**UNITED STATES SECURITIES AND EXCHANGECOMMISSION**

**Washington,DC 20549**

 

#### **FORM 10-K**

####  

**(Mark One)**

 
| **ý**                                                                                                                                                                                                                    | ** ** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                          |       |                                                                                                |
| **For the fiscal year ended  December 31, 2005**                                                                                                                                                                         |
|                                                                                                                                                                                                                          |       |                                                                                                |
| **o**                                                                                                                                                                                                                         | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE EXCHANGE ACT OF 1934**        |
|                                                                                                                                                                                                                          |       |                                                                                                |
| **For the transition period from                   to                ** |

 

**Commissionfile number 333-68532**

 

**SMALL WORLD KIDS, INC.**

 
| **Nevada**                       | ** ** | **86-0678911**      |
|----------------------------------|------------|---------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer    |
| incorporation or  organization)  |       | Identification No.) |

 

**5711Buckingham Parkway, Culver City, California 90230**

(Address of principalexecutive offices)

 

**(310) 645-9680**

(Issuer’s telephone number:)

 

Securities registered pursuant to Section 12(b) ofthe Exchange Act:

 

**None**

 

Securities registered pursuant to Section 12(g) ofthe Exchange Act:

 

**None**

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.       Yes  o    No  ý

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Exchange Act.       Yes  o    No  ý

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period as the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes  ý    No  o

 

Indicate by check mark ifdisclosure of delinquent filers in response to Item 405 ofRegulation S-K is not contained herein, and no disclosure will becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K.  ý

 

Indicate by a check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of theExchange Act.

 
| Large accelerated filer   o |   | Accelerated filer   o  |   | Non-accelerated filer   ý |
|---------------------------------------|--------|---------------------------------------|--------|------------------------------------------|

 

Indicate by check mark ifthe registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).       Yes o     No ý

 

The aggregate marketvalue of the voting and non-voting common equity (the only such common  equity being Common Stock, $.001 par value)held by non-affiliates of the registrant as of the last business day of theregistrants most recently completed second fiscal quarter was $2,572,000.

 

The number of sharesoutstanding of the registrant’s Common Stock, $.001 par value (being the onlyclass of its common stock) is 5,410,575 (as of March 31, 2006).

 

**DocumentsIncorporated by Reference**

 

None.

 

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**Table of Contents**

** **
| PART I   |                                                                                                                                 |   |
|---------------|--------------------------------------------------------------------------------------------------------------------------------------|--------|
|          | ITEM 1. Description of Business                                                                                                      |   |   |
|          | ITEM 1A. Risk Factors                                                                                                                |   |   |
|          | ITEM 1B. Unresolved Staff  Comments                                                                                                  |   |   |
|          | ITEM 2. Description of Property                                                                                                      |   |   |
|          | ITEM 3. Legal Proceedings                                                                                                            |   |   |
|          | ITEM 4.  Submission of Matters to a Vote of Security Holders                                                                         |   |   |
|          |                                                                                                                                 |   |   |
| PART II  |                                                                                                                                 |   |
|          | ITEM 5.  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer  Purchases of Equity Securities          |   |   |
|          | ITEM 6.  Consolidated Selected Financial Data                                                                                        |   |   |
|          | ITEM 7.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                                 |   |   |
|          | ITEM 8.  Financial Statements and Supplemental Data                                                                                  |   |   |
|          | ITEM 8A.  Quantitative and Qualitative Disclosures about Market Risk                                                                 |   |   |
|          | ITEM 9.  Changes in and Disagreements with Accountants on Accounting and Financial  Disclosure                                       |   |   |
|          | ITEM 9A. Controls  and Procedures                                                                                                    |   |   |
|          | ITEM 9B. Other  Information                                                                                                          |   |   |
|          |                                                                                                                                 |   |   |
| PART III |                                                                                                                                 |   |
|          | ITEM 10.  Directors, Executive Officers, Promoters and Control Persons; Compliance with  Section 16(a) of the Exchange Act |   |   |
|          | ITEM 11. Executive  Compensation                                                                                                     |   |   |
|          | ITEM 12.  Security Ownership of Certain Beneficial Owners and Management and Related  Stockholder Matters                            |   |   |
|          | ITEM 13.  Certain Relationships and Related Transactions                                                                             |   |   |
|          | ITEM 14.  Principal Accountant Fees and Services                                                                                     |   |   |
|          | ITEM 15.  Exhibits and Reports on Form 8-K                                                                                      |   |   |
|          | SIGNATURES                                                                                                                           |   |   |
|          | Index to  Consolidated Financial Statements                                                                                          |   |   |

 

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**Part I**

 

**Forward-LookingStatements**

 

The following discussionshould be read in conjunction with the Company’s consolidated financialstatements and the notes thereto appearing elsewhere in this prospectus. Thisannual report on Form 10-K, including the “Management’s Discussion andAnalysis” section in Part II, Item 7 of this report, and othermaterials accompanying this annual report on Form 10-K contain forwardlooking statements within the meaning of Section 27A of the Securities Actof 1933, as amended, and Section 21E of the Securities Act of 1934, asamended.  For example, statements included in thisprospectus regarding our financial position, business strategy and other plansand objectives for future operations, and assumptions and predictions aboutfuture product demand, supply, manufacturing, costs, marketing and pricingfactors are all forward-looking statements. When we use words like “intend,” “anticipate,”“believe,” “estimate,” “plan,” “will” or “expect,” we are makingforward-looking statements. We believe that the assumptions and expectationsreflected in such forward-looking statements are reasonable, based oninformation available to us on the date hereof, but we cannot assure you thatthese assumptions and expectations will prove to have been correct or that wewill take any action that we may presently be planning. However, theseforward-looking statements are inherently subject to known and unknown risksand uncertainties. Actual results or experience may differ materially fromthose expected or anticipated in the forward-looking statements. Factors thatcould cause or contribute to such differences include, but are not limited to,regulatory policies, competition from other similar businesses, and market andgeneral economic factors.

 

**ITEM 1.    DESCRIPTION OF BUSINESS**

 

Small World Kids, Inc. was organized on July 28,2001 under the name SavOn Team Sports, Inc. in the State of Utah to sellsporting goods over the Internet.  On May 20,2004, we acquired Fine Ventures, LLC, a Nevada limited liability company, andSmall World Toys, a California corporation. As a result of these acquisitions,we had a change of our management, our controlling shareholders, our financialposition and our business plan. Small World Kids is now a holding company andhas no significant business operations or assets other than its interest inSmall World Toys. Since the acquisition of Small World Toys, the Company hasbeen engaged in the development, manufacturing, marketing and distribution ofeducational and developmental toys. To more accurately reflect our operationsafter the acquisitions, we changed our name from SavOn Team Sports, Inc.to Small World Kids, Inc.  We alsochanged our place of incorporation from the state of Utah to the state ofNevada.

 

SmallWorld Kids became a holding company as a result of the May 20, 2004transactions and has no significant business operations or assets other thanits interest in

 

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Small World Toys, the accounting predecessor company.  As such, accounting guidelines dictate thatthe results of operations for the predecessor and successor entities be clearlysegregated for financial reporting purposes. However, for the purpose of describing and analyzing the results ofoperations in this section, both predecessor and successor entities have beencombined.

 

Asof December 31, 2005, Small World Kids is comprised solely of Small WorldToys and as such the balances and results for each entity are one in the same.

 

**Overview of Small World Toys**

 

SmallWorld Toys has been distributing toys for almost 40 years. Our Small World Toys’proprietary product lines features toys for children ages zero to ten with afocus of promoting early learning, education, discovery and imagination. SmallWorld Toys develops, manufactures, markets and distributes toys to promotehealthy minds and bodies in infant, pre-school, early learning, imaginativeplay and active play categories. The company distributes products in specialty,mass, chain, education, catalog, online and international channels throughsales representative firms as well as in-house sales executives.  Proprietary brands include IQ Baby®, IQPreschool®, Ryan’s Room®, Gertie Ball®, Small World Living, Puzzibilities®, AllAbout Baby®, Neurosmith® and ImagiixTM. We also exclusively distribute productfor several brands such as TOLO®, Star ElectronicsTM, BAO, Little Tikes® andBaby Culture to the specialty toy market in the United States through our “SWExpress” distribution arm. Small World Toys has had acquired licenses for ourdevelopmental toy products including the works of Eric Carle, including “TheVery Hungry Caterpillar”, Garfield and Jay Jay the Jet Plane.  Small World Toys has also acquired thelicense of “Clifford the Big Red Dog” from Scholastic Entertainment for our Gertie Ball line of products.

 

**Recent Developments**

 

On October 14,2005, The Company and its newly-formed acquisition subsidiary, Fashion AngelsEnterprises, Inc., a Wisconsin corporation (“Fashion Angels”), enteredinto an Agreement for Purchase and Sale of Assets (the “Purchase Agreement”)with M&G Partners, LLP, a Wisconsin limited liability partnership, d/b/aThe Bead Shop (“Seller”), and Mark Miller, Goldi Miller and Myra Mouloudji, thepartners of Seller.  The PurchaseAgreement was amended on January 5, 2006 to extend the closing date to January 16,2006.  Seller designs and manufactures “tween” girl products, includingarts and crafts, accessories, dolls and back to school products (the “Business”).Pursuant to the terms of the Purchase Agreement, Fashion Angels was to purchaseall of the assets utilized in connection with the Business and was to assumecertain of Seller’s liabilities associated with the Business.  On February 17, 2006, Seller sentnotification to the Company that the Purchase Agreement is terminated as theclosing did not occur on or before January 16, 2006.

 

On April 28,2005 the Company entered into Term Credit Agreements (“Credit Agreements”) withHong Kong League Central Credit Union and PCCW Credit Union (collectively the “Lenders”)for unsecured loans totaling $750,000 due on or before

 

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August 31, 2005.  Interestis charged at a rate of 2% per month and is payable monthly in arrears.  On June 10, 2005 the Company enteredinto additional Credit Agreements with Hong Kong League Central Credit Unionand HIT Credit Union for unsecured loans totaling $250,000 due on or before September 30,2005.  Effective August 31, 2005 thematurity dates of all outstanding unsecured loans with the Lenders wereextended to the earlier of the closing of a financing transaction with netproceeds of at least $20 million or March 1, 2006.  Effective February 28, 2006 the maturitydates of all outstanding unsecured loans with the Lenders were extended to theearlier of the closing of a financing transaction with net proceeds of at least$20 million or August 11, 2006.

 

On February 28,2006, Small World Kids, Inc. issued a Secured Non-Convertible RevolvingNote (the “Revolving Note”) with Laurus Master Fund, Ltd. (“Laurus”).  Theterm of the Revolving Note is two years and provides that we may borrow up to$16,500,000 subject to certain conditions.  Interest is payablemonthly, in arrears at a rate per annun equal to the Prime Rate (as publishedin The Wall Street Journal) plus two percent (2.0%). The Revolving Notehas no financial covenants and is collateralized by a security interest insubstantially all of the assets of the Company and its subsidiaries, includingits operating subsidiary, Small World Toys.

 

On February 28,2006, Small World Kids, Inc., also issued pursuant to a security agreement(the Laurus “Security Agreement”) a $2.0 million, two year SecuredNon-Convertible Term Note (the “Term Note “) with Laurus. Commencing April 1,2006 and each succeeding month after, the Company will make principal paymentsof $33,333 with all the balance of the unpaid principal amount due upon thematurity date of February 28, 2008.  Interest is payable monthly, inarrears at a rate per annum equal to the Prime Rate (as published in TheWall Street Journal) plus three percent (3.0%). The Term Note has nofinancial covenants and is collateralized by the Laurus Security Agreement.

 

In considerationfor the Revolving Note and the Term Note, the Company issued to Laurus awarrant (“Warrant”) to purchase 1,036,000 shares of common stock at a $0.001per share exercise price.

 

On March 20, 2006, Small World Kids, Inc., a Nevadacorporation (the “Company”) enteredinto a Purchase Order Revolving Credit Line (“PO Credit Line”) of FiveMillion Dollars ($5,000,000.00) with HorizonFinancial Services Group USA to financepurchase orders.  The term of the POCredit Line is eighteen (18) months and provides that we may borrow up to$5,000,000 subject to certain conditions including Horizon’s approval of theapplicable vendors.  A financing fee equal to Four and OneHalf Percent (4.50%) of the gross amount or face value of each Horizonfinancing instrument will be charged for the first forty-five (45) day periodor part thereof that the financing instrument remains outstanding.  An additional fee of fifty basis points(.50%) for each additional period of 15 days, or part thereof, during which theHorizon financing instrument remains outstanding will be charged.  ThePO Credit Line has no financial covenants and is collateralized by a securityinterest, junior in position to that of our senior lender, Laurus MasterFunds, Ltd, to the assets related to the PO Credit Line transactions.

 

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On March 27, 2006, the Company appointed JohnMatise as Chief Operating Officer.  Mr. Matise has been on the boardof directors of the Company since 2004. The Company’s prior Chief Operating Officer, John Nelson, will continueto assist the company in a consulting capacity.

 

**StrategicPlan**

 

Our strategic plan is market expansion through bothgrowth of existing product lines, and the acquisition of product lines andcompanies that create synergies in operations, production and distribution.

 

The anticipated benefits ofthis proposed strategy include:

 

•                  Enhanced channels of distribution forproducts through the combination of the potential target’s alternativedistribution channels with our specialtyretail distribution channels.

 

•                  Diversified product lines within high growthcategories to create additional in-store placement in multiple sections of thestore, which we believe will increase per store orders and a greater percentageof shelf space.

 

•                  Greater number of unit sales for a productthat will decrease manufacturing costs, therefore increasing margins andallowing us to benefit from price breaks that vendors offer for larger quantityorders.

 

•                  Fuller utilization of operations as apercentage of sales, which will increase operating margins, combined operatingdepartments.

 

•                  Cost improvements in production anddistribution coupled with expanded and improved product lines leading toincreased profitability and growth.

 

•                  Expansion into international markets throughmulti-country distributors.

 

Weregard product line extensions, new customer relationships, and opportunitiesfor increased cost reductions as particularly important in our analysis of apotential acquisition’s strategic value. However, acquisitions involve uncertainties, and our attempts toidentify appropriate acquisitions, and finance and complete any particularacquisition, may not be successful.  Inaddition, growth by acquisition involves risks that could adversely affect ourresults of operations, including difficulties in integrating the operations,the potential loss of key employees of acquired companies and potentialincrease of indebtedness to finance the acquisition.

 

**Industry Overview**

 

According to the NDP Group,the Toy Industry growth has returned back to its historical growth rates with5% annual growth expected in 2005 after three years of negative growth duringthe periods of 2002-4.  The traditionaltoy market is $20 billion in the United States and $50 billion world wide.

 

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Management believes that thetoy industry growth will be primarily driven by the following trends:

 

•                  According to Packaged Facts, the U.S.population of children under the age of 12 is at an all-time high at close to38% of the population, or 64 million children.

 

•                  According to Packaged Facts, the U.S.birthrate is higher than it has been in 30 years due to an increase infertility and the trend of mothers giving birth later in life.

 

•                  The last census revealed that thereare over 70 million people in the United States over the age of 55. That numberis expected to grow 60% by 2007, which is six times faster than the rest of thepopulation.  A vast majority of personsin this demographic are grandparents and according to Packaged Facts,grandparents currently spend more than $2 billion annually in toys for theirgrandchildren.

 

•                  Increase in dual income families.

 

**Product Overview**

** **

Wedevelop and manufacture, market and distribute high-quality toys that wedistribute through Specialty, Chain, Education, Catalog, Online andInternational Channels.  Our Small WorldToy’s proprietary product lines features toys for children ages zero to tenwith a focus of promoting, early learning, education, discovery andimagination.  Our product lines includeover 800 products.  Most of our productshave long life cycles (5-7 years on average) and our brands are commonlyreferred to in the toy industry as “evergreen” or long life cycle products thatare less seasonal in nature.  We believethat evergreen brands are less subject to market fads and trends.

 

# 

#  

**Small World Toys Brands**

** **

SmallWorld Toys’ proprietary brands feature toys for children ages 0 – 10 years witha focus on early learning, discovery, imagination and active play.

 

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***Learning Brands:***

*** ***

 

 

**IQ Baby®** –Infant toys that invite exploration, encourage discovery and reward developmentin the critical years from birth through toddler hood.

 

 

**IQ Baby® – The Softer Side**– Infants toys that bring tranquility and comfort to your preciouslittle one, while creating a relaxing learning environment with cuddly,ultra-soft toys.  A peaceful baby is ahappy baby!

 

 

**IQ Preschool®**– Preschool toys that inspire discovery and imagination, fostering valuabledevelopmental skills kids will use for a lifetime.

 

 

**Neurosmith®** –Innovative, open-ended, electronic learning toys that combine the latest childdevelopment research with fun, interactive play patterns.

 

 

**Puzzibilities®**– Innovative, high quality, wooden puzzles designed in four progressive levelsto stimulate “piece by piece” fun learning across a range of ages anddevelopmental skills.

 

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***Imaginative Play Brands:***

*** ***

 

**Ryan’s Room®**– Classic wooden play sets and accessories that allow children to imagine,create and bring to life their very own worlds.

 

**All About Baby®** – Sweet, huggable dolls to love and nurturecomplete with popular and imaginative accessories.

 

****

** **

**Small World LivingTM** – The ultimate in realistic role play toys and environments toencourage your child to play out his dreams of “what I want to be when I growup!”

 

 

**ImagiixTM***-*Award winning toys for infant,toddler & pre-school.

 

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***Active Play Brands:***

 

****

** **

**Gertie Ball®**– “The world’s most catchable ball!” – an award-winning line of balls for allages, designed with a wide variety of unique textures, designs and features.

 

 

** **

**Active Edge®**– Sports and activity toys designed to give a child a sense of mastery andempowerment and build a foundation for an active, fit lifestyle.  Encourages your child to get out and play.

 

 

**Active Edge®****Extreme**– Sports and activity toys designed with a twistthereby allowing your child’s play to reach the next level while building afoundation for an active, healthy and fit lifestyle! Rethink the game!

 

***Distribution***

*** ***

SmallWorld Toys has been distributing its products to a broad spectrum of retail andother accounts for almost 40 years. Some of these accounts include toyspecialty, chain, gift, education, catalog and e-commerce. The company has over80 sales representatives, within 11 representative firms that sell to theseaccounts by geographic locations. The representative firms are managed inhouse.  In addition, a five member salesteam handles in house accounts as well as develops new channels ofdistribution. The company has utilized its distribution strength to representother, high quality companies that did not have distribution into the specialtymarket in the United States such as Tolo® and Star ElectronicsTM.

 

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SW Express is our arm that distributes high-qualityproducts produced by partner companies, including Tolo® and Star ElectronicsTM.  Distribution allows us to increase category presence,expand market share, limit manufacturing (tooling) risk and sell into newchannels.  Currently, most of ourdistributed products are plastic toys produced in China.

 

 

Bright, whimsical infant and preschool toys made ofquality plastic and plush, which are produced in China by British founders witha strong European market presence. Small World has distributed Tolo products inthe USA for over ten years.

 

 

**Star Electronics – Early Star**–

 

**Star ElectronicsTM** - Early learning, discovery, imagination andactive play electronic toys for children 0-3 years old.

 

**International**

 

Outsideof the United States, our primary markets are Canada, Western Europe, andAsia.  Sales of our products abroadaccounted for approximately $1,097,000 or 3.2 % and $670,000 or 2.3% of our netsales in 2005 and 2004, respectively.  Webelieve that foreign markets present an attractive opportunity, and we plan tointensify our marketing efforts and further expand our distribution channelsabroad.

 

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**Marketing**

** **

Generally,our products and brands are promoted through local market promotions,merchandising displays and advertising print. Our product launches includein-store merchandising displays, trade advertising and newspaper ads that areco-oped with our retail customers.  Weparticipate in the New York Toy Fairs in October and February. We alsoattend gift and juvenile shows including JPMA (Juvenile Products ManufacturersAssoc.), NSSEA (National School Supply & Education Assoc., and ABC(All Baby’s and Children Expo).  Goingforward, we will maintain our trade and local marketing efforts while expandingprograms to reach the consumer on a more national level, including an increasedfocus on public relations outreach, strengthening partnerships with keyinfluencers in the fields of early learning and child development,participation in relevant event marketing and sponsorships, utilization ofdirect-to-consumer media and the establishment of consumer loyalty programs.

 

**Manufacturing**

** **

Weoutsource the manufacturing of our proprietary products to vendors in Asia. Webelieve our outsourcing strategy enhances the scalability of our manufacturingefforts. We use numerous manufacturers to source components and build finishedproducts to our specifications. During the year ended December 31, 2005,the top ten vendors accounted for 65% of the total product purchases. The toptwo of these vendors accounted for 11% and 9% of total purchases,respectively.  Manufacturers are selectedbased on their technical and production capabilities and are matched toparticular products to achieve cost and quality efficiencies. We have longstanding relationships with our manufacturers and have been manufacturing inAsia for more than 15 years. The majority of our products are shipped directlyto our warehouse in Carson, California and are later shipped to meet thedemands of our retailers and distributors.

 

**Customersand Customer Service**

** **

Ourthree largest customers, TJX Companies, Costco Wholesale Corporation andRoss Stores, Inc. collectively represented 27.3% and 21.7 % of 2005 and2004 sales, respectively. No other customer represents greater than 5% of oursales in 2005 or 2004.  Although we donot have long term contracts with any of our customers, we believe that ourability to establish and maintain long-term relationships with our customersdepends, in part, on the strength of our customer support and serviceoperations. We encourage and utilize frequent communication with and feedbackfrom our customers and retailers to continually improve our products andservice. We offer toll-free telephone support for customers who prefer to talkdirectly with a customer service representative. We also respond to e-mailinquiries received through our website.

 

**ProductDevelopment**

** **

Whilemany of our products are evergreen brands or long life cycle products, we arecontinually developing new products and the refreshing of existing products. Weexpensed approximately $1,972,000 and $1,173,000 in 2005 and 2004,respectively, on activities relating to the development and design of newproducts.  Our product offerings are acombination of proprietary products that we design, sourced product that wefind in other countries, purchase and package in our packaging for exclusivedistribution in the

 

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United Sates specialty market and a small amount of open market productthat we put through our distribution chain for retailers.

 

Wehave the capability to create and develop products from inception to finishedgoods.  Additionally, we usethird-parties to provide a portion of the sculpting, sample making,illustration and package design required for our products.  Typically, the development process takes fromnine to eighteen months from concept to production and shipment to ourcustomers.

 

Wehave launched an electronic learning line through our 2004 acquisition ofNeurosmith.

 

Weemploy a staff of designers.  Weoccasionally acquire other product concepts from unaffiliated thirdparties.  If we accept and develop athird party’s concept for new toys, we generally pay a royalty on the toysdeveloped from this concept that are sold, and may, on an individual basis,guarantee a minimum royalty.  Royaltiespayable to inventors and developers generally range from 5% to 10% of thewholesale sales prices for each unit of a product sold by us.  We believe that utilizing experiencedthird-party inventors gives us access to a wide range of development talent.

 

Wealso have license agreements with third parties that permit us to utilize thetrademark, characters or inventions of the licensor in products that we sell.

 

**Competition**

** **

Competitionin the toy industry is intense.  Wecompete with several medium and small toy companies in our product categoriesthat distribute products into the specialty toy market such as Alex,International Playthings Inc., Melissa and Doug, Playmobil U.S.A., RC2Corporation, and Toysmith Group.  We alsocompete with several large toy companies such as Mattel, Hasbro and JakksPacific.  These competitors have greaterfinancial resources, larger sales and marketing and product developmentdepartments, stronger name recognition, longer operating histories and benefitfrom greater economies of scale.  Thesefactors, among others, may enable our competitors to market their products atlower prices or on terms more advantageous to customers than those we couldoffer for our competitive products. These competitors may have a greater ability to procure productlicenses, as well as to market and distribute products and obtain shelfspace.  Competition may result in pricereductions, reduced gross margins and loss of market share, any of which couldhave a material adverse effect on our business, financial condition and resultsof operations.  We compete primarily inthe infant and pre-school category and the educational toy category of the U.S.toy industry and, to some degree, in the International toy industry.  Our platform company, Small World Toys, hasbeen distributing our products into the specialty retail, catalog, educationand chains for over 40 years and we believe that our relationships and qualityof our product brand awareness have been critical to our penetration.

 

**Distribution Arrangements**

** **

SmallWorld Toys has the exclusive U.S. distribution to the specialty toy market forTOLO® Toys Ltd and Star ElectronicsTM. We also provide limited marketing supportfor TOLO®.

 

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**Seasonality**

** **

Ourbusiness is subject to seasonal fluctuations. In 2005 and 2004, approximately 60% and 59%, respectively of net saleswere generated in the third and fourth calendar quarters.  We have traditionally introduced new productcatalogs in January and in July. Generally, the first quarter is the period of lowest shipments and salesand therefore the least profitable due to fixed costs.  Seasonality factors may cause our operatingresults to fluctuate from quarter to quarter. However, we employ customer programs for retailers or “early buy”programs to lesson the seasonality. These programs provide an opportunity for our customers to purchase ourproducts in the first and second quarters and stock through the year byoffering dating programs, where they pay in their highest sales quarters,typically in the third and fourth quarters.

 

**Employees**

** **

AtDecember 31, 2005, we had 59 full time employees. None of our employeesare covered by a collective bargaining agreement.  We consider our relations with our employeesto be good.

 

**ITEM 1A.    RISK FACTORS**

 

Ourbusiness faces many risks.  The risksdescribed below may not be the only risks we face.  Additional risks that we do not yet know of,or that we currently think are material, may also impair our businessoperations or financial results.  If anyof the events or circumstances described in the following risks actuallyoccurs, our business, financial conditions or results of operations couldsuffer and the trading price of our common stock could decline.

 

### ***We are have limited cashavailable for operations.  We may nothave sufficient liquidity to continue to meet our debt obligations.***

###  

Asof December 31, 2005, we had approximately $1,136,000 of unrestricted cashand availability on our line of credit.

 

As of December 31,2005, we had $4.7 million in principal payments due in 2006.  We may not be able to generate sufficientcash flow from operations to meet our debt obligations.  There can be no assurance that we will beable to obtain additional financing or restructuring our debt obligations orthat, if we were to be successful in obtaining additional financing orrestructuring our debt obligations, it would be on favorable terms.  Failure to obtain additional financing orrestructuring our debt obligations may cause us to default on these debtobligations.  In addition, under crossdefault provisions in the Laurus Security Agreement, defaults under our debtobligations may cause the acceleration of the repayment of the Revolving andTerm Notes andaffect our ability to continue as a going concern*.*

 

### ***Our continued success in the toy industry will depend on our ability toredesign, restyle and extend our existing core products and product lines asconsumer preferences evolve, and to develop, introduce and gain customeracceptance of new products and product lines.***

 

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Ourbusiness and operating results depend largely upon the appeal of ourproducts.  Our continued success in thetoy industry will depend on our ability to redesign, restyle and extend ourexisting core products and product lines as consumer preferences evolve, and todevelop, introduce and gain customer acceptance of new products and productlines. Several trends in recent years have presented challenges for the toyindustry, including:

 

•      aslow economic recovery;

 

•      thephenomenon of children outgrowing toys at younger ages, particularly in favorof interactive and high technology products;

 

•      increasinguse of technology;

 

•      customersgoing out of business;

 

•      baddebts (uncollectible receivables);

 

•      risingcosts of raw materials;

 

•      competition;and

 

•      higherconsumer expectations for product quality, functionality and value.

 

We cannot assure you that:

 

•      ourcurrent products will continue to be popular with consumers;

 

•      theproduct lines or products that we introduce will achieve any significant degreeof market acceptance;

 

•      wewill be able to expand into new channels; or

 

•      thelife cycles of our products will be sufficient to permit us to recover design,manufacturing, marketing and other costs associated with those products.

 

### ***The toy industry is highly competitive.***

###  

Thetoy industry is highly competitive.  Someof our competitors have financial and strategic advantages over us, including:

 

•      greaterfinancial resources;

 

•      largersales, marketing and product development departments;

 

•      strongername recognition;

 

•      longeroperating histories; and

 

•      greatereconomies of scale.

 

Inaddition, the toy industry has no significant barriers to entry.  Competition is based primarily on the abilityto design and develop new toys, to sell the products into retail and sellthrough to consumers through successful marketing. Many of our competitorsoffer similar products or alternatives to our products.  We cannot assure you that we will be able toobtain adequate shelf space in retail stores to support our existing productsor to expand our products and product lines or that we will be able to continueto compete effectively against current and future competitors.

 

***The toy industry is subjectto high rates of seasonality.***

*** ***

Ourbusiness and the toy industry in general experience the lowest sales rates inthe first quarter and second quarters of the calendar year.  In 2005 and 2004, approximately

 

15

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60% of net sales were made in the third and fourth quarters.  Seasonality factors may cause our operatingresults to fluctuate significantly from quarter to quarter.  In addition, our results of operations mayalso fluctuate as a result of the timing of new product releases.

