**U. S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

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**FORM 10-QSB**

 

**(Mark One)**

 

**ý****QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2005**

 

**o****TRANSITION REPORT UNDER SECTION 13 OR15(d) OF THE EXCHANGE ACT**

 

**For the transition period from               to               **

 

**Commission File Number: 000-50638**

 

**GRAYMARK PRODUCTIONS, INC.**

(Name of small business issuer in its Charter)

 
| **OKLAHOMA**                                                    | ** ** | **20-0180812**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | ** ** | (I.R.S. Employer  Identification No.) |

 

**101 N. Robinson, Suite 920**

**Oklahoma City, Oklahoma 73102**

(Address of principal executive offices)

** **

**(405) 601-5300**

(Issuer’s telephone number)

 

 

(Former name, former address and former fiscal year, if changed sincelast report)

 

**APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY**

**PROCEEDINGS DURING THE PRECEDING FIVE YEARS**

 

Checkwhether the registrant filed all documents and reports required to be filed by Section 12,13 or 15(d) of the Exchange Act after the distribution of securities undera plan confirmed by a court.  Yes ý No o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act.)

Yes o No ý

**APPLICABLE ONLY TO CORPORATE ISSUERS**

 

Statethe number of shares outstanding of each of issuer’s classes of common equity,as of the latest practicable date:  As ofNovember 11, 2005, 8,279,151 shares of the issuer’s common stock, $0.0001par value, were outstanding.

 

TransitionalSmall Business Disclosure Format (Check One): Yes o No ý

 

 

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**GRAYMARK PRODUCTIONS, INC**.

FORM 10-QSB

For the Quarter Ended September 30, 2005

 

TABLE OF CONTENTS

 
| Part I.  | Financial Information                                           |   |
|---------------|-----------------------------------------------------------------|--------|
| Item 1.       | Financial Statements                                            |   |
| Item 2.       | Management’s Discussion and Analysis or Plan of  Operation |   |
| Item 3.       | Controls and Procedures                                         |   |
|          |                                                            |   |
| Part II. | Other Information                                               |   |
| Item 1.       | Legal Proceedings                                               |   |
| Item 2.       | Unregistered Sale of Equity  Securities and Use of Proceeds     |   |
| Item 3.       | Defaults Upon Senior Securities                                 |   |
| Item 4.       | Submission of Matters to a  Vote of Security Holders            |   |
| Item 5.       | Other Information                                               |   |
| Item 6.       | Exhibits                                                        |   |
| SIGNATURES    |                                                            |

 

Throughoutthis report the first personal plural pronoun in the nominative case form “we”and its objective case form “us”, its possessive and the intensive case forms “our”and “ourselves” and its reflexive form “ourselves”  refer collectively to GrayMark Productions, Inc.,its predecessor, GrayMark Productions, L.L.C., and its executive officers anddirectors.  The term “independent,” asused in this report, is used to distinguish us from the term “major studios”that is generally regarded in the entertainment industry to mean UniversalPictures, Warner Bros., Twentieth Century Fox, Sony Pictures Entertainment,Paramount Pictures, The Walt Disney Company, Metro Goldwyn Mayer and theirrespective affiliates.  The terms “low-budgetmotion pictures,” “low-budget films” or “low-budget movie” within this report,refer to motion pictures that have a production budget of $250,000 to $3million.

 

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**PART I.FINANCIAL INFORMATION**

 

**Item 1.****          ****Financial Statements**

 

Ourfinancial statements presented in this report were prepared and included inthis report in accordance with Regulation S-X and Regulation S-B an appear inthis report beginning on page F-1.

 

**Item 2.****          ****Management’s Discussion andAnalysis or Plan of Operation**

 

Youshould read the following discussion in conjunction with our financialstatements and notes thereto appearing elsewhere in this report.

 

**Overview**

 

Weoperated historically as a limited liability company, GrayMark Productions,L.L.C. that was formed in August 2001. Since commencement of our operations in August 2001, we did notgenerate a material amount of revenue from operations until June 2005 whenwe generated $450,000 of revenue from our first motion film project, *Cloud 9*. Effective August 18, 2003, pursuant to an exchange agreement, theowners of the member interests in GrayMark Productions, L.L.C. exchanged theirrespective member interests in GrayMark Productions, L.L.C. for 4,870,000shares of our common stock.  As a resultof this exchange, GrayMark Productions, L.L.C. became a wholly-owned subsidiaryof GrayMark Productions, Inc. and the plan of operation of GrayMarkProductions, L.L.C. became that of GrayMark Productions, Inc.

 

Wehave completed production of our first motion picture project, *Cloud 9*, and have entered into licensingagreements covering the foreign and domestic distribution and broadcast rightsto this motion picture.  In June 2005,we received a non-refundable advance of $450,000 from the domestic distributionlicensee.  We have competed the filmingand are in the post-production of our second and third motion picture filmprojects, *The Hunt*, and *Surveillance*, and are in pre-production ofour forth motion picture project, *Soul’sMidnight*.

 

Thefollowing discussion covers our plan of operations for the next 12 months.  As with any plan, there is no assurance thatour operations as described will go as planned or that we will be successful inachieving the anticipated results.

 

**Movie Development and Production**

 

Themovie industry generally consists of two principal activities, production anddistribution.  Production encompasses thedevelopment, financing and creation of feature-length movies.  Distribution entails the promotion andmarketing of movies in the various media markets, including theatrical, homevideo and television presentation.

 

Weprimarily produce English language motion pictures intended for domestictheatrical release and ancillary market release (home video and television, includingpay-per-view, cable, satellite and network broadcast), that have productionbudgets of $250,000 to $3 million (“low-budget motion pictures,” “low budgetmovies” or “low-budget films”).  Weinitially anticipated producing motion pictures that had production budgets of$2 million to $5 million, but based on the production of our first two motionpictures, we believe that a range of $250,000 to $3 million is appropriate.

 

Thedevelopment and production costs of a low-budget film and each cost category variesfrom movie-to-movie and this variation may be substantial.  Each movie is unique and the storyline,special effects, production locations, creative personnel involved, etc. affectthe budget amount of each cost category. Accordingly, we believe the cost categories are somewhat indeterminableuntil the particular movie is identified and developed.

 

Ratherthan retain and employ personnel to develop screenplays and perform other moviedevelopment activities, we typically acquire movies for production that are inthe development phase, generally to the point that the initial screenplay hasbeen written, and that are low-budget films. In the pre-production and production phases of a

 

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motionpicture, we intend to hire skilled creative and production personnel, includingcinematographers, editors, costume designers, set designers, sound and lightingtechnicians and actors on an as needed basis.

 

Weexpect to enter into various production cost and revenue sharing arrangements,including joint ventures, partnerships and limited liability companies, on amovie-by-movie basis.  These sharingarrangements are intended to complement or expand our business to permit theproduction of a greater number of movies, while sharing the financial risks ofthe movie.  We may not realize theanticipated financial benefits when we entered into these arrangements.  In addition, the negotiation of thesearrangements, whether successful or not, could require us to incur significantcosts and cause diversion of management’s time and resources.  Accordingly, the costs of obtaining thesesharing arrangements will increase our invested cost in a movie withoutproviding a correlating increase in the movies revenues and, consequently, adverselyaffect the financial performance of the movie.

 

Followingour production of the movie, we intend to arrange for distribution throughthird-parties primarily into the domestic (United States and Canada) andinternational ancillary market (home video or pay and free television).  Depending upon our ability to obtainfavorable distribution arrangements, which depends in many cases upon thedistributor’s assessment of the movie’s revenue potential, a particular moviemay be distributed in the domestic and international theatrical markets as wellas the ancillary markets. As of the date of this report, we have not enteredinto any arrangements for the theatrical release of our produced andin-production motion pictures.  Asubstantial amount of time may elapse between our expenditure of funds in theproduction of a motion picture and the receipt of revenue from the motionpicture.

 

Ourproduced movies will be distributed domestically pursuant to licensingarrangements with unrelated third-parties that are independently engaged in thepromotion and distribution of movies. Our foreign market distribution arrangements will be pursuant to sale orlicense of the international distribution rights to an unrelated third-partydistributor for either a single up-front payment (in U.S. currency) without anyretained participation in international source revenues or for the right toreceive a percentage of gross receipts received by the distributor.  As of the date of this report, we haveentered into domestic (United States and Canada) distribution arrangementscovering our three motion picture projects and have entered into internationaldistribution arrangements covering *Cloud 9*.

 

Ourability to obtain international market distribution, whether in the ancillarymarket or the theatrical market, will be subject to:

 

•                                          changes in local regulatory requirements,including restrictions on content,

 

•                                          changes in the laws and policies affectingtrade, investment and taxes (including laws and policies relating to therepatriation of funds and withholding taxes),

 

•                                          differing degrees of protection forintellectual property,

 

•                                          instability of foreign economies andgovernments,

 

•                                          cultural barriers, and

 

•                                          wars and acts of terrorism.

 

Anyof these factors could have a material adverse effect on our ability to sellthe international distribution rights of any motion picture.

