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United States
Securities & Exchange Commission Washington, D.C. 20549
 FORM 10-QSB (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2005o
    
    TRANSITION REPORT UNDER SECTION
13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 Commission file number 0-25764 Spectre Gaming, Inc.  Minnesota
    
    41-1675041(State or other jurisdiction
    
    (IRS Employerof incorporation or organization)
    
    Identification No.)
 1466 Pioneer Way, #10
El Cajon, CA 92020
(Address of principal executive offices) 619-440-6183
(Issuers telephone number) (Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report) Check whether the issuer (1) filed all reports required to be filed by section 13 or
15(d) of the Exchange Act during the past 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES þ NO o APPLICABLE TO CORPORATE ISSUERS  Transitional Small Business Disclosure Format (check one): YES o NO þ




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Spectre Gaming, Inc.
Form 10-QSB
Quarter Ended March 31, 2005 Table of Contents Page No.PART I
    
    Financial Information
    
    
    2Item 1.
    
    Financial StatementsBalance Sheets at March 31, 2005 (unaudited) and December 31, 2004 (audited)
    
    
    2Statements of Operations for the three months ended March 31, 2005 and 2004 (unaudited)
    
    
    3Statements of Cash Flows for the three months ended March 31, 2005 and 2004 (unaudited)
    
    
    4Notes to Financial Statements
    
    
    5Item 2.
    
    Managements Discussion and Analysis or Plan of Operation
    
    
    15Item 3.
    
    Controls and Procedures
    
    
    28PART II
    
    Other Information
    
    
    28Item 2.
    
    Changes in Securities and Small Business Issuer Purchases of Equity Securities
    
    
    28Item 6.
    
    Exhibits
    
    
    29SIGNATURES
    
    
    29Certification of CEOCertification of CFOSection 1350 Certification




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##### Table of Contents



PART I  Financial Information 
 Item 1. Financial Statements Spectre Gaming, Inc.
 
 Balance Sheets
 As of
    
    
    As ofMarch 31, 2005
    
    
    December 31, 2004Unaudited
    
    
    AuditedASSETSCURRENT ASSETS:Cash and cash equivalents
    
    $
    1,100,030
    
    
    $
    2,431,280Accounts receivable
    
    
    56,473
    
    
    
    7,347Inventory
    
    
    2,363,529
    
    
    
    2,530,683Prepaid license fees
    
    
    187,500
    
    
    
    187,500Deposits
    
    
    22,864
    
    
    
    51,258Prepaid expenses
    
    
    54,532
    
    
    
    36,939Total current assets:
    
    
    3,784,928
    
    
    
    5,245,007Property, equipment and leasehold improvements, net
    
    
    126,082
    
    
    
    77,677Leased gaming equipment, net
    
    
    1,009,063
    
    
    
    734,720Other assets
    
    
    164,753
    
    
    
    213,587Total Assets:
    
    $
    5,084,826
    
    
    $
    6,270,991LIABILITIES AND SHAREHOLDERS EQUITYCURRENT LIABILITIES:Convertible note payable, net
    
    $
    269,556
    
    
    $
    354,134Short-term debt, net
    
    
    1,500,000
    
    
    
    1,373,611Accounts payable
    
    
    575,552
    
    
    
    687,518Accrued payroll
    
    
    13,830
    
    
    
    Accrued expenses
    
    
    208,744
    
    
    
    168,791Total current liabilities:
    
    
    2,567,682
    
    
    
    2,584,054SHAREHOLDERS EQUITY:Capital stock, par value $.01 per share, 100,000,000 shares
authorized:Series A Convertible Preferred Stock, par value $.01 per share:Authorized shares466,666Issued and outstanding shares:173,334 and 206,667 shares at March 31, 2005 and December
31, 2004, respectively
    
    
    1,733
    
    
    
    2,067($260,000 and $310,000 liquidation preference at March
31, 2005 and December 31, 2004, respectively)Common stock, par value $.01 per share:Authorized shares99,533,334Issued and outstanding shares:13,001,132 and 12,888,213 at March 31, 2005 and December
31, 2004, respectively
    
    
    130,011
    
    
    
    128,882Additional paid-in capital
    
    
    24,688,060
    
    
    
    25,087,624Accumulated deficit
    
    
    (21,846,949
    )
    
    
    (20,608,011
    )Deferred equity compensation
    
    
    (455,711
    )
    
    
    (923,625
    )Total shareholders equity:
    
    
    2,517,144
    
    
    
    3,686,937Total liabilities and shareholders equity:
    
    $
    5,084,826
    
    
    $
    6,270,991
 See accompanying notes to financial statements. 2




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Spectre Gaming, Inc. 
 Statements of Operations
(Unaudited)
 For the Three Months EndedMarch 31,2005
    
    
    2004Gaming revenue  participation and lease
    
    $
    89,100
    
    
    $
    Cost of revenues
    
    
    43,093
    
    
    
    Gross profit
    
    
    46,007
    
    
    
    OPERATING EXPENSES:Research and development
    
    
    94,932
    
    
    
    850,000Sales and Marketing
    
    
    404,217
    
    
    
    General and administrative
    
    
    396,576
    
    
    
    186,983Total Operating Expenses:
    
    
    895,725
    
    
    
    1,036,983Operating loss
    
    
    (849,718
    )
    
    
    (1,036,983
    )OTHER INCOME (EXPENSE):Interest income
    
    
    9,984
    
    
    
    656Interest expense
    
    
    (399,204
    )
    
    
    Net Loss:
    
    $
    (1,238,938
    )
    
    $
    (1,036,327
    )NET LOSS PER COMMON SHARE:Basic and diluted
    
    $
    (0.10
    )
    
    $
    (0.12
    )WEIGHTED-AVERAGE NUMBER OF SHARES OUTSTANDING:Basic and diluted
    
    
    12,941,308
    
    
    
    8,813,752
 See accompanying notes to financial statements. 3




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Spectre Gaming, Inc. 
 Statements of Cash Flows
(Unaudited)
 For the Three Months EndedMarch 31,2005
    
    
    2004Operating activitiesNet loss
    
    $
    (1,238,938
    )
    
    $
    (1,036,327
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation and amortization
    
    
    59,387
    
    
    
    Common stock issued for purchased research and development
    
    
    
    
    
    
    600,000Stock options and warrants issued for services
    
    
    (6,582
    )
    
    
    Amortization of original issue discount
    
    
    258,055
    
    
    
