5,000 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
5,000 shares of authorized but unissued Preferred Stock as Series A Convertible
Preferred Stock (the "Series A 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 A Preferred Stock will be identical with each other in
all respects. All of the shares of Series A 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 A 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 A Preferred Stock so long as any shares
of Series A 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 A 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 A 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 A 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 A 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 A Preferred Stock, an amount (the
"Liquidation Preference") for each share of Series A 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 A 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 A Preferred Stock and the holders
of any other series of Preferred Stock with a liquidation preference equal to
that of the Series A Preferred Stock, in proportion to the shares of Series A
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 A 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 this Part 3.
Part 4. Conversion. The holders of Series A Preferred Stock will have the
----------
following conversion rights:
(a) Right to Convert. Each share of Series A Preferred Stock shall be
----------------
convertible, on and after the Conversion Dates and at the Conversion Ratio set
forth below, into fully paid and non-assessable shares of Common Stock.
3
<PAGE>
(b) Method of Conversion. Subject to paragraph (c) below, each holder of
--------------------
Series A 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. 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 three business days after receipt of the
Notice of Conversion and the certificate or certificates for the shares of
Series A 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 A Preferred Stock shall become
---------------
convertible into shares of Common Stock at any time commencing forty-five (45)
days after the closing date for the original issuance of the Series A 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 A 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 A Preferred Stock for which conversion
is elected.
Conversion Price = the lesser of (a) 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 three consecutive trading days
immediately preceding the Notice Date and (y) .80 (the floating conversion
price) or (b) the average closing bid price as reported on the Nasdaq (or other
national securities exchange or automated quotation system on which the Common
Stock is then primarily traded) of the Common Stock for the three consecutive
trading days immediately preceding the closing date for the original issuance of
the Series A Preferred Stock (the fixed conversion price).
(e) Automatic Conversion. Each share of Series A Preferred Stock
--------------------
outstanding on July 16, 1997 automatically shall be converted into Common Stock
on such date at the Conversion Ratio then in effect, and July 16, 1997 shall be
deemed to be the Notice Date with respect to such conversion; provided however,
if July 16, 1997 is not a day on which the Nasdaq system is open for trading or
quotation, the deemed Notice Date shall be the next succeeding day on which the
Nasdaq system is open for trading or quotation.
4
<PAGE>
(f) Fractional Shares. No fractional share will be issued upon the
-----------------
conversion of any shares of Series A Preferred Stock. All shares of Common Stock
(including fractions thereof) issuable on conversion of Series A 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 wo uld 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 A Preferred
Stock, the number of shares of Common Stock or Series A Preferred Stock is
increased by a stock split, stock dividend, or similar event, or if the number
of shares of Common Stock or Series A 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 A
Preferred Stock written notice of each change in the Conversion Ratio.
(ii) If, prior to conversion of all shares of Series A 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 changed into the same or a different number of shares of
the same or a different class or classes of stock or other securities of the
Company or another entity, then the holders of Series A Preferred Stock will
thereafter have the right to purchase and receive upon conversion of shares of
Series A 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 the shares
of Series A Preferred Stock had such event not taken place. In any case subject
to this subsection, appropriate provision shall be made with respect to the
rights and interests of the holders of Series A 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 A 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 resulting successor or
acquiring entity (if not the Company) assumes by written instrument the
obligation to deliver to the holders of the Series A Preferred Stock such shares
of stock or securities, as in accordance with the foregoing provisions, the
holders of the Series A Preferred Stock may be entitled to purchase upon
conversion.
5
<PAGE>
(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 A 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 A 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 A 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 A 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 A 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 A
Preferred Stock outstanding, voting separately as a class, the holders of Series
A Preferred Stock shall have no voting power whatsoever, and no holder of Series
A 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 will be satisfactory) of the ownership and
the loss, theft, destruction or mutilation of any certificate evidencing shares
of Series A 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 shares of
Series A Preferred Stock represented by such lost, stolen, destroyed or
mutilated certificate, and dividends will accrue on the shares of Series A
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.
6
<PAGE>
FURTHER RESOLVED, that the statements contained in the foregoing resolutions
creating and designating the Series A 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 A Convertible Preferred Stock, none of which has
been issued, is 5,000.
7
<PAGE>
IN WITNESS WHEREOF, Citadel Computer Systems Incorporated has caused this
Certificate to be executed by its duly authorized representative as of July 11,
1996.
CITADEL COMPUTER SYSTEMS INCORPORATED
By: /s/ Steven B. Solomon
Steven B. Solomon, Chief Operating Officer
8
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from Financial
Statements of Citadel Computer Systems Incorporated as of and for the quarters
ended May 31, 1996 and 1995 and is qualified in its entirety by reference to
such statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> FEB-28-1997
<PERIOD-START> MAR-01-1996
<PERIOD-END> MAY-31-1996
<CASH> 68,860
<SECURITIES> 1,567,186
<RECEIVABLES> 963,825
<ALLOWANCES> 58,705
<INVENTORY> 0
<CURRENT-ASSETS> 2,755,484
<PP&E> 125,365
<DEPRECIATION> 0
<TOTAL-ASSETS> 2,755,484
<CURRENT-LIABILITIES> 5,256,144
<BONDS> 0
0
0
<COMMON> 119,843
<OTHER-SE> 402,135
<TOTAL-LIABILITY-AND-EQUITY> 5,778,122
<SALES> 1,124,411
<TOTAL-REVENUES> 1,124,411
<CGS> 46,872
<TOTAL-COSTS> 1,654,444
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (34,652)
<INCOME-PRETAX> (1,611,557)
<INCOME-TAX> 0
<INCOME-CONTINUING> (1,611,557)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (1,611,557)
<EPS-PRIMARY> (.14)
<EPS-DILUTED> (.14)
</TABLE>