 

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**Recent Developments**

 

*Distribution of Cloud 9. *In conjunctionwith the production of *Cloud 9*,with the other producers of *Cloud 9*,we formed Out of the Blue Productions, LLC (the “Production Company”).  The Production Company has entered into threeagreements covering the domestic (United States and Canada) and internationaldistribution of *Cloud 9* in theancillary market (home video market) and as the broadcast rights (pay and freetelevision, video on demand and pay-per-view) for *Cloud 9*.  Pursuant tothe agreement covering domestic distribution (“Domestic Agreement”), theProduction Company received in June 2005 a non-refundable advance of$450,000 on our share of the net receipts from the domestic distribution of *Cloud 9* that was distributed to us.  The Domestic Agreement allows the licensee toreceive a distribution fee equal to 20% of gross domestic receipts of *Cloud 9*after its recoupment of allmanufacturing, distribution and marketing costs from those receipts.  We anticipate that *Cloud 9* will be released in the domestic video market duringJanuary 2006.

 

DuringJune 2005, the Production Company entered in to an agreement for theinternational distribution of *Cloud 9*(“InternationalAgreement”).  Under the InternationalAgreement the licensee is entitled to receive recoupment of its manufacturing,distribution and marketing costs and thereafter a distribution fee of equal to15% of gross international receipts up to $2,000,000 and 10% of grossinternational receipts above $2,000,000.

 

Furthermore,during June 2005, the Production Company entered in to a Sales AgencyAgreement for the marketing of the broadcast rights (pay and free television,video-on-demand and pay-per-view) of *Cloud 9*(“Broadcast Agreement”).  Pursuant to theBroadcast Agreement, the licensee is entitled to a fee equal to 20% of thegross receipts from broadcast of *Cloud 9*on pay and free television, video-on-demand and pay-per-view after itsrecoupment of its distribution expenses.

 

Asa result of the agreements with the director, casting company, actors andco-finance providers, our residual net profits interest in *Cloud 9* is 30.6% after recoupment andpayment of all distribution costs, expenses and fees.  Furthermore, our co-finance providers areentitled to receive the first $500,000 of proceeds we receive from thelicensing of the distribution rights of *Cloud9* of which we have paid $450,000. After giving effect to the recovery of the $500,000 contributions to theproduction costs of *Cloud 9* underthe co-financing agreements and then the recovery of our production costs andother invested costs and interest, our net profits interest in *Cloud 9* will be 30.6%.  In conjunction with the production of *Cloud 9*, the producers formed Out of theBlue Productions, LLC (the “Production Company”).  Our entitlement to distributions from theProduction Company and the profits interest granted to Bert Reynolds providefor interest at a rate of 2% above the prime rate (limited to 5%) for purposesof determining recovery of the production and other costs of *Cloud 9*.

 

*Post-Production of The Hunt*. During March 2005, we commenced and completed principal filming ofour second motion picture project titled, *TheHunt*.  We are currently inpost-production of *The Hunt*.  We anticipate that the total production costsfor *The Hunt* will beapproximately $430,000.

 

InJuly 2005, we entered into an agreement for the domestic distribution of *The Hunt*. The agreement grants the licensee a distribution fee equal to 22.5% ofgross receipts and allows for the recoupment of all manufacturing, distributionand marketing costs.  In addition, wesold 35% of the copyright interest in *TheHunt* to the licensee for an amount equal to 50% of the budget of *The Hunt*. As of September 30, 2005, we have received approximately $214,000from the licensee under the terms of the agreement.  The company that developed the story conceptfor *The Hunt* retained a 25%interest in the net receipts of *The Hunt*.  Net receipts is defined as receipts after werecoup our production costs, interest and overhead.  In addition, we entered in to netparticipation agreements with the director, casting company and others equal to7% of the net receipts of *The Hunt*.

 

*Post-Production of Surveillance*. During August 2005, we commenced and completed principal filming ofour third motion picture project titled, *Surveillance*.  We are currently in post-production of *Surveillance*.  We anticipate that our total production costsfor *Surveillance* will beapproximately $610,000.

 

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InJuly 2005, we entered into an agreement for the domestic distribution of *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  In addition, we sold 50% of the copyrightinterest in *Surveillance* to thelicensee for an amount equal to 50% of the budget of *Surveillance*.  As of September 30,2005, we have received $285,000 from the licensee under the terms of theagreement.  In addition, we entered in tonet participation agreements with the director, casting company and othersequal to 8% of the net receipts of *The Hunt*.

 

*Pre-Production and Filming of Soul’s Midnight*. During September 2005, we commenced the pre-production phase of ourfourth motion picture project titled, *Soul’sMidnight*.  We anticipatecompleting the filming of this movie in November 2005.  We anticipate that our total production costsfor *Soul’s Midnight* will beapproximately $650,000.

 

InOctober 2005, we entered into an agreement for the domestic distributionof *Soul’s Midnight*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  In addition, we sold 75% of the copyrightinterest in *Soul’s Midnight* tothe licensee for an amount equal to 75% of the budget of *Soul’s Midnight*.

 

**Convertible Note Financing**

 

InAugust 2005, the Company issued a promissory note (the “Note”) in theprincipal amount of $750,000.  The Noteis secured by all assets of the Company including all purchase agreements andany options or rights to acquire, all intellectual and real property, allassets and properties of the Company and all of its existing and futuresubsidiaries.  The Note bears interest atthe rate of 8% per annum.  Interest dueon the note is payable quarterly and can be paid in cash or shares of Companystock.

 

TheNote will become due and payable on the first to occur of: (i) July 27,2007 (the “Maturity Date”); (ii) the consummation of a QualifiedFinancing; or (iii) the continuation of and Event of Default, as defined,for more than 30 days following notice of the occurrence of an Event ofDefault.  Upon consummation of aQualified Financing, the outstanding principal amount of the Note and allaccrued and unpaid interest (collectively the “Note Balance”) willautomatically convert into shares of equity securities of the Company equal to120% of the Note Balance divided by the price per share of the equitysecurities sold in the Qualified Financing. The maximum price or value of the equity securities into which the NoteBalance converts may not exceed the equivalent of $1.10 per common stockshare.  Qualified Financing refers to anyequity financing pursuant to which the Company receives aggregate gross cashproceeds of $2,000,000 or more on or before the Maturity Date.

 

Inconjunction with issuance of the Note, the Company and the holder of the Noteentered into two common stock purchase warrant agreements, each evidencingwarrants exercisable on or before August 5, 2010.  One agreement provides for the purchase of250,000 common stock shares at $2.00 and the other agreement provides for thepurchase of 250,000 common stock shares at $3.00.

 

Thefair value of each warrant issued was estimated on the date of issuance usingthe Black-Scholes option pricing model with the following assumptions used:weighted average risk free interest rate of 4.0%; no dividend yield; volatilityof 78%; and expected life less than five years. The fair value of the options were based on the difference between thepresent value of the exercise price of the option and the estimated fair valueprice of the common share.  The fairvalue of the warrants was estimated to be $244,776 and was recorded as paid-incapital.  The value of the warrants willincrease interest expense over the life of the Note.

 

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**Output Agreement**

 

InJune 2005 we entered into an agreement providing Image Entertainment (“Image”)with the first-look right at the movies we produce (the “Output Agreement”).  Image will have a “first look” on allprojects up to $2,000,000 that we undertake during the three-year periodbeginning on the date of delivery of *TheHunt*.  If Image were to choosenot to become involved in a motion picture project, we have the right to produceand distribute the motion picture with another person without any furtherobligation to Image.  Image agreed tofund up to 50% of each production budget for mutually agreed upon motionpicture projects.  This funding ispayable in three installments:  20% ofthe approved the production budget through pre-production, 60% of through thephysical shooting schedule, and 20% through the post production process.

 

Fora term of 20 years, Image will have domestic distribution rights of each motionpicture we co-produce with Image.  Imageis entitled to receive a 25% distribution fee from gross domestic sales and aback-end profit participation from all sales after payment of the distributionfee.  In general, the back-end profitparticipation interest and ownership interest in each co-produced motionpicture will be based upon Image’s funding of the budgeted share of productioncosts.  The actual back-end profitparticipation percentage shall be equal to the percentage Image funds of themotion picture project after recovery from sales of the mutually approvedexpenses.  Our joint exploitation of thebroadcast rights with Image have been left to future negotiation.

 

**Accounting Methods**

 

Theapplication of the following accounting policies, which are important in presentingour financial position and results of operations, requires significantjudgments and estimates on the part of management. For a summary of all of ouraccounting policies, including the accounting policies discussed below, seenote 2 to the unaudited consolidated financial statements appearing elsewherein this report.

 

InJune 2000, the Accounting Standards Executive Committee of the AmericanInstitute of Certified Public Accountants issued Statement of Position 00-2,Accounting by Producers or Distributors of Films (“SoP 00-2”).  SoP 00-2 establishes accounting standards forproducers or distributors of films, including changes in revenue recognition,capitalization and amortization of costs of acquiring films and televisionprograms and accounting for exploitation costs, including advertising andmarketing expenses. These accounting standards are as follows:

 

•                                          advertising and marketing costs are expensedthe first time the advertising takes place; and

 

•                                          the capitalization of production costs forepisodic television series is limited to revenue that has been contracted foron an episode-by-episode basis until the time that the criteria for recognizingsecondary market revenues are met.

 

Wecapitalize the costs of production, including financing costs, to investment inmotion pictures.  These costs will beamortized to direct operating expenses in accordance with SoP 00-2. These costsare stated at the lower of unamortized motion picture costs or fair value (netpresent value).  These costs for an individualmotion picture will be amortized in the proportion that current period actualrevenues bear to management’s estimates of the total revenue expected to bereceived from the motion picture over a period not to exceed 10 years from thedate of delivery.  We will be required toregularly review and revise when necessary the total revenue estimates of eachmotion picture produced.  As a result, ifrevenue estimates change with respect to a motion picture, it may be necessaryto write down all or a portion of the unamortized costs of the motionpicture.  There is no assurance thatrevised revenue estimates will not occur that result in significant write-downsaffecting our results of operations and financial condition.