    Amortization of debt issuance costs
    
    
    86,334
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (49,126
    )
    
    
    Inventory
    
    
    (149,615
    )
    
    
    Deposits
    
    
    28,394
    
    
    
    Prepaid expenses
    
    
    (17,593
    )
    
    
    19,039Accounts payable
    
    
    (111,966
    )
    
    
    20,262Accrued payroll
    
    
    13,830
    
    
    
    2,672Accrued expenses
    
    
    39,953
    
    
    
    6,300Net cash used in operating activities:
    
    
    (1,087,867
    )
    
    
    (388,054
    )Investing activitiesPurchases of property, equipment and leasehold improvements
    
    
    (65,366
    )
    
    
    Net cash used in investing activities:
    
    
    (65,366
    )
    
    
    Financing activitiesDebt financing costs
    
    
    (37,500
    )
    
    
    Proceeds from sale of common stock, net of issuance costs
    
    
    
    
    
    
    1,075,039Payments on convertible notes payable
    
    
    (140,517
    )
    
    
    Net cash provided by (used in) financing activities:
    
    
    (178,017
    )
    
    
    1,075,039Increase (decrease) in cash and cash equivalents
    
    
    (1,331,250
    )
    
    
    686,985Cash and cash equivalents at beginning of year
    
    
    2,431,280
    
    
    
    323,675Cash at end of year:
    
    $
    1,110,030
    
    
    $
    1,010,660Supplemental cash flow information:Cash paid for interest
    
    $
    75,890
    
    
    $
    Non-cash Investing and Financing Activities:Common stock issued for payment on convertible notes payable
    
    $
    75,727
    
    
    $
    Inventory transferred to leased gaming equipment
    
    $
    316,769
    
    
    $
    
 See accompanying notes to financial statements. 4




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Spectre Gaming, Inc. 
 
 Note 1. Business Description. Spectre Gaming, Inc. (the Company or Spectre, we, us or ours) (formerly OneLink,
Inc.) was incorporated in Minnesota in June 1990 under the name MarketLink, Inc. At that time, the
Company provided telecommunications-based business-intelligence services to client end users. In
January 1997, the Company changed its name to OneLink Communications, Inc., and later in June 2000,
changed its name to OneLink, Inc. In July 2002, the Company ceased operating its
telecommunications-based business, and in December 2002 sold substantially all of its assets. In
September 2003, the Company adopted a new business plan focused on providing interactive electronic
games to the Native American and charitable gaming markets, and in January 2004 changed its name to
Spectre Gaming, Inc. The Company now designs and develops networks, software and content that
provide its customers with a comprehensive gaming system, and begun placing its gaming machines on
casino floors. To fund its business opportunities, the Company has engaged in debt and equity financing. The
Company anticipates engaging in additional financings in the future. Nevertheless, there can be no
assurance the Company will raise the necessary capital to fund its business. The accompanying financial statements have been prepared on the basis that the Company will
continue as a going concern. The Company had net losses for the quarter ended March 31, 2005 and
the years ended December 31, 2004 and 2003, had an accumulated deficit at March 31, 2005 and does
not have adequate liquidity to fund its operations through out fiscal 2005. The financial
statements do not include any adjustments that might result from the outcome of this condition. Note 2. Summary of Significant Accounting Policies. Interim Financial Information. The accompanying unaudited financial statements have been
prepared in accordance with accounting principles generally accepted in the United States of
America and pursuant to the rules and regulations of the U. S. Securities and Exchange Commission
(the SEC) for interim financial information. Accordingly, certain information and footnote
disclosures normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been omitted pursuant to such
rules and regulations. Operating results for the three months ended March 31, 2005 are not
necessarily indicative of the results that may be expected for the year ending December 31, 2005.
The accompanying financial statements and related notes should be read in conjunction with the
Companys audited financial statements, and notes thereto, for the fiscal year ended December 31,
2004, contained in its Annual Report on Form 10-KSB for the year ended December 31, 2004. 5




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The financial information furnished reflects, in the opinion of management, all adjustments,
consisting of normal recurring accruals, necessary for a fair presentation of the results of the
interim periods presented. Revenue Recognition.The Company derives its gaming revenues primarily in two ways, outright
sales of machines or participation arrangements with its Native American customers. Revenue for
machine sales is recorded upon shipment and upon the expiration of any applicable trial periods
granted to the customer. Under the participation arrangements, the Company retains ownership of
the equipment installed at a customer site and receives revenue based on a percentage of the hold
per day generated by each gaming system, which is generally considered both realizable and earned
at the end of each gaming day. The Company accounts for the revenue received on participation
agreements as operating lease revenue. The Company records amounts being charged to customers for shipping and handling as sales in
accordance with Emerging Issues Task Force (EITF) Issue 00-10, Accounting for Shipping and
Handling Fees and Costs. Shipping and handling costs incurred by the Company are included in cost
of goods sold. The SEC issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition which sets
forth the SEC staffs position regarding the point at which it is appropriate for a registrant to
recognize revenue. The staff believes that revenue is realizable and earned when all of the
following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred or
service has been rendered, the sellers price to the buyer is fixed or determinable, and
collectibility is reasonably assured. The Company used the above criteria to determine whether
revenue could be recognized, and is recognizing revenue in accordance with SAB 104. Cash and Cash Equivalents. The Company includes as cash and cash equivalents highly liquid,
short-term investments with maturity of three months or less when purchased, which are readily
convertible into known amounts of cash. The Company maintains its cash in high quality financial
institutions. The balances, at times, may exceed federally insured limits. Accounts Receivable.The Company reviews customers credit history before extending unsecured
credit and establishes an allowance for uncollectible accounts based upon factors surrounding the
credit risk of specific customers and other information. Accounts receivable over 30 days are
considered past due. The Company does not accrue interest on past due accounts receivable.
Receivables are written off only after all collection attempts have failed and are based on
individual credit evaluation and specific circumstances of the customer. No allowance was
considered necessary at March 31, 2005 and December 31, 2004, respectively. The Company extended unsecured credit to customers in the normal course of business. Inventory.Inventory, which consists principally of gaming products and related materials, is
stated at the lower of cost (determined on the first-in, first-out method) or market. At March 31,
2005, the Company had $497,510 of finished goods inventory and $1,866,019 of spare parts and gaming
cabinets. At December 31, 2004 the Company had $652,114 of finished goods inventory and $1,878,569
of spare parts and gaming cabinets. 6