 

***Our growth strategy depends in part uponour ability to acquire companies and new product lines.***

 

Futureacquisitions will succeed only if we can effectively assess characteristics of potentialtarget companies and product lines, such as:

 

•      salabilityof products;

 

•      suitabilityof distribution channels;

 

•      managementability;

 

•      financialcondition and results of operations; and

 

•      thedegree to which acquired operations can be integrated with our operations.

 

Wecannot assure you that we can identify strategic acquisition candidates ornegotiate acceptable acquisition terms, and a failure to do so may adverselyaffect our results of operations and our ability to sustain growth.  Our acquisition strategy involves a number ofrisks, each of which could adversely affect our results, including:

 

•      difficultiesin integrating acquired businesses or product lines

 

•      assimilatingnew facilities and personnel

 

•      harmonizingdiverse business strategies and methods of operation;

 

•      diversionof management attention from operation of the existing business;

 

•      lossof key personnel from acquired companies; and

 

•      failureof an acquired business to achieve targeted financial results.

 

### ***A substantial reduction in or termination of orders from any of ourlargest customers could adversely affect our financial condition and results ofoperations.***

###  

Ourthree largest customers, TJX Companies, COSTCO and Ross Stores, Inc.collectively represented 27.3% and 21.7 % of 2005 and 2004 sales, respectively.No other customer represents greater than 5% of our sales in 2005 or 2004.Except for outstanding purchase orders for specific products, we do not havewritten contracts with or commitments from any of our customers.  A substantial reduction in or termination oforders from any of our largest customers could adversely affect our business,financial condition and results of operations. In addition, pressure by largecustomers seeking price reductions, financial incentives, changes in otherterms of sale or for us to bear the risks and the cost of carrying inventoryalso could adversely affect our business, financial condition and results ofoperations.  If one or more of our majorcustomers were to experience difficulties in fulfilling their obligations tous, cease doing business with us, significantly reduce the amount of theirpurchases from us, it could have a material adverse affect our business,financial condition and results of operations. In addition, the bankruptcy orother lack of success of one or more of our significant retailers couldnegatively impact our revenues and bad debt expense.

 

16

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### ***We depend on third-party manufacturers who develop, provide and use thetools and dies that we own to manufacture our products and we have limitedcontrol over the manufacturing processes.***

###  

Anydifficulties encountered by the third-party manufacturers that result inproduct defects, production delays, cost overruns or the inability to fulfillorders on a timely basis could adversely affect our business, financialcondition and results of operations.

 

### ***We do not have long-term contracts with our third-party manufacturersand our operations would be impaired if we lost our current suppliers.***

###  

Ouroperation would be impaired if we lost current suppliers or if our currentsuppliers’ operations or sea or air transportation with our overseasmanufacturers were disrupted or terminated even for a relatively short periodof time.  During the fiscal year ended December 31,2005, our top ten suppliers accounted for 65% of the total product purchases.The top two suppliers accounted for 11% and 9% of total purchases,respectively.  Our tools and dies arelocated at the facilities of our third-party manufacturers.  Although we do not purchase the raw materialsused to manufacture our products, we are potentially subject to variations inthe prices we pay third-party manufacturers for products, depending on whatthey pay for their raw materials.

 

### ***We have manufacturing operations outside of the United States,subjecting us to risks associated with international operations.***

###  

Weutilize third-party manufacturers located principally in The People’s Republicof China, or the PRC.  Our PRC sales andmanufacturing operations are subject to the risks normally associated withinternational operations, including:

 

•      currencyconversion risks and currency fluctuations;

 

•      limitations,including taxes, on the repatriation of earnings;

 

•      politicalinstability;

 

•      civilunrest and economic instability;

 

•      complicationsin complying with laws in varying jurisdictions and changes in governmentalpolicies;

 

•      greaterdifficulty and expenses associated with recovering from natural disasters;

 

•      risingcost of raw material;

 

•      risingcost of gas;

 

•      testing;

 

•      blackoutsdue to energy shortages;

 

•      transportationdelays, interruptions and strikes; and

 

•      thepotential imposition of tariffs.

 

Ifwe were prevented from obtaining our products due to medical, political, laboror other factors, our operations would be disrupted while alternative sourcesof products were secured.  Also, theimposition of trade sanctions by the United States against a class of productsimported by us from, or the loss of “normal trade relations” status by China,could significantly increase our cost of products imported from the PRC.

 

17

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***Our products sold in the United States aresubject to various laws, including the Federal Hazardous Substances Act, theConsumer Product Safety Act, the Federal Hazardous Substances Act, theFlammable Fabrics Act and the rules and regulations promulgated underthese acts.***

 

Thesestatutes are administered by the Consumer Product Safety Commission (“CPSC”), whichhas the authority to remove from the market products that are found to bedefective and present a substantial hazard or risk of serious injury ordeath.  The CPSC can require amanufacturer to recall, repair or replace these products under certain circumstances.  We cannot assure you that defects in ourproducts will not be alleged or found. Any such allegations or findings could result in:

 

•      productliability claims;

 

•      lossof sales;

 

•      diversionof resources;

 

•      damageto our reputation;

 

•      increasedwarranty costs; and

 

•      removalof our products from the market.

 

Therecan be no assurance that our product liability insurance will be sufficient toavoid or limit our loss in the event of an adverse outcome of any productliability claim.

 

### ***Other risks include***:

###  

•      theability to obtain external financing on terms acceptable to us in order to meetworking capital needs;

 

•      theability to generate sufficient available cash flow to service our outstandingdebt;

 

•      restrictionsthat we are subject to under the credit agreement;

 

•      unforeseencircumstances, such as severe softness in or collapse of the retail environmentthat may result in a significant decline in revenues and operating results,thereby causing us to be in non-compliance with our debt covenants and therebybeing unable to utilize borrowings under its revolving credit facility, acircumstance likely to occur when operating shortfalls would result in being inthe greatest need of such supplementary borrowings;

 

•      therisk that reported goodwill may become impaired, requiring us to take a chargeagainst the Company’s income;

 

***Because of the limitedtrading and because of the possible price volatility, you may not be able tosell your shares of common stock when you desire to do so.***

*** ***

The trading price of our common stock is not necessarilyan indicator of what the trading price of our common stock might be in thefuture.

 

Because of the limited trading market for the commonstock, and because of the possible price volatility, you may not be able tosell your shares of common stock when you desire to do so.  The inability to sell your shares in arapidly declining market may substantially increase your risk of loss becauseof such illiquidity and because the price for the common stock may suffer greaterdeclines because of its price volatility.

 

18

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Certain factors, some of which are beyond our control,that may cause the share price to fluctuate significantly include, but are notlimited to, the following:

 

•      announcement by us or our competitors of significant contracts,acquisitions, strategic partnerships, joint ventures or capital commitments;

 

•      changes in market valuations of similar companies;

 

•      variations in our quarterly operating results;

 

•      inability to complete or integrate an acquisition;

 

•      additions or departures of key personnel; and

 

•      fluctuations in stock market price and volume.

 

Additionally, in recent years the stock market ingeneral, and the Over-the-Counter Bulletin Board in particular, haveexperienced extreme price and volume fluctuations.  In some cases, these fluctuations areunrelated or disproportionate to the operating performance of the underlyingcompany.  These market and industryfactors may materially and adversely affect our stock price, regardless of ouroperating performance.

 

In the past, class action litigation has often beenbrought against companies following periods of volatility in the market priceof those companies’ common stock.  If webecome involved in this type of litigation in the future, it could result insubstantial costs and diversion of management attention and resources, whichcould have a further negative effect on your investment in our stock.

 

**ITEM 1B.UNRESOLVED STAFF COMMENTS**

 

Notapplicable.

 

**ITEM 2.  DESCRIPTION OF PROPERTIES**

 

Ourcorporate headquarters are located at 5711 Buckingham Parkway, Culver City,California 90230, where we lease approximately 28,000 square feet and subleaseapproximately 17,000.  This lease expireson June 30, 2006.  We also lease approximately 62,000 squarefeet of warehouse space in Carson, California. This lease also expires on June 30, 2006.  We are currently in discussion to extend theterms of both leases.  We also lease1,200 square feet of office space in China in the town of ChangAn, in theGuangDong Province.  This one year leaseexpires November 1, 2006.  We believe these facilities and additional oralternative space available to us will be adequate to meet our needs in thenear term.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

On September 7,2005, Small Play, Inc. (“Small Play”) filed an action in the United StatesDistrict Court for the Southern District of New York against our subsidiarySmall World Toys alleging $3 million in damages in connection with a supposed breachof an

 

19

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alleged oral licensing agreement. We dispute Small Play’s claims andintend to defend strenuously against these claims.  We filed a motion todismiss that was briefed as of February 13, 2006.  The motion has not yetbeen decided, and no trial date has yet been set for the case.

 

On August 5, 2005, GeminiPartners, Inc. (“Gemini”) filed an action in the Superior Court of theState of California for the County of Los Angeles against our subsidiary SmallWorld Toys, our Chief Executive Officer Debra Fine, and Fineline Services,LLC.  Gemini’s complaint arises out of a written consulting agreementdated as of November 10, 2003 entered into by and between Gemini andFineline Services.   The complaintalleges causes of action for:  (1) breach of written contract;(2) breach of implied covenant of good faith and fair dealing;(3) fraud; (4) negligent misrepresentation; (5) promissoryestoppel; (6) quantum merit; and (7) unfair competition.  Geminihas asked for damages in the amount of 3% of the Small World Toys transactionand fees on the St. Cloud note totaling approximately $1 million. We filedan answer to the complaint on October 11, 2005.  No trial date hasyet been set. We dispute Gemini’s claims and intend to defend strenuouslyagainst these claims.

 

Other than the foregoing, weare not a party to any material legal proceedings and there are no materiallegal proceedings pending with respect to our property. We are not aware of anylegal proceedings contemplated by any governmental authorities involving eitherus or our property. None of our directors, officers or affiliates is an adverseparty in any legal proceedings involving us or our subsidiaries, or has aninterest in any proceeding which is adverse to us or our subsidiaries.

 

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matters were submitted to a vote ofsecurity holders during the fourth quarter of the fiscal year covered by thisreport.

 

**PART II**

** **

**ITEM 5.****MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITEIS**

 

Our common stock is quotedon the OTC Bulletin Board of the National Association of Securities Dealers,Inc. (the “NASD”) under the symbol “SMWK.OB”. Our stock was not actively tradeduntil May 20, 2004, and the following table sets forth, for the periodsindicated, the high and low bid prices for the period from May 20, 2004 throughDecember 31, 2005. These quotations reflect inter-dealer prices, without retailmark-up, mark-down or commission, and may not represent actual transactions.

 

20

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| **Fiscal Year Ending December 31, 2005** | ** ** | **Low** | ** ** | **High** | ** ** |
|-------------------------------------------------------------------|------------|---------|------------|----------|------------|
| First Quarter  ended March 31, 2005                               |       | $       | 4.20       |     | $          | 7.00 |   |
| Second Quarter  ended June 30, 2005                               |       | $       | 4.70       |     | $          | 5.50 |   |
| Third Quarter  ended September 30, 2005                           |       | $       | 4.70       |     | $          | 5.20 |   |
| Fourth Quarter  ended December 31, 2005                           |       | $       | 3.10       |     | $          | 6.00 |   |

 
| ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Fiscal Year Ending December 31, 2004** | ** ** | **Low**    | ** ** | **High**   | ** ** |
| Second Quarter  Ended June 30, 2004                               |       | $          | 2.50       |       | $          | 7.50 |   |
| Third Quarter  ended September 30, 2004                           |       | $          | 4.60       |       | $          | 6.50 |   |
| Fourth Quarter  ended December 31, 2004                           |       | $          | 4.60       |       | $          | 7.00 |   |

 

**Holders**

** **

As ofDecember 31, 2005, we currently have outstanding 5,410,575 shares of our commonstock outstanding. As of December 31, 2005, our shares of common stock are heldby approximately 60 stockholders of record. This does not include an indeterminate numberof beneficial owners of securities whose shares are held in the names ofvarious dealers and clearing agencies.

 

**Dividends**

 

We have never paid cashdividends on our common stock. However, in August 2005 we issued shares to SWT,LLC of 10% Class A Convertible Preferred Stock atan initial fixed conversion price of $4.00 subject to adjustment based on theterms of future financings should they occur. Dividends accrue at a rate of 10%per annum and are payable quarterly in cash or a combination of 50% cash and50% common stock at our option. In addition, in conjunction with the issuanceof the Preferred Stock, a non-cash dividend of approximately $2.2 million wasrecorded in relation to an in-the-money conversion feature that allows for theconversion at a price lower than fair market value on the day of issuance.

 

Our future dividend policywill be determined by our Board of Directors and will depend upon a number offactors, including our financial condition and performance, our cash needs andexpansion plans, income tax consequences, and the restrictions that applicablelaws and our credit arrangements then impose.

 

**Securities Authorized ForIssuance under Equity Compensation Plans**.

 

The following tablesummarizes the securities authorized for issuance as of December 31, 2005 underour 2004 Stock Compensation Plan, the number of shares of our common stockissuable upon the exercise of outstanding options, the weighted averageexercise price of such options and the number of additional shares of ourcommon stock still authorized for issuance under such plan. 

 

21

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| **Plan category **                            | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights ** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights ** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans ** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders |       | 677,500                                                                                                                                                    |       | $                                                                                                                 | 3.87       |                                                                                                                                          | 702,500    |   |
|                                                    |       |                                                                                                                                                       |       |                                                                                                              |       |                                                                                                                                          |       |
| Total                                                   |       | 677,500                                                                                                                                                    |       | $                                                                                                                 | 3.87       |                                                                                                                                          | 702,500    |   |

 

**ITEM**** 6.**               **CONSOLIDATED SELECTIVEFINANCIAL DATA**

 

The following selectedconsolidated financial data is derived from our audited consolidated financialstatements for the years ended December 31, 2005, 2004 and 2003, for the elevenmonths ended (short year, transition period) December 31, 2002 and the fiscalyear ended January 31, 2002. The selected financial data may not be indicativeof our future performance.

 
| ** **                                                                                               | ** ** | ** **                                  | ** **                  | **Eleven  Months  Ended ** | ** **                 | ** **                | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|-----------------------------|---------------------------------|----------------------------|---------------------------|------------|
| ** **                                                                                               | ** ** | **Years Ended December 31,** | ** **                  | **(short year) **     | ** **                 | **Year Ended ** | ** ** |
| ** **                                                                                               | ** ** | ** **                                  | **December 31, ** | ** **                      | **January 31, ** | ** **                |
| **(Amounts in thousands, except share and   per share amounts)** | ** ** | **2005**                                    | ** **                  | **2004 (2)**               | ** **                 | **2003 (1)**         | ** ** | **2002 (1)** | ** ** | **2002 (1)** | ** ** |
| **Operating  Data:**                                                                                     |       |                                        |                        |                            |                       |                      |       |   |   |   |   |
| Net sales                                                                                                |       | $                                           | 33,756                      |                            | $                          | 29,493                    |       | $ | 25,970 |   | $ | 24,344 |   | $ | 25,172 |   |
| Gross profit                                                                                             |       | 13,137                                      |                        | 12,102                          |                       | 10,982                    |       | 10,055 |   | 10,771 |   |
| Operating  expenses                                                                                      |       | 17,218                                      |                        | 13,527                          |                       | 10,242                    |       | 9,004 |   | 10,044 |   |
| Other income  (expense)                                                                                  |       | (2,982                                      | )                           | (416                            | )                          | 396                       |       | 831 |   | 195 |   |
| Net income  (loss)                                                                                       |       | (6,770                                      | )                           | (1,218                          | )                          | 740                       |       | 1,052 |   | 727 |   |
| Non-cash  Preferred Stock dividend                                                                       |       | (2,168                                      | )                           | —                          |                       | —                    |       | — |   | — |   |
| Net loss  attributable to Common Stock                                                                   |       | (8,939                                      | )                           | (1,218                          | )                          | 740                       |       | 1,052 |   | 727 |   |
|                                                                                                     |       |                                        |                        |                            |                       |                      |       |   |   |   |   |
| Net income  (loss) per share:                                                                            |       |                                        |                        |                            |                       |                      |       |   |   |   |   |
| Basic &  diluted                                                                                     |       | $                                           | (1.67                       | )                               | $                          | (.23                      | )          | $ | 74.03 |   | $ | 105.15 |   | $ | 72.66 |   |
|                                                                                                     |       |                                        |                        |                            |                       |                      |       |   |   |   |   |
| Weighted average  shares of Common Stock outstanding:                                                    |       |                                        |                        |                            |                       |                      |       |   |   |   |   |
| Basic and  diluted                                                                                       |       | 5,363,961                                   |                        | 5,277,986                       |                       | 10,000                    |       | 10,000 |   | 10,000 |   |

 
| ** **                           | ** ** | ** ** | ** ** | **December 31,** | ** ** | **January 31, ** | ** ** |
|--------------------------------------|------------|------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                           | ** ** | **2005**   | ** ** | **2004 (2)**     | ** ** | **2003 (1)**          | ** ** | **2002 (1)** | ** ** | **2002 (1)** | ** ** |
| **Balance  Sheet Data:**             |       |       |       |                  |       |                       |       |   |   |   |   |
| Current assets                       |       | $          | 13,253     |                  | $          | 12,888                     |       | $ | 10,078 |   | $ | 8,778 |   | $ | 8,301 |   |
| Working capital  (deficit)           |       | (5,246     | )          | 6,704                 |       | 2,864                      |       | 4,203 |   | 2,862 |   |
| Total assets                         |       | 19,510     |       | 19,840                |       | 10,798                     |       | 9,482 |   | 9,174 |   |
| Current  liabilities                 |       | 18,499     |       | 6,184                 |       | 7,214                      |       | 4,575 |   | 5,439 |   |
| Long-term  liabilities               |       | 249        |       | 14,727                |       | 171                        |       | 1,327 |   | 605 |   |
| Stockholders’  equity (deficit) |       | 762        |       | (1,071                | )          | 3,413                      |       | 3,580 |   | 3,130 |   |
|                                      |            |            |            |                       |            |                            |            |  |  |  |  |  |  |  |  |  |

 

----

(1) Reflects thepredecessor entity, Small World Toys prior to the May 20, 2004 acquisition bySmall World Kids, Inc.

 

(2) Reflects thefinancial position and results of operations for the predecessor entity, SmallWorld Toys from January 1, 2004 through May 20, 2004 and the successor entity,Small World Kids, Inc. from May 21, 2004 through December 31, 2004.

 

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**ITEM**** 7.**               **MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Overview

 

Small World Kids was organizedon July 28, 2001 in the state of Utah under the name Savon Team Sports, Inc. (“Savon”)to sell sporting goods over the Internet. The business operations generatedlimited revenues and operated at a loss since inception. On August 1, 2004, asa result of the May 20, 2004 transactions discussed below, we changed our namefrom Savon Team Sports, Inc. to Small World Kids, Inc. We also changed ourdomicile from Utah to Nevada.

 

May 20, 2004 Transactions

 

Pursuantto an Exchange Agreement dated as of May 20, 2004, by and among the Company anda group of investors (“the Investors’), we issued 4,531,375 shares of itscommon stock, par value $0.001 per share, in exchange for all of the equityinterests of Fine Ventures, LLC (“FVL”). Prior to May 20, 2004, FVL had nooperating activities. As a condition to the closing of this transaction,Michael Rubin, the then-majority shareholder of the Company, sold 553,000shares of his 618,000 shares of Small World Kids common stock for $10,000 tothe Investors.

 

Simultaneously,pursuant to the terms of a Stock Purchase Agreement dated as of May 20, 2004,by and among Small World Kids, Debra Fine, Small World Toys, Eddy Goldwasserand Gail S. Goldwasser, Trustee of the Gail S. Goldwasser and Mark ChatinskyFamily Trust (“Gail Goldwasser”; collectively with Eddy Goldwasser, (“Goldwassers”),Small World Kids acquired from the Goldwassers all of the issued andoutstanding equity interests of Small World Toys (the “SWT Shares”). Asconsideration for the SWT Shares, Small World Kids paid an aggregate sum of$7,200,000, delivered as follows; (i) $5,000,000 in cash; and (ii) $2,200,000in the form of a $500,000 six month promissory note, a $1,000,000 seven monthpromissory note, and a $700,000 two year promissory note payable in quarterlyinstallments commencing April 2005. The $5,000,000 in cash was from theproceeds of a loan from SWT, LLC, a Delaware limited liability company whosemembers are some of the Investors. Pursuant to the terms of the loan agreement,Small World Kids executed a five-year note with interest payable at 10% perannum.

 

Asa result of the May 20, 2004 transactions, we have had a change of ourmanagement, our controlling shareholders, our financial position and ourbusiness plan. Small World Kids became a holding company and has no significantbusiness operations or assets other than our interest in Small World Toys, theaccounting predecessor company. Since Small World Kids, our accountingsuccessor, had no significant business operations or assets prior to the May20, 2004 transactions described above, presenting

 

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comparativeperiods would not be meaningful. As such, the results of operations presentedbelow for the predecessor are those of Small World Toys.

 

On October 14, 2005 wecompleted a ten for one (10:1) reverse stock split (“Reverse Split”). After theReverse Split, there were approximately 5,400,000 shares of common stockoutstanding. The Reverse Split did not reduce the number of authorized sharesof common stock, alter the par value or modify any voting rights or other termsthereof. As a result of the Reverse Split, the conversion price and/or thenumber of shares issuable upon conversion or exercise of our outstandingderivative securities were proportionally adjusted pursuant to the respectiveterms thereof. We did not issue any fractional shares and any fractional shareswere rounded down to the next full share.  All references to units of securities (e.g.Common Stock shares) or per share amounts are reflective of the Reverse Splitfor all periods reported.

 

### ***Acquisitions***

###  

On June 24, 2005, theCompany acquired certain assets of Imagiix LP (the “Seller”) for $150,000 incash (excluding transaction expenses) and 50,000 restricted shares of the Company’sstock. Imagiix is a developer and marketer of infant, toddler and preschooltoys sold under the Imagiix® brand name and under various licenses, includingGarfield and Jay Jay the Jet Plane. The 50,000 shares of stock issued to theSeller were determined to have a value of $245,000 based on the closing priceof the Company’s stock on June 24, 2005. Of the $150,000 cash purchasecomponent, $100,000 was paid upon closing with $50,000 paid in December 2005. Additionalcash consideration may be earned by the Seller based on sales by the Company of3% of the products in the Seller’s catalogs and 5% of new products developed bythe Seller and future products developed within the Jay Jay the Jet Plane andGarfield product lines.The Company also incurred approximately $34,000 in acquisition related costswhich are included in the total purchase price. This transaction has beenaccounted for under the purchase method of accounting and was allocated to thenet assets of Imagiix based on their estimated relative fair values on June 24,2005. See the accompanying financial statements for detail of the individualcomponents of the assets purchased.

 

On October 14, 2005, the Company and itsnewly-formed acquisition subsidiary, Fashion Angels Enterprises, Inc., aWisconsin corporation (“Fashion Angels”), entered into an Agreement forPurchase and Sale of Assets (the “Purchase Agreement”) with M&G Partners,LLP, a Wisconsin limited liability partnership, d/b/a The Bead Shop (“Seller”),and Mark Miller, Goldi Miller and Myra Mouloudji, the partners of Seller. ThePurchase Agreement was amended on January 5, 2006 to extend the closing date toJanuary 16, 2006.  Seller designs and manufactures “tween” girl products,including arts and crafts, accessories, dolls and back to school products (the “Business”).Pursuant to the terms of the Purchase Agreement, Fashion Angels was to purchaseall of the assets utilized in connection with the Business and was to assumecertain of Seller’s liabilities associated with the Business. On February 17,2006, M&G Partners, LLP sent notification to the Company that the PurchaseAgreement is terminated as the closing did not occur on or before January 16,2006.

 

24

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**2005 Compared to 2004**

 

The following table providesa summary of the Company’s consolidated results of operations and thepercentage of total net sales represented by the line items reflected in theCompany’s consolidated statements of operations:

 
| ** **                                 | ** ** | **Years Ended  December 31,** | ** ** | **Years Ended  December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                | ** ** | **2004(1)**                             | ** ** | **2005** | ** ** | **2004(1)** | ** ** |
| Net sales                                  |       | $                                       | 33,755,929 |                                    | $          | 29,492,888 |   | 100.0 | % | 100.0 | % |
| Cost of sales                              |       | 20,619,047                              |       | 17,391,282                              |       | 61.1 | % | 59.0 | % |
| Gross profit                               |       | 13,136,882                              |       | 12,101,606                              |       | 38.9 | % | 41.0 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Operating  expenses:                       |       |                                    |       |                                    |       |   |   |   |   |
| Selling, general  and administrative       |       | 14,793,258                              |       | 12,163,526                              |       | 43.8 | % | 41.2 | % |
| Research and  development                  |       | 1,972,343                               |       | 1,173,365                               |       | 5.9 | % | 4.0 | % |
| Intangibles  amortization                  |       | 452,252                                 |       | 190,372                                 |       | 1.3 | % | 0.6 | % |
| Total operating  expenses                  |       | 17,217,853                              |       | 13,527,263                              |       | 51.0 | % | 45.8 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Loss from  operations                      |       | (4,080,971                              | )          | (1,425,657                              | )          | (12.1 | )% | (4.8 | )% |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Other income  (expense):                   |       |                                    |       |                                    |       |   |   |   |   |
| Interest expense                           |       | (3,521,012                              | )          | (988,974                                | )          | (10.4 | )% | (3.3 | )% |
| Warrant  valuation adjustment              |       | 291,113                                 |       | (114,916                                | )          | .9 | % | (0.4 | )% |
| Other                                      |       | 247,870                                 |       | 458,173                                 |       | .7 | % | 2.3 | % |
| Total other  income (expense)              |       | (2,982,029                              | )          | (415,885                                | )          | (8.8 | )% | (1.4 | )% |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Loss before  income taxes                  |       | (7,063,000                              | )          | (1,841,542                              | )          | (20.9 | )% | (6.2 | )% |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Provision  (benefit from) for income taxes |       | (292,419                                | )          | (623,695                                | )          | (.9 | )% | (2.1 | )% |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Net loss                                   |       | $                                       | (6,770,581 | )                                       | $          | (1,217,847 | ) | (20.0 | )% | (4.1 | )% |

 

----

(1) Reflects thefinancial position and results of operations for the predecessor entity, SmallWorld Toys from January 1, 2004 through May 20, 2004 and the successor entity,Small World Kids, Inc. from May 21, 2004 through December 31, 2004.

 

### ***Net sales***

###  

Net sales for the year endedDecember 31, 2005 increased $4,263,000 or 14.5 % to $33,756,000 from$29,493,000 for the year ended December 31, 2004. The revenue increase ismainly attributable to the expansion of the Company’s product lines includingbrands such as Active Edge®, Small World LivingTM, IQ Baby®, IQ Preschool®, GertieBalls®, and the All about Baby products. The introduction of the Neurosmithproduct line in the second quarter resulted in 2005 sales of approximately $1,200,000.Sales to new 2005 mass retailers, Costco Wholesale Corporation and Target Corporationresulted in an increase of $4,200,000 in 2005. Small World ExpressTM, theCompany’s distribution arm experienced over a 45% increase for the year endedDecember 31, 2005 over the comparable prior year period. Somewhat offsettingthese increases were decreased shipments relating to the following core brands;Puzzibilities®, Ryan’s Room® and Tolo® products and the following item classes;Imaginative Play, Tub Tints, Preschool and Vehicles.

 

25

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### ***Gross Profit***

###  

Gross profit for the yearended December 31, 2005 increased $1,035,000 or 8.6% to $13,137,000 from$12,102,000 for the year ended December 31, 2004. Gross profit margin of 38.9%declined for the year ended December 31, 2005 as compared to 41.0% for the yearended December 31, 2004. The decrease in gross margin primarily resulted from agreater mix of sales to national chains and mass retailers of 33.7% of netsales for the year ended December 31, 2005, as compared to 25.5% of net salesfor the year ended December 31, 2004. Sales to national chains and massretailers typically have lower gross margins than sales to the specialtystores, but do not incur freight out or warehousing expenses and have lowercommissions. In addition, there was an increase in promotional rebates androyalties for the year ended December 31, 2005 as compared to the same periodof the prior year.

 

***Operating Expenses***

 

Operating expenses for theyear ended December 31, 2005 increased approximately $3,691,000 or 27.3% and asa percentage of sales increased to 51.0% from 45.8% for the year ended December31, 2004.

 

The increase in operatingexpenses was partly related to an increase in research and development costs of$799,000 or 68.1% incurred in the development of new products for the yearended December 31, 2005 as compared to the year ended December 31, 2004.

