** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-K/A**

 
| **ý**                                        | **ANNUAL  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
|---------------------------------------------------|-----------------------------------------------------------------------------------------|
|                                              |                                                                                    |
| **For the fiscal year ended September 30,  2002** |
|                                              |                                                                                    |
| **o**                                             | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission file number 001-15789**

 

**STRATUS SERVICES GROUP, INC.**

(Exactname of Registrant as specified in its charter)

 

| **Delaware**                                                                                         |   | **22-3499261**                       |
|------------------------------------------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                      |   | (I.R.S. Employer Identification No.) |
|                                                                                                 |   |                                 |
| **500 Craig Road, Suite 201, Manalapan, New  Jersey  07726**                                    |
| (Address of  principal executive offices)                                                            |
|                                                                                                 |   |                                 |
| **(732) 866-0300**                                                                                   |
| (Registrant’s  telephone number, including area code)                                           |
|                                                                                                 |   |                                 |
| Securities registered under Section 12(b)  of the Exchange Act:**   Not  Applicable** |
|                                                                                                 |   |                                 |
| Securities registered under Section 12(g)  of the Exchange Act:                                      |
| **Common Stock, $.01 par value**                                                                     |
| (Title of class)                                                                                     |

 

Indicate by check mark whether the registrant has (1) filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark if disclosure ofdelinquent filers in response to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K. o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes o  No ý

 

The aggregate market value of the voting and non-voting common equityheld by non-affiliates, computed by reference to the last sale price of suchstock as reported by the OTC Bulletin Board, as of the last business day of theRegistrant’s most recently completed second fiscal quarter, was $4,526,767,based upon 6,117,253 shares held by non-affiliates.

 

The number of shares of Common Stock, $.01 par value, outstanding as ofDecember 17, 2002 was 16,289,161.

 

 

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**This Annual Report on Form 10-Kcontains “forward-looking statements” within the meaning of Section 27A of the SecuritiesAct of 1933, as amended and Section 21E of the Securities Exchange Act of 1934,as amended.  These statements relate tofuture economic performance, plans and objectives of management for futureoperations and projections of revenue and other financial items that are basedon the beliefs of our management, as well as assumptions made by, andinformation currently available to, our management.  The words “expect”, “estimate”, “anticipate”, “believe”, “intend”,and similar expressions are intended to identify forward-lookingstatements.  Such statements involveassumptions, uncertainties and risks. If one or more of these risks or uncertainties materialize or underlyingassumptions prove incorrect, actual outcomes may vary materially from those anticipated,estimated or expected.  Among the keyfactors that may have a direct bearing on our expected operating results,performance or financial condition are economic conditions facing the staffingindustry generally; uncertainties related to the job market and our ability toattract qualified candidates; uncertainties associated with our brief operatinghistory; our ability to raise additional capital; our ability to achieve andmanage growth; our ability to successfully identify suitable acquisition candidates,complete acquisitions or integrate the acquired business into our operations;our ability to attract and retain qualified personnel; our ability to developnew services; our ability to cross-sell our services to existing clients; ourability to enhance and expand existing offices; our ability to open newoffices; general economic conditions; our ability to continue to maintainworkers’ compensation, general liability and other insurance coverages; thecontinued cooperation of our creditors; and other factors discussed in Item 1of this Annual Report under the caption “Factors Affecting Future OperatingResults” and from time to time in our filings with the Securities and ExchangeCommission.  These factors are notintended to represent a complete list of all risks and uncertainties inherentin our business.  The followingdiscussion and analysis should be read in conjunction with the FinancialStatements and notes appearing elsewhere in this Annual Report.**

 

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**FORM 10-K**

 

**STRATUS SERVICES GROUP, INC.**

**Form 10-K for the Fiscal Year Ended September 30, 2002**

 

**Table of Contents**

 
| **PART I**                         |                                                                                                                    |
|------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
| ITEM 1.                            | BUSINESS                                                                                                                |
| ITEM 2.                            | PROPERTIES                                                                                                              |
| ITEM 3.                            | LEGAL PROCEEDINGS                                                                                                       |
| ITEM 4.                            | SUBMISSION OF MATTERS TO A VOTE  OF SECURITY HOLDERS                                                                    |
|                               |                                                                                                                    |
| **PART II**                        |                                                                                                                    |
| **ITEM 5.**                        | **MARKET FOR COMMON EQUITY AND  RELATED STOCKHOLDER MATTERS**                                                           |
| **ITEM 6.**                        | **SELECTED FINANCIAL DATA**                                                                                             |
| **ITEM 7.**                        | **MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                         |
| **ITEM 7A.**                       | **QUANTITATIVE AND  QUALITATIVE DISCLOSURE ABOUT MARKET RISK**                                                          |
| **ITEM 8.**                        | **FINANCIAL STATEMENTS AND  SUPPLEMENTARY DATA**                                                                        |
| **ITEM 9.**                        | **CHANGES IN AND DISAGREEMENT WITH  ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**                                |
|                               |                                                                                                                    |
| **PART III**                       |                                                                                                                    |
| **ITEM 10.**                       | **DIRECTORS, EXECUTIVE OFFICERS,  PROMOTERS AND CONTROL PERSONS;  COMPLIANCE WITH SECTIONS 16(c) OF THE EXCHANGE ACT.** |
| **ITEM 11.**                       | **EXECUTIVE COMPENSATION**                                                                                              |
| **ITEM 12.**                       | **SECURITIES OWNERSHIP OF CERTAIN  BENEFICIAL OWNERS AND MANAGEMENT**                                                   |
| **ITEM 13.**                       | **CERTAIN RELATIONSHIPS AND  RELATED TRANSACTIONS**                                                                     |
| **ITEM 14.**                       | **CONTROLS AND PROCEDURES**                                                                                             |
|                               |                                                                                                                    |
| **PART IV**                        |                                                                                                                    |
| **ITEM 15.**                       | **EXHIBITS, FINANCIAL STATEMENT  SCHEDULES AND REPORTS ON FORM 8-K**                                                    |
|                               |                                                                                                                    |
| **INDEX TO FINANCIAL  STATEMENTS** |

 

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**PART I**

 

###### **ITEM 1.**          BUSINESS

 

***General***

 

We are a national businessservices company engaged in providing outsourced labor and operationalresources on a long-term, contractual basis. We were incorporated in Delaware in March 1997 and began operations inAugust 1997 with the purchase of certain assets of Royalpar Industries, Inc.and its subsidiaries.  This purchaseprovided us with a foundation to become a national provider of comprehensivestaffing services.  We believe that asbusinesses increasingly outsource a wider range of human resource functions inorder to focus on their core operations, they will require more sophisticatedand diverse services from their staffing providers.

 

We offer different groups ofstaffing services comprised of Staffing Services, SMARTSolutionsTM andInformation Technology Services.  OurStaffing Services offering provides temporary workers for short-term needs,extended-term temporary employees, temporary-to-permanent placements,recruiting, permanent placements, payroll processing, on-site supervising andhuman resource consulting. Our SMARTSolutionsTM technology, available throughour Staffing Services branch offices, provides a comprehensive, customizedstaffing program designed to reduce labor and management costs and increaseworkforce efficiency.  StratusTechnology Services (“STS”) provides information technology (“IT”) staffingsolutions to Fortune 1000, middle market and emerging companies.  STS offers expertise in a wide variety oftechnology practices and disciplines ranging from networking professionals tointernet development specialists and application programmers.  All service groups seek to act as businesspartners to our clients rather than merely a vendor.  In doing so, they seek to systematically enhance clientproductivity and positively impact our and our clients’ financial results.  We are headquartered at 500 Craig Road,Suite 201, Manalapan, New Jersey 07726 and our telephone number is (800)777-1557.

 

Between September 1997 and December2002, we completed ten acquisitions of staffing businesses, representing thirtyoffices in seven states.  As of December17, 2002 we were providing services from forty locations in nine states.  We also maintain a presence on the Internetwith our website at www.stratusservices.com, an informational site designed togive prospective customers and employees additional information regarding ouroperations.

 

***Material Recent Events***

 

EffectiveDecember 1, 2002 (the “Effective Date”), we purchased substantially all of thetangible and intangible assets, excluding accounts receivable, of six officesof Elite Personnel Services, Inc. (“Elite”). We also took over Elite’s Downey, California office, from which Eliteserviced no accounts, but which it utilized as a corporate office.  We will continue to utilize the Downeyoffice as a regional corporate facility. Detailed information regarding this transaction is set forth in Part II– Item 7 of this Report under the caption “Results of Operations – DiscontinuedOperations/Acquisitions or Disposition of Assets.”

 

OnNovember 22, 2002, we received notification from the Nasdaq Listing and HearingReview Council (“Review Council”), that it was affirming the Nasdaq ListingQualifications Panel’s decision to delist our securities from the Nasdaq StockMarket.  However, the Review Councilalso noted that, pursuant to Nasdaq Marketplace Rule 4850 (a), the NASD Boardof Governors may call this decision for review in connection with an upcomingBoard meeting.  We will be provided withwritten notice if the Review Council decision represents the final action ofthe NASD following that meeting.

 

***Principal Services & Markets***

 

Our business operations are classified as onesegment of different types of staffing services that consists of StaffingServices, SMARTSolutionsTM and Information Technology Services serviceofferings, each service

 

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offering having a particularspecialty niche within our broad array of targeted markets for all our staffingservices.

 

###### **Staffing Services** includes both personnel placement and employer services such aspayrolling, outsourcing, on-site management and administrative services.  Payrolling typically involves the placementof individuals identified by a customer as short-term seasonal or special useworkers to our payroll for a designated period.  Outsourcing represents a growing trend among businesses tocontract with third parties to provide a particular function or businessdepartment for an agreed price over a designated period.  On-site services involve the placement of aCompany employee at the customer’s place of business to manage all of thecustomer’s temporary staffing requirements. Administrative services include skills testing, drug testing and riskmanagement services.  Skills testingavailable to the Company’s customers include cognitive, personality andpsychological evaluation and drug testing that is confirmed through anindependent, certified laboratory.

 

###### **Staffing Services can also be separated into assignmenttypes into supplemental staffing, long-term staffing and project staffing.  Supplemental staffing provides workers tomeet variability in employee cycles, and assignments typically range from daysto months.  Long-term staffing providesemployees for assignments that typically last three to six months but cansometimes last for years.  Projectstaffing provides companies with workers for a time specific project and mayinclude providing management, training and benefits.**

 

Staffingservices are marketed through our on-site sales professionals throughout ournationwide network of offices. Generally, new customers are obtained through customer referrals,telemarketing, advertising and participating in numerous community and trade organizations.

 

**SMARTSolutionsTM .  **SMARTSolutionsTMis a customized staffing program provided through our staffing services officesdesigned to reduce labor and management costs and increase workplaceefficiency.  While we assist the clientin attempting to reach certain targets and milestones, our billings do notdepend on the success or failure of the client achieving or not achieving suchmilestones.

 

While SMARTSolutionsTM is designed to be most effective inmanufacturing, distribution and telemarketing operations, it is marketed to allcompanies that have at least 50 people dedicated to specific work functionsthat involve repetitive tasks measurable through worker output and couldbenefit from proactive workforce management. Since SMARTSolutionsTM is a more sophisticated offering of ourtraditional staffing services, we have developed a national marketing teamdedicated strictly to marketing these programs.  However, the team utilizes our Staffing Services branch staff toidentify companies within their geographic regions that could potentiallybenefit from a SMARTSolutionsTM program. Once identified, the team assumes full responsibility for the salesprocess.  A significant portion of ourSMARTSolutionsTM clients have been obtained through this process or from “wordof mouth” recommendations from current SMARTSolutionsTM customers.

 

**StratusTechnology Services, LLC. **We provide Information Technology (“IT”)services throughout our branch network through our affiliate, StratusTechnology Services, LLC (“STS”).  STSwas formed in November 2000 as a 50/50 joint venture between us and FusionBusiness Services, LLC, a New Jersey based technology project management firm,to consolidate and manage the****company-wide technology services businessinto a single entity focused on establishing market share in the IT market forstaffing services.  See “Part III-Item13 Certain Relationships and Related Party Transactions”, STS markets itsservices to client companies seeking staff for project staffing, systemmaintenance, upgrades, conversions, installations, relocations, etc.  STS provides broad-based professionals insuch disciplines as finance, pharmaceuticals, manufacturing and media andinclude such job specifications as Desktop Support Administrators, ServerEngineers, Programmers, Mainframe IS Programmers, System Analysts, SoftwareEngineers and Programmer Analysts.  Inaddition, STS, through its roster of professionals, can initiate and manageturnkey IT projects and provide outsourced IT support on a twenty-four hour,seven day per week basis.

 

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##### ***Business Strategy***

##### ** **

Our objective is to become a leading provider ofstaffing services throughout the United States.  Key elements of our business strategy include:

 

FOCUS ON SALES WITHIN THE CLERICAL, LIGHT INDUSTRIAL AND LIGHTTECHNICAL SECTOR.  We focus on placingsupport personnel in markets for clerical, light industrial and light technicaltemporary staffing.  We believe thatthese services are the foundation of the temporary staffing industry, willremain so for the foreseeable future and best leverages our assets andexpertise.  We also believe thatemployees performing these functions are, and will remain, an integral part ofthe labor market in local, regional and national economies around theworld.  We believe that we arewell-positioned to capitalize on these business segments because of our abilityto attract and retain qualified personnel and our knowledge of the staffingneeds of customers.

 

ENHANCE RECRUITING OF QUALIFIED PERSONNEL.  We believe that a key component of our success is our ability torecruit and maintain a pool of qualified personnel and regularly place theminto desirable positions.  We usecomprehensive methods to assess, select and, when appropriate, train our temporaryemployees in order to maintain a pool of qualified personnel to satisfy ongoingcustomer demand.  We offer our temporaryemployees comprehensive benefit, retention and recognition packages, includingbonuses, vacation pay, holiday pay and opportunities to participate in ourcontributory 401(K) plan.

 

EMPHASIZE BUSINESS CORRIDORS. Our strategy is to capitalize on our presence along the I-95 businesscorridor from New York to Delaware, to grow our presence in the California WestCoast markets, and to build market share by targeting small to mid-sizedcustomers, including divisions of Fortune 500 companies.  We believe that in many cases, such marketsare less competitive and less costly in which to operate than the more centralareas of metropolitan markets, where a large number of staffing servicescompanies frequently compete for business and occupancy costs are relativelyhigh.  In addition, we believe thatbusiness corridor markets are more likely to provide the opportunity to sellrecurring business that is characterized by relatively higher grossmargins.  We focus on this type ofbusiness while also selectively servicing strategic national and regionalcontracts.

 

MAINTAIN ENTREPRENEURIAL AND DECENTRALIZED OFFICES WITH STRONGCORPORATE SUPPORT.  We seek to foster anentrepreneurial environment by operating each office as a separate profitcenter, by giving managers and staff considerable operational autonomy andfinancial incentives.  We have designedprograms to encourage a “team” approach in all aspects of sales and recruiting,to improve productivity and to maximize profits.  We believe that this structure allows us to recruit and retainhighly motivated managers who have demonstrated the ability to succeed in acompetitive environment.  This structurealso allows managers and staff to focus on branch operations while relying oncorporate headquarters for support in back-office operations, such as riskmanagement programs and unemployment insurance, credit, collections, advice onlegal and regulatory matters, quality standards and marketing.

 

ENHANCE INFORMATION SYSTEMS.  Webelieve our management information systems are instrumental to the success ofour operations.  Our business depends onour ability to store, retrieve, process and manage significant amounts ofdata.  We continually evaluate thequality, functionality and performance of our systems in an effort to ensurethat these systems meet our operation needs. During fiscal 2001, we completed the implementation and rollout of theKeynote Staffing Business Software System. This AS/400 based system comes complete with a rich automated skillsearch capability, quality and performance measurement reporting capabilitiesand user friendly, proactive tools that we believe will improve the level ofservice our branch offices are capable of delivering.

 

In addition, we have fully upgraded both our hardware and software atour corporate headquarters.  Our AS/400based system is capable of sustaining the user demand with the exponentialgrowth that we are currently experiencing for the next 2-3 years.  We are currently implementing a nationwidearea network based upon a reliable, secure, inexpensive, and high performanceFrame Relay network that has integrated all of our offices onto one internalnetwork linked through our servers at corporate.  Once fully completed, all of our branches

 

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will share a common server forcritical operating data utilized with the Keynote and other back officesoftware systems, as well as having access to other less critical but, missionessential applications, i.e., real-time e-mail and internet access.

 

We believe that our investments in information technology will increaseour management’s ability to store, retrieve, process and manageinformation.  As a result, we believe wewill be able to improve service to our customers and employees by reducingerrors and speeding the resolution of inquiries, while more efficientlyallocating resources devoted to developing and maintaining the Company’sinformation technology infrastructure.

 

CONTROL COSTS THROUGH EMPHASIS ON RISK MANAGEMENT.  Workers’ compensation and unemploymentinsurance premiums are significant expenses in the temporary staffingindustry.  Workers’ compensation costsare particularly high in the light industrial sector.  Furthermore, there can be significant volatility in thesecosts.  We have a dedicated riskmanagement department that has developed risk management programs and losscontrol strategies that we believe will improve management’s ability to controlthese employee-related costs through pre-employment safety training, safetyassessment and precautions in the workplace, post-accident procedures andreturn to work programs.  We believethat its emphasis on controlling employee-related costs enables branch officemanagers to price services more competitively and improve profitability.

 

##### ***Growth Strategy***

 

Our current growth strategy focuses evenly on acombination of internal growth and strategic external and complementaryacquisitions.

 

INTERNAL GROWTH.  Asignificant element of our growth strategy has been, and continues to be, ourfocus on internal growth.  Our internalgrowth strategy consists of the following:

 

•      IncreaseSales and Profitability at Existing Offices.  We believe that a substantialopportunity exists to increase sales of services and profitability in existingoffices.  We have incentive compensationplans to encourage branch office managers and staff to increase productivityand profits at the branch level while maintaining accountability for costs andcollections of accounts receivable.  Inaddition, we have maintained our corporate-level branch management function toestablish and monitor branch office performance targets and develop programs tosupport branch operations.

 

•      ExpandSMARTSolutionsTM and Vendor-on-Premise Programs.  Wehave taken advantage of industry trends by continuing to promote ourSMARTSolutionsTM program and “vendor-on-premises” programs.  As of December 17, 2002, we had fourSMARTSolutionsTM sites and vendor-on-premises programs.  Under these programs, we assumeadministrative responsibility for coordinating all essential staffing servicesthroughout a customer’s location, including skills testing and training.

 

•      PursueExpansion by Establishment of New Offices.  We seek to open new officesprimarily in existing markets to benefit from common area management,cross-marketing opportunities and leveraging of administrative expenses.  Our corporate and operating management jointlydevelop expansion plans for new offices based upon various criteria, includingmarket demand, availability of qualified personnel, the regulatory environmentin the relevant market and whether a new office would complement or broaden ourcurrent geographic network.

 

PURSUIT OF COMPLEMENTARY AND STRATEGIC ACQUISITIONS.  Weintend to focus on opportunities for growth through acquisitions in existing aswell as new markets.  We made fourstrategic external acquisitions in fiscal 2002 and one strategic externalacquisition in December, 2002 and are continuously evaluating other potentialacquisition opportunities.

 

In evaluating potential acquisition candidates, wefocus on independent staffing companies with a history of profitableoperations, a strong management team, a recognized presence in secondarymarkets

 

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and compatible corporate philosophies andculture.  We have used, and may continueto use, a team approach by making select corporate officers and outsideconsultants responsible for identifying prospective acquisitions, performingdue diligence, negotiating contracts and subsequently integrating the acquiredcompanies.  The integration of newlyacquired companies generally involves standardizing each company’s accountingand financial procedures with those of ours. Acquired companies typically are brought under our uniform riskmanagement program and key personnel of acquired companies often become part offield management.  Marketing, sales,field operations and personnel programs must be reviewed and, whereappropriate, conformed to the practices of our existing operations.

 

Between September 1997 and December 2002, wecompleted eleven acquisitions of primarily staffing companies or divisions ofstaffing companies.  These acquisitionsincluded forty offices located in nine states and collectively generated over$90 million in revenue for the twelve months preceding such acquisitions.  Pursuantto our acquisition strategy we made the following purchases:

 

•      In August1998, we acquired the assets of J.P. Industrial, LLC, a $1 million (in annualrevenues) Canby, Oregon based Engineering Services firm. We made thisacquisition to expand our presence in the engineering services intensive powergeneration and paper/wood product industries in the Pacific Northwest.

 

•      InJanuary 1999, we completed the acquisition of the assets of B & REmployment, Inc. (“B & R”), a $4 million (in annual revenues) Wilmington,Delaware based provider of traditional temporary staffing services.   This acquisition gave us an immediatepresence in the industrial and banking center of Delaware.

 

•      In April1999, we acquired certain assets of Adapta Services Group, Inc., a singlelocation, $2 million (in annual revenues) New Castle, Delaware based providerof traditional staffing services.  Thisacquisition was an excellent complement to our acquisition of B&REmployment, Inc., gave us full coverage of all of the major Delawaremetropolitan areas and provided us with additional quality customers.

 

•      In June2000, we acquired the assets of the eight New Jersey and Pennsylvania branchesof Tandem, a $25 million (in annual revenues) division of OutsourceInternational, Inc.  This acquisitiongreatly expanded our presence in our home state of New Jersey and continued ourMid-Atlantic regional expansion.

 

•      In July2000, we acquired certain assets of Apoxiforce, Inc., a $1 million (in annualrevenues) Elizabeth, New Jersey based provider of traditional staffingservices.  This acquisition provided uswith a strong presence in the commercial food service industry and an excellentcustomer list.  These operations wereincorporated into our existing Elizabeth, New Jersey office and the personnelassimilated throughout our New Jersey operations.

 

•      InOctober 2000, we acquired the assets of seven New Hampshire and Massachusettsbranches of Tandem, a $9 million (in annual revenues) division of OutsourceInternational, Inc.  This acquisitionfurther continued our East Coast expansion plan and provided us with a platformto further expand our New England presence.

 

•      InJanuary 2001, we acquired certain assets of Cura Staffing Inc. and WorkGroupProfessional Services, Inc. sister companies, producing $4.8 million in annualrevenues from offices in Coral Gables and Miami Springs, Florida.  This acquisition further expanded our SouthFlorida presence and provided SMARTSolutionsTM opportunities.

 

•      In August2001, we acquired certain assets of the light industrial and clericalbusinesses of Source One Personnel, Inc., a $15 million (in annual revenues)Lawrenceville, New Jersey based, closely-held corporation.  This acquisition significantly expanded ourI-95 corridor coverage in New Jersey and provided inroads into the lucrativePhiladelphia suburb market.

 

•      InJanuary 2002, we acquired the assets of the seven Southern California branchesof Provisional Employment Services, Inc. (“PES”), a $23 million (in annualrevenues) Orange, California based

 

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provider of light industrialand clerical staffing services.  Thisacquisition establishes a strong base in Southern California for regionalexpansion.

 

•      In March2002, we acquired certain assets (the “Sale Assets”) of Eden Health EmploymentServices (“Eden”), a temporary staffing firm located in Union City, New Jerseyfrom Wells Fargo Credit, Inc. (“Wells Fargo”). Pursuant to the terms and conditions of the transaction, Wells Fargotransferred its rights, title and interest in the Sale Assets free and clear ofany liens of Wells Fargo and any liens subordinated thereto.  The purchase price for the Sale Assets is aroyalty payable monthly through October 20, 2004.  The royalty is an amount based on a percentage derived fromsales/placements attributable to Eden.  Any invoices billed by Eden on or after March 4, 2002 are ourproperty, from which we will deduct any royalties due.

 

•      InDecember 2002, we acquired the assets of six California and Nevada branches ofElite Personnel Services, Inc., a $30 million (in annual revenues), Downey,California based provider of light industrial and clerical staffingservices.  This acquisition expands thealready-existing California region for continued West Coast expansion.

 

Due to these acquisitions, as well as new offices weopened, the number of our offices increased from five in five states after theRoyalpar, Inc. acquisition in August 1997 to forty in nine states at December17, 2002.

 

***Competitive Business Conditions***

 

Staffing companies provide one or more of fourbasic services to clients:  (i) flexiblestaffing; (ii) Professional Employer Organization (“PEO”) services; (iii)placement and search; and (iv) outplacement. Based on information provided by the American Staffing Association(formerly the National Association of Temporary and Staffing Services), theNational Association of Professional Employer Organizations and StaffingIndustry Analysts, Inc., 2001 staffing industry revenues were approximately $97billion.  Over the past seven years, thestaffing industry has experienced significant growth, growing at an averagerate of 10% per year largely due to the utilization of temporary help across abroader range of industries, as well as the emergence of the PEO sector.  Currently, over 90% of the companiessurveyed by the American Staffing Association reported using temporarypersonnel.

 

The U.S. staffing industry is highly fragmentedand has been experiencing consolidation in recent years, particularly withrespect to temporary staffing companies. Recent industry statistics indicate that approximately 7,000 companiesprovide temporary staffing services in the United States.  Many of these companies are small,owner-operated businesses with limited access to capital for development andexpansion.  We believe that the industryis consolidating in response to:

 

•      Theincreased demands of companies for a single supplier of a full range ofstaffing and human resource services;

 

•      Increasedcompetition from larger, better capitalized competitors; and

 

•      Owner’sdesires for liquidity.

 

Although some consolidation activity has alreadyoccurred, we believe that consolidation in the U.S. staffing industry willcontinue and that there will be numerous available acquisition candidates.

 

Historically, the demand for temporary staffingemployees has been driven by a need to temporarily replace regularemployees.  More recently, competitivepressures have forced businesses to focus on reducing costs, includingconverting fixed labor costs to variable and flexible costs.  Increasingly, the use of temporary staffingemployees has become widely accepted as a valuable tool for managing personnelcosts and for meeting specialized or fluctuating employment requirements.  Organizations also use temporary staffing toreduce administrative overhead by outsourcing operations that are not part oftheir core business operations, such as recruiting, training and benefitsadministration.  By utilizing staffingservices companies, businesses are able to avoid the management andadministrative costs that would be incurred if full time employees wereemployed.  An ancillary benefit,particularly for smaller business, is that the use of temporary personnelreduces certain

 

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employment costs and risks,such as workers’ compensation and medical and unemployment insurance, that atemporary personnel provider can spread over a much larger pool of employees.

 

In the past decade, the staffing industry hasseen an evolution of services move away from “temp help” or supplementalstaffing to more permanent staffing relationships.  The industry has developed specialization among various sectorsand can be classified into four categories: integrated staffing service providers, professional services providers,information technology providers and commodity providers.  Integrated staffing services provide avendor-on-premise, acting as the general contractor managing the workforce andmaintaining the payroll.  Through thisarrangement, providers are able to establish long-term relationships with theircustomers, reduce cyclicality of employees, and maintain relationships withcustomers that are less price-sensitive. The professional services providersupplies employees in the fields of engineering, finance, legal, accounting andother professions.  In general, theseservices are less cyclical than the light industrial and clerical segments andcarry higher margins.  Informationtechnology companies offer technical employees to maintain and implement allforms of information systems. The commodity segment of the staffing industry isthe traditional temporary employer business in which an employee of the serviceis placed at the customer for a short period. It is characterized by intense competition and low margins.  This sector is most exposed to economiccycles and price competition to win market share.  Growth in this segment has been constrained over the past threeyears due to a competitive labor market for low-end workers.

 

***We compete with other companies inthe recruitment of qualified personnel, the development of client relationshipsand the acquisition of other staffing and professional service companies. Alarge percentage of temporary staffing and consulting companies are localoperators with fewer than five offices and have developed strong local customerrelationships within local markets. These operators actively compete with usfor business and, in most of these markets, no single company has a dominantshare of the market. We also compete with larger, full-service and specializedcompetitors in national, regional and local markets. The principal nationalcompetitors include MPS Group, Manpower, Inc., Kelly Services, Inc., OlstenCorporation, Interim Services, Inc., and Norrell Corporation, all of which mayhave greater marketing, financial and other resources than Stratus. We believethat the primary competitive factors in obtaining and retaining clients are thenumber and location of offices, an understanding of clients’ specific jobrequirements, the ability to provide temporary personnel in a timely manner,the monitoring of the quality of job performance and the price of services. Theprimary competitive factors in obtaining qualified candidates for temporaryemployment assignments are wages, responsiveness to work schedules and numberof hours of work available. We believe our long-term client relationships andstrong emphasis on providing service and value to our clients and temporarystaffing employees makes us highly competitive.***

*** ***

***Customers***

 

During the year ended September 30, 2002, weprovided services to 1,560 customers in 18 states.  Our five largest customers represented 19% of our revenue but noone customer exceeded 10% and only one customer exceeded 5%.

 

**GovernmentalRegulation**

 

Staffing services firms are generally subject toone or more of the following types of government regulation: (1) regulation ofthe employer/employee relationship between a firm and its temporary employees;and  (2) registration, licensing, recordkeeping and reporting requirements. Staffing services firms are the legalemployers of their temporary workers. Therefore, laws regulating theemployer/employee relationship, such as tax withholding and reporting, socialsecurity or retirement, anti-discrimination and workers’ compensation, governthese firms. State mandated workers’ compensation and unemployment insurancepremiums have increased in recent years and have directly increased our cost ofservices. In addition, the extent and type of health insurance benefits thatemployers are required to provide employees have been the subject of intensescrutiny and debate in recent years at both the national and state level.Proposals have been made to mandate that employers provide health insurancebenefits to staffing employees, and some states could impose sales tax, orraise sales tax rates on staffing services. Further increases in such premiums or rates, or the introduction of newregulatory provisions, could substantially raise the costs associated withhiring and employing staffing

 

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employees.

 

Certain states have enacted laws that govern theactivities of “Professional Employer Organizations,” which generally providepayroll administration, risk management and benefits administration to clientcompanies.  These laws vary from stateto state and generally impose licensing or registration requirements forProfessional Employer Organizations and provide for monitoring of the fiscalresponsibility of these organizations. We believe that Stratus is not aProfessional Employer Organization and not subject to the laws that govern suchorganizations; however, the definition of “Professional Employer Organization”varies from state to state and in some states the term is broadly defined. Ifwe are determined to be a Professional Employer Organization, we can give noassurance that we will be able to satisfy licensing requirements or otherapplicable regulations. In addition, we can give no assurance that the statesin which we operate will not adopt licensing or other regulations affectingcompanies that provide commercial and professional staffing services.

 

##### **Trademarks**

 

We have not obtained federal registration of anyof the trademarks we use in our business, including SMARTSolutions, SMARTReport,SMARTTraining, our slogan, name or logo. Currently, we are asserting Common Lawprotection by holding the marks out to the public as the property of Stratus.However, no assurance can be given that this Common Law assertion will beeffective to prevent others from using any of our marks concurrently or inother locations. In the event someone asserts ownership to a mark, we may incurlegal costs to enforce any unauthorized use of the marks or defend ourselvesagainst any claims.

 

***Employees***

 

As of September 30, 2002, we were employing4,603****totalemployees.  Of that amount, 138 wereclassified as staff employees and 4,465 were classified as field or “temp”employees, those employees placed at client facilities.  As of December 17, 2002, those numbers hadchanged to 194 and 5,313**,**respectively.

 

A key factor contributing to future growth andprofitability will be the ability to recruit and retain qualified personnel. Toattract personnel, we employ recruiters, called “Staffing Specialists” whoregularly visit schools, churches and professional associations and presentcareer development programs to various organizations. In addition, applicantsare obtained from referrals by existing staffing employees and from advertisingon radio, television, in the Yellow Pages, newspapers and through the Internet.Each applicant for a Staffing Services position is interviewed with emphasis onpast work experience, personal characteristics and individual skills. Wemaintain software-testing and training programs at our offices for applicantsand employees who may be trained and tested at no cost to the applicant orcustomer.  Management Personnel aretargeted and recruited for specific engagements. We usually advertise forprofessionals who possess specialized education, training or work experience.

 

To promote loyalty and improve retention amongour employees and to differentiate ourselves from competing staffing firms, weoffer a comprehensive benefits package after only ninety days of employmentinstead of the industry standard of one hundred eighty days. The benefitspackage includes paid time off, holiday and vacation time, medical coverage,dental, vision, prescription, mental health, life insurance, disabilitycoverage and a 401(K) defined contribution plan. The average length ofassignment for employees ranges from six months to five years depending on theclient requirements.

 

**FactorsAffecting Future Operating Results**

 

ThisForm 10-K contains forward-looking statements concerning our future programs,products, expenses, revenue, liquidity and cash needs as well as our plans andstrategies.  These forward-lookingstatements are based on current expectations and the Company assumes noobligation to update this information. Numerous factors could cause actual results to differ significantly fromthe results described in these forward-looking statements, including thefollowing risk factors.

 

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**We havelimited liquid resources and a history of net losses**.

 

AtSeptember 30, 2002, we had limited liquid resources.  Current liabilities were $17,988,216 and our current assets were$14,701,093.  The difference of$3,287,123 is a working capital deficit which is primarily the result of thelosses incurred during the last two years. Current liabilities as of September 30, 2002 also include a cashoverdraft of $731,501, which is represented by outstanding checks.  We have incurred net losses in recentperiods, including net losses of $2,412,145 in the year ended September 30, 1998,$1,527,043 in the year ended September 30, 1999, $5,910,457 in the year endedSeptember 30, 2001 and $6,261,581 in the year ended September 30, 2002.  Although we had net earnings in the yearended September 30, 2000 of $1,045,910, we can provide no assurance that ouroperations will be profitable in the future. This situation has also made it difficult for us to make timely paymentsto our vendors and we can make no assurances that vendors and creditors will notexercise remedies against us.  The workingcapital deficit will remain until additional capital is raised.

 

Theseconditions raise substantial doubts about our ability to operate as a goingconcern.  Our financial statements donot include any adjustments to reflect the possible future effect on therecoverability and classification of assets or the amounts and classificationof liabilities that may result from the outcome of this uncertainty.

 

Ourcontinuation of existence is dependent upon our ability to generate sufficientcash flow to meet our continuing obligations on a timely basis, to fund theoperating and capital needs, and to obtain additional financing as may benecessary.  Our management has takensteps to revise and reduce our operating requirements, which we believe will besufficient to assure continued operations and implementation of our plans.  The steps include closing branches that arenot profitable, consolidating branches, and reduction in staffing and otherselling, general and administrative expenses.