 

Revenuefrom the sale or licensing of motion pictures will be recognized upon meetingall recognition requirements of SoP 00-2. Revenue from the theatrical release of motion pictures will berecognized at the time of exhibition based on our participation in box officereceipts.  If applicable, revenue fromthe sale of DVDs in the retail market, net of an allowance for estimatedreturns, will be recognized on the later of shipment to the customer or “streetdate” (when it is available for sale by the customer).  Furthermore, if applicable, under revenuesharing arrangements, rental revenue would be recognized when we would becomeentitled to receipts.  For contracts thatprovide for rights to

 

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exploita motion picture on multiple media (e.g. theatrical, video, television) with afee for a single motion picture where the contract specifies the permissibletiming of release to various media, the fee will be allocated to the variousmedia based on an assessment of the relative fair value of the rights toexploit each media and will be recognized as the movie is released to eachmedia.  For multiple-title contracts witha fee, the fee will be allocated on a title-by-title basis, based on anassessment of the relative fair value of each title.  If applicable, revenues from televisionlicensing are recognized when the motion picture becomes available to thelicensee for telecast.  Cash paymentsreceived are to be recorded as deferred revenue until all the conditions ofrevenue recognition have been met.  Ifapplicable, we will accrue for video returns and provide for allowances in thefinancial statements based on previous returns and our allowances history on atitle-by-title basis in each of the video businesses. In this case, there maybe differences between actual returns and allowances and our historicalexperience that we currently do not have.

 

Wewill depend on the distributors of any motion picture we produce to account forand accurately report our share of exhibition revenue.  While we expect to have certain audit rightsto verify exhibition revenues received by our North American distributors,

 

•                                          distributors are often in a position toaccount for revenues in a manner that understates or fails accurately toaccount for revenues or

 

•                                          distributors may fail to maintain appropriateaccounting records making it difficult to determine a producer’s actual shareof revenues upon audit.

 

Althoughwe do not have any experience related to auditing distributors’ revenueaccounting, we anticipate that the costs associated with this type of audit maybe substantial and may vary significantly from distributor-to-distributor andeven picture-to-picture.  Therefore,there is no assurance that, in all cases, we will be able to obtain an accurateaccounting of exhibition revenues or that audits will result in increases inthe revenues that justify the associated audit costs.

 

**Recent Accounting Pronouncements**

 

*SFAS 123(R)* – In December 2004, the Financial Accounting Standards Board(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R),*Share-Based Payment*.  SFAS 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*,and supersedes *Accounting Principles Board*(APB) Opinion No. 25, *Accounting forStock Issued to Employees*. SFAS 123(R) requires compensation costs related to share-based paymenttransactions to be recognized in the financial statements over the period thatan employee provides service in exchange for the award.  Public companies are required to adopt thenew standard using a modified prospective method and may elect to restate priorperiods using the modified retrospective method.  Under the modified prospective method,companies are required to record compensation cost for new and modified awardsover the related vesting period of such awards prospectively and recordcompensation cost prospectively for the unvested portion at time of adoption,of previously issued and outstanding awards over the remaining vesting periodof such awards.  No change to priorperiods presented is permitted under the modified prospective method.  Under the modified retrospective method,companies record compensation costs for prior periods retroactively throughrestatement of such periods using the exact pro forma amounts disclosed in thecompanies’ footnotes.  Also, in theperiod of adoption and after, companies record compesation cost based on themodified prospective method.  SFAS 123(R)is effective for periods beginning after December 15, 2005.  Early application is encouraged, but notrequired.

 

Wehave not yet determined the date or method of adoption.  If we were to adopt SFAS 123(R) on December 15,2005 using the modified prospective method, we estimate that there will be nostock-based compensation expense for the year ending December 31,2005.  If we elect to adopt SFAS 123(R)using the modified retrospective method, we are permitted to eitherretroactively restate only the 2005 interim periods or restate all priorperiods.  If we elect to restate priorperiods using the modified retrospective method, net loss for the year ended December 31,2004, would be restated and would increase by $63,574.  Net loss for the three months ended September 30,2005, would not be impacted.

 

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**Results of Operations**

 

Thefollowing table sets forth selected results of our operations for the threemonths and six months ended September 30, 2005 and 2004.  The following information was derived andtaken from our unaudited financial statements appearing elsewhere in thisreport.

 
| ** **                         | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                         | ** ** | **2005**                                           | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue                            |       | $                                                  | —     |                                              | $          | — |   | $ | 450,000 |   | $ | — |   |
| Operating  expenses:               |       |                                               |       |                                              |       |   |   |   |   |
| Amortization of film costs         |       | 10,500                                             |       | —                                            |       | 419,737 |   | — |   |
| Film participation costs           |       | —                                             |       | —                                            |       | 4,167 |   | — |   |
| Salaries and employee benefits     |       | 67,628                                             |       | 58,960                                            |       | 203,726 |   | 176,951 |   |
| Legal and professional fees        |       | 13,010                                             |       | 3,100                                             |       | 56,324 |   | 77,918 |   |
| Consulting and management fees     |       | 24,500                                             |       | 261                                               |       | 24,500 |   | 10,261 |   |
| Stock transfer and reporting costs |       | 2,349                                              |       | 2,762                                             |       | 6,724 |   | 5,777 |   |
| Film marketing                     |       | —                                             |       | 6,000                                             |       | — |   | 10,200 |   |
| Other                              |       | 11,315                                             |       | 8,843                                             |       | 27,491 |   | 28,221 |   |
| Total operating expenses           |       | 129,302                                            |       | 79,926                                            |       | 742,669 |   | 309,328 |   |
| Operating  loss                    |       | (129,302                                           | )          | (79,926                                           | )          | (292,669 | ) | (309,328 | ) |
| Other income  (expense):           |       |                                               |       |                                              |       |   |   |   |   |
| Interest and other income          |       | 3,450                                              |       | 2,551                                             |       | 8,241 |   | 13,926 |   |
| Interest expense                   |       | (39,306                                            | )          | —                                            |       | (39,306 | ) | — |   |
| Net other expense                  |       | (35,856                                            | )          | 2,551                                             |       | (31,065 | ) | 13,926 |   |
| Net loss  before income taxes      |       | (165,158                                           | )          | (77,375                                           | )          | (323,734 | ) | (295,402 | ) |
| Provision  for income taxes        |       | —                                             |       | —                                            |       | — |   | — |   |
| Net loss                           |       | $                                                  | (165,158   | )                                                 | $          | (77,375 | ) | $ | (323,734 | ) | $ | (295,402 | ) |

 

**Comparison of the Three-Month Periods Ended September 30,2005 and 2004**

 

Duringthe three months ended September 30, 2004, our operations had advanced tothe development and production of motion picture projects and we were in thefilming phase on our first motion picture project titled *Cloud 9*. During the three months ended September 30, 2004, we incurredsalary and benefits expense of $58,960 for our management and administrativeteam.  Legal and professional fees of$3,100 were incurred during the three months ended September 30, 2004 andwere attributable to legal and auditing services incurred in conjunction withour United States Securities and Exchange Commission registration andreporting.  We also incurred stocktransfer and reporting costs of $2,762. We incurred $6,000 in film marketing expenses relating the marketing of *Cloud 9*. Other expenses of $8,843 were incurred during the three months ended September 30,2004 and were primarily comprised of expenses associated with the day to dayoperations of our corporate office.

 

Duringthe three months ended September 30, 2005, the distributor of our firstmotion picture, *Cloud 9*, wasplanning and developing the marketing plan for *Cloud9*.  We anticipate that Cloud 9will be available for sale in domestic markets during the first quarter of2006.  We were in the post-productionphase on our second and third motion picture projects *The Hunt* and *Surveillance*.  We werein the pre-production phase of our fourth motion picture project titled *Soul’s Midnight*.  Our operational expenses were similar innature to those incurred in 2004.  Duringthe three months ended September 30, 2005, we incurred salary and benefitsexpense of $67,628, a $8,668 increase over 2004.

 

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Thisincrease is attributable to increased salaries for our President, ChiefFinancial Officer and production accountant. Legal and professional fees of $13,010 were incurred during the threemonths ended September 30, 2005 and were attributable to legal andauditing services incurred in conjunction with our United States Securities andExchange Commission registration and reporting. We utilized investment banking related consulting services in the amountof $24,500.  We also incurred stocktransfer and reporting costs of $2,349. As of June 30, 2005, we had two film projects in progress that wehad incurred $10,500 in costs that had been recorded as investment infilms.  During the third quarter,management made the determination that these projects were no longer viable andas a result, the $10,500 investment in films was written-off as amortization offilm costs.  Other expenses of $11,315were incurred during the three months ended September 30, 2005 and wereprimarily comprised of expenses associated with the day-to-day operations ofour corporate office.