 

Selling, general andadministrative expenses for the year ended December 31, 2005 increased $2,630,000or 21.6% to $14,793,000 from $12,163,000 for the year ended December 31, 2004. Increasedselling, shipping and handling expenses for the year ended December 31, 2005 of$351,000 or 5.6% over the prior year was driven by the 14.5% increase in salesin 2005 over 2004. Also, legal, auditing, insurance and investor relationsexpenses, driven primarily by the costs of being a public company, increased by$686,000 for the year ended December 31, 2005 as compared to the prior year. Thesecosts were incurred for a full year in 2005 as compared to only seven monthsduring 2004 as we became a public entity in late May 2004. Also contributing tothe increase was an increase in marketing and branding expenses byapproximately $291,000 for the year ended December 31, 2005 as compared to theprior year as we have introduced the following new brands since the acquisitionof Small World Toys in May 2004; Small World LivingTM, Active Edge®, Active EdgeExtreme®, IQ Baby The Softer Side®, Neurosmith® and ImagiixTM. The write off of$348,000 of barter credits also contributed to the increase (Note 2 of theaccompanying financial statements). Due to the amendments to our Credit Facilitywith PNC (Note 5 of the accompanying financial statements), our bank chargesincreased by $269,000 for the year ended December 31, 2005 as compared to theprior year. In addition, the Company incurred non-cash consulting expenses forthe ended December 31, 2005 in the amount of $535,000 attributable to theissuance of 300,000 stock options granted to consultants for services valued byusing the Black-Scholes option-pricing model. Only 16,000 of the options issuedto the consultants were exercised, the balance expired or were terminated. Thebalance of the increase or $150,000 was attributable to increased travel andairfare expenses relating to the acquisition and fund raising activities in2005 over prior year activities.

 

26

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The Company also incurredadditional costs of $262,000 for the year ended December 31, 2005 related tothe amortization of intangible assets acquired in the purchase of Small WorldToys, the Neurosmith product line and Imagiix as opposed to the previous year.

 

### ***Other Income andExpense***

###  

Interest expense for theyear ended December 31, 2005 increased $2,532,000 or 256.0% to $3,521,000 from$989,000 for the year ended December 31, 2004. The increase is partly due tothe increase of $1,310,000 in non-cash interest expense resulting from theamortization of debt discounts that occurred for the year ended December 31,2005 over the prior year. The balance of the increase resulted from theincrease in the outstanding balances of the Company’s notes payable and therevolving credit line (Note 5 of the accompanying financial statements). Cashinterest paid for the year ended December 31, 2005 increased by $999,000 overthe prior fiscal year primarily due to the increased debt obligations.

 

The agreements with the $1.5million 10% Convertible Debentures note holders obligated us to file aregistration statement to register the warrant shares and the common sharesunderlying the conversion. Accordingly, pursuant to EITF 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the relative net value of the warrants at the date ofissuance of $1,077,000 was recorded as a warrant liability on the balance sheet.Any change in fair value from the date of issuance to the date the underlyingshares are registered will be included in other (expense) income. The change infair market value (“FMV”) of the warrant liability is a non-cash chargedetermined by the difference in FMV from period to period. The Companycalculates the FMV of the warrants outstanding using the Black-Scholes model. Thedecrease in the fair value of the warrant liability associated with the 10%Convertible Debentures from the date of issuance to December 31, 2005 was $388,000.

 

Also due to fluctuations inthe Company’s stock price, the Company also experienced a $97,000 increase inthe FMV of the warrant liability associated with the St. Cloud Capital PartnersLP Bridge Notes. As a result of the July 20, 2005 amendment to the notes heldby St Cloud Capital Partners LP, the FMV of the warrant liability has beenreclassified to equity (Note 5 of the accompanying financial statements).

 

Lower commission incomeaccounted for the $207,000 decrease in Other.

 

### ***Provision forIncome Tax***

###  

Income tax benefit for theyear ended December 31, 2005 was $292,000, due to the benefit realized in recognizingfor losses on which a valuation allowance has not been recorded.

 

**2004 Compared to 2003**

 

The following table providesa summary of the Company’s consolidated results of operations and thepercentage of total net sales represented by the line items reflected in theCompany’s consolidated statements of operations:

 

27

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| ** **                                 | ** ** | **Years Ended  December 31,** | ** ** | **Years Ended  December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                 | ** ** | **2004(1)**                             | ** ** | **2003(2)**                             | ** ** | **2004(1)** | ** ** | **2003(2)** | ** ** |
| Net sales                                  |       | $                                       | 29,492,888 |                                    | $          | 25,970,397 |   | 100.0 | % | 100.0 | % |
| Cost of sales                              |       | 17,391,282                              |       | 14,988,070                              |       | 59.0 | % | 57.7 | % |
| Gross profit                               |       | 12,101,606                              |       | 10,982,327                              |       | 41.0 | % | 42.3 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Operating  expenses:                       |       |                                    |       |                                    |       |   |   |   |   |
| Selling, general  and administrative       |       | 12,163,526                              |       | 9,606,118                               |       | 41.2 | % | 37.0 | % |
| Research and  development                  |       | 1,173,365                               |       | 1,032,174                               |       | 4.0 | % | 4.0 | % |
| Intangibles  amortization                  |       | 190,372                                 |       | —                                  |       | .6 | % | — |   |
| Total operating  expenses                  |       | 13,527,263                              |       | 10,638,292                              |       | 45.8 | % | 41.0 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Income (Loss)  from operations             |       | (1,425,657                              | )          | 344,035                                 |       | (4.8 | )% | 1.3 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Other income  (expense):                   |       |                                    |       |                                    |       |   |   |   |   |
| Interest expense                           |       | (988,974                                | )          | (301,434                                | )          | (3.3 | )% | (1.1 | )% |
| Warrant  valuation adjustment              |       | 114,916                                 |       | —                                  |       | (0.4 | )% | — |   |
| Other                                      |       | 458,173                                 |       | 697,710                                 |       | 2.3 | % | 2.7 | % |
| Total other  income (expense)              |       | (415,885                                | )          | 396,276                                 |       | (1.4 | )% | 1.6 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Income (Loss)  before income taxes         |       | (1,841,542                              | )          | 740,311                                 |       | (6.2 | )% | 2.9 | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Provision (benefit  from) for income taxes |       | (623,695                                | )          | —                                  |       | (2.1 | )% | — | % |
|                                       |       |                                    |       |                                    |       |   |   |   |   |
| Net loss                                   |       | $                                       | (1,217,847 | )                                       | $          | 740,311 |   | (4.1 | )% | 2.9 | % |

 

----

(1) Reflects thefinancial position and results of operations for the predecessor entity, SmallWorld Toys from January 1, 2004 through May 20, 2004 and the successor entity,Small World Kids, Inc. from May 21, 2004 through December 31, 2004.

 

(2) Reflects thepredecessor entity, Small World Toys prior to the May 20, 2004 acquisition bySmall World Kids, Inc.

 

***Net Sales***

*** ***

Net sales for the year endedDecember 31, 2004 increased $3,523,000 or 13.6 % to $29,493,000 from $25,970,000for the year ended December 31, 2003. Revenues were positively impacted byincreased shipments of products related to certain core brands, such as Ryan’sRoom®, Small World Kids (product line), Tolo®, IQ Preschool®, Gertie Balls® andAll About Baby® contributing a 34.4% increase over their respective sales forthe year ended December 31, 2004 versus the comparable prior year period.Offsetting this increase were decreased shipments of products relating to CaféPlay®, IQ Baby®, Puzzibilities® and products relating to the following itemclasses; Arts and Crafts, Science and Nature, and Vehicles.

 

Net revenue for the ninemonths ended September 30, 2005 increased approximately $3.2 million or 16.1%from the same periods one year ago. The revenue increase is mainly attributableto the expansion of the Company’s product lines including brands such as ActiveEdge®, IQ Baby®, Small World LivingTM, Gertie Balls®, Tolo® and the All aboutBaby products. The introduction of the Neurosmith product line in the SecondQuarter resulted in year to date sales of approximately $645,000. SW ExpressTM,our distribution arm experienced over a 60% increase for both the quarter andthe nine months ended September 30, 2005 over the comparable prior year periods.Offsetting these increases were decreased shipments relating to certain corebrands, such as

 

28

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Puzzibilities® and Ryan’s Room® products relating tothe following item classes; Imaginative Play, Tub Tints, Preschool andVehicles.

 

***Gross Profit***

*** ***

Gross profit for the yearended December 31, 2004 increased $1,120,000 or 10.2% to $12,102,000 from$10,982,000 for the year ended December 31, 2003. Gross profit margin of 41.0%declined for the year ended December 31, 2004 as compared to 42.3% for the yearended December 31, 2003. The decrease in gross margin resulted from a greatermix of sales to national chains of 24.6% of net sales for the year endedDecember 31, 2004 versus the 21.2% of net sales for the year ended December 31,2003. Sales to national chains have lower gross margins than to the specialtystores, but do not incur commissions, freight out or warehousing expenses.

 

***Operating Expenses***

*** ***

Operating expenses increased$2,889,000 or 27.2% to $13,527,000 for the year ended December 31, 2004 from$10,638,000 for the year ended December 31, 2003. Operating expenses as apercent of net sales increased to 45.9% for the year ended December 31, 2004from 41.0% for the year ended December 31, 2003. Operations and sellingexpenses increased by $1,132,000 in support of the increased sales volume asnet sales increased by 13.6% in 2004 over 2003 and as we strengthened ourbranding and packaging efforts. Research and development increased by $141,000as we also strengthened our development efforts. General and administrativeexpenses also increased $1,250,000 for the year ended December 31, 2004 ascompared to the prior year period principally as a result of the cost ofbecoming a public company including increased legal, auditing, insurance andinvestor relation expenses. Amortization of intangibles was $190,000 for theyear ended December 31, 2004.

 

***Other Income and Expense***

*** ***

Other income includessublease rental income and commission income and decreased $129,000 to $569,000for the year ended December 31, 2004 from $698,000 for the year ended December31, 2003. The agreements with St. Cloud and Strome obligated us to includethe warrant shares and note shares and the common shares issued with thoseagreements with a registration statement filed in connection with the PutAgreements (Note 5 of the accompanying financial statements). Accordingly,pursuant to EITF 00-19, “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock”, the relativenet value of the warrants at the date of issuance of $851,000 was recorded as awarrant liability on the balance sheet. The change in fair value of the warrantliability from the date of issuance to December 31, 2004 was $115,000. Lowercommission income accounted for the balance of the change.

 

Interest expense increased$688,000 to $989,000 for the year ended December 31, 2004 from the year endedDecember 31, 2003 due principally to the $5 million Note that was entered intoin May 2004 with SWT, LLC (Note 5 of the accompanying financial statements) andthe $3.2 million Notes payable, bridge that was entered into in September 2004with St. Cloud and Strome (Note 5 of the accompanying financial statements). Cashinterest paid for the year ended December 31, 2004 increased by $210,000 overthe prior fiscal year primarily due to the $5 million Note.

 

29

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***Provision for Income Tax***

*** ***

Income tax benefit for theyear ended December 31, 2004 was $624,000 due to the decrease in the deferredtax liability. Small World Toys (predecessor) was a Subchapter Scorporation.

 

## **Liquidity and Capital Resources**

##  

Cash has historically beengenerated from operations. Operations and liquidity needs are funded primarilythrough cash flows from operations, as the well as utilizing, when needed,borrowings under the Company’s secured credit facilities and short term notes. Workingcapital needs generally reach peak levels from August through November of eachyear. To gain shelf space and address the seasonality of the toy industry, theCompany offers early buy programs that are volume related with extended paymentterms. The Company’s historical revenue pattern is one in which the second halfof the year is more significant to the Company’s overall business than thefirst half and, within the second half of the year, the fourth quarter is themost prominent. The trend of retailers over the past few years has been to makea higher percentage of their purchases of toy and game products within or closeto the fourth quarter holiday consumer buying season, which includes Christmas.The Company expects that this trend will continue. As such, historically, themajority of cash collections for Small World Toys occur late in the fourthquarter as the extended payment terms become due from the Company’s early buyprograms. As receivables are collected, the proceeds are used to repayborrowings under the Company’s Revolving Note.

 

We have incurredsignificant losses since our purchase of Small World Toys in May 2004. As ofDecember 31, 2005, our accumulated deficit was $10,022,000. As of December31, 2005, we have $4,700,000 in principal payments due in 2006. We may not beable to generate sufficient cash flow from operations to meet our debtobligations. There can be no assurance that we will be able to obtainadditional financing or restructuring our debt obligations or that, if we wereto be successful in obtaining additional financing or restructuring our debtobligations, it would be on favorable terms. Failure to obtain additionalfinancing or restructuring our debt obligations may cause us to default onthese debt obligations. In addition, under cross default provisions in theLaurus Security Agreement, defaults under our debt obligations may cause theacceleration of the repayment of the Revolving and Term Notes. This raises substantial doubt about theCompany’s ability to continue as a going concern for a reasonable period oftime. Managementintends to take the following actions (i) reducing operating expenses, (ii)seeking to obtain new equity and (iii) restructuring the debt obligations.

 

Additionally, the Companymay need additional financing to fund the Company’s acquisition strategy, theamount of which will depend on the price and structure of potentialacquisitions.

 

On February 28, 2006,Small World Kids, Inc. issued a Secured Non-Convertible Revolving Note(the “Revolving Note”) with Laurus Master Fund, Ltd. (“Laurus”).  The termof the Revolving Note is two years and provides that we may borrow up to$16,500,000 subject to certain conditions.  Interest is payablemonthly, in arrears at a rate per annun equal to the Prime Rate (as publishedin The Wall Street Journal) plus two

 

30

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percent (2.0%). TheRevolving Note has no financial covenants and is collateralized by a securityinterest in substantially all of the assets of the Company and its subsidiaries,including its operating subsidiary, Small World Toys.

 

On February 28, 2006, Small WorldKids, Inc., also issued pursuant to a security agreement (the Laurus “SecurityAgreement”) a $2.0 million, two year Secured Non-Convertible Term Note (the “TermNote “) with Laurus. Commencing April 1, 2006 and each succeeding month after,the Company will make principal payments of $33,333 with all the balance of theunpaid principal amount due upon the maturity date of February 28, 2008. Interest is payable monthly, in arrears at a rate per annum equal to thePrime Rate (as published in The Wall Street Journal) plus three percent(3.0%). The Term Note has no financial covenants and is collateralized by theLaurus Security Agreement.

 

On March 20, 2006, The Company entered into a Purchase Order Revolving Credit Line (“PO CreditLine”) of Five Million Dollars ($5,000,000) with Horizon Financial Services Group USA to provide financing for the acquisition of product from our overseasvendors. The term of the PO Credit Line is eighteen (18) months and providesthat we may borrow up to $5,000,000 subject to certain conditions includingHorizon’s approval of the applicable vendors.  A financing feeequal to Four and One Half Percent (4.50%) of the gross amount or face value ofeach Horizon financing instrument will be charged for the first forty-five (45)day period or part thereof that the financing instrument remains outstanding. Anadditional fee of fifty basis points (.50%) for each additional period of 15days, or part thereof, during which the Horizon financing instrument remainsoutstanding will be charged. The POCredit Line has no financial covenants and is collateralized by a securityinterest, junior in position to that of our senior lender, Laurus MasterFund, Ltd, to the assets related to the PO Credit Line transactions.

 

As of December 31, 2005,we had approximately $524,000 of cash and unrestricted cash which compares to $1,785,000at December 31, 2004 and $24,000 at December 31, 2003. Also, as of December 31,2005, we had approximately $612,000 of availability on our line of credit whichcompares to $1,807,000 as of December 31, 2004.

 

Inthe year ended December 31, 2005, the Company used cash for operatingactivities of $2,760,000 as compared to $3,517,000 for the year ended December 31, 2004. Inclusiveof this decrease were the following: (i) a slight increase in accountsreceivable of 136,000 attributable to the 10% increase in revenues in thefourth quarter of 2005 as compared to the fourth quarter of 2004 offset byimproved collections as our days sales outstanding improved; (ii) an increasein inventory of $2,058,000 in the year ended December 31, 2005 driven by the increasein sales in 2005 and in support of a mass retailer’s first quarter 2006 program;and (iii) offset by an increase in accounts payable of $1,882,000 related tothe increase in inventory over 2004.

 

For the year endedDecember 31, 2004, the Company used cash from operating activities of $3,517,000as compared to the year ended December 31, 2003, where cash from operatingactivities generated $804,000. For the year ended December 31, 2004,

 

31

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accounts receivableincreased $2,282,000 driven partially by the increase of net sales of $1,293,000in the fourth quarter ended December 31, 2004 as compared to the fourth quarterof 2003. This compares to the year ended December 31, 2003 where accountsreceivables increased by $263,000. Somewhat offsetting this increase inreceivables was the decrease in inventory of $1,800,000 for the year endedDecember 31, 2004 again partly driven by the increase in sales for the fourthquarter ended December 31, 2004. This compares to year ended December 31, 2003where inventories increased by $1,172,000. Accounts payable decreased by$1,039,000 for the year ended December 31, 2004. This compares to year endedDecember 31, 2003 where accounts payable increased by $1,152,000.

 

Since the Companyoutsources manufacturing of products to Asia, the Company has historically lowrequirements for additions to property and equipment. For the year endedDecember 31, 2005, the Company spent approximately $214,000 in additions tocapital equipment as compared to $185,000 and $132,000 for the years endedDecember 31, 2004 and 2003, respectively.

 

In the second quarter of2005, the Company acquired certain assets of Imagiix LP for $150,000 in cash(excluding transaction expenses) and 50,000 shares of restricted stock. Of the$150,000 cash purchase component, $100,000 was paid upon closing and $50,000paid in December 2005.

 

The Company completed thefollowing transactions in 2005 to secure additional funds for working capital:

 

•                  On April 28, 2005 the Company entered intoTerm Credit Agreements (“Credit Agreements”) with Hong Kong League CentralCredit Union and PCCW Credit Union (collectively the “Lenders”) for unsecuredloans totaling $750,000 due on or before August 31, 2005. Interest is chargedat a rate of 2% per month and is payable monthly in arrears. On June 10, 2005the Company entered into additional Credit Agreements with Hong Kong LeagueCentral Credit Union and HIT Credit Union for unsecured loans totaling $250,000due on or before September 30, 2005. Effective August 31, 2005 the maturitydates of all outstanding unsecured loans with the Lenders were extended to theearlier of the closing of a financing transaction with net proceeds of at least$20 million or March 1, 2006. Effective February 28, 2006 the maturity dates ofall outstanding unsecured loans with the Lenders were extended to the earlierof the closing of a financing transaction with net proceeds of at least $20million or August 11, 2006.

 

•                  On July 20, 2005 the Company amended the $2.0million 10% Bridge Note due to St Cloud Capital Partners LP (“St Cloud”) pursuantto which St. Cloud agreed to advance to the Company an additional $500,000 foran aggregate loan of $2.5 million at an interest rate of 10% per annum payablemonthly in arrears. The aggregate loan is secured by certain Company assetsincluding Receivables, Inventory, Equipment and other assets.

 

32

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•                  Effective August 11, 2005, the Companycompleted the issuance of an aggregate of $500,000 in Notes to variousinvestors which included Debra Fine, the Company’s President and ChiefExecutive Officer who provided $175,000 of the total borrowing. The Notesmature one year from the date of execution with interest payable monthly inarrears at a rate of 10% per annum. The Notes are secured by certain Company assetsincluding Receivables, Inventory, Equipment and other assets.

 

•                  On August 11, 2005 the Company converted the$5 million Bridge Note dated May 21, 2004 issued to SWT, LLC, a related party,to 10% Class A Convertible Preferred Stock (“Preferred Stock”). The PreferredStock is immediately convertible at the option of the holder into the Company’sCommon Stock at an initial fixed conversion price of $4.00 subject toadjustment based on the terms of future financings should they occur. ThePreferred Stock accrues a quarterly dividend at a rate of 10% per annum and ispayable in cash or a combination of 50% cash and 50% Common Stock at theCompany’s option.

 

•                  As a result of the conversion of the July 20,2005 amended agreement with St. Cloud, the issuance of $500,000 in Notes onAugust 11, 2005 and the $5 million Bridge Note discussed above, the stockpurchase agreement (“Put Agreements”) entered into by the Company in 2004 witheach of Wire Mill Partners III LLC, LLC and Pewter Hill Partners LLC (“Purchasers”)that obligated each of them to purchase, upon the Company’s election, up to 1,010,000shares of the Company’s Common Stock for an aggregate purchase price of $6.3million (representing a total commitment of $12.6 million) have beenautomatically terminated.

 

•                  On September 30, 2005 the company completedthe issuance of an aggregate of $1.5 million in principal amount of 10%Convertible Debentures (the “Debentures”) and entered into a SecuritiesPurchase Agreement (“Stock Purchase Agreement”) with Gamma Opportunity CapitalPartners LP and Bushido Capital Master Fund LP. The Debentures will mature onSeptember 30, 2008 and bear an interest rate of 10% per annum payable quarterlyin arrears. The Company may make interest payments in cash or shares of its CommonStock, subject, in the case of payment in shares, to satisfaction of certainconditions. The Debentures are immediately convertible to the Company’s CommonStock at the option of the holder. The conversion price is $4.00, subject toadjustments for stock splits, stock dividends or rights offerings combinations,recapitalization, reclassifications, extraordinary distributions and similarevents and certain subsequent equity sales.

 

•                  On October 3, 2005 the Company used theproceeds obtained through the issuance of the Debentures and retired the $1.2million 10% Bridge Notes due to Strome Hedgecap Ltd.

 

•                  On November 11, 2005, the Company entered into a Second Amendmentto the Agreement with St. Cloud pursuant to which the Company issued to St.Cloud a new promissory note (the “Replacement Note”) replacing the existingnote to St. Cloud in the principal amount of $2,500,000 (the “Loan Amount”). Under the Replacement Note, the maturity date of the Loan Amount was extendedto

 

33

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September 15,2006.  The Replacement Note is convertible into shares of the Common Stockof the Company at $4.00 per share (subject to adjustment) or, as to up to 50%of the Loan Amount, into securities issued by the Company in a financing withgross proceeds of at least $12,500,000.

 

All securities issuances were made pursuant to anexemption from the registration requirements of the Securities Act of 1933, asamended, pursuant to Regulation D promulgated thereunder.

 

## **Contractual Obligations andOff-Balance Sheet Arrangements**

##  

As part of the purchase forSWT Shares on May 20, 2004, the Company entered into a contingent earnout withthe former shareholder of Small World Toys. The Company agreed to a two yearpromissory note, payable in quarterly installments commencing April 2005 with aminimum payment of $700,000 and a maximum payment of $1,500,000, if certainsales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000based on the Company obtaining $33.7 million in net sales of which $350,000 waspaid in quarterly installments in 2005 and the balance due in 2006 to be paidon a $60,000 per month payment schedule commencing on April 2006. The 2006earnout is based on 2% of 2006 net sales up to a maximum of $800,000. Of the2006 earnout, a minimum quarterly payment of $87,500 will be paid with thebalance earned due January 2007.

 

The following tables summarize our total contractual cash obligationsby year:

 
| **Payments due by period (000’s)** | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **After 2008** | ** ** |
|-------------------------------------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|---------------------|------------|
| Notes payables  (1)                                         |       | $         | 6,175      |     | $          | 4,587    |       | $        | 88         |                | $          | 1,500 |   | $ | — |   |
| Employment and  consulting agreements                       |       | 670       |       | 543      |       | 127      |       | —   |       | —              |       |
| Operating leases                                            |       | 346       |       | 346      |       | —   |       | —   |       | —              |       |
|                                                        |       |      |       |     |       |     |       |     |       |                |       |
| Total  contractual cash obligations                         |       | $         | 15,307     |     | $          | 13,591   |       | $        | 215        |                | $          | 1,500 |   | $ | — |   |

 

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(1) Prior to debtissuance costs, see Footnote 5

 

The Company has no otheroff-balance sheet arrangements as defined by Regulation S-K that have or arereasonably likely to have a current or future effect on the Company’s financialcondition, revenues or expense or liquidity.

 

**Critical Accounting Policies and Significant Estimates**

 

Management’s discussion andanalysis of our financial condition and results of operations are based uponthe consolidated financial statements, which have been prepared in accordancewith accounting principles generally accepted in the United States.  Thepreparation of these financial statements requires management to make estimatesand judgments that affect the reported amounts of assets, liabilities, revenuesand expenses, and related disclosures of contingent assets andliabilities.  On an on-going basis, management evaluates estimates,including those related to the valuation of inventory and the allowance foruncollectible accounts receivable. We base our estimates on historicalexperience and on various other assumptions that are believed to be reasonableunder the circumstances, the results of which form the basis for makingjudgments about the carrying values of assets and liabilities that are notreadily apparent from other sources.  Actual results may differ from theseestimates under different

 

34

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assumptions or conditions. A summary of thesignificant accounting policies can be found in Note 2 of the Notes toConsolidated Financial Statements. The significant accounting policies whichmanagement believes are the most critical to aid in fully understanding andevaluating our reported financial results include revenue recognition,inventory and long lived assets.

 

**Revenue Recognition**

 

We recognize revenue whenall four revenue recognition criteria have been met: persuasive evidence of anarrangement exists, the product has been delivered or the service has beenrendered, the price is fixed or determinable and collection is probable. Werecognize revenue from product sales upon when all of the foregoing conditionsare met which in general is at the time of shipment where the risk of loss andtitle has passed to the customer. However, for certain shipments such as directshipments from our vendors to our customers or where we use consolidators todeliver our products (usually export shipments) revenue is recognized inaccordance with the sales terms specified by the respective sales agreements.

 

Sales allowances forcustomer promotions, discounts and returns are recorded as a reduction ofrevenue when the related revenue is recognized. We routinely commit topromotional sales allowance programs with our customers. These allowancesprimarily relate to fixed programs, which the customer earns based on purchasesof our products during the year. Discounts are recorded as a reduction ofrelated revenue at the time of sale. Sales to customers are generally notsubject to any price protection or return rights.

 

We offer extended terms tosome of our customers in the first three quarters of the year by way of salespromotions whereby payment will not become due until the fourth quarter if aspecified purchase threshold has been met. This promotion allows us to captureadditional shelf space and to capture more of the annual budgets of our retailcustomers. The result of this promotion gives rise to a significant increase inaccounts receivable through the fourth quarter until substantially all accountsbecome due and are collected. Based upon historically low rates of return andcollection of substantially all of these extended term accounts, we havedetermined that revenue is appropriately recognized in accordance with itsnormal procedures described above.

 

**Inventory**

 

Inventory is valued at thelower of average cost or market. Inventory costs consist of the purchases offinished goods from our vendors and the associated costs necessary to obtainthose inventories. As necessary, we write down inventory to its estimatedmarket value based on assumptions about future demand and market conditions. Failureto accurately predict and respond to consumer demand could result in the underproduction of popular items or overproduction of less popular items which mayrequire additional inventory write-downs which could materially affect ourfuture results of operations.

 

**Long-lived Assets**

 

We evaluate long-livedassets whenever events or changes in business circumstances or our planned useof assets indicate that their carrying amounts may not be fully recoverable orthat their useful lives are no longer appropriate.  Reviews are performedto determine whether the carrying values of assets are impaired based oncomparison to

 

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either the discounted expected future cash flows (inthe case of goodwill and intangible assets) or to the undiscounted expectedfuture cash flows (for all other long-lived assets).  If the comparisonindicates that impairment exists, the impaired asset is written down to itsfair value.  Significant management judgment is required in the forecastof future operating results that are used in the preparation of expecteddiscounted and undiscounted cash flows.

 

The total purchase price ofour acquisitions are allocated to the fair value of the assets acquired andliabilities assumed in accordance with the provisions of Statements ofFinancial Accounting Standards (“SFAS”) No. 141, Business Combinations and No.142, Goodwill and Other Intangible Assets. In accordance with Statement ofFinancial Accounting Standards No. 141, the estimated the fair value of theassets acquired for purpose of allocating the purchase price.

 

At December 31, 2005, we hada net amount of $5.7 million of goodwill and purchased intangible assets on ourConsolidated Balance Sheet.  As no impairment indicators were presentduring fiscal 2005, we believe this value remains recoverable based on thediscounted estimated future cash flows of the associated products andtechnologies.

 

**Recent Accounting Pronouncements**

 

In December 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004),“*Share-Based Payment*” (SFAS 123R). SFAS 123R eliminates the alternative of applying the intrinsic valuemeasurement provisions of APB 25 to stock compensation awards issued toemployees.  Rather, the new standard requires enterprises to measure thecost of employee services received in exchange for an award of equityinstruments based on the grant-date fair value of the award.  That costwill be recognized over the period during which an employee is required toprovide services in exchange for the award, usually the vesting period.

 

The pro forma effects on netincome and earnings per share as if we had applied the fair value recognitionprovisions of original SFAS 123 on stock compensation awards (rather thanapplying the intrinsic value measurement provisions of APB 25) are in the Notesto Consolidated Financial Statements (see Note 2).  Although the pro formaeffects of applying original SFAS 123 may be indicative of the effects ofadopting SFAS 123R, the provisions of these two statements differ in someimportant respects.  The actual effects of adopting SFAS 123R will bedependent on numerous factors including, but not limited to, the valuationmodel chosen by to value stock-based awards; the assumed award forfeiture rate;the accounting policies adopted concerning the method of recognizing the fairvalue of awards over the requisite service period; and the transition method chosenfor adopting SFAS 123R.  Adoption of this accounting standard will have amaterial adverse impact on our consolidated financial statements.  Thisstatement will be effective for our first quarter ending March 31, 2006.