 

**Fluctuationsin the general economy could have an adverse impact on our business**.

 

Demandfor our staffing services is significantly affected by the general level ofeconomic activity and unemployment in the United States.  Companies use temporary staffing services tomanage personnel costs and staffing needs. When economic activity increases, temporary employees are often addedbefore full-time employees are hired. However, as economic activity slows, many companies reduce theirutilization of temporary employees before releasing full-time employees.  In addition, we may experience less demandfor our services and more competitive pricing pressure during periods ofeconomic downturn.  Therefore, anysignificant economic downturn could have a material adverse effect on our business,results of operations, cash flows or financial condition.

 

**We may beunable to continue and manage our growth**.

 

Ourability to continue growth will depend on a number of factors, including:  the strength of demand for temporaryemployees in our markets; the availability of capital to fund acquisitions; theability to maintain or increase profit margins despite pricing pressures; andexisting and emerging competition.  Wemust also adapt our infrastructure and systems to accommodate growth andrecruit and train additional qualified personnel.  Furthermore, the United States economy is continuing to showsigns of an economic slowdown.  Shouldthe economic slowdown or a recession continue for an extended period,competition for customers in the staffing industry would increase and mayadversely impact management’s allocation of our resources and result indeclining revenues.

 

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**We relyheavily on executive management and could be adversely affected if ourexecutive management team was not available.**

 

We arehighly dependent on our senior executives, including Joseph J. Raymond, ourChairman, CEO and President since September 1, 1997; Michael A. Maltzman,Executive Vice President and Chief Financial Officer who has been serving inthat capacity since September 1, 1997; and on the other members of our seniormanagement team.  We entered into anemployment agreement with Mr. Raymond effective September 1, 1997 for continuingemployment until he chooses to retire or until his death and that agreementremains in effect as written. Employment arrangements with all of our executive officers areat-will.  The loss of the services ofeither Mr. Raymond or Mr. Maltzman and other senior executives or other keyexecutive personnel could have a material adverse effect on our business,results of operations, cash flows or financial condition.

 

**We relyheavily on our management information systems and our business would suffer ifour systems fail or cannot be upgraded or replaced on a timely basis.**

 

Webelieve our management information systems are instrumental to the success ofour operations.  Our business depends onour ability to store, retrieve, process and manage significant amounts of data.  We continually evaluate the quality,functionality and performance of our systems in an effort to ensure that thesesystems meet our operational needs. We have, in the past, encountered delays inimplementing, upgrading or enhancing systems and may, in the future, experiencedelays or increased costs.  There can beno assurance that we will meet anticipated completion dates for systemreplacements, upgrades or enhancements that such work will be competed in thecost-effective manner, or that such replacements, upgrades and enhancementswill support our future growth or provide significant gains in efficiency.  The failure of the replacements, upgradesand enhancements to meet these expected goals could result in increased systemcosts and could have a material adverse effect on our business, results ofoperations, cash flows or financial condition.

 

**Increases inemployee-related costs would have an adverse effect on our business**.

 

We areresponsible for all employee-related expenses for the temporary employees,including workers’ compensation, unemployment insurance, social security taxes,state and local taxes and other general payroll expenses.  We maintain workers’ compensation insurancefor all claims in excess of a loss cap of $150,000 per incident, except withrespect to locations in states where private insurance is permitted and whichare covered by state insurance funds. We accrue for workers’ compensation costs based upon payroll dollarspaid to temporary employees.  Theaccrual rates vary based upon the specific risks associated with the workperformed by the temporary employee.  Atthe beginning of each policy year, we review the overall accrual rates with ouroutside actuaries and makes changes to the rates as necessary based primarilyupon historical loss trends.  Periodically,we evaluate our historical accruals based on an actuarially developed estimateof the ultimate cost for each open policy year and adjust such accruals asnecessary.  These adjustments can eitherbe increases or decreases to workers’ compensation costs, depending upon ouractual loss experience.  There can be noassurance that our programs to control workers’ compensation and otherpayroll-related expenses will be effective or that loss development trends willnot require a charge to costs of services in future periods to increaseworkers’ compensation accruals. Unemployment insurance premiums are set by the states in which ouremployees render their services.  Asignificant increase in these premiums or in workers’ compensation-relatedcosts or our inability to continue to maintain workers’ compensation coveragecould have a material adverse effect on our business, results of operations,cash flows or financial condition.

 

**Our financialresults will suffer if we lose any of our significant customers**.

 

As iscommon in the temporary staffing industry, our engagements to provide servicesto our customers are generally of a non-exclusive, short-term nature andsubject to termination by the customer with little or no notice.  During fiscal 2001 and 2002, no singlecustomer of ours accounted for more than 10% and 10%, respectively, of oursales or services.  Nonetheless, theloss of any of our significant customers could have an adverse effect on ourbusiness, results of operations, cash flows or financial condition.  We are also subject to credit risksassociated with our trade receivables. During fiscal 2001 and fiscal 2002, we incurred costs of $661,000 and$1,650,000, respectively, for bad debts. Should any of our principal customers default on their

 

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largereceivables, our business results of operations, cash flows or financialcondition could be adversely affected.

 

**We haveexperienced significant fluctuations in our operating results and anticipate thatthese fluctuations may continue.**

 

Operatingresults may fluctuate due to a number of factors, including the demand for ourservices, the level of competition within our markets, our ability to increasethe productivity of our existing offices, control costs and expand operations,the timing and integration of acquisitions and the availability of qualifiedtemporary personnel.  In addition, ourresults of operations could be, and have in the past been, adversely affectedby severe weather conditions.  Moreover,our results of operations have also historically been subject to seasonalfluctuations.  Demand for temporarystaffing historically has been greatest during our fourth fiscal quarter duelargely to the planning cycles of many of our customers.  Furthermore, sales for the first fiscalquarter are typically lower due to national holidays as well as plant shutdownsduring and after holiday season.  Theseshutdowns and post-holiday season declines negatively impact job ordersreceived by us, particularly in the light industrial sector.  Due to the foregoing factors, we haveexperienced in the past, and may possibly experience in the future, results ofoperations below the expectations of public market analysts and investors.  The occurrence of such an event could likelyhave a material adverse effect on the price of the common stock.

 

**If we are notable to attract and retain the services of qualified temporary personnel, ourbusiness will suffer.**

 

Wedepend upon our ability to attract and retain qualified personnel who possessthe skills and experience necessary to meet the staffing requirements of ourcustomers.  During periods of increasedeconomic activity and low unemployment, the competition among temporary staffingfirms for qualified personnel increases. Many regions in which we operate have in the past and may continue toexperience historically low rates of unemployment and we have experienced, andmay continue to experience, significant difficulties in hiring and retainingsufficient numbers of qualified personnel to satisfy the needs of ourcustomers.  Furthermore, we may faceincreased competitive pricing pressures during such periods.  While the current economic environment isfacing uncertainties, competition for individuals with the requisite skills isexpected to remain strong for the foreseeable future.  There can be no assurance that qualified personnel will continueto be available to us in sufficient numbers and on terms of employmentacceptable to us.  We must continuallyevaluate and upgrade our base of available qualified personnel to keep pacewith changing customer needs and emerging technologies.  Furthermore, a substantial number of ourtemporary employees during any given year will terminate their employment withus to accept regular staff employment with our customers.  The inability to attract and retainqualified personnel could have a material adverse effect on the business,results of operations, cash flows or financial condition.

 

**Our successdepends upon the performance of our field management.**

 

We aredependent on the performance and productivity of our local managers,particularly branch, and regional managers. This loss of some of our key managers could have an adverse effect onour operations, including our ability to establish and maintain customerrelationships.  Our ability to attractand retain business is significantly affected by local relationships and thequality of services rendered by branch, area, regional and zone managerialpersonnel.  If we are unable to attractand retain key employees to perform these services, our business, results ofoperations, cash flows or financial condition could be adversely affected.  Furthermore, we may be dependent on thesenior management of companies that may be acquired in the future.  If any of these individuals do not continuein their management roles, there could be material adverse effect on ourbusiness, results of operations, cash flows or financial condition.

 

**We may besubject to claims as a result of actions taken by our temporary staffingpersonnel.**

 

Providersof temporary staffing services place people in the workplaces of otherbusinesses.  An inherent risk of suchactivity includes possible claims of errors and omissions, discrimination orharassment, theft of customer property, misappropriation of funds, misuse ofcustomers’ proprietary information,

 

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employmentof undocumented workers, other criminal activity or torts, claims under healthand safety regulations and other claims. There can be no assurance that we will not be subject to these types ofclaims, which may result in negative publicity and our payment of monetarydamages or fines, which, if substantial, could have a material adverse effecton our business, results of operations, cash flows or financial condition.

 

**Our CommonStock was delisted from the Nasdaq Stock Market and is not likely to berelisted.**

 

Thereare several requirements for continued listing on the Nasdaq SmallCap Marketincluding, but not limited to, a minimum stock bid price of $1.00 per share and$2.5 million in stockholder’s equity. As of September 30, 2001, our stockholder’s equity was below the Nasdaqrequirement and, as aresult, our common stock was delisted by Nasdaq in February 2002.  Although we appealed the delistingdetermination and the Nasdaq Listing and Hearing Council reversed and remandedthe decision to the Nasdaq Listing Qualification Panel, subject to conditions,the Panel notified us in August 2002 that it was denying relisting due to ourfailure to meet conditions specified in the Council’s decision that required usto have stockholder’s equity of at least $4,500,000 as of June 30, 2002 and aminimum stock bid price of at least $1.00 for 10 consecutive trading days.  We subsequently filed an appeal of thisdecision.  Our common stock is currentlytrading on the NASD’s OTC Bulletin Board. On November 22, 2002, we received notification from the Nasdaq Listingand Hearing Review Council (the “Review Council”), that it was affirming thePanel’s decision to de-list our securities from the Nasdaq Stock Market.  However, the Review Council also noted that,pursuant to Nasdaq Marketplace Rule 4850(a), the NASD Board of Governors maycall this decision for review in connection with an upcoming Boardmeeting.  We will be provided withwritten notice if the Review Council’s decision represents the final action ofthe NASD following that meeting.  Delistingfrom Nasdaq could adversely affect the liquidity and price of our common stockand this could have a long-term impact on our ability to raise future capitalthrough a sale of our common stock.  Inaddition, it could make it more difficult for investors to obtain quotations totrade our stock.

 

**Futureacquisitions could increase the risk of our business**.

 

Whilewe intend to pursue acquisitions in the future, there can be no assurance thatwe will be able to expand our current market presence or successfully enterother markets through acquisitions. Competition for acquisitions may increase to the extent other temporaryservices firms, many of which have significantly greater financial resourcesthan us, seek to increase their market share through acquisitions.  In addition, we are subject to certainlimitations on the incurrence of additional indebtedness under our creditfacilities, which may restrict our ability to finance acquisitions.  Further, there can be no assurance that wewill be able to identify suitable acquisition candidates or, if identified,complete such acquisitions or successfully integrate such acquired businessesinto our operations.  Acquisitions alsoinvolve special risks, including risks associated with unanticipated problems,liabilities and contingencies, diversion of management’s attention and possibleadverse effects on earnings resulting from increased interest costs andworkers’ compensation costs, as well as difficulties related to the integrationof the acquired businesses, such as retention of management.  Furthermore, once integrated, acquisitionsmay not achieve comparable levels of revenue or profitability as our existinglocations.  In addition, to the extentthat we consummate acquisitions in which a portion of the consideration is inthe form of common stock, current shareholders may experience dilution.  The failure to identify suitableacquisitions, to complete such acquisitions or successfully integrate suchacquired businesses into our operations could have a material adverse effect onour business, results of operations, cash flows or financial condition.

 

**Potential conversions of ourconvertible preferred stock will reduce the percentage ownership interest ofexisting stockholders and may cause a reduction in our share price.**

 

As of December 17, 2002 we had outstanding1,458,933 shares of Series A Preferred Stock, 16,683 shares of Series EPreferred Stock, 10,000 shares of Series F Preferred stock and 5,000 shares ofSeries H Preferred Stock.  If all of theholders of preferred stock convert their preferred stock into shares of commonstock, we will be required to issue no less than 4,168,269 shares of commonstock based on an assumed conversion price of $.312 per share for the Series EPreferred Stock and $.20 per share for the Series H Preferred Stock.  If the trading price of the common stock islow when the conversion price of the Series E Preferred Stock or the Series HPreferred Stock is determined, we would be required to issue a higher number ofshares of

 

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common stock, which could causea further reduction in each of our stockholder’s percentage ownership interestsin our company.  In addition, if aholder of preferred stock converts our preferred stock and sells the commonstock, it could result in an imbalance of supply and demand for our commonstock and a decrease in the market price of our common stock.  The further our stock price declines, themore the conversion price of our Series E Preferred Stock and Series HPreferred Stock will fall and the greater the number of shares we will have toissue upon conversion.

 

**Weare controlled by principal stockholder and management**.

 

As of December 17, 2002, our Chairman of theBoard, Joseph J. Raymond, owned or had the right to vote shares representingapproximately 59.5% of the outstanding voting power of our capital stock.  Our directors and executive officers, as agroup, own or have the right to vote shares representing approximately 66.91%of the outstanding voting power of our capital stock.  As a result, Mr. Raymond and, if they should determine to acttogether, our directors and executive officers as a group, will be able toexercise significant influence over the outcome of any matters or block certainmatters which might normally be submitted to our stockholders for approval,including the election of directors and the authorization of other corporateactions requiring stockholder approval.

 

**ITEM 2.****         ****PROPERTIES**

 

We ownno real property.  We leaseapproximately 6,841 square feet in a professional office building in Manalapan,New Jersey as our corporate headquarters. That facility houses all of our centralized corporate functions,including the Executive management team, payroll processing, accounting, humanresources and legal departments.  Ourlease expires on September 30, 2007.  Asof September 30, 2002, we leased 30 additional facilities, primarily flexiblestaffing offices, in 8 states.  With theaddition of new space at our corporate headquarters, we believe that ourfacilities are generally adequate for our needs and we do not anticipate anydifficulty in replacing such facilities or locating additional facilities, ifneeded.

 

**ITEM 3.****         ****LEGAL PROCEEDINGS**

 

We areinvolved, from time to time, in routine litigation arising in the ordinarycourse of business. Other than as set forth below, we do not believe that anycurrently pending litigation will have a material adverse effect on ourfinancial position or results of operations.

 

Thematter of ACE American Insurance Company v. Stratus Services Group, Inc., filedin the Superior Court of New Jersey, Law Division, Essex County, in September,2002, is a contract/tort action in which the Plaintiff alleges that we havefailed to pay $323,775.00 plus interest of $44,444.44 for earned commercialliability insurance premium for the period May 1, 2000 to May 1, 2001.  We previously accrued a liability of$323,775.00 relative to this matter, and dispute the total amount owed butacknowledge a portion of the debt.

 

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

 

A Special Meeting of Stockholders was held at our corporate offices at500 Craig Road, Suite 201, Manalapan, New Jersey 07726 on July 26, 2002.  Information with respect to the mattersacted upon at the Special Meeting was included in our Quarterly Report on Form10-Q for the fiscal quarter ended June 30, 2002.

 

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**PART II**

 

**ITEM 5.****         ****MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

On April 11, 2000, our registration statement onForm SB-2 (Commission File No. 333-83255) for our initial public offering ofcommon stock, $.01 par value, became effective and our shares commenced tradingon the Nasdaq SmallCap Market under the symbol “SERV” on April 26, 2000.  On February 27, 2002, our common stock wasdelisted from the Nasdaq SmallCap Market and is currently trading on the NASDOTC Bulletin Board under the symbol “SERV”. There were approximately 1,618 holders of record of common stock as ofDecember 17, 2002.  This number includesthe number of shareholders whose shares were held in “nominee” or “streetname”.  The table below sets forth, forthe periods indicated, the high and low sales prices of our common stock asreported by the Nasdaq Stock Market and by the NASD OTC Bulletin Board.

 
|                             |   | **Sales  Prices** |   |
|----------------------------------|--------|-------------------|--------|
| **Fiscal Year 2001**             |   | **High**          |   | **Low** |   |
| Quarter Ended December 31, 2000  |   | 6.75              |   | 3.625 |   |
| Quarter Ended March 31, 2001     |   | 4.875             |   | 1.3125 |   |
| Quarter Ended June 30, 2001      |   | 2.05              |   | 1.16 |   |
| Quarter Ended September 30, 2001 |   | 1.90              |   | 1.00 |   |

 
| **Fiscal Year 2002**             |   | **High** |   | **Low** |   |
|----------------------------------|--------|----------|--------|---------|--------|
| Quarter Ended December 31, 2002  |   | 1.19     |   | 0.51    |   |
| Quarter Ended March 31, 2002     |   | 1.00     |   | 0.25    |   |
| Quarter Ended June 30, 2002      |   | 0.75     |   | 0.13    |   |
| Quarter Ended September 30, 2002 |   | 0.30     |   | 0.08    |   |

 

On December 17, 2002, the closing price of ourcommon stock as reported by the NASD OTC Bulletin Board was $.43 pershare.  We have never paid cashdividends on our common stock and we intend to retain earnings, if any, tofinance future operations and expansion. In addition, our credit agreement restricts the payment of dividends,therefore, we do not anticipate paying cash dividends on our common stock inthe foreseeable future.  Any futurepayment of dividends on our common stock will depend upon our financialcondition, capital requirements and earnings as well as other factors that theBoard of Directors deems relevant.

 

As set forth more fully in Note 3 to theFinancial Statements included with this Report, in June 2002, Source OnePersonnel, Inc. (“Source One”) agreed to forebear from exercising remediesagainst us until June 30, 2002.  On July31, 2002, we cured all payment defaults under the notes we issued to SourceOne.  In exchange for the forbearance,we issued 250,000 shares of Common Stock, which was valued at the aggregatefair market value of $37,500, to Source One, in an offering relying on Section4(2) of and Rule 506 under the Securities Act of 1933.

 

On September 30, 2002, we sold 5,000 shares ofSeries H Preferred Stock at $100.00 per share to Pinnacle Investment Partners,LLP (“Pinnacle”) in an offering relying on Section 4(2) of and Rule 506 underthe Securities Act of 1933.  The SeriesH Preferred Stock is convertible into Common Stock at a conversion price equalto the lower of $.20 per share of the average market price of Common Stock forthe five trading days immediately preceding the conversion date.  The number of shares issuable uponconversion is determined by multiplying the number of shares of Series HPreferred Stock to be converted by $100 and dividing the result by theconversion price then in effect.

 

See “Part III, Item 12, Security Ownership ofCertain Beneficial Owners and Management” for information regarding securitiesauthorized for issuance under equity compensation plans.

 

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**ITEM 6.****         ****SELECTED FINANCIAL DATA.**

(Inthousands except per share)

 

The selected financial datathat follows should be read in conjunction with our financial statements andthe related notes thereto and Management’s Discussion and Analysis of FinancialCondition and Results of Operations appearing elsewhere in this report.

 
|                                                                                               |   | **Year Ended  September 30,** |       |
|----------------------------------------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                                                               |   | **2002**                      |       | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                               |   | **As Restated**               |       | **As Restated** |   | **As  Restated** |   |   |   |   |   |
| Income statement data:                                                                             |   |                          |       |   |   |   |   |   |   |   |   |
| Revenues                                                                                           |   | $                             | 65,121     |   | $ | 50,008 |   | $ | 34,443 |   | $ | 24,806 |   | $ | 17,968 |   |
| Gross profit                                                                                       |   | 11,520                        |       | 10,952 |   | 8,372 |   | 5,261 |   | 3,297 |   |
| Operating earnings (loss) from continuing  operations                                              |   | (3,529                        | )          | (3,545 | ) | 528 |   | (807 | ) | (2,315 | ) |
| Net earnings (loss) from continuing operations                                                     |   | (7,580                        | )          | (5,993 | ) | 161 |   | (1,696 | ) | (2,733 | ) |
| Net earnings (loss) from continuing operations  attributable to common stockholders                |   | (8,622                        | )          | (6,056 | ) | 161 |   | (1,696 | ) | (2,733 | ) |
|                                                                                               |   |                          |       |   |   |   |   |   |   |   |   |
| Per share data:                                                                                    |   |                          |       |   |   |   |   |   |   |   |   |
| Net earnings (loss) from continuing operations  attributable to common stockholders – basic   |   | $                             |  (.82 | ) | $ |  (1.01 | ) | $ |  .03 |   | $ |  (.44 | ) | $ |  (.76 | ) |
| Net earnings (loss) from continuing operations  attributable to common stockholders – diluted |   | $                             |  (.82 | ) | (1.01 | ) | .03 |   | (.44 | ) | (.76 | ) |
| Cash dividends declared                                                                            |   | 3⁄4                        |       | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |

 
|                                             |   | **September  30,** |   |
|--------------------------------------------------|--------|--------------------|--------|
|                                             |   | **2002**           |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| Balance sheet data:                              |   |               |   |   |   |   |   |   |   |   |   |
| Net working capital (deficiency)                 |   | $                  | (3,287 | ) | $ | (1,546 | ) | $ | 2,086 |   | $ | (3,777 | ) | $ | (1,985 | ) |
| Long-term obligations, including current portion |   | 3,296              |   | 3,153 |   | 462 |   | 1,370 |   | 3⁄4 |   |
| Convertible debt                                 |   | 40                 |   | 1,125 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Preferred stock                                  |   | 6,279              |   | 2,792 |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Temporary equity                                 |   | 823                |   | 869 |   | 3⁄4 |   | 2,138 |   | 1,618 |   |
| Stockholders’ equity (deficiency)           |   | 3,043              |   | 1,283 |   | 6,799 |   | (3,012 | ) | (3,356 | ) |
| Total assets                                     |   | 24,031             |   | 22,268 |   | 10,318 |   | 4,926 |   | 1,095 |   |
|                                                  |        |                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM7****.****          MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

** **

### **Introduction**

 

We provide a wide range of staffing services andproductivity consulting services associated with such staffing servicesnationally through a network of offices located throughout the UnitedStates.  Regardless of the type oftemporary service offering we provide, we recognize revenues based on hoursworked by assigned personnel. Generally, we bill our customers a pre-negotiated, fixed rate per hourfor the hours worked by our temporary employees.  Therefore we do not separate our various service offerings intoseparate offering segments.  We do notroutinely provide discrete financial information about any particular serviceoffering.  We also do not conduct anyregular reviews of, nor make decisions about, allocating any particularresources to a particular service offering to assess its performance.  As set forth below, certain of our serviceofferings target specific markets, but we do not necessarily conduct separatemarketing campaigns for such services. We are responsible for workers’ compensation, unemployment compensationinsurance, Medicare and Social Security taxes and other general payroll relatedexpenses for all of the temporary employees we place.  These expenses are included in the cost of revenue.  Because we pay our temporary employees onlyfor the hours they actually work, wages for our temporary personnel are avariable cost that increases or decreases in proportion to revenues.  Gross profit margin varies depending on thetype of services offered.  In someinstances, temporary employees placed by us may decide to accept an offer ofpermanent employment from the customer and thereby “convert” the temporaryposition to a permanent position.  Feesreceived from such conversions are included in our revenues.  Selling, general and administrative expensesinclude payroll for management and administrative employees, office occupancycosts, sales and marketing expenses and other general and administrative costs.

 

**CriticalAccounting Policies and Estimates**

 

The following accounting policies are consideredby us to be “critical” because of the judgments and uncertainties affecting theapplication of these policies and because of the likelihood that materiallydifferent amounts would be reported under different conditions or usingdifferent assumptions.

 

**RevenueRecognition**

 

We recognize revenue as the services areperformed by our workforce.  Our customersare billed weekly.  At balance sheetdates, there are accruals for unbilled receivables and related compensationcosts.

 

We changed our method of reporting the revenuesfor payrolling services (“payrolling”) from gross billing to a net revenuebasis. The change in reporting, which is reflected in all current and priorperiods, resulted in a reduction in both reported revenues and related cost ofrevenues, with no effect on our operating results.

 

Unlike traditional staffing services, under apayrolling arrangement, the Company’s customer recruits and identifiesindividuals for the Company to hire to provide services to the customer.  The Company becomes the statutory employeralthough the customer maintains substantially all control over those employees.  Accordingly, Emerging Issues Task Force(“EITF”) 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent”requires that we do not reflect the direct payroll costs paid to such employeesin revenues and cost of revenue.

 

**Allowancefor Doubtful Accounts Receivable**

 

We provide customary credit terms to ourcustomers and generally do not require collateral.  We perform ongoing credit evaluations of the financial conditionof our customers and maintain an allowance for doubtful accounts receivablebased upon historical collection experience and expected collectibility ofaccounts.  As of September 30, 2002, wehad recorded an allowance for doubtful accounts of approximately $1.7 million.  The actual bad debts may differ fromestimates and the difference could be significant.

 

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**Impairmentof Goodwill**

 

Goodwill is amortized on a straight-line basisover fifteen years except for acquisitions after June 30, 2001, where goodwillis not being amortized.  The carryingamount of goodwill is reviewed whenever events or changes in circumstancesindicate that it may not be recoverable. We use an estimate of the future undiscounted net cash flows of theacquired business over the remaining life of the asset in measuring whether theassets are recoverable.  Where suchestimate of the future undiscounted cash flows is less than the carrying amountof goodwill, a potential impairment exists.

 

We are required to adopt the provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill andOther Intangible Assets” beginning October 1, 2002.  This statement requires that goodwill no longer be amortized, andit requires instead that goodwill be tested at least annually forimpairment.  If the carrying value ofgoodwill were determined to be greater than its estimated fair value under theimpairment test, then it would be written down to its estimated fair value.

 

The discontinuance of goodwill amortization isnot expected to have a significant effect on our future results ofoperations.  We have not completed atransitional impairment test, as required by SFAS No. 142.

 

**ValuationAllowance Against Deferred Income Tax Assets**

 

Deferred tax assets and liabilities aredetermined based on differences between the financial reporting and tax basesof assets and liabilities, and are measured using the enacted tax rates andlaws that are expected to be in effect when the differences reverse.  We have recorded a valuation allowance ofapproximately $5.3 million to offset the entire balance of the deferred taxasset as of September 30, 2002.  Thevaluation allowance was recorded as a result of the losses incurred by us andour belief that it is more likely than not that we will be unable to recoverthe net deferred tax assets.

 

##### **Results of Operations**

**Discontinued Operations/Acquisition or Disposition of Assets**

 

On January 24, 2002, weentered into an agreement to sell the assets of our Engineering ServicesDivision (the “Division”) to SEA Consulting Services Corporation (“SEA”).  Closing of the sale was contingent uponshareholder approval and the receipt of a fairness opinion by us.

 

On March 28, 2002, we completed the sale of theassets of the Division to SEA pursuant to the Asset Purchase Agreement dated asof January 24, 2002 among us, SEP, LLC (“SEP”), Charles Sahyoun, SahyounHoldings LLC and SEA.  The transactionwas approved by a vote of our stockholders at the annual meeting ofstockholders held on March 28, 2002.

 

The assets of the Division had been transferredto SEP, a limited liability company in which we own a 70% interest, at the timeof the execution of the Asset Purchase Agreement.  Sahyoun Holdings, LLC, a company wholly owned by Charles Sahyoun,the President of the Division, owns the remaining 30% interest in SEP.

 

Under the terms of the Asset Purchase Agreement,we received an initial cash payment of $1,560,000, which represented 80% of theinitial $2,200,000 installment of the purchase price payable to SEP after thesatisfaction of certain liabilities and expenses of SEP.  Sahyoun Holdings, LLC received the other 20%of the initial net installment of the purchase price, or $440,000.

 

The Asset Purchase Agreement requires thepurchaser to make the following additional payments to SEP:

 

(a)           A payment of $1 million, plus or minusthe amount by which SEA’s profit for the six months ended June 30, 2002, asdetermined pursuant to the Asset Purchase Agreement, is greater or less than$600,000 (the “Second Payment”);

 

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(b)           A payment of $1 million, plus or minusthe amount by which the SEA’s profit for the six months ending December 31,2002, as determined pursuant to the Asset Purchase Agreement, is greater orless than $600,000 (the “Third Payment”);

 

(c)           Five subsequent annual payments (the“Subsequent Payments”) which will be based upon a multiple of the annualsuccessive increases, if any, in the SEA’s profit during the five year periodbeginning on January 1, 2003 and ending December 31, 2007.

 

Pursuant to an allocationand indemnity agreement entered into by us, Sahyoun Holdings, LLC and Mr.Sahyoun (the “Allocation and Indemnity Agreement”), we were entitled to$250,000 of the Second Payment and $250,000 of the Third Payment.  On April 15, 2002, by letter agreementbetween us, Sahyoun Holdings, LLC and Joseph J. Raymond, Sr., our Chairman andChief Executive Officer, the parties agreed to a modification of the Allocationand Indemnity Agreement.  Per thatletter agreement, Sahyoun Holdings, LLC provided us with $200,000 cash inexchange for our short-term, 90-day demand note, due and payable by August 1,2002 in the amount of $250,000.  The$250,000 was paid by us from our share of the Second Payment which was receivedby us in June 2002.

 

Sahyoun Holdings LLC and Mr. Sahyoun haveguaranteed the $250,000 payment to be made to us from the Third Payment,regardless of the operating results of SEA. In December 2002, Mr. Sahyoun and we agreed to offset the $250,000against $250,000 of accrued commissions due Mr. Sahyoun.  As a result, we will not be entitled to anyadditional payments under the Asset Purchase Agreement, including theSubsequent Payments.  Sahyoun Holdings LLCis entitled to all amounts paid to SEP under the Asset Purchase Agreement otherthan $500,000 of payments made or payable to us pursuant to the Allocation andIndemnity Agreement and guaranteed by Charles Sahyoun and Sahyoun Holdings, LLCas described above.  Under the terms ofthe Asset Purchase Agreement, Sahyoun Holdings LLC will not be entitled to anySubsequent Payments or its allocable share of the Second and Third Payments ifMr. Sahyoun’s employment with SEA ceases for any reason other than death orpermanent disability prior to December 31, 2003.

 

Effective January 1, 2002, we purchased substantially all of thetangible and intangible assets, excluding accounts receivable, of seven officesof PES.  The initial purchase price was$1,480,000, represented by a $1,100,000 promissory note and 400,000 shares ofour common stock.  There was anadditional $334,355 of costs incurred in connection with the acquisitions.  In addition, PES is entitled to earnoutpayments of 15% of pretax profit of the acquired business up to a total of$1.25 million or the expiration of ten years, whichever occurs first.  The note bears interest at 6% a year and ispayable over a ten-year period in equal quarterly payments.  See Note 3 to the Financial Statementsincluded with this Report.

 

EffectiveDecember 1, 2002, we purchased substantially all of the tangible and intangibleassets, excluding accounts receivable, of six offices of Elite PersonnelServices, Inc.  We also took overElite’s Downey, California office, from which Elite serviced no accounts, butwhich it utilized as a corporate office. We will continue to utilize the Downey office as a regional corporatefacility.  Pursuant to a Asset PurchaseAgreement dated November 19, 2002 between us and Elite (the “Asset PurchaseAgreement”), the purchase price paid at closing (the “Base Purchase Price”) was$1,264,000, all of which was represented by a promissory note (the “Note”)payable over eight years, in equal monthly installments.  Imputed interest at the rate of 4% per yearis included in the Note amount. Accordingly, the net Base Purchase Price was $1,083,813.

 

Inaddition to the Base Purchase Price, Elite may also receive as deferredpurchase price an amount equal to 10% of “Gross Profits” as defined in theAsset Purchase Agreement, of the acquired business between $2,500,000 and$3,200,000 per year, plus 15% of Gross Profits of the acquired business inexcess of $3,200,000 per year, for a minimum of one year from the EffectiveDate, and for a period of two years from the Effective Date if Gross Profitsfor the first year reach specified levels.

 

Inconnection with this acquisition, we also entered into an employment andnon-compete agreement for a five-year period with the President and solestockholder of Elite.

 

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### **Continuing Operations**

### **Year Ended September 30, 2002 Compared to the YearEnded September 30, 2001**

 

***Revenues.*** Revenues increased 30.2% to $65,121,095 for the year ended September 30,2002 from $50,008,285 for the year ended September 30, 2001.  Approximately $13.2 million of the increasewas attributable to acquisitions. Excluding acquisitions revenues increased 3.8%.  This increase was a result of an increase inbillable hours.

 

***Gross Profit.*** Gross profit increased 5.2% to $11,520,400 for the year ended September30, 2002 from $10,952,053 for the year ended September 30, 2001.  Gross profit as a percentage of revenuesdecreased to 17.7% for the year ended September 30, 2002 from 21.9% for theyear ended September 30, 2001.  Thisdecrease was a result of increased pricing competition of staffingservices.  We also saw a deteriorationin margins as a result of the downturn in the economy.

 

***Selling, General and AdministrativeExpenses.**** *Selling, general and administrative expenses,not including depreciation and amortization and provision for doubtfulaccounts, decreased 0.5% to $12,119,207 for the year ended September 30, 2002from $12,185,770 for the year ended September 30, 2001.  Selling, general and administrativeexpenses, not including depreciation and amortization and provision fordoubtful accounts, as a percentage of revenues decreased to 18.6% for the yearended September 30, 2002 from 24.4% for the year ended September 30, 2001.  The decrease is attributable to significantcost reductions implemented by us, which were offset in part by additionalcosts associated with the expansion of our business.

 

***Loss on Impairment of Goodwill.***  Weperiodically determine if there has been a permanent impairment ofgoodwill.  In this connection, werecorded an impairment loss of $400,000 and $700,000 in the years endedSeptember 30, 2002 and 2001, respectively.

 

***Depreciation and Amortization.*** Depreciation and amortization expenses increased 39.9% to $983,000 forthe year ended September 30, 2002 from $625,864 for the year ended September30, 2001.  Depreciation and amortizationas a percentage of revenues increased to 1.5% for the year ended September 30,2002 from 1.3% for the year ended September 30, 2001.  The increase was primarily due to the amortization of goodwilland other intangibles associated with acquisitions and the impact of increasedcapital expenditures.