 

**Comparison of the Nine-Month Periods Ended September 30,2005 and 2004**

 

Duringthe nine months ended September 30, 2004, our operations had advanced tothe development and production of motion picture projects and we were in thefilming phase on our first motion picture project titled *Cloud 9*. During the first nine months of 2004, we incurred salary and benefitsexpense of $176,951 for the management and administrative team put in placeduring 2004.  Legal and professional feesof $77,918 were incurred during the nine months ended September 30, 2004and were attributable to legal and auditing services incurred in conjunctionwith our public filings.  During the ninemonths ended September 30, 2004, we paid a $10,000 consulting fee forservices performed in relation to rewriting a script for a potential filmproject.  We incurred film marketingcosts of $10,200 relating to the marketing of *Cloud9*.  We also incurred stocktransfer and reporting costs of $5,777. Other expenses of $28,221 were incurred during the nine months ended September 30,2004 and were primarily comprised of expenses associated with the day to dayoperations of our corporate office.

 

Duringthe nine months ended September 30, 2005, we completed the negotiation oflicensing agreements for the foreign, domestic and broadcast rights of *Cloud 9*. We generated revenue of $450,000 in conjunction with the domesticlicensing of *Cloud 9*.  Based on our estimate of the total ultimaterevenue from *Cloud 9*, weamortized $409,237 of the film costs incurred on *Cloud 9*.  As of June 30,2005, we had two film projects in progress that we had incurred $10,500 incosts that had been recorded as investment in films.  During the third quarter, management made thedetermination that these projects were no longer viable and as a result, the$10,500 investment in films was written-off as amortization of film costs.  We were in the post-production phase of oursecond and third motion picture projects, *TheHunt* and *Surveillance*.  We were in the pre-production phase of ourfourth motion picture project, *Soul’sMidnight*.  Our operationalexpenses were similar in nature to those incurred in 2004.  During the nine months ended September 30,2005, we incurred salary and benefits expense of $203,726, a $26,775 increaseover 2004.  This increase is attributableto increased salaries for our President, Chief Financial Officer and productionaccountant.  Legal and professional feesof $56,324 were incurred during the nine months ended September 30, 2005and were attributable to legal and auditing services incurred in conjunctionwith our United States Securities and Exchange Commission registration andreporting.  We utilized investment bakingrelated consulting services in the amount of $24,500. We also incurred stocktransfer and reporting costs of $6,724. Other expenses of $27,491 were incurred during the nine months ended September 30,2005 and were primarily comprised of expenses associated with the day to dayoperations of our corporate office.

 

**Liquidity and Capital Resources**

 

InApril 2004, we completed our private placement offering of our commonstock shares and redeemable warrants in units of one common stock share and oneredeemable warrant. During 2003 and 2004, we received net proceeds of$2,535,224 from this private placement offering.  During June 2005, we received a $450,000non-refundable advance on the domestic revenues of Cloud 9.  The $450,000 was subsequently used to reduceour co-finance liability on *Cloud 9*from $500,000 to $50,000.  Based upon ourcash and cash equivalents at September 30, 2005 (that totaled $777,521),the anticipated revenue from our motion picture projects,*Cloud 9, The Hunt* and *Surveillance*, and the proceeds from thesell of profits interests in *The Hunt*and *Surveillance*,  we anticipate that our cash requirements willbe met for at least the next 12 months. In July 2005, we received $750,000 in proceeds from a convertiblenote payable.

 

8

----

 

AtSeptember 30, 2005, we had working capital of $690,081.  Operating activities for the nine monthsended September 30, 2005, used net cash of $406,412.  We used cash as the result of a net loss of$323,734, which was reduced by depreciation of $3,649, amortization of filmcosts of $419,737, the issuance of stock for consulting services in the amountof $14,500, a decrease in film deposits of $44,101 and an increase in accruedliabilities of $6,810.  Additionaloperating uses of cash included the costs we incurred in the production of ourmotion picture projects totaling $524,948 and a prepaid loan fee of$68,322.  During the first nine months of2004, our operating activities used net cash of $2,523,724 as the result of anet loss of $295,402 that was offset by depreciation of $3,650 and the issuanceof stock for legal services in the amount of $25,000.  Additional operating uses of cash during thenine months ended September 30, 2004, included the costs we incurred inthe production of our motion picture project, *Cloud9*, totaling $2,148,748 and decrease in accrued liabilities of$1,308.

 

Financingactivities during the nine months ended September 30, 2005, generated$300,000.  In June 2005, we used$450,000 for the repayment of film co-financing agreements and in July 2005,we received $750,000 from the issuance of a convertible note payable.  During the nine months ended September 30,2004, our financing activities generated $521,750 through the sale of stock of$21,750 and proceeds from film co-financing agreements of $500,000.

 

***Financial Commitments***

 

***FilmCapital, Inc. Agreement.**** *In March 2002, Messrs. Frederickson and Stansberry, membersof GrayMark Productions, L.L.C., entered into an agreement to pay FilmCapital, Inc.$50,000 for services performed.  Thisliability is only payable in the event GrayMark Productions, L.L.C. or itsaffiliates obtain funding for film projects from outside investors.  Messrs. Frederickson and Stansberry haveeach represented that their intent was not to cause GrayMark Productions,L.L.C. to be liable for this obligation and each has agreed to indemnify us forany liability that may arise out of this agreement.  In December 2003, we recorded aconsulting expense and liability of $50,000 related to the agreement withFilmCapital.  At the time that we paythis recorded liability, Messrs. Frederickson and Stansberry will berequired immediately to reimburse us for the payment.

 

***Registration Obligations.***** Weagreed, at our expense, to register the common stock shares and redeemablewarrants offered for sale pursuant to our private placement of 2,995,000 commonstock shares and redeemable warrants exercisable for the purchase of 2,995,000common stock shares under the 1933 Act and to maintain effectiveness of theregistration for a seven-year period ending on April 14, 2010.  Registration of the common stock shares andredeemable warrants became effective July 13, 2004.

 

Furthermore,we also similarly agreed to register (and maintain effective of theregistration under the 1933 Act for the seven-year period) the 443,250 commonstock shares underlying the placement agent warrants sold to the underwriter ofour private placement offering, Viewtrade Financial, and 383,425 common stockshares issued pursuant to the one-year Financial Advisor Agreement to ViewtradeFinancial.  In accordance with thisobligation, we initially included these common stock shares in the registrationstatement that registered the private placement common stock shares andredeemable warrants; however, on February 27, 2004, Viewtrade Financial,on its own behalf as well as the other holders of the placement agent warrantsand the recipients and holders of the common stock shares assigned toaffiliates of Viewtrade Financial, elected to remove those shares from theregistration statement.  These commonstock shares are currently subject to a one-year agreement that does not permitsale or transfer except under very limited circumstances.  Although we have been informed by our legalcounsel that the common stock shares other than those underlying the placementagent warrant may be sold without further restriction pursuant to Rule 144as promulgated by the Securities and Exchange Commission, we intend to file aregistration statement in accordance with this registration obligation duringthe last half of 2005.

 

***Office Space Arrangement*****.** Ourcorporate headquarters and offices are located at 101 North Robinson, Suite 920,Oklahoma City, Oklahoma.  These officefacilities consist approximately of 1,500 square feet and are occupied under anunwritten month-to-month lease arrangement, requiring monthly rental paymentsof $500.  The costs of building-out andimproving our offices was approximately $15,000 which we paid rather thanCorporate Tower, LLC, our landlord.  RoyT. Oliver, one of our greater than 5% shareholders and affiliates, controlsCorporate Tower, LLC.

 

9

----

 

Mr.Oliver on behalf of Corporate Tower, LLC has orally indicated that as of thedate of this report there is no intent to terminate our occupancy of the officefacilities.  Under Oklahoma law,termination of our month-to-month lease arrangement requires at least 30 daysprior written notice.  In the event ofthis termination, we believe there is adequate office space and facilitiesavailable in the Oklahoma City area.  Inthe event we are required to move from our current office facilities, the termsof occupancy, including the increased rental payments, will be substantiallydifferent than those under which our office space is currently occupied and theannual rental rate will probably be from $8 to $12 per square foot ($12,000 to$18,000 per year based upon 1,500 square feet of office facilities).

 

***12-Month Overhead Budget***

 

Ourbudgeted overhead expenses for the next 12 months are as follows:

 
| **Expenditure**                   | ** ** | **Monthly** | ** ** | **12  Months** | ** ** |
|-----------------------------------|------------|-------------|------------|----------------|------------|
| Administrative  expenditures:     |       |        |       |           |       |
| Executive officer compensation    |       | $           | 18,333     |           | $          | 220,000 |   |
| Administrative salaries           |       | 1,517       |       | 18,200         |       |
| Payroll taxes                     |       | 2,527       |       | 30,330         |       |
| Film marketing                    |       | 2,000       |       | 24,000         |       |
| Telephone                         |       | 700         |       | 8,400          |       |
| Rent                              |       | 500         |       | 6,000          |       |
| Legal                             |       | 2,917       |       | 35,000         |       |
| Accounting                        |       | 2,917       |       | 35,000         |       |
| Public relations                  |       | 417         |       | 5,000          |       |
| Travel                            |       | 4,167       |       | 50,000         |       |
| Health insurance                  |       | 1,020       |       | 12,240         |       |
| Automobile                        |       | 500         |       | 6,000          |       |
| Miscellaneous                     |       | 485         |       | 5,820          |       |
| Total Administrative Expenditures |       | $           | 38,000     |           | $          | 455,990 |   |

 

***Additional Financial Commitments***

 

Otherthan our commitments discussed above, we do not have any capitalcommitments.  Although we do not have anycommitments, we may enter into long-term lending arrangements during the next12 months to provide additional working capital and fund additional movieprojects we desire to undertake.  Inaddition, we may receive additional funds from the exercise of outstandingwarrants and stock options, the exercise of which is generally not within ourcontrol.