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Prepaid License Fees.Prepaid license fees relate to licenses associated with the themes of
certain gaming machines which are licensed from unrelated parties. Under participation agreements
and upon the placement of the machines into service, the Company will begin amortizing the licenses
over the estimated useful life of the pertinent machines of 3 years. Leased Gaming Equipment and Property, Equipment and Leasehold Improvements. Leased gaming
equipment and property, equipment and leasehold improvements were stated at cost. Gaming machines
placed with customers under participation arrangements are included in leased gaming equipment.
Depreciation of an asset is recognized on the straight-line basis over the assets estimated useful
life ranging from three to five years. Leasehold improvements are amortized using the
straight-line method over the shorter of the lease term or the estimated useful life. Maintenance,
repairs and minor renewals are expensed when incurred. Sales and retirements of depreciable
property are recorded by removing the related cost and accumulated depreciation from the accounts.
Gains or losses on sales and retirements of property are reflected in the Companys results of
operations. Depreciation and amortization expense on leased gaming equipment and property,
equipment and leasehold improvements was $59,387 and $0 for the three months ended March 31, 2005
and 2004, respectively. Management reviews long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability
of assets to be held and used is measured by a comparison of the carrying amount of an asset to its
fair value, which considers the future undiscounted cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment recognized is measured by the
amount by which the carrying amount of the assets exceeds their fair value. Assets to be disposed
of are reported at the lower of the carrying amount or the fair value less costs of disposal. Debt Issuance Costs.The Company capitalizes debt issuance costs and amortizes the costs over
the life of the loan using the straight-line method, which approximates the interest method. The
capitalized costs related to the convertible debt investment from Pandora Select Partners L.P.
(Pandora) in May 2004 include the origination fee paid to Pandora of $33,000, the $50,000 cash
paid to Blake Capital Advisors, LLC (Blake), the value of the warrants issued to Blake and
$10,000 of legal fees, and are included in other assets in the financial statements. The warrants
issued to Blake were valued at $225,000 using the Black-Scholes pricing model. The capitalized
costs related to the loans from Pandora and Whitebox Intermarket Partners L.P. in September 2004
include the origination fee paid of $45,000 and $5,000 of legal fees. The capitalized costs
related to the loans from Pandora and Whitebox Intermarket Partners L.P. in September 2004 also
include the fee paid in March 2005 of $37,500 to allow the Company to extend the due date of the
notes. At March 31, 2005 and December 31, 2004, the Company had debt issuance costs of $158,103
and $206,937, respectively, classified as other assets on the balance sheet. Amortization expense
of the debt issuance costs for the three months ended March 31, 2005 and 2004 was $86,334 and $0,
respectively. Estimated amortization for debt issuance costs is $244,437 for the year ending
December 31, 2005. Research and Development Costs.Costs related to research, design and development of products
are charged to research and development expense as incurred. Software development costs are
capitalized beginning when a softwares technological feasibility has been established and ending
when the software code is completed and incorporated in gaming systems. The 7




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Company uses the working model approach to determine technological feasibility. Generally,
the Companys software is placed into gaming products soon after technological feasibility has been
established. As a result, the Company has not capitalized any internal software development costs,
since such costs have not been significant and the products are released shortly after
technological feasibility. Research and development expense was $94,932 and $850,000 for the three
months ended March 31, 2005 and 2004, respectively. Net Loss Per Common Share. Basic and diluted loss per common share is computed by dividing
net loss by the weighted-average number of common shares outstanding for the reporting period.
Dilutive common-equivalent shares have not been included in the computation of diluted net loss per
share because their inclusion would be antidilutive. Antidilutive common-equivalent shares
issuable based on future exercise of stock options or warrants could potentially dilute basic loss
per common share in subsequent years. All options and warrants outstanding were antidilutive for
the three months ended March 31, 2005 and 2004. Employees Stock-Based Compensation. In accordance with Accounting Principles Board (APB) Opinion No.
25 and related interpretations, the Company uses the intrinsic value-based method for measuring
stock-based compensation cost which measures compensation cost as the excess, if any, of the quoted
market price of the Companys common stock at the grant date over the amount the employee must pay
for the stock. The Companys general policy is to grant stock options and warrants at fair value
at the date of grant. Options and warrants issued to non-employees are recorded at fair value, as
required by Statement of Financial Accounting Standards (SFAS) No. 123 Accounting for Stock
Based Compensation, using the Black-Scholes pricing model. The Company has adopted the disclosure
only provision of SFAS No. 148, Accounting for Stock Based Compensation. The Company applies APB No. 25 and related interpretations in accounting for its stock options
and warrants issued to employees. Had compensation costs for the Companys stock options and
warrants been determined based on the fair value at the grant dates consistent with the method of
SFAS No. 123, the Companys net loss and loss per share would have been changed to the approximate
pro forma amounts indicated below: Three Months Ended March 31,2005
    
    
    2004Net loss:As reported
    
    $
    (1,238,938
    )
    
    $
    (1,036,327
    )Pro forma
    
    
    (1,470,713
    )
    
    
    (1,149,626
    )Basic and diluted net loss per common
shareAs reported
    
    $
    (0.10
    )
    
    $
    (0.12
    )Pro forma
    
    
    (0.11
    )
    
    
    (0.13
    )Stock-based compensationAs reported
    
    $
    
    
    
    $
    Pro forma
    
    
    231,775
    
    
    
    113,299
 8




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The following significant assumptions were utilized to calculate the fair value information
presented utilizing the Black-Scholes pricing model: Three Months Ended March 31,2005
    