 

In February 2006, theFASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments”(“SFAS 155”), which amends SFAS No. 133, “Accounting for DerivativesInstruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140, “Accountingfor Transfers and Servicing of Financial Assets and Extinguishment ofLiabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scopeexception

 

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for interest-only andprincipal-only strips on debt instruments to include only such stripsrepresenting rights to receive a specified portion of the contractual interestor principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifyingspecial-purpose entities to hold a passive derivative financial instrumentpertaining to beneficial interests that itself is a derivative instrument. TheCompany is currently evaluating the impact this new Standard, but believes thatit will not have a material impact on the Company’s financial position, resultsof operations or cash flows. We will adopt SFAS 155 on January 1, 2007.

 

In May 2005, the FASBissued Statement No. 154, “*Accounting Changes andError Corrections—a replacement of APB Opinion No. 20 and FASB StatementNo. 3*” (“SFAS No. 154”). This Statement replaces APB OpinionNo. 20, “Accounting Changes” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS No. 154 applies to all voluntary changes in an accountingprinciple and to any changes required by an accounting pronouncement in theunusual instance that the pronouncement does not include specific transitionprovisions. SFAS No. 154 requires that all voluntary changes in accountingprinciples are retrospectively applied to prior financial statements as if thatprinciple had always been used, unless it is impracticable to do so. SFAS No.154 is effective for accounting changes and error corrections occurring infiscal years beginning after December 15, 2005. The adoption of thisstandard, beginning in fiscal year 2006, is not expected to have any materialeffect on our operating results or financial condition.

 

In December  2004, the FASB issued Statement  153,”*******Exchanges of NonmonetaryAssets - An Amendment of APB Opinion No. 29*****“(SFAS 153). The standard  is based on theprinciple that  exchanges ofnonmonetary  assets should be measuredbased on the fair  value of theassets  exchanged  and eliminates  the  exception under APB Opinion No. 29 for an exchange of similar productive assetsand replaces it with an exception for exchanges of  nonmonetary  assets that do not have  commercial substance. The standard iseffective for nonmonetary exchanges occurring in fiscal periods beginning  after June 15, 2005.The adoption of SFAS 153 did not have a material impact on the Company’s  financial position or results of operations.

 

In November 2004, theFASB issued SFAS No. 151, “*Inventory Costs*”,an amendment of Accounting Research Bulletin No. 43, Chapter 4.  ThisStatement is the result of a broader effort by the FASB working with theInternational Accounting Standards Board to reduce differences between U.S. andinternational accounting standards. SFAS No. 151 eliminates the “so abnormal”criterion in ARB No. 43 and companies will no longer be permitted to capitalizeinventory costs on their balance sheets when the production defect rate variessignificantly from the expected rate.  It also makes clear that fixedoverhead should be allocated based on “normal capacity.” SFAS No. 151 iseffective for inventory costs incurred during fiscal years beginning afterSeptember 15, 2005. We will adopt this standard in the first quarter of2006 but does not believe that it will have a material effect on the results ofoperations or consolidated financial position.

 

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On September 28, 2005,the FASB ratified the following consensus reached in EITF Issue 05-8 (“IncomeTax Consequences of Issuing Convertible Debt with a Beneficial ConversionFeature”): a) The issuance of convertible debt with a beneficial conversionfeature results in a basis difference in applying SFAS No. 109, Accounting forIncome Taxes. Recognition of such a feature effectively creates a debt instrumentand a separate equity instrument for book purposes, whereas the convertibledebt is treated entirely as a debt instrument for income tax purposes. b) Theresulting basis difference should be deemed a temporary difference because itwill result in a taxable amount when the recorded amount of the liability isrecovered or settled. c) Recognition of deferred taxes for the temporarydifference should be reported as an adjustment to additional paid-in capital.This consensus is effective in the first interim or annual reporting periodcommencing after December 15, 2005, with early application permitted. Theeffect of applying the consensus should be accounted for retroactively to alldebt instruments containing a beneficial conversion feature that are subject toEITF Issue 00-27 , “Application of Issue No. 98-5 to Certain Convertible DebtInstruments” (and thus is applicable to debt instruments converted orextinguished in prior periods but which are still presented in the financialstatements). Management is evaluating the impact of this pronouncement on theCompany’s financial statements

 

In September 2005, the FASB approved EITF Issue 05-7,“Accounting for Modifications to Conversion Options Embedded in Debt Securitiesand Related Issues” (“EITF 05–7”). EITF 05–7 addresses that the changes in thefair value of an embedded conversion option upon modification should beincluded in the analysis under EITF Issue 96–19, “Debtor’s Accounting for aModification or Exchange of Debt Instruments,” to determine whether amodification or extinguishment has occurred and that changes to the fair valueof a conversion option affects the interest expense on the associated debtinstrument following a modification. Therefore, the change in fair value of theconversion option should be recognized upon the modification as a discount orpremium associated with the debt, and an increase or decrease in additionalpaid-in capital. EITF 05–7 is effective for all debt modifications in annual orinterim periods beginning after December 15, 2005. The adoption of EITF05–7 is not expected to have significant impact, if any, on the Company’sfinancial position and results of operations.

 

In June 2005, the EmergingIssues Task Force, or EITF, reached a consensus on Issue 05-6, *Determining the Amortization Period for LeaseholdImprovements*, which requires that leasehold improvements acquired ina business combination or purchased subsequent to the inception of a lease beamortized over the lesser of the useful life of the assets or a term thatincludes renewals that are reasonably assured at the date of the businesscombination or purchase. EITF 05-6 is effective for periods beginning afterJuly 1, 2005. We do not expect the provisions of this consensus to have amaterial impact on the company’s financial position, results of operations orcash flows.

 

In June 2005, the FASBratified EITF Issue No. 05-2, “The Meaning of ‘Conventional Convertible DebtInstrument’ in EITF Issue No. 00-19, ‘Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in a Company’s Own Stock” (“EITFNo. 05-2”), which addresses when a convertible debt instrument should beconsidered ‘conventional’ for the purpose of applying the guidance in EITF No.00-19.

 

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EITF No. 05-2 alsoretained the exemption under EITF No. 00-19 for conventional convertible debtinstruments and indicated that convertible preferred stock having a mandatoryredemption date may qualify for the exemption provided under EITF No. 00-19 forconventional convertible debt if the instrument’s economic characteristics aremore similar to debt than equity. EITF No. 05-2 is effective for newinstruments entered into and instruments modified in periods beginning afterJune 29, 2005. The Company has applied the requirements of EITF No. 05-2 to newinstruments entered into and instruments modified in periods beginning afterJune 29, 2005. The Company does not expect its financial statements to besignificantly impacted by this statement.

 

**ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA**

 

Our audited ConsolidatedFinancial Statements, including the notes thereto, appear beginning on page F-2of this report.

 

 

**ITEM**** 8A.**      **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

Our principal financialinstrument is our Secured Non-Convertible Revolving Note and SecuredNon-Convertible Term Note with Laurus Master Funds, Ltd. (“Laurus”) whichprovides for an interest rate of Prime Rate (as published in The Wall StreetJournal) plus two percent (2.0%) for the Revolving Note and Prime Rate (aspublished in The Wall Street Journal) plus three percent (3.0%) for theTerm Note. We are affected by market risk exposure primarily through the effectof changes in the Prime Rate on our interest rates on our obligations under theRevolving and Term Notes. At February 28, 2006, an aggregate principal amountof $6,768,000 was outstanding under the Revolving and Term Notes. If the principalamounts outstanding remained at this level for an entire  year and the prime rate increased ordecreased, respectively, by 0.5%, we would pay or save, respectively, anadditional $34,000 in interest in that year.

 

Weare also exposed to risk from a change in interest rates to the extent we arerequired to refinance existing fixed rate indebtedness at rates higher thanthose prevailing at the time the existing indebtedness was incurred. We have $4.7million in fixed rate indebtedness due in 2006. If we would refinance all thisdebt, a hypothetical change in the interest rates of .5% would increase ourinterest expense on these indebtedness by an approximately $24,000 per year.

 

Our business outside theUnited States is conducted in United States Dollars. Although we purchase andsell products and services in United States Dollars and do not engage inexchange swaps, futures or options contracts or other hedging techniques,fluctuations in currency exchange rates could reduce demand for products soldin United States dollars. We cannot predict the effect that future exchange ratefluctuations will have on our operating results. We may in the future engage incurrency hedging transactions, which could result in our incurring significantadditional losses.

 

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**ITEM 9.  CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL****DISCOSURES**

None.

 

**ITEM 9A.CONTROLS AND PROCEDURES**

 

As a result of the May 20,2004 transactions, the internal control structure in place for Small WorldToys, Inc. has succeeded to Small World Kids, Inc. Since the acquisition ofSmall World Toys, the Company’s system of internal controls has evolvedconsistent with the development of the business.

 

(a) Evaluation of disclosurecontrols and procedures: As of December 31, 2005, the end of the period coveredby this report, the Company’s chief executive and the Company’s chief financialofficer reviewed and evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as defined in Exchange Act Rule 13a-15 andRule 15d-15(e)), which are designed to ensure that material informationthe Company must disclose in the Company’s report filed or submitted under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded,processed, summarized, and reported on a timely basis, and have concluded,based on that evaluation, that as of such date, the disclosure controls andprocedures the were effective to ensure that information required to bedisclosed in reports filed or submitted under the Exchange Act is accumulatedand communicated to the Company’s chief executive officer and chief financialofficer as appropriate to allow timely decisions regarding required disclosure.

 

(b) Changes in internalcontrol over financial reporting:  In thesecond quarter of 2005 the Company implemented several policies which in theopinion of management improved the operating effectiveness of the Company’sinternal controls. There have been no other changes in the Company’s internalcontrol structure over that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**ITEM 9B. OTHER INFORMATION**

 

None

 

**PART III**

 

**ITEM 10.**        ******DIRECTORS, EXECUTIVEOFFICERS, PROMOTERS AND CONTROL PERSONS**

 

The following table and textset forth the names of all directors and executive officers of our Company asof December 31, 2005. The Board of Directors is comprised of only oneclass. All of the directors will serve until the next annual meeting ofshareholders and until their successors are elected and qualified, or untiltheir earlier death, retirement, resignation or removal. There are no familyrelationships between or among the directors, executive officers or personsnominated or charged by our Company to become directors or executive officers. Executiveofficers serve at the discretion of the Board of Directors, and are appointedto serve until the first Board of Directors meeting following

 

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theannual meeting of shareholders.  Alsoprovided herein are brief descriptions of the business experience of eachdirector and executive officer and an indication of directorships held by eachdirector in other companies subject to the reporting requirements under theFederal securities laws.

 

The directors and executiveofficers of the Company are as follows: 

 
| **Name**             | ** ** | **Age** | ** ** | **Position Held with the Company** |
|----------------------|------------|---------|------------|--------------------------------------------------------|
| Debra Fine           |       | 43      |       | Chairman, CEO,  President and Director                 |
| John Nelson          |       | 63      |       | Chief Operating Officer                                |
| Bob Rankin           |       | 54      |       | Chief Financial Officer  and Secretary                 |
| Gary Adelson (b)     |       | 51      |       | Director                                               |
| Alex Gerstenzang (a) |       | 52      |       | Director                                               |
| Robert Lautz         |       | 56      |       | Director                                               |
| John Matise (b)      |       | 33      |       | Director                                               |
| Lane Nemeth (a)      |       | 57      |       | Director                                               |
| Shelly Singhal (a)   |       | 37      |       | Director                                               |
| David Swartz (b)     |       | 62      |       | Director                                               |

 

(a)          Member of theCompensation Committee

(b)         Member of the AuditCommittee

 

**Biographies of Directors and Executive Officers:**

** **

*DebraFine, Chief Executive Officer, Chairman and President*

* *

Debra Fine has served asthe Chief Executive Officer, Chairman and President since May 20, 2004.Prior to joining the Company, Fine served as a principal at EM Ventures(Venture Capital Fund) and the President and Chief Executive Officer of threeconsumer product companies, Fandom Media, a “tween” products company from 2000to 2002, President of New Media for Digital Domain, an academy award winningmovie production company from 1998 to 2000 and Cloud 9 Children’sproducts.   With over 15 years ofexperience in consumer products, entertainment and media, Fine has developedexpertise in operations, marketing, licensing and creating growth in start-upventures.  She holds a Bachelor of Artsin Journalism and Advertising from the University of Southern California and aMBA from the Anderson School, Executive Program at University of California,Los Angeles.

 

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*John J. Nelson Jr., ChiefOperating Officer*

 

John Nelson began servingas Chief Operating Officer in May 2004.  On March 27, 2006,John Nelson resigned as Chief Operation Officer for the Company and willcontinue to assist the company in a consulting capacity for the balance of2006.  Prior toserving in his current position, he served as President and Chief OperatingOfficer for Small World Toys from February 2001 to May 2004.  From 1985 until joining Small World Toys,Mr. Nelson has been a consultant along with having President, ChiefExecutive and Financial Officer responsibilities for several manufacturingcompanies with revenues over $25 million, including Stainless Steel Products(Burbank, CA), and Softub, Inc. (Chatsworth, CA).  From 1974 to 1985, he held senior executivepositions with Ford Aerospace.  Hecurrently sits on the Board of Directors for the Mortgage Oil Corporation.  After graduating from Villanova Universitywith a B.S. degree in Electrical Engineering, Nelson was commissioned as anofficer in the United States Marine Corps, of which he spent 24 years, retiringas a Colonel. He received his M.B.A. from Pepperdine University.

 

*RobertRankin, Chief Financial Officer and Secretary*

* *

Robert Rankin has servedas the Chief Financial Officer and Secretary since May 24, 2004.  From 2002, Mr. Rankin served as aconsultant including serving as an interim CFO for a semiconductor start-upcompany from 2003 until joining the Company. From 1992 through 2002, Mr. Rankin held positions as ChiefFinancial Officer of public and private, mid-cap and start-up companies in thehigh technology and aerospace industries. In 2000, Rankin co-founded an application service provider softwarecompany.  In 2000, while serving as theChief Financial Officer of webcasts.com, a private company, Rankin directed thesale of this software start-up for a valuation over $100 million.  From 1992 through 1998 under his leadershipas CFO, DeCrane Aircraft Holdings, Inc. grew from a highly leveraged, VCfunded, private aerospace company with sales of $13 million in 1991 to amultinational public company with sales of almost $200 million in 1998.  Rankin’s background also includes seniorfinancial management positions with B.F. Goodrich and ColtecIndustries.  Mr. Rankin has a Bachelor ofScience in Mechanical Engineering and a Master of Science in Business, bothfrom Carnegie-Mellon University. 

 

*GaryAdelson, Director*

* *

Gary Adelson has been amanaging director of Houlihan Lokey Howard & Zukin and co-head of the firm’sMedia & Entertainment Investment Banking Group since 2003. Prior to joiningthe firm, he was a principal of Media Connect Partners, a provider of financialand operating advisory services to media, entertainment, sports andcommunications companies that he co-founded in 2003 and that was acquired byHoulihan. In 1996, Adelson co-founded EastWest Venture Group, which is aprivate venture capital, company managing a fund of over $250 million andserved until 2002.  From 1990 to 1995, Heco-founded and served as Chairman and Chief Executive Officer of ICS, atelephony and cable company that was acquired by MCI in 1995.  He earned a Bachelor of Arts degree inEconomics from the University of California, Los Angeles

 

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and has served as thechairman of UCLA’s Venture Fund. Mr. Adelson serves on the board of the Pediatric Aids Foundationand was executive director of Israel’s 50th anniversary jubilee. 

 

*AlexGerstenzang, Director*

* *

Alex Gerstenzanghas been a senior executive with a big box retailer, overseeing a diverseproduct sales mix of approximately $12 billion since 1997.  He has managed the East Coast region for ParisBoutique Corporation and subsequently founded a consulting business servingclients as diverse as prisons to the City of Portland and Georgia PacificCorporation.  He attended Dalton School,Columbia University, Pace University and New York University. He earned aBachelor of Specialized Studies degree in finance and a Master of BusinessAdministration. 

 

*BobLautz, Director*

* *

Bob Lautz is a ManagingDirector of St. Cloud Capital Partners L.P. Formerly, he was the Chairman ofREO.com, leading Internet-based sales mechanism for bank foreclosed propertiesand Chief Executive Officer of ListingLink, an Internet-based residentialproperty multiple listing service.  Heformed and was Chairman and CEO of Indenet, Inc., a Nasdaq listed privatesatellite-based network that delivered digital advertisements and programmingto national broadcast and cable television networks.  He owned and operated Peerless Capital, aventure capital business that invested in various management led leveragedbuyouts and private equity transactions. He currently serves on the Board of Directors of Prolong InternationalCorporation (AMEX:PRL); and Compact Power, Inc. He earned a Master’s degreefrom the American Graduate School of International Management (Thunderbird),and a BS in Business Administration from Miami University in Oxford, Ohio.

 

*JohnMatise, Director*

* *

On March 27, 2006, Mr. Matise wasappointed Chief Operating Officerof the Company.  He has beenserving as a consultant for the Company since January 2006. Since 2004Mr. Matise has been a private equity investor. He most recently served asVice President of Wedbush, Inc., a private equity investment and holdingcompany from 2001 to 2004.  Prior to his tenure with Wedbush, Inc., heserved as a Vice President with Encore Venture Partners from 1999 to2001.  In addition, he has served as an executive with Accenture, aconsulting company from 1997 to 1999 and 1992 to 1994 and Deloitte Consulting aconsulting company from 1994 to 1997 advising clients on improving manufacturingoperations, the integration of acquisitions, launching new business lines andbusiness growth planning and analysis. He currently serves as co-chairman ofthe UCLA Venture Capital and Private Equity Alumni Association and as adirector of UCLA Anderson School Alumni Board. In addition, he is currently on the Board of Directors of CargoTechnology, Inc.  He received a Master ofBusiness Administration degree from the UCLA Anderson School and a Bachelor ofArts degree with high honors from the University of California, Davis.

 

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*LaneNemeth, Director*

* *

Lane Nemeth hasbeen the founder and chief executive officer of Pet Lane, a direct salesenterprise since 2003. Prior to founding Pet Lane, she was an author, speakerand consultant from 1998 to 2003.  She isthe founder of Discovery Toys, an educational toy company based in Livermore,California, that was acquired by Avon (NYSE:AVP) in 1997 and was with Discoveryfrom 1978 to 1998.  She has receivednumerous entrepreneurial awards and is a regularly featured speaker at nationalchild development, business leadership seminars, including the StanfordLeadership Academy and the National Association of Women Business Owners. Sheis a member of the Women’s Executive Leadership Council. Her recent book, *Discovering Another Way, Raising Brighter Children,While Having a Meaningful Career*, has received national recognition.She earned a Bachelor of Arts degree from the University of Pittsburgh and aMaster of Arts degree in education from Seton Hall University.

 

*ShellySinghal, Director*

* *

Shelly Singhalcurrently serves as the Chairman and Chief Executive Officer of the SBI Group,a position he has held since 2001.  Priorto joining SBI, Mr. Singhal was managing director of corporate finance ata brokerage firm in Orange County, California, joining the firm in 1995. He wasresponsible for several areas, including its E-Commerce Group from 1995 to 2000and serving as manager of the Firm’s Bridge Fund.  He earned a Bachelor of Science degree fromSeaver College at Pepperdine University.

 

*DavidSwartz, Director*

* *

David Swartz is theManaging Partner of Good Swartz Brown & Berns, which is a regionalaccounting and business advisory firm which he joined in 1990. Prior to joiningGood Swartz Brown & Berns, he served as the chief financial officer ofWestfield, Inc., a publicly held shopping center development company, from1988-1990. From 1968 to 1988, Swartz was a managing partner and on the nationalboard of BDO Seidman, an international accounting firm. He is also a Directorof Primedex Corporation, a public company. Mr. Swartz has more thanthirty-five years of experience providing business advisory services to clientsin several industries, including manufacturing, wholesale, retail,entertainment, real estate and professional services, and his professionalexperience also includes acquisitions, merger transactions, businessvaluations, and ESOPs. He has lectured extensively at several SouthernCalifornia universities, and is a frequent speaker to trade and professionalorganizations. Swartz is past president of the Jewish Big Brothers of LosAngeles and serves on the boards of several other charitable foundations. Swartzearned his Bachelor of Science degree in Accounting from California StateUniversity, Northridge and is a member of the California Society of CertifiedPublic Accountants and the American Institute of Certified Public Accountants.He also served as treasurer of the Los Angeles chapter of the CaliforniaSociety of Certified Public Accountants. He is now a Vice President on theCalifornia Board of Accountancy, a division of the California Department ofConsumer Affairs.

 

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**Family Relationships**

** **

There are no family relationshipsbetween any of our directors or executive officers. 

 

**Code Of Ethics And Conduct**

** **

On October 15, 2004, theBoard of Directors adopted a Code of Ethics and Conduct.

 

**Audit Committee**

** **

The Company has an auditcommittee consisting of three independent directors David Swartz, Gary Adelsonand John Matise.  On March 27, 2006,Mr. Matise was appointed ChiefOperating Officer of the Company.  Our Board of Directors has determined thatMr. Swartz is an “audit committee financial expert” as that term is defined inItem 401(e) of Regulation S-B under the Exchange Act of 1934.

 

**ITEM 11: EXECUTIVECOMPENSATION**

** **

Thefollowing table sets forth aggregate amounts of compensation paid or accrued byus to our Chief Executive Officer and the other four most highly compensatedexecutive officers (the “Named Executive Officers”) whose annual compensationexceeded $100,000 as of December 31, 2005. Further, we have only includedannualized 2004 figures as each of the following executive officers did notcommence employment with the company until on or after May 20, 2004.

 
| ** **                  | ** ** | **Annual Compensation** | ** ** | ** ** | ** **    | ** ** | ** ** | ** **            | ** ** |
|-----------------------------|------------|------------------------------|------------|------------|---------------|------------|------------|-----------------------|------------|
| **Name and**           | ** ** | ** **                   | ** ** | ** ** | ** **    | ** ** | ** ** | **Restricted**        | ** ** | **Securities  Underlying** | ** ** | **All Other ** | ** ** |
| **Principal Position** | ** ** | **Year**                     | ** ** | **Salary** | ** **    | **Bonus**  | ** ** | **Stock Awards** | ** ** | **Options** | ** ** | **Compensation** | ** ** |
|                        |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Debra Fine,                 |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Chairman, Chief             |       | 2005                         |       | $          |  250,000 |       |       |                  | —     |   |   |   | — |   |
| Executive  Officer          |       | 2004                         |       | $          | 250,000       |       | $          | 20,000                |       |   |   | 2,600,000 |   |   |   |
| and President               |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
|                        |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| John J. Nelson,             |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Chief Operating             |       | 2005                         |       | $          |  200,000 |       |       |                  | —     |   |   |   | — |   |
| Officer                     |       | 2004                         |       | $          | 175,000       |       | $          | 45,000                |       |   |   | 70,000 |   |   |   |
|                        |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Robert Rankin,              |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Chief Financial             |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Officer and                 |       | 2005                         |       | $          |  190,000 |       |       |                  | —     |   |   |   | — |   |
| Secretary                   |       | 2004                         |       | $          | 175,000       |       | $          | 20,000                |       |   |   | 52,000 |   |   |   |
|                        |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Howard Bennett,             |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Vice President,             |       | 2005                         |       | $          |  120,120 |       | $          | 50,000                |       | — |   |   |   | — |   |
| Sales                       |       | 2004                         |       | $          | 120,120       |       | $          | 60,020                |       |   |   | 55,000 |   |   |   |
|                        |       |                         |       |       |          |       |       |                  |       |   |   |   |   |
| Sheri Brownrigg*            |       | 2005                         |       | $          |  115,000 |       | $          | 35,000                |       | — |   |   |   | $ | 32,500 |   |
|                        |       | 2004                         |       | $          | 115,000       |       | $          | 10,000                |       |   |   | 52,000 |   |   |   |   |

 

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***Ms. Brownrigg’s employment with the Companyterminated on December 30, 2005.**

** **

**Option Grants in Last Fiscal Year**

** **

No options were grantedduring the fiscal year ended December 31, 2005 to any of the Named ExecutiveOfficers.

 

****AggregatedOption Exercises and Fiscal Year End Option Values****

** **

The following table providesinformation regarding the number of shares covered by both exercisable andunexercisable stock options as of December 31, 2005 and the values of “in-the-money”options, which values represent the positive spread between the exercise priceof any such option and either the actual or estimated fair market value of theunderlying security, as applicable.  Noneof the options were exercised during the fiscal year ended December 31, 2005

 
| **Name**        | ** ** | **Shares Acquired  Upon Exercise** | ** ** | **Value Realized** | ** ** | **No. of Shares  Underlying  Unexercised Options  at Fiscal Year-End  Exercisable/Unexercisable** | ** ** | **Value of Unexercised  In-the Money  Options at Fiscal  Year-End  Exercisable/Unexercisable** | ** **                   |
|-----------------|------------|----------------------------------------------|------------|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------------------------|
|            |       |                                         |       |                    |       |                                                                                                                       |       |                                                                                                                    |                         |   |
| Debra Fine      |       | —                                       |       | —                  |       | 162,500/97,500                                                                                                             |       | $                                                                                                                       |  $ 113,750/$68,250 |   |
| John Nelson     |       | —                                       |       | —                  |       | 54,531/15,469                                                                                                              |       | $                                                                                                                       | 0/0                          |   |
| Bob Rankin      |       | —                                       |       | —                  |       | 42,250/7,750                                                                                                               |       | $                                                                                                                       | 0/0                          |   |
| Howard Bennett  |       | —                                       |       | —                  |       | 25,835/29,165                                                                                                              |       | $                                                                                                                       | 0/0                          |   |
| Sheri Brownrigg |       | —                                       |       | —                  |       | 10,835/11,665                                                                                                              |       | $                                                                                                                       | 0/0                          |   |
|                 |            |                                              |            |                         |            |                                                                                                                            |            |                                                                                                                         |                              |  |  |

 

**Employment Agreements **

** **

We entered into anemployment agreement with Debra Fine, our Chairman, CEO and President on May20, 2004 for a three-year term, which may continue upon the mutual agreement ofthe parties thereto except the employment relationship will be on an “at will”basis.  The employment agreement providescompensation of a base salary of $250,000 per annum, an annual bonus, asdetermined and awarded by the Board from time to time in its sole discretion,but not less than an amount equal to 5% of EBIT, meaning earnings beforeinterest and taxes, if such amount for any year is in excess of $1,000,000; 4%if such amount for any year is in excess of $2,000,000; and 3% if such amountis over $3,000,000, and 2,600,000 stock options at the exercise price of $.25per share of which 650,000 vested immediately and the balance vesting on aquarterly basis in equal amounts of 162,500 shares each over the course of heragreement.  The employment agreementprovides that in the event that Ms. Fine is terminated prior to the end of theinitial three (3) year term, other than for cause, we will pay her salary forthe remainder of the three (3) year term without any deduction or offset forany compensation earned or received from any other sources.  In addition, we will pay any earned, butunpaid, bonus for the prior year, any unused vacation or other time-offbenefits and any unpaid reimbursable business expenses incurred through thelast day of her services.  For anadditional one (1) year after the termination, we shall continue benefits, atour expense.  All unvested portion(s) ofthe options granted to her pursuant to

 

46

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heremployment agreement shall vest and immediately become exercisable upon theeffective date of such termination.

 

We entered into anemployment agreement with John Nelson, our Chief Operating Officer on September22, 2004 for a two-year term, which may continue upon the mutual agreement ofthe parties thereto except the employment relationship will be on an “at will”basis.  The employment agreement providescompensation of a base salary of $175,000 per annum increasing to $200,000 onJanuary 1, 2005, an annual bonus, as determined and awarded by the Board fromtime to time in its sole discretion and 550,000 stock options at the exerciseprice of $.48 per share of which 137,500 vested immediately and the balancevesting on a quarterly basis in equal amounts of 51,562 shares each over thecourse of his agreement, except for the final quarterly vest of 51,566.  The employment agreement provides that in theevent that Mr. Nelson is terminated prior to the end of the initial two (2)year term, other than for cause, we will pay his salary for an additional sixmonths without any deduction or offset for any compensation earned or receivedfrom any other sources. In addition, we will pay any earned, but unpaid, bonusfor the prior year, any unused vacation or other time-off benefits and anyunpaid reimbursable business expenses incurred through the last day of hisservices.  For an additional six months,we shall continue benefits, at our expense. All unvested portion(s) of the options granted to him pursuant to hisemployment agreement shall expire and be null and void.