 

Ifour production activities are successful (of which there is no assurance) ormovie production budgets increase, we may be required to increase overhead byhiring additional employees and increase our office facilities.  We anticipate that during the next 12 monthswe will not be required to increase the number of our employees or increase ouroffice facilities.

 

Webelieve that our operations as a result of our motion picture projects, *Cloud 9, The Hunt* and *Surveillance*, will achieveprofitability.  We provide no assurancethat

 

•                                          we will be successful in implementing ourbusiness plan or

 

•                                          unanticipated expenses or problems ortechnical difficulties will not occur which would result in significant delays.

 

10

----

 

Anyone of these will adversely affect our ability to become profitable or tomaintain profitability.

 

**Cautionary Statement Relating to Forward Looking Information**

 

Wehave included some forward-looking statements in this section and otherplaces in this report regarding our expectations.  These forward-looking statements involveknown and unknown risks, uncertainties and other factors which may cause ouractual results, levels of activity, performance or achievements, or industryresults, to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by these forward-lookingstatements.  Some of these forward-lookingstatements can be identified by the use of forward-looking terminologyincluding “believes,” “expects,” “may,” “will,” “should” or “anticipates” orthe negative thereof or other variations thereon or comparable terminology, orby discussions of strategies that involve risks and uncertainties.  You should read statements that contain thesewords carefully because they:

 

•                                          discuss our future expectations;

 

•                                          contain projections of our future operatingresults or of our future financial condition; or

 

•                                          state other “forward-looking” information.

 

Webelieve it is important to discuss our expectations; however, it must be recognizedthat events may occur in the future over which we have no control and which weare not accurately able to predict. Readers are cautioned to consider the specific business risk factorsdescribed under the caption “Additional Factors that May Affect Our FutureResults” appearing under “Item 1. Description of Business” of our Annual Reporton Form 10-KSB filed with the United States Securities and ExchangeCommission on March 29, 2005, and not to place undue reliance on theforward-looking statements contained herein, which speak only as of the date ofthis report.  We undertake no obligationto publicly revise forward-looking statements to reflect events orcircumstances that may arise after the date of this report.

 

**Item3.  Controls and Procedures**

 

OurChief Executive Officer and Chief Financial Officer are responsible primarilyfor establishing and maintaining disclosure controls and procedures designed toensure that information required to be disclosed in our reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”) is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the U.S. Securities and ExchangeCommission.  These controls andprocedures are designed to ensure that information required to be disclosed inour reports filed or submitted under the Exchange Act is accumulated andcommunicated to our management, including our principal executive and principalfinancial officers, or persons performing similar functions, as appropriate toallow timely decisions regarding required disclosure.

 

Furthermore,our Chief Executive Officer and Chief Financial Officer are responsible for thedesign and supervision of our internal controls over financial reporting thatare then effected by and through our board of directors, management and otherpersonnel, to provide reasonable assurance regarding the reliability of ourfinancial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles.  These policies and procedures (i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that our receipts and expenditures are being madeonly in accordance with authorizations of our management and directors; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use or disposition of our assets that could have a material effecton our financial statements.

 

OurExecutive Officer and Chief Financial Officer, based upon their evaluation ofthe effectiveness of our disclosure controls and procedures and the internalcontrols over financial reporting as of the last day of the period covered bythis report, concluded that our disclosure controls and procedures and internalcontrols over financial

 

11

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reportingwere fully effective as of the last day of the period covered by this reportand reported to our auditors and board of directors that no change occurred inour disclosure controls and procedures and internal control over financialreporting occurred during the period covered by this report that wouldmaterially affect or is reasonably likely to materially affect our disclosure controlsand procedures or internal control over financial reporting.  In conducting their evaluation of ourdisclosure controls and procedures and internal controls over financialreporting, these executive officers did not discover any fraud that involved managementor other employees who have a significant role in our disclosure controls andprocedures and internal controls over financial reporting.  Furthermore, there were no significantchanges in our disclosure controls and procedures, internal controls overfinancial reporting, or other factors that could significantly affect ourdisclosure controls and procedures or internal controls over financialreporting subsequent to the date of their evaluation.  Because no significant deficiencies ormaterial weaknesses were discovered, no corrective actions were necessary ortaken to correct significant deficiencies and material weaknesses in ourinternal controls and disclosure controls and procedures.

 

**PART II OTHER INFORMATION**

 
| **Item 1.** | **Legal  Proceedings**                                          |
|-------------|-----------------------------------------------------------------|
|        |                                                            |
|        | None                                                            |
|        |                                                            |
| **Item 2.** | **Unregistered Sales of Equity Securities and Use of Proceeds** |
|        |                                                            |
| (a)         | None                                                            |
|        |                                                            |
| (b)         | None                                                            |
|        |                                                            |
| (c)         | None                                                            |
|        |                                                            |
| **Item 3.** | **Defaults Upon Senior Securities**                             |
|        |                                                            |
|        | None                                                            |
|        |                                                            |
| **Item 4.** | **Submission of Matters to a Vote of Security Holders**         |
|        |                                                            |
|        | None                                                            |
|        |                                                            |
| **Item 5.** | **Other  Information**                                          |
|        |                                                            |
|        | None                                                            |
|        |                                                            |
| **Item 6.** | **Exhibits**                                                    |

 
|   | **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                   |
|--------|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                 |       |                                                                                                                                                                                              |
|   | 3.1                  |       | Registrant’s  Certificate of Incorporation, incorporated by reference to Registration  Statement on Form SB-2 (No. 333-111819) filed with the Commission  on January 9, 2004. |
|   |                 |       |                                                                                                                                                                                              |
|   | 3.2                  |       | Registrant’s  Bylaws, incorporated by reference to Registration Statement on Form SB-2  (No. 333-111819) filed with the Commission on January 9, 2004.                        |

 

12

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|   | 31.1   |   | Certification  of John Simonelli, Chief Executive Officer of Registrant.                                                                                                                               |
|--------|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                   |
|   | 31.2   |   | Certification  of Mark R. Kidd, Chief Financial Officer and Controller of Registrant.                                                                                                                  |
|   |   |   |                                                                                                                                                                                                   |
|   | 32.1   |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of Sarbanes-Oxley Act of 2002 of John Simonelli, Chief  Executive Officer of Registrant.              |
|   |   |   |                                                                                                                                                                                                   |
|   | 32.2   |   | Certification  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of Sarbanes-Oxley Act of 2002 of Mark R. Kidd, Chief  Financial Officer and Controller of Registrant. |

 

**SIGNATURES**

 

Inaccordance with the Exchange Act, the Registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                          |   | GRAYMARK  PRODUCTIONS, INC. |
|-------------------------------|--------|-----------------------------|
|                          |   | (Registrant)                |
|                          |   |                        |
|                          |   | By:                         | /S/JOHN  SIMONELLI |   |
|                          |   |                        | John Simonelli |
|                          |   |                        | Chief Executive Officer |
| Date:  November 14, 2005 |   |                        |
|                          |   | By:                         | /S/MARK  R. KIDD |   |
|                          |   |                        | Mark R. Kidd |
|                          |   |                        | Chief Financial Officer and Controller |
| Date:  November 14, 2005 |   |                        |
|                               |        |                             |  |  |  |  |

 

13

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**GRAYMARK PRODUCTIONS, INC.**

 

**INDEX TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 
| Condensed  Consolidated Balance Sheets as of September 30, 2005 and  December 31, 2004                   |   |
|--------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                               |   |
| Condensed  Consolidated Statements of Operations for the  Three Months Ended September 30, 2005 and 2004      |   |
|                                                                                                               |   |
| Condensed  Consolidated Statements of Operations for the  Nine Months Ended September 30, 2005 and 2004       |   |
|                                                                                                               |   |
| Condensed  Consolidated Statements of Shareholders’ Equity for the  Nine Months Ended September 30, 2005 |   |
|                                                                                                               |   |
| Condensed  Consolidated Statements of Cash Flows for the  Nine Months Ended September 30, 2005 and 2004       |   |
|                                                                                                               |   |
| Notes to Condensed  Consolidated Financial Statements                                                              |   |

 