    
    2004Risk Free interest rate
    
    
    3.71
    %
    
    
    2.77
    %Expected life
    
    4.7 years
    
    5.0 yearsExpected volatility
    
    
    145
    %
    
    
    636
    %Expected dividends
    
    
    0
    %
    
    
    0
    %
 Non-employees Through March 31, 2005, the Company issued options and warrants to purchase 1,111,666 shares
of the Companys common stock to non-employees, mostly consultants, with exercise prices ranging
from $0.75 per share to $3.30 per share and expiring at various times through June 2014. Pursuant
to Emerging Issues Task Force 96-18 (EITF 96-18), Accounting for Equity Instruments that are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services,
the Company will value and record an expense related to the options on the earlier of the date a
performance commitment is met or the date the performance is complete. Of the options issued to
non-employees, 500,000 are earned and vest as specific milestones are achieved as described in the
agreement, and at March 31, 2005, $9,936 had been recorded for expense of these options. The
Company recorded a reduction of expense, due to a change in the fair value of the options and
warrants, of $6,582 and $0 for the three months ended March 31, 2005 and 2004, respectively, in
accordance with EITF 96-18. During the three months ended March 31, 2005, options for 65,000
shares of the Companys common stock were cancelled. Reclassifications.Certain accounts in the prior quarter financial statements have been
reclassified for comparative purposes to conform with the presentation in the current quarter
financial statement. These reclassifications had no effect on the net loss or shareholders
equity. Note 3. Software On March 4, 2004, the Company signed a Software Development Agreement with MET Games, Inc.
(MET) to purchase certain Linux-based software and technology being developed by and owned by MET
for the operation of certain gaming computers and systems. Pursuant to the agreement, the Company
made a $250,000 cash payment to MET and issued 800,000 unregistered, restricted shares of the
Companys common stock. The Company anticipates utilizing the software as it develops its business
opportunities in the Native American Class II and charitable gaming markets. The Company had the right to terminate the agreement and recover the $250,000 payment and
800,000 unregistered, restricted shares of the Companys common stock if MET failed to deliver
software that met the specifications detailed in the agreement or in the event that MET failed to
provide the software in accordance with the development schedule detailed in the agreement.
Despite this fact, due to the development of the software not having reached 9




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technological feasibility on the date of the agreement and the $250,000 cash payment being a
significant performance commitment, the Company expensed the cash payment and the value of the
common stock, $600,000, as research and development expense. For his purpose, the common stock was
valued at $0.75 per share, based upon the price of the Companys then recently completed private
placement. MET is wholly-owned by an individual who became an employee of the Company on March 4, 2004. On February 3, 2005, the Company and MET executed an amendment to the Software Development
Agreement to be effective January 24, 2005. The amendment provides for the Companys acceptance of
METs non-conforming delivery of the bingo software in exchange for METs reimbursement to the
Company of up to $100,000 for all internal and external costs and expenses related to the
completion of the bingo software and the Companys access to METs office and warehouse space to
facilitate the completion of the bingo software. The Company intends to complete the development
of the bingo software internally. In connection with the amendment, The Company agreed to release
the restrictions on 100,000 shares of common stock immediately and on the remaining 700,000 shares
commensurate with revised milestone achievements. The amendment did not change the Companys
ownership rights to the completed software. As a result there were no accounting adjustments or
revisions attributable to this amendment. Note 4. Shareholders Equity Common Stock In November 2003, the Company began a private placement which ended in March 2004 (the
Offering). A majority of the sales of the Companys common stock occurred after December 31,
2003. In the Offering, the Company sold a total of 1,796,829 shares of its common stock (of which
1,531,989 were sold in 2004) for a per share price of $0.75 (i.e., raising a gross total of
$1,347,626, $1,148,996 of which was raised in 2004). The Offering was a private placement made
under Rule 506 promulgated under the Securities Act of 1933, as amended. The Company raised funds
in this private placement in anticipation of entering into the business of developing,
manufacturing, distributing and servicing gaming machines, primarily for the Native American and
charitable gaming markets. The Company used an agent for a portion of these sales. As a fee, the
Company paid the agent $62,550 in cash and issued the agent fully-vested five-year warrants to
purchase up to 83,400 shares of the Companys common stock for an exercise price of $0.75 per
share. In addition, the Company incurred legal fees and other expenses of $19,407 related to the
Offering. In November, 2004, the Company completed a private placement (the Second Offering) of
1,811,429 Units (Units), each consisting of one share of common stock, par value $.01 per share,
and five-year warrants to purchase one additional share of common stock at a purchase price of
$3.75 per share. The per-Unit price was $2.50 (i.e., raising a gross total of $4,528,573). The
Company used two agents in completing the sale of the Units in the Second Offering. As a fee, the
Company paid the agents $362,286 in cash, and issued the agents fully-vested five-year 10




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warrants to purchase up to 181,143 Units for an exercise price of $2.50 per Unit. In
addition, the Company incurred legal fees and other expenses of $70,898 related to the Second
Offering. In connection with the two transactions, the cash paid and the legal fees incurred were
recorded as reductions in the proceeds received. Preferred Stock The Companys Series A Convertible Preferred Stock has voting rights identical to common
stock. In the event of liquidation, the Series A Convertible Preferred shareholders receive a
liquidation preference. Although no dividends are required with respect to the Series A Preferred
Stock, no dividend shall be paid on any shares of common stock unless comparable dividends are paid
on the Series A Convertible Preferred Stock. The holders of Series A Convertible Preferred Stock may elect to convert all or a portion of
such shares into shares of the Companys common stock in the manner set forth in the Series A
Convertible Preferred Stock Certificate of Designation on file with the Minnesota Secretary of
State. After adjustment pursuant to the terms of the Certificate of Designation, each share of
Series A Convertible Preferred Stock currently converts into 2.257 shares of the Companys common
stock. As of December 31, 2004, holders of 233,333 shares of the Companys Series A Convertible
Preferred Stock had converted their preferred shares into 526,597 shares of the Companys $.01 par
value common stock. In February 2005, holders of an additional 33,333 shares of the Companys
Series A Convertible Preferred Stock converted their preferred shares into 75,228 shares of the
Companys $.01 par value common stock. At March 31, 2005 there were outstanding 173,334 shares of
Series A Convertible Preferred Stock which were convertible into an aggregate of 391,191 shares of
the Companys common stock with a liquidation preference of $260,000. Note 5. Convertible Note Payable On May 20, 2004, the Company received $1,100,000 in a convertible debt investment from
Pandora. The note was payable in interest only, at 10% per annum, through August 20, 2004, and
thereafter is payable in equal monthly installments over the next 15 months. The note is
convertible by Pandora into common stock of Spectre at $2.50 per share, and allows Spectre, subject
to certain conditions and limitations, to make monthly installment payments with its common stock
at a price per share equal to 90% of the average closing bid price of the common stock over the 30
trading days immediately preceding the payment date. In connection with the financing, Spectre
paid a 3% origination fee, issued a fully-vested five-year warrant for the purchase of 200,000
shares of Spectres common stock at $2.50 per share, and granted Pandora a security interest in the
Companys assets. The gross proceeds of $1,100,000 were allocated between the convertible note and
the common stock warrants based on the relative fair values of the securities at the time of
issuance. The common stock warrants were valued using the Black-Scholes pricing model. The
resulting original issue discount, the fair value of the warrants and the beneficial conversion of
the note into common stock as defined in EITF 00-27, Application of Issue No. 98-5 to Certain
Convertible Instruments, will be amortized over the life of the 11