 

We entered into anemployment agreement with Robert Rankin, our Chief Financial Officer on May 24,2004 for a two-year term, which may continue upon the mutual agreement of theparties thereto except the employment relationship will be on an “at will”basis.  The employment agreement providescompensation of a base salary of $175,000 per annum, an annual bonus, asdetermined and awarded by the Board from time to time in its sole discretionand 520,000 stock options at the exercise price of $.38 per share of which130,000 vested immediately and the balance vesting on a quarterly basis inequal amounts of 48,750 shares each over the course of his agreement.  The employment agreement provides that in theevent that Mr. Rankin is terminated prior to the end of the initial two (2)year term, other than for cause, we will pay his salary for an additional sixmonths without any deduction or offset for any compensation earned or receivedfrom any other sources.  In addition, wewill pay any earned, but unpaid, bonus for the prior year, any unused vacationor other time-off benefits and any unpaid reimbursable business expensesincurred through the last day of his services. For an additional six months, we shall continue benefits, at our expense.  All unvested portion(s) of the optionsgranted to him pursuant to his employment agreement shall expire and be nulland void.

 

****DirectorCompensation****

**** ****

The Directors who are notemployees receive $1,500 for each meeting attended, $1,000 for each committeemeeting attended and 40,000 stock options per year. Further, the chairman ofthe audit committee will receive an additional $5,000 annually.

 

47

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**ITEM 12.**                 **SECURITY OWNERSHIP OF CERTAINBENFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

 

The following table setsforth, as of March 24, 2006, certain information regarding beneficial ownershipof our common stock by (i) each person or entity who is known by us to ownbeneficially more than 5% of the outstanding shares of common stock, (ii) eachof our directors, (iii) each of the Named Executive Officers, and (iv) alldirectors and executive officers as a group. As of December 31, 2005, therewere 5,410,575 shares of our common stock issued and outstanding. In computingthe number and percentage of shares beneficially owned by a person, shares ofcommon stock that a person has a right to acquire within sixty (60) days of March24, 2006, pursuant to options, warrants or other rights are counted asoutstanding, while these shares are not counted as outstanding for computingthe percentage ownership of any other person. Unless otherwise indicated, theaddress for each shareholder listed in the following table is c/o Small WorldKids, Inc., 5711 Buckingham Parkway, Culver City, California 90230. This tableis based upon information supplied by directors, officers and principalshareholders and reports filed with the Securities and Exchange Commission. 

 
| **Name and Address of  Beneficial Owner** | ** ** | **Shares of Common Stock  Beneficially Owned** | ** ** | **Percentage of  Total Common Stock  (1)** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                    | ** ** | ** **                                                         | ** ** | ** **                                                | ** ** |
| **Directors and Officers**                          | ** ** | ** **                                                         | ** ** | ** **                                                | ** ** |
|                                                          |       |                                                               |       |                                                      |       |
| Debra L. Fine  (2)                                            |       | 1,919,606                                                          |       | 35.5                                                      | %          |
|                                                          |       |                                                               |       |                                                      |       |
| John J. Nelson  (3)                                           |       | 54,531                                                             |       | *                                                         |       |
|                                                          |       |                                                               |       |                                                      |       |
| Robert Rankin  (4)                                            |       | 47,125                                                             |       | *                                                         |       |
| Gary Adelson (5)                                              |       | 4,000                                                              |       | *                                                         |       |
| Alex Gerstenzang  (6)                                         |       | 4,000                                                              |       | *                                                         |       |
| Robert Lautz (7)                                              |       | *                                                                  |       | *                                                         |       |
| John Matise (8)                                               |       | 4,000                                                              |       | *                                                         |       |
| Lane Nemeth (9)                                               |       | 4,000                                                              |       | *                                                         |       |
|                                                          |       |                                                               |       |                                                      |       |
| Shelly Singhal  (10)                                          |       | 1,745,160                                                          |       | 32.3                                                      | %          |
|                                                          |       |                                                               |       |                                                      |       |
| David Swartz  (11)                                            |       | 4,000                                                              |       | *                                                         |       |
|                                                          |       |                                                               |       |                                                      |       |
| Total Directors  and Officers as a Group                      |       | 3,770,172                                                          |       | 69.7                                                      | %          |
|                                                          |       |                                                               |       |                                                      |       |
| **5% Beneficial Owners**                            | ** ** | ** **                                                         | ** ** | ** **                                                | ** ** |
|                                                          |       |                                                               |       |                                                      |       |
| David Marshall,  Inc. (12)                                    |       | 1,146,718                                                          |       | 21.2                                                      | %          |
|                                                          |       |                                                               |       |                                                      |       |
| St. Cloud  Capital Partners, LP (13)                          |       | 825,000                                                            |       | 15.2                                                      | %          |
|                                                          |       |                                                               |       |                                                      |       |
| SWT, LLC (14)                                                 |       | 1,454,082                                                          |       | 26.9                                                      | %          |
|                                                               |            |                                                                    |            |                                                           |            |  |

 

----

* Less than 1%

 

(1)           Based on 5,410,575 shares outstandingas of December 31, 2005.

 

(2)           Debra Fine is the Chief ExecutiveOfficer, and President of the Company. Her shares are held indirectly in theFine Family Trust of which she is the Co-Trustee.  Includes 3,063 shares underlying warrants.  Also included are 195,000 shares underlying stock

 

48

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optionsthat may be exercisable or will be exercisable within 60 days of the date of March24, 2006.  Does not include the sharesissuable upon conversion of the Series A Preferred Stock owned by SWT, LLCof which The Fine Family Trust is a member.

 

(3)           John Nelson is the Chief OperatingOfficer of the Company.  Consists of54,531 shares underlying stock options that may be exercisable or will beexercisable within 60 days of the date of March 24, 2006.

 

(4)           Robert Rankin is the Chief FinancialOfficer and Secretary. Consists of 47,125 shares underlying stock options thatmay be exercisable or will be exercisable within 60 days of the date of March24, 2006.

 

(5)           Gary Adelson is a director of the Company.  Consists of 4,000 shares underlying stockoptions, which are exercisable or will be exercisable within 60 days of March24, 2006.

 

** **(6)          Alex Gerstenzang is a director of theCompany.  Consists of 4,000 sharesunderlying stock options, which are exercisable or will be exercisable within60 days of March 24, 2006.

 

(7)**         **Mr. Lautz is a director of the Company and aManaging Director of St.Cloud Capital Partners L.P., which is the beneficial owner of 825,000shares of our common stock.  Mr. Lautzdisclaims beneficial ownership of said shares.

 

(8)           John Matise is a director of theCompany.  Consists of 4,000 sharesunderlying stock options, which are exercisable or will be exercisable within60 days of March 24, 2006.

 

(9)           Lane Nemeth is a director of theCompany.  Consists of 4,000 sharesunderlying stock options, which are exercisable or will be exercisable within60 days of March 24, 2006.

 

(10)         Shelly Singhal is a director of theCompany. Of the shares beneficially owned by Mr. Singhal, 1,297,673 shares areowned by SWT Investments, LLC, a Delaware limited liability company, of whichMr. Singhal owns 100%, 193,678 shares are owned by SBI Holdings of which he isa managing director and Consists of 100,000 shares underlying warrants, 249,809are owned by Curried Clover in which he has beneficial ownership and Consistsof 4,000 shares underlying stock options which are exercisable or will beexercisable within 60 days of March 24, 2006.The address for SWT Investments is610 Newport Center Drive, Suite 1205 Newport Beach, CA  92660.  Does not include any shares issuable uponconversion of the Series A Preferred Stock owned by SWT, LLC of which SWTInvestments, LLC is a member.

 

(11)         David Swartz is a director of theCompany.  Consists of 4,000 shares underlyingstock options, which are exercisable or will be exercisable within 60 days of March24, 2006.

 

(12)         David Marshall, Inc. is beneficiallyowned by David Marshall, an investor. The address for David Marshall, Inc. is 5901 De Soto Avenue, WoodlandHills, CA 91367.  Does not include theshares issuable upon conversion of the Series A Preferred Stock held bySWT, LLC of which David Marshall, Inc. is a member.

 

(13)         Consists of 743,750 shares issuable uponthe conversion of certain notes and 118,750 underlying warrants.  The address of St. Cloud is 10866 WilshireBoulevard, Suite 1450, Los Angeles, CA 90024.

 

(14)         Each of Russell Fine and Debra Fine astrustees of the Fine Family Trust, SWT Investments, LLC, which is 100% owned byShelly Singhal who is a director of the Company and David Marshall; Inc. aremembers of SWT, LLC.  GlenhavenCorporation manages SWT, LLC, and is [100%] owned by David Marshall.  The address for SWT,LLC is 9229 SunsetBoulevard, Suite 505, Los Angeles, California 90069 

 

**ITEM 13.**                 **CERTAIN****RELATIONSHIPS AND RELATED PARTYTRANSACTIONS**

 

This section describes thetransactions we have engaged in with persons who were directors, officers oraffiliates at the time of the transaction, and persons known by us to be thebeneficial owners of 5% or more of our common stock since January 1, 2004.

 

As of December 31,2005, we owed $2,500,000 of principal indebtedness to St. Cloud CapitalPartners L.P. Robert Lautz, a director of the Company, is a Managing Directorof St. Cloud.  The original loan of$2,000,000 was made on September 15, 2004. On July 20, 2005, St. Cloud agreed to advance an additional $500,000 foran aggregate loan of $2.5 million.  OnNovember 11, 2005, we entered into a second amendment with St. Cloudpursuant to which we issued to St. Cloud a new promissory note replacing theexisting note to St. Cloud in the principal amount of $2,500,000.  The maturity date of the loan was extended toSeptember 15, 2006.  The replacement note is convertible into sharesof the common stock at $4.00 per share (subject to adjustment) or, as to up to50% of the loan amount, into securities issued in a financing with grossproceeds of at least $12,500,000.  Pursuant to the terms of the note agreement with St. Cloud, during theperiod that note is outstanding, Mr. Lautz will be appointed to theCompany’s Board of

 

49

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Directors.  In addition, as long as St. Cloud owns inexcess of 300,000 shares, a designee of St. Cloud reasonably acceptable to usis entitled to an observer seat on the board of directors.  

 

On April 28, 2005 we enteredinto Term Credit Agreements (“Credit Agreements”) with Hong Kong League CentralCredit Union and PCCW Credit Union (collectively the “Lenders”) for unsecuredloans totaling $750,000 due on or before August 31, 2005.  Interest is charged at a rate of 2% per monthand is payable monthly in arrears.  OnJune 10, 2005 we entered into additional Credit Agreements with Hong KongLeague Central Credit Union and HIT Credit Union for unsecured loans totaling$250,000 due on or before September 30, 2005. Effective August 31, 2005, the maturity dates of all outstandingunsecured loans with the Lenders were extended to the earlier of the closing ofa financing transaction with net proceeds of at least $20 million or March 1,2006.  In consideration for thisextension, we issued a four-year warrant to purchase up to 100,000 shares ofthe common stock exercisable at $5.00 per share to SBI Advisors, LLC, of whichShelly Singhal, one of our directors, is Chairman and Chief Executive Officer. EffectiveFebruary 28, 2006 the maturity dates of all outstanding unsecured loans withthe Lenders were extended to the earlier of the closing of a financingtransaction with net proceeds of at least $20 million or August 11, 2006.  

 

On August 11, 2005, weissued aggregate of $500,000 in notes to various accredited investors includingRussell Fine and Debra Fine**(**our President and Chief ExecutiveOfficer)**,**as trustees of the Fine Family Trust, who provided $175,000 of thetotal borrowing.  The notes mature oneyear from the date of execution with interest payable monthly in arrears at arate of 10% per annum.  The notes aresecured by certain assets including receivables, inventory, equipment and otherassets.

 

On August 11, 2005, weconverted the $5 million Bridge Note dated May 21, 2004 issued to SWT, LLC,into 10% Class A Convertible Preferred Stock. The preferred stock is immediately convertible at the option of the holderinto the common stock at an initial fixed conversion price of $4.00 subject toadjustment based on the terms of future financings should they occur.  The preferred stock accrues a quarterlydividend at a rate of 10% per annum and is payable in cash or a combination of50% cash and 50% common stock at our option. In addition, we issued a three-year immediately exercisable warrant topurchase up to 204,082 shares of the common stock exercisable at $4.90 pershare.  Each of Russell Fine and DebraFine as trustees of the Fine Family Trust, SWT Investments, LLC, which iswholly owned by Shelly Singhal, a director of the Company and David Marshall;Inc. are members of SWT, LLC.  GlenhavenCorporation manages SWT, LLC, and is owned by David Marshall who is thebeneficially owner of more than 20% of our common stock.  

 

**ITEM  14. PRINCIPAL  ACCOUNTANT  FEES AND  SERVICES**

** **

Audit Fees: The aggregate fees billed for theyear ended December 31, 2005 for professional services rendered by theStonefield Josephson, Inc. (“Stonefield”) for the audit of our annual financialstatements and the quarterly review of financial statements for the Quartersended March 31, 2005, June 30, 2005 and September 30, 2004 was $113,000 ascompared to $140,000 for the audit fees for the audit of our 2004 annual

 

50

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financial statements and the review of financial statements for theQuarter ended September 30, 2004, along with the review of financial statementsfor Small World Toys, our predecessor for the Quarter ended March 31, 2004. Theaggregate fees billed by BDO Seidman, LLP (“BDO”) for the review of financialstatements included in our filed Form 10QSB for the Quarter ended June 30, 2004was $49,000.  The aggregate fees billedby HJ Associates, LLC (“HJA”) for the review of the financial statements forSavOn Team Sports for the Quarter ended March 31, 2004 was $5,000.  

 

Tax Fees: The aggregate fees billed for theyear ended December 31, 2005 for professional services rendered by the GrantThornton LLP for tax compliance and tax planning was approximately $33,000 ascompared to $2,000 by Stonefield for the year ended December 31, 2004.  The aggregate fees billed for the year endedDecember 31, 2004 for professional services rendered by the BDO for taxcompliance and tax planning was approximately $2,000.  The aggregate fees billed for the year endedDecember 31, 2004 for professional services rendered by the HJA for taxcompliance and tax planning for SavOn Team Sports prior to May 20, 2004 wasapproximately $400.  

 

All Other Fees: The aggregate fees billed forthe year ended December 31, 2005 for products and services provided byStonefield other than the services reported above was approximately $19,000 ascompared to $18,000 for the year ended December 31, 2004.  The aggregate fees billed for the year endedDecember 31, 2004 for products and services provided by BDO other than theservices reported above was $23,000.

 

**Audit Committee Pre-Approval Policies andProcedures**

 

OurAudit Committee’s policy is to pre-approve all audit and permissible non-auditservices provided by our independent auditors. These services may include auditservices, audit-related services, tax services and other services. Pre-approvalis generally provided for up to one year and any pre-approval is detailed as tothe particular service or category of services. The independent auditor andmanagement are required to periodically report to the Audit Committee regardingthe extent of services provided by the independent auditor in accordance withthis pre-approval.

 

Each person whose signature appears below,constitutes and appoints Debra Fine with full power to act without the other,such person’s true and lawful attorney-in-fact, with full power of substitutionand resubstitution, for him and in his name, place and stead, in any and allcapacities, to sign this Annual Report on Form 10-K and any and all amendmentsto such report and other documents in connection therewith, and to file thesame, and all exhibits thereto and other documents in connection therewith,with the Securities and Exchange Commission, granting unto saidattorneys-in-fact, and each of them, full power and authority to do and performeach and every act and thing necessary or desirable to be done in and about thepremises, as fully to all intents and purposes as he or she might or could doin person, thereby ratifying and confirming all that said attorneys-in-fact, orany of them, or their or his or her substitute or substitutes, may lawfully door cause to be done by virtue hereof.

 

51

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**ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

** **

(a)Exhibits

 
| **Exhibit No.** | ** ** | **Exhibit Description**                                                                                                                                                    |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                            |
| 3.1                  |       | Articles of Incorporation*                                                                                                                                                      |
| 3.2                  |       | Bylaws*                                                                                                                                                                         |
| 4.1                  |       | Pledge Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                 |
| 4.2                  |       | Stock Pledge Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                           |
| 4.3                  |       | Registration Rights Agreement, dated as of May 20,  2004 incorporated by  reference from the Form 8-K filed with  the SEC on June 4, 2004. File No. 333-68532.                  |
| 4.4                  |       | Note Purchase Agreement, dated September 7, 2004 (St.  Cloud) incorporated by  reference from the Form 8-K filed with  the SEC on September 23, 2004. File No. 333-68532.       |
| 4.5                  |       | Note Purchase Agreement, dated September 16, 2004  (Strome) incorporated  by reference from the Form 8-K filed with  the SEC on September 23, 2004. File No. 333-68532.         |
| 4.6                  |       | Asset Purchase Agreement, dated as of September 17,  2004 incorporated by  reference from the Form 8-K filed with  the SEC on September 23, 2004. File No. 333-68532.           |
| 4.7                  |       | Exchange Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                               |
| 4.8                  |       | Stock Purchase Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                         |
| 4.9                  |       | Stock Purchase Agreement (Pewter Hill), dated as of  September 23, 2004 incorporated  by reference from the Form 8-K filed with  the SEC on October 4, 2004. File No 333-68532. |
| 4.10                 |       | Stock Purchase Agreement (Wire Mill), dated as of  September 23, 2004 incorporated  by reference from the Form 8-K filed with  the SEC on October 4, 2004. File No 333-68532.   |
| 4.11                 |       | 2004 Stock Compensation Plan incorporated by reference from the Form S-8 filed with the SEC on  February 4, 2005. File No. 333-68532.                                           |
| 4.12                 |       | Securities Purchase Agreement incorporated by reference from the Form 8-K filed with the SEC on October  4, 2005. File No. 333-68532.                                           |
| 4.13                 |       | Registration Rights Agreement incorporated by reference from the Form 8-K filed with the SEC on October  4, 2005. File No. 333-68532.                                           |
| 4.14                 |       | 10% Convertible Debenture incorporated by reference from the Form 8-K filed with the SEC on October  4, 2005. File No. 333-68532.                                               |
| 4.15                 |       | Common Stock Purchase Warrant incorporated by reference from the Form 8-K filed with the SEC on October  4, 2005. File No. 333-68532.                                           |
| 4.16                 |       | Common Stock Purchase Warrant incorporated by reference from the Form 8-K filed with the SEC on October  11, 2005. File No. 333-68532.                                          |

 

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| 5.1   |   | Legal Opinion of Troy & Gould, dated as of  February 4, 2005, incorporated  by reference from the Form S-8 filed with  the SEC on February 4, 2005. File No. 333-68532.            |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1  |   | Loan Agreement, dated as of May 20, 2004 incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                          |
| 10.2  |   | $5,000,000 Term Note incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                                              |
| 10.3  |   | $700,000 Promissory Note incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                                          |
| 10.4  |   | $500,000 Promissory Note incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                                          |
| 10.5  |   | $1,000,000 Promissory Note incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                                        |
| 10.6  |   | 2004 Stock Option Plan incorporated by reference from the Form 8-K filed with the SEC on June 4,  2004. File No. 333-68532.                                                            |
| 10.7  |   | Press Release incorporated by reference from  the Form 8-K filed with the SEC on September 23, 2004. File No. 333-68532.                                                               |
| 10.8  |   | Press Release incorporated by reference from  the Form 8-K filed with the SEC on October 25, 2004. File No. 333-68532.                                                                 |
| 10.9  |   | Revolving Credit and Security Agreement dated December  15, 2004 (PNC Bank) incorporated  by reference from the Form 8-K filed with  the SEC on December 20, 2004. File No. 333-68532. |
| 10.10 |   | $1,500,000 Seasonal  Advance Note incorporated by reference from the Form 8-K filed with the SEC  on December 20, 2004. File No. 333-68532.                                            |
| 10.11 |   | Pledge Agreement  incorporated by reference from the Form 8-K filed with the SEC on December  20, 2004. File No. 333-68532.                                                            |
| 10.12 |   | Subordination Agreement  incorporated by reference from the Form 8-K filed with the SEC on December  20, 2004. File No. 333-68532.                                                     |
| 10.13 |   | Continuing Guaranty (Fine)  incorporated by reference from the Form 8-K filed with the SEC on December  20, 2004. File No. 333-68532.                                                  |
| 10.14 |   | Continuing Guaranty  (Small World Toys) incorporated by reference from the Form 8-K filed with the  SEC on December 20, 2004. File No. 333-68532.                                      |
| 10.15 |   | Security Agreement  incorporated by reference from the Form 8-K filed with the SEC on December  20, 2004. File No. 333-68532.                                                          |
| 10.16 |   | $15,000,000 Revolving  Credit Note incorporated by reference from the Form 8-K filed with the SEC on  December 20, 2004. File No. 333-68532.                                           |
| 10.17 |   | Press Release  incorporated by reference from the Form 8-K filed with the SEC on February 8,  2005. File No. 333-68532.                                                                |
| 10.18 |   | Employment Agreement  (Fine) incorporated by reference from the Form 10KSB filed with the SEC on  March 28, 2005. File No. 333-68532.                                                  |
| 10.19 |   | Employment Agreement  (Rankin) incorporated by reference from the Form 10KSB filed with the SEC on  March 28, 2005. File No. 333-68532.                                                |
| 10.20 |   | Employment Agreement  (Nelson) incorporated by reference from the Form 10KSB filed with the SEC on  March 28, 2005. File No. 333-68532.                                                |
| 10.21 |   | Press Release  incorporated by reference from the Form 8-K filed with the SEC on June 1,  2005. File No. 333-68532.                                                                    |

 

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| 10.22 |   | Press Release  incorporated by reference from the Form 8-K filed with the SEC on June 30,  2005. File No. 333-68532.                                                                            |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23 |   | Press Release  incorporated by reference from the Form 8-K filed with the SEC on June 30,  2005. File No. 333-68532.                                                                            |
| 10.24 |   | Press Release incorporated  by reference from the Form 8-K filed with the SEC on October 20, 2005. File  No. 333-68532.                                                                         |
| 10.25 |   | Lock-up Agreement  incorporated by reference from the Form 8-K filed with the SEC on November  18, 2005. File No. 333-68532.                                                                    |
| 10.26 |   | Second Amendment to  Note Purchase Agreement incorporated by reference from the Form 8-K filed  with the SEC on November 18, 2005. File No. 333-68532.                                          |
| 10.27 |   | Press Release  incorporated by reference from the Form 8-K filed with the SEC on February  21, 2006. File No. 333-68532.                                                                        |
| 10.28 |   | Secured Non-Convertible Revolving Note dated February  28, 2006 (Laurus Master Fund, LTD) incorporated by reference from  the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532. |
| 10.29 |   | Secured Non-Convertible Term Note dated February 28,  2006 (Laurus Master Fund, LTD) incorporated by reference from  the Form 8-K filed with the SEC on March 3, 2006. File No. 333-68532.      |
| 10.30 |   | Security Agreement dated February 28, 2006 (Laurus  Master Fund, LTD) incorporated  by reference from the Form 8-K filed with  the SEC on March 3, 2006. File No. 333-68532.                    |
| 10.31 |   | Common Stock Purchase Warrant dated February 28, 2006  (Laurus Master Fund, LTD) incorporated  by reference from the Form 8-K filed with  the SEC on March 3, 2006. File No. 333-68532.         |
| 10.32 |   | Financing  Agreement, dated as of March 20, 2006 Horizon Financial Services Group USA)  incorporated by reference from the Form  8-K filed with the SEC on March 23, 2006. File No. 333-68532.  |
| 10.33 |   | Employment Agreement dated March 27, 2006 incorporated by reference from the Form 8-K filed with the SEC on March  30, 2006. File No. 333-68532.                                                |
| 16.1  |   | Letter regarding change  of certifying accountant incorporated by reference from the Form 8-K filed  with the SEC on July 23, 2004. File No. 333-68532.                                         |

 

Set forth below is a listof the Exhibits to this Annual Report on Form 10-K. 

 
| 31.1 |   | Certification  of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 |
|------|--------|----------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification  of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002 |
| 32.1 |   | Certification  of the Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of  2002       |
| 32.2 |   | Certification  of the Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of  2002       |

 

54

----

 

**SIGNATURES**

** **

In accordance with the requirements of the SecuritiesAct of 1933, the Company certifies that it has reasonable grounds to believethat it meets all of the requirements for filing this Annual Report on Form 10-K and has authorized this registration statementto be signed on its behalf by the undersigned, thereunto duly authorized, inCulver City, State of California on March 31, 2006.

 
|   | SMALL  WORLD KIDS, INC. |
|--------|-------------------------|
|   |                    |
|   | By:                     |       /s/  Debra Fine |   |
|   |                    |
|   |                    | Name:  Debra Fine |
|   |                    | Title:  Chief Executive Officer |
|        |                         |  |  |  |

 

Pursuant to the requirements of the Securities Act of1933, this report has been signed by the following persons in the capacitiesand on the dates indicated.

 
| **Signature**              | ** ** | **Title**                                     | ** ** | **Date**       |
|----------------------------|------------|-----------------------------------------------|------------|----------------|
|                       |       |                                          |       |           |
| /s/ Debra  Fine       |       | Chairman, Chief  Executive Officer and        |       | March 31, 2006 |
| **Debra  Fine**            |       | Director  (Principal Executive Officer)       |       |           |
| ** **                 |       |                                          |       |           |
| /s/ Robert  Rankin    |       | Chief Financial  Officer (Principal Financial |       | March 31, 2006 |
| **Robert  Rankin**         |       | and Accounting  Officer)                      |       |           |
| ** **                 |       |                                          |       |           |
| /s/ Gary  Adelson     |       | Director                                      |       | March 31, 2006 |
| **Gary  Adelson**          |       |                                          |       |           |
| ** **                 |       |                                          |       |           |
| /s/ Alex  Gerstenzang |       | Director                                      |       | March 31, 2006 |
| **Alex  Gerstenzang**      |       |                                          |       |           |
| ** **                 |       |                                          |       |           |
| /s/ Bob  Lautz        |       | Director                                      |       | March 31, 2006 |
| Bob Lautz                  |       |                                          |       |           |
|                       |       |                                          |       |           |
| /s/ John  Matise      |       | Director                                      |       | March 31, 2006 |
| **John  Matise**           |       |                                          |       |           |
| ** **                 |       |                                          |       |           |
| /s/ Lane  Nemeth      | ** ** | Director                                      |       | March 31, 2006 |
| **Lane  Nemeth**           | ** ** |                                          |       |           |

 

55

----

 
| /s/ Shelly  Singhal | ** ** | Director |   | March 31, 2006 |
|--------------------------|------------|----------|--------|----------------|
| **Shelly  Singhal**      | ** ** |     |   |           |
| ** **               | ** ** |     |   |           |
| /s/ David  Swartz   | ** ** | Director |   | March 31, 2006 |
| **David  Swartz**        | ** ** |     |   |           |

 

56

----

 

**SMALL WORLD KIDS, INC.**

** **

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

 
|                                                                                                                                                                                                                               |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Report of Independent Registered Public Accounting  Firm                                                                                                                                                                           |   |
|                                                                                                                                                                                                                               |   |
| Consolidated Balance Sheets as of  December 31, 2005 and December 31, 2004                                                                                                                                                         |   |
|                                                                                                                                                                                                                               |   |
| Consolidated Statements of  Operations for the Year Ended December 31, 2005, the periods May 21, 2004 to  December 31, 2004 and January 1, 2004 to May 20, 2004 and for the Year Ended  December 31, 2003                          |   |
|                                                                                                                                                                                                                               |   |
| Consolidated Statements of  Stockholders’ Equity (Deficit) for the Year Ended December 31, 2005, the  periods May 21, 2004 to December 31, 2004 and January 1, 2004 to May 20, 2004  and for the Year Ended December 31, 2003 |   |
|                                                                                                                                                                                                                               |   |
| Consolidated  Statements of Cash Flows for the Year Ended December 30, 2005, the periods  May 21, 2004 to December 31, 2004 and January 1, 2004 to May 20, 2004 and for  the Year Ended December 31, 2003                          |   |
|                                                                                                                                                                                                                               |   |
| Notes to  Condensed Consolidated Financial Statements                                                                                                                                                                              |   |

 

F-1

----

 

**SMALLWORLD KIDS, INC.**

** **

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

** **

***To The Board Of Directors And Stockholders Of Small WorldKids,  Inc.***

*CulverCity, Ca*

 

We have audited theaccompanying consolidated balance sheets of Small World Kids, Inc. andSubsidiary as of December 31, 2005 and 2004 and the related statements ofoperations, stockholders’ deficit and cash flows for the years then ended.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. We were not engaged to perform an audit of theCompany’s internal control over financial reporting. Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but not forthe purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no suchopinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financialstatements referred to above present fairly, in all material respects, thefinancial position of Small World Kids, Inc. and Subsidiary as of December 31,2005 and 2004, and the results of its operations and its cash flows for theyears then ended, present fairly, in all material respects, the financialposition of Small World Kids, Inc. and Subsidiary and the results of theiroperations and their cash in conformity with accounting principles generallyaccepted in the United States of America.