F-1

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

 
| ** **                                                                                                                                                                                      | ** ** | **September  30,  2005** | ** ** | **December  31,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------------|------------|
| ASSETS                                                                                                                                                                                          |       |                     |       |                    |       |
|                                                                                                                                                                                            |       |                     |       |                    |       |
| Cash and  cash equivalents                                                                                                                                                                      |       | $                        | 771,521    |                    | $          | 877,933 |   |
| Film  deposits                                                                                                                                                                                  |       | 4,500                    |       | 48,601                  |       |
| Total current assets                                                                                                                                                                            |       | 776,021                  |       | 926,534                 |       |
| Investment  in films                                                                                                                                                                            |       | 2,333,156                |       | 2,227,945               |       |
| Prepaid loan  fees                                                                                                                                                                              |       | 68,322                   |       | —                  |       |
| Fixed  assets, net                                                                                                                                                                              |       | 17,541                   |       | 21,190                  |       |
| Total assets                                                                                                                                                                                    |       | $                        | 3,195,040  |                    | $          | 3,175,669 |   |
|                                                                                                                                                                                            |       |                     |       |                    |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                       |       |                     |       |                    |       |
|                                                                                                                                                                                            |       |                     |       |                    |       |
| Liabilities:                                                                                                                                                                                    |       |                     |       |                    |       |
| Accounts payable and accrued liabilities                                                                                                                                                        |       | $                        | 85,940     |                    | $          | 79,130 |   |
| Total current liabilities                                                                                                                                                                       |       | 85,940                   |       | 79,130                  |       |
| Convertible note payable                                                                                                                                                                        |       | 527,019                  |       | —                  |       |
| Film obligations                                                                                                                                                                                |       | 50,000                   |       | 500,000                 |       |
| Total liabilities                                                                                                                                                                               |       | 662,959                  |       | 579,130                 |       |
|                                                                                                                                                                                            |       |                     |       |                    |       |
| Shareholders’  Equity:                                                                                                                                                                     |       |                     |       |                    |       |
| Preferred stock $0.0001 par value,  10,000,000 authorized; no shares issued and outstanding                                                                                                     |       | —                   |       | —                  |       |
| Common stock $0.0001 par value, 90,000,000  shares authorized; 8,268,425 issued and outstanding at September 30,  2005 (8,258,425 shares issued and outstanding at December 31, 2004) |       | 827                      |       | 826                     |       |
| Paid-in capital                                                                                                                                                                                 |       | 4,096,964                |       | 3,837,689               |       |
| Accumulated deficit                                                                                                                                                                             |       | (1,565,710               | )          | (1,241,976              | )          |
| Total shareholders’ equity                                                                                                                                                                 |       | 2,532,081                |       | 2,596,539               |       |
| Total liabilities and shareholders’ equity                                                                                                                                                 |       | $                        | 3,195,040  |                    | $          | 3,175,669 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-2

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements ofOperations**

**(Unaudited)**

 
| ** **                                             | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004**   | ** ** | ** ** | ** ** |
|                                                   |       |                                       |       |       |       |   |   |
| Revenues                                               |       | $                                          | —     |       | $          | — |   |   |   |
| Operating  expenses:                                   |       |                                       |       |       |       |   |   |
| Amortization of film costs                             |       | 10,500                                     |       | —     |       |   |   |
| Salaries and employee benefits                         |       | 67,628                                     |       | 58,960     |       |   |   |
| Consulting and management fees                         |       | 24,500                                     |       | 261        |       |   |   |
| Legal and professional fees                            |       | 13,010                                     |       | 3,100      |       |   |   |
| Stock transfer and reporting costs                     |       | 2,349                                      |       | 2,762      |       |   |   |
| Film marketing                                         |       | —                                     |       | 6,000      |       |   |   |
| Other                                                  |       | 11,315                                     |       | 8,843      |       |   |   |
| Total operating expenses                               |       | 129,302                                    |       | 79,926     |       |   |   |
| Operating  loss                                        |       | (129,302                                   | )          | (79,926    | )          |   |   |
|                                                   |       |                                       |       |       |       |   |   |
| Other Income  (Expense):                               |       |                                       |       |       |       |   |   |
| Interest and other income                              |       | 3,450                                      |       | 2,551      |       |   |   |
| Interest expense                                       |       | (39,306                                    | )          | —     |       |   |   |
| Net other income (expense)                             |       | (35,856                                    | )          | 2,551      |       |   |   |
| Net loss  before provision for income taxes            |       | (165,158                                   | )          | (77,375    | )          |   |   |
| Provision  for income taxes                            |       | —                                     |       | —     |       |   |   |
| Net loss                                               |       | $                                          | (165,158   | )          | $          | (77,375 | ) |   |   |
| Net loss per  share of common stock, basic and diluted |       | $                                          | (0.02      | )          | $          | (0.01 | )  | (0.01 | ) |
| Weighted  average number of common shares outstanding  |       | 8,265,092                                  |       | 8,241,758  |       |   |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-3

----

 
| ** **                                             | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|
| ** **                                             | ** ** | **2005**                                  | ** ** | **2004**   | ** ** | ** ** | ** ** |
|                                                   |       |                                      |       |       |       |   |   |
| Revenues                                               |       | $                                         | 450,000    |       | $          | — |   |   |   |
| Operating  expenses:                                   |       |                                      |       |       |       |   |   |
| Amortization of film costs                             |       | 419,737                                   |       | —     |       |   |   |
| Film participation costs                               |       | 4,167                                     |       | —     |       |   |   |
| Salaries and employee benefits                         |       | 203,726                                   |       | 176,951    |       |   |   |
| Legal and professional fees                            |       | 56,324                                    |       | 77,918     |       |   |   |
| Consulting and management fees                         |       | 24,500                                    |       | 10,261     |       |   |   |
| Stock transfer and reporting costs                     |       | 6,724                                     |       | 5,777      |       |   |   |
| Film marketing                                         |       | —                                    |       | 10,200     |       |   |   |
| Other                                                  |       | 27,491                                    |       | 28,221     |       |   |   |
| Total operating expenses                               |       | 742,669                                   |       | 309,328    |       |   |   |
| Operating  loss                                        |       | (292,669                                  | )          | (309,328   | )          |   |   |
| Other Income  (Expense):                               |       |                                      |       |       |       |   |   |
| Interest and other income                              |       | 8,241                                     |       | 13,926     |       |   |   |
| Interest expense                                       |       | (39,306                                   | )          | —     |       |   |   |
| Net other income (expense)                             |       | (31,065                                   | )          | 13,926     |       |   |   |
| Net loss  before provision for income taxes            |       | (323,734                                  | )          | (295,402   | )          |   |   |
| Provision  for income taxes                            |       | —                                    |       | —     |       |   |   |
| Net loss                                               |       | $                                         | (323,734   | )          | $          | (295,402 | ) |   |   |
| Net loss per  share of common stock, basic and diluted |       | $                                         | (0.04      | )          | $          | (0.04 | )  | (0.04 | ) |
| Weighted  average number of common shares outstanding  |       | 8,260,647                                 |       | 8,227,869  |       |   |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-4

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements ofShareholders’ Equity**

**(Unaudited)**

 
| ** **                                     | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** |
|------------------------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|
| ** **                                     | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Deficit** | ** ** |
|                                           |       |             |       |        |       |            |       |   |   |
| Balance,  December 31, 2004               |       | 8,258,425        |       | $           | 826        |            | $          | 3,837,689 |   | $ | (1,241,976 | ) |
|                                           |       |             |       |        |       |            |       |   |   |
| Issuance of stock for consulting services      |       | 10,000           |       | 1           |       | 14,499          |       | — |   |
| Warrants issued with convertible note  payable |       | —           |       | —      |       | 244,776         |       | — |   |
| Net loss                                       |       | —           |       | —      |       | —          |       | (323,734 | ) |
|                                           |       |             |       |        |       |            |       |   |   |
| Balance,  September 30, 2005              |       | 8,268,425        |       | $           | 827        |            | $          | 4,096,964 |   | $ | (1,565,710 | ) |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-5

----

 

**GRAYMARK PRODUCTIONS, INC.**

 

**CondensedConsolidated Statements of CashFlows**

**(Unaudited)**

 
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                         |       |                                      |       |   |   |
| Operating  activities:                                                       |       |                                      |       |   |   |
| Net loss                                                                     |       | $                                         | (323,734   | ) | $ | (295,402 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities: |       |                                      |       |   |   |
| Depreciation                                                                 |       | 3,649                                     |       | 3,650 |   |
| Amortization of film costs                                                   |       | 419,737                                   |       | — |   |
| Issuance of stock for consulting services                                    |       | 14,500                                    |       | — |   |
| Issuance of stock for legal services                                         |       | —                                    |       | 25,000 |   |
| Interest expense allocated to warrants                                       |       | 21,795                                    |       | — |   |
| Changes in assets and liabilities –                                     |       |                                      |       |   |   |
| Film deposits                                                                |       | 44,101                                    |       | (106,916 | ) |
| Investment in films                                                          |       | (524,948                                  | )          | (2,148,748 | ) |
| Prepaid loan fees                                                            |       | (68,322                                   | )          | — |   |
| Accrued liabilities                                                          |       | 6,810                                     |       | (1,308 | ) |
|                                                                         |       |                                      |       |   |   |
| Net cash used by operating activities                                        |       | (406,412                                  | )          | (2,523,724 | ) |
|                                                                         |       |                                      |       |   |   |
| Financing  activities:                                                       |       |                                      |       |   |   |
| Proceeds from convertible note payable                                       |       | 505,224                                   |       | — |   |
| Proceeds from warrants issued with  convertible note payable                 |       | 244,776                                   |       |   |   |
| Partial repayment of film co-financing  agreements                           |       | (450,000                                  | )          | — |   |
| Proceeds from film co-financing agreement                                    |       | —                                    |       | 500,000 |   |
| Sale of stock                                                                |       | —                                    |       | 21,750 |   |
|                                                                         |       |                                      |       |   |   |
| Net cash provided by financing activities                                    |       | 300,000                                   |       | 521,750 |   |
|                                                                         |       |                                      |       |   |   |
| Net change  in cash and cash equivalents                                     |       | (106,412                                  | )          | (2,001,974 | ) |
|                                                                         |       |                                      |       |   |   |
| Cash and  cash equivalents at beginning of period                            |       | 877,933                                   |       | 2,953,159 |   |
|                                                                         |       |                                      |       |   |   |
| Cash and  cash equivalents at end of period                                  |       | $                                         | 771,521    |   | $ | 951,185 |   |

 

See Accompanying Notes to Condensed Consolidated Financial Statements

 

F-6

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**GRAYMARK PRODUCTIONS, INC.**

 

**Notes to Condensed ConsolidatedFinancial Statements**

**(Unaudited)**

 

**For the Periods Ended September 30, 2005 and 2004**

 

Note1 – Nature of Business

 

GrayMarkProductions, Inc. (the “Company”) is organized in Oklahoma and anindependent producer and distributor of film entertainment content.  The Company began operations in 2001 asGrayMark Productions, L.L.C. (the “LLC”), all of the assets of which wereacquired by the Company through our incorporation-reorganization, effective August 18,2003.