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promissory note using the straight-line method, which approximates the interest method. The
note is convertible by the holder any time in whole or in part upon written notice to the Company.
Such conversion is limited to the extent the holders beneficial ownership interest would exceed
4.99% of outstanding common stock at conversion. In addition, Spectre agreed to file a
registration statement by November 3, 2004, which date was extended to November 30, 2004, with the
SEC, covering the issuance or resale of the shares of Spectres common stock which may be issued in
connection with the note and warrant issued to Pandora, and cause the same to be effective by
February 1, 2005. The Company filed the registration statement on November 30, 2004 and the
registration statement was declared effective on January 24, 2005. In connection with the
financing, the Company also paid a finders fee to Blake of $50,000 and issued a fully-vested
five-year warrant for the purchase of 50,000 shares of the Companys common stock at $2.50 per
share and a fully-vested five-year warrant for the purchase of 50,000 shares at $3.00 per share,
and paid legal fees of $10,000. The fees and the value of the warrants were recorded as deferred
financing costs and will be amortized over the life of the convertible debt. The allocation of the gross proceeds of the convertible note payable is summarized below as of
March 31, 2005: Convertible note payable, total borrowed
    
    $
    1,100,000Value of 200,000 warrants allocated to additional paid
in capital
    
    
    (450,000
    )Value of beneficial conversion of note payable
allocated to additional paid in capital
    
    
    (340,000
    )Convertible note payable, net of original issue discount
    
    
    310,000Amortization of original issue discount
    
    
    455,878Principal payments on convertible note
    
    
    (496,322
    )Convertible note payable, net
    
    $
    269,556
 Note 6. Short-term Debt On September 10, 2004, the Company issued two $750,000 promissory notes bearing interest at
the rate of 10% per annum. One note was issued to Pandora and the other note was issued to
Whitebox Intermarket Partners, L.P. (Whitebox). The notes were payable interest only through
March 10, 2005, at which time the principal was due. In connection with the financing, Spectre
paid a 3% origination fee, issued five-year warrants for the purchase of 50,000 shares of Spectres
common stock at $3.00 per share to both Pandora and Whitebox, and granted Pandora and Whitebox
security interests in the Companys assets. The gross proceeds of $1,500,000 were allocated
between the notes and the common stock warrants based on the relative fair values of the securities
at the time of issuance. The common stock warrants were valued using the Black-Scholes pricing
model. The resulting original issue discount and the fair value of the warrants will be amortized
over the life of the promissory notes using the straight-line method, which approximates the
interest method. In addition, Spectre agreed to file a registration statement by February 1, 2005
with the SEC, covering the issuance or resale of the shares of Spectres common stock which may be
issued in connection with the warrants issued to 12




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Pandora and Whitebox. The Company filed the
registration statement on November 30, 2004 and the registration statement was declared effective
on January 24, 2005. On March 10, 2005, the Company signed amendments to the two $750,000 secured promissory notes
issued to Pandora and Whitebox. The amendments extend the due date of the notes to June 10, 2005,
which date can be further extended by the Company to September 10, 2005. As part of the amendments
the Company agreed to maintain assets whose value equals or exceeds the principal interest amounts
then owned under the notes. For purposes of valuing the assets for compliance under this
provision, the Companys cash shall be valued at 100%, the Companys accounts receivable shall be
valued at 80% and the Companys inventory and fixed assets shall be valued at 50% of their
respective book values. As consideration for the amendments, the Company paid Pandora and Whitebox
each $18,750 and is amortizing the expense over the extended period. If the Company elects to
extend the notes to September 10, 2005, Pandora and Whitebox will each be entitled to a 2.5%
origination fee on the then outstanding principal amount of their respective notes. The allocation of the gross proceeds of the short-term debt is summarized below as of March
31, 2005: Short-term debt, total borrowed
    
    $
    1,500,000Value of 100,000 warrants allocated to additional paid
in capital
    
    
    (325,000
    )Short-term debt, net of original issue discount
    
    
    1,175,000Amortization of original issue discount
    
    
    325,000Total short-term debt, net
    
    $
    1,500,000
 Note 7. License Agreement On June 30, 2004, the Company signed a three-year non-exclusive license agreement (License
Agreement) with Bally Gaming Inc. (Bally). The License Agreement calls for the Company to
purchase up to 3,000 game cabinets from Bally over the term of the License Agreement.
Nevertheless, if the Company has purchased at least 70% of its Class II cabinet purchases from
Bally during the term, Bally shall waive the 3,000 game cabinet purchase minimum. In addition, the
Company was obligated to purchase at least 100 game cabinets from Bally, and incur certain minimum
license-fee charges of $187,500, by June 30, 2004. As of March 31, 2005, the Company had not taken
delivery of any of the products that include the license fee charges and therefore the minimum
license fee paid is included in prepaid expenses at March 31, 2005 and December 31, 2004. Upon
receipt of the machines that include the license fees and the placement of the machines, through a
participation agreement, into service, the Company will begin amortizing the licenses over the
estimated useful life of the machines of 3 years. Note 8. Related Party Transactions The Company incurred expenses from a corporation, owned by a former director of the Company
and employing another director and officer of the Company, for rent and consulting 13