 

***Provision for Doubtful Accounts.*** Provision for doubtful accounts increased 130.5% to $1,406,000 for theyear ended September 30, 2002 from $610,000 for the year ended September 30,2001.  Provision for doubtful accountsas a percentage of revenues increased to 2.2% for the year ended September 30,2002 from 1.2% for the year ended September 30, 2001.  The increase was due to a change in estimate in light of thedownturn in the economy and our evaluation of the recoverability of certain ofour accounts.

 

***Finance Charges.*** Finance charges for the year ended September 30, 2001 were the amountscharged under an agreement with a factor, which was terminated on December 12,2000.

 

***Loss on Sale of Investment.***  Inthe year ended September 30, 2002, we sold 63,025,000 shares, representing ourentire 26.3% investment in a publicly-traded foreign company for net proceedsof $206,631 and realized a loss of $2,159,415.

 

***Interest and Financing Costs.*** Interest and financing costs decreased to $1,975,932 for the year ended30, 2002 from**$1,999,246 for theyear ended September 30, 2001.  Includedin the amounts for the years ended September 30, 2002 and 2001, is $104,535 and$1,213,747, respectively, which is the portion of the discount on thebeneficial conversion feature of convertible debt and $291,755 and $135,374,respectively, of costs we incurred in connection with the issuance of theconvertible debt.  Interest andfinancing costs, not including these convertible debt costs, as a percentage ofrevenue increased to 2.4% for the year ended September 30, 2002, from 1.3% forthe year ended September 30, 2001.  Thisincrease was primarily the result of debt incurred by us in connection withacquisitions.

 

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***Income Taxes (Benefit).*** Income tax expense for the year ended September 30, 2001, is the resultof a change in judgment about the reliability of deferred tax assets.

 

***Net Earnings (Loss****) **and Net Earnings (Loss) Attributable to Common Stockholders. ***As a result of the foregoing, we had a net loss and net lossattributable to common stockholders of ($7,580,487) and ($8,622,292),respectively, for the year ended September 30, 2002, compared to a net loss andnet loss attributable to common stockholders of ($5,993,387) and ($6,056,387)for the year ended September 30, 2001.

 

**Year EndedSeptember 30, 2001 Compared to Year Ended September 30, 2000**

 

***Revenues.*** Revenues increased 45.2% to $50,008,285 for the year ended September 30,2001 from $34,443,283 for the year ended September 30, 2000.  Approximately $14.9 million of the increasewas attributable to acquisitions.  Excludingacquisitions revenues increased 1.9%. This increase was a result of an increase in billable hours.

 

***Gross Profit.*** Gross profit increased 30.8% to $10,952,053 for the year ended September30, 2001, from $8,372,134 for the year ended September 30, 2000, primarily as aresult of increased revenues attributable to acquisitions.  Gross profit as a percentage of revenuesdecreased to 21.9% for the year ended September 30, 2001, from 24.3% for theyear ended September 30, 2000.  Thisdecrease was due to lower gross profit percentages realized by the acquiredbusinesses as compared to our historical gross profit percentages.

 

***Selling, General and AdministrativeExpenses***.  Selling, general and administrative expensesnot including depreciation and amortization increased 69.3% to $12,795,770 forthe year ended September 30, 2001, from $7,553,926 for the year ended September30, 2000.  Selling, general andadministrative expenses as a percentage of revenues increased to 25.6% for theyear ended September 30, 2001, from 21.9% for the year ended September 30,2000.  The increases are primarilyattributable to costs associated with the integration of the acquisitions, anincrease in credit losses and additional management and other costs inanticipation of future growth and acquisitions.

 

***Loss on Impairment of Goodwill.***  Weperiodically determine if there has been a permanent impairment ofgoodwill.  In this connection, werecorded an impairment loss of $700,000 in the year ended September 30, 2001.

 

***Other Charges.*** During the year ended September 30, 2001, we discontinued efforts tomake certain acquisitions.  We alsowrote off costs we incurred in connection with various financing not obtainedand costs associated with closed offices. The total of all these costs was $375,306.

 

***Depreciation and Amortization.*** Depreciation and amortization expenses increased 115.4% to $625,864 forthe year ended September 30, 2001, from $290,608 for the year ended September30, 2000.  Depreciation and amortizationexpenses as a percentage of revenues increased to 1.3% for the year endedSeptember 30, 2001, from 0.8% for the year ended September 30, 2000.  These increases were primarily due to theamortization of goodwill associated with acquisitions and the impact ofincreased capital expenditures.

 

***Finance Charges.*** Finance charges were the amounts charged under an agreement with afactor, which was terminated on December 12, 2000.  Finance charges decreased 86.5% to $61,291 for the year endedSeptember 30, 2001, from $453,827 for the year ended September 30, 2000.  As a percentage of revenues, finance chargesdecreased to 0.1% for the year ended September 30, 2001, from 1.3% for the yearended September 30, 2000.  This decreasewas due to the agreement being terminated December 12, 2000.

 

***Interest and Financing Costs.*** Interest and financing costs increased to $1,999,246 for the year endedSeptember 30, 2001, from $298,386 for the year ended September 30, 2000.  Included in the amount for the year endedSeptember 30, 2001, is $1,213,747, which is the portion of the discount on thebeneficial conversion feature of convertible debt issued during the year and$135,374 of costs we incurred in connection with the issuance of theconvertible debt.  Interest andfinancing costs, not including these debt costs, as a percentage of revenueincreased to 1.3% for the year ended September 30, 2001, from 0.9% for the yearended September 30, 

 

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2000.  The increase was primarily attributable to the line of creditagreement which replaced the agreement with the factor (see “Finance Changes”above) on December 12, 2000.

 

***Income Taxes (Benefit).*** Income tax benefit of $340,000 for the year ended September 30, 2000, isthe result of the utilization of a portion of the net operating losscarryforwards.  Income tax expense forthe year ended September 30, 2001, is the result of a change in judgment aboutthe realizability of deferred tax assets.

 

***Net Earnings (Loss) and Net Earnings (Loss)Attributable to Common Stockholders. ***As a result of the foregoing, we had a netloss and net loss attributable to common stockholders of ($5,993,387) and($6,056,387), respectively, for the year ended September 30, 2001, compared tonet earnings and net earnings attributable to common stockholders of $161,322for the year ended September 30, 2000.

 

**Liquidity and Capital Resources**

 

At September 30, 2002, we had limited liquidresources.  Current liabilities were$17,988,216 and current assets were $14,701,093.  The difference of $3,287,123 is a working capital deficit, whichis primarily the result of losses incurred during the last two years.  These conditions raise substantial doubtsabout our ability to continue as a going concern.  The financial statements do not include any adjustments toreflect the possible future effect on the recoverability and classification ofassets or the amounts and classification of liabilities that may result fromthe outcome of this uncertainty.

 

Our continuation of existence is dependent uponour ability to generate sufficient cash flow to meet our continuing obligationson a timely basis, to fund the operating and capital needs, and to obtainadditional financing as may be necessary.

 

We have taken steps to revise and reduce ouroperating requirements, which we believe will be sufficient to assure continuedoperations and implementation of our plans. The steps include closing branches that are not profitable,consolidating branches and reductions in staffing and other selling, generaland administrative expenses.  Wecontinue to pursue other sources of equity or long-term debt financings.  We also continue to negotiate payment plansand other accommodations with our creditors.

 

Net cash used in operating activities was$3,679,332 and $2,405,464 in the years ended September 30, 2002 and 2001,respectively.

 

Net cash provided by (used in) investingactivities was $1,256,236 and ($2,032,021) in the years ended September 30,2002 and 2001, respectively.  The saleof our Engineering Division and sale of an investment in the year ended September30, 2002, generated net cash proceeds of $1,709,079 and $206,631, respectively,which was used to fund operating activities. Cash used for acquisitions for the year ended September 30, 2002 and2001, was $336,726 and $1,218,674, respectively.  The balance in both periods was primarily for capitalexpenditures.

 

Net cashprovided by financing activities was $2,413,920 and $3,578,585 in the yearended September 30, 2002 and 2001, respectively.  We had net borrowings of $432,536 and $2,065,156 under our lineof credit in the year ended September 30, 2002 and 2001, respectively.  We also received net proceeds, lessredemptions, of $24,879 and $441,356 from the issuance of convertible debt inthe year ended September 30, 2002 and 2001, respectively.  During the years ended September 30, 2002 and2001, we received $2,154,214 and $1,412,722, respectively, in proceeds from theissuance of our Common Stock and Preferred Stock and we redeemed $455,000 ofSeries B Preferred Stock in the year ended September 30, 2002.  Net borrowings during the year endedSeptember 30, 2002 include $200,000 advanced to us by Source One Personnel,Inc. (“Source One”).  This loan wasrepresented by a promissory note bearing interest at a rate of 7% per year andwas made in connection with a modification of Source One’s agreement to forbearfrom exercising remedies under promissory notes we issued to it in connectionwith an acquisition transaction completed in July 2001 in the principal amountsof $600,000 and $1,800,000, respectively. The $200,000 note and the $600,000 note were repaid in full on July 31,2002 from the proceeds we received from the issuance of the Series E PreferredStock.  The $1,800,000 note is payablequarterly over a four year period which commenced in November 2001.

 

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Our principal uses of cash are to fund temporaryemployee payroll expense and employer related payroll taxes; investment incapital equipment; start-up expenses of new offices; expansion of servicesoffered; workers’ compensation, general liability and other insurancecoverages; debt service and costs relating to other transactions such asacquisitions.  Temporary employees arepaid weekly.

 

At various times during the years endedSeptember 30, 2002 and 2001, we issued convertible debentures through privateplacements.  The debentures boreinterest at 6% a year, payable quarterly and had a maturity date of five yearsfrom issuance.  Each debenture wasconvertible after 120 days from issuance into the number of shares of ourcommon stock determined by dividing the principal amount of the debenture bythe lesser of (a) 120% of the closing bid price of the common stock on thetrading day immediately preceding the issuance date or (b) 75% of the averageclosing bid price of the common stock for the five trading days immediatelypreceding the date of the conversion. We had the right to prepay any of the debentures at any time at aprepayment rate that varied from 115% to 125% of the amount of the debenturedepending on when the prepayment was made.

 

The discount arising from the 75% beneficial conversion feature wascharged to interest expense during the period from the issuance of thedebenture to the earliest time at which the debenture became convertible.

 

As a result of conversions of the debentures and certain transactionswith the debenture holders, only $40,000 of debentures remains outstanding atSeptember 30, 2002.

 

On December 12, 2000, we entered into a loan and security agreementwith a lending institution which replaced our prior factoring arrangement andprovides for a line of credit up to 85% of eligible accounts receivable, asdefined, not to exceed $12,000,000. Advances under the credit agreement bear interest at a rate of primeplus one and one-half percent (11⁄2 %). The credit agreement restricts our ability to incur other indebtedness,pay dividends and repurchase stock. Borrowings under the agreement are collateralized by substantially allof our assets.  As of September 30,2002, $7,739,117 was outstanding under the credit agreement.

 

At September 30, 2002, we were in violation ofthe following covenants under the loan and security agreement:

 

(i)        Failing to meet the tangible net worthrequirement;

 

(ii)       Our common stock being delisted from theNasdaq SmallCap Market

 

We have received a waiver from the lender on allof the above violations; however, advances under the credit agreement will bearinterest at an additional .25 percent (1/4%) while we remain in violation.

 

Holders of the 1,458,933 outstanding shares ofour Series A Preferred Stock are entitled to dividends at a rate of $.21 pershare per annum when and if declared by our Board of Directors in preferenceand priority to any payment of dividends on our common stock or any otherseries of our capital stock.  Dividends onthe Series A Preferred Stock may be paid in additional shares of PreferredStock if the shares of common stock issuable upon the conversion of the SeriesA Preferred Stock have been registered for resale under the Securities Act of1933.  We are obligated to pay quarterlydividends to holders of our Series E Preferred Stock and, commencing March2004, holders of our Series H Preferred Stock, at a rate of 6% per annum of thestated value of the stock in preference and priority to any payment of dividendson our common stock.  We are obligatedto pay monthly dividends on our Series F Preferred Stock at a rate of 7% perannum of the stated value of the stock in preference and priority to anypayment of dividends on our common stock. The aggregate stated values of the Series E, Series F and Series HPreferred Stock was $1,668,300, $1,000,000 and $500,000, respectively, as ofSeptember 30, 2002.  Dividends on theSeries E, Series F and Series H Preferred Stock may be paid at the Company’soption in shares of common stock (valued at the conversion price of theapplicable class of preferred stock) if such shares have been registered forresale under the Securities Act of 1933.

 

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We are obligated to redeem any shares of SeriesA Preferred Stock outstanding on June 30, 2008 at a redemption price of $3.00per share together with accrued and unpaid dividends.  We have the option to pay the redemption price through theissuance of shares of common stock.  Forpurposes of determining the number of shares we will be required to issue if wepay the redemption price in shares of common stock, the common stock will havea value equal to the average closing price of the common stock during the fivetrading days preceding the date of redemption.

 

Other fixed obligations that we had as ofSeptember 30, 2002 include:

 

•   $1,403,843 under a promissory notebearing interest at 7% per annum which was issued in connection with ouracquisition of Source One and which is payable in equal quarterly installmentsof $130,717 until its maturity date in August 2005.

•   $1,059,156 under a promissory notebearing interest at 6% per annum which was issued in connection with ouracquisition of certain assets of PES and which is payable in equal quarterlyinstallments of $36,770 until its maturity date in December 2011.

•   $80,000 under a promissory note that wasdue in April 2002 which bears interest at 18% per annum.

•   $26,000 due under promissory notesbearing interest at 6% per annum which were issued in connection with anacquisition transaction completed in January 2001 and which are past due.

•   $168,120 under a promissory note whichbears interest at 15% per annum and which requires us to make payments ofprincipal and interest of $8,000 per month until its maturity date in October2004.

•   $215,000 under a non-interest bearingpromissory note which requires us to make monthly payments of principal andinterest of $13,437 and which is due in full upon the demand of the holder.

•   $41,000 under a demand note bearinginterest at 10% per annum issued to a corporation wholly owned by the son ofJoseph J. Raymond, our President and Chief Executive Officer.

•   $75,000 owed to Joseph J. Raymond, ourChief Executive Officer, in connection with a non-interest bearing demand loan.

•   $125,000 under a demand loan which bearsinterest at various rates.

•   $104,971 under promissory notes used toacquire, and secured by, motor vehicles which require aggregate monthlypayments of principal and interest of $3,453 and which becomes due in full atvarious dates between July and August, 2005.

 

Allof our offices are leased through operating leases that are not included on thebalance sheet.  As of September 30,2002, future minimum lease payments under lease agreements having initial termsin excess of one year were:  2003 -$538,000, 2004-$239,000, 2005-$194,000, 2006 - $140,000 and 2007 - $137,000.

 

Wemay be required to make certain “earnout” payments to sellers of businessesthat we have acquired in recent years, including Source One, PES andElite.  The amount of these payments, ifany, will depend upon the results of the acquired businesses.  There were no earnout payments made infiscal 2002.

 

SourceOne has the right to require us to repurchase 400,000 shares of our commonstock at a price of $2.00 per share at any time after July 27, 2003 and beforethe later of July 27, 2005 and the full payment of the outstanding note that weissued to it in connection with the acquisition transaction completed withSource One in July 2001.  In addition,the holder of the $80,000 note which was due in April 2002 has the right torequire us to repurchase 20,000 shares of common stock at a price of $1.00 pershare plus interest at a rate of 15% per annum until the note is paid in full.

 

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Asof September 30, 2002, there were no off-balance sheet arrangements,unconsolidated subsidiaries, commitments or guarantees of other parties, exceptas disclosed in the notes to financial statements.  Stockholders’ equity at that date was $3,042,683 whichrepresented 13% of total assets.

###### ** **

We engaged in varioustransactions with related parties during fiscal 2002 including the following:

 

•      *Consulting Arrangements*:  We paid $125,000 to JeffreyJ. Raymond and $141,000 to an entity owned by Joseph J. Raymond, Jr., each ofwhom is the son of Joseph J. Raymond, our Chairman, President and ChiefExecutive Officer, in fiscal 2002 for consulting services.  These amounts were included in selling,general and administrative expense.  Theservices provided included the identification of acquisition candidates,acquisition advisory services, due diligence, post-acquisition transitionservices, customer relations, accounts receivable collection and strategic planningadvice.

 

•      *Transactions with CEO:*  On April 9, 2001 TransworldManagement Services, Inc. (“Transworld”), a company wholly owned by Joseph J.Raymond, our Chairman, President and Chief Executive Officer, loaned us$160,000 so that we would have enough working capital to meet certain of ourcommitments.  This loan was laterconverted into 32,000 shares of Series B Preferred Stock.  In July 2002, we issued 1,600 shares of SeriesE Preferred Stock to Transworld in exchange for the 32,000 shares of Series BPreferred Stock and Transworld waived the payment of all accrued dividends andpenalties associated with the Series E Preferred Stock.

 

InJuly 2002, we sold 10,000 shares of our Series F Preferred Stock to Mr. Raymondfor $1,000,000 so that we would have sufficient capital to sustain ouroperations.

 

•      *Other Sales of Securities:*  To assist us in meeting ourcapital requirements, we sold an aggregate of 560,721 shares of common stock torelatives of Joseph J. Raymond at prices ranging from $.87 to $1.43, resultingin gross proceeds to us of $566,833. Each of these sales was made at a price equal to or exceeding the marketprice of the common stock at the time of the sale.

 

•      *SEP, LLC:*  In January 2002, we transferred the assetsof our Engineering Division to SEP, LLC, a New Jersey limited liabilitycompany, of which we were the sole owner. AT the same time, we transferred a thirty percent (30%) interest in SEP,LLC to Charles Sahyoun, the President of the Engineering Division and thebrother-in-law of Mr. Raymond, in connection with the proposed sale of theEngineering Division.  Details of theseand related transactions are set forth in this Report under the caption“Discontinued Operations/Acquisition or Disposition of Assets” and “CertainRelationships and Related Party Transactions”.

 

We believe that alltransactions with related parties have been on terms no less favorable to usthan those that could have been obtained from unaffiliated third parties.

 

###### **Seasonality**

 

Our business follows theseasonal trends of our customer’s business. Historically, we have experienced lower revenues in the first calendarquarter with revenues accelerating during the second and third calendarquarters and then starting to slow again during the fourth calendar quarter.

 

###### **Impact of Inflation**

 

We believe that since ourinception, inflation has not had a significant impact on our results ofoperations.

 

**Impact of Recent Accounting Pronouncements**

 

In June 2001, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standard (SFAS) No. 141, “BusinessCombinations”.  SFAS No. 141 establishesnew standards for 

 

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accounting and reportingrequirements for business combinations and requires that the purchase method ofaccounting be used for all business combinations initiated after June 30,2001.  SFAS No. 141 also requires thatacquired intangible assets be recognized as assets apart from goodwill if theymeet one of the two specified criteria. Additionally, the statement adds certain disclosure requirements tothose required by APB 16, including disclosure of the primary reasons for thebusiness combination and the allocation of the purchase price paid to theassets acquired and liabilities assumed by major balance sheet caption.  This statement is required to be applied toall business combinations initiated after June 30, 2001 and to all businesscombinations accounted for using the purchase method for which the date ofacquisition is July 1, 2001 or later. Use of the pooling-of-interests method is prohibited.  The adoption of SFAS No. 141 did not have animpact on our financial condition or results of operations.

 

In June 2001, the FASB issued SFAS No. 142, “Goodwill and OtherIntangible Assets”.  SFAS No. 142, whichmust be applied to fiscal years beginning after December 15, 2001, modifies theaccounting and reporting of goodwill and intangible assets.  The pronouncement requires entities todiscontinue the amortization of goodwill, reallocate all existing goodwillamong its reporting segments based on criteria set by SFAS No. 142 and performinitial impairment tests by applying a fair-value-based analysis on thegoodwill in each reporting segment.  Anyimpairment at the initial adoption date shall be recognized as the effect of achange in accounting principle. Subsequent to the initial adoption, goodwill shall be tested forimpairment annually or more frequently if circumstances indicate a possibleimpairment.

 

Under SFAS No. 142, entities are required to determine the useful lifeof other intangible assets and amortize the value over the useful life.  If the useful life is determined to beindefinite, no amortization will be recorded. For intangible assets recognized prior to the adoption of SFAS No. 142,the useful life should be reassessed. Other intangible assets are required to be tested for impairment in amanner similar to goodwill.  At June 30,2002, our goodwill subject to amortization was approximately $3,451,000, andannual amortization of such goodwill was approximately $291,000.  We will adopt SFAS No. 142 during our firstfiscal quarter of fiscal 2003.  Becauseof the extensive effort required to comply with the remaining provisions ofSFAS Nos. 141 and 142, we cannot reasonably estimate the impact on itsfinancial statements of these provisions beyond discontinuing amortization.

 

In August 2001, the FASB issued SFAS No. 144, “Impairment of Long-LivedAssets”.  FAS 144 supercedes SFAS No.121, “Accounting for the Impairment of Long-Lived Assets and for Long-LivedAssets to be Disposed of”.  FAS 144retains the requirements of FAS 121 to (a) recognize an impairment loss only ifthe carrying amount of a long-lived asset is not recoverable from itsundiscounted cash flows and (b) measure an impairment loss as the differencebetween the carrying amount and the fair value of the asset.  FAS 144 removes goodwill from itsscope.  FAS 144 is applicable tofinancial statements issued for fiscal years beginning after December 15, 2001,or for our fiscal year ended September 30, 2003.  We do not expect the adoption to have any material adverse impacton our financial position or results of our operations.

 

In July 2002, the FASB issued SFAS No. 146 “Accounting for CostsAssociated with Exit or Disposal Activities”. SFAS 146 addresses financial accounting and reporting for costsassociated with exit or disposal activities and nullified Emerging Issues TaskForce (“EITF”) Issue No. 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)”. The principal difference between SFAS 146 and EITF 94-3 relates to thetiming of the recognition of a liability for a cost associated with an exit ordisposal activity.  SFAS 146 requiresthat a liability for a cost associated with an exit or disposal activity berecognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost as generally defined inEITF 94-3 is to be recognized at the date of an entity’s commitment to an exitplan.  SFAS 146 is effective for exit ordisposal activities that are initiated after December 31, 2002.  The effect of adoption of FAS 146 isdependent on our related activities subsequent to the date of adoption.

 

27

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**Quantitativea****nd Qualitative Disclosure About Market Risks**

 

We are subject to the risk of fluctuating interest rates in theordinary course of business for borrowings under our Loan and Security Agreementwith Capital Tempfunds, Inc.  Thiscredit agreement provides for a line of credit up to 85% of eligible accountsreceivable, not to exceed $12,000,000. Advances under this credit agreement bear interest at a rate of primeplus one and one-half percent (1-1/2%); however, advances will bear interest atan additional .25 percent (1/4%) while we remain in violation of certaincovenants.

 

As a result of the disposition of our interest in enterpriseAsia.com, apublicly-traded foreign company, we are no longer exposed to equity price risk.

 

We believe that our business operations are not exposed to market riskrelating to foreign currency exchange risk or commodity price risk.

 

**ITEM 8.****         ****FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA****.**

 

Theresponse to this item is submitted in a separate section of this reportcommencing on Page F-1.

 

**ITEM9.****         ****CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

Nochange in accountants or disagreement requiring disclosure pursuant toapplicable regulations took place within the reporting period or in anysubsequent interim period.

 

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**PART III**

 

**ITEM10.****              ****DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;COMPLIANCE WITH SECTIONS 16(c) OF THE EXCHANGE ACT.**

 

##### **TheBoard of Directors and Officers**

##### ** **

The name and age of each the directors and theexecutive officers of the Company and their respective positions with theCompany are set forth below.  Additionalbiographical information concerning each of the directors and the executiveofficers follows the table.

 
| **Name**              |   | **Age** |   | **Position**                                                  |
|-----------------------|--------|---------|--------|---------------------------------------------------------------|
|                  |   |    |   |                                                          |
| Joseph J. Raymond     |   | 67      |   | Chairman of the Board, President and  Chief Executive Officer |
|                  |   |    |   |                                                          |
| Michael J. Rutkin     |   | 51      |   | Director                                                      |
|                  |   |    |   |                                                          |
| Harry Robert Kingston |   | 80      |   | Director                                                      |
|                  |   |    |   |                                                          |
| Donald W. Feidt       |   | 70      |   | Director                                                      |
|                  |   |    |   |                                                          |
| Sanford I. Feld       |   | 74      |   | Director                                                      |
|                  |   |    |   |                                                          |
| Michael A. Maltzman   |   | 54      |   | Chief Financial Officer & Treasurer                       |
|                  |   |    |   |                                                          |
| J. Todd Raymond       |   | 34      |   | Corporate Secretary                                           |

 

**JosephJ. Raymond**has served as Chairman of the Board and Chief Executive Officer of Stratussince its inception in 1997.  Priorthereto, he served as Chairman of the Board, President and Chief ExecutiveOfficer of Transworld Home Healthcare, Inc. (NASDAQ:TWHH), a provider of healthcareservices and products, from 1992 to 1996. From 1987 through 1997, he served as Chairman of the Board and Presidentof Transworld Nurses, Inc., a provider of nursing and paraprofessionalservices, which was acquired by Transworld Home Healthcare, Inc. in 1992.

 

**MichaelJ. Rutkin**has served as a Director of Stratus since November 1997 and was Chief OperatingOfficer and President from March 1997 to October 1998.  Since November 1998, Mr. Rutkin has servedas General Manager/Chief Executive Officer of Battleground Country Club.  From 1996 to 1998, Mr. Rutkin served as VicePresident of Transworld Management Services, Inc.  From February 1993 to October 1996, he served as Chief OperatingOfficer of HealthCare Imaging Services, Inc. Prior thereto, Mr. Rutkin was the Executive Vice President of AdvancedDiagnostic Imaging from February 1987 to February 1993.  From March 1981 to September 1984, he servedas Director of New Business Development for the United States PharmaceuticalDivision of CIBA-Geigy.  Mr. Rutkin isthe brother-in-law of Joseph J. Raymond.

 

**HarryRobert Kingston**has served as a Director of Stratus since November 1997.  From 1977 until his retirement in 1989, heserved as the President and Chief Executive Officer of MainStream EngineeringCompany, Inc., an engineering staffing firm located in California.  From 1965 to 1968, he served as Presidentand Partner of VIP Engineering Company, a subsidiary of CDI Corporation, astaffing and engineering services business. From 1968 to 1977, Mr. Kingston served as Vice President for CDI Corporation.

 

**DonaldW. Feidt**has served as a Director of Stratus since November 1997.  From 1987 to December 1998, Mr. Feidt was aManaging Partner of Resource Management Associates, an information technologyconsulting company.  Since December1998, Mr. Feidt has served as a Vice President to the Chief Executive Officerof

 

29

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Skila Inc., a global web-based businessintelligence platform company providing services to the medical industry.

 

**SanfordI. Feld**has served as a Director of the Company since November 1997.  Mr. Feld is currently president of LeaflandAssociates, Inc., an advisor to Feld Investment and Realty Management, a realestate development and management company. He also serves as Chairman of Flavor and Food Ingredients, a privatesavory and flavor company.  From 1973 to1979, he served as Director of the Chelsea National Bank of New York City.

 

**MichaelA. Maltzman**has served as Treasurer and Chief Financial Officer of Stratus since September1997 when it acquired the assets of Royalpar Industries, Inc.  Mr. Maltzman served as a Chief FinancialOfficer of Royalpar, which filed for protection under United States BankruptcyCode in 1997, from April 1994 to August 1997. From June 1988 to July 1993, he served as Vice President and ChiefFinancial Officer of Pomerantz Staffing Services, Inc., a national staffingcompany.  Prior thereto, he was aPartner with Eisner & Lubin, a New York accounting firm.  Mr. Maltzman is a Certified Public Accountant.

 

**J.Todd Raymond**has served as Secretary of the Company since September 1997 and as GeneralCounsel from September 1997 until March 2002. He currently serves as Secretary, Controller and General Counsel of TelxGroup, Inc., a telecommunications company. From December 1994 to January 1996, Mr. Raymond was an associate andmanaging attorney for Pascarella & Oxley, a New Jersey general practice lawfirm.  Prior thereto, Mr. Raymond actedas in-house counsel for Raymond & Perri, an accounting firm.  From September 1993 to September 1994, Mr.Raymond was an American Trade Policy Consultant for Sekhar-Tunku Imran HoldingsSdn Berhad, a Malaysian multi-national firm. He is the nephew of Joseph J. Raymond.

 

**Compliancewith Section 16(a) of the Exchange Act**

 

Section 16(a) of the Exchange Act requires theCompany’s executive officers and directors, and persons who own more than tenpercent of a registered class of the Company’s equity securities, to filereports of ownership and changes in ownership on Forms 3, 4 and 5 with theSecurities and Exchange Commission (the “SEC”).  Officers, directors and greater than ten percent stockholders arerequired by SEC regulation to furnish the Company with copies of all Forms 3, 4and 5 they file.

 

Based solely on the Company’s review of thecopies of such forms it has received, the Company believes that all of itsexecutive officers, directors and greater than ten percent stockholderscomplied with all filing requirements applicable to them with respect to eventsor transactions during fiscal 2002, except that each of Joseph J. Raymond,Charles Sahyoun, Michael A. Maltzman, J. Todd Raymond, Sanford I. Feld andDonald W. Feidt were late in filing their Forms 4, which were due in connectionwith the grant of options made to such individuals in March, 2002.

** **

**30**

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# **ITEM 11****.****              ****EXECUTIVE COMPENSATION**

** **

**The following table provides certain summary informationregarding compensation paid by the Company during the fiscal years endedSeptember 30, 2000, 2001 and 2002 to the Chief Executive Officer of the Companyand to each of the Company’s other two most highly paid executive officers whoearned compensation of $100,000 or more in fiscal 2001 (together with the ChiefExecutive Officer, the “Named Executive Officers”):**

** **
|                               |   |          |       | **Long  Term  Compensation  Awards** |       |
|------------------------------------|--------|---------------|------------|--------------------------------------|------------|
| **Name and Principal Position**    |   |          |       |                                 |       |   |   | **Number  of Shares  Underlying Stock  Options (#)** |   |
| **Annual  Compensation**           |
| **Fiscal  Year**                   |   | **Salary($)** |       | **Bonus  ($)**                       |
|                               |   |          | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| **Joseph  J. Raymond**             |   | **2002**      | ** ** | **49,472**                           | ** ** | **3⁄4** | ** ** | **1,750,000** | ** ** |
| **Chairman  and Chief Executive**  |   | **2001**      |       | **175,000**                          |       | **3⁄4** |   | **1,200,000** |   |
| **Officer**                        |   | **2000**      | ** ** | **127,855**                          | ** ** | **25,900** | ** ** | **1,102,115** | ** ** |
|                               |   |          |       |                                 |       |   |   |   |   |
| **Michael  A. Maltzman**      |   | **2002**      | ** ** | **165,000**                          | ** ** | **3⁄4** | ** ** | **300,000** | ** ** |
| **Treasurer  and Chief Financial** |   | **2001**      |       | **165,000**                          |       | **3⁄4** |   | **200,000** |   |
| **Officer**                        |   | **2000**      |       | **155,039**                          |       | **21,975** |   | **102,115** |   |
|                               |   |          | ** ** |                                 | ** ** |   | ** ** |   | ** ** |
| **Charles  Sahyoun**          |   | **2002**      | ** ** | **100,000**                          | ** ** | **3⁄4** | ** ** | **50,000** | ** ** |
| **Former  President, Engineering** |   | **2001**      |       | **190,577**                          |       | **115,000** |   | **200,000** |   |
| **Services  Division (1)**         |   | **2000**      |       | **160,962**                          |       | **54,400** |   | **102,115** |   |

 

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(1)                                  The Company sold its Engineering ServicesDivision in March 2002.  As a result,Mr. Sahyoun is no longer employed by the Company

 

##### **Directors’Compensation**

##### ** **

Directors who are employeesof the Company are not compensated for serving on the Board of Directors.  Non-employee directors are paid a fee of$1,000 per Board of Directors or committee meeting attended in person and $500for telephonic attendance.

 

##### **EmploymentAgreements**

##### ** **

In September 1997, the Company entered into anemployment agreement (the “Raymond Agreement”) with Joseph J. Raymond, Chairmanand Chief Executive Officer, which had an initial term that expired inSeptember 2000.  The Raymond Agreementhas been extended through September 30, 2007. Pursuant to the Raymond Agreement and subsequent amendments, Mr. Raymondis entitled to a minimum annual base salary of $175,000 which is reviewedperiodically and subject to such increases as the Board of Directors, in itssole discretion, may determine.  Duringthe term of the Raymond Agreement, if Stratus is profitable, Mr. Raymond isentitled to a bonus/profit sharing award equal to .4% of Stratus’ gross margin,but not in excess of 100% of his base salary. If Stratus is not profitable, he is entitled to a $10,000 bonus.  Mr. Raymond is eligible for all benefitsmade available to senior executive employees, and is entitled to the use of anautomobile.  In fiscal 2002, Mr. Raymondvoluntarily did not take a substantial portion of his minimum annual basesalary.

 

In the event Stratus terminates Mr. Raymondwithout “Good Cause”, Mr. Raymond will be entitled to severance compensationequal to 2.9 times his base salary then in effect plus any accrued and unpaidbonuses and unreimbursed expenses.  Asdefined in the Raymond Agreement “Good Cause” shall exist only if Mr. Raymond:

 

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•                  willfully or repeatedly fails in any materialrespect to perform his obligations under the Raymond Agreement, subject tocertain opportunities to cure such failure;

 

•                  is convicted of a crime which constitutes afelony or misdemeanor or has entered a plea of guilty or no contest withrespect to a felony or misdemeanor during his term of employment;

 

•                  has committed any act which constitutes fraudor gross negligence;

 

•                  is determined by the Board of Directors to bedependent upon alcohol or drugs; or

 

•                  breaches confidentiality or non-competitionprovisions of the Raymond Agreement.