 

The accompanyingfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States of America, whichcontemplate continuation of the company as a going concern.  As discussedin Note 1, the Company has incurred significant net losses since its inception,has an accumulated deficit of $ 10,021,600 and used cash for operatingactivities of $ 2,760,413 during the year ended December 31, 2005.The Companyhas $4,700,000 in principal debt obligations due in 2006. Failure to obtainadditional financing or restructuring the Company’s debt obligations may causea default on these debt obligations.  The Company’s continuation as a going concern is dependent upon itsability to increase revenues, receiving additional financing from outsidesources and a return to profitable operations. The foregoing matters raisesubstantial doubt about the ability of the Company to continue as a goingconcern.  Management’s plans in regard to these matters are also describedin Note 1.  These financial statements do not include any adjustments thatmight result from the outcome of these uncertainties.

 
| /s/ Stonefield Josephson, Inc. |   |
|--------------------------------|--------|

Los Angeles, California

March 31, 2006

 

F-2

----

 

**SMALL WORLD KIDS, INC.**

** **

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Current assets:                                                                                           |       |                        |       |                        |       |
| Cash                                                                                                      | ** ** | $                           | 524,418    |                        | $          | 1,785,084 |   |
| Accounts  receivable - net of allowances of $350,000 and $252,212, respectively                           |       | 7,142,141                   |       | 7,005,764                   |       |
| Inventory                                                                                                 |       | 4,529,864                   |       | 2,471,556                   |       |
| Prepaid expenses  and other current assets                                                                |       | 1,056,459                   |       | 1,625,695                   |       |
| Total current  assets                                                                                     |       | 13,252,882                  |       | 12,888,099                  |       |
| Property and  equipment, net                                                                              |       | 491,123                     |       | 505,059                     |       |
| Goodwill                                                                                                  |       | 2,477,117                   |       | 2,308,145                   |       |
| Other intangible  assets, net                                                                             |       | 3,105,005                   |       | 3,113,242                   |       |
| Other assets                                                                                              |       | 184,266                     |       | 401,592                     |       |
| Deferred tax assets                                                                                       |       | 0                           |       | 623,695                     |       |
| Total assets                                                                                              | ** ** | $                           | 19,510,393 |                        | $          | 19,839,832 |   |
|                                                                                                      |       |                        |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                   | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Current  Liabilities:                                                                                     |       |                        |       |                        |       |
| Accounts payable                                                                                          | ** ** | $                           | 3,690,970  |                        | $          | 1,808,637 |   |
| Accrued  liabilities                                                                                      |       | 2,153,008                   |       | 814,201                     |       |
| Current portion  of long-term debt                                                                        |       | 11,290,741                  |       | 2,562,348                   |       |
| Current portion  of notes payable to related parties                                                      |       | 675,119                     |       | 262,500                     |       |
| Warrant  liability                                                                                        |       | 688,698                     |       | 736,484                     |       |
| Total current  liabilities                                                                                |       | 18,498,536                  |       | 6,184,170                   |       |
| Long term debt:                                                                                           |       |                        |       |                        |       |
| Long-term debt                                                                                            |       | 249,370                     |       | 8,229,262                   |       |
| Notes payable,  related parties                                                                           |       | —                      |       | 5,437,500                   |       |
| Total long term  debt                                                                                     |       | 249,370                     |       | 13,666,762                  |       |
| Deferred tax  liabilities                                                                                 |       | —                      |       | 1,060,000                   |       |
| Total  liabilities                                                                                        |       | 18,747,906                  |       | 20,910,931                  |       |
| Stockholders equity (deficit):                                                                            |       |                        |       |                        |       |
| 10% Class A  Convertible Preferred Stock, no par:                                                         |       |                        |       |                        |       |
| Authorized -  5,000,000 shares

Outstanding –  250,000 shares and no shares, respectively            |       | 4,992,080                   |       | —                      |       |
| Common Stock,  $.001 par value:                                                                           |       |                        |       |                        |       |
| Authorized -  100,000,000 shares

Outstanding –  5,410,575 shares and 5,312,075 shares, respectively |       | 5,411                       |       | 5,312                       |       |
| Additional  paid-in capital                                                                               |       | 5,786,596                   |       | 6,574                       |       |
| (Accumulated deficit)                                                                                     |       | (10,021,600                 | )          | (1,082,986                  | )          |
| Total  stockholders’ (deficit)                                                                       |       | 761,407                     |       | (1,071,100                  | )          |
| Total  liabilities and stockholders’ equity (deficit)                                                | ** ** | $                           | 19,510,393 |                        | $          | 19,839,832 |   |

* *

*SeeAccompanying Notes to Consolidated Financial Statements.*

 

F-3

----

 

**SMALL WORLDKIDS, INC.**

** **

#### **CONSOLIDATEDSTATEMENTS OF OPERATIONS**

#### ** **

| ** **                                      | ** ** | **Successor**                                            | ** ** | **Predecessor**                                      | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                      | ** ** | **Year Ended   December 31,   2005** | ** ** | **May 21 –  December 31,  2004** | ** ** | **January 1 –  May 20,  2004** | ** ** | **Year Ended   December 31,  2003** | ** ** |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Net Sales                                       | ** ** | $                                                        | 33,755,929 |                                                 | $          | 19,156,388 |   | $ | 10,336,500 |   | $ | 25,907,397 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Cost of sales                                   |       | 20,619,047                                               |       | 11,610,502                                           |       | 5,780,780 |   | 14,988,070 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Gross profit                                    |       | 13,136,882                                               |       | 7,545,886                                            |       | 4,555,720 |   | 10,982,327 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Operating  expenses:                            |       |                                                     |       |                                                 |       |   |   |   |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Selling, general  and administrative            |       | 14,793,258                                               |       | 7,821,961                                            |       | 4,341,565 |   | 9,606,118 |   |
| Research and  development                       |       | 1,972,343                                                |       | 800,331                                              |       | 373,034 |   | 1,032,174 |   |
| Amortization of  intangibles                    |       | 452,252                                                  |       | 190,372                                              |       | — |   | — |   |
| Total operating  expenses                       |       | 17,217,853                                               |       | 8,812,664                                            |       | 4,714,599 |   | 10,638,292 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Loss from  operations                           |       | (4,080,971                                               | )          | (1,266,778                                           | )          | (158,879 | ) | 344,035 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Other income  (expense):                        |       |                                                     |       |                                                 |       |   |   |   |   |
| Interest expense                                |       | (3,521,012                                               | )          | (927,499                                             | )          | (61,475 | ) | (301,434 | ) |
| Warrant  valuation adjustment                   |       | 291,113                                                  |       | 114,916                                              |       | — |   | — |   |
| Other                                           |       | 247,870                                                  |       | 372,680                                              |       | 81,850 |   | 697,710 |   |
| Total other  income (expense)                   |       | (2,982,029                                               | )          | (439,903                                             | )          | 20,375 | ) | 740,311 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Income (loss)  before income taxes              |       | (7,063,000                                               | )          | (1,706,681                                           | )          | (138,504 | ) | 740,311 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Provision  (benefit from) for income taxes      |       | (292,419                                                 | )          | (623,695                                             | )          | (3,643 | ) | **—** | ** ** |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Net income  (loss)                              |       | (6,770,581                                               | )          | (1,082,986                                           | )          | (134,861 | ) | 740,311 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Non-cash  preferred stock dividend              |       | (2,168,033                                               | )          | ** **                                           | ** ** | **—** |   | **—** |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| (Net loss)  income attributable to common stock | ** ** | $                                                        | (8,938,614 | )                                                    | $          | (1,082,986 | ) | $ | (134,861 | ) | $ | 740,311 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Loss per share:                                 |       |                                                     |       |                                                 |       |   |   |   |   |
| Basic &  diluted                            | ** ** | $                                                        | (1.67      | )                                                    | $          | (0.21 | ) | $ | (13.49 | ) | $ | 74.03 |   |
|                                            |       |                                                     |       |                                                 |       |   |   |   |   |
| Weighted average  number of shares:             |       |                                                     |       |                                                 |       |   |   |   |   |
| Basic &  diluted                            |       | 5,363,961                                                |       | 5,277,986                                            |       | 10,000 |   | 10,000 |   |

 

*SeeAccompanying Notes to Consolidated Financial Statements.*

 

F-4

----

** **

**SMALL WORLD KIDS, INC.**

** **

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY**

 
| ** **                                                                                                                                  | ** ** | **Preferred** | ** ** | **Common Stock** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------------------|------------|------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **Shares**    | ** ** | **Amount**            | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Additional   Paid-in   Capital** | ** ** | **Retained   Earnings** | ** ** | **Total** | ** ** |
|                                                                                                                                        |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| **Balance  at January 1, 2003 (Predecessor)**                                                                                               |       |          |       | —                |       | 10,000     |       | $          | 10,000     |                                         | —     |   | $ | 3,569,523 |   | $ | 3,579,523 |   |
|                                                                                                                                        |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| Dividends                                                                                                                                   |       |          |       |                  |       |       |       |       |       |                                         |       | (906,707 | ) | (906,707 | ) |
| Net income (loss)                                                                                                                           |       |          |       |                  |       |       |       |       |       |                                         |       | 740,311 |   | 740,311 |   |
| ** **                                                                                                                                  |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| **Balance  at December 31, 2003 (Predecessor)**                                                                                             |       | —        |       | —                |       | 10,000     |       | 10,000     |       | —                                       |       | 3,403,127 |   | 3,413,127 |   |
| Sale of  predecessor company                                                                                                                |       | —        |       | —                |       | (10,000    | )          | (10,000    | )          | —                                       |       | (3,268,266 | ) | (3,278,266 | ) |
| Net income (loss)                                                                                                                           |       | —        |       | —                |       | —     |       | —     |       | —                                       |       | (134,861 | ) | (134,861 | ) |
|                                                                                                                                        |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| **Balance  at May 20, 2004**                                                                                                                |       | —        |       | —                |       | —     |       | —     |       | —                                       |       | — |   | — |   |
|                                                                                                                                        |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| Contributed  capital                                                                                                                        |       | —        |       | —                |       | —     |       | —     |       | 11,821                                       |       | — |   | 11,821 |   |
| Issuance of  common shares in recapitalization                                                                                              |       | —        |       | —                |       | 5,247,075  |       | 5,247      |       | (5,247                                       | )          | — |   | — |   |
| Issuance of  common shares in debt transaction                                                                                              |       | —        |       | —                |       | 65,000     |       | 65         |       | —                                       |       | — |   | 65 |   |
| Net income (loss)                                                                                                                           |       | —        |       | —                |       | —     |       | —     |       | —                                       |       | (1,082,986 | ) | (1,082,986 | ) |
| ** **                                                                                                                                  |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| **Balance  at December 31, 2004**                                                                                                           |       | —        |       | —                |       | 5,312,075  |       | 5,312      |       | 6,574                                        |       | (1,082,986 | ) | (1,071,100 | ) |
|                                                                                                                                        |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| Issuance of  Series A Convertible Preferred Stock                                                                                           |       | 250,000       |       | 4,992,080             |       | —     |       | —     |       | —                                       |       | — |   | 4,992,080 |   |
| Net issuances  under stock plans                                                                                                            |       |          |       | —                |       | 16,000     |       | 16         |       | 79,984                                       |       | — |   | 80,000 |   |
| Stock  compensation                                                                                                                         |       | —        |       | —                |       | —     |       | —     |       | 535,213                                      |       | — |   | 535,213 |   |
| Common stock  issuance related to acquisitions                                                                                              |       | —        |       | —                |       | 50,000     |       | 50         |       | 244,950                                      |       | — |   | 245,000 |   |
| Common stock and  warrants issued in connection with debt financing                                                                         |       | —        |       | —                |       | 32,500     |       | 33         |       | 219,817                                      |       | — |   | 219,850 |   |
| Beneficial  conversion feature related to issuance of Convertible Debentures                                                                |       | —        |       | —                |       | —     |       | —     |       | 1,335,025                                    |       | — |   | 1,335,025 |   |
| Warrants issued  in connection with extension of notes payable                                                                              |       | —        |       | —                |       | —     |       | —     |       | 556,958                                      |       | — |   | 556,958 |   |
| Non-cash dividend  related to warrants issued and the beneficial conversion feature related to  the issuance of convertible preferred stock |       |          |       |                  |       |       |       |       |       | 2,168,033                                    |       | (2,168,033 | ) | — |   |
| Reclassification  of warrant liability                                                                                                      |       | —        |       | —                |       | —     |       | —     |       | 509,185                                      |       | — |   | 509,185 |   |
| Reclassification  of stock liability                                                                                                        |       | —        |       | —                |       | —     |       | —     |       | 324,350                                      |       | — |   | 324,350 |   |
| Accrued dividends  on convertible preferred stock                                                                                           |       | —        |       | —                |       | —     |       | —     |       | (193,494                                     | )          | — |   | — |   |
| Net income (loss)                                                                                                                           |       | —        |       | —                |       | —     |       | —     |       | —                                       |       | (6,770,581 | ) | (6,770,581 | ) |
| ** **                                                                                                                                  |       |          |       |                  |       |       |       |       |       |                                         |       |   |   |   |   |
| **Balance  at December 31, 2005**                                                                                                           |       | 250,000       |       | $                     | 4,992,080  |       | 5,410,575  |       | $          | 5,411                                        |       | $ | 5,786,595 |   | $ | (10,021,600 | ) | $ | 762,486 |   |
|                                                                                                                                             |            |               |            |                       |            |            |            |            |            |                                              |            |  |  |  |  |  |  |  |  |  |

 

*SeeAccompanying Notes to Consolidated Financial Statements.*

 

F-5

----

 

**SMALL WORLD KIDS, INC.**

 

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

** **
| ** **                                                                                                                | ** ** | **Successor**                           | ** ** | **Predecessor**                                 | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                | ** ** | **Year Ended  December 31,  2005** | ** ** | **May 21 –  December 31,  2004** | ** ** | **January 1 –  May 20, 2004** | ** ** | **Year Ended  December 31,  2003** | ** ** |
| **Cash flows from operating activities:**                                                                                 |       |                                    |       |                                            |       |   |   |   |   |
| Net income  (loss)                                                                                                        | ** ** | $                                       | (6,770,581 | )                                               | $          | (1,082,986 | ) | $ | (134,861 | ) | $ | 740,311 |   |
| Adjustments to  reconcile net loss to net cash used in operating activities:                                              |       |                                    |       |                                            |       |   |   |   |   |
| Depreciation                                                                                                              |       | 228,219                                 |       | 111,685                                         |       | 62,325 |   | 182,556 |   |
| Amortization of  intangibles                                                                                              |       | 452,252                                 |       | 190,372                                         |       | — |   | — |   |
| Non-cash  compensation expense                                                                                            |       | 535,213                                 |       | —                                          |       | — |   | — |   |
| Non-cash  interest expense                                                                                                |       | 1,524,216                               |       | 214,397                                         |       |   |   | — |   |
| Change in fair  value of warrant liability                                                                                |       | (291,112                                | )          | (114,916                                        | )          |   |   | — |   |
| Changes in  operating assets and liabilities in:                                                                          |       |                                    |       |                                            |       |   |   |   |   |
| Receivables                                                                                                               |       | (136,377                                | )          | 1,224,770                                       |       | (3,507,170 | ) | (263,358 | ) |
| Inventories                                                                                                               |       | (2,058,308                              | )          | 353,777                                         |       | 1,445,781 |   | (1,172,181 | ) |
| Prepaid expenses  and other assets                                                                                        |       | 676,605                                 |       | (651,144                                        | )          | 182,695 |   | (140,518 | ) |
| Accounts payable                                                                                                          |       | 1,882,333                               |       | 1,012,666                                       |       | (2,052,019 | ) | 1,151,505 |   |
| Accrued  liabilities                                                                                                      |       | 1,145,314                               |       | (22,530                                         | )          | (56,155 | ) | 243,815 |   |
| Other                                                                                                                     |       | 51,813                                  |       | (759,832                                        | )          | 66,584 |   | 61,709 |   |
| Net cash used in operating activities                                                                                     |       | (2,760,413                              | )          | 476,259                                         |       | (3,992,820 | ) | 803,839 |   |
|                                                                                                                      |       |                                    |       |                                            |       |   |   |   |   |
| **Cash flows from investing activities:**                                                                                 |       |                                    |       |                                            |       |   |   |   |   |
| Purchases of  property and equipment                                                                                      |       | (214,283                                | )          | (134,005                                        | )          | (81,372 | ) | (132,499 | ) |
| Acquisitions of  businesses, net of cash acquired                                                                         |       | (133,429                                | )          | (6,386,432                                      | )          |   |   | — |   |
| Net cash used in investing activities                                                                                     |       | (347,712                                | )          | (6,520,437                                      | )          | (81,372 | ) | (132,499 | ) |
|                                                                                                                      |       |                                    |       |                                            |       |   |   |   |   |
| **Cash flows from financing activities:**                                                                                 |       |                                    |       |                                            |       |   |   |   |   |
| Short-term debt  borrowings (payments), net of expenses                                                                   |       | 625,379                                 |       | 1,129,262                                       |       | 4,200,000 |   | 700,000 |   |
| Long-term debt  borrowings (payments), net of expenses                                                                    |       | 1,492,080                               |       | 8,200,000                                       |       | — |   | — |   |
| Payments to  former shareholder                                                                                           |       | (350,000                                | )          | (1,500,000                                      | )          | (76,393 | ) | (653,837 | ) |
| Proceeds from  common stock issuances                                                                                     |       | 80,000                                  |       | —                                          |       | — |   | — |   |
| Dividends paid                                                                                                            |       | —                                  |       | —                                          |       | — |   | (864,507 | ) |
| Net cash provided by financing (used for) activities                                                                      |       | 1,847,459                               |       | 7,829,262                                       |       | 4,123,607 |   | (818,344 | ) |
|                                                                                                                      |       |                                    |       |                                            |       |   |   |   |   |
| Net increase (decrease) in cash                                                                                           |       | (1,260,666                              | )          | 1,785,084                                       |       | 49,415 |   | (147,004 | ) |
| Cash - beginning of period                                                                                                |       | 1,785,084                               |       | —                                          |       | 24,202 |   | 171,206 |   |
| Cash - end of period                                                                                                      | ** ** | $                                       | 524,418    |                                            | $          | 1,785,084 |   | $ | 73,617 |   | $ | 24,202 |   |
|                                                                                                                      |       |                                    |       |                                            |       |   |   |   |   |
| **Supplemental cash flow information:**                                                                                   |       |                                    |       |                                            |       |   |   |   |   |
| Cash payments  for interest                                                                                               | ** ** | $                                       | 1,557,753  |                                            | $          | 488,323 |   | $ | 70,462 |   | $ | 349,282 |   |
|                                                                                                                      |       |                                    |       |                                            |       |   |   |   |   |
| **Non-cash investing and financing activities:**                                                                          |       |                                    |       |                                            |       |   |   |   |   |
| Fair value of  common stock issuance related to acquisition  (Note 4)                                                     | ** ** | $                                       | 244,950    |                                            | —     |   | — |   | — |   |
| Fair value of  in-the-money conversion feature and common stock and warrant issuances  related to debt financing (Note 5) | ** ** | $                                       | 2,111,800  |                                            | —     |   | — |   | — |   |
| Non-cash  dividend associated with in-the-money conversion feature of convertible  preferred stock issuance (Note 5)      | ** ** | $                                       | 2,168,033  |                                            | —     |   | — |   | — |   |

* *

*SeeAccompanying Notes to Consolidated Financial Statements.*

 

F-6

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**SMALL WORLDKIDS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

## **NOTE 1****                    BASIS OFCONSOLIDATION**

##  

As a result of the May 20, 2004 transactionsdescribed in the following paragraph, the Company had a change in management,controlling shareholders, financial position and business plan.

 

On May 20, 2004, Small World Kids, Inc.,formerly SavOn Team Sports, Inc. (“Small World”, “SWK” or the “Company”)executed an Exchange Agreement (the “Agreement”) whereby SWK issuedcommon stock in exchange for all of the equity interests of Fine Ventures, LLC(“FVL”).  Prior to the Agreement, SWK wasconsidered a shell company as it had minimal net assets and operations.  As the shareholders of FVL control theCompany subsequent to the transaction, the Agreement was accounted for as a purchaseby FVL of SWK and the financial statements presented for the Company are acontinuation of FVL.  Simultaneously SWK acquiredall of the issued shares of Small World Toys, Inc. (“SWT”) in atransaction accounted for as a purchase resulting in a change in management, controllingshareholders, financial position and business plan of SWT.  As such, SWT is considered to be thepredecessor business and SWK the successor for accounting purposes.  As SWK is considered a holding company because it currently has nosignificant business operations or assets other than SWT, the predecessorcompany’s results of operations are also presented for comparative purposes.

 

On October 14, 2005the Company completed a ten for one (10:1) reverse stock split (“Reverse Split”).  As of the date of the Reverse Split, therewere 54,105,750 shares of the Company’s Common Stock outstanding.  Immediately after the split there were5,410,575 Common shares outstanding. Accordingly, all references to units of securities (e.g. shares ofCommon Stock) or per share amounts are reflective of the Reverse Split for allperiods reported.

 

## **NOTE 2****                    SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

##  

These financial statementshave been prepared in accordance with U.S. GAAP, assuming that the Company willcontinue as a going concern. The Company will continue to prepare its financialstatements on the assumption that it will continue as a going concern. As such,the financial statements do not include any adjustments to reflect possiblefuture effects of the recoverability and classification of assets or theamounts and classification of liabilities that may result from liquidityuncertainties or any future decisions made with respect to the Company’sstrategic alternatives.

 

Wehave incurred significant losses since our purchase of Small World Toys in May 2004.  As of December 31, 2005, our accumulateddeficit was $10,022,000.  As of December 31,2005, we have $4,700,000 in principal payments due in 2006.  We may not be able to generate sufficientcash flow from operations to meet our debt obligations.  There can be no assurance that we will beable to obtain additional financing or restructuring our debt obligations orthat, if we were to be successful in obtaining additional financing orrestructuring our debt obligations, it would be on favorable terms.  Failure to obtain additional financing orrestructuring our debt obligations may cause us to default on these debtobligations.  In addition, under crossdefault provisions in the Laurus Security Agreement, defaults under our debtobligations may cause the acceleration of the repayment of the Revolving andTerm Notes. This raises substantial doubt about the Company’s ability tocontinue as a going concern for a reasonable period of time.Managementintends to take the following actions (i) reducing operating expenses, (ii) seekingto obtain new equity and (iii) restructuring the debt obligations.

 

### ***Use of Estimates***

###  

The preparation offinancial statements in conformity with generally accepted accounting principlesin the United States requires management to make estimates and assumptions thataffect the amounts reported  in thefinancial statements and the accompanying notes during the reportingperiod.  Estimates in these

 

F-7

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financial statements may include but are not limited to inventoryvaluations, sales returns reserves, allowance for doubtful accounts receivable,income taxes and other contingent liabilities. Actual results could differ from those estimates.

 

***Segments of anEnterprise and Related Information***

 

The Company follows SFAS No. 131,“Disclosures about Segments of an Enterprise and Related Information.”  SFAS No. 131 requires that a publicbusiness enterprise report financial and descriptive information about itsreportable operating segments on the basis that is used internally forevaluating segment performance and deciding how to allocate resources tosegments.  We sell developmental toys tothe specialty toy market.  We have noother segment which meets the quantitative thresholds for reportablesegments.  Our international salesaccounted for 3.2% and 2.3% of our net sales in 2005 and 2004, respectively.

 

**Revenue Recognition**

 

We recognize revenue whenall four revenue recognition criteria have been met: persuasive evidence of anarrangement exists, the product has been delivered or the service has beenrendered, the price is fixed or determinable and collection is probable.  We recognize revenue from product sales uponwhen all of the foregoing conditions are met which in general is at the time ofshipment where the risk of loss and title has passed to the customer.  However, for certain shipments such as directshipments from our vendors to our customers or where we use consolidators todeliver our products (usually export shipments) revenue is recognized inaccordance with the sales terms specified by the respective sales agreements.

 

Sales allowances forcustomer promotions, discounts and returns are recorded as a reduction ofrevenue when the related revenue is recognized. We routinely commit to promotional sales allowance programs with ourcustomers.  These allowances primarilyrelate to fixed programs, which the customer earns based on purchases of ourproducts during the year. Discounts are recorded as a reduction of relatedrevenue at the time of sale.  Sales tocustomers are generally not subject to any price protection or return rights.

 

We offer extended termsto some of our customers in the first three quarters of the year by way of salespromotions whereby payment will not become due until the fourth quarter if aspecified purchase threshold has been met. This promotion allows us to capture additional shelf space and tocapture more of the annual budgets of our retail customers.  The result of this promotion gives rise to asignificant increase in accounts receivable through the fourth quarter untilsubstantially all accounts become due and are collected.  Based upon historically low rates of returnand collection of substantially all of these extended term accounts, we havedetermined that revenue is appropriately recognized in accordance with itsnormal procedures described above.

 

### ***Advertising Costs***

###  

All advertising costs areexpensed as incurred and charged to operations within Selling, General andAdministrative expenses.  Such costs were$137,000 and $129,000 for the years ended December 31 2005 and December 312004, respectively.

 

### ***Shipping andHandling***

###  

All shipping and handlingcosts related to sales to customers are expensed as incurred and charged toSelling, General and Administrative expenses. These expenses were $3.1 million and $2.8 million for the years ended December 312005 and December 31 2004, respectively.

 

***Barter Transaction***

 

Infiscal year 2004, the Company exchanged $351,000 of excess inventory foradvertising, travel and other barter credits valued by the barter provider atthe cost of inventory.  The Companyrecorded the barter credits as a prepaid expense at the $351,000 market valueof the inventory exchanged. Additionally, in accordance with Emerging IssuesTask Force No. 99-17, “Accounting for Advertising Barter Transactions,”the Company accounted for this transaction as a sale, recording revenue andcost of sales of $351,000 leaving no net impact to income.  The Company did not use any credits in 2005and only $3,000

 

F-8

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of barter credits for travel in 2004. Since there are no assurances that the company will utilize thesecredits before they expire at the end of 2006, the Company has determined thatthe realizability of the credits can not be assured and therefore has writtenoff the credits in 2005

 

***ForeignCurrency and International Operations***

 

The Companyhas no significant foreign assets.  Almostall of our purchases are in US dollar denominations.  Our nominal foreign currency transactionexposures include gains and losses realized on unhedged inventory purchasesthat are denominated in a currency other than the applicable functionalcurrency.

 

***Cashand Cash Equivalents, Short and Long-Term Investments***

 

Forpurposes of cash flows, the Company considers all highly liquid investmentspurchased with a maturity of three months or less to be cash equivalents, thosewith original maturities not greater than three months and current maturitiesless than twelve months from the balance sheet date are considered short-terminvestments, and those with maturities greater than twelve months from thebalance sheet date are considered long-term investments. The Company maintainsbank accounts with balances which, at times, may exceed federally insuredlimits. The Company has not experienced any losses on such accounts. TheCompany believes it is not exposed to any significant risk on bank depositaccounts. As of December 31, 2005, the Company had cash balances of$524,000, of which individual bank accounts over $100,000 were not insured bythe FDIC.

 

***AccountsReceivable***

 

TheCompany’s receivables are recorded when billed and represent claims againstthird parties that will be settled in cash. The carrying value of the Company’sreceivables, net of the allowance for doubtful accounts, represents theirestimated net realizable value.   TheCompany evaluates the collectibility of accounts receivable on acustomer-by-customer basis. The Company records a reserve for bad debts againstamounts due to reduce the net recognized receivable to an amount the Companybelieves will be reasonably collected. The reserve is a discretionary amountdetermined from the analysis of the aging of the accounts receivables,historical experience and knowledge of specific customers.

 
| ** **                             | ** ** | **Year Ended  December 31** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Trade Receivables                      |       | $                                | 7,492,141  |   | $ | 7,257,976 |   |
| Less: Allowances for doubtful accounts |       | (350,000                         | )          | (252,212 | ) |
| Accounts receivable,  net              |       | $                                | 7,142,141  |   | $ | 7,005,764 |   |

 

***Inventory***

 

Inventory is valued atthe lower of average cost or market. Inventory costs consist of the purchases of finished goods from ourvendors and the associated costs necessary to obtain those inventories.  As necessary, we write down inventory to itsestimated market value based on assumptions about future demand and marketconditions.  Failure to accuratelypredict and respond to consumer demand could result in the under production ofpopular items or overproduction of less popular items which may requireadditional inventory write-downs which could materially affect our futureresults of operations.

 

***Propertyand Equipment***

 

Property and equipmentare recorded at cost and are depreciated over the estimated useful lives of theassets using the straight-line method. Estimated useful lives for financial reporting purposes are as follows:furniture and fixtures, five to seven years; computer hardware and software,three years; leasehold improvements, over the shorter of five years or thelease term.  The cost and relatedaccumulated depreciation of all property and equipment retired or otherwisedisposed of are removed from the accounts. Any gain or loss is recognized in the current period.  Various accelerated methods are used for tax

 

F-9

----

 

purposes.