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services of
approximately $28,000 and $33,000 during the three months ended March 31, 2005 and 2004,
respectively. The Company incurred expenses from a corporation, partially owned by the CEO and director of
the Company, for consulting services and expense reimbursements of approximately $25,000 and $0
during the three months ended March 31, 2005 and 2004, respectively. The Companys CEO also serves
as a director of the corporation. In February 2004, the Company entered into a consulting agreement with D. Bradly Olah, a
greater-than-five-percent shareholder of the Company. Pursuant to the consulting agreement, Mr.
Olah received $12,500 per month for four months (ending as of May 31, 2004) in exchange for general
consulting services. On June 1, 2004, the Company entered into a new consulting agreement with Mr.
Olah providing for payments of $12,500 per month for a two-year term. In connection with the new
consulting agreement, Mr. Olah received options to purchase up to 300,000 shares of the Companys
common stock at an exercise price of $2.15 per share (the fair value of the stock on the date of
grant). Beginning on June 15, 2005, the option vests in 100,000-share increments on each June 15
through 2007, and has a five-year term during which the options must be exercised or forfeited.
The options will be valued on the date performance is complete under variable plan accounting using
the Black-Scholes pricing model. The options had a value of $487,675 at March 31, 2005, of which
$203,198 had been charged to expense through March 31, 2005. In connection with the convertible debt financing from Pandora, the Company paid $50,000 and
issued two fully-vested three-year warrants to Blake Advisors, LLC, a Minnesota limited liability
company wholly owned by Wayne W. Mills, a greater-than-five-percent shareholder of the Company.
The warrants were issued in exchange for financial-advisory services rendered by Blake. One
warrant grants Blake the right to obtain up to 50,000 shares of the Companys common stock at an
exercise price of $2.50 per share, and the second warrant grants Blake the right to obtain up to
50,000 shares of the Companys common stock at an exercise price of $3.00 per share. The warrants
were valued at $225,000 using the Black-Scholes pricing model and will be expensed using the
straight-line method over the term of the promissory note. For the three months ended March 31,
2005, the Company recorded expense of $37,500 related to these warrants. Note 9. Significant Customers Revenues to three customers accounted for 74% of total revenues during the three months ended
March 31, 2005. Note 10. Subsequent Events In April 2005, holders of 130,000 shares of the Companys Series A Convertible Preferred Stock
converted their preferred shares into an aggregate of 293,389 shares of the Companys $.01 par
value common stock. 14




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Item 2. Managements Discussion and Analysis or Plan of Operation The accompanying managements discussion and analysis of the Companys financial condition and
results of operations should be read in conjunction with Managements Discussion and Analysis of
Financial Condition and Results of Operations and the Companys audited financial statements, and
notes thereto, for the fiscal year ended December 31, 2004, included in our Annual Report on Form
10-KSB for the year ended December 31, 2004. Results of Operations The Three Months Ended March 31, 2005 Compared to the Three Months Ended March 31, 2004 Revenues.Revenues for the three months ended March 31, 2005 were $89,000 as compared with $0
for the three months ended March 31, 2004. The increase in revenues is the result of the Company
placing its gaming machines in Native American casinos starting in October 2004. The Company had
not placed any machines, and therefore recognized no revenue, during the three months ended March
31, 2004. Research and Development Expenses.Research and development expenses for the three months
ended March 31, 2005 and 2004 were $95,000 and $850,000, respectively. Research and development
expenses during the three months ended March 31, 2005 consisted primarily of salary expense and
consulting expense. On March 4, 2004, the Company signed an agreement with MET Games, Inc. (MET)
to purchase certain Linux-based software and technology being developed by and owned by MET for the
operation of certain gaming computers and systems. Pursuant to the agreement, the Company made a
$250,000 cash payment to MET and issued 800,000 unregistered, restricted shares of the Companys
common stock. The Company will utilize the software as it develops its business opportunities in
the Native American Class II and charitable gaming markets. Due to the development of the software not having reached technological feasibility on the
date of the agreement and the $250,000 cash payment being a significant performance commitment, the
Company expensed the cash payment and the value of the common stock, $600,000, as research and
development expense. The common stock was valued at $0.75 per share, based upon the price of the
Companys then recently completed private placement. Sales and Marketing Expenses.Sales and marketing expenses for the three months ended March
31, 2005 were $404,000 as compared with $0 for the three months ended March 31, 2004. Sales and
marketing expense for the three months ended March 31, 2005 consisted primarily of salary and
consulting expenses. In addition, there were expenses related to travel, promotions, regulatory
game approval and theme development during the three months ended March 31, 2005. General and Administrative Expenses. General and administrative expenses for the three months
ended March 31, 2005 and 2004 were $397,000 and $187,000, respectively. The selling, general and
administrative expenses for the three months ended March 31, 2005 primarily consisted of salary and
employee related epenses, travel expense, professional fees, insurance and rent expense. General
and administrative expenses for the three months ended March 31, 2004 15




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primarily consisted of
salaries, professional services, consulting and travel expenses. The increases in expense in 2005
as compared to 2004 primarily resulted from the Company
commencing operations in the Native American and charitable gaming markets. To execute on the
opportunity in these markets, the Company has hired employees and engaged consultants which
significantly increased these expenses. General and administrative expense for the three months
ended March 31, 2005, includes an offset against expenses of $86,000 related to changes in fair
value of options and warrants granted to consultants. Net Other Expense.Net interest expense was $389,000 for the three months ended March 31,
2005 as compared with net interest income of $1,000 for the three months ended March 31, 2004. The
increase in other expense is primarily due to interest on notes payable to Pandora Select Partners,
L.P. (Pandora) and Whitebox Intermarket Partners L.P. (Whitebox) along with the amortization of
the associated debt issuance costs and the amortization of the original issue discounts. Net Loss. The Company incurred a net loss of $1,239,000 and $1,036,000 for the three months
ended March 31, 2005 and 2004, respectively. The increased net losses for the three months ended
March 31, 2005 as compared with March 31, 2004 is primarily the result of the Company commencing
operations in the Native American and charitable gaming markets which involve significant increases
in employee and consulting expense. The net loss for the three months ended March 31, 2004,
includes the expense related to the consideration given in the MET transaction. The net loss also
includes $399,000 of interest expense for the three months ended March 31, 2005. Liquidity and Capital Resources. The Company had working capital of $1,217,000 and $2,661,000
at March 31, 2005 and December 31, 2004, respectively. Cash used in operations was $1,088,000 and
$388,000 for the three months ended March 31, 2005 and 2004, respectively. For the three months
ended March 31, 2005, the primary uses of cash were to fund the Companys net loss, purchase
inventory and a decrease in accounts payable. These uses were partially offset by non-cash charges
related to amortization of original debt issue discount, amortization of debt issuance costs and
depreciation and amortization. For the three months ended March 31, 2004, the primary use of cash
was to fund the Companys net loss partially offset by a decrease in prepaid expenses and increases
in accounts payable, payroll and related taxes and accrued expenses. For the three months ended
March 31, 2004, a non-cash expense related to common stock issued for development services also
partially offset cash used to fund the Companys operating loss. Cash used in investing activities was $65,000 and $0 for the three months ended March 31, 2005
and 2004, respectively. For the three months ended March 31, 2005 the Company used cash for
capital expenditures, primarily at its El Cajon, California location. Cash used in financing activities was $178,000 for the three months ended March 31, 2005 as
compared with cash provided by financing activities of $1,075,000 for the three months ended March
31, 2004. Payments on notes payable used $140,000 and debt financing costs used $37,500 of cash
during the three months ended March 31, 2005. In November 2003, the Company began a private
placement which ended in March 2004 (the Offering). A majority of the sales of the Companys
common stock occurred after December 31, 2003. In the Offering, the Company sold a total of
1,796,829 shares of its common stock (of which 1,531,989 were sold 16