 

Mr. Raymond is also entitled to severancecompensation in the event that he terminates the Raymond Agreement for “GoodReason” which includes:

 

•                  the assignment to him of any dutiesinconsistent in any material respect with his position or any action whichresults in a significant diminution in his position, authority, duties orresponsibilities;

 

•                  a reduction in his base salary unless hisbase salary is, at the time of the reduction, in excess of $200,000 and thepercentage reduction does not exceed the percentage reduction of gross sales ofStratus over the prior twelve month period;

 

•                  Stratus requires Mr. Raymond to be based atany location other than within 50 miles of Stratus’ current executive officelocation; and

 

•                  a Change in Control of Stratus, whichincludes the acquisition by any person or persons acting as a group ofbeneficial ownership of more than 20% of the outstanding voting stock ofStratus, mergers or consolidations of Stratus which result in the holders ofStratus’ voting stock immediately before the transaction holding less than 80%of the voting stock of the surviving or resulting corporation, the sale of allor substantially all of the assets of Stratus, and certain changes in theStratus Board of Directors.

 

In the event that the aggregate amount ofcompensation payable to Mr. Raymond would constitute an “excess parachutepayment” under the Internal Revenue Code of 1986, as amended (the “Code”), thenthe amount payable to Mr. Raymond will be reduced so as not to constitute an“excess parachute payment.”  Allseverance payments are payable within 60 days after the termination ofemployment.

 

Mr. Raymond has agreed that during the term ofthe Raymond Agreement and for a period of one year following the termination ofhis employment, he will not engage in or have any financial interest in anybusiness enterprise in competition with Stratus that operates anywhere within aradius of 25 miles of any offices maintained by the Company as of the date ofthe termination of employment.

 

The Company entered into employment agreementswith each of the other two (2) officers named in the Executive Compensationtable set forth above.  The agreementwith Mr. Maltzman provides for a base salary of $165,000 per annum.  The agreement with Mr. Sahyoun entitled himto an annual base salary of $200,000 and a profit sharing award equal to 10% ofthe Engineering Services Division’s pre-tax income, but not in excess of hisbase salary.  As of March 31, 2002, dueto the sale of the Engineering Division, Mr. Sahyoun is no longer an employeeof the Company.  Mr. Maltzman isentitled to profit sharing awards based upon the Company’s overall profitability.  The agreement with Mr. Maltzman isterminable by either party at any time without cause.  However, in the event that this agreement is terminated by theCompany without cause or by the executive with good reason, Mr. Maltzman willbe entitled to a severance payment equal to the greater of one month’s salaryfor each year worked or three months salary. In addition, the Company will pay Mr. Maltzman any earned but unusedvacation time and any accrued but unpaid profit sharing.  The Company is also required to maintaininsurance and benefits for Mr. Maltzman during the severance period.

 

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##### **OptionGrants**

##### ** **

Shown below is further information with respectto grants of stock options in fiscal 2002 to the Named Officers by the Companywhich are reflected in the Summary Compensation Table set forth under thecaption “Executive Compensation.”

 
|                                                                                                 |   | **Individual Grants**                                          |   |                                                                   |   |
|------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------|--------|------------------------------------------------------------------------|--------|
| **Name**                                                                                             |   | **Number of  Securities  Underlying  Options  Granted (#)(1)** |   | **Percent of  Total  Options  Granted to  Employees  in Fiscal  Year** |   | **Exercise or  Base Price  ($/Sh)** |   | **Expiration  Date** |   |   |   |
|                                                                                                 |
|                                                                                                 |
| **Potential Realizable Value at  Assumed Annual Rates of Stock  Price Appreciation for Option Term** |
| **5%**                                                                                               |   | **10%**                                                        |
| Joseph J. Raymond                                                                                    |   | 1,750,000                                                      | (1)    | 49.1                                                                   | %      | $ | .65 |   | 3/28/12 |   | $ | 1,852,873 |   | $ | 2,950,334 |   |
|                                                                                                 |   |                                                           |   |                                                                   |   |   |   |   |   |   |   |   |   |
| Michael A. Maltzman                                                                                  |   | 300,000                                                        | (1)    | 8.4                                                                    |   | .65 |   | 3/28/12 |   | 317,636 |   | 505,771 |   |
|                                                                                                 |   |                                                           |   |                                                                   |   |   |   |   |   |   |   |   |   |
| Charles Sahyoun                                                                                      |   | 50,000                                                         | (1)    | 1.4                                                                    |   | .65 |   | 3/28/12 |   | 52,939 |   | 84,295 |   |
|                                                                                                      |        |                                                                |        |                                                                        |        |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)   Exercisableimmediately.

 

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

 

Shown below is information with respect tooptions exercised by the Named Executive Officers during fiscal 2001 and thevalue of unexercised options to purchase the Company’s Common Stock held by theNamed Executive Officers at September 30, 2001.

 
| **Name**             |                   | **Shares  Acquired  on  Exercise(#)** |   |              |   | **Number of Securities  Underlying Unexercised  Options at FY End (#)** |   | **Value of Unexercised  In-The-Money Options at FY End ($)** |   |
|----------------------|------------------------|---------------------------------------|--------|-------------------|--------|-------------------------------------------------------------------------|--------|-------------------------------------------------------------------|--------|
|                 |                   |                                  |   |              |
|                 | **Value  Realized($)** |                                  |   |              |
|                 |                   | **Exercisable**                       |   | **Unexercisable** |   | **Exercisable**                                                         |   | **Unexercisable**                                                 |   |
| Joseph  J. Raymond   |                   | 3⁄4                                |   | 3⁄4            |   | 3,168,782                                                               |   | 850,000                                                           |   | $ | 0 |   | $ | 0 |   |
| Charles  Sahyoun     |                   | 3⁄4                                |   | 3⁄4            |   | 50,000                                                                  |   | 0                                                                 |   | 0 |   | 0 |   |
| Michael  A. Maltzman |                   | 3⁄4                                |   | 3⁄4            |   | 635,448                                                                 |   | 50,000                                                            |   | 0 |   | 0 |   |
|                      |                        |                                       |        |                   |        |                                                                         |        |                                                                   |        |  |  |  |  |  |  |

 

No options were exercised by the Named Executive Officers during thefiscal year ended September 30, 2002.

 

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(1)                                  Represents market value of shares covered byin-the-money options on September 30, 2002. The closing price of the Common Stock on such date was $.15.  Options are in-the-money if the market valueof shares covered thereby is greater than the option exercise price.

 

33

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**ITEM 12**.                                            SECURITIESOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

** **

The following table sets forth information, asof December 17, 2002 with respect to (a) each person who is known by theCompany to be the beneficial owner (as defined in Rule 13d-3 (“Rule13d-3”) of the Securities and Exchange Act of 1934) of more than five percent(5%) of the Company’s Common Stock, Series A Preferred Stock and Series FPreferred Stock and (b) the beneficial ownership of Common Stock, Series APreferred Stock and Series F Preferred Stock by each director and each of theCompany’s current Executive Officers who earned in excess of $100,000 in fiscal2002 and by all directors and executive officers as a group.  Except as set forth in the footnotes to thetable, the stockholders have sole voting and investment power over such shares.

 
|                                                                                                |   | **Common Stock**                                 |   | **Series A  Preferred Stock** |   | **Series F  Preferred Stock**                    |   |
|-----------------------------------------------------------------------------------------------------|--------|--------------------------------------------------|--------|-------------------------------|--------|--------------------------------------------------|--------|
| **Name of Beneficial Owner**                                                                        |   | **Amount and  Nature of  Beneficial  Ownership** |   | **% of  Class**               |   | **Amount and  Nature of  Beneficial  Ownership** |   | **% of  Class** |   | **Amount and  Nature of  Beneficial  Ownership** |   | **% of  Class** |   |
| Joseph J. Raymond                                                                                   |   | 16,946,468                                       | (1)    | 59.5                          | %      | 1,458,933                                        | (5)    | 100.0 | % | 10,000 | (3) | 100.0 | % |
| Artisan.com Limited                                                                                 |   | 2,275,933                                        | (4)    | 16.4                          | %      | 1,375,933                                        | (7)    | 94.3 | % |   |   |   |   |
| Cater Barnard (USA)  plc                                                                            |   | 83,000                                           | (6)    | (13                           | )      | 83,000                                           | (8)    | 5.7 | % |   |   |   |   |
| Michael A. Maltzman                                                                                 |   | 682,116                                          | (8)    | 5.59                          | %      | 3⁄4                                           |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Michael J. Rutkin                                                                                   |   | 213,075                                          | (9)    | 1.82                          | %      | 3⁄4                                           |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Sanford I Feld                                                                                      |   | 107,834                                          | (10)   | (13                           | )      | 3⁄4                                           |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| H. Robert Kingston                                                                                  |   | 93,333                                           | (11)   | (13                           | )      | 3⁄4                                           |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| Donald W. Feidt                                                                                     |   | 80,000                                           | (13)   | (13                           | )      | 3⁄4                                           |   | 3⁄4 |   | 3⁄4 |   | 3⁄4 |   |
| All Directors and  Executive Officers as a Group (8)Persons) (1)(2)(3)(8)(9)(10) (11)(12) and  (14) |   | 18,237,608                                       |   | 66.91                         | %      | 1,458,933                                        |   | 100.0 | % | 10,000 |   | 100.0 | % |

 

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(1)               Includes 900,000 shares of Common Stock ownedby Artisan.com, 1,375,933 shares of Common Stock issuable upon the conversion,at the holder’s option, of an equal number of shares of Series A PreferredStock owned by Artisan.com and 83,000 shares of Common Stock issuable upon theconversion, at the holder’s option, of an equal number of shares of Series APreferred Stock owned by Cater Barnard U.S.A. All of such shares are subject to proxies granted by Artisan.com andCater Barnard U.S.A. which give Joseph J. Raymond the right to vote theseshares until July 2004, provided that he remains Chairman of the Company’sBoard of Directors.  Also includes (i)10,000,000 shares of Common Stock issuable as of December 17, 2002, uponconversion of 10,000 shares of Series F Preferred Stock held by a corporationof which Mr. Raymond is sole owner; (ii) 1,066,667 shares of Common Stock issuableas of December 17, 2002, upon conversion of 1,600 shares of Series E PreferredStock, assuming a conversion price of $.15; and (iii) 3,193,782 shares ofCommon Stock subject to options which are currently exercisable or may becomeexercisable within 60 days of December 17, 2002.  Excludes 850,000 shares of Common Stock subject to options whichare not vested or exercisable within 60 days of December 17, 2002.

 

(2)               These shares are held by Artisan.com(1,375,933 shares) and Cater Barnard (83,000 shares).  Each of Artisan.com and Cater Barnard has granted Mr. Raymond aproxy to vote these shares as described in Note 1 above.

 

(3)               These shares are owned directly by Mr.Raymond.

 

(4)               Includes 1,375,933 shares of Common Stockissuable upon conversion, at the holder’s option, of an equal number of sharesof Series A Preferred Stock. Artisan.com Limited has granted Joseph J. Raymond a proxy to vote theseshares as described in Note 1 above.

 

34

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(5)               Artisan.com Limited has granted Joseph J.Raymond a proxy to vote these shares as described in Note 1 above.

 

(6)               Represents 83,000 shares of Common Stockissuable upon the conversion, at the holder’s option, of an equal number ofshares of Series A Preferred Stock.  CaterBarnard (USA) plc has granted Joseph J. Raymond a proxy to vote these shares asdescribed in Note 1 above.  Stephen Deanis the Chairman and a significant shareholder of each of the parent company ofArtisan.com Limited and the parent company of Cater Barnard (USA) plc.

 

(7)               Cater Barnard (USA) plc has granted Joseph J.Raymond a proxy to vote these shares as described in Note 1 above.

 

(8)               Includes 635,448 shares subject to currentlyexercisable stock options.  Excludes50,000 shares subject to options that are not vested or exercisable within 60days of December 17, 2002.

 

(9)               Includes 30,000 shares held by the childrenof Michael Rutkin, living in his household and 10,000 shares held by his wife.

 

(10)   Includes 49,167 shares subject to currently exercisable stock optionsand warrants.

 

(11)         Includes 60,000 shares subject to currently exercisable options.

 

(12)         Includes 60,000 shares subject to currently exercisable options.

 

(13)         Shares beneficially owned do not exceed 1% of the Company’s outstandingCommon Stock.

 

(14)         Includes 114,782 shares of Common Stock that are beneficially owned byJ. Todd Raymond, the Company’s Corporate Secretary, including 88,782 sharessubject to currently exercisable options.

** **

**Securities Authorized forIssuance under Equity Compensation Plans**

** **

**Thenumber of stock options outstanding under our equity compensation plans, theweighted average exercise price of outstanding options, and the number ofsecurities remaining available for issuance, as of September 30, 2002, were asfollows:**

** **
| **Plan Category**                                                   |   | **Number  of securities  to be issued upon  exercise of  outstanding options,  warrants and rights  (a)** |       | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** |       | **Number  of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))  (c)** |          |
|---------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|---------------|
|                                                                |   |                                                                                                      | ** ** |                                                                                    | ** ** |                                                                                                                                                        | ** **    |
| **Equity  compensation plans approved by security holders**         |   | **4,596,349**                                                                                             | ** ** | **$**                                                                                   | **1.24**   | ** **                                                                                                                                                  | **2,403,651** | **(1)** |
|                                                                |   |                                                                                                      | ** ** |                                                                                    | ** ** |                                                                                                                                                        | ** **    |
| **Equity  compensation plans not approved by security holders (2)** |   | **1,660,000**                                                                                             | ** ** | **4.16**                                                                                | ** ** | **743,651**                                                                                                                                                 | ** **    |
|                                                                |   |                                                                                                      | ** ** |                                                                                    | ** ** |                                                                                                                                                        | ** **    |
| **Total**                                                           |   | **6,256,349**                                                                                             | ** ** | **2.01**                                                                                | ** ** | **743,651**                                                                                                                                                 | ** **    |
|                                                                     |        |                                                                                                           |            |                                                                                         |            |                                                                                                                                                             |               |  |

** **

----

**(1)**                                  Ourequity incentive plans provide for the issuance of incentive awards toofficers, directors, employees and consultants in the form of stock options, stockappreciation rights, restricted stock and deferred stock, and in lieu of cashcompensation.

** **

**(2)**                                  Representsshares subject to options granted to certain officers pursuant to employmentagreements and individual stock option agreements, including (a) options withrespect to 1,000,000 shares granted to Joseph J. Raymond which expire inJanuary 2010 and which become exercisable only if we achieve earnings of $1.00per share in a fiscal year and options with respect to 50,000 shares granted toJoseph J. Raymond which expire in April, 2010, and (b) options with respect to83,333 shares granted to Michael A Maltzman which expire in September, 2007,options with respect to 26,667 shares granted to J. Todd Raymond, which expirein September, 2007, and options with respect to 50,000 shares granted toCharles Sahyoun which expire in March, 2012.

** **

**35**

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** **

** **

**ITEM13**.                                              CERTAINRELATIONSHIPS AND RELATED PARTY TRANSACTIONS.

** **

Jeffrey J. Raymond, the son of Joseph J.Raymond, our Chairman and Chief Executive Officer, serves as a consultant to uspursuant to an agreement which requires him to supervise the collection ofcertain accounts receivable, to use his best efforts to maintain relationshipswith certain clients and to assist in due diligence investigations ofacquisitions of other companies.  Totalconsulting fees paid to Jeffrey Raymond were $125,000 in fiscal 2002.

 

During the fiscal year 2002, we paid consultingfees of $141,000 to RVR Consulting, Inc., a corporation of which Joseph J.Raymond, Jr., the son of Joseph J. Raymond, our Chairman and Chief ExecutiveOfficer, is an officer and 100% stockholder.

 

In November 2000, we formed the StratusTechnology Services, LLC joint venture (“STS”) with Fusion Business Services,LLC.  Jamie Raymond, son of Joseph J.Raymond, Chairman and CEO, is the managing member of STS and Fusion, which ownsa 50% interest in Stratus Technology Services, LLC.

 

During the year ended September 30, 2002, we sold 177,722 shares of ourcommon stock in private placements to a relative of the Chief Executive Officerat prices approximating the then current market of $.87 to $.93 per share, fortotal gross proceeds of $156,833. During the year ended September 30, 2002, we sold 382,999 shares of ourcommon stock in private placements to relatives of our Chief Executive Officerat prices approximating the then current market of $.93 to $1.43 per share, fortotal gross proceeds of $410,000, less expenses of $5,958.

 

In March 2002, Transworld Management Services,Inc. (“Transworld”), the holder of a $160,000 promissory note previously issuedby us, exchanged the note for 32,000 shares of Series B Preferred Stock.  Joseph J. Raymond, Sr., our Chairman andChief Executive Officer, holds a 100% interest in Transworld.  On July 19, 2002, Transworld entered into anExchange Agreement with us, whereby it exchanged its 32,000 shares of Series BPreferred Stock, waiving all accrued dividends and penalties, in exchange for1,600 shares of Series E Preferred Stock.

 

In January 2002, we transferred the assets ofour Engineering Services Division to SEP, LLC, a New Jersey limited liabilitycompany of which we were the sole owner. At the same time, we transferred a thirty percent (30%) interest in SEP,LLC to Charles Sahyoun, the President of the Engineering ServicesDivision.  We transferred this thirtypercent (30%) interest in SEP, LLC in consideration of (i) Mr. Sahyoun’sagreement to cancel options to acquire 385,448 shares of our Common Stockhaving exercise prices ranging from $1.10 to $6.00 per share, (ii) inrecognition of his contributions to the development of the business of theEngineering Services Division, (iii) in recognition of the significant role heplayed in arranging and negotiating the sale of the Engineering ServicesDivision, (iv) in consideration of his agreement to guaranty a certain level ofcontingent payments from the purchaser and to indemnify us in the event wesustain losses attributable to breaches of certain representations andwarranties contained in the Asset Purchase Agreement pursuant to which we soldthe Engineering Services Division or our obligation to indemnify the purchaserfor losses and damages

 

36

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arisingout of certain events prior to the closing of the sale, (v) in consideration ofhis agreement to enter into a non-compete agreement with the purchaser and (vi)to accommodate the purchaser’s requirement that Mr. Sahyoun have an interest inthe contingent portion of the consideration payable by the purchaser for theassets sold.

 

Pursuant to an Allocation and IndemnityAgreement entered into by us, Mr. Sahyoun and Sahyoun Holdings LLC (a companywholly-owned by Mr. Sahyoun and to which he transferred his interest in SEP,LLC), Sahyoun Holdings LLC received $440,000 of the $2,200,000 payment made bythe purchaser at the closing of the sale of the Engineering Services Divisionand all but $250,000 of a payment made in June 2002 that was based upon thepurchaser’s profit during the six months ended June 30, 2002.  Sahyoun Holdings LLC is entitled to all but$250,000 of a payment due from the purchaser in 2003, the total amount of whichwill be equal to $1 million plus or minus the amount by which the purchaser’sprofit for the six (6) months ending December 31, 2002 is greater or less than$600,000.  Sahyoun Holdings LLC will beentitled to the entire amount of five (5) annual payments required to be madeby the purchaser that will be based upon a multiple of the annual successiveincreases, if any, in the purchaser’s profit during the five (5) year periodbeginning on January 1, 2003 and ending December 31, 2007.

 

In April 2002, Sahyoun Holdings LLC advanced$200,000 in cash to us in exchange for our short-term ninety (90) day demandnote in the amount of $250,000.  Werepaid the $250,000 note from our share of the payment made by the purchaser ofthe Engineering Services Division in June 2002.  Sahyoun Holdings LLC and Mr. Sahyoun have guaranteed the paymentof $250,000 by the purchaser which is due to us in January 2003; however, inDecember 2002, we agreed with Mr. Sahyoun to offset the $250,000 due to us inJanuary 2003 against $250,000 of accrued commissions owed to Mr. Sahyoun.

 

On July 30, 2002, the Company’s President andCEO, Joseph J. Raymond, Sr., invested $1,000,000 of his personal funds in theCompany in exchange for 10,000 shares of the Company’s newly created Series FPreferred Stock, with a stated value of $100 per share.

 

At various times throughout our history, we haveborrowed funds from Joseph J. Raymond, our Chairman and CEO.  As of September 30, 2002, we owed $75,000 toMr. Raymond pursuant to a non-interest bearing promissory note which is due ondemand.

 

**In fiscal2002, Joseph J. Raymond, Jr., the son of our Chief Executive Officer, loaned us$41,000.  The loan is represented by a$41,000 promissory note bearing interest at 10% a year which is due upondemand.**

** **

**ITEM 14****.****              ****CONTROLS AND PROCEDURES**

 

As required by Rule 13d-15 under the SecuritiesExchange Act of 1934, within the 90 days prior to the filing date of thisreport, the Company carried out an evaluation of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures.  This evaluation was carried out under thesupervision and with the participation of the Company’s management, includingthe Company’s Chairman and Chief Executive Officer along with the Company’sChief Financial Officer, who concluded that the Company’s disclosure controlsand procedures are effective.  Therehave been no significant changes in the Company’s internal controls or in otherfactors, which could significantly affect internal controls subsequent to thedate the Company carried out its evaluation.

 

Disclosure controls and procedures are controlsand other procedures that are designed to ensure that information required tobe disclosed in the Company reports filed or submitted under the Exchange Actis recorded, processed, summarized and reported, within the time periodsspecified in the Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designated to ensure thatinformation required to be disclosed in Company reports filed under theExchange Act is accumulated and communicated to management, including theCompany’s Chief Executive Officer and Chief Financial Officer as appropriate,to allow timely decisions regarding required disclosure.

 

37

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**PARTIV**

** **

**ITEM15**.       EXHIBITS, FINANCIALSTATEMENT SCHEDULES AND REPORTS ON FORM 8-K

** **

**(a)**                                  Financial statements andfinancial statement schedules.  Reference is made to Index of FinancialStatements and Financial Statement Schedules hereinafter contained.

 

(b)           Reportson Form 8-K

 

OnSeptember 27, 2002, the Company filed a Report on Form 8-K to reflect areclassification of its year end financial statements which was necessitated bythe filing of a Form S-1 Registration Statement on September 27, 2002.  Due to the filing of the S-1 RegistrationStatement and because the Company had discontinued a business segmentpreviously disclosed in the April 4, 2002 Form 8-K, the Company was required toretroactively restate the financial statements contained in its Annual Reporton Form 10-K/A for the fiscal year ended September 30, 2001, to reflect thediscontinued operations in accordance with Accounting Principles Board OpinionNo. 30 “Reporting the Results of Operations – Reporting the Effects of Disposalof a Segment of a Business and Extraordinary, Unusual and InfrequentlyOccurring Events and Transactions.”

 

OnNovember 26, 2002, the Company filed a report on Form 8-K to report thecompletion of its acquisition of six (6) offices of Elite Personnel Services,Inc., which excluded certain financial statements and pro forma financialinformation not available at the time of filing.

** **

**(c)**           Exhibits

** **
| **Number** |   | **Description**                                                                                                                                                                                                                                                                                                         |
|------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.1        |   | Asset  Purchase Agreement, dated July 9, 1997, among Stratus Services Group, Inc.  and Royalpar Industries, Inc., Ewing Technical Design, Inc., LPL Technical  Services, Inc. and Mainstream Engineering Company, Inc., as amended by  Amendment No. 1 to the Asset Purchase Agreement, dated as of July 29, 1997.  (1) |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.2        |   | Asset  Purchase Agreement, effective January 1, 1999, by and between Stratus  Services Group, Inc. and B&R Employment Inc. (1)                                                                                                                                                                                      |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.3        |   | Asset  Purchase Agreement, dated June 16, 2000, by and between Stratus Services  Group, Inc. and Outsource International of America, Inc. (5)                                                                                                                                                                           |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.4        |   | Asset  Purchase Agreement, dated October 13, 2000, by and between Stratus Services  Group, Inc. and Outsource International of America, Inc. (6)                                                                                                                                                                        |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.5        |   | Asset  Purchase Agreement, dated January 2, 2001, by and between Stratus Services  Group, Inc. and Cura Staffing Inc. and  Professional Services, Inc. (15)                                                                                                                                                             |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.6        |   | Asset  Purchase Agreement, dated July 27, 2001, by and between Stratus Services  Group, Inc. and Source One Personnel, Inc. (8)                                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.7        |   | Asset  Purchase Agreement, dated December 27, 2001, by and between Stratus Services  Group, Inc. and Provisional Employment Solutions, Inc. (9)                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                                                    |
| 2.8        |   | Asset  Purchase Agreement, dated as of January 24, 2002 among Stratus Services  Group, Inc., Charles Sahyoun, Sahyoun Holdings, LLC and SEA Consulting  Services Corporation.                                                                                                                                           |

 

38

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|   |   | Information  has been omitted from the exhibit pursuant to an order granting confidential  treatment.(16)                                                                                                                                  |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                       |
| 2.9    |   | Asset  Purchase Agreement dated as of March 4, 2002, by and among Wells Fargo  Credit, Inc. and Stratus Services Group, Inc. (22)                                                                                                          |
|   |   |                                                                                                                                                                                                                                       |
| 2.10   |   | Asset  Purchase Agreement dated November 19, 2002, by and between Stratus Services  Group, Inc. and Elite Personnel Services, Inc. (23)                                                                                                    |
|   |   |                                                                                                                                                                                                                                       |
| 3.1    |   | Amended  and Restated Certificate of Incorporation of the Registrant. (1)                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.1  |   | Certificate  of Designation, Preferences and Rights of Series A Preferred Stock. (10)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.2  |   | Certificate  of Amendment to Certificate of Designation of Series A Preferred Stock. (14)                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.3  |   | Certificate  of Designation, Preferences and Rights of Series B Preferred Stock. (14)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.4  |   | Certificate  of Designation, Preferences and Rights of Series E Preferred Stock. (21)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.5  |   | Certificate  of Amendment to Certificate of Designation, Preferences and Rights of Series  E Preferred Stock. (21)                                                                                                                         |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.6  |   | Certificate  of Designation, Preferences and Rights of Series F Preferred Stock. (21)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 3.1.7  |   | Certificate  of Designation, Preferences and Rights of Series H Preferred Stock (filed  herewith).                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                       |
| 3.2    |   | By-Laws  of the Registrant. (2)                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.1  |   | Specimen  Common Stock Certificate of the Registrant. (1)                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.2  |   | Form  of 6% Convertible Debenture. (11)                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.3  |   | Specimen  Series A Preferred Stock Certificate of the Registrant. (14)                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.4  |   | Agreement  dated as of June 26, 2001 between Stratus Services Group, Inc. and Artisan  (UK) plc. (10)                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.5  |   | Subscription  Agreement dated as of June 26, 2001 between Stratus Services Group, Inc. and  Artisan.com Limited. (10)                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.8  |   | Specimen  Series E Stock Certificate of Registrant. (21)                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.9  |   | Specimen  Series F Stock Certificate of Registrant. (21)                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.10 |   | Exchange  Agreement between Pinnacle Investment Partners, LP and the Registrant. (21)                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.11 |   | Exchange  Agreement between Transworld Management Services, Inc. and the Registrant.  (21)                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.12 |   | Stock  Purchase Agreement between Joseph J. Raymond, Sr., and the Registrant  regarding Series F Preferred Stock. (21)                                                                                                                     |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.13 |   | Specimen  Series H Stock Certificate of Registrant. (24)                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                       |
| 4.1.14 |   | Securities  Purchase Agreement between Pinnacle Investment Partners, LP and the  Registrant regarding the Series H Preferred Stock. (24)                                                                                                   |
|   |   |                                                                                                                                                                                                                                       |
| 4.2.1  |   | Warrant  for the Purchase of 10,000 Shares of Common Stock of Stratus Services Group,  Inc., dated November 30, 1998, between Alan Zelinsky and Stratus Services  Group, Inc., and supplemental letter thereto dated December 2, 1998. (1) |
|   |   |                                                                                                                                                                                                                                       |
| 4.2.2  |   | Warrant  for the Purchase of 40,000 Shares of Common Stock of Stratus Services Group,  Inc., dated November 23, 1998, between David Spearman and Stratus Services  Group, Inc. (1)                                                         |
|   |   |                                                                                                                                                                                                                                       |
| 4.2.3  |   | Warrant  for the Purchase of 10,000 Shares of Common Stock of Stratus Services Group,  Inc., dated November 30, 1998, between Sanford Feld and Stratus Services  Group, Inc., and supplemental letter thereto dated December 2, 1998. (1)  |
|   |   |                                                                                                                                                                                                                                       |
| 4.2.4  |   | Warrant  for the Purchase of 20,000 Shares of Common Stock of Stratus Services Group,  Inc., dated November 30, 1998, between Peter DiPasqua, Jr. and Stratus  Services Group, Inc. (1)                                                    |

 

39

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| 4.2.5   |   | Warrant  for the Purchase of 20,000 Shares of Common Stock of Stratus Services Group,  Inc., dated December 2, 1998, between Shlomo Appel and Stratus Services  Group, Inc. (1)         |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|    |   |                                                                                                                                                                                    |
| 4.2.6   |   | Form  of Underwriter’s Warrant Agreement, including form of warrant certificate.  (7)                                                                                              |
|    |   |                                                                                                                                                                                    |
| 4.2.7   |   | Warrant  for the Purchase of common stock dated as of December 4, 2000 issued to May  Davis Group, Inc. (13)                                                                            |
|    |   |                                                                                                                                                                                    |
| 4.2.8   |   | Warrant  for the Purchase of common stock dated as of December 4, 2000 issued to  Hornblower & Weeks, Inc. (13)                                                                     |
|    |   |                                                                                                                                                                                    |
| 4.2.9   |   | Warrant  for the Purchase of common stock dated as of December 12, 2001 issued to  International Capital Growth. (15)                                                                   |
|    |   |                                                                                                                                                                                    |
| 4.2.10  |   | Warrant  for the Purchase of Common Stock dated as of April 9, 2002 issued to CEOCast.  (21)                                                                                            |
|    |   |                                                                                                                                                                                    |
| 4.2.11  |   | Warrant  for the Purchase of Common Stock dated as of October 17, 2001 issued to  Stetson Consulting.  (22)                                                                        |
|    |   |                                                                                                                                                                                    |
| 9.1.1   |   | Voting  proxy agreement between Artisan (UK) plc, Stratus Services Group, Inc. and  Joseph J. Raymond, Sr. (17)                                                                         |
|    |   |                                                                                                                                                                                    |
| 10.1.1  |   | Employment  Agreement dated September 1, 1997, between Stratus Services Group, Inc. and  Joseph J. Raymond. (1)                                                                         |
|    |   |                                                                                                                                                                                    |
| 10.1.6  |   | Executive  Employment Agreement dated September 1, 1997 between Stratus Services Group,  Inc. and Michael A. Maltzman. (1)                                                              |
|    |   |                                                                                                                                                                                    |
| 10.1.7  |   | Consulting  Agreement, dated as of August 11, 1997, between Stratus Services Group, Inc.  and Jeffrey J. Raymond. (1)                                                                   |
|    |   |                                                                                                                                                                                    |
| 10.1.8  |   | Non-Competition  Agreement, dated June 19, 2000 between Stratus Services Group, Inc. and  Outsource International of America, Inc. (5)                                                  |
|    |   |                                                                                                                                                                                    |
| 10.1.9  |   | Non-Competition  Agreement, dated October 27, 2000 between Stratus Services Group, Inc. and  Outsource International of America, Inc. (6)                                               |
|    |   |                                                                                                                                                                                    |
| 10.1.10 |   | Option  to purchase 1,000,000 shares of Stratus Services Group, Inc. Common Stock  issued to Joseph J. Raymond. (11)                                                                    |
|    |   |                                                                                                                                                                                    |
| 10.1.11 |   | Option  to purchase 500,000 shares of Stratus Services Group, Inc. Common Stock  issued to Joseph J. Raymond. (19)                                                                      |
|    |   |                                                                                                                                                                                    |
| 10.1.12 |   | Option  to purchase 1,750,000 shares of Stratus Services Group, Inc. Common Stock  issued to Joseph J. Raymond. (19)                                                                    |
|    |   |                                                                                                                                                                                    |
| 10.1.13 |   | Non-Competition  Agreements dated December 1, 2002 between Stratus Services Group, Inc. and  each of Elite Personnel Services, Inc. and Bernard Freedman.  (23)                    |
|    |   |                                                                                                                                                                                    |
| 10.1.14 |   | Employment  Agreement dated December 1, 2002 between Stratus Services Group, Inc. and  Bernard Freedman.  (23)                                                                     |
|    |   |                                                                                                                                                                                    |
| 10.2.1  |   | Lease,  effective October 1, 2002, for offices located at 500 Craig Road, Manalapan,  New Jersey 07726 (22)                                                                             |
|    |   |                                                                                                                                                                                    |
| 10.3.1  |   | Loan  and Security Agreement, dated December 8, 2000, between Capital Tempfunds,  Inc. and Stratus Services Group, Inc. (11)                                                            |
|    |   |                                                                                                                                                                                    |
| 10.4.2  |   | Promissory  Note and Security Agreement in the amount of $400,000, dated as of June 19,  2000, issued by Stratus Services Group, Inc. to Outsource International of  America, Inc.(5)   |
|    |   |                                                                                                                                                                                    |
| 10.4.3  |   | Promissory  Note in the amount of $100,000, dated as of June 19, 2000, issued by Stratus  Services Group, Inc. to Outsource International of America, Inc.(5)                           |
|    |   |                                                                                                                                                                                    |
| 10.4.4  |   | Promissory  Note and Security Agreement in the amount of $75,000, dated as of October 27,  2000, issued by Stratus Services Group, Inc. to Outsource International of  America, Inc.(6) |

 