 

Maintenance and repaircosts are charged to expense as incurred, and renewals and improvements thatextend the useful lives of the assets are capitalized and added to the propertyand equipment.

 

### Propertyand equipment consist of the following:

 
| ** **                                      | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Computer equipment                              |       | $                           | 324,436    |                        | $          | 174,300 |   |
| Mold cost                                       |       | 246,706                     |       | 228,332                     |       |
| Warehouse equipment                             |       | 93,249                      |       | 65,744                      |       |
| Furniture and fixtures                          |       | 69,930                      |       | 56,353                      |       |
| Leasehold improvements                          |       | 96,706                      |       | 92,015                      |       |
|                                            |       | 831,027                     |       | 616,744                     |       |
| Less: accumulated depreciation and amortization |       | (339,904                    | )          | (111,685                    | )          |
| Property and equipment, net                     |       | $                           | 491,123    |                        | $          | 505,059 |   |
|                                                 |            |                             |            |                             |            |  |  |  |

 

Depreciation expense forthe years ended December 31, 2005 and 2004 was approximately $228,000 and$174,000 respectively.

 

***IntangibleAssets***

 

We evaluate long-livedassets whenever events or changes in business circumstances or our planned useof assets indicate that their carrying amounts may not be fully recoverable orthat their useful lives are no longer appropriate.  Reviews are performedto determine whether the carrying values of assets are impaired based oncomparison to either the discounted expected future cash flows (in the case ofgoodwill and intangible assets) or to the undiscounted expected future cashflows (for all other long-lived assets).  If the comparison indicates thatimpairment exists, the impaired asset is written down to its fair value. Significant management judgment is required in the forecast of future operatingresults that are used in the preparation of expected discounted andundiscounted cash flows.

 

In accordance with SFAS142, an intangible asset that is not subject to amortization such as goodwillshall be at a minimum, tested for impairment annually.  The first of the impairment tests consists ofa comparison of the total fair value of the Company based upon the closingstock price and the Company’s net assets on the date of the test.  If the fair value is in excess of the netassets, there is no indication of impairment and no need to perform the secondtier impairment test.  The Companyperformed this test as of May 19, 2005, the one year mark of the purchaseof Small World Toys which resulted in the recording of the goodwill carried onthe Company’s books.  As the market valueof the Company significantly exceeded the net assets of the Company, there isno indication of impairment and no adjustment was required to be made.

 

The Company alsoperformed an impairment test as of September 2005 for the fair value ofthe assets acquired from Neurosmith LLC in September 2004.  In 2005, the Company sold $1.2 million inNeurosmith products and approximately met the projections used for thevaluation of the assets acquired.  Assuch, there is no indication of impairment and no adjustment was required to bemade.

 

Components of the Company’sidentifiable amortizable intangible assets are as follows (in thousands):

 
| ** **             | ** ** | **December 31, 2005**   | ** ** | **December 31, 2004**    | ** ** |
|------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **             | ** ** | **Gross   Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Gross   Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| Trade names            |       | $                            | 2,092,839  |                          | $          | 314,025 |   | $ | 1,778,814 |   | $ | 2,002,643 |   | $ | 111,760 |   | $ | 1,890,883 |   |
| Customer lists         |       | 1,155,685                    |       | 152,854                       |       | 1,002,831 |   | 840,000 |   | 51,333 |   | 788,667 |   |
| Purchased technology   |       | 320,971                      |       | 82,912                        |       | 238,059 |   | 320,971 |   | 18,721 |   | 302,250 |   |
| Non-compete  agreement |       | 162,549                      |       | 77,248                        |       | 85,301 |   | 140,000 |   | 8,558 |   | 131,442 |   |
| Total                  |       | $                            | 3,732,044  |                          | $          | 627,039 |   | $ | 3,105,005 |   | $ | 3,303,614 |   | $ | 190,372 |   | $ | 3,113,242 |   |
|                        |            |                              |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

F-10

----

 

Amortization expense ofintangible assets for the years ended December 31, 2005 was approximately$452,000 and $190,000 respectively. Estimated amortization expense for thenext five succeeding fiscal years and all years thereafter are as follows:

 
| **  ** | ** ** | **Estimated  Amortization  Expense** | ** ** |
|------------------|------------|--------------------------------------|------------|
| 2006             |       | $                                    | 472,000    |   |
| 2007             |       | 443,000                              |       |
| 2008             |       | 421,000                              |       |
| 2009             |       | 399,000                              |       |
| 2010             |       | 318,000                              |       |
| Thereafter       |       | 1,060,000                            |       |
| Total            |       | $                                    | 3,113,000  |   |
|                  |            |                                      |            |  |  |

###  

### ***Prepaid expensesand other current assets***

###  

Prepaid expenses andother current assets include deferred design and packaging expenses that areamortized over the life of the applicable product, a barter contract, otherprepaid expenses and miscellaneous items as follows:

 
| ** **                                               | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Design and packaging expenses                            |       | $                           | 395,709    |                        | $          | 401,206 |   |
| Prepaid inventory purchases                              |       | —                      |       | 142,290                     |       |
| Barter contract                                          |       | —                      |       | 160,624                     |       |
| Prepaid insurance                                        |       | 157,331                     |       | 66,198                      |       |
| Prepaid marketing fees                                   |       | 77,161                      |       | 123,629                     |       |
| Miscellaneous prepaid expenses and other current  assets |       | 426,258                     |       | 731,748                     |       |
|                                                     |       | $                           | 1,056,459  |                        | $          | 1,625,695 |   |

###  

### ***Major Vendors***

###  

### During the year ended December 31, 2005, our topten suppliers accounted for 64.7% of the total product purchases. The top twosuppliers accounted for 11% and 9% of total purchases, respectively.  Our tools and dies are located at thefacilities of our third-party manufacturers.

###  

### During the year ended December 31, 2004, our topten suppliers accounted for 58% of the total product purchases. The top twosuppliers accounted for 10% and 8% of total purchases, respectively.

###  

### ***Stock BasedCompensation***

###  

As permitted by SFAS No. 123,“*Accounting for Stock-Based Compensation*”(“SFAS 123”) the stock options granted are accounted for under the intrinsicvalue recognition and measurement principles of APB Opinion No. 25, “*Accounting for Stock Issued to Employees*” (“APB 25”).  Accordingly, no compensation expense has beenrecorded for stock options granted with exercise prices greater than or equalto the fair value of the underlying common stock at the option grant date.

 

SFAS 123 requires thedisclosure of pro forma net income (loss) and earnings (loss) per share as ifthe Company had adopted the fair value method.  Under SFAS 123, thefair value of stock-based awards to employees is calculated through the use ofoption pricing models, even though such models were developed to estimate thefair value of freely tradable, fully transferable options without vestingrestrictions, which significantly differ from the Company’s stock optionawards.  These models also require subjective assumptions, includingfuture stock price volatility and expected time to exercise, which greatlyaffect the calculated values.  For purposes of estimating the effect ofSFAS 123 on the Company’s net income (loss) the fair value of the Company’soptions was estimated at the grant date using the Black-Scholes option pricingmodel with the following the weighted average assumptions:

 

F-11

----

 
| ** **               | ** ** | **Successor**                            | ** ** | **Predecessor**                            | ** ** |
|--------------------------|------------|------------------------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **Year Ended  December 31,   2005** | ** ** | **May 21 –  December  31, 2004** | ** ** | **January 1 –  May 21,  2004** | ** ** |
| ** **               | ** ** | ** **                               | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Expected life (in years) |       | 10.0                                     |       | 10.0                                       |       | — |   |
| Expected volatility      |       | 108.6                                    | %          | 111.8                                      | %          | — |   |
| Risk-free interest rate  |       | 4.0                                      | %          | 4.0                                        | %          |   |   |
| Expected dividend        |       | —                                   |       | —                                     |       | — |   |

 

The calculations arebased on a single option valuation approach and forfeitures are recognized asthey occur.  During the periods presented, no compensation expense wasrecorded under APB 25.  Under the fair valuemethod prescribed by SFAS 123, the estimated fair value of stock-basedincentive awards is charged against income over the vesting period.  The following pro forma net loss and loss pershare information is presented as if the Company accounted for stock-based compensationawarded using the fair value recognition provisions of SFAS 123:

 
| ** **                                                                                                                              | ** ** | **Successor**                           | ** ** | **Predecessor**                                  | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                                                              | ** ** | **Year Ended  December 31,  2005** | ** ** | **May 21 –  December 31,,  2004** | ** ** | **January 1 –  May 21,  2004** | ** ** |
| Net loss attributable to Common Stock as reported                                                                                       |       | $                                       | (8,938,614 | )                                                | $          | (1,082,986 | ) | $ | (134,861 | ) |
| Deduct:  Stock-based employee compensation expense determined under the fair value  method for all awards,

Net of related tax  effects |       | (264,441                                | )          | (420,475                                         | )          | — |   |
| Pro forma net loss                                                                                                                      |       | $                                       | (9,203,055 | )                                                | $          | (1,503,461 | ) | $ | (134,861 | ) |
| Basic and diluted net loss per share:                                                                                                   |       |                                    |       |                                             |       |   |   |
| As reported                                                                                                                             |       | $                                       | (1.67      | )                                                | $          | (0.02 | ) | $ | (13.49 | ) |
| Pro forma                                                                                                                               |       | $                                       | (1. 72     | )                                                | $          | (0. 03 | ) | $ | (13.49 | ) |
|                                                                                                                                         |            |                                         |            |                                                  |            |  |  |  |  |  |  |  |  |

 

The Company granted300,000 stock options to four consultants in the first quarter of 2005 for workto be completed throughout the year.  These options were to vestimmediately and expire six months from the date of grant.  These options were granted with an exerciseprice greater than the traded per share value of the underlying common stock onthe date of grant.  The value of theoptions of $535,000 was calculated using the Black-Scholes option-pricing modeland recorded as non-cash compensation expense in the year ended December 30,2005.  16,000 options were exercised bythe consultants in the nine months ended September 30, 2005 at an averageexercise price of $5.00.  In addition,140,000 options which had an original expiration date of July 4, 2005 wereextended to December 31, 2005 but were cancelled before expiring at yearend and the remaining 140,000 options expired unexercised.

 

The Company also granted50,000 stock options to a consultant in the first quarter of2005.  These options vest quarterly over a three year periodbeginning in the second quarter ended June 30, 2005.  Any unexercised options expire three monthsafter the completion or termination of the consulting agreement.  The value of the options was determined usingthe Black-Scholes option-pricing model and will be recorded as non-cashcompensation expense during service period of the consulting agreement.  The Company recorded compensation expense of$48,000 related to these options during the year ended 2005.

 

***Recent Accounting Pronouncements***

 

In December 2004,the Financial Accounting Standards Board (FASB) issued SFAS No. 123(revised 2004), “*Share-Based Payment*” (SFAS123R).  SFAS 123R eliminates the alternative of applying the intrinsicvalue measurement provisions of APB 25 to stock compensation awards issued toemployees.  Rather, the new standard requires enterprises to measure thecost of employee services received in exchange for an award of equityinstruments based on the grant-date fair value of the award.  That costwill 

 

F-12

----

 

be recognized over the period during which an employee is required toprovide services in exchange for the award, usually the vesting period.

 

The pro forma effects onnet income and earnings per share as if we had applied the fair valuerecognition provisions of original SFAS 123 on stock compensation awards(rather than applying the intrinsic value measurement provisions of APB 25) arein the Notes to Consolidated Financial Statements (see Note 2).  Althoughthe pro forma effects of applying original SFAS 123 may be indicative of theeffects of adopting SFAS 123R, the provisions of these two statements differ insome important respects.  The actual effects of adopting SFAS 123R will bedependent on numerous factors including, but not limited to, the valuationmodel chosen by to value stock-based awards; the assumed award forfeiture rate;the accounting policies adopted concerning the method of recognizing the fairvalue of awards over the requisite service period; and the transition methodchosen for adopting SFAS 123R.  Adoption of this accounting standard willhave a material adverse impact on our consolidated financial statements. This statement will be effective for our first quarter ending March 31,2006.

 

In February 2006,the FASB issued SFAS No. 155, “Accounting for Certain Hybrid FinancialInstruments” (“SFAS 155”), which amends SFAS No. 133, “Accounting forDerivatives Instruments and Hedging Activities” (“SFAS 133”) and SFAS No. 140,“Accounting for Transfers and Servicing of Financial Assets and Extinguishmentof Liabilities” (“SFAS 140”). SFAS 155 amends SFAS 133 to narrow the scopeexception for interest-only and principal-only strips on debt instruments toinclude only such strips representing rights to receive a specified portion ofthe contractual interest or principle cash flows. SFAS 155 also amends SFAS 140to allow qualifying special-purpose entities to hold a passive derivativefinancial instrument pertaining to beneficial interests that itself is aderivative instruments. The Company is currently evaluating the impact this newStandard, but believes that it will not have a material impact on the Company’sfinancial position, results of operations or cash flows. We will adopt SFAS 155on January 1, 2007.

 

In May 2005, theFASB issued Statement No. 154, “*Accounting Changes andError Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3*”(“SFAS No. 154”).  This Statementreplaces APB Opinion No. 20, “Accounting Changes” and FASB Statement No. 3,“Reporting Accounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  SFAS No. 154 applies toall voluntary changes in an accounting principle and to any changes required byan accounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. SFAS No. 154 requires that all voluntary changes in accountingprinciples are retrospectively applied to prior financial statements as if thatprinciple had always been used, unless it is impracticable to do so.  SFAS No. 154 is effective for accountingchanges and error corrections occurring in fiscal years beginning after December 15,2005.  The adoption of this standard,beginning in fiscal year 2006, is not expected to have any material effect onour operating results or financial condition.

 

In December 2004, the FASB Statement 153,“*Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29*” (SFAS 153).  The standard is based on the principle that exchangesof nonmonetary assets should be measured based on the fair value of the assetsexchanged and eliminates the exception under APB Opinion No. 29 for anexchange of similar productive assets and replaces it with an exception forexchanges of nonmonetary assets that do not have commercial substance.  The standard is effective for nonmonetaryexchanges occurring in fiscal periods beginning after June 15, 2005. Theadoption of SFAS 153 did not have a material impact on the Company’s financial positionor results of operations.

 

In November 2004,the FASB issued SFAS No. 151, “*Inventory Costs*”,an amendment of Accounting Research Bulletin No. 43, Chapter 4.  ThisStatement is the result of a broader effort by the FASB working with theInternational Accounting Standards Board to reduce differences between U.S. andinternational accounting standards. SFAS No. 151 eliminates the “soabnormal” criterion in ARB No. 43 and companies will no longer bepermitted to capitalize inventory costs on their balance sheets when theproduction defect rate varies significantly from the expected rate.  Italso makes clear that fixed overhead should be allocated based on “normalcapacity.” SFAS No. 151 is effective for inventory costs incurred duringfiscal years 

 

F-13

----

 

beginning after September 15, 2005.  We will adopt this standard in the firstquarter of 2006 but does not believe that it will have a material effect on theresults of operations or consolidated financial position.

 

On September 28,2005, the FASB ratified the following consensus reached in EITF Issue 05-8 (“IncomeTax Consequences of Issuing Convertible Debt with a Beneficial ConversionFeature”): a) The issuance of convertible debt with a beneficial conversionfeature results in a basis difference in applying SFAS No. 109, Accountingfor Income Taxes. Recognition of such a feature effectively creates a debtinstrument and a separate equity instrument for book purposes, whereas theconvertible debt is treated entirely as a debt instrument for income tax purposes.b) The resulting basis difference should be deemed a temporary differencebecause it will result in a taxable amount when the recorded amount of theliability is recovered or settled. c) Recognition of deferred taxes for thetemporary difference should be reported as an adjustment to additional paid-incapital. This consensus is effective in the first interim or annual reportingperiod commencing after December 15, 2005, with early applicationpermitted. The effect of applying the consensus should be accounted forretroactively to all debt instruments containing a beneficial conversionfeature that are subject to EITF Issue 00-27, “Application of Issue No. 98-5to Certain Convertible Debt Instruments” (and thus is applicable to debtinstruments converted or extinguished in prior periods but which are stillpresented in the financial statements). Management is evaluating the impact ofthis pronouncement on the Company’s financial statements

 

In September 2005,the FASB approved EITF Issue 05-7, “Accounting for Modifications to ConversionOptions Embedded in Debt Securities and Related Issues” (“EITF 05–7”). EITF05–7 addresses that the changes in the fair value of an embedded conversionoption upon modification should be included in the analysis under EITF Issue96–19, “Debtor’s Accounting for a Modification or Exchange of Debt Instruments,”to determine whether a modification or extinguishment has occurred and thatchanges to the fair value of a conversion option affects the interest expenseon the associated debt instrument following a modification. Therefore, thechange in fair value of the conversion option should be recognized upon themodification as a discount or premium associated with the debt, and an increaseor decrease in additional paid-in capital. EITF 05–7 is effective for all debtmodifications in annual or interim periods beginning after December 15,2005. Management is evaluating the impact of this pronouncement on the Company’sfinancial statements

 

In June 2005, theEmerging Issues Task Force, or EITF, reached a consensus on Issue 05-6, *Determining the Amortization Period for LeaseholdImprovements*, which requires that leasehold improvements acquired ina business combination or purchased subsequent to the inception of a lease beamortized over the lesser of the useful life of the assets or a term thatincludes renewals that are reasonably assured at the date of the businesscombination or purchase. EITF 05-6 is effective for periods beginning after July 1,2005. We do not expect the provisions of this consensus to have a materialimpact on the company’s financial position, results of operations or cashflows.

 

In June 2005,the FASB ratified EITF Issue No. 05-2, “The Meaning of ‘ConventionalConvertible Debt Instrument’ in EITF Issue No. 00-19, ‘Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in aCompany’s Own Stock” (“EITF No. 05-2”), which addresses when a convertibledebt instrument should be considered ‘conventional’ for the purpose of applyingthe guidance in EITF No. 00-19. EITF No. 05-2 also retained theexemption under EITF No. 00-19 for conventional convertible debtinstruments and indicated that convertible preferred stock having a mandatoryredemption date may qualify for the exemption provided under EITF No. 00-19for conventional convertible debt if the instrument’s economic characteristicsare more similar to debt than equity. EITF No. 05-2 is effective for newinstruments entered into and instruments modified in periods beginning after June 29,2005. The Company has applied the requirements of EITF No. 05-2 to newinstruments entered into and instruments modified in periods beginning after June 29,2005. The Company does not expect its financial statements to be significantlyimpacted by this statement.

 

F-14

----

 

## **NOTE 3****                    INCOME TAXES**

##  

The Company accounts forits income taxes using the Financial Accounting Standards Board Statements ofFinancial Accounting Standards No. 109, “Accounting for Income Taxes,”which requires the establishment of a deferred tax asset or liability for therecognition of future deductible or taxable amounts and operating loss and taxcredit carryforwards.  Deferred taxexpense or benefit is recognized as a result of timing differences between therecognition of assets and liabilities for book and tax purposes during theyear.

 

Deferred tax assets andliabilities are measured using enacted tax rates expected to apply to taxableincome in the years in which those temporary differences are expected to berecovered or settled.  Deferred taxassets are recognized for deductible temporary differences and operating loss,and tax credit carryforwards.  A valuationallowance is established to reduce that deferred tax asset if it is “more likelythan not” that the related tax benefits will not be realized.

 

Noprovision for federal taxes has been provided for year ended 2003 and theperiod January 1 - May 20, 2004 as the predecessor was a S corporation.

 
| The provision (benefit) for income taxes |
|------------------------------------------|

 

| ** **                     | ** ** | **Successor**                      | ** ** |
|--------------------------------|------------|------------------------------------|------------|
| ** **                     | ** ** | **Year Ended  December 31,  2005** | ** ** | **May 21 –   December 31,  2004** | ** ** |
| Current                        |       |                               |       |   |   |
| State                          |       | $                                  | 459        |   | $ | 0 |   |
| Federal                        |       | 0                                  |       | 0 |   |
|                           |       | 459                                |       | 0 |   |
|                           |       |                               |       |   |   |
| Deferred                       |       |                               |       |   |   |
| State                          |       | (600,573                           | )          | (138,410 | ) |
| Federal                        |       | (2,094,989                         | )          | (485,285 | ) |
|                           |       | 2,695,563                          |       | (623,695 | ) |
| Change in  Valuation Allowance |       | 2,402,685                          |       | 0 |   |
|                           |       |                               |       |   |   |
| Total                          |       | $                                  | (292,419   | ) | $ | (623,695 | ) |

 
| The reconciliation of income tax provision computed  at federal statutory rates to income tax expense is as follows |
|---------------------------------------------------------------------------------------------------------------------|

 

| Tax at federal  statutory rates |   | 35.0   | %      | 34.0   | %      |
|---------------------------------|--------|--------|--------|--------|--------|
| State taxes                     |   | 5.8    | %      | 4.0    | %      |
| Goodwill amortization           |   | 0.0    | %      | 0.0    | %      |
| Meals and Entertainment         |   | -0.1   | %      | 0.0    | %      |
| Penalties                       |   | 0.0    | %      | 0.0    | %      |
| Change in valuation allowance   |   | -35.5  | %      | 0.0    | %      |
| Other                           |   | -1.0   | %      | -4.0   | %      |
|                            |   |   |   |   |   |
| Total                           |   | 4.3    | %      | 34.0   | %      |

 

Net deferred tax assets at December 31, 2005 and2004 are as follows:

 

| Current                                      |   |    |          |   |   |
|----------------------------------------------|--------|---------|---------------|--------|--------|
|                                         |   |    |          |   |   |
| Allowance for  returns and doubtful accounts |   | $       | 150,096       |   | $      | 0 |   |
| Accrued expenses                             |   | 0       |          | 0      |   |
| Inventory                                    |   | 264,511 |          | 0      |   |
| Net operating  loss carryforwards            |   | 0       |          | 0      |   |
| Accrued pension                              |   | 0       |          | 0      |   |
| Contributions  Carryover                     |   | 4,409   |          | 0      |   |
| State tax                                    |   | 183,841 |          | 0      |   |
|                                         |   |    |          |   |   |
|                                         |   | $       |  602,857 |   | 0      |   |
|                                              |        |         |               |        |        |  |  |

 

F-15

----

 

| Noncurrent                             |   |      |             |     |     |
|----------------------------------------|--------|-----------|------------------|----------|----------|
|                                   |   |      |             |     |     |
| Basis difference  in fixed assets      |   | $         |  (216       | )        | $        | 13,304 |   |
| Mark-to-market  adjustment on warrants |   | (174,124  | )                | 0        |     |
| Intangibles  assets                    |   | (933,251  | )                | (848,000 | )        |
| Net operating  loss carryforwards      |   | 3,043,823 |             | 432,251  |     |
| Other                                  |   | 0         |             | 39,730   |     |
| State tax                              |   | (136,404  | )                | (73,592  | )        |
|                                   |   | $         |  1,799,828  |     | (436,307 | ) |
|                                   |   |      |             |     |     |
| Net deferred tax asset/(liability)     |   | $         |  2,402,685  |     | (436,307 | ) |
|                                   |   |      |             |     |     |
| Valuation allowance                    |   | $         |  (2,402,685 | )        |     |   |
|                                        |        |           |                  |          |          |  |  |

 

The Company has loss carryforwards of approximately$6,890,000 and 1,566,000 for the Years Ended December 31, 2005 and 2004,respectively, from continuing operations, which may be used to offset futureUnited States federal taxes, which begin to expire in 2024 and state incometaxes, which begin to expire in 2014.

 

## **NOTE 4****                    ACQUISITIONS**

##  

On June 24, 2005,the Company acquired certain assets of Imagiix LP (the “Seller”) for $150,000in cash (excluding transaction expenses) and 50,000 restricted shares of theCompany’s Common Stock.  Imagiix is adeveloper and marketer of infant, toddler and preschool toys sold under theImagiix® brand name and under various licenses, including Garfield and Jay Jaythe Jet Plane.  The 50,000 shares ofCommon Stock issued to the Seller had a value of $245,000 based on the closingprice of the Company’s Common Stock on June 24, 2005.  Of the $150,000 cash purchase component,$100,000 was paid upon closing with $50,000 due on December 15, 2005.  Additional cash consideration may be earnedby the Seller based on sales by the Company of 3% of the products in the Seller’scatalogs and 5% of new products developed by the Seller and future productsdeveloped within the Jay Jay the Jet Plane and Garfield product lines.  The Company also incurred approximately$35,000 in acquisition related costs which are included in the total purchaseprice.  In addition, the Company paid$20,000 to the Seller as an advance against sales of the Seller’s existinginventory which the Company has agreed to sell, splitting the proceedsequally.  This transaction has beenaccounted for under the purchase method of accounting and was allocated to thenet assets of Imagiix based on their estimated relative fair values on June 24,2005.

 

On October 14, 2005,The Company and its newly-formed acquisition subsidiary, Fashion AngelsEnterprises, Inc., a Wisconsin corporation (“Fashion Angels”), enteredinto an Agreement for Purchase and Sale of Assets (the “Purchase Agreement”)with M&G Partners, LLP, a Wisconsin limited liability partnership, d/b/aThe Bead Shop (“Seller”), and Mark Miller, Goldi Miller and Myra Mouloudji, thepartners of Seller.  The PurchaseAgreement was amended on January 5, 2006 to extend the closing date to January 16,2006.  Seller designs and manufactures “tween” girl products, includingarts and crafts, accessories, dolls and back to school products (the “Business”).Pursuant to the terms of the Purchase Agreement, Fashion Angels was to purchaseall of the assets utilized in connection with the Business and was to assumecertain of Seller’s liabilities associated with the Business.  On February 17, 2006, M&G Partners,LLP sent notification to the Company that the Purchase Agreement is terminated asthe closing did not occur on or before January 16, 2006.

 

F-16

----

 

## **NOTE 5****                    LONG-TERM DEBT**

##  

Components of long-termdebt are as follows (net of discounts):

 
| ** **                                                                               | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Senior Secured Credit Facility                                                           |       | $                           | 8,115,641  |                        | $          | 8,229,262 |   |
| 10% Bridge Notes Due 2006 (less discounts of  $762,576 and $637,652, respectively)       |       | 1,737,424                   |       | 2,562,348                   |       |
| 24% Notes Due 2006 (less discounts of $0 and $0,  respectively)                          |       | 1,000,000                   |       | —                      |       |
| 10% Convertible Debentures Due 2008 (less discounts  of $1,250,630 and $0, respectively) |       | 249,370                     |       | —                      |       |
| 10% Note Due 2009 – SWT LLC (related party)                                         |       | —                      |       | 5,000,000                   |       |
| 5% Note Due 2005 & 2006 – Former  shareholder (related party)              |       | 675,119                     |       | 700,000                     |       |
| 10% Note Due 2006 - Related party (less discounts of  $62,324 and $0, respectively)      |       | 437,676                     |       | —                      |       |
|                                                                                     |       | 12,215,230                  |       | 16,491,610                  |       |
| Less: current portion                                                                    |       | (11,965,860                 | )          | (2,824,848                  | )          |
|                                                                                     |       | $                           | 249,370    |                        | $          | 13,666,762 |   |

***Senior Secured Credit Facility***

 

Small World Toysmaintains an asset-based revolving credit facility (“Credit Facility”) with PNCBank (“PNC) with a maximum asset based borrowing limit of $16.5 millionincluding a Seasonal Advance of $1.5 million and was subsequently repaid on February 28,2006 with the use of proceeds from the Secured Non-Convertible Revolving Notethat the Company entered into with Laurus Master Funds, Ltd.   The assetbase includes all eligible Receivables and Inventory as defined in theRevolving Credit and Security Agreement (“Credit Agreement”) dated December 15,2004.  Interest is payable monthly at PNC’sprime rate plus 0.50%.  The Company’sobligation under the Credit Facility is collateralized by a security interestin the assets of Small World Toys, a guaranty by Small World Kids which issecured by certain shares of Small World Toys and a limited guaranty of DebraFine, the Chief Executive Officer and President of Small World Kids and SmallWorld Toys.  On January 14, 2005,PNC agreed to amend the Credit Agreement to March 14, 2005 increasing theconcentration limit for receivables with standard terms owing from the Company’slargest customer from 10% to 25%.  On May 12,2005 the PNC agreed to amended the Credit Agreement to adjust the borrowinglimit based on a percentage of eligible Receivables as follows: (i) from80% to 90% until December 14, 2005; (ii) from 90% to 85% for theperiod December 15, 2005 to December 31, 2005.  On January 1, 2006 the eligibilitypercentages will revert to the original Credit Agreement terms which are 80%from January 1 to June 30, and 85% from July 1 to December 31until its scheduled expiration on November 30, 2007.  Additionally, the amended Credit Agreementrequires that repayment of any borrowings under the Seasonal Advance which wasrepaid in-full in increments of $500,000 each on November 30, 2005, December 15,2005 and December 31, 2005.