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in 2004) for a per share price
of $0.75 (i.e., raising a gross total of $1,347,626, $1,148,996 of which was raised in 2004). The
Company used an agent for a portion of these sales. As a fee, the
Company paid the agent $62,550 in cash and issued the agent five-year warrants to purchase up
to 83,400 shares of the Companys common stock for an exercise price of $0.75 per share. On May 20, 2004, the Company received $1,100,000 in a convertible debt investment from
Pandora. The related promissory note was payable in interest only, at 10% per annum, through
August 20, 2004, and thereafter is payable in equal monthly installments over the next 15 months.
The note is convertible by Pandora into common stock of Spectre at $2.50 per share, and allows
Spectre, subject to certain conditions and limitations, to make monthly installment payments with
its common stock at a price per share equal to 90% of the average closing bid price of the common
stock over the 30 trading days immediately preceding the payment date. In connection with the
financing, Spectre paid a 3% origination fee, issued a fully-vested five-year warrant for the
purchase of 200,000 shares of Spectres common stock at $2.50 per share, and granted Pandora a
security interest in the Companys assets. In addition, Spectre agreed to file a registration
statement by November 3, 2004 with the U.S. Securities and Exchange Commission (the SEC),
covering the issuance or resale of the shares of Spectres common stock which may be issued in
connection with the note and warrant issued to Pandora, and cause the same to be declared effective
by February 1, 2005. The registration statement was declared effective on January 24, 2005. In
connection with the financing, the Company also paid a finders fee to Blake Capital Advisors, LLC
(Blake) of $50,000 and issued a fully-vested five-year warrant for the purchase of 50,000 shares
of the Companys common stock at $2.50 per share and a fully-vested five-year warrant for the
purchase of 50,000 shares at $3.00 per share. Net cash received by the Company after paying the
finders fee, origination fee and legal cost of the lender of $10,000 was $1,007,000. On September 10, 2004, the Company issued two $750,000 promissory notes accruing interest at
10% per annum. One note was issued to Pandora and the other note was issued to Whitebox. The
notes are payable interest only through March 10, 2005, at which time the principal is due. In
connection with the financing, Spectre paid a 3% origination fee, issued fully-vested five-year
warrants for the purchase of 50,000 shares of Spectres common stock at $3.00 per share to both
Pandora and Whitebox, and granted Pandora and Whitebox security interests in the Companys assets.
In addition, Spectre agreed to file a registration statement by November 3, 2004 with the SEC,
covering the issuance or resale of the shares of Spectres common stock which may be issued in
connection with the warrants issued to Pandora and Whitebox, and cause the same to be declared
effective by February 1, 2005. The registration statement was declared effective on January 24,
2005. Net cash received by the Company after paying the origination fee and legal costs of the
lenders of $5,000 was $1,450,000. On March 10, 2005, the Company signed amendments to the two $750,000 secured promissory notes
issued to Pandora and Whitebox. The amendments extend the due date of the notes to June 10, 2005,
which date can be further extended by the Company to September 10, 2005. As part of the amendments
the Company agreed to maintain assets whose value equals or exceeds the principal interest amounts
then owned under the notes. For purposes of valuing the assets for compliance under this
provision, the Companys cash shall be valued at 100%, the Companys accounts receivable shall be
valued at 80% and the Companys inventory and fixed assets shall be valued at 50% of their
respective book values. As consideration for the amendments, the Company paid Pandora and Whitebox
each $18,750. If the Company elects to 17




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extend the notes to September 10, 2005, Pandora and
Whitebox will each be entitled to a 2.5% origination fee on the then outstanding principal amount
of their respective note. The decrease in additional paid-in capital relates to a $474,497 reduction for cancelled
options and a change in the fair value of options issued to non-employees pursuant to EITF 96-18 On June 30, 2004, the Company signed a three-year non-exclusive license agreement (License
Agreement) with Bally Gaming Inc. (Bally). The License Agreement calls for the Company to
purchase up to 3,000 game cabinets from Bally over the term of the License Agreement.
Nevertheless, if the Company has purchased at least 70% of its Class II cabinet purchases from
Bally during the term, Bally shall waive the 3,000 game cabinet purchase minimum. In addition, the
Company was obligated to purchase at least 100 game cabinets from Bally, and incur certain minimum
license-fee charges of $187,500, by June 30, 2004. As of March 31, 2005, the Company had purchased
100 game cabinets from Bally. The Company expects to spend a significant amount on capital equipment purchases over the next
twelve months, primarily as it places its gaming machines in Native American and charitable gaming
facilities. The Company expects that it will use debt and/or equity financing to purchase this
equipment. Management believes that its cash should be sufficient to satisfy its cash requirements for
the next three months. The Company will need to obtain additional cash to meet its needs,
including repaying the notes described above, beyond that period and has been actively pursuing
additional financing. Risk Factors We have no operating history and our business plan is currently being tested. We anticipate
incurring future losses. We are in the early stages of providing interactive electronic games to
the Native American and charitable gaming industry. We are therefore subject to all of the risks
and uncertainties inherent in establishing a new business. We have no prior operating history for
these products from which to evaluate our success, or our likelihood of success in operating our
business, generating any revenues or achieving profitability. In sum, we have very limited assets,
very little operating revenue and uncertain prospects of future profitable operations. We cannot
assure you that our operations will be successful and the likelihood of our success must be
considered in light of the problems, expenses, difficulties, complications and delays frequently
encountered in connection with the formation of a new business, development of technology and the
competitive environment in which we operate. We anticipate that we will incur losses in the near
future. We will need additional financing in the future and any such financing will likely be dilutive
to our existing shareholders. We will likely require additional sources of financing before we can
generate revenues needed to sustain operations. In particular, management believes that the
Companys current cash is sufficient to continue operations only through July 2005. Our
operations, as currently conducted or anticipated to be conducted, generate costs related to the
exploration of additional business opportunities, as well as ongoing personnel, legal and
accounting expenses. If we are unable to capitalize on existing opportunities or locate and 18