40

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| 10.4.5 |   | Promissory  Note and Security Agreement in the amount of $600,000, dated as of July 27,  2001, issued by Stratus Services Group, Inc. to Source One Personnel, Inc.  (8)                            |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                |
| 10.4.6 |   | Promissory  Note and Security Agreement in the amount of $1.8 million, dated as of July  27, 2001, issued by Stratus Services Group, Inc. to Source One Personnel,  Inc. (8)                        |
|   |   |                                                                                                                                                                                                |
| 10.4.7 |   | Promissory  Note in the amount of $1,264,000 dated as of December 1, 2002, issued by  Stratus Services Group, Inc. to Elite Personnel Services, Inc.  (23)                                     |
|   |   |                                                                                                                                                                                                |
| 10.5.1 |   | Registration  Rights Agreement, dated August, 1997, by and among Stratus Services Group,  Inc. and AGR Financial, L.L.C. (1)                                                                        |
|   |   |                                                                                                                                                                                                |
| 10.5.2 |   | Registration  Rights Agreement, dated August 1997, by and among Stratus Services Group,  Inc. and Congress Financial Corporation (Western).(1)                                                      |
|   |   |                                                                                                                                                                                                |
| 10.5.3 |   | Form  of Registration Rights Agreement, dated December 4, 2000, by and among  Stratus Services Group, Inc. and purchasers of the Stratus Services Group,  Inc. 6% Convertible Debenture. (11)       |
|   |   |                                                                                                                                                                                                |
| 10.5.4 |   | Registration  Rights Agreement, dated as of December 4, 2000, between Stratus Services  Group, Inc., May Davis Group, Inc., Hornblower & Weeks, Inc. and the  other parties named therein. (13) |
|   |   |                                                                                                                                                                                                |
| 10.6.1 |   | Stock  Purchase and Investor Agreement, dated August 1997, by and between Stratus  Services Group, Inc. and Congress Financial Corporation (Western).(1)                                            |
|   |   |                                                                                                                                                                                                |
| 10.6.2 |   | Stock  Purchase and Investor Agreement, dated August 1997, by and among Stratus  Services Group, Inc. and AGR Financial, L.L.C. (1)                                                                 |
|   |   |                                                                                                                                                                                                |
| 10.6.3 |   | Form  of Securities Purchase Agreement, dated December 4, 2000 by and between  Stratus Services Group, Inc. and purchasers of the Stratus Services Group,  Inc. 6% Convertible Debenture. (11)      |
|   |   |                                                                                                                                                                                                |
| 10.7.1 |   | 1999  Equity Incentive Plan (1)                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                |
| 10.7.2 |   | 2000  Equity Incentive Plan (11)                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.7.3 |   | 2001  Equity Incentive Plan (12)                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.7.4 |   | 2002  Equity Incentive Plan (19)                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.7.5 |   | Form  of Option issued under 1999 Equity Incentive Plan. (19)                                                                                                                                       |
|   |   |                                                                                                                                                                                                |
| 10.7.6 |   | Form  of Option issued under 2000 Equity Incentive Plan. (19)                                                                                                                                       |
|   |   |                                                                                                                                                                                                |
| 10.7.7 |   | Form  of Option issued under 2001 Equity Incentive Plan. (19)                                                                                                                                       |
|   |   |                                                                                                                                                                                                |
| 10.7.8 |   | Form  of Option issued under 2002 Equity Incentive Plan. (19)                                                                                                                                       |
|   |   |                                                                                                                                                                                                |
| 10.8   |   | Debt  to Equity Conversion Agreement by and between Stratus Services Group, Inc.  and B&R Employment, Inc. (3)                                                                                  |
|   |   |                                                                                                                                                                                                |
| 10.8.1 |   | Amendment  to Debt to Equity Conversion Agreements by and between Stratus Services Group  and B&R Employment, Inc. (2)                                                                          |
|   |   |                                                                                                                                                                                                |
| 10.8.2 |   | Forbearance  Agreement dated January 24, 2002 between Stratus Services Group, Inc. and  Source One Personnel. (20)                                                                                  |
|   |   |                                                                                                                                                                                                |
| 10.8.3 |   | Modification  of Forbearance Agreement dated June 4, 2002 between Stratus Services Group,  Inc. and Source One Personnel, together with Exhibits thereto. (21)                                      |
|   |   |                                                                                                                                                                                                |
| 10.10  |   | Allocation  and Indemnity Agreement dated as of January 24, 2002 among the Company,  Charles Sahyoun and Sahyoun Holdings, LLC. (20)                                                                |

 

41

----

 
| 10.11  |   | Letter  Agreement dated April 15, 2002 between Stratus Services Group, Inc., Sahyoun  Holdings, LLC and Joseph J. Raymond, Sr. amending the Allocation and  Indemnity Agreement dated April 18, 2002. (17) |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                       |
| 10.12  |   | Exchange  Agreement dated March 11, 2002 by and between Transworld Management Services,  Inc. and Stratus Services Group, Inc. (22)                                                                        |
|   |   |                                                                                                                                                                                                       |
| 10.13  |   | Securities  Purchase Agreement dated March 11, 2002, by and between Pinnacle Investment  Partners, LP and Stratus Services Group, Inc. (22)                                                                |
|   |   |                                                                                                                                                                                                       |
| 21     |   | Subsidiaries  of Registrant. (15)                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                       |
| 23.1   |   | Consent  of Amper, Politzner & Mattia, P.C., Independent Accountants. (filed  herewith)                                                                                                                |
|   |   |                                                                                                                                                                                                       |
| 99.1   |   | Certification  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002. (filed herewith)                                                                                     |
|   |   |                                                                                                                                                                                                       |
| 99.2   |   | Certification  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002. (filed herewith)                                                                                     |
|   |   |                                                                                                                                                                                                       |

 

----

| Footnote  1  |   | Incorporated  by reference to similarly numbered Exhibits filed with Amendment No. 1 to the  Company’s Registration Statement on Form SB-2 (Registration Statement No.  333-83255) as filed with the Securities and Exchange Commission on September  3, 1999. |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  2  |   | Incorporated  by reference to similarly numbered Exhibits filed with Amendment No. 6 to the  Company’s Registration Statement on Form SB-2 (Registration Statement No.  333-83255) as filed with the Securities and Exchange Commission on February  1, 2000.  |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  3  |   | Incorporated  by reference to similarly numbered Exhibits filed with Amendment No. 3 to the  Company’s Registration Statement on Form SB-2 (Registration Statement No.  333-83255) as filed with the Securities and Exchange Commission on December  17, 1999. |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  4  |   | Incorporated  by reference to similarly numbered Exhibits filed with Amendment No. 7 to the  Company’s Registration Statement on Form SB-2 (Registration Statement No.  333-83255) as filed with the Securities and Exchange Commission on March 17,  2000.    |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  5  |   | Incorporated  by reference to the Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on June 30, 2000                                                                                                                   |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  6  |   | Incorporated  by reference to the Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on November 3, 2000                                                                                                                |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  7  |   | Incorporated  by reference to Exhibit 1.2 filed with Amendment No. 5 to the Company’s  Registration Statement on Form SB-2 (Registration Statement No. 333-83255) as  filed with the Securities and Exchange Commission on February 11, 2000.                  |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  8  |   | Incorporated  by reference to the Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on August 9, 2001.                                                                                                                 |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  9  |   | Incorporated  by reference to the Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on January 2, 2002.                                                                                                                |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  10 |   | Incorporated  by reference to Exhibit 3 filed with Form 10-Q for the Quarter ended June 30,  2001 as filed with the Securities and Exchange Commission on August 14, 2001.                                                                                          |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  11 |   | Incorporated  by reference to similarly number Exhibits to the Company’s Form 10-KSB, as  filed with the Securities and Exchange Commission on December 29, 2000.                                                                                              |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  12 |   | Incorporated  by reference to similarly numbered Exhibits filed with the Company’s  Registration Statement on Form S-1 (Registration Statement No. 333-55312) as  filed with the Securities and Exchange Commission on February 9, 2001.                       |
|         |   |                                                                                                                                                                                                                                                                |
| Footnote  13 |   | Incorporated  by reference to the similarly numbered Exhibits to the Company’s Form S-1/A,  as filed with the Securities and Exchange Commission on April 11, 2001.                                                                                            |

 

42

----

 
| Footnote  14 |   | Incorporated  by reference to the Exhibits to the Company Form 8-K, as filed with the  Securities and Exchange Commission on April 4, 2002.                                                                                                                                                      |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  15 |   | Incorporated  by reference to similarly numbered Exhibits filed with the Registrant’s Form  10K for the fiscal year ended September 30, 2001, and filed with the  Securities and Exchange Commission on January 25, 2002.                                                                   |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  16 |   | Incorporated  by reference to similarly numbered Exhibits filed with the Registrant’s Form  10-K/A for the fiscal year ended September 30, 2001, as filed with the  Securities and Exchange Commission on March 5, 2002.                                                                    |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  17 |   | Incorporated  by reference to the Exhibits to the Company’s Form 10-Q for the quarter ended  March 31, 2002, as filed with the Securities and Exchange Commission on May  15, 2002.                                                                                                         |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  18 |   | Incorporated  by reference to the Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on April 4, 2002.                                                                                                                                               |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  19 |   | Incorporated  by reference to the Exhibits to the Company’s Form S-8, as filed with the  Securities and Exchange Commission on September 17, 2002.                                                                                                                                          |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  20 |   | Incorporated  by reference to the similarly numbered Exhibits to the Company’s Form 10-K,  as filed with the Securities and Exchange Commission on January 25, 2002, as  amended by the Company’s Form 10-K/A, as filed with the Securities and  Exchange Commission on March 5, 2002. |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  21 |   | Incorporated  by reference to the Company’s 10-Q, for the quarter ended June 30, 2002, as  filed with the Securities and Exchange Commission on August 14, 2002.                                                                                                                            |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  22 |   | Incorporated  by reference to the similarly numbered Exhibits filed with the Company’s  Registration Statement on Form S-1 (Registration Statement No. 333-100149) as  filed with the Securities and Exchange Commission on September 27, 2002.                                             |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  23 |   | Incorporated  by reference to Exhibits to the Company’s Form 8-K, as filed with the  Securities and Exchange Commission on November 26, 2002.                                                                                                                                               |
|         |   |                                                                                                                                                                                                                                                                                             |
| Footnote  24 |   | Incorporated  by reference to the similarly numbered Exhibits to the Company’s Form 10-K,  for the fiscal year ended September 30, 2002, as filed with the Securities  and Exchange Commission on December 23, 2002, such Form 10-K being amended by  this Form 10-K/A.                     |

 

43

----

 

SIGNATURES

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on behalf of theundersigned, thereunto duly authorized.

 
|   | STRATUS SERVICES GROUP, INC. |
|--------|------------------------------|
|   |                         |   |
|   |                         |   |
|   | By:                          |      /s/ Joseph J. Raymond |   |
|   |                         | Joseph J. Raymond |
|   |                         | Chairman of the Board of Directors,  President and Chief Executive Officer |
|   |                         |   |
|   | Date:  October 14, 2003 |

 

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENTS that each individual whose signatureappears below constitutes and appoints Joseph J. Raymond and each of them, ashis true lawful attorney-in-fact and agent, with full power of substitution forhim or her and in his or her name, place and stead, in any and all capacities,to sign any and all amendments to this Form 10-K/A, and to file the same,together with all the exhibits thereto and all documents in connectiontherewith, with the Securities and Exchange Commission, granting unto saidattorneys-in-fact and agents, and each of them, full power and authority to doand perform each and every act and being requisite and necessary to be done inand about the premises, as fully to all intents and purposes as he or she mightor could do in person, hereby ratifying and confirming all that saidattorneys-in-fact and agents or any of them, of his or her or their substituteor substitutes, may lawfully do or cause to be done by virtue hereof.

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**            |                                          | **Title**                                   |              | **Date** |   |
|--------------------------|-----------------------------------------------|---------------------------------------------|-------------------|----------|--------|
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ Joseph  J. Raymond   |                                          | Chairman,  Chief Executive Officer          | October 14,  2003 |
| Joseph J.  Raymond       | (Principal  Executive Officer)                |                                        |
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ Michael  A. Maltzman |                                          | Vice  President and Chief Financial Officer | October 14,  2003 |
| Michael A.  Maltzman     | (Principal  Financing and Accounting Officer) |                                        |
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ Michael  J. Rutkin   |                                          | Director                                    | October 14,  2003 |
| Michael J.  Rutkin       |                                          |                                        |
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ H.  Robert Kingston  |                                          | Director                                    | October 14,  2003 |
| H. Robert  Kingston      |                                          |                                        |
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ Sanford  I. Feld     |                                          | Director                                    | October 14,  2003 |
| Sanford I.  Feld         |                                          |                                        |
|                     |                                          |                                        |
|                     |                                          |                                        |
| /s/ Donald  W. Feidt     |                                          | Director                                    | October 14,  2003 |
| Donald W.  Feidt         |                                          |                                        |
|                          |                                               |                                             |                   |          |        |  |

 

44

----

 

**STRATUSSERVICES GROUP, INC.**

**INDEX TO FINANCIAL STATEMENTS**

 

**As ofSeptember 30, 2002 and 2001**

**and for theYears Ended September 30, 2002, 2001 and 2000**

 
| Independent Auditors  Report             |
|------------------------------------------|
| Financial  Statements                    |
| Balance Sheets                           |
| Statements of Operations                 |
| Statements of Cash Flows                 |
| Statements of Stockholders’  Equity |
| Statements of Comprehensive  Income      |
| Notes to Financial  Statements           |

 

F-1

----

 

Independent Auditors’ Report

 

 

To the Stockholders of

Stratus Services Group, Inc.

 

We have audited the accompanying balance sheets of Stratus ServicesGroup, Inc. as of September 30, 2002 and 2001, and the related statements ofoperations, stockholders’ equity, cash flows and comprehensive income for eachof the three years in the period ended September 30, 2002.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, thefinancial position of Stratus Services Group, Inc. as of September 30, 2002 and2001, and the results of its operations and its cash flows for each of thethree years in the period ended September 30, 2002, in conformity withaccounting principles generally accepted in the United States of America.

 

The accompanying financial statements have been prepared assuming thatthe Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company hassuffered recurring losses from operations and has a net capital deficiency,which raises substantial doubt about its ability to continue as a goingconcern.  Management’s plans regardingthose matters also are described in Note 1. The financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

 

In connection with our audits of the financial statements referred toabove, we audited the financial Schedule II. In our opinion, the financial schedule, when considered in relation tothe financial statements taken as a whole, presents fairly, in all materialrespects, the information stated therein.

 

As discussed in Note 1 to the financial statements, the accompanyingfinancial statements have been restated to revise certain revenue recognitionpolicies.

 
|   | /s/  AMPER, POLITZINER & MATTIA, P.C. |   |
|--------|-------------------------------------------|--------|
|   | AMPER,  POLITZINER & MATTIA, P.C.     |   |

 

Edison, New Jersey

December17, 2002, except as to information presented in Note 1, for which the date isSeptember 12, 2003.

 

F-2

----

 

**STRATUS SERVICES GROUP, INC.**

Balance Sheets

 
|                                                                                                                                                                                                      |   | **September  30,** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|
|                                                                                                                                                                                                      |   | **2002**           |       | **2001** |   |
| Assets                                                                                                                                                                                                    |   |               |       |   |   |
| Current assets                                                                                                                                                                                            |   |               |       |   |   |
| Cash and cash equivalents                                                                                                                                                                                 |   | $                  | 162,646    |   | $ | 171,822 |   |
| Accounts receivable – less allowance for doubtful  accounts of $1,742,000 and $551,000                                                                                                               |   | 9,179,543          |       | 8,540,112 |   |
| Unbilled receivables                                                                                                                                                                                      |   | 2,065,972          |       | 1,566,417 |   |
| Other receivables                                                                                                                                                                                         |   | 250,000            |       | 3⁄4 |   |
| Prepaid insurance                                                                                                                                                                                         |   | 2,709,331          |       | 1,436,278 |   |
| Investment                                                                                                                                                                                                |   | 3⁄4             |       | 1,166,046 |   |
| Prepaid expenses and other current assets                                                                                                                                                                 |   | 333,601            |       | 77,146 |   |
| Net assets of discontinued Engineering Division                                                                                                                                                           |   | 3⁄4             |       | 199,610 |   |
|                                                                                                                                                                                                      |   | 14,701,093         |       | 13,157,431 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Property and equipment, net of accumulated  depreciation                                                                                                                                                  |   | 1,281,817          |       | 1,427,216 |   |
| Intangible assets, net of accumulated amortization                                                                                                                                                        |   | 7,887,727          |       | 7,078,428 |   |
| Deferred financing costs, net of accumulated  amortization                                                                                                                                                |   | 5,768              |       | 454,878 |   |
| Other assets                                                                                                                                                                                              |   | 154,991            |       | 150,205 |   |
|                                                                                                                                                                                                      |   | $                  | 24,031,396 |   | $ | 22,268,158 |   |
| Liabilities  and Stockholders’ Equity                                                                                                                                                                |   |               |       |   |   |
| Current liabilities                                                                                                                                                                                       |   |               |       |   |   |
| Loans payable (current portion)                                                                                                                                                                           |   | $                  | 580,830    |   | $ | 347,289 |   |
| Notes payable – acquisitions (current portion)                                                                                                                                                       |   | 578,040            |       | 1,110,726 |   |
| Line of credit                                                                                                                                                                                            |   | 7,739,117          |       | 7,306,581 |   |
| Cash overdraft                                                                                                                                                                                            |   | 731,501            |       | 3⁄4 |   |
| Insurance obligation payable                                                                                                                                                                              |   | 128,075            |       | 549,460 |   |
| Accounts payable and accrued expenses                                                                                                                                                                     |   | 5,472,696          |       | 3,421,796 |   |
| Accrued payroll and taxes                                                                                                                                                                                 |   | 1,828,629          |       | 1,461,738 |   |
| Payroll taxes payable                                                                                                                                                                                     |   | 929,328            |       | 306,230 |   |
|                                                                                                                                                                                                      |   | 17,988,216         |       | 14,503,820 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Loans payable (net of current portion)                                                                                                                                                                    |   | 217,965            |       | 291,243 |   |
| Notes payable – acquisitions (net of current  portion)                                                                                                                                               |   | 1,919,532          |       | 1,403,847 |   |
| Convertible debt                                                                                                                                                                                          |   | 40,000             |       | 1,125,399 |   |
|                                                                                                                                                                                                      |   | 20,165,713         |       | 17,324,309 |   |
| Series A voting redeemable convertible preferred  stock, $.01 par value, 1,458,933 shares issued and outstanding, liquidation  preference of $4,376,799 (including unpaid dividends of $39,000)           |   | 3⁄4             |       | 2,792,000 |   |
| Temporary equity – put options                                                                                                                                                                       |   | 823,000            |       | 869,000 |   |
| Commitments and contingencies                                                                                                                                                                             |   |               |       |   |   |
| Stockholders’ equity                                                                                                                                                                                 |   |               |       |   |   |
| Preferred stock, $.01 par value, 5,000,000 shares  authorized                                                                                                                                             |   | 3⁄4             |       | 3⁄4 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Series A voting redeemable convertible preferred  stock, $.01 par value, 1,458,933 shares issued and outstanding, liquidation  preference of $4,376,799 (including unpaid dividends of $345,376 and $-0-) |   | 3,293,376          |       | 3⁄4 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Series E non-voting convertible preferred stock,  $.01 par value, 16,683 and -0- shares issued and outstanding, liquidation  preference of $1,668,300 (including unpaid dividends of $20,000 and $-0-)    |   | 1,485,947          |       | 3⁄4 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Series F voting convertible preferred stock, $.01  par value, 10,000 and -0- shares issued and outstanding, liquidation  preference of $1,000,000                                                         |   | 1,000,000          |       | 3⁄4 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Series H non-voting convertible preferred stock,  $.01 par value, 5,000 and -0- shares issued and outstanding, liquidation  preference of $500,000                                                        |   | 500,000            |       | 3⁄4 |   |
|                                                                                                                                                                                                      |   |               |       |   |   |
| Common stock, $.01 par value, 25,000,000 shares  authorized; 11,522,567 and 8,217,764 shares issued and outstanding                                                                                       |   | 115,226            |       | 82,178 |   |
| Additional paid-in capital                                                                                                                                                                                |   | 12,626,733         |       | 11,992,685 |   |
| Accumulated deficit                                                                                                                                                                                       |   | (15,978,599        | )          | (9,592,014 | ) |
| Accumulated other comprehensive loss                                                                                                                                                                      |   | 3⁄4             |       | (1,200,000 | ) |
| Total stockholders’ equity                                                                                                                                                                           |   | 3,042,683          |       | 1,282,849 |   |
|                                                                                                                                                                                                      |   | $                  | 24,031,396 |   | $ | 22,268,158 |   |

 

Seeaccompanying summary of accounting policies and notes to financial statements.

 

F-3

----

 

**STRATUS SERVICES GROUP, INC.**

Statements of Operations

 
|                                                                                   |   | **Years  Ended September 30,** |       |
|----------------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                                   |   | **2002**                       |       | **2001** |   | **2000** |   |
|                                                                                   |   | **As  Restated**               |       | **As  Restated** |   | **As  Restated** |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Revenues                                                                               |   | $                              | 65,121,095 |   | $ | 50,008,285 |   | $ | 34,443,283 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Cost of revenues                                                                       |   | 53,600,695                     |       | 39,056,232 |   | 26,071,159 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Gross profit                                                                           |   | 11,520,400                     |       | 10,952,053 |   | 8,372,124 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Selling, general and administrative expenses                                           |   | 14,508,207                     |       | 13,421,634 |   | 7,844,534 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Loss on impairment of goodwill                                                         |   | 400,000                        |       | 700,000 |   | 3⁄4 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Other charges                                                                          |   | 140,726                        |       | 375,306 |   | 3⁄4 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Operating earnings (loss) from continuing  operations                                  |   | (3,528,533                     | )          | (3,544,887 | ) | 527,590 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Other income (expenses)                                                                |   |                           |       |   |   |   |   |
| Finance charges                                                                        |   | 3⁄4                         |       | (61,291 | ) | (453,827 | ) |
| Interest and financing costs                                                           |   | (1,975,932                     | )          | (1,999,246 | ) | (298,386 | ) |
| (Loss) on sale of investment                                                           |   | (2,159,415                     | )          | 3⁄4 |   | 3⁄4 |   |
| Other income (expense)                                                                 |   | 83,398                         |       | (47,963 | ) | 45,944 |   |
|                                                                                   |   | (4,051,949                     | )          | (2,108,500 | ) | (706,269 | ) |
|                                                                                   |   |                           |       |   |   |   |   |
| Earnings (loss) from continuing operations before  income taxes                        |   | (7,580,482                     | )          | (5,653,387 | ) | (178,678 | ) |
|                                                                                   |   |                           |       |   |   |   |   |
| Income taxes (benefit)                                                                 |   | 3⁄4                         |       | 340,000 |   | (340,000 | ) |
|                                                                                   |   |                           |       |   |   |   |   |
| Earnings (loss) from continuing operations                                             |   | (7,580,482                     | )          | (5,993,387 | ) | 161,322 |   |
| Discontinued operations — earnings (loss) from  discontinued Engineering Division |   | (565,159                       | )          | 145,930 |   | 884,588 |   |
| Gain on sale of Engineering Division                                                   |   | 1,759,056                      |       | 3⁄4 |   | 3⁄4 |   |
| Net earnings (loss)                                                                    |   | (6,386,585                     | )          | (5,847,457 | ) | 1,045,910 |   |
| Dividends and accretion on preferred stock                                             |   | (1,041,810                     | )          | (63,000 | ) | 3⁄4 |   |
| Net earnings (loss) attributable to common  stockholders                               |   | $                              | (7,428,395 | ) | $ | (5,910,457 | ) | $ | 1,045,910 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Basic:                                                                                 |   |                           |       |   |   |   |   |
| Earnings (loss) from continuing operations                                             |   | $                              | (.82       | ) | $ | (1.01 | ) | $ | .03 |   |
| Earnings from discontinued operations                                                  |   | .12                            |       | .02 |   | .18 |   |
| Net earnings (loss)                                                                    |   | $                              | (.70       | ) | $ | (.99 | ) | $ | .21 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Diluted:                                                                               |   |                           |       |   |   |   |   |
| Earnings (loss) from continuing operations                                             |   | $                              | (.82       | ) | $ | (1.01 | ) | $ | .03 |   |
| Earnings from discontinued operations                                                  |   | .12                            |       | .02 |   | .17 |   |
| Net earnings (loss)                                                                    |   | $                              | (.70       | ) | $ | (.99 | ) | $ | .20 |   |
|                                                                                   |   |                           |       |   |   |   |   |
| Weighted average shares, outstanding per common  share                                 |   |                           |       |   |   |   |   |
| Basic                                                                                  |   | 10,555,815                     |       | 5,996,134 |   | 4,931,914 |   |
| Diluted                                                                                |   | 10,555,815                     |       | 5,996,134 |   | 5,223,508 |   |

 

Seeaccompanying summary of accounting policies and notes to financial statements.

 

F-4

----

 

**STRATUS SERVICES GROUP, INC.**

Statements of Cash Flows

 
|                                                                                                                  |   | **Years Ended  September 30,** |       |
|-----------------------------------------------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                                                                  |   | **2002**                       |       | **2001** |   | **2000** |   |
| Cash flows from operating activities                                                                                  |   |                           |       |   |   |   |   |
| Net earnings (loss) from continuing operations                                                                        |   | $                              | (7,580,482 | ) | $ | (5,993,387 | ) | $ | 161,322 |   |
| Net earnings from discontinued operations                                                                             |   | 1,193,897                      |       | 145,930 |   | 884,588 |   |
| Adjustments to reconcile net earnings (loss) to net  cash used by operating activities                                |   |                           |       |   |   |   |   |
| Depreciation                                                                                                          |   | 510,059                        |       | 409,860 |   | 175,419 |   |
| Amortization                                                                                                          |   | 565,427                        |       | 359,134 |   | 191,710 |   |
| Provision for doubtful accounts                                                                                       |   | 1,658,000                      |       | 661,000 |   | 122,500 |   |
| Loss on impairment of goodwill                                                                                        |   | 400,000                        |       | 700,000 |   | 3⁄4 |   |
| Deferred financing costs amortization                                                                                 |   | 405,471                        |       | 209,897 |   | 3⁄4 |   |
| Loss on sale of investment                                                                                            |   | 2,159,415                      |       | 3⁄4 |   | 3⁄4 |   |
| Loss on extinguishments of convertible debt                                                                           |   | (3,277                         | )          | 70,560 |   | 3⁄4 |   |
| Accrued penalties on Series B Convertible Preferred  Stock                                                            |   | 28,080                         |       | 3⁄4 |   | 3⁄4 |   |
| Gain on sale of Engineering Division                                                                                  |   | (1,759,056                     | )          | 3⁄4 |   | 3⁄4 |   |
| Deferred taxes                                                                                                        |   | 3⁄4                         |       | 340,000 |   | (340,000 | ) |
| Interest expense amortization for the intrinsic  value of the beneficial conversion feature of convertible debentures |   | 104,535                        |       | 1,146,463 |   | 3⁄4 |   |
| Imputed interest                                                                                                      |   | 3⁄4                         |       | 3⁄4 |   | 57,652 |   |
| Accrued interest                                                                                                      |   | 106,687                        |       | 64,410 |   | 41,522 |   |
| Compensation – stock options                                                                                     |   | 3⁄4                         |       | 67,900 |   | 46,800 |   |
| Changes in operating assets and liabilities                                                                           |   |                           |       |   |   |   |   |
| Due from factor/accounts receivable                                                                                   |   | (2,796,986                     | )          | (2,347,247 | ) | (2,938,890 | ) |
| Prepaid insurance                                                                                                     |   | (1,273,053                     | )          | (1,003,604 | ) | (175,461 | ) |
| Prepaid expenses and other current assets                                                                             |   | (26,455                        | )          | 201,023 |   | (262,261 | ) |
| Other assets                                                                                                          |   | (5,111                         | )          | (65,652 | ) | 19,593 |   |
| Insurance obligation payable                                                                                          |   | (421,385                       | )          | 182,360 |   | 114,214 |   |
| Accrued payroll and taxes                                                                                             |   | 366,891                        |       | 356,375 |   | 171,028 |   |
| Payroll taxes payable                                                                                                 |   | 623,098                        |       | (106,283 | ) | 186,281 |   |
| Accounts payable and accrued expenses                                                                                 |   | 2,064,913                      |       | 2,195,797 |   | (80,469 | ) |
| Total adjustments                                                                                                     |   | 2,707,253                      |       | 3,441,993 |   | (2,670,362 | ) |
|                                                                                                                  |   | (3,679,332                     | )          | (2,405,464 | ) | (1,624,452 | ) |
| Cash flows (used in) investing activities                                                                             |   |                           |       |   |   |   |   |
| Purchase of property and equipment                                                                                    |   | (322,748                       | )          | (755,801 | ) | (780,975 | ) |
| Proceeds from sale of investment                                                                                      |   | 206,631                        |       | 3⁄4 |   | 3⁄4 |   |
| Payments for business acquisitions                                                                                    |   | (336,726                       | )          | (1,218,674 | ) | (1,053,868 | ) |
| Net proceeds from sale of Engineering Division                                                                        |   | 1,709,079                      |       | 3⁄4 |   | 3⁄4 |   |
| Costs incurred in connection with investment                                                                          |   | 3⁄4                         |       | (17,046 | ) | 3⁄4 |   |
| Loans receivable                                                                                                      |   | 3⁄4                         |       | (40,500 | ) | (120,500 | ) |
|                                                                                                                  |   | 1,256,236                      |       | (2,032,021 | ) | (1,955,343 | ) |
| Cash flows from financing activities                                                                                  |   |                           |       |   |   |   |   |
| Proceeds from initial public offering                                                                                 |   | 3⁄4                         |       | 3⁄4 |   | 6,034,169 |   |
| Proceeds from issuance of common stock                                                                                |   | 222,083                        |       | 1,412,772 |   | 3⁄4 |   |
| Proceeds from issuance of preferred stock                                                                             |   | 1,932,131                      |       | 3⁄4 |   | 3⁄4 |   |
| Proceeds from loans payable                                                                                           |   | 1,729,898                      |       | 255,000 |   | 1,125,000 |   |
| Payments of loans payable                                                                                             |   | (1,073,440                     | )          | (70,180 | ) | (1,457,624 | ) |
| Payments of notes payable – acquisitions                                                                         |   | (1,117,001                     | )          | (320,394 | ) | (1,164,100 | ) |
| Net proceeds from line of credit                                                                                      |   | 432,536                        |       | 2,065,156 |   | 3⁄4 |   |
| Net proceeds from convertible debt                                                                                    |   | 327,775                        |       | 2,664,239 |   | 3⁄4 |   |
| Redemption of convertible debt                                                                                        |   | (302,896                       | )          | (2,222,883 | ) | 3⁄4 |   |
| Proceeds from temporary equity - put options                                                                          |   | 3⁄4                         |       | 60,000 |   | 3⁄4 |   |
| Cash overdraft                                                                                                        |   | 731,501                        |       | 3⁄4 |   | 3⁄4 |   |
| Cost in connection with common stock issued for  acquisition                                                          |   | (2,000                         | )          | 3⁄4 |   | 3⁄4 |   |
| Redemption of preferred stock                                                                                         |   | (455,000                       | )          | 3⁄4 |   | 3⁄4 |   |
| Purchase of treasury stock                                                                                            |   | 3⁄4                         |       | (265,125 | ) | (350,000 | ) |
| Dividends paid                                                                                                        |   | (11,667                        | )          | 3⁄4 |   | 3⁄4 |   |
|                                                                                                                  |   | 2,413,920                      |       | 3,578,585 |   | 4,187,445 |   |
| Net change in cash and cash equivalents                                                                               |   | (9,176                         | )          | (858,900 | ) | 607,650 |   |
| Cash and cash equivalents – beginning                                                                            |   | 171,822                        |       | 1,030,722 |   | 423,072 |   |
| Cash and cash equivalents – ending                                                                               |   | $                              | 162,646    |   | $ | 171,822 |   | $ | 1,030,722 |   |

 

See accompanying summary of accounting policies and notes to financialstatements.

 

F-5

----

 
|                                                                                                            |   | **Years  Ended September 30,** |      |
|-----------------------------------------------------------------------------------------------------------------|--------|--------------------------------|-----------|
|                                                                                                            |   | **2002**                       |      | **2001** |   | **2000** |   |
|                                                                                                            |   |                           |      |   |   |   |   |
| Supplemental disclosure of cash paid                                                                            |   |                           |      |   |   |   |   |   |   |   |
| Interest                                                                                                        |   | $                              | 1,937,930 |   | $ | 739,872 |   | $ | 201,718 |   |
| Schedule of Non-cash Investing and Financing  Activities                                                        |   |                           |      |   |   |   |   |
| Fair value of assets acquired                                                                                   |   | $                              | 1,816,727 |   | $ | 4,568,674 |   | $ | 1,548,097 |   |
| Less: cash paid                                                                                                 |   | (336,727                       | )         | (1,218,674 | ) | (1,048,097 | ) |
| Less: common stock and put options issued                                                                       |   | (380,000                       | )         | (800,000 | ) | 3⁄4 |   |
| Liabilities assumed                                                                                             |   | $                              | 1,100,000 |   | $ | 2,550,000 |   | $ | 500,000 |   |
| Issuance of common stock in exchange for notes  payable                                                         |   | $                              | —    |   | $ | — |   | $ | 1,000,000 |   |
| Purchase of property and equipment for notes                                                                    |   | $                              | —    |   | $ | — |   | $ | 163,836 |   |
| Purchase of treasury stock in exchange for loans                                                                |   | $                              | —    |   | $ | 402,000 |   | $ | — |   |
| Issuance of common stock in exchange for  investment                                                            |   | $                              | —    |   | $ | 61,000 |   | $ | — |   |
| Issuance of common stock upon conversion of  convertible debt                                                   |   | $                              | 736,003   |   | $ | 542,500 |   | $ | — |   |
| Issuance of Series B Preferred Stock in exchange  for convertible and other debt                                |   | $                              | 1,016,499 |   | $ | — |   | $ | — |   |
| Issuance of Series E Preferred Stock in exchange  for Series B Preferred Stock                                  |   | $                              | 875,210   |   | $ | — |   | $ | — |   |
| Issuance of common stock in exchange for accounts  payable and accrued expenses                                 |   | $                              | 59,000    |   | $ | — |   | $ | — |   |
| Issuance of warrants for fees                                                                                   |   | $                              | 55,000    |   | $ | — |   | $ | — |   |
| Issuance of preferred stock in exchange for  investment                                                         |   | $                              | —    |   | $ | 1,592,000 |   | $ | — |   |
| Issuance of preferred stock for fees in connection  with private placement ($410,000) and investment ($727,000) |   | $                              | —    |   | $ | 1,137,000 |   | $ | — |   |
| Issuance of common stock for fees in connection  with private placement and investment                          |   | $                              | —    |   | $ | 30,000 |   | $ | — |   |
| Cumulative dividends and accretion on preferred  stock                                                          |   | $                              | 1,030,143 |   | $ | 63,000 |   | $ | — |   |

 

See accompanying summary of accounting policies and notes to financialstatements.