 

The Credit Agreementcontains a number of financial covenants including a Fixed Charge CoverageRatio (“FCCR”) covenant.  The FCCRcovenant requires the Company to maintain a ratio of 1:1 of available cash flowfrom operations to required payments as a result of the Company’s debtobligations.  As of December 31,2005, the Company’s FCCR calculated per the terms of the Credit Agreement was1:0.02.  As a result the Company was indefault under the terms of the Credit Agreement.

 

On February 28,2006, Small World Kids, Inc. entered into a Secured Non-ConvertibleRevolving Note (the “Revolving Note Agreement”) with Laurus Master Funds, Ltd.(“Laurus”).  Proceeds from the Revolving Note were used to repay fundsborrowed under the secured asset-based revolving credit facility with PNC Bank(“PNC”) and the PNC facility was terminated (Note 13 Subsequent Events).

 

***10%Bridge Notes Due 2006 - St Cloud Capital Partners LP***

 

On September 15,2004, we entered into a Note Purchase Agreement with St. Cloud Capital PartnersL.P. (“St. Cloud”), pursuant to which we issued to St. Cloud a 10% ConvertiblePromissory Note in the aggregate amount of $2,000,000, due September 15,2005. The Company also was required to pay a closing fee of $80,000 and amanagement fee of $80,000 to St.Cloud. In connection with the issuance of the note, we issued St. Cloud 650,000shares of common stock and warrants to purchase an additional 350,000 shares ofcommon stock.  The warrants areexercisable at an exercise price per share equal to the lesser of 

 

F-17

----

 

$.50 per share or the average price of the Put Agreements (Note7).  The warrants expire in September 2008.  St.Cloud can elect at its option, but limitedto one time, to convert any unpaid principal portion and accrued interest onthis note into shares of the Company common stock at the conversion price equalto the average price per share of the Put Agreements for all tranches.  The Company has granted certain registrationrights whereby the Company agreed to include the common stock and warrants inthe registration statement which will be filed by the Company with theSecurities and Exchange Commission (the “SEC”) in connection with the PutAgreements.

 

In thefirst quarter of 2005 the Company reclassified the value of 165,000 shares ofstock granted to St. Cloud Capital Partners LP in conjunction with the NotePurchase Agreement (the “Agreement”) as of September 15, 2004 from aliability to equity.  At inception it wasbelieved that the Company may have had an unconditional obligation as set forthunder SFASNo. 150, *Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity *(“SFAS 150”) andrecorded the value of $325,000 as a liability.  During the first quarter of 2005, based uponfurther information and analysis of the Agreement, the Company reclassified theamount as it was determined that the Shares granted are more appropriately classifiedas equity.

 

On July 20, 2005 theCompany amended the Agreement (the “Amendment”) pursuant to which St. Cloudagreed to advance to the Company an additional $500,000 for an aggregate loanof $2.5 million at an interest rate of 10% per annum payable monthly inarrears.  The aggregate loan is securedby certain Company assets including Receivables, Inventory, Equipment and otherassets.  In consideration for theadvance, the Company issued to St. Cloud an additional 16,250 shares of theCompany’s Common Stock and four year immediately exercisable warrants for theright to acquire 8,750 shares (“Warrant Shares”) of the Company’s CommonStock.  The aggregate Warrants underlying43,750 shares of Common Stock are exercisable at an exercise price per shareequal to the lowest of (a) $4.00 per share or; (b) the per shareprice (or conversion price if a derivative security) of the next financing ofthe Company with gross proceeds of at least $5 million.  The Amendment also provides piggybackregistration rights with respect to the shares of Common Stock and WarrantShares in the event the Company files a qualified Registration Statement withthe SEC.  At inception the fair value ofthese warrants was determined to be $120,000 using the Black-Scholes option pricingmodel and applied to the principal as a discount to be accreted over the lifeof the loan.

 

In addition, as a resultof the termination of the Put Agreements, the Notes no longer have registrationobligations.  As such, the Company hasreclassified the $115,000 fair market value of those September 15, 2004warrants issued in conjunction with the Notes initially classified as aliability to permanent equity in accordance with SFAS 150 and EITF 00-19, *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*(“EITF 00-19”)*.*

 

On November 11,2005, the Company entered into a Second Amendment to the Agreement with St.Cloud pursuant to which the Company issued to St. Cloud a new promissory note(the “Replacement Note”) replacing the existing note to St. Cloud in theprincipal amount of $2,500,000 (the “Loan Amount”).  Under the ReplacementNote, the maturity date of the Loan Amount was extended to September 15,2006.  The Replacement Note is convertible into shares of the Common Stockof the Company at $4.00 per share (subject to adjustment) or, as to up to 50%of the Loan Amount, into securities issued by the Company in a financing withgross proceeds of at least $12,500,000.  As the Replacement Note is convertibleat a price below the fair market value on the date of issuance, it is deemed tohave a beneficial conversion feature with an intrinsic value of $912,000.  In consideration of the agreement of St.Cloud to accept the Replacement Note, the Company issued to St. Cloud twowarrants to purchase an aggregate of 75,000 shares of Common Stock (the “NewWarrant Shares”) as follows:  a First Warrant for 50,000 shares at $6.00per share exercisable for a number of New Warrant Shares (each, a “Tranche”) inaccordance with the following:  12,500 shares to be vested at Closing and12,500 shares (or the prorated portion thereof as provided in the Warrant) tobe vested on January 1, 2006, April 1, 2006 and July 1, 2006 (a “VestingDate”); and a Second Warrant for 25,000 shares at $7.50 per share, 6,250 sharesto be is vested at Closing and 6,250 shares (or the prorated portion thereof asprovided in the Warrant) to be vested on each Vesting Date, provided that theapplicable Warrant may not be exercised for a specific Tranche if theReplacement Note is not outstanding on the applicable Vesting Date.  Thenumber of New Warrant Shares is proportionally reduced, as of a Vesting Date,if the principal amount of the Note is less than the Loan 

 

F-18

----

 

Amount. The Company determined the Replacement Note resulted in asubstantial modification due to the new maturity date and the conversionfeature and accordance with Emerging Issues Task Force EITF Issue 96-19 *Debtor’s Accounting for a Modification or Exchange ofDebt,*the exchangetransaction was accounted for as an extinguishment of debt.  As such, the relative fair market value weredeemed to be fees paid associated with the extinguishment of the olddebt instrument and included as debt extinguishment loss to be recognized inthe current period.    Therelative fair value of these warrants was determined to be $231,000 using theBlack-Scholes option pricing model.

 

 ***10% Bridge Notes Due 2006- Strome Hedgecap Ltd Bridge Notes***

 

On September 16,2004, we entered into a Note Purchase Agreement with Strome Hedgecap Ltd. (“Strome”),pursuant to which we issued to Strome a 10% Convertible Promissory Note in theaggregate amount of $1,200,000, due September 16, 2005.  The Company also was required to pay aclosing fee of $96,000 to Strome.  Inconnection with the issuance of the Note we issued Strome warrants to purchase1,344,000 shares of common stock.  The warrantsare exercisable at an exercise price per share equal to the lesser of $.50 pershare or the average price of the Put Agreements (Note 7).  The warrants expire in September 2008.  The Company has granted certain registrationrights whereby the Company agreed to include the common stock and warrants inthe registration statement which may be filed by the Company with the SEC inconnection with the Put Agreements.  On October 3,2005 the Company obtained additional funding through the issuance of $1.5million in 10% Convertible Debentures and retired the $1.2 million Bridge Notes.

 

In addition, as a resultof the termination of the Put Agreements, the 10% Convertible Promissory Noteno longer had registration obligations. As such, the Company has reclassified the $395,000 fair market value of thoseSeptember 16, 2004 warrants issued in conjunction with this note initiallyclassified as a liability to permanent equity in accordance with SFAS 150 andEITF 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*(“EITF00-19”)*.*

 

***24% Notes Due 2006***

 

On April 28, 2005the Company entered into Term Credit Agreements (“Credit Agreements”) with HongKong League Central Credit Union and PCCW Credit Union (collectively the “Lenders”)for unsecured loans totaling $750,000 due on or before August 31,2005.  Interest is charged at a rate of2% per month and is payable monthly in arrears. On June 10, 2005 the Company entered into additional CreditAgreements with Hong Kong League Central Credit Union and HIT Credit Union forunsecured loans totaling $250,000 due on or before September 30,2005.  Effective August 31, 2005 thematurity dates of all outstanding unsecured loans with the Lenders wereextended to the earlier of the closing of a financing transaction with netproceeds of at least $20 million or March 1, 2006.  In consideration of the extension, theCompany agreed to issue four year immediately exercisable warrants to purchase100,000 shares of the Company’s Common Stock exercisable at $5.00 per share toSBI Advisors, a related party, as a placement fee.  At inception the fair value was determined tobe $325,000 using the Black-Scholes option pricing model and applied to theprincipal as a discount to be accreted over the expected life of the unsecuredloans.

 

***10% Convertible Debentures Due 2008***

 

On September 30,2005 the Company completed the issuance of an aggregate of $1.5 million inprincipal amount of 10% Convertible Debentures (the “Debentures”) and enteredinto a Securities Purchase Agreement (“Stock Purchase Agreement”) with GammaOpportunity Capital Partners LP and Bushido Capital Master Fund LP.  The Debentures will mature on September 30,2008 and bear an interest rate of 10% per annum payable quarterly inarrears.  The Company may make interestpayments in cash or shares of its Common Stock, subject, in the case of paymentin shares, to satisfaction of certain conditions.  The Debentures are immediately convertible tothe Company’s Common Stock at the option of the holder.  The conversion price is $4.00, subject toadjustments for stock splits, stock dividends or rights offerings combinations,recapitalization, reclassifications, extraordinary distributions and similarevents and certain subsequent equity sales. As the Debentures are convertibleat a price below the fair market value on the date of issuance, they are deemedto have a beneficial conversion feature with an intrinsic value of $425,000.

 

F-19

----

 

In consideration for theissuance of the Debentures, the Company issued five year immediatelyexercisable warrants to purchase an aggregate of 281,250 shares of the Company’sCommon Stock.  Of the shares underlyingthe warrants, 93,750 have an exercise price of $7.50 per share (subject toadjustment) and 187,550 have an exercise price of $6.00 per share.  These warrants have a fair value of $1.1million calculated using the Black Scholes option pricing model.  These warrants are subject to registrationrights requiring the Company to register the underlying shares with the SECwithin 120 days of the issuance of the Debentures.  In accordance with EITF 00-19, the value ofthe warrants has been recorded as a liability subject to mark-to-marketrevaluation at each period end.

 

In connection with theDebentures the Company paid a success fee (including expenses) of $165,000 andissued five year immediately exercisable warrants to purchase 37,500 shares ofthe Company’s Common Stock at an exercise price of $4.00 per share to CambriaCapital LLC (“Cambria”) in connection with the placement of the Debentures.

 

The cumulative value ofthe beneficial conversion feature, the warrants and the cash fee paid capped at$1.5 million was recorded as a discount to the debt issuance to be amortizedover the life of the loan.

 

***10% Note Due 2009 – SWT LLC - Conversion***

 

On August 11, 2005the Company converted the $5 million Bridge Note dated May 21, 2004 issuedto SWT, LLC, a related party, to 10% Class A Convertible Preferred Stock (“PreferredStock”). The Preferred Stock is immediately convertible at the option of theholder into the Company’s Common Stock at an initial fixed conversion price of$4.00 subject to adjustment based on the terms of future financings should theyoccur. The Preferred Stock accrues a quarterly dividend at a rate of 10% perannum and is payable in cash or a combination of 50% cash and 50% Common Stockat the Company’s option. The Company also issued three year immediatelyexercisable warrants to purchase 204,082 shares of the Company’s Common Stockexercisable at $4.90 per share. In addition, the Preferred Stock has abeneficial conversion feature which allows the holders to acquire Common Stockof the Company at an effective conversion price of approximately $1.00 belowfair value at the date of issuance. In accordance with EITF 98-5, Accountingfor Convertible Securities with Beneficial Conversion Features or ContingentlyAdjustable Conversion Ratios, the Company has determined the intrinsic value ofthis in-the-money conversion feature accounted for it and the warrants as adiscount to the Preferred Stock. The fair market value of the warrants and theintrinsic value of the beneficial conversion feature was determined to beapproximately $2.2 million. As the Preferred Stock is immediately convertible,the full value of both the conversion feature and the warrants are deemed adividend upon issuance and as such have been recorded directly to retainedearnings.

 

***5% Note Due 2005 & 2006 – Former shareholder***

 

As part of the purchasefor SWT Shares on May 20, 2004, the Company entered into a contingentearnout with the former shareholder of Small World Toys.  The Company agreed to a two year promissorynote, payable in quarterly installments commencing April 2005 with aminimum payment of $700,000 and a maximum payment of $1,500,000, if certainsales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000 based on the Company obtaining $33.7million in net sales of which $350,000 was paid in quarterly installments in2005 and the balance due in 2006 to be paid on a $60,000 per month payment schedule commencingon April 2006.  The 2006 earnout isbased on 2% of 2006 net sales up to a maximum of $800,000.  Of the 2006 earnout, a minimum quarterlypayment of $87,500 will be paid with the balance earned due January 2007.

 

***10% Note Due 2006 - Related Party***

 

Effective August 11,2005, the Company completed the issuance of an aggregate of $500,000 in Notesto various investors which included Debra Fine, the Company’s President andChief Executive Officer who provided $175,000 of the total borrowing.  The Notes mature one year from the date ofexecution with interest payable monthly in arrears at a rate of 10% perannum.  The Notes are secured by certainCompany assets including Receivables, Inventory, Equipment and other assets.  The Notes also provide piggyback 

 

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registration rights in the event the Company files a qualifiedRegistration Statement with the SEC.  Inconsideration for the loans, the Company agreed to issue an aggregate of 16,250shares of the Company’s Common Stock and four year immediately exercisablewarrants to purchase an aggregate of 8,750 shares of the Company’s CommonStock.  The Warrants are exercisable atan exercise price per share equal to the lowest of (a) $4.00 per share, or(b) the per share price (or conversion price if a derivative security) ofthe next financing of the Company with gross proceeds of at least $5million.  At inception the fair value ofthese warrants was determined to be $100,000 using the Black-Scholes optionpricing model and applied to the principal as a discount to be accreted as anon-cash interest cost over the life of the loan.

 

## **NOTE 6: WARRANT LIABILITY**

##  

The warrants issued toGamma Opportunity Capital Partners LP and Bushido Capital Master Fund LP inconsideration for the issuance of the Debentures are subject to registrationrights requiring the Company to register the underlying shares with the SECwithin 120 days of the issuance of the Debentures.  In accordance with EITF 00-19, the value ofthe warrants of $1,077,000 has been recorded as a liability subject tomarket-to-market revaluation at each period end.  Any change in fair value from the date ofissuance to the date the underlying shares are registered will be included inother (expense) income.  The change infair value from the date of issuance to December 31, 2005 of $388,000 hasbeen included in other income.

 

## **NOTE 7: PUT AGREEMENT**

##  

As a result of the conversion of the July 20,2005 amended agreement with St. Cloud, the issuance of $500,000 in Notes on August 11,2005 and the $5 million Bridge Note discussed above, the stock purchaseagreement (“Put Agreements”) entered into by the Company in 2004 with each ofWire Mill Partners III LLC, LLC and Pewter Hill Partners LLC (“Purchasers”)that obligated each of them to purchase, upon the Company’s election, up to1,010,000 shares of the Company’s Common Stock for an aggregate purchase priceof $6.3 million (representing a total commitment of $12.6 million) have beenautomatically terminated.

 

## **NOTE 8: COMMITMENTS AND CONTINGENCIES**

##  

As part of the purchasefor SWT Shares on May 20, 2004, the Company entered into a contingentearnout with the former shareholder of Small World Toys.  The Company agreed to a two year promissorynote, payable in quarterly installments commencing April 2005 with aminimum payment of $700,000 and a maximum payment of $1,500,000, if certainsales targets are achieved in 2005 and 2006. In 2005, the seller earned $673,000 based on the Company obtaining $33.7million in net sales of which $350,000 was paid in quarterly installments in2005 and the balance due in 2006 to be paid on a $60,000 per month payment schedule commencingon April 2006.  The 2006 earnout isbased on 2% of 2006 net sales up to a maximum of $800,000.  Of the 2006 earnout, a minimum quarterlypayment of $87,500 will be paid with the balance earned due January 2007.

 

On May 20, 2004, theCompany entered into a $72,000 per annum three-year consulting agreement withDavid Marshall, Inc., a related party. On each anniversary date, the fee shall be increased by the increase inthe consumer index for the Los Angeles metropolitan statistical area.  During the term, David Marshall, Inc.will provide consulting services relating to business plan development,strategic planning, public relations, investor relations, acquisitions andfinancing activities.

 

On September 7,2005, Small Play, Inc. (“Small Play”) filed an action inthe United States District Court for the Southern District of NewYork against Small World Toys alleging $3 million in damages inconnection with a supposed breach of an alleged oral licensingagreement.  As the contemplated licensestipulated a $12,000 per year guaranteed royalty payment, the alleged damagesare believed to be excessive. The Company disputes Small Play’s claims andintends to defend strenuously against these claims.  We filed a motion to dismiss that wasbriefed as of February 13, 2006.  The motion has not yet beendecided, and no trial date has yet been set for the case.

 

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On August 5, 2005,Gemini Partners, Inc. (“Gemini”) filed an action in the Superior Court ofthe State of California for the County of Los Angeles against Small World Toys,Debra Fine, and Fineline Services, LLC. Gemini’s complaint arises out of a written consulting agreement dated asof November 10, 2003 entered into by and between Gemini and FinelineServices.  The complaint alleges causesof action for:  (1) breach of writtencontract; (2) breach of implied covenant of good faith and fair dealing; (3) fraud;(4) negligent misrepresentation; (5) promissory estoppel; (6) quantummerit; and (7) unfair competition. The Company disputes Gemini’s claims and intends to defend strenuouslyagainst these claims.  The Company filedan answer to the complaint on October 11, 2005.  No trial date has yet been set.  The case is in the early stages of discovery.

 

Additionally, the Companyis subject to legal proceedings and claims which arise in the ordinary courseof business.  In the opinion ofmanagement, such matters are without merit and are of such kind that ifdisposed of unfavorably, would not have a material adverse effect on theCompany’s consolidated financial position or results of operations orliquidity.

 

Ourcorporate headquarters are located at 5711 Buckingham Parkway, Culver City,California 90230, where we lease approximately 28,000 square feet and subleaseapproximately 17,000.  This lease expireson June 30, 2006.  We also lease approximately 62,000 squarefeet of warehouse space in Carson, California. This lease expires on June 30, 2006.  We are currently in negotiations with bothlandlords to extend the leases.  We alsolease 1,200 square feet of office space in China in the town of ChangAn, in theGuangDong Province.  This one year leaseexpires November 1, 2006.  Theaggregate future rental rates are:

 
| Year Ending  December 31, 2006 |   | $ | 346,000 |   |
|-------------------------------------|--------|---|---------|--------|

 

The Company is party to several license agreements forthe acquisition and development of certain toys and related manufacturing,licensing and distribution rights. Royalties range from 3% to 10% of various categories of sales.  The agreements remain in effect for as longas the Company manufactures and sells the toys.

 

## **NOTE 9: EARNINGS (LOSS) PER SHARE**

##  

Basic earnings per shareare computed by dividing income or loss available to common shareholders by theweighted average number of common shares outstanding during the reportingperiod.  Diluted earnings per share is computed based on the weightedaverage number of shares outstanding during the period increased by the effectof the potential dilution that could occur if securities or other contracts,such as stock options and stock purchase contracts that were exercised or convertedinto common stock using the treasury stock method.  Earnings per share have been computed asfollows:

 

The Company had nodilutive securities for the years ended December 31, 2005 and 2004 due tothe Company having a net loss for each year and therefore none of theoutstanding stock options and warrants aggregating 9,222,809 and 8,264,000 for2005 and 2004, respectively, potential common shares were included in thecalculations of earnings per share.  Forthe year ended December 31, 2003, the predecessor had no dilutivesecurities since there were no outstanding options or warrants.

 

## **NOTE 10: PROFIT SHARING PLAN**

##  

The Company has a qualified 401(k) profit sharing planin effect for eligible employees.  Theplan provides for pre-tax employee contributions.  A portion of the pre-tax employeecontributions will be matched by the Company on a discretionary basis.  The plan also provides for annualcontributions at the discretion of the Company. Total contributions are not to exceed annual amounts deductible underInternal Revenue Service regulations.  Nocontributions were made for the years ended December 31, 2005 and December 31,2004.

 

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## **NOTE 11: SELECTED QUARTERLY FINANCIAL DATA (Unaudited)**

 
| ** **                                     | ** ** | **Quarters Ended**                        | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                     | ** ** | **Mar. 31, 2005**               | ** ** | **Jun. 30, 2005** | ** ** | **Sep. 30, 2005** | ** ** | **Dec. 31, 2005** | ** ** |
| ** **                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Net sales                                      |       | $                                         | 7,152      |   | $ | 6,164 |   | $ | 9,532 |   | $ | 10,907 |   |
| Gross profit                                   |       | $                                         | 3,248      |   | $ | 2,310 |   | $ | 3,358 |   | $ | 4,221 |   |
| Net Income (loss)                              |       | $                                         | (1,992     | ) | $ | (1,805 | ) | $ | (1,206 | ) | $ | (1,768 | ) |
| Net Income (loss) attributed to common stock   |       | $                                         | (1,992     | ) | $ | (1,805 | ) | $ | (3,374 | ) | $ | (1,768 | ) |
| Income (loss) per share (basic and diluted)(1) |       | $                                         | (0.38      | ) | $ | (0.34 | ) | $ | (0.62 | ) | $ | (0.33 | ) |

 
| ** **                                      | ** ** | **Quarters Ended**                        | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                      | ** ** | **Mar. 31, 2004**               | ** ** | **Jun. 30, 2004** | ** ** | **Sep. 30, 2004** | ** ** | **Dec. 31, 2004** | ** ** |
| ** **                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| Net sales                                       |       | $                                         | 6,597      |   | $ | 5,400 |   | $ | 7,678 |   | $ | 9,819 |   |
| Gross profit                                    |       | $                                         | 2,945      |   | $ | 2,377 |   | $ | 3,088 |   | $ | 3,692 |   |
| Net Income  (loss)                              |       | $                                         | 43         |   | $ | (795 | ) | $ | (25 | ) | $ | (434 | ) |
| Net Income  (loss) attributed to common stock   |       | $                                         | 43         |   | $ | (795 | ) | $ | (25 | ) | $ | (434 | ) |
| Income (loss)  per share (basic and diluted)(1) |       | $                                         | 4.31       |   | $ | (0.33 | ) | $ | (0.00 | ) | $ | (0.08 | ) |

 

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(1) Per share amounts are reflective of the Reverse Split for allperiods reported.

 

## **NOTE 12: VALUATION**

 
| **Description**                                | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Write-offs** | ** ** | **Balance  at end of  Period** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|----------------|------------|--------------------------------|------------|
| Allowance for doubtful accounts:               |       |                                 |       |                                |       |           |       |                           |       |
|                                           |       |                                 |       |                                |       |           |       |                           |       |
| Year ended  December 31, 2003             |       | $                                    | 434,164    |                                | $          | 152,904        |       | $                              | (412,068   | ) | $ | 175,000 |   |
| Year ended  December 31, 2004             |       | $                                    | 128,180    |                                | $          | 271,154        |       | $                              | (147,122   | ) | $ | 252,212 |   |
| Year ended  December 31, 2005(1)          |       | $                                    | 252,212    |                                | $          | 3,055          |       | $                              | 94,733     |   | $ | 350,000 |   |
|                                           |       |                                 |       |                                |       |           |       |                           |       |
| Reserve for shrinkage, obsolescence, and scrap |       |                                 |       |                                |       |           |       |                           |       |
|                                           |       |                                 |       |                                |       |           |       |                           |       |
| Year ended  December 31, 2003             |       | $                                    | 0          |                                | $          | 0              |       | $                              | (0         | ) | $ | 0 |   |
| Year ended  December 31, 2004             |       | $                                    | 0          |                                | $          | 0              |       | $                              | (0         | ) | $ | 0 |   |
| Year ended  December 31, 2005             |       | $                                    | 0          |                                | $          | 315,000        |       | $                              | (0         | ) | $ | 315,000 |   |

 

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(1) Includes recovery of $141,000 that waswritten off in 2003.

 

## **NOTE 13: SUBSEQUENT EVENTS**

##  

On October 14, 2005,The Company and its newly-formed acquisition subsidiary, Fashion AngelsEnterprises, Inc., a Wisconsin corporation (“Fashion Angels”), enteredinto an Agreement for Purchase and Sale of Assets (the “Purchase Agreement”)with M&G Partners, LLP, a Wisconsin limited liability partnership, d/b/aThe Bead Shop (“Seller”), and Mark Miller, Goldi Miller and Myra Mouloudji, thepartners of Seller.  The PurchaseAgreement was amended on January 5, 2006 to extend the closing date to January 16,2006.  Seller designs and manufactures “tween” girl products, includingarts and crafts, accessories, dolls and back to school products (the “Business”).Pursuant to the terms of the Purchase Agreement, Fashion Angels was to purchaseall of the assets utilized in connection with the Business and was to assumecertain of Seller’s liabilities associated with the Business.  On February 17, 2006, M&G Partners,LLP sent notification to the Company that the Purchase Agreement is terminatedas the closing did not occur on or before January 16, 2006.

 

On April 28, 2005 theCompany entered into Term Credit Agreements (“Credit Agreements”) with HongKong League Central Credit Union and PCCW Credit Union (collectively the “Lenders”)for unsecured loans totaling $750,000 due on or before August 31,2005.  Interest is charged at a rate of2% per month and is payable monthly in arrears. On June 10, 2005 the Company entered into additional Credit 

 

F-23

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Agreements with Hong Kong League Central Credit Union and HIT CreditUnion for unsecured loans totaling $250,000 due on or before September 30,2005.  Effective August 31, 2005 thematurity dates of all outstanding unsecured loans with the Lenders were extendedto the earlier of the closing of a financing transaction with net proceeds ofat least $20 million or March 1, 2006. Effective February 28, 2006 the maturity dates of all outstandingunsecured loans with the Lenders were extended to the earlier of the closing ofa financing transaction with net proceeds of at least $20 million or August 11,2006.

 

On February 28,2006, Small World Kids, Inc. issued a Secured Non-Convertible RevolvingNote (the “Revolving Note”) with Laurus Master Fund, Ltd. (“Laurus”).  Theterm of the Revolving Note is two years and provides that we may borrow up to$16,500,000 subject to certain conditions.  Interest is payablemonthly, in arrears at a rate per annun equal to the Prime Rate (as publishedin The Wall Street Journal) plus two percent (2.0%). The Revolving Notehas no financial covenants and is collateralized by a security interest insubstantially all of the assets of the Company and its subsidiaries, includingits operating subsidiary, Small World Toys. Proceeds from the Revolving Notewere used to repay funds borrowed under the secured asset-based revolvingcredit facility with PNC Bank (“PNC”) and the PNC facility was terminated.

 

On February 28, 2006,Small World Kids, Inc., also issued pursuant to a security agreement (theLaurus “Security Agreement”) a $2.0 million, two year Secured Non-ConvertibleTerm Note (the “Term Note “) with Laurus. Commencing April 1, 2006 andeach succeeding month after, the Company will make principal payments of$33,333 with all the balance of the unpaid principal amount due upon thematurity date of February 28, 2008.  Interest is payable monthly, inarrears at a rate per annum equal to the Prime Rate (as published in TheWall Street Journal) plus three percent (3.0%). The Term Note has no financialcovenants and is collateralized by the Laurus Security Agreement.

 

In consideration for theRevolving Note and the Term Note, the Company issued to Laurus a warrant (“Warrant”)to purchase 1,036,000 shares of common stock at a $0.001 per share exerciseprice.

 

On March 20, 2006,the Company entered into a Purchase Order Revolving Credit Line (“PO CreditLine”) of Five Million Dollars ($5,000,000) with Horizon Financial ServicesGroup USA to finance purchase orders. The term of the PO Credit Line iseighteen (18) months and provides that we may borrow up to $5,000,000 subjectto certain conditions including Horizon’s approval of the applicablevendors.  A financing fee equal to Four and One Half Percent (4.50%)of the gross amount or face value of each Horizon financing instrument will becharged for the first forty-five (45) day period or part thereof that thefinancing instrument remains outstanding. An additional fee of fifty basispoints (.50%) for each additional period of 15 days, or part thereof, duringwhich the Horizon financing instrument remains outstanding will be charged. ThePO Credit Line has no financial covenants and is collateralized by a securityinterest, junior in position to that of our senior lender, Laurus Master Funds,Ltd, to the assets related to the PO Credit Line transactions.

 

On March 23,2006, the Company appointed John Matise as Chief Operating Officer.  Mr. Matisehas been on the board of directors of the Company since 2004.  The Company’s prior Chief Operating Officer,John Nelson, will continue to assist the company in a consulting capacity.

 

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