 

TheCompany has completed the production of its first motion picture projecttitled, *Cloud 9,*completed thefilming of its second and third motion pictures titled, *The Hunt* and *Surveillance* and is in pre-production of its fourth motionpicture project titled, *Soul’s Midnight*.  The Company has negotiated agreements for themarketing and distribution of all four films. The Company intends to produce and distribute additional films that arecompleted and marketed using smaller budgets than those of major studios.  Management believes that producing and distributinglow- or modest-budget, commercially successful films will afford the Companyaccess to Hollywood talent and scripts and third-party production packages foracquisition, without compromising management’s approach to managing financialrisk.

 

Note2 – Summary of Significant Accounting Policies

 

*Interim Financial Information* – The unaudited condensed consolidatedfinancial statements have been prepared in accordance with generally acceptedaccounting principles for interim financial information, they do not includeall of the information and footnotes required by generally accepted accountingprinciples for complete financial statements.

 

Theaccompanying financial statements are unaudited, but include all adjustments(consisting only of normal recurring adjustments) which are, in the opinion ofmanagement, necessary for a fair presentation of the financial position at suchdates and of the operations and cash flows for the periods then ended.  Operating results for the periods ended September 30,2005 and 2004 are not necessarily indicative of results that may be expectedfor the entire year.

 

*Consolidation* – The accompanying consolidated financial statements include theaccounts of GrayMark Productions, Inc. and its majority owned andcontrolled subsidiaries.  The Companycontrols a subsidiary company through a combination of existing votinginterests and the ability to exercise various rights under certain shareholderor operating agreements.  The Company’ssubsidiaries include GrayMark Productions, L.L.C. (the “LLC”), Out of the BlueProductions, LLC (“Out of the Blue”), The Hunt, The Motion Picture LLC (“TheHunt”), Surveillance, The Motion Picture LLC (“Surveillance”) and Soul’sMidnight LLC (“Soul’s Midnight”).  TheLLC became a subsidiary of the Company in August 2003 as a result of theincorporation-reorganization of the Company. Out of the Blue, a variable interest entity, was formed in December 2003as the entity under which the Company’s first motion picture project, *Cloud 9*, was produced.  At September 30, 2005, the Company hasfunded $2,397,866 of the acquisition and production costs of *Cloud 9*. The Company is entitled to recover its capital contributions to Out ofthe Blue plus interest at 2% above the prime rate (defined as “investmentrecoupment”) from cash distributions before the other interest owners andthereafter 50% of cash distributions and is entitled to receive a majority ofthe proceeds from rights sales,

 

F-7

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distributionand any and all exploitation of the Picture. The Company has 100% voting control of Out of the Blue.  The Hunt, Surveillance and Soul’s Midnightare 100% owned by the Company.

 

*Use of estimates* – The preparation of financial statements in conformity with generallyaccepted accounting principles requires management of the Company to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from those estimates.

 

*Revenue recognition* – Revenues from the sale of the rights to a film are recognized whenthe feature film is available to the distributor for exploitation and noconditions for delivery exist, which under most sales contracts requires thatfull payment has been received from the distributor.  Revenues from the theatrical distribution ofmotion pictures are recognized when motion pictures are exhibited.  Revenues from video sales are recognized onthe date that video units are made widely available for sale by retailers.  Revenues from the licensing of motion picturefilms are recorded when the material is available for telecasting by thelicensee and when certain other conditions are met.  Revenues from consulting services arerecognized when earned.

 

*Investment in Films* – Investment in films includes capitalizable direct negative costs,production overhead, interest and development costs and are stated at the lowerof cost, less accumulated amortization, or fair value.  Film production and participation costs areexpensed based on the ratio of the current period’s gross revenues to estimatedremaining total gross revenues from all sources on an individual productionbasis.

 

Investmentin films is stated at the lower of amortized cost or estimated fair value on anindividual film basis.  The valuation ofinvestment in films is reviewed on a title-by-title basis, when an event orchange in circumstances indicate that the fair value of a film is less than itsunamortized cost.  The fair value of thefilm is determined using management’s future revenue and cost estimates and adiscounted cash flow approach. Additional amortization is recorded in the amount by which theunamortized costs exceed the estimated fair value of the film.  Estimates of future revenue involvemeasurement uncertainty and it is therefore possible that reductions in thecarrying value of investment in films may be required as a consequence ofchanges in management’s future revenue estimates.

 

*Recently Issued Accounting Standards* –

 

*SFAS 123(R)* – In December 2004, the Financial Accounting Standards Board(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123(R),*Share-Based Payment*.  SFAS 123(R) replaces SFAS No. 123, *Accounting for Stock-Based Compensation*,and supersedes *Accounting Principles Board*(APB) Opinion No. 25, *Accounting forStock Issued to Employees*. SFAS 123(R) requires compensation costs related to share-based paymenttransactions to be recognized in the financial statements over the period thatan employee provides service in exchange for the award.  Public companies are required to adopt thenew standard using a modified prospective method and may elect to restate priorperiods using the modified retrospective method.  Under the modified prospective method,companies are required to record compensation cost for new and modified awardsover the related vesting period of such awards prospectively and recordcompensation cost prospectively for the unvested portion at time of adoption,of previously issued and outstanding awards over the remaining vesting periodof such awards.  No change to priorperiods presented is permitted under the modified prospective method.  Under the modified retrospective method, companiesrecord compensation costs for prior periods retroactively through restatementof such periods using the exact pro forma amounts disclosed in the companies’footnotes.  Also, in the period ofadoption and after, companies record compesation cost based on the modifiedprospective method.  SFAS 123(R) iseffective for periods beginning after December 15, 2005.  Early application is encouraged, but notrequired.

 

TheCompany has not yet determined the date or method of adoption.  If the Company were to adopt SFAS 123(R) on December 15,2005 using the modified prospective method, the Company estimates that therewill be no stock-based compensation expense for the year ending December 31,2005.  If the Company elects to adoptSFAS 123(R) using the modified retrospective method, it is permitted to eitherretroactively

 

F-8

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restateonly the 2005 interim periods or restate all prior periods.  If the Company elects to restate priorperiods using the modified retrospective method, net loss for the year ended December 31,2004, would be restated and would increase by $63,574.  Net loss for the nine months ended September 30,2005, would not be impacted.

 

Note3 – Investment in Films

 
| ** **                                 | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                       |       |                         |       |                        |       |
| Released,  net of accumulated amortization |       | $                            | 2,010,647  |                        | $          | — |   |
| Completed  and not released                |       | 130,422                      |       | 2,217,945                   |       |
| In progress                                |       | 192,087                      |       | —                      |       |
| In  development                            |       | —                       |       | 10,000                      |       |
|                                       |       |                         |       |                        |       |
| Total                                      |       | $                            | 2,333,156  |                        | $          | 2,227,945 |   |

 

TheCompany estimates that 100% of the unamortized investment in films at September 30,2005 will be amortized within the next three years.  Approximately $1,293,000 of film costs areexpected to be amortized during the next twelve months.  None of the accrued participation liabilitiesincluded in accounts payable and accrued liabilities are expected to be paidduring the next twelve months.

 

Note4 – Convertible Note Payable

 

InAugust 2005, the Company issued a promissory note (the “Note”) in theprincipal amount of $750,000.  The Noteis secured by all assets of the Company including all purchase agreements andany options or rights to acquire, all intellectual and real property, allassets and properties of the Company and all of its existing and futuresubsidiaries.  The Note bears interest atthe rate of 8% per annum.  Interest dueon the note is payable quarterly and can be paid in cash or shares of Companystock.

 

TheNote will become due and payable on the first to occur of: (i) July 27,2007 (the “Maturity Date”); (ii) the consummation of a QualifiedFinancing; or (iii) the continuation of and Event of Default, as defined,for more than 30 days following notice of the occurrence of an Event ofDefault.  Upon consummation of aQualified Financing, the outstanding principal amount of the Note and allaccrued and unpaid interest (collectively the “Note Balance”) willautomatically convert into shares of equity securities of the Company equal to120% of the Note Balance divided by the price per share of the equitysecurities sold in the Qualified Financing. The maximum price or value of the equity securities into which the NoteBalance converts may not exceed the equivalent of $1.10 per common stockshare.  Qualified Financing refers to anyequity financing pursuant to which the Company receives aggregate gross cashproceeds of $2,000,000 or more on or before the Maturity Date.

 

Inconjunction with issuance of the Note, the Company and the holder of the Noteentered into two common stock purchase warrant agreements, each evidencingwarrants exercisable on or before August 5, 2010.  One agreement provides for the purchase of250,000 common stock shares at $2.00 and the other agreement provides for thepurchase of 250,000 common stock shares at $3.00.