 

F-6

----

 

**STRATUS SERVICES GROUP, INC.**

### **Statement of Stockholders’ Equity**

 
|                                                                                      |   |       |       | **Common  Stock** |   | **Preferred  Stock** |   |
|-------------------------------------------------------------------------------------------|--------|------------|------------|-------------------|--------|----------------------|--------|
|                                                                                      |   | **Total**  |       | **Amount**        |   | **Shares**           |   | **Amount** |   | **Shares** |   |
|                                                                                      |   |       |       |              |   |                 |   |   |   |   |   |
| Balance – September 30, 1999                                                         |   | $          | (3,011,665 | )                 | $      | 42,725               |   | 4,272,470 |   | $ | 3⁄4 |   | 3⁄4 |   |
| Net earnings                                                                              |   | 1,045,910  |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Compensation expense in connection with  stock options granted (no tax effect)            |   | 46,800     |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of common stock in exchange for  notes payable                                   |   | 1,000,000  |       | 1,933             |   | 193,333              |   | 3⁄4 |   | 3⁄4 |   |
| Proceeds from the initial public offering  of common stock (net of costs of ($1,869,660)  |   | 5,930,340  |       | 13,000            |   | 1,300,000            |   | 3⁄4 |   | 3⁄4 |   |
| Transfer from temporary equity                                                            |   | 2,138,060  |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Purchase and retirement of treasury stock                                                 |   | (350,000   | )          | (538              | )      | (53,766              | )      | 3⁄4 |   | 3⁄4 |   |
| Balance – September 30, 2000                                                         |   | $          | 6,799,445  |              | $      | 57,120               |   | 5,712,037 |   | $ | 3⁄4 |   | 3⁄4 |   |
| Net (loss)                                                                                |   | (5,847,457 | )          | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Unrealized loss on securities available for  sale                                         |   | (1,200,000 | )          | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Dividends and accretion on preferred stock                                                |   | (63,000    | )          | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Purchase and retirement of treasury stock                                                 |   | (15,125    | )          | (33               | )      | (3,333               | )      | 3⁄4 |   | 3⁄4 |   |
| Purchase of treasury stock                                                                |   | (652,000   | )          | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Beneficial conversion feature of  convertible debt                                        |   | 1,213,747  |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Warrants issued in connection with issuance  of convertible debt                          |   | 88,000     |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Compensation expense in connection with  stock options granted (no tax effect)            |   | 67,900     |       | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Beneficial conversion feature of  convertible debt redeemed                               |   | (631,881   | )          | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Conversion of convertible debt                                                            |   | 429,448    |       | 5,194             |   | 519,394              |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of common stock in connection with  acquisition                                  |   | 3⁄4     |       | 4,000             |   | 400,000              |   | 3⁄4 |   | 3⁄4 |   |
| Proceeds from the private placements of  common stock (net of costs of $432,228) for cash |   | 1,002,772  |       | 14,497            |   | 1,449,666            |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of shares for services provided                                                  |   | 30,000     |       | 300               |   | 30,000               |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of stock in exchange for  investment                                             |   | 61,000     |       | 500               |   | 50,000               |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of stock with put options                                                        |   | 3⁄4     |       | 600               |   | 60,000               |   | 3⁄4 |   | 3⁄4 |   |
| Balance – September 30, 2001                                                         |   | $          | 1,282,849  |              | $      | 82,178               |   | 8,217,764 |   | $ | 3⁄4 |   | 3⁄4 |   |

 
|                                                                                      |   | **Treasury  Stock** |   | **Additional  Paid-In  Capital** |   | **Deferred  Compensation** |   | **Accumulated  Other  Comprehensive  Loss** |     | **Accumulated  Deficit** |   |
|-------------------------------------------------------------------------------------------|--------|---------------------|--------|----------------------------------|--------|----------------------------|--------|---------------------------------------------|----------|--------------------------|--------|
|                                                                                      |   |                |   |                             |   |                       |   |                                        |     |                     |   |
| Balance – September 30, 1999                                                         |   | $                   | — |                             | $      | 1,850,777                  |   | $                                           | (114,700 | )                        | $      | 3⁄4 |   | $ | (4,790,467 | ) |
| Net earnings                                                                              |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |     | 1,045,910                |   |
| Compensation expense in connection with  stock options granted (no tax effect)            |   | 3⁄4              |   | 3⁄4                           |   | 46,800                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Issuance of common stock in exchange for notes  payable                                   |   | 3⁄4              |   | 998,067                          |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Proceeds from the initial public offering  of common stock (net of costs of ($1,869,660)  |   | 3⁄4              |   | 5,917,340                        |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Transfer from temporary equity                                                            |   | 3⁄4              |   | 2,138,060                        |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Purchase and retirement of treasury stock                                                 |   | 3⁄4              |   | (349,462                         | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Balance – September 30, 2000                                                         |   | $                   | — |                             | $      | 10,554,782                 |   | $                                           | (67,900  | )                        | 3⁄4 |   | $ | (3,744,557 | ) |
| Net (loss)                                                                                |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |     | (5,847,457               | )      |
| Unrealized loss on securities available for  sale                                         |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | (1,200,000                                  | )        | 3⁄4                   |   |
| Dividends and accretion on preferred stock                                                |   | 3⁄4              |   | (63,000                          | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Purchase and retirement of treasury stock                                                 |   | 3⁄4              |   | (15,092                          | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Purchase of treasury stock                                                                |   | (652,000            | )      | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Beneficial conversion feature of  convertible debt                                        |   | 3⁄4              |   | 1,213,747                        |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Warrants issued in connection with issuance  of convertible debt                          |   | 3⁄4              |   | 88,000                           |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Compensation expense in connection with  stock options granted (no tax effect)            |   | 3⁄4              |   | 3⁄4                           |   | 67,900                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Beneficial conversion feature of  convertible debt redeemed                               |   | 3⁄4              |   | (631,881                         | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Conversion of convertible debt                                                            |   | 652,000             |   | (227,746                         | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Issuance of common stock in connection with  acquisition                                  |   | 3⁄4              |   | (4,000                           | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Proceeds from the private placements of  common stock (net of costs of $432,228) for cash |   | 3⁄4              |   | 988,275                          |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Issuance of shares for services provided                                                  |   | 3⁄4              |   | 29,700                           |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Issuance of stock in exchange for  investment                                             |   | 3⁄4              |   | 60,500                           |   | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Issuance of stock with put options                                                        |   | 3⁄4              |   | (600                             | )      | 3⁄4                     |   | 3⁄4                                      |     | 3⁄4                   |   |
| Balance – September 30, 2001                                                         |   | $                   | — |                             | $      | 11,992,685                 |   | $                                           | 3⁄4   |                     | $      | (1,200,000 | ) | $ | (9,592,014 | ) |

 

See accompanying summary of accounting policies and notes to financialstatements.

 

F-7

----

 
|                                                                                          |   |       |      | **Common  Stock** |   | **Preferred  Stock** |   |
|-----------------------------------------------------------------------------------------------|--------|------------|-----------|-------------------|--------|----------------------|--------|
|                                                                                          |   | **Total**  |      | **Amount**        |   | **Shares**           |   | **Amount** |   | **Shares** |   |
|                                                                                          |   |       |      |              |   |                 |   |   |   |   |   |
| Net (loss)                                                                                    |   | (6,386,585 | )         | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Dividends and accretion on preferred stock                                                    |   | (135,667   | )         | 3⁄4            |   | 3⁄4               |   | 906,143 |   | 3⁄4 |   |
| Beneficial conversion feature of  convertible debt and convertible preferred stock            |   | 136,000    |      | 3⁄4            |   | 3⁄4               |   | (695,000 | ) | 3⁄4 |   |
| Beneficial conversion feature of  convertible debt redeemed                                   |   | (69,541    | )         | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Conversion of convertible debt                                                                |   | 736,003    |      | 25,375            |   | 2,537,479            |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of common stock in connection with  acquisition                                      |   | 378,000    |      | 4,000             |   | 400,000              |   | 3⁄4 |   | 3⁄4 |   |
| Proceeds from the private placements of  common stock (net of costs of $9,750) for cash       |   | 222,083    |      | 2,777             |   | 277,724              |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of warrants for services provided                                                    |   | 55,000     |      | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Issuance of Series B preferred stock in  exchange for loans payable                           |   | 934,907    |      | 3⁄4            |   | 3⁄4               |   | 1,016,499 |   | 203,300 |   |
| Issuance of common stock in exchange for  accounts payable and accrual expenses               |   | 59,000     |      | 896               |   | 89,600               |   | 3⁄4 |   | 3⁄4 |   |
| Proceeds from the issuance of preferred  stock (net of costs $402,870) for cash               |   | 2,162,131  |      | 3⁄4            |   | 3⁄4               |   | 2,565,001 |   | 82,650 |   |
| Redemption of Series B Preferred Stock                                                        |   | (455,000   | )         | 3⁄4            |   | 3⁄4               |   | (455,000 | ) | (91,000 |   |
| Redemption of convertible debt                                                                |   | (20,577    | )         | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Reclassification adjustment for loss on  securities available for sale included in net income |   | 1,200,000  |      | 3⁄4            |   | 3⁄4               |   | 3⁄4 |   | 3⁄4 |   |
| Reclassification of Series A Preferred  Stock to Stockholders’ Equity                    |   | 2,916,000  |      | 3⁄4            |   | 3⁄4               |   | 2,916,000 |   | 1,458,933 |   |
| Conversion of Series B Preferred Stock to  Series E Preferred Stock                           |   | 28,080     |      | 3⁄4            |   | 3⁄4               |   | 28,080 |   | (163,267 |   |
| Forgiveness of dividends on Series B  Preferred Stock                                         |   | 3⁄4     |      | 3⁄4            |   | 3⁄4               |   | (2,400 | ) | 3⁄4 |   |
| Balance – September 30, 2002                                                             |   | $          | 3,042,683 |              | $      | 115,226              |   | 11,522,567 |   | $ | 6,279,323 |   | 1,490,616 |   |
|                                                                                               |        |            |           |                   |        |                      |        |  |  |  |  |  |  |  |

 
|                                                                                          |   | **Treasury  Stock** |   | **Additional  Paid-In  Capital** |   | **Deferred  Compensation** |   | **Accumulated  Other  Comprehensive  Loss** |   | **Accumulated  Deficit** |   |
|-----------------------------------------------------------------------------------------------|--------|---------------------|--------|----------------------------------|--------|----------------------------|--------|---------------------------------------------|--------|--------------------------|--------|
|                                                                                          |   |                |   |                             |   |                       |   |                                        |   |                     |   |
| Net  (loss)                                                                                   |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |   | (6,386,585               | )      |
| Dividends and accretion on preferred stock                                                    |   | 3⁄4              |   | (1,041,810                       | )      | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Beneficial conversion feature of  convertible debt and convertible preferred stock            |   | 3⁄4              |   | 831,000                          |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Beneficial conversion feature of  convertible debt redeemed                                   |   | 3⁄4              |   | (69,541                          | )      | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Conversion of convertible debt                                                                |   | 3⁄4              |   | 710,628                          |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Issuance of common stock in connection with  acquisition                                      |   | 3⁄4              |   | 374,000                          |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Proceeds from the private placements of  common stock (net of costs of $9,750) for cash       |   | 3⁄4              |   | 219,306                          |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Issuance of warrants for services provided                                                    |   | 3⁄4              |   | 55,000                           |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Issuance of Series B preferred stock in  exchange for loans payable                           |   | 3⁄4              |   | (81,592                          | )      | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Issuance of common stock in exchange for  accounts payable and accrual expenses               |   | 3⁄4              |   | 58,104                           |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Proceeds from the issuance of preferred  stock (net of costs $402,870) for cash               |   | 3⁄4              |   | (402,870                         | )      | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Redemption of Series B Preferred Stock                                                        |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Redemption of convertible debt                                                                |   | 3⁄4              |   | (20,577                          | )      | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Reclassification adjustment for loss on  securities available for sale included in net income |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 1,200,000                                   |   | 3⁄4                   |   |
| Reclassification of Series A Preferred  Stock to Stockholders’ Equity                    |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Conversion of Series B Preferred Stock to  Series E Preferred Stock                           |   | 3⁄4              |   | 3⁄4                           |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Forgiveness of dividends on Series B  Preferred Stock                                         |   | 3⁄4              |   | 2,400                            |   | 3⁄4                     |   | 3⁄4                                      |   | 3⁄4                   |   |
| Balance – September 30, 2002                                                             |   | $                   | — |                             | $      | 12,626,733                 |   | $                                           | 3⁄4 |                     | $      | 3⁄4 |   | $ | (15,978,599 | ) |
|                                                                                               |        |                     |        |                                  |        |                            |        |                                             |        |                          |        |  |  |  |  |  |

 

See accompanying summary of accounting policies and notes to financialstatements.

 

F-8

----

 

**STRATUSSERVICES GROUP, INC.**

Statementsof Comprehensive Income

 
|                                                                                          |   | **Years  Ended September 30,** |       |
|-----------------------------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                                          |   | **2002**                       |       | **2001** |   | **2000** |   |
|                                                                                          |   |                           |       |   |   |   |   |
| Net earnings (loss)                                                                           |   | $                              | (6,386,585 | ) | $ | (5,847,457 | ) | $ | 1,045,910 |   |
|                                                                                          |   |                           |       |   |   |   |   |
| Unrealized loss on securities available for sale                                              |   | 3⁄4                         |       | (1,200,000 | ) | 3⁄4 |   |
|                                                                                          |   |                           |       |   |   |   |   |
| Reclassification adjustment for loss on securities  available for sale included in net income |   | 1,200,000                      |       | 3⁄4 |   | 3⁄4 |   |
|                                                                                          |   |                           |       |   |   |   |   |
| Comprehensive income (loss)                                                                   |   | $                              | (5,186,585 | ) | $ | (7,047,457 | ) | $ | 1,045,910 |   |

 

See accompanying summary of accounting policies and notes to financialstatements.

 

F-9

----

 

**STRATUSSERVICES GROUP, INC.**

**Notes to Financial Statements**

** **

**Note 1 -****         ****Nature of Operations and Summary of Significant AccountingPolicies**

## **Operations**

StratusServices Group, Inc. (the “Company”) is a national provider of staffing andproductivity consulting services.  As ofSeptember 30, 2002, the Company operated a network of thirty-three offices innine states.

 

TheCompany operates as one business segment. The one business segment consists of its traditional staffing servicesand SMARTSolutionsTM, a structured program to monitor and enhance the productionof a client’s labor resources.  TheCompany’s customers are in various industries and are located throughout theUnited States.  Credit is granted tosubstantially all customers.  Nocollateral is maintained.

 

#### **Basis of Presentation**

Theaccompanying financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the satisfaction ofliabilities in the normal course of business. As shown in the financial statements, the Company incurred significantlosses from continuing operations of $7,580,000 and $5,993,000 during the yearsended September 30, 2002 and 2001, respectively, and has a working capital deficitof $3,287,000 at September 30, 2002. These factors, among others, indicate that the Company may be unable tocontinue as a going concern.  Thefinancial statements do not include any adjustments relating to therecoverability and classification of liabilities that might be necessary shouldthe Company be unable to continue as a going concern.

 

Managementrecognizes that the Company’s continuation as a going concern is dependent uponits ability to generate sufficient cash flow to allow it to satisfy itsobligations on a timely basis, to fund the operation and capital needs, and toobtain additional financing as may be necessary.

 

Managementof the Company has taken steps to revise and reduce its operating requirements,which it believes will be sufficient to assure continued operations andimplementation of the Company’s plans. The steps include closing branches that are not profitable,consolidating branches and reductions in staffing and other selling, generaland administrative expense.

 

**Revenue Recognition**

TheCompany recognizes revenue as the services are performed by its workforce.  The Company’s customers are billedweekly.  At balance sheet dates, thereare accruals for unbilled receivables and related compensation costs.

 

TheCompany has changed the method of reporting the revenues from payrollingservices (“payrolling”) from gross billing to a net revenue basis.  Accordingly, reported revenues and relatedcost of revenues have been reduced and restated by $7,919,313, $7,018,053 and$1,756,388 in the year ended September 30, 2002, 2001 and 2000,respectively.  The change had no effecton the Company’s net operating results.

 

Thefollowing summarizes revenues:

 
|       |   | **Years  Ended September 30,** |       |
|------------|--------|--------------------------------|------------|
|       |   | **2002**                       |       | **2001** |   | **2000** |   |
| Staffing   |   | $                              | 64,414,563 |   | $ | 49,170,040 |   | $ | 34,223,787 |   |
|       |   |                           |       |   |   |   |   |
| Payrolling |   | 706,532                        |       | 838,245 |   | 219,496 |   |
|       |   | $                              | 65,121,095 |   | $ | 50,008,285 |   | $ | 34,443,283 |   |

 

F-10

----

 

Unliketraditional staffing services, under a payrolling arrangement, the Company’scustomer recruits and identifies individuals for the Company to hire to provideservices to the customer.  The Companybecomes the statutory employer although the customer maintains substantiallyall control over those employees. Accordingly, Emerging Issues Task Force (“EITF”) 99-19, “ReportingRevenue Gross as a Principal versus Net as an Agent” requires that we do notreflect the direct payroll costs paid to such employees in revenues and cost ofrevenue.

 

**Use ofEstimates**

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

**CashEquivalents and Concentration of Cash**

TheCompany considers all highly liquid investments with original maturities ofthree months or less to be cash equivalents. The Company maintains its cash in bank deposit accounts, which, at timesmay exceed federally insured limits. The Company has not experienced any losses in such accounts.

 

**ComprehensiveIncome (Loss)**

Comprehensiveincome (loss) is the total of net income (loss) and other non-owner changes inequity including unrealized gains or losses on available-for-sale marketablesecurities.

 

F-11

----

 

**Earnings/LossPer Share**

TheCompany utilizes Statement of Financial Accounting Standards No. 128 “EarningsPer Share”, (SFAS 128), whereby basic earnings per share (“EPS”) excludesdilution and is computed by dividing earnings available to common stockholdersby the weighted-average number of common shares outstanding during theperiod.  Diluted EPS assumes conversionof dilutive options and warrants, and the issuance of common stock for allother potentially dilutive equivalent shares outstanding.

 

Followingis a reconciliation of the numerator and denominator of Basic EPS to thenumerator and denominator of Diluted EPS for all years presented.

 
|                                                              |   | **Year Ended  September 30,** |       |
|-------------------------------------------------------------------|--------|-------------------------------|------------|
|                                                              |   | **2002**                      |       | **2001** |   | **2000** |   |
| Numerator:                                                        |   |                          |       |   |   |   |   |
| Basic EPS                                                         |   |                          |       |   |   |   |   |
| Net earnings (loss)                                               |   | $                             | (6,386,585 | ) | $ | (5,847,457 | ) | $ | 1,045,910 |   |
| Dividends and accretion on preferred stock                        |   | 1,041,810                     |       | 63,000 |   | 3⁄4 |   |
|                                                              |   |                          |       |   |   |   |   |
| Net earnings (loss) attributable to common  stockholders          |   | $                             | (7,428,395 | ) | $ | (5,910,457 | ) | $ | 1,045,910 |   |
|                                                              |   |                          |       |   |   |   |   |
| Denominator:                                                      |   |                          |       |   |   |   |   |
| Basic EPS                                                         |   |                          |       |   |   |   |   |
| Weighted average shares outstanding                               |   | 10,555,815                    |       | 5,996,134 |   | 4,931,914 |   |
| Per share amount                                                  |   | $                             | (.70       | ) | $ | (.99 | ) | $ | .21 |   |
|                                                              |   |                          |       |   |   |   |   |
| Effect of stock options and warrants                              |   | 3⁄4                        |       | 3⁄4 |   | 291,594 |   |
|                                                              |   |                          |       |   |   |   |   |
| Dilutive EPS                                                      |   |                          |       |   |   |   |   |
| Weighted average shares outstanding including  incremental shares |   | 10,555,815                    |       | 5,996,134 |   | 5,223,508 |   |
| Per share amount                                                  |   | $                             | (.70       | ) | $ | (.99 | ) | $ | .20 |   |

 

**Investment**

Theinvestment represented securities available for sale which were stated at fairvalue.  Unrealized holding gains andlosses were reflected as a net amount in accumulated other comprehensive lossuntil realized.  The entire investment,which consisted of an investment in a publicly-traded foreign company (see Note5), was sold in the year ended September 30, 2002 at a gross realized loss of$2,159,415.  There were no grossrealized gains and losses on sales of available-for-sale securities for theyears ended September 30, 2001 and 2000.

 

**Propertyand Equipment**

Propertyand equipment is stated at cost, less accumulated depreciation.  Depreciation is provided over the estimateduseful lives of the assets as follows:

 
|                   |   | **Method**        |   | **Estimated  Useful Life** |   |
|------------------------|--------|-------------------|--------|----------------------------|--------|
| Furniture and fixtures |   | Declining balance |   | 5 years                    |   |
| Office equipment       |   | Declining balance |   | 5 years                    |   |
| Computer equipment     |   | Straight-line     |   | 5 years                    |   |
| Computer software      |   | Straight-line     |   | 3 years                    |   |
| Vans                   |   | Straight-line     |   | 5 years                    |   |

 

F-12

----

 

**Goodwill**

Goodwillis amortized on a straight-line basis over fifteen years except foracquisitions after June 30, 2001 where goodwill is not being amortized.

 

TheCompany evaluates the carrying value of its long-lived assets under theprovisions of statement of Financial Accounting Standards (“SFAS”) No. 121,Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets tobe Disposed Of.  SFAS No. 121 requiresimpairment losses to be recorded on long-lived assets used in operations,including goodwill, when indicators of impairment are present and theundiscounted future cash flows, estimated to be generated by those assets areloess than the assets’ carrying value. If such assets are impaired, the impairment to be recognized is measuredby the amount by which the carrying amount of the asset exceeds the fair marketvalue of the assets.

 

TheCompany recorded charges of $400,000, $700,000 and $-0- in the years endedSeptember  30, 2002, 2001 and 2000,respectively relating to the impairment of goodwill related with variousacquisitions previously made by the Company. The steady decline in revenue and earnings of those acquired businessunits and in the case of one business unit, the loss of a major customerrequired that the Company adjust the carrying value of the goodwill.  Using discounted cash flow projections forthese acquired business units, the related goodwill was written down to theirestimated fair values.

 

**Factoring**

TheCompany’s factoring agreement (see Note 6) with a financing institution(“factor”) had been accounted for as a sale of receivables under Statement ofFinancial Accounting Standards No. 125 “Accounting for Transfers and Servicesof Financial Assets and Extinguishment of Liabilities”. (“SFAS” No. 125)

 

**Fair Valuesof Financial Instruments**

Fairvalues of cash and cash equivalents, accounts receivable, accounts payable andshort-term borrowings approximate cost due to the short period of time tomaturity.  Fair values of long-termdebt, which have been determined based on borrowing rates currently availableto the Company for loans with similar terms or maturity, approximate thecarrying amounts in the financial statements.

 

**Stock –Based Compensation**

Statementof Financial Accounting Standards No. 123 “Accounting for Stock BasedCompensation” (“SFAS” 123”) allows a company to adopt a fair value based methodof accounting for its stock-based compensation plans or continue to follow theintrinsic value method of accounting prescribed by Accounting Principles BoardOpinion (“APB”) No. 25, “Accounting for Stock Issued to Employees”.  The Company accounts for stock-basedcompensation in accordance with the provisions of APB No. 25, and complies withthe disclosure provisions of SFAS No. 123. Under APB No. 25, compensation cost for stock options is measured as theexcess, if any, of the quoted market price of the Company’s stock at the dateof the grant over the amount an employee must pay to acquire the stock.

 

**IncomeTaxes**

TheCompany recognizes deferred tax assets and liabilities based on differencesbetween the financial reporting and tax bases of assets and liabilities usingthe enacted tax rates and laws that are expected to be in effect when thedifferences are expected to be recovered. The Company provides a valuation allowance for deferred tax assets for whichit does not consider realization of such assets to be more likely than not.

 

**AdvertisingCosts**

Advertisingcosts are expensed as incurred.  Theexpenses for the years ended September 30, 2002, 2001 and 2000 were $154,000,$188,000 and $181,000, respectively, and are included in selling, general andadministrative expenses.

 

F-13

----

 

**Impairmentof Long-Lived Assets**

TheCompany evaluates the recoverability of its long-lived assets in accordancewith Statement of Financial Accounting Standards No. 121 “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of”(“SFAS No. 121”).  SFAS No. 121 requiresrecognition of impairment of long-lived assets in the event the net book valueof such assets exceeds the future undiscounted cash flows attributable to suchassets.

 

**NewAccounting Pronouncements**

InJune 1998, the Financial Accounting Standards Board (“FASB”) issued Statementof Financial Accounting Standards (“SFAS”) No. 133, Accounting for DerivativeInstruments and Hedging Activities.  Asamended by SFAS 138, SFAS No. 133 is effective for all fiscal quarters of allfiscal years beginning after June 15, 2000. SFAS No. 133 establishes accounting and reporting standards forderivative instruments, including certain derivative instruments embedded inother contracts, and for hedging activities. This statement did not have a material impact on the Company’s financialposition and results of operations.

 

InDecember 1999, the Securities and Exchange Commission staff released StaffAccounting Bulletin No. 101, Revenue Recognition in Financial Statements (SAB101), which provides guidance on the recognition, presentation and disclosureof revenue in financial statements.  TheCompany believes its revenue recognition policies do not significantly differfrom SAB 101.

 

InSeptember 2000, the FASB issued SFAS No. 140 “Accounting for Transfers andServicing of Financial Assets and Extinguishment of Liabilities” which is areplacement of SFAS No. 125.  SFAS No.140 is effective for transfers and servicing of financial assets andextinguishment of liabilities occurring after March 31, 2001.  This statement did not have a materialimpact on the Company’s financial position and results of operations.

 

InJune 2001, the FASB issued SFAS No. 141, “Business Combinations”.  SFAS No. 141 establishes new standards foraccounting and reporting requirements for business combinations and requiresthat the purchase method of accounting be used for all business combinationsinitiated after June 30, 2001.  SFAS No.141 also requires that acquired intangible assets be recognized as assets apartfrom goodwill if they meet one of the two specified criteria.  Additionally, the statement adds certaindisclosure requirements to those required by APB 16, including disclosure ofthe primary reasons for the business combination and the allocation of thepurchase price paid to the assets acquired and liabilities assumed by majorbalance sheet caption.  This statement isrequired to be applied to all business combinations initiated after June 30,2001 and to all business combinations accounted for using the purchase methodfor which the date of acquisition is July 1, 2001 or later.  Use of the pooling-of-interests method isprohibited.  The adoption of SFAS No.141 did not have an impact on the Company’s financial condition or results ofoperations.

 

InJune 2001, the FASB issued SFAS No. 142, “Goodwill and Other IntangibleAssets”.  SFAS No. 142, which must beapplied to fiscal years beginning after December 15, 2001, modifies theaccounting and reporting of goodwill and intangible assets.  The pronouncement requires entities todiscontinue the amortization of goodwill, reallocate all existing goodwillamong its reporting segments based on criteria set by SFAS No. 142 and performinitial impairment tests by applying a fair-value-based analysis on thegoodwill in each reporting segment.  Anyimpairment at the initial adoption date shall be recognized as the effect of achange in accounting principle. Subsequent to the initial adoption, goodwill shall be tested forimpairment annually or more frequently if circumstances indicate a possibleimpairment.

 

F-14

----

 

UnderSFAS No. 142, entities are required to determine the useful life of otherintangible assets and amortize the value over the useful life.  If the useful life is determined to beindefinite, no amortization will be recorded. For intangible assets recognized prior to the adoption of SFAS No. 142,the useful life should be reassessed. Other intangible assets are required to be tested for impairment in amanner similar to goodwill.  AtSeptember 30, 2002, the Company’s net goodwill was approximately $7,150,000,and annual amortization of such goodwill was approximately $291,000.  The Company will adopt SFAS No. 142 duringits first fiscal quarter of fiscal 2003. Because of the extensive effort required to comply with the remaining provisionsof SFAS Nos. 141 and 142, the Company cannot reasonably estimate the impact onits financial statements of these provisions beyond discontinuing amortization.

 

In August 2001, the FASB issued SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets”.  SFAS No. 144 supercedes SFAS No. 121,“Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assetsto be Disposed of”.  SFAS No. 144establishes a single accounting model for long-lived assets to be disposed ofby sale and requires that those long-lived assets be measured at the lower ofcarrying amount or fair value less cost to sell, whether reported in continuingoperations or in discontinued operations. SFAS No. 144 is effective for fiscal years beginning after December 15,2001.  The Company does not anticipatethat this statement will have a material impact on its financial position andresults of operations.

 

In July 2002, the FASB issued SFAS No. 146“Accounting for Costs Associated with Exit or Disposal Activities”.  SFAS 146 addresses financial accounting andreporting for costs associated with exit or disposal activities and nullifiedEmerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity(including Certain Costs Incurred in a Restructuring)”.  The principal difference between SFAS 146and EITF 94-3 relates to the timing of the recognition of a liability for acost associated with an exit or disposal activity.  SFAS 146 requires that a liability for a cost associated with anexit or disposal activity be recognized when the liability is incurred.  Under EITF 94-3, a liability for an exitcost as generally defined in EITF 94-3 is to be recognized at the date of anentity’s commitment to an exit plan. SFAS 146 is effective for exit or disposal activities that are initiatedafter December 31, 2002.  The effect ofadoption of FAS 146 is dependent on the Company’s related activities subsequentto the date of adoption.

 

**Note 2 -****         ****Initial Public Offering**

On May 5, 2000, the Company completed its initialpublic offering (“IPO”) of 1,300,000 shares of common stock at a price of $6.00per share, generating net proceeds of approximately $5,930,000 after deductingunderwriters discounts and offering costs of approximately $1,870,000.

 

**Note 3 -****         ****Acquisitions**

 

On June 26, 2000, the Company purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of eight offices of Tandem, a division of Outsource International,Inc. (“Outsource”).  The purchase pricewas $1,300,000, of which $800,000 was paid in cash at the closing and theremaining $500,000 was represented by two promissory notes.  The first note, representing $400,000 waspayable in two installments of $200,000 plus accrued interest at 8.5% a year,within 90 days and 180 days after closing. The second note, representing $100,000 bears interest at 8.5% a year andis payable in twelve equal monthly installments beginning January 1, 2001.  As of September 30, 2002, a balance ofapproximately $8,000 remains unpaid and is included in the current portion of“Notes payable — acquisitions” on the attached balance sheet as of September30, 2002.

 

F-15

----

 

The excess of cost paid over net assetsacquired resulted in goodwill of $1,562,693, computed as follows:

** **
| Net assets acquired                                                        |   |      |      |
|----------------------------------------------------------------------------|--------|-----------|-----------|
| Furniture and equipment                                                    |   | $         | 38,175    |   |
| Accrued holiday and  vacation pay                                          |   | (47,000   | )         |
|                                                                       |   | (8,825    | )         |
| Amounts paid                                                               |   |      |      |
| Cash                                                                       |   | 800,000   |      |
| Notes payable                                                              |   | 500,000   |      |
| Finder’s fees ($143,000)  and professional fees paid to third parties |   | 253,868   |      |
|                                                                       |   | 1,553,868 |      |
|                                                                       |   |      |      |
| Excess of amounts paid  over net assets acquired – goodwill           |   | $         | 1,562,693 |   |

 

On October 27, 2000, the Company purchasedsubstantially all of the tangible and intangible assets, excluding accountsreceivable, of seven offices of Tandem, a division of Outsource International,Inc. The initial purchase price for the assets was $125,000; of which $50,000was paid in cash at the closing and the remaining $75,000 was represented by apromissory note secured by the assets purchased by the Company.  The note was payable in twenty-four equalmonthly installments of principal and interest at a variable rate of prime plustwo percent beginning December 1, 2000. In January 2001, the Company exercised an option to repay theoutstanding balance of the note plus $175,000 in lieu of an earnout payment ofthirty percent of the Earnings Before Interest, Taxes, Depreciation andAmortization (“EBITDA”) of the acquired business for a two year period.

 

Theexcess of cost paid over net assets acquired resulted in goodwill of $855,718,computed as follows:

 
| Net assets acquired                                                       |   |    |    |
|---------------------------------------------------------------------------|--------|---------|---------|
| Furniture  and equipment                                                  |   | $       | 31,650  |   |
| Accrued holiday and vacation pay                                          |   | (21,758 | )       |
|                                                                      |   | 9,892   |    |
| Amounts paid                                                              |   |    |    |
| Cash                                                                      |   | 50,000  |    |
| Note payable                                                              |   | 75,000  |    |
| Earnout payable                                                           |   | 175,000 |    |
| Finder’s fees ($511,250) and professional fees  paid tothird parties |   | 565,610 |    |
|                                                                      |   | 865,610 |    |
|                                                                      |   |    |    |
| Excess of amounts paid over net assets acquired –  goodwill          |   | $       | 855,718 |   |

 

On January 2, 2001, the Company purchasedsubstantially all of the tangible and intangible assets of Cura Staffing, Inc.and The WorkGroup Professional Services, Inc. The purchase price was $175,000 of which $100,000 was paid in cash atthe closing and the remaining $75,000 was represented by a 90-day promissorynote for $50,000 and $25,000 payable $5,000 a month beginning after the paymentof the 90-day promissory note.  Thepromissory note bears interest at 6% a year. As of September 30, 2002, the Company has not paid a portion of the$50,000 note and the entire $25,000 note. The balance of approximately $26,000 is included in the current portionof “Notes payable — acquisitions” on the attached balance sheet as of September30, 2002.

 

F-16

----

 

The excess of cost paid over net assetsacquired resulted in goodwill of $228,144, computed as follows:

** **
| Net assets acquired                                                      |   |    |    |
|--------------------------------------------------------------------------|--------|---------|---------|
| Furniture  and equipment                                                 |   | $       | 11,000  |   |
| Accrued holiday and vacation pay                                         |   | (12,000 | )       |
|                                                                     |   | (1,000  | )       |
| Amounts paid                                                             |   |    |    |
| Cash                                                                     |   | 100,000 |    |
| Note payable and other payables                                          |   | 75,000  |    |
| Finder’s fees ($25,000) and professional fees paid  tothird parties |   | 52,144  |    |
|                                                                     |   | 227,144 |    |
|                                                                     |   |    |    |
| Excess of amounts paid over net assets acquired —  goodwill         |   | $       | 228,144 |   |

 

OnJuly 27, 2001, the Company purchased substantially all of the tangible andintangible assets, excluding accounts receivable of the clerical and lightindustrial staffing division of Source One Personnel, Inc. (“Source One”).  As a result of the acquisition, the Companyhas expanded its presence in the Philadelphia to New York corridor.

 

The initial purchase price for the assets was $3,400,000, of which$200,000 in cash, and 400,000 shares of the Company’s restricted common stockwere paid at the closing and the remaining $2,400,000 was represented by twopromissory notes.  In addition, SourceOne is entitled to earnout payments based upon the acquired business achievingcertain performance levels during each of the three fiscal years beginningOctober 1, 2001.  There was no earnoutpayment due for the year ended September 30, 2002.  There was an additional $42,163 of costs paid to third parties inconnection with the acquisition.  Thefirst note, representing $600,000, was payable in one installment of $600,000plus accrued interest at 7% per year, at 180 days after the closing.  The second note, representing $1,800,000bears interest at 7% per year and is payable over a four-year period in equalquarterly payments beginning 120 days after the closing.  Source One had agreed to allow the Companyto defer the payment of the first note and the February 2002 installment of thesecond note until the earlier of the receipt of the proceeds from the sale ofthe Company’s Engineering Division (see Note 4) or April 30, 2002.  In June 2002, Source One agreed to forbearfrom exercising remedies against the Company until June 30, 2002.  On July 31, 2002, the Company cured allpayment defaults under the first and second notes.  In exchange for the forbearance, the Company agreed to issue250,000 shares of its restricted Common Stock to Source One.  The $37,500 value of the shares which wereissued in October 2002, is included in “Accounts Payable and Accrued Expenses”on the attached balance sheet as of September 30, 2002.  Source One has a put option to sell 400,000shares back to the Company at $2 per share between 24 months after the closingand final payment of the second note, but not less than 48 months (see Note18).

 

Thefollowing table summarizes the fair value of the assets acquired at the date ofacquisition based upon a third-party valuation of certain intangible assets:

 
| Property and Equipment |   | $         | 105,000   |   |
|------------------------|--------|-----------|-----------|--------|
| Intangible assets      |   | 636,300   |      |
| Goodwill               |   | 2,700,863 |      |
|                   |   |      |      |
| Total assets acquired  |   | $         | 3,442,163 |   |

 

F-17

----

 

Of the $636,300 of intangible assets, $127,300 was assigned to acovenant-not-to-compete and $509,000 was assigned to the customer list.  The intangible assets are being amortized overtheir estimated useful life of four years. Goodwill is not being amortized under the provision of SFAS No.142.  All of the goodwill is expected tobe deductible for tax purposes.

 

Effective January 1, 2002, the Company purchased substantially all ofthe tangible and intangible assets, excluding accounts receivable, of sevenoffices of Provisional Employment Solutions, Inc. (“PES”).  The initial purchase price was $1,480,000,represented by a $1,100,000 promissory note and 400,000 shares of the Company’scommon stock.  There was an additional$334,355 of costs paid to third parties in connection with theacquisitions.  In addition, PES isentitled to earnout payments of 15% of pretax profit of the acquired businessup to a total of $1.25 million or the expiration of ten years, whichever occursfirst.  There was no earnout payment duefor the year ended September 30, 2002. The note bears interest at 6% a year and is payable over a ten-yearperiod in equal quarterly payments.

 

The following table summarizes the fair value of the assets acquired atthe date of acquisition based upon a third-party valuation of certainintangible assets:

 

| Property and  equipment |   | $         | 42,000    |   |
|-------------------------|--------|-----------|-----------|--------|
| Intangible  assets      |   | 468,596   |      |
| Goodwill                |   | 1,306,131 |      |
|                    |   | $         | 1,816,727 |   |

 

Of the $468,596 of intangible assets, $85,880 was assigned to acovenant-not-to-compete and $382,716 was assigned to the customer list.  The intangible assets are being amortizedover their estimated useful life of two to four years.  Goodwill is not being amortized under theprovision of Statement of Financial Accounting Standards No. 142, “Goodwill andOther Intangible Assets”.  All of thegoodwill is expected to be deductible for tax purposes.

 

The above acquisitions have been accounted for as purchases.  The results of operations are included inthe Company’s statements of operations from the effective date of acquisition.

 

The unaudited pro forma results of operations presented below assumethat the acquisitions had occurred at the beginning of fiscal 2001.  This information is presented for informationalpurposes only and includes certain adjustments such as goodwill amortizationresulting from the acquisitions and interest expense related to acquisitiondebt.

** **
|                                                                       |   | **Unaudited  Year Ending September 30,** |       |
|----------------------------------------------------------------------------|--------|------------------------------------------|------------|
|                                                                       |   | **2002**                                 |       | **2001** |   |
| Revenues                                                                   |   | $                                        | 70,279,095 |   | $ | 84,464,285 |   |
|                                                                       |   |                                     |       |   |   |
| Net (loss) from continuing  operations attributable to common stockholders |   | (8,461,292                               | )          | (4,967,387 | ) |
|                                                                       |   |                                     |       |   |   |
| Net (loss) per share  attributable to common stockholders                  |   |                                     |       |   |   |
| Basic                                                                      |   | $                                        | (.80       | ) | $ | (.78 | ) |
| Diluted                                                                    |   | $                                        | (.80       | ) | $ | (.78 | ) |

 

F-18

----

 

The maturities on notes payable-acquisitions are as follows:

 

| **Year  Ending September 30** |   |    |      |
|-------------------------------|--------|---------|-----------|
| 2003                          |   | $       | 578,040   |   |
| 2004                          |   | 559,227 |      |
| 2005                          |   | 598,453 |      |
| 2006                          |   | 103,671 |      |
| 2007                          |   | 110,033 |      |
| Thereafter through 2013       |   | 548,198 |      |
|                          |   | $       | 2,497,572 |   |

** **

**Note 4 -****         ****Discontinued Operations – Sale of Engineering Division**

On January 24, 2002, the Company entered into an agreement to sell theassets of its Engineering Services Division (the “Division”) to SEA ConsultingServices Corporation (“SEA”).

 

On March 28, 2002, the Company completed the sale of the assets of theDivision to SEA pursuant to the Asset Purchase Agreement dated as of January24, 2002, among the Company, SEP, LLC (“SEP”), Charles Sahyoun, Sahyoun HoldersLLC and SEA.  The transaction wasapproved by a vote of the Company’s stockholders at the Company’s annualmeeting of stockholders held on March 28, 2002.

 

The assets of the Division had been transferred to SEP, a limitedliability company in which the Company owns a 70% interest, at the time of theexecution of the Asset Purchase Agreement. Sahyoun Holders, LLC, a company wholly-owned by Charles Sahyoun, thePresident of the Division, owns the remaining 30% interest in SEP.

 

Under the terms of the Asset Purchase Agreement, theCompany received an initial cash payment of $1,560,000, which represented 80%of the initial $2,200,000 installment of the purchase price payable to SEP netof a $200,000 broker’s fee due to a third party.  Sahyoun Holdings, LLC received the other 20% of the initial netinstallment of the purchase price, or $440,000.

 

The Asset Purchase Agreement requires SEA to make the followingadditional payments to SEP:

 

(i)        A payment of $1 million,plus or minus the amount by which SEA’s profit for the six months ending June30, 2002, as determined pursuant to the Asset Purchase Agreement, is greater orless than $600,000 (the “Second Payment”);

 

(ii)       A payment of $1 million,plus or minus the amount by which SEA’s profit for the six months endingDecember 31, 2002, as determined pursuant to the Asset Purchase Agreement, isgreater or less than $600,000 (the “Third Payment”);

 

(iii)      Five subsequent annualpayments (the “Subsequent Payments”) which will be based upon a multiple of theannual successive increases, if any, in SEA’s profit during the five yearperiod beginning on January 1, 2003 and ending December 31, 2007.

 

Pursuant to an allocation and indemnity agreement entered into by theCompany, Sahyoun Holdings, LLC and Charles Sahyoun (the “Allocation andIndemnity Agreement”), the Company was entitled to $250,000 of the SecondPayment and $250,000 of the Third Payment. On April 15, 2002, by letter agreement between the Company, SahyounHoldings, LLC and Joseph J. Raymond, Sr., the Chairman and Chief ExecutiveOfficer of the Company, the parties agreed to a modification of the Allocationand Indemnity Agreement.  Per thatletter agreement, Sahyoun Holdings, LLC provided the Company with $200,000 cashin exchange for the Company’s short-term, 90-day demand note, due and payableby August 1, 2002 in the amount of $250,000. Such $250,000 was repaid by the Company from its $250,000 share of theSecond Payment which was received in June 2002.

 

F-19

----

 

Sahyoun Holdings, LLC and Charles Sahyoun have guaranteed the $250,000payment to be made to the Company from the Third Payment, regardless of theoperating results of SEA (see Note 25). Upon its receipt of all of the payments required under the Allocationand Indemnity Agreement, the Company’s interest in SEP will terminate and theCompany will not be entitled to any additional payments under the AssetPurchase Agreement, including the Subsequent Payments.  Sahyoun Holdings, LLC is entitled to allamounts paid to SEP under the Asset Purchase Agreement other than $500,000 ofpayments made or payable to the Company pursuant to the Allocation andIndemnity Agreement and guaranteed by Charles Sahyoun and Sahyoun Holdings,LLC, as described above.

 

The transaction resulted in a gain, which was calculated as follows:

 
| Initial cash  payment                 |   | $         | 2,200,000 |   |
|---------------------------------------|--------|-----------|-----------|--------|
| Guaranteed  additional payments       |   | 500,000   |      |
| Less costs  of sale:                  |   |      |      |
| Allocations  to Sahyoun Holdings, LLC |   | (440,000  | )         |
| Broker’s fee                     |   | (200,000  | )         |
| Other costs                           |   | (100,921  | )         |
| Balance                               |   | 1,959,079 |      |
| Net assets  sold                      |   | 200,023   |      |
| Gain                                  |   | $         | 1,759,056 |   |

 

Revenues from the Division were $2,730,000, $7,245,000 and $5,477,000for the years ended September 30, 2002, 2001 and 2000, respectively.

 

The statements of operations for all period presented have beenreclassified to reflect the operating results of the Division as discontinuedoperations.

 

**Note 5 -****         ****Transactions with Artisan (UK) plc**

On June 26, 2001, the Company entered into an agreement to purchase63,025,000 ordinary shares, representing 26.3% of the outstanding shares ofenterpriseAsia. com (“EPA”), a London AIM listed company (see Note 1), fromArtisan (UK) plc (“Artisan”).  Inexchange, the Company issued to Artisan 850,837 shares of the Company’s SeriesA preferred stock (see Note 15).  Thistransaction was consummated, effective August 15, 2001.

 

The cost of the investment in EPA and value assigned to the preferredstock issued was based upon the market price per share of EPA on the date thetransaction was consummated. Accordingly, the original cost of the investment was $1,592,000 and,therefore, the 850,837 shares of preferred stock were assigned a value of $1.87per share.

 

On July 3, 2001, the Company received $900,000 from Artisan.com Limited(“Artisan.com”), a company affiliated with Artisan, in exchange for 900,000shares of the Company’s common stock in a private placement.  The transaction was in accordance with anagreement dated June 26, 2001 between the Company and Artisan.com.

 

In connection with the transactions with Artisan and Artisan.com, theCompany issued 608,096 shares of its Series A preferred stock and 30,000 sharesof its common stock for finders’ fees to third parties.

 

The Company entered into the transactions with Artisan to provideimmediate and possible future working capital through the sale of the Company’sstock to Artisan and to provide the Company with business expansionopportunities in Asia through the investment in and relationship with EPA.

 

F-20

----

 

The value of the preferred stock and common stock issued for finders’fees was allocated to the investment in EPA and a reduction to additionalpaid-in capital based on the relative value of the original investment of$1,592,000 and the $900,000 received for the 900,000 shares of the Company’scommon stock.  Accordingly, the originalcost of the investment in EPA increased by $757,000 and additional paid-incapital was reduced by $417,700.

 

The Company was unable to exercise significant influence over EPA’soperating and financial policies. Therefore, the investment in EPA was classified as available-for-salesecurities and was reported at fair value in the attached balance sheet.

 

**Note 6 -****         ****Factoring Agreement**

The Company had a factoring agreement with an unrelated party underwhich it was able to sell qualified trade accounts receivable, with limitedrecourse provisions.  The Company wasrequired to repurchase or replace any receivable remaining uncollected for morethan 90 days.  During the years endedSeptember 30, 2001, and 2000, gross proceeds from the sale of receivables was$10,204,208, and $34,179,692, respectively. There were no gains or losses in connection with the sale or repurchaseof receivables under the factoring agreement.

 

On December 12, 2000, the Company terminated its agreement with thefactor.  As part of the terminationagreement, the Company repurchased all accounts receivable from the factor withproceeds from a new line of credit (See Note 7).

 

**Note7 -****         Lineof Credit**

On December 12, 2000, the Company entered into a loan and securityagreement with a lending institution whereby the Company can borrow up to 90%of eligible accounts receivable, as defined, not to exceed the lesser of $12million or six times the Company’s tangible net worth (as defined).  Borrowings under the agreement bear interestat 1 1⁄2% above the prime rate and are collateralized by substantially all of theCompany’s assets.  The agreement expireson June 12, 2003.  Approximately$5,100,000 of the initial borrowing under this agreement was used to repurchaseaccounts receivable from the factor (see Note 6).  The prime rate at September 30, 2002 was 4.75%.

 

At September 30, 2002, the Company was in violation of the followingcovenants under the loan and security agreement:

 

(i)            Failingto meet the tangible net worth requirement, and;

(ii)           TheCompany’s Common Stock being delisted from the Nasdaq SmallCap Market

 

The Company has received a waiver from the lender on the aboveviolations (see Note 24).

 

**Note 8 -****         Propertyand Equipment**

Property and equipment consist of the following as of September 30:

 
|                       |   | **2002**   |      | **2001**  |   |
|----------------------------|--------|------------|-----------|-----------|--------|
| Furniture and fixtures     |   | $          | 666,941   |      | $      | 494,398 |   |
| Office equipment           |   | 119,719    |      | 109,498   |   |
| Computer equipment         |   | 1,163,135  |      | 978,809   |   |
| Computer software          |   | 193,028    |      | 193,028   |   |
| Vans                       |   | 216,319    |      | 216,319   |   |
|                       |   | 2,359,142  |      | 1,992,052 |   |
| Accumulated depreciation   |   | (1,077,325 | )         | (564,836  | )      |
| Net property and equipment |   | $          | 1,281,817 |      | $      | 1,427,216 |   |

 

F-21

----

 

**Note 9 -****          IntangibleAssets**

Intangible assets consist of the following asof September 30:

 
|                            |   | **2002**   |      | **2001** |   |
|---------------------------------|--------|------------|-----------|----------|--------|
|                            |   |       |      |     |   |
| Goodwill                        |   | $          | 8,020,953 |     | $      | 7,114,822 |   |
| Covenant-not-to-compete         |   | 213,180    |      | 127,300  |   |
| Customer list                   |   | 891,716    |      | 509,000  |   |
| Less: accumulated  amortization |   | (1,238,122 | )         | (672,694 | )      |
|                            |   | $          | 7,887,727 |     | $      | 7,078,428 |   |

 

**Note 10 -****        LoansPayable**

Loans payableconsist of the following as of September 30:

 
|                                                                                  |   |   |   | **2002** |    | **2001** |   |
|---------------------------------------------------------------------------------------|--------|--------|--------|----------|---------|----------|--------|
| Notes, secured by vans  with a book value of $110,549 as of   September 30, 2002 |   | (i)    |   | $        | 104,971 |     | $      | 134,698 |   |
| 18% promissory notes                                                                  |   | (ii)   |   | 80,000   |    | 240,000  |   |
| Stock repurchase note                                                                 |   | (iii)  |   | 168,121  |    | 248,834  |   |
| Demand note                                                                           |   | (iv)   |   | 204,703  |    | 3⁄4   |   |
| Demand note                                                                           |   | (v)    |   | 41,000   |    | 3⁄4   |   |
| Short-term loan                                                                       |   | (vi)   |   | 75,000   |    | 3⁄4   |   |
| Short-term loan                                                                       |   | (vii)  |   | 125,000  |    | 3⁄4   |   |
| Other                                                                                 |   |   |   | 3⁄4   |    | 15,000   |   |
|                                                                                  |   |   |   | 798,795  |    | 638,532  |   |
| Less current portion                                                                  |   |   |   | (580,830 | )       | (347,289 | )      |
| Non-current portion                                                                   |   |   |   | $        | 217,965 |     | $      | 291,243 |   |

 

----

(i)                       Payable$3,453 per month, including interest at 9.25% to 10% a year.

(ii)                    Notes in theamount of $160,000 and $80,000 were due in April 2002.  In addition, the Company issued 40,000 and20,000 shares of its common stock, respectively, to the noteholders.  The noteholders have the right to demand therepurchase by the Company of the shares issued, until the notes are paid infull, at $1.00 per share plus 15% interest. Accordingly, $9,000 was charged to interest expense in the year endedSeptember 30, 2001 and $69,000, representing the put option plus interest, isincluded in “Temporary equity — put options” on the attached balance sheet asof September 30, 2001.  In March 2002,the holder of the $160,000 note, a company owned by the Chief Executive Officerof the Company, exchanged the note for 32,000 shares of Series B PreferredStock (see Note 15).  In thisconnection, 46,000 was transferred from “Temporary equity — put options” to “StockholdersEquity”.

(iii)                 Promissory noteissued in January 2001 in connection with the purchase of treasury stock.  Note is payable $8,000 per month, includinginterest at 15% a year.

(iv)                On September 30,2002, the Company converted $215,000 of accounts payable due to Source One (seeNote 3) into a demand note.  Thenon-interest bearing note is due in sixteen monthly installments of $13,437.50beginning in October 2002.  The amountreflected above is net of $10,297 of imputed interest.

(v)                   Due to an entitywhose stockholder is the son of the Chief Executive Officer of theCompany.  The note bears interest at 10%a year.

(vi)                Due to the ChiefExecutive Officer of the Company, the loan does not bear any interest.

(vii)             Short-term loan thatbears interest at various rates.

 

The maturitieson loans payable are as follows:

 
| **Year Ending September 30,** |   |    |    |
|-------------------------------|--------|---------|---------|
| 2003                          |   | $       | 580,830 |   |
| 2004                          |   | 176,494 |    |
| 2005                          |   | 41,471  |    |
|                          |   | $       | 798,795 |   |

 

F-22

----

 

Other loans during the year ended September 30, 2000,aggregating $100,000, $200,000 and $200,000, were settled by the issuance of26,667 shares at $3.75 per share and 50,000 shares at $4.00 per share and33,333 shares at $6.00 per share, respectively.

 

**Note 11 -****        RelatedParty Transactions**

**Consulting Agreement**

The son of theChief Executive Officer of the Company provides consulting services to theCompany.  Consulting expense was$125,000, $281,000 and $156,000 for the years ended September 30, 2002, 2001and 2000, respectively.

 

The Company haspaid consulting fees to an entity whose stockholder is another son of the ChiefExecutive Officer of the Company. Consulting fees amounted to $141,000, $119,000 and $9,000 for the yearsended September 30, 2002, 2001 and 2000, respectively.

 

The Companyprovided payroll services to an entity whose Chief Executive Officer was theson of the Chief Executive Officer of the Company.  Revenues related thereto for the years ended September 30, 2002,2001 and 2000, were $-0-, $-0- and $364,000, respectively.

 

**Sale of Common Stock**

During theyear ended September 30, 2002, the Company sold 177,722 shares of its commonstock in private placements to a relative of the Chief Executive Officer of theCompany at prices approximating the then current market of $.87 to $.93 pershare, for total gross proceeds of $156,833.

 

During theyear ended September 30, 2001, the Company sold 382,999 shares of its commonstock in private placements to relatives of the Chief Executive Officer of theCompany at prices approximating the then current market of $.93 to $1.43 pershare, for total gross proceeds of $410,000, less expenses of $5,958.

 

**Joint Venture**

The Companyprovides information technology staffing services through a joint venture,Stratus Technology Services, LLC (“STS”), in which the Company has a 50%interest.  A son of the Chief ExecutiveOfficer of the Company has a majority interest in the other 50% venturer.  STS commenced operations during the yearended September 30, 2001.  The Company’sgain (loss) from operations of STS of $46,312 and $(36,344) for the years endedSeptember 30, 2002 and 2001, respectively, is included in other income(expense) in the statements of operations.

 

Summarizedfinancial information of STS is not provided because the investment is not material.

 

**Note 12 -****        AccountsPayable and Accrued Expenses**

 
|                                        |   | **2002** |      | **2001** |   |
|---------------------------------------------|--------|----------|-----------|----------|--------|
| Accounts payable                            |   | $        | 3,675,922 |     | $      | 2,513,749 |   |
| Accrued compensation                        |   | 383,545  |      | 285,022  |   |
| Accrued workers’  compensation expense |   | 768,739  |      | —   |   |
| Workers’ compensation  claims reserve  |   | 365,131  |      | 273,657  |   |
| Accrued other                               |   | 279,359  |      | 349,368  |   |
|                                        |   | $        | 5,472,696 |     | $      | 3,421,796 |   |

 

F-23

----

 

**Note 13 -****        IncomeTaxes**

Deferred taxattributes resulting from differences between financial accounting amounts and taxbases of assets and liabilities follow:

 
|                                |   | **2002**   |      | **2001**   |   |
|-------------------------------------|--------|------------|-----------|------------|--------|
| Current assets and  liabilities     |   |       |      |       |   |
| Allowance for doubtful  accounts    |   | $          | 697,000   |       | $      | 220,000 |   |
| Valuation allowance                 |   | (697,000   | )         | (220,000   | )      |
| Net current deferred tax  asset     |   | $          | —    |       | $      | — |   |
|                                |   |       |      |       |   |
| Non-current assets and  liabilities |   |       |      |       |   |
| Net operating loss  carryforward    |   | $          | 4,572,000 |       | $      | 2,694,000 |   |
| Valuation allowance                 |   | (4,572,000 | )         | (2,694,000 | )      |
| Net non-current deferred  tax asset |   | $          | —    |       | $      | — |   |

 

The change invaluation allowance was an increase of $2,355,000 and $2,316,000 and a decreaseof $560,000 for the years ended September 30, 2002, 2001,  and 2000, respectively.

 
|                                     |   | **2002**   |   | **2001**   |   | **2000** |   |
|------------------------------------------|--------|------------|--------|------------|--------|----------|--------|
|                                     |   |       |   |       |   |     |   |
| Income taxes (benefit) is  comprised of: |   |       |   |       |   |     |   |
| Current                                  |   | $          | — |       | $      | —   |   | $ | — |   |
| Deferred                                 |   | (2,355,000 | )      | (1,976,000 | )      | 220,000  |   |
| Change in valuation  allowance           |   | 2,355,000  |   | 2,316,000  |   | (560,000 | )      |
|                                     |   | $          | — |       | $      | 340,000  |   | $ | (340,000 | ) |

 

At September30, 2002, the Company has available the following federal net operating losscarryforwards for tax purposes:

 
| **Expiration Date  Year Ending  September 30,** |   |      |    |
|-------------------------------------------------|--------|-----------|---------|
|                                            |   |      |    |
| 2012                                            |   | $         | 122,000 |   |
| 2018                                            |   | 1,491,000 |    |
| 2019                                            |   | 392,000   |    |
| 2021                                            |   | 4,730,000 |    |
| 2022                                            |   | 4,738,000 |    |
|                                                 |        |           |         |  |

 

Theutilization of the net operating loss carryforwards may be limited due tochanges in control.

 

F-24

----

 

The effectivetax rate on net earnings (loss) varies from the statutory federal income taxrate for periods ended September 30, 2002, 2001 and 2000.

 
|                                           |   | **2001** |   | **2001** |   | **2000** |    |
|------------------------------------------------|--------|----------|--------|----------|--------|----------|---------|
|                                           |   |     |   |     |   |     |    |
| Statutory rate                                 |   | (34.0    | )%     | (34.0    | )%     | 34.0     | %       |
| State taxes net                                |   | (6.0     | )      | (6.0     | )      | 6.0      |    |
| Other differences, net                         |   | 3⁄4   |   | (0.4     | )      | 1.4      |    |
| Valuation allowance                            |   | 40.0     |   | 40.4     |   | (79.4    | )       |
| Benefit from net operating  loss carryforwards |   | 3⁄4   |   | 3⁄4   |   | (10.2    | )       |
|                                           |   | —   | %      | —   | %      | (48.2    | )  |

 

**Note 14 -****        ConvertibleDebt**

At various timesduring the years ended September 30, 2002 and 2001, the Company issued, throughprivate placements, a total of $508,050 and $3,643,402, respectively, ofconvertible debentures.  The debenturesbore interest at 6% a year, payable quarterly and had a maturity date of fiveyears from issuance.  Each debenture wasconvertible after 120 days from issuance into the number of shares of theCompany’s common stock determined by dividing the principal amount of thedebenture by the lesser of (a) 120% of the closing bid price of the commonstock on the trading day immediately preceding the issuance date or (b) 75% ofthe average closing bid price of the common stock for the five trading daysimmediately preceding the date of the conversion.  The Company had the right to prepay any of the debentures at anytime at a prepayment rate that varied from 115% to 125% of the amount of thedebenture depending on when the prepayment was made.

 

The discountarising from the 75% beneficial conversion feature aggregated $136,000 and$1,213,747 in the years ended September 30, 2002 and 2001, respectively, andwas being charged to interest expense during the period from the issuance ofthe debenture to the earliest time at which the debenture became convertible.

 

Deferredfinance costs incurred in connection with the issuance of the debenturesaggregated approximately $100,000 and $738,000 in the years ended September 30,2002 and 2001, respectively, and was being amortized over the five year term ofthe debentures.  Included in the $738,000is $88,000 for 50,000 five-year $5.00 warrants and 100,000 five-year $7.50warrants issued as finders’ fees.  Inaddition, the Company paid approximately $80,000 and $280,000 in the yearsended September 30, 2002 and 2001, respectively, in exchange for extending theearliest conversion date and the maturity date by an additional 120 days onapproximately $592,000 and $1,048,500 of debentures, respectively.  These amounts were charged to deferredfinance costs and were being amortized over 120 days.  Included in interest expense for the years ended September 30,2002 and 2001 is approximately $290,000 and $146,000, respectively, foramortization of deferred finance costs in connection with the debentures.

 

During theyears ended September 30, 2002 and 2001, the Company redeemed $270,180 and$1,897,220 of debentures, respectively, resulting in a gain (loss) ofapproximately $3,000 an ($71,000), respectively, which is included in “Otherincome (expense)” in the statements of operations.  The gain (loss) is comprised of the following:

 
|                           |   | **2002** |   | **2001** |   |
|--------------------------------|--------|----------|--------|----------|--------|
| Beneficial conversion  feature |   | $        | 90,000 |     | $      | 632,000 |   |
| Forgiveness of debt            |   | 12,000   |   | 3⁄4   |   |
| Prepayment premiums            |   | (44,000  | )      | (326,000 | )      |
| Deferred finance costs         |   | (54,000  | )      | (377,000 | )      |
| Other costs                    |   | (1,000   | )      | 3⁄4   |   |
|                           |   | $        | 3,000  |     | $      | (71,000 | ) |

 

F-25

----

 

During theyear ended September 30, 2002, $970,593 of debentures were converted into2,537,479 shares of common stock at prices ranging from $.30 to $.60 pershare.  During the year ended September30, 2001, $542,500 of debentures were converted into 628,060 shares of commonstock at prices ranging from $.85 to $.90 per share.  The Company issued 108,666 shares of treasury stock to a debentureholder in connection with a conversion.

 

In March 2002,the Company entered into an agreement with the holder (the “Debenture Holder”)of all but $40,000 of the outstanding debentures pursuant to which it issued tothe Debenture Holder 231,300 shares of Series B Convertible Preferred Stock (seeNote 16) in exchange for (i) $456,499 aggregate principal amount of debentures,(ii) the cancellation of a $400,000 promissory note issued by the Company tothe Debenture Holder in January 2002, and (iii) $300,000 in cash.  As a result, only $40,000 of Debenturesremains outstanding at September 30, 2002.

 

**Note 15 -****        PreferredStock**

**a.****          Series A**

 

In August2001, the Company issued 1,458,933 shares of Series A Convertible PreferredStock (the “Series A Preferred Stock”) in connection with transactions with Artisan(see Note 5).

 

The shares ofSeries A Preferred Stock have a stated value of $3.00 per share.  The difference between the carrying valueand redemption value of the Series A Preferred Stock is being accreted througha charge to additional paid-in-capital through the June 30, 2008 redemptiondate.

 

The Series APreferred Stock entitles the holders thereof to cumulative dividends at $.21per share per year, payable semi-annually, commencing on December 31, 2001,when and if declared by the Board of Directors.  The shares of Series A Preferred Stock are convertible at theoption of the holder into shares of the Company’s Common Stock on a one-for-onebasis.  On June 30, 2008, the companywill be required to redeem any shares of Series A Preferred Stock outstandingat a redemption price of $3.00 per share together with accrued and unpaiddividends, payable at the Company’s option, either in cash or in shares ofcommon stock.  For purposes ofdetermining the number of shares which the Company will be required to issue ifit chooses to pay the redemption price in shares of Common Stock, the CommonStock will have a value equal to the average closing price of the Common Stockduring the five trading days immediately preceding the date of redemption.

 

At the Company’sAnnual Meeting of Stockholders held on March 28, 2002, the stockholdersapproved the issuance by the Company of the full number of shares of CommonStock, which may be issued by the Company in connection with the conversion ofthe Series A Preferred Stock. Accordingly, the Company’s obligation to redeem a portion of theoutstanding shares of Series A Preferred Stock, if such approval was notobtained, was terminated and the Series A Preferred Stock was reclassified topermanent equity.

 

**b.****     Series B**

 

In March 2002,the Company issued 32,000 shares of Series B Convertible Preferred Stock (the“Series B Preferred Stock”) in exchange for a $160,000 note due to a companyowned by the Chief Executive of the Company (see Note 10).  An additional 231,300 shares were issued tothe Debenture Holder (see Note 14) in exchange for (i) 456,499 aggregateprincipal amount of debentures, (ii) cancellation of a $400,000 promissory notedue to the Debenture Holder and (iii) $300,000 in cash.

 

F-26

----

 

The shares ofSeries B Convertible Preferred Stock have a stated value of $5 per share.  Holders of the Series B Preferred Stock areentitled to cumulative dividends at a rate of 6% of the stated value per year,payable when and as declared by the Board of Directors.  Dividends may be paid in cash or, at theoption of the Company, in shares of Common Stock, under certaincircumstances.  Holders of Series BPreferred Stock are entitled to a liquidation preference of $5.00 per shareplus accrued dividends.  The Series BPreferred Stock is convertible into shares of Common Stock at the option of theholder at any time.  The number ofshares of Common Stock into which each share of Series B Preferred Stock isconvertible is determined by dividing the aggregate liquidation preference ofthe shares being converted by the lesser of (i) $4.65 or (ii) 75% of theclosing bid price of the Common Stock on the trading day preceding the date ofconversion.  The discount arising fromthe beneficial conversion feature was treated as a dividend from the date ofissuance to the earliest conversion date.

 

In June 2002,the Company redeemed for cash, 91,000 shares of Series B Preferred Stock at$5.00 per share, totaling $455,000.

 

At a SpecialMeeting of Stockholders held on July 26, 2002, the Company received approvalfrom its stockholders of a proposal to approve the issuance of shares of CommonStock upon conversion of the Series B Preferred Stock in excess of the limitsimposed by the rules of the Nasdaq Stock Market, in the event that theCompany’s Common Stock is reinstated for trading on the Nasdaq Stock Market.

 

In July 2002,the remaining 172,300 shares of Series B Preferred Stock (including 32,000shares held by a company owned by the Chief Executive Officer of the Company)were exchanged for 8,615 shares of Series E Convertible Preferred Stock (the“Series E Preferred Stock”).

 

**c.****         Series E**

 

In July 2002,The Company sold 7,650 shares of newly created Series E Preferred Stock in aprivate placement for $765,000 in cash and issued an additional 8,615 shares ofSeries E Preferred Stock in exchange for all of the outstanding shares ofSeries B Preferred Stock, which had an aggregate stated value of $861,500.  In addition, $41,790 of dividends and penaltieswhich had accrued on the Series B Preferred Stock prior to the exchange wereexchanged for 418 shares of Series E Preferred Stock.

 

The shares ofSeries E Preferred Stock have a stated value of $100 per share.  The holders of the Series E Preferred stockare entitled to cumulative dividends at a rate of 6% of the stated value peryear, payable every 120 days, in preference and priority to any payment of anydividend on the Company’s Common Stock. Dividends may be paid, at the Company’s option, either in cash or inshares of Common Stock, valued at the Series E Conversion Price (as definedbelow).  Holders of Series E PreferredStock are entitled to a liquidation preference of $100 per share, plus accruedand unpaid dividends.

 

The Series EPreferred Stock is convertible into Common Stock at a conversion price equal to75% of the average of the closing bid prices, for the five trading dayspreceding the conversion date, for the Common Stock.  The number of shares issuable upon conversion is determined bymultiplying the number of shares of Series E Preferred Stock to be converted by$100, and dividing the result by the Series E Conversion Price then in effect.

 

Holders ofSeries E Preferred Stock do not have any voting rights, except as required by law.

 

The Companymay redeem the shares of the Series E Preferred Stock at any time prior toconversion, at a redemption price of 115% of the purchase price paid for theSeries E Preferred Shares, plus any accrued but unpaid dividends.

 

The discountarising from the beneficial conversion feature is being treated as a dividendfrom the date of issuance to the earliest conversion date.