 

Thefair value of each warrant issued was estimated on the date of issuance usingthe Black-Scholes option pricing model with the following assumptions used:weighted average risk free interest rate of 4.0%; no dividend yield; volatilityof 78%; and expected life less than five years. The fair value of the options were based on the difference between the presentvalue of the exercise price of the option and the estimated fair

 

F-9

----

 

valueprice of the common share.  The fairvalue of the warrants was estimated to be $244,776 and was recorded as paid-incapital.  The value of the warrants willincrease interest expense over the life of the Note.

 

Inaddition, the Company’s financial advisor was paid a fee of $75,000 forservices rendered in conjunction with execution of the Note.  The fee was recorded as a prepaid loan feeand will be amortized over the life of the Note.

 

Note5 – Film Obligations

 

DuringMay 2004, the Company obtained $500,000 of funding under co-financeagreements for its motion picture project, *Cloud9*.  The terms of theco-financing provide for the investors to recoup their contribution from thefirst proceeds of *Cloud 9*.  After all *Cloud9* costs are recouped by the Company, the investors are entitled to aprofit participation in the Company’s profit from *Cloud 9*.  As a group,the investors are entitled to 20% of the net profits paid to the Company, butthe investors do not have any ownership rights in the film.  The $500,000 received under the co-financingagreements represents 21% of the anticipated total cost of *Cloud 9*. During June 2005, $450,000 was repaid to investors from the firstproceeds from *Cloud 9*.  The funding under the co-financing agreementscame from related parties to the Company as described below:

 
| **Source  of Funding**                                             | ** ** | **Original  Amount** | ** ** | **Remaining  Balance** | ** ** |
|--------------------------------------------------------------------|------------|----------------------|------------|------------------------|------------|
|                                                               |       |                 |       |                   |       |
| Greater than  5% shareholder                                       |       | $                    | 250,000    |                   | $          | — |   |
| Company’s  chairman and chief executive officer               |       | 100,000              |       | 50,000                 |       |
| A company  50% owned by the Company’s chief financial officer |       | 100,000              |       | —                 |       |
| Company  shareholder                                               |       | 50,000               |       | —                 |       |
|                                                               |       |                 |       |                   |       |
| Total                                                              |       | $                    | 500,000    |                   | $          | 50,000 |   |

 

Note6 – Film Profit Participation and Contingent Compensation

 

Pursuantto an investor agreement between the Company and the developers of thescreenplay for *Cloud 9*(the “Picture”),the Company shares the development and productions costs and revenue of *Cloud 9*. For its financial contribution to the costs of making *Cloud 9*, the Company is entitled toreceive the following:

 

•                                          100% of revenue and proceeds from the rightssales, distribution and/or any and all exploitation of *Cloud 9* until the Company recovers itsinvestment in the Picture, plus interest at the prime rate plus 2% per annumfrom the date of the contribution until the Company is repaid its investment inthe Picture.

 

•                                          50% of “net profits” received from the rightssales, distribution and/or any and all exploitation of the Picture.  “Net Profits” is defined as the sum remainingafter deduction of third party distribution fees; cash deferments to cast,equipment suppliers, rights holders or any other approved party.

 

TheCompany’s subsidiary, Out of the Blue Productions, LLC (the “Production Company”),entered into contingent compensation agreements with the director and certaincast members of *Cloud 9* in theform of “net and gross profit participations” that are customary in the filmindustry.  These participations aretypically based on the profit of a film after all production and distributioncosts have been recouped (“gross participation”) or all production anddistribution costs and overhead have been recouped (“net participations”).  A percentage of these “gross and net profits”,as negotiated between the participants, are paid out as contingent compensationfor creative participants in a motion picture film.  The participations negotiated by theProduction Company for *Cloud 9*total 23.5% of which the Company’s interest in *Cloud9* is burdened by one-half of these net profit participations.  The Company’s residual profits interest in *Cloud 9* is 30.6% after giving effect tothe gross and net profits participations given pursuant to contingent compensationarrangements and

 

F-10

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theco-finance agreements (see Note 5 – Film Obligations).

 

TheProduction Company also agreed to pay additional contingent bonuses to certaincast members when aggregate United States and Canada box office receipts asreported in Daily Variety reach various levels between $8,500,000 and$20,000,000.  The total contingentamounts that would be paid if box office receipts reach $20,000,000 is$300,000.

 

InJuly 2005, the Company entered into agreements for the domesticdistribution of its motion picture projects titled *The Hunt* and *Surveillance*.  The agreement grants the licensee adistribution fee equal to 25% of gross receipts and allows for the recoupmentof all manufacturing, distribution and marketing costs.  In addition, the Company sold 35% and 50% ofthe copyright interests in *The Hunt*and *Surveillance*, respectively,for amounts equal to 50% of the budgets for *TheHunt* and *Surveillance*.  The Company’s subsidiaries, The Hunt andSurveillance entered into contingent compensation agreements with the director,casting company and others in the form of “net profit participations”.  The net participations negotiated for TheHunt and Surveillance total 7% and 8%, respectively.

 

Note7 – Capital Structure

 

InAugust 2005, the Company issued 10,000 shares of stock for consultingservices to be performed over a 12 month period.  Due to the nature of the consulting servicesbeing performed, the Company was not able to establish verifiable outputmeasures of the actual services to be performed over the life of theagreement.  Accordingly, the Companyincreased paid-in capital and consulting fees for the period ended September 30,2005, by the market value of the shares issued, $14,500.

 

InSeptember 2004, the Company issued 25,000 shares of stock to the Company’slegal counsel for services rendered and fully performed.  The shares were valued at the fair value ofthe services received of $25,000.

 

Note8 – Stock Options and Warrants

 

Informationwith respect to stock options and warrants outstanding follows:

 
| ** **                              | ** ** | **Shares** | ** ** | **Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------|------------|
|                                    |       |       |       |                         |       |
| Outstanding  at December 31, 2003  |       | 3,498,250  |       | $                            | 1.86       |   |
| Granted at market value                 |       | 165,000    |       | 1.24                         |       |
| Exercised                               |       | —     |       | —                       |       |
| Forfeited                               |       | —     |       | —                       |       |
| Outstanding  at December 31, 2004  |       | 3,663,250  |       | 1.84                         |       |
| Granted at market value                 |       | 500,000    |       | 2.50                         |       |
| Exercised                               |       | —     |       | —                       |       |
| Forfeited                               |       | —     |       | —                       |       |
| Outstanding  at September 30, 2005 |       | 4,163,250  |       | $                            | 1.92       |   |

 

F-11

----

 
| ** **        | ** ** | **Options and Warrants Outstanding** | ** ** | **Options and Warrants  Exercisable** | ** ** |
|-------------------|------------|--------------------------------------|------------|---------------------------------------|------------|
| ** **        | ** ** | **Shares  Outstanding  at 9/30/05**  | ** ** | **Average  Remaining  Life  (Years)** | ** ** | **Average  Exercise  Price** | ** ** | **Shares  Outstanding  at 9/30/05** | ** ** | **Average  Exercise  Price** | ** ** |
|              |       |                                 |       |                                  |       |   |   |   |   |   |   |
| $1.01 to $2.00    |       | 3,913,250                            |       | 3.2                                   |       | $ | 1.85 |   | 3,913,250 |   | $ | 1.85 |   |
| $2.01 to $3.00    |       | 250,000                              |       | 4.8                                   |       | $ | 3.00 |   | 250,000 |   | $ | 3.00 |   |
|              |       |                                 |       |                                  |       |   |   |   |   |   |   |
| Total outstanding |       | 4,163,250                            |       | 3.3                                   |       | $ | 1.92 |   | 4,163,250 |   | $ | 1.92 |   |

 

Note9 – Subsequent Events

 

InOctober 2005, the Company issued 10,726 shares of common stock to payaccrued interest due, as of September 30, 2005, under the Company’sconvertible note payable.

 

InOctober 2005, the Company issued a second promissory note (the “Note”) inthe principal amount of $750,000.  TheNote is secured by all assets of the Company including all purchase agreementsand any options or rights to acquire, all intellectual and real property, allassets and properties of the Company and all of its existing and futuresubsidiaries.  The Note bears interest atthe rate of 8% per annum.

 

TheNote will become due and payable on the first to occur of: (i) October 25,2007 (the “Maturity Date”); (ii) the consummation of a QualifiedFinancing; or (iii) the continuation of and Event of Default, as defined,for more than 30 days following notice of the occurrence of an Event ofDefault.  Upon consummation of aQualified Financing, the outstanding principal amount of the Note and allaccrued and unpaid interest (collectively the “Note Balance”) willautomatically convert into shares of equity securities of the Company equal to120% of the Note Balance divided by the price per share of the equitysecurities sold in the Qualified Financing. The maximum price or value of the equity securities into which the NoteBalance converts may not exceed the equivalent of $1.10 per common stockshare.  Qualified Financing refers to anyequity financing pursuant to which the Company receives aggregate gross cashproceeds of $2,000,000 or more on or before the Maturity Date.

 

Inconjunction with issuance of the Note, the Company and the holder of the Noteentered into two common stock purchase warrant agreements, each evidencingwarrants exercisable on or before October 25, 2010.  One agreement provides for the purchase of250,000 common stock shares at $2.00 and the other agreement provides for thepurchase of 250,000 common stock shares at $3.00.  In addition, the Company’s financial advisorwas paid a fee of $75,000 for services rendered in conjunction with executionof the Note which will be amortized over the term of the Note.

 

F-12

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