 

F-27

----

 

**d.****         Series F**

 

In July 2002,the Company’s Chief Executive Officer invested $1,000,000 in the Company inexchange for 10,000 shares of newly created Series F Convertible PreferredStock (the “Series F Preferred Stock”), which has a stated value of $100 pershare.

 

The holder ofthe Series F Preferred Stock is entitled to receive, from assets legallyavailable therefore, cumulative dividends at a rate of 7% per year, accrueddaily, payable monthly, in preference and priority to any payment of anydividend on the Common Stock and on the Series F Preferred Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series FConversion Price (as defined below). Holders of Series F Preferred Stock are entitled to a liquidationpreference of $100 per share, plus accrued and unpaid dividends.

 

The Series FPreferred Stock is convertible into Common Stock at a conversion price (the“Series F Conversion Price”) equal to $.10 per share.  The number of shares issuable upon conversion is determined bymultiplying the number of shares of Series F Preferred Stock to be converted by$100, and dividing the result by the Series F Conversion Price.

 

Except asotherwise required by law, holders of Series F Preferred Stock and holders ofCommon Stock shall vote together as a single class on each matter submitted toa vote of stockholders.  Eachoutstanding share of Series F Preferred Stock shall be entitled to the numberof votes equal to the number of full shares of Common Stock into which eachsuch share of Series F Preferred Stock is then convertible on the date fordetermination of stockholders entitled to vote at the meeting.  Holders of the Series F Preferred Stock areentitled to vote at the meeting. Holders of the Series F Preferred Stock are entitled to vote as aseparate class on any proposed amendment to the terms of the Series F PreferredStock which would increase or decrease the number of authorized shares ofSeries F Preferred Stock or have an adverse impact on the Series F PreferredStock and on any proposal to create a new class of shares having rights orpreferences equal to or having priority to the Series F Preferred Stock.

 

The Companymay redeem the shares of the Series F Preferred Stock at any time prior toconversion at a redemption price of 115% of the purchase price paid for theSeries F Preferred Shares plus any accrued but unpaid dividends.

 

**e.****         Series H**

 

In September2002, the Company sold 5,000 shares of newly created Series H ConvertiblePreferred Stock (the “Series H Preferred Stock”) in a private placement for$500,000 in cash.

 

The holders ofthe Series H Preferred Stock are entitled to cumulative dividends at a rate of6% per year, payable quarterly, commencing on March 30, 2004, in preference andpriority to any payment of any dividend on the Company’s Common Stock.  Dividends may be paid, at the Company’soption, either in cash or in shares of Common Stock, valued at the Series HConversion Price (as defined below). Holders of Series H Preferred Stock are entitled to a liquidationpreference of $100 per share, plus accrued and unpaid dividends before anyliquidation payment may be made to holders of the Company’s Common Stock.

 

The Series HPreferred Stock is convertible into Common Stock at a conversion price (the“Series H Conversion Price”) equal to the lower of $.20 per share or theaverage market price of the Common Stock for the five trading days immediatelypreceding the conversion date.  Thenumber of shares issuable upon conversion is determined by multiplying the numberof shares of Series H Preferred Stock to be converted by $100 and dividing theresult by the Series H Conversion Price then in effect.

 

F-28

----

 

Holders ofSeries H Preferred Stock do not have any voting rights, except as required bylaw.

 

The Companyhas the right, but not the obligation, to redeem the shares of Series HPreferred Stock at any time prior to conversion at a redemption price of 115%of the purchase price paid for the Series H Preferred Shares plus any accruedbut unpaid dividends.

 

**Note 16 -****    OtherCharges**

**Year ended September 30, 2002:**

Included in“Other Charges” are costs incurred in connection with financing not obtained($75,066), penalties associated with the Series B Preferred Stock ($28,160)(see Note 15), and the fair value of shares issued to Source One in connectionwith a forbearance agreement ($37,500) (see Note 3).

 

**Year ended September 30, 2001:**

During theyear ended September 30, 2001, the Company discontinued negotiations to sellthe Engineering Division and discontinued efforts to make certainacquisitions.  In this connection, costsassociated with these activities were charged to operations.  The Company also charged operations forcosts incurred in connection with various financing not obtained and costsassociated with closed offices.  Thetotal charged to operations for the foregoing was $460,800.

 

In September2001, the Company placed 1,500,000 of unregistered shares of its common stockinto an escrow account in anticipation of receiving a loan which was to be collateralizedby the shares of common stock.  The loantransaction was never consummated, but in October 2001 the shares wereillegally transferred out of the escrow account by a third party to a foreignjurisdiction.  Subsequent thereto, allbut 89,600 shares were returned to the Company and cancelled.  The Company, which made several attempts torecover the shares, recorded a $59,000 charge to operations in the year endedSeptember 30, 2001, representing the market value of the shares notreturned.  The 89,600 shares wererecorded as issued shares in the year ended September 30, 2002 and $59,000 wascredited to stockholders’ equity.  TheCompany has not pursued litigation to attempt to recover the remaining 89,600shares, due to the prohibitive costs of retaining counsel and instituting anaction in a foreign jurisdiction.

 

**Note 17 -****    Commitmentsand Contingencies**

**Office Leases**

The Companyleases offices and equipment under various leases expiring through 2007.  Monthly payments under these leases are$49,000.

 

The followingis a schedule by years of approximate future minimum rental payments requiredunder operating leases that have initial or remaining non-cancelable leaseterms in excess of one year, as of September 30, 2002.

 
| **For the Years Ending September 30,** |   |    |    |
|----------------------------------------|--------|---------|---------|
|                                   |   |    |    |
| 2003                                   |   | $       | 538,000 |   |
| 2004                                   |   | 239,000 |    |
| 2005                                   |   | 194,000 |    |
| 2006                                   |   | 140,000 |    |
| 2007                                   |   | 137,000 |    |
|                                        |        |         |         |  |

 

Rent expensewas $801,000, $697,000 and $356,000 for the years ended September 30, 2002,2001 and 2000, respectively.

 

**Other**

From time totime, the Company is involved in litigation incidental to its businessincluding employment practices claims. There is currently no litigation that management believes will have amaterial impact on the Company’s financial portion.

 

F-29

----

 

**Note 18 -****    TemporaryEquity**

Certainstockholders of the Company may have had a right to pursue claims against theCompany as a result of possible technical violations of the laws andregulations governing the private placement and issuance of securities.  Accordingly, the Company had recorded theoriginal total proceeds of the sale of the shares to these certain stockholdersin the amount of $1,618,060 as temporary equity – common shares in the balancesheet.  The Company made a rescission offerto stockholders holding approximately 2.8 million shares, pursuant to which theCompany offered to repurchase the shares at their original purchase price (plusapplicable interest) which ranged from $0.75 to $3.75 per share.  As a result of no one accepting therescission offer during the rescission period and the expiration, in certaincases, of applicable statutes of limitation, the $1,618,060 of temporary equity– common shares was transferred to additional paid-in capital during the yearended September 30, 2000.

 

Temporaryequity-put options consist of the following as of September 30:

 
|                                                                                                                                    |   | **2002** |    | **2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|----------|---------|----------|--------|
|                                                                                                                                    |   |     |    |     |   |
| Put options on 400,000  shares of the Company’s Common Stock issued in connection with the  acquisition of Source One (see Note 3) |   | $        | 800,000 |     | $      | 800,000 |   |
|                                                                                                                                    |   |     |    |     |   |
| Put options on 20,000 and  60,000 shares of the Company’s Common Stock issued in connection with loans  payable (see Note 10)      |   | 23,000   |    | 69,000   |   |
|                                                                                                                                    |   | $        | 823,000 |     | $      | 869,000 |   |

 

**Note 19 -****    StockOptions and Warrants**

The Companyhas issued stock options to employees with terms of five to ten years.  The options may be exercised for 4,756,349shares.

 

In addition, the Company has issued to the Chief Executive Officer ofthe Company, options to acquire 1,000,000 shares at $6.00 per share and 500,000shares at $1.10 per share.  Theseoptions have a ten-year term and are exercisable at the earlier of five yearsor when the Company achieves earnings of $1.00 per share in a fiscal year.  These options will be forfeited if the ChiefExecutive Officer leaves the employment of the Company.

 

The Company currently has in place four stock option plans, the 1999Equity Incentive Plan (“1999 Plan”), the 2000 Equity Incentive Plan (“2000Plan”), the 2001 Equity Incentive Plan (“2001 Plan”), and the 2002 EquityIncentive Plan (“2002 Plan”) (collectively the “Equity Incentive Plans” or the“Plans”).  The terms of these Plans aresubstantially similar.  The aggregatenumber of shares reserved for issuance under each of the Plans and the sharescurrently vested are, respectively, as follows:

 
| 500,000 shares authorized, 66,099 vested      |   | — |   | 1999 Plan |
|-----------------------------------------------|--------|--------|--------|-----------|
| 500,000 shares authorized, 97,500 vested      |   | — |   | 2000 Plan |
| 1,000,000 shares authorized, 800,000 vested   |   | — |   | 2001 Plan |
| 5,000,000 shares authorized, 3,284,000 vested |   | — |   | 2002 Plan |

 

The Equity Incentive Plans are administered by the CompensationCommittee of the Board of Directors, which are authorized to grant (i)“incentive stock options” within the meaning of Section 422 of the InternalRevenue Code; (ii) nonqualified stock options; (iii) stock appreciation rights;(iv) restricted stock grants; (v) deferred stock awards; and (vi) other stockbased awards to employees of the Company and its subsidiaries.  The Compensation Committee determines (a)the recipient of awards under the Plans (“Awards”); (b) the times at whichAwards will be made; (c) the size and type or types of Awards to be made toeach recipient; and (d) will set forth in each such Award the terms, conditionsand limitations applicable to the Award granted.  The Compensation Committee has full and exclusive power tointerpret the Plan, to adopt rules, regulations and guidelines relating to thePlan, to grant waivers of Plan restrictions and to make all of thedeterminations necessary for its administration.

 

F-30

----

 

Pro formainformation regarding net income and earnings per share is required by theFinancial Accounting Standards Board Statement (“FASB No. 123”), and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method.  The fair valuefor these options was estimated at the date of grant using the Black-Scholesoption-pricing model.

 

TheBlack-Scholes method option-pricing model was developed for use in estimatingthe fair value of traded options, which have no vesting restrictions and arefully transferable.  In addition, optionvaluation models require the input of highly subjective assumptions.  Because the Company’s employee stock optionshave characteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of its employeestock options.

 

The followingweighted-average assumptions were used:

 
|                     |   | **September 30,** |   |
|--------------------------|--------|-------------------|--------|
|                     |   | **2002**          |   | **2001** |   | **2000** |   |
| Risk- free interest rate |   | 4                 | %      | 5 | % | 6 | % |
| Dividend yield           |   | 0                 | %      | 0 | % | 0 | % |
| Expected life            |   | 4-7 years         |   | 4-7 years |   | 4-7 years |   |
| Volatility               |   | 100               | %      | 84 | % | 54 | % |

 

For purposesof pro forma disclosures, the estimated fair value of the options is amortizedto expense over the options’ vesting period. The Company’s pro forma information follows:

 
|                                                                                |   | **For the Years Ended  September 30,** |       |
|-------------------------------------------------------------------------------------|--------|----------------------------------------|------------|
|                                                                                |   | **2002**                               |       | **2001** |   | **2000** |   |
|                                                                                |   |                                   |       |   |   |   |   |
| Pro forma net earnings  (loss) attributable to common stockholders                  |   | $                                      | (9,820,485 | ) | $ | (8,064,810 | ) | $ | 507,051 |   |
| Pro forma net earnings  (loss) per common share attributable to common stockholders |   |                                   |       |   |   |   |   |
| Basic                                                                               |   | $                                      | (.93       | ) | $ | (1.35 | ) | $ | .10 |   |
| Diluted                                                                             |   | (.93                                   | )          | (1.35 | ) | .10 |   |

 

Compensationexpense under APB 25 for the years ended September 30, 2002, 2001 and 2000 was$-0-, $67,900 and $46,800, respectively.

 

F-31

----

 

A summary of the Company’s stock option activity and relatedinformation for the years ended September 30 follows:

 
|                               |   | **Options** |   | **Weighted Average  Exercise Price** |   |
|------------------------------------|--------|-------------|--------|--------------------------------------|--------|
|                               |   |        |   |                                 |   |
| Outstanding at September  30, 1999 |   | 534,000     |   | $                                    | 2.55   |   |
| Granted                            |   | 1,453,205   |   | 5.91                                 |   |
| Canceled                           |   | 3⁄4      |   | 3⁄4                               |   |
| Exercised                          |   | 3⁄4      |   | 3⁄4                               |   |
|                               |   |        |   |                                 |   |
| Outstanding at September  30, 2000 |   | 1,987,205   |   | 5.01                                 |   |
| Granted                            |   | 1,900,000   |   | 2.05                                 |   |
| Canceled                           |   | (279,464    | )      | 4.08                                 |   |
| Exercised                          |   | 3⁄4      |   | 3⁄4                               |   |
|                               |   |        |   |                                 |   |
| Outstanding at September  30, 2001 |   | 3,607,741   |   | 3.52                                 |   |
| Granted                            |   | 3,659,000   |   | .66                                  |   |
| Canceled                           |   | (1,010,392  | )      | 2.49                                 |   |
| Exercised                          |   | 3⁄4      |   | 3⁄4                               |   |
| Outstanding at September  30, 2002 |   | 6,256,349   |   | $                                    | 2.01   |   |
| Exercisable at September  30, 2002 |   | 5,107,599   |   | $                                    | 1.19   |   |

 

The exerciseprices range from $.65 to $6.00 per share.

 

Theweighted-average fair value of options granted was $.37, $1.40 and $3.66 in theyears ended September 30, 2002, 2001 and 2000, respectively.

 

Following is asummary of the status of stock options outstanding at September 30, 2002:

 
|                |   | **Outstanding Options** |       |                                                  |       | **Exercisable Options**                            |       |
|---------------------|--------|-------------------------|------------|-------------------------------------------------------|------------|----------------------------------------------------|------------|
| **Exercise  Price** |   | **Number**              | ** ** | **Weighted  Average  Remaining  Contractual****Life** | ** ** | **Weighted  Weighted  Average  Exercise****Price** | ** ** | **Number** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                |   |                    |       |                                                  |       |                                               |       |   |   |   |   |
| $                   | .65    |                    | 3,334,000  |                                                  | 9.5  years |                                               | $          | .65 |   | 3,334,000 |   | $ | .65 |   |
| .75                 |   | 20,000                  |       | 9.5  years                                            |       | .75                                                |       | 3⁄4 |   | .75 |   |
| 1.10                |   | 1,300,000               |       | 8.5  years                                            |       | 1.10                                               |       | 1,300,000 |   | 1.10 |   |
| 1.32                |   | 30,000                  |       | 9.2  years                                            |       | 1.32                                               |       | 3⁄4 |   | 1.32 |   |
| 3.00                |   | 110,000                 |       | 5.0  years                                            |       | 3.00                                               |       | 110,000 |   | 3.00 |   |
| 5.625               |   | 430,000                 |       | 7.8  years                                            |       | 5.625                                              |       | 131,250 |   | 5.625 |   |
| 6.00                |   | 1,032,349               |       | 7.5  years                                            |       | 6.00                                               |       | 232,349 |   | 6.00 |   |
|                |   | 6,256,349               |       |                                                  |       |                                               |       | 5,107,599 |   |   |   |
|                     |        |                         |            |                                                       |            |                                                    |            |  |  |  |  |  |  |  |

 

F-32

----

 

In connectionwith the IPO, the Company issued 130,000 warrants to its underwriters topurchase shares at $8.70 per share, expiring in 2004.  The Company has also issued the following warrants:

 
| **Number of  Warrants** |   | **Price Per Share** |   | **Expiring In** |   |
|-------------------------|--------|---------------------|--------|-----------------|--------|
|                    |   |                |   |            |   |
| 66,667                  |   | $                   | 7.50   |            | 2004   |   |
| 65,000                  |   | 4.00                |   | 2005            |   |
| 10,000                  |   | 5.00                |   | 2005            |   |
| 20,000                  |   | 6.00                |   | 2005            |   |
| 26,667                  |   | 0.75                |   | 2006            |   |
| 50,000                  |   | 5.00                |   | 2006            |   |
| 100,000                 |   | 7.50                |   | 2006            |   |
| 200,000                 |   | 1.00                |   | 2007            |   |
| 30,000                  |   | 5.00                |   | 2007            |   |
|                         |        |                     |        |                 |        |  |

 

These warrantswere issued in, respectively, the years ended 2000, 2001 and 2002 inconsideration for the following:

 

(i)            95,000 warrants issued to the investors inconnection with a private placement (“Private Placement III”);

 

(ii)           150,000 warrants issued to the investors inconnection with a private placement of debentures “Private Placement IV”) and16,667 warrants issued to the Placement Agent in connection with PrivatePlacement IV; and

 

(iii)          240,000 warrants issued to two consultants inpayment for fees and to the placement agent for a private placement (“PrivatePlacement V”).

 

A summary ofthe Company’s warrant activity and related information for the years endedSeptember 30 follows:

 
|                               |   | **Warrants** |   | **Weighted Average  Exercise Price** |   |
|------------------------------------|--------|--------------|--------|--------------------------------------|--------|
|                               |   |         |   |                                 |   |
| Outstanding at September  30, 1999 |   | 66,667       |   | $                                    | 7.50   |   |
| Granted                            |   | 225,000      |   | 6.94                                 |   |
| Canceled                           |   | 3⁄4       |   | 3⁄4                               |   |
| Exercised                          |   | 3⁄4       |   | 3⁄4                               |   |
|                               |   |         |   |                                 |   |
| Outstanding at September  30, 2000 |   | 291,667      |   | 7.07                                 |   |
| Granted                            |   | 166,667      |   | 5.27                                 |   |
| Canceled                           |   | 3⁄4       |   | 3⁄4                               |   |
| Exercised                          |   | 3⁄4       |   | 3⁄4                               |   |
|                               |   |         |   |                                 |   |
| Outstanding at September  30, 2001 |   | 458,334      |   | 6.50                                 |   |
| Granted                            |   | 240,000      |   | 1.52                                 |   |
| Canceled                           |   | 3⁄4       |   | 3⁄4                               |   |
| Exercised                          |   | 3⁄4       |   | 3⁄4                               |   |
| Outstanding at September  30, 2002 |   | 698,334      |   | $                                    | 4.91   |   |

 

The exerciseprices range from $.65 to $6.00 per share.

 

The weighted-average fairvalue of options granted was $.29, $.59 and $2.90 in the years ended September30, 2002, 2001 and 1999, respectively. As of September 30, 2002, no stock options or warrants have been exercised.

 

F-33

----

 

 

**Note 20 -****    MajorCustomers**

The Companyhad no customers who accounted for more than 10% of total revenues for theyears ended September 30, 2002 and 2001, and one customer who accounted for 10%of total revenues for the year ended September 30, 2000.  Major customers are those who account formore than 10% of total revenues.

 

**Note 21 -****    RetirementPlans**

The Companymaintains two 401(k) savings plans for its employees.  The terms of the plan define qualified participants as those withat least three months of service. Employee contributions are discretionary up to a maximum of 15% ofcompensation.  The Company can match upto 20% of the employees’ first 5% contributions.  The Company’s 401(k) expense for the years ended September 30,2002, 2001 and 2000 was $8,000, $50,000 and $37,000, respectively.

 

**Note 22 -****    PrivatePlacements**

In June 2001,the Company entered into an agreement with an investment banker to raise$1,200,000 through the sale of the Company’s stock through private placementsat a price per share calculated at a 30% discount to the 20-day average of themean between the closing bid and asked prices. The agreement provided that the Company pays a placement fee to theinvestment banker of 10% of the gross proceeds received from the privateplacements and also issues five-year warrants equal to 10% of the number ofshares sold at an exercise price equal to the price per share of the privateplacement.  In addition, the Company wasto pay the investment banker’s expenses in connection with the agreement, notto exceed $50,000.  During the yearsended September 30, 2002 and 2001,****the Company sold 100,002 and 166,667shares, respectively, at $.75 per share under this agreement.  In connection therewith, the Company paid$91,750 and $16,250 to the investment banker and issued warrants to purchase10,000 and 16,667 shares of the Company’s common stock in the years endedSeptember 30, 2002 and 2001, respectively.

 

For the yearsended September 30, 2002 and 2001, private placements resulted in the issuanceof 277,724 and 1,449,666 shares of common stock, respectively (see Notes 5, 11and 15).

 

**Note 23 -****    SelectedQuarterly Financial Data (unaudited)**

 
|                                                                    |   | **First  Quarter** |       | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |       |
|-------------------------------------------------------------------------|--------|--------------------|------------|---------------------|--------|--------------------|--------|---------------------|------------|
|                                                                    |   | **As  Restated**   |       | **As  Restated**    |   | **As  Restated**   |   | **As  Restated**    |       |
| **Year ended September 30, 2002:**                                      |   |               |       |                |   |               |   |                |       |
| Revenues from continuing operations, as amended                         |   | $                  | 13,131,819 |                | $      | 15,816,142         |   | $                   | 17,198,651 |   | $ | 18,974,483 |   |
| Gross profit from continuing operations                                 |   | 2,673,902          |       | 2,668,678           |   | 2,882,173          |   | 3,295,647           |       |
| Net earnings (loss) from discontinued Engineering  Division             |   | 73,266             |       | 1,446,997           |   | (7,366             | )      | (319,000            | )          |
| Net earnings (loss) from continuing operations                          |   | (857,943           | )          | (1,218,441          | )      | (4,645,496         | )      | (1,900,412          | )          |
| Net earnings (loss) attributable to common  stockholders                |   | (784,677           | )          | 228,556             |   | (4,652,862         | )      | (2,219,412          | )          |
|                                                                    |   |               |       |                |   |               |   |                |       |
| Basic earnings (loss) per share attributable to  common stockholders:   |   |               |       |                |   |               |   |                |       |
| Continuing operations                                                   |   | (.09               | )          | (.12                | )      | (.40               | )      | (.16                | )          |
| Discontinued operations                                                 |   | .01                |       | .14                 |   | 3⁄4             |   | (.03                | )          |
| Total                                                                   |   | (.08               | )          | .02                 |   | (.40               | )      | (.19                | )          |
|                                                                    |   |               |       |                |   |               |   |                |       |
| Diluted earnings (loss) per share attributable to  common stockholders: |   |               |       |                |   |               |   |                |       |
| Continuing operations                                                   |   | (.09               | )          | (.12                | )      | (.40               | )      | (.16                | )          |
| Discontinued operations                                                 |   | .01                |       | .14                 |   | 3⁄4             |   | (.03                | )          |
| Total                                                                   |   | (.08               | )          | .02                 |   | (.40               | )      | (.19                | )          |
|                                                                         |        |                    |            |                     |        |                    |        |                     |            |  |  |  |  |

 

F-34

----

 
|                                                                    |   | **First  Quarter** |       | **Second  Quarter** |   | **Third  Quarter** |   | **Fourth  Quarter** |       |
|-------------------------------------------------------------------------|--------|--------------------|------------|---------------------|--------|--------------------|--------|---------------------|------------|
|                                                                    |   | **As  Restated**   |       | **As  Restated**    |   | **As  Restated**   |   | **As  Restated**    |       |
| **Year ended September 30, 2001:**                                      |   |               |       |                |   |               |   |                |       |
| Revenues from continuing operations, as amended                         |   | $                  | 15,749,050 |                | $      | 11,080,481         |   | $                   | 10,526,078 |   | $ | 12,652,676 |   |
| Gross profit from continuing operations                                 |   | 3,837,116          |       | 2,449,282           |   | 2,197,927          |   | 2,467,728           |       |
| Net earnings (loss) from discontinued Engineering  Division             |   | 77,422             |       | 2,229               |   | (10,226            | )      | 76,505              |       |
| Net earnings (loss) from continuing operations                          |   | 236,077            |       | (2,154,877          | )      | (1,514,282         | )      | (2,560,305          | )          |
| Net earnings (loss) attributable to common  stockholders                |   | 313,499            |       | (2,152,648          | )      | (1,524,508         | )      | (2,546,800          | )          |
|                                                                    |   |               |       |                |   |               |   |                |       |
| Basic earnings (loss) per share attributable to  common stockholders:   |   |               |       |                |   |               |   |                |       |
| Continuing operations                                                   |   | .04                |       | (.38                | )      | (.26               | )      | (.37                | )          |
| Discontinued operations                                                 |   | .01                |       | 3⁄4              |   | 3⁄4             |   | .01                 |       |
| Total                                                                   |   | .05                |       | (.38                | )      | (.26               | )      | (.36                | )          |
|                                                                    |   |               |       |                |   |               |   |                |       |
| Diluted earnings (loss) per share attributable to  common stockholders: |   |               |       |                |   |               |   |                |       |
| Continuing operations                                                   |   | .04                |       | (.38                | )      | (.26               | )      | (.37                | )          |
| Discontinued operations                                                 |   | .01                |       | 3⁄4              |   | 3⁄4             |   | .01                 |       |
| Total                                                                   |   | .05                |       | (.38                | )      | (.26               | )      | (.36                | )          |
|                                                                         |        |                    |            |                     |        |                    |        |                     |            |  |  |  |  |

 
|                                                                    |   | **First  Quarter** |      | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|-------------------------------------------------------------------------|--------|--------------------|-----------|---------------------|------------|--------------------|------------|---------------------|------------|
|                                                                    |   | **As  Restated**   |      | **As  Restated**    |       | **As  Restated**   |       | **As  Restated**    |       |
| **Year ended September 30, 2000:**                                      |   |               |      |                |       |               |       |                |       |
| Revenues from continuing operations, as amended                         |   | $                  | 6,287,347 |                | $          | 7,903,124          |       | $                   | 7,176,532  |   | $ | 13,076,280 |   |
| Gross profit from continuing operations                                 |   | 1,496,995          |      | 1,946,929           |       | 1,845,038          |       | 3,083,162           |       |
| Net earnings from discontinued Engineering  Division                    |   | 316,334            |      | 29,617              |       | 208,690            |       | 329,947             |       |
| Net earnings (loss) from continuing operations                          |   | (160,398           | )         | 131,986             |       | (30,794            | )          | 220,528             |       |
| Net earnings (loss) attributable to common  stockholders                |   | 155,936            |      | 161,603             |       | 177,896            |       | 550,475             |       |
|                                                                    |   |               |      |                |       |               |       |                |       |
| Basic earnings (loss) per share attributable to  common stockholders:   |   |               |      |                |       |               |       |                |       |
| Continuing operations                                                   |   | (.03               | )         | .03                 |       | (.01               | )          | .04                 |       |
| Discontinued operations                                                 |   | .07                |      | .01                 |       | .04                |       | .04                 |       |
| Total                                                                   |   | .04                |      | .04                 |       | .03                |       | .10                 |       |
|                                                                    |   |               |      |                |       |               |       |                |       |
| Diluted earnings (loss) per share attributable to  common stockholders: |   |               |      |                |       |               |       |                |       |
| Continuing operations                                                   |   | (.03               | )         | .03                 |       | (.01               | )          | .04                 |       |
| Discontinued operations                                                 |   | .06                |      | .01                 |       | .04                |       | .06                 |       |
| Total                                                                   |   | .03                |      | .04                 |       | .03                |       | .10                 |       |
|                                                                         |        |                    |           |                     |            |                    |            |                     |            |  |  |  |  |

 

F-35

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**Note****24 -****    Subsequent Events**

a.             Effective December 1, 2002 (the “EffectiveDate”), the Company purchased substantially all of the tangible and intangibleassets, excluding accounts receivable, of six offices of Elite PersonnelServices, Inc. (“Elite”).  The purchaseprice, payable at closing, was $1,264,000 (the “Base Purchase Price”), all ofwhich was represented by a promissory note (the “Note”) payable over eightyears, in equal monthly installments. Imputed interest at the rate of 4% per year is included in the Noteamount.  Accordingly, the net BasePurchase Price was $1,083,813.

 

In addition, Elite may alsoreceive as additional purchase price, an amount equal to 10% of “Gross Profits”as defined in the Asset Purchase Agreement, of the acquired business between$2,500,000 and $3,000,000 per year plus 15% of Gross Profits of the acquiredbusiness in excess of $3,200,000 per year for a minimum of one year from theEffective Date, and for a period of two years from the Effective Date if GrossProfits for the first year reach specified levels.

 

In connection with theacquisition, the Company also entered into an employment and non-competeagreement for a five-year period with the President and sole stockholder ofElite.

 

b.             On November 22, 2002, the Company receivednotification from the Nasdaq Listing and Hearing Review Council (“ReviewCouncil”), that it was affirming a previous decision to decision to de-list theCompany’s securities from the Nasdaq Stock Market.  However, the Review Council also noted that, pursuant to NasdaqMarketplace Rule 4850 (a), the NASD Board of Governors may call this decisionfor review in connection with an upcoming Board meeting.

 

c.             In October and November 2002, holders ofSeries E Preferred Stock converted 5,205 shares into 4,486,911 shares of theCompany’s Common Stock at conversion prices between $.108 and $.1365.

 

d.             In December 2002, the Company and CharlesSahyoun agreed to offset the $250,000 of the Third Payment due to the Companyin connection with the sale of its Engineering Division against $250,000 ofaccrued commissions due Charles Sahyoun.

 

e,             In December 2002, in connection with thelender granting a waiver to the Company for violations of certain covenantsunder the loan and security agreement (the “Agreement”), the Company enteredinto a modification of the Agreement. The modification provides that borrowings under the agreement bearinterest at 1 3⁄4% above the prime rate, as long as the Company is in violationof any of the covenants under the Agreement.

 

F-36

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**Stratus Services Group, Inc.**

**Schedule II – Valuation and QualifyingAccounts**

 

**Allowancefor Doubtful Accounts**

 
|          |   | **Balance at  beginning of  period** |    | **Charged to  bad debt  expense (3)** |    | **Other (1)** |   | **Deductions  (Write-offs of  bad debts)** |     | **Balance at  end of  period** |    |
|---------------|--------|--------------------------------------|---------|---------------------------------------|---------|---------------|--------|--------------------------------------------|----------|--------------------------------|---------|
|          |   |                                 |    |                                  |    |          |   |                                       |     |                           |    |
| September 30: |   |                                 |    |                                  |    |          |   |                                       |     |                           |    |
| 2002          |   | $                                    | 551,000 |                                  | $       | 1,650,000     |   | $                                          | —   |                           | $       | (459,000 | ) | $ | 1,742,000 |   |
| 2001          |   | 255,000                              |    | $                                     | 661,000 |          | 30,000 |                                       | (395,000 | )                              | 551,000 |   |
| 2000          |   | 703,000                              |    | 3⁄4                                |    | 142,500       |   | (590,500                                   | )        | 255,000                        |    |
|               |        |                                      |         |                                       |         |               |        |                                            |          |                                |         |  |  |  |  |  |

 

**Allowancefor Recourse Obligation**

 
|          |   | **Balance at  beginning of  period** |   | **Charged to  bad debt  expense** |   | **Other (1)** |   | **Deductions  (Write-offs of  bad debts)** |   | **Balance at  end of  period** |   |
|---------------|--------|--------------------------------------|--------|-----------------------------------|--------|---------------|--------|--------------------------------------------|--------|--------------------------------|--------|
|          |   |                                 |   |                              |   |          |   |                                       |   |                           |   |
| September 30: |   |                                 |   |                              |   |          |   |                                       |   |                           |   |
| 2002          |   | $                                    | — |                              | $      | —        |   | $                                          | — |                           | $      | — |   | $ | — |   |
| 2001          |   | 30,000                               |   | 3⁄4                            |   | (30,000       | )      | 3⁄4                                     |   | 3⁄4                         |   |
| 2000          |   | 50,000                               |   | 122,500                           |   | (142,500      | )      | 3⁄4                                     |   | 30,000                         |   |
|               |        |                                      |        |                                   |        |               |        |                                            |        |                                |        |  |  |  |  |  |

 

**Allowancefor Investment in Related Party**

 
|          |   | **Balance at  beginning of  period** |   | **Charged to  bad debt  expense** |   | **Other (1)** |   | **Deductions  (Write-offs of  bad debts)** |   | **Balance at  end of  period** |   |
|---------------|--------|--------------------------------------|--------|-----------------------------------|--------|---------------|--------|--------------------------------------------|--------|--------------------------------|--------|
|          |   |                                 |   |                              |   |          |   |                                       |   |                           |   |
| September 30: |   |                                 |   |                              |   |          |   |                                       |   |                           |   |
| 2002          |   | $                                    | — |                              | $      | —        |   | $                                          | — |                           | $      | — |   | $ | — |   |
| 2001          |   | 663,000                              |   | 3⁄4                            |   | 3⁄4        |   | (663,000                                   | )      | 3⁄4                         |   |
| 2000          |   | 663,000                              |   | 3⁄4                            |   | 3⁄4        |   | 3⁄4                                     |   | 663,000                        |   |
|               |        |                                      |        |                                   |        |               |        |                                            |        |                                |        |  |  |  |  |  |

 

**ValuationAllowance for Deferred Taxes**

 
|          |   | **Balance at  beginning of  period** |      | **Charged to  costs and  expenses (2)** |   | **Other** |   | **Deductions** |   | **Balance at  end of  period** |   |
|---------------|--------|--------------------------------------|-----------|-----------------------------------------|--------|-----------|--------|----------------|--------|--------------------------------|--------|
|          |   |                                 |      |                                    |   |      |   |           |   |                           |   |
| September 30: |   |                                 |      |                                    |   |      |   |           |   |                           |   |
| 2002          |   | $                                    | 2,914,000 |                                    | $      | 2,355,000 |   | $              | — |                           | $      | — |   | $ | 5,269,000 |   |
| 2001          |   | 598,000                              |      | 2,316,000                               |   | 3⁄4    |   | 3⁄4         |   | 2,914,000                      |   |
| 2000          |   | 1,158,000                            |      | (560,000                                | )      | 3⁄4    |   | 3⁄4         |   | 598,000                        |   |
|               |        |                                      |           |                                         |        |           |        |                |        |                                |        |  |  |  |  |  |

 

----

(1) Transfers between valuation accounts.

 

(2) Reflects the increase (decrease) in the valuation allowance associatedwith net operating losses of the Company.

 

(3) Includes $244,000 charged to discontinued operations in the year endedSeptember 30,2002.

 

F-37

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