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act on
other business opportunities, or if expenditures exceed our current expectations, we will be
required to find additional sources of financing. Even if we successfully avail ourselves of
current or future opportunities, additional financing may be required to expand or continue being
involved in such opportunities. Additional financing could be sought from a number of sources, including but not limited to
additional sales of equity or debt securities (including equity-linked or convertible debt
securities), loans from banks, loans from affiliates of the Company or other financial
institutions. No assurance, however, can be given that we will be able to sell any securities or
obtain any such additional financing when needed, or do so on terms and conditions acceptable or
favorable to the Company, if at all. If financing is not available, we may be forced to abandon
our business plans or our entire business, discontinue our preparation and filing of public
disclosure reports with the United States Securities and Exchange Commission, or dissolve the
Company. If we successfully enter into a financing transaction, any additional equity or
equity-linked financing would be dilutive to shareholders, and additional debt financing, if
available, may involve restrictive covenants. Our independent auditors have substantial doubt about our ability to continue as a going
concern.We have had net losses for the three months ended March 31, 2005 and the year ended
December 31, 2004, and we had an accumulated deficit as of March 31, 2005 and December 31, 2004.
Since the financial statements for each of these periods were prepared assuming that we would
continue as a going concern, in the view of our independent auditors, these conditions raise
substantial doubt about our ability to continue as a going concern. Furthermore, since we are
pursuing a new line of business, this diminishes our ability to accurately forecast our revenues
and expenses. Our ability to continue as a going concern depends, in large part, on our ability to
raise sufficient capital through equity or debt financing transactions. If we are unable to raise
additional capital, we may be forced to discontinue our business. The proprietary operating system and related gaming products critical to our future success
have not been, and may never be, fully developed.Pursuant to our software development agreement
with MET Games, Inc., we are developing a Linux-based operating system for use with our proposed
Class II Central Determination Games. The development process has not yet been completed and we
cannot be certain that the operating system will work as anticipated and required for use in a
highly regulated marketplace. The completion of the development of our proposed Linux-based
operating system remains subject to all the risks associated with the development and manufacture
of new products based on innovative technologies, including unanticipated technical or other
problems, failures to meet regulatory requirements or performance objectives, and the possible
insufficiency of the funds allocated for the completion of such development, which could result in
a change in the design, delay in the development, or abandonment of such system and its products.
Consequently, there can be no assurance that our proprietary Linux-based operating system will be
fully developed or successfully manufactured. The Company believes that its greatest opportunity
for financial success lies in its ability to capitalize on the Class II gaming market. Of course,
our failure to complete the Linux-based operating system for our proposed Class II games will
likely have a materially adverse effect on our business and prospects for future profitability. Even if successfully developed, our Class II operating system and gaming products may not be
accepted by the marketplace.Our Class II gaming system and the gaming products 19




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associated with
it, even if successfully tested, developed and manufactured, will be competing
against existing competing games and products in the gaming marketplace. There can be no
assurance that the market will accept our system and products. Evolving law may adversely affect the Companys entry into the gaming industry.On November
25, 2003, the United States Department of Justice, at the request of the Bush administration, filed
two formal requests asking the United States Supreme Court to review two cases decided in the
Eighth and Tenth U.S. Circuits Courts of Appeal, respectively (see United States of America v.
Santee Sioux Tribe of Nebraska(3/20/03, No. 02-1503); and Seneca-Cayuga Tribe of Oklahoma et al.
v. Natl Indian Gaming Commn et al., 4/17/03, No. 01-5066). The Eight and Tenth Circuits cover
the west and northern plains states, where dozens of Native American tribes are located. The two
circuit court decisions examined whether certain electronic gaming devices were Class II or Class
III gaming machines under IGRA. Under IGRA, bingo generally qualifies as a Class II game. Class
II games, including bingo, do not lose their designation as such if electronic, computer or
technological aids are used in connection with the games; but an electronic facsimile of any game
of chance (including bingo) does not qualify as a Class II game. Class III games (e.g., slot
machines, video poker, other table games, etc.) encompass all other games not Class I (social games
played for prizes of minimal value) or Class II games. In both the Eighth and Tenth Circuit cases, the courts determined that electronic machines
that dispensed paper pull-tabs (another game of chance) were Class II machines under the IGRA
because they merely dispensed paper pull-tabs and displayed results. The courts found, in essence,
that the games in question were not electronic facsimiles of the game of pull-tabs, but instead
merely facilitated the playing of pull-tabs. Regulations promulgated under the IGRA indicate that
the use of electronic and electromechanical formats which broaden player participation by allowing
multiple players to play with or against each (other than with or against a machine) will not
constitute electronic facsimiles (see 25 C.F.R. § 502.8). The classification of electronically linked bingo-style games is important to the Company and
its business plan. For one, state-tribal compacts typically limit the number of Class III
slot-machine games able to be installed in any one gaming location. Second, our involvement in the
gaming industry is directly related to these kinds of bingo/slot-machine games. Therefore, if
games that we anticipate will qualify as Class II games were to be classified by regulatory
authorities as Class III games, the size of our available market would significantly shrink. On March 2, 2004, the Supreme Court denied the Justice Departments petition for writ of
certiorari for the Eighth and Tenth Circuit decisions, which means the Court declined to review the
Eighth and Tenth Circuit Court decisions. Because of this action, the Eighth and Tenth Circuit
decisions stand. While this result is positive for the gaming industry in general and for us in
particular, there can be no assurance that there will not be other legal actions that will result
in a classification of our Class II games as Class III games, or that current IGRA regulations will
not be repealed. Furthermore, the cases discussed above did not involve bingo-style gaming
machines or Central Determination Games (and their corresponding gaming systems) such as those
distributed by the Company. The result of any such further attempts to overturn precedent or to
reclassify bingo-style gaming machines, such as ours, is beyond our control, and its outcome must
be considered a material and significant risk factor. 20




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In May 2004, the Oklahoma Legislature passed legislation authorizing certain forms of gaming
at racetracks, and additional types of games at tribal gaming facilities, pursuant to a
tribal-state compact. This legislation was subject to approval in a statewide referendum, which
was subsequently obtained in the November 2004 elections. The Oklahoma gaming legislation allows
the tribes to sign a compact with the State of Oklahoma to operate an unlimited number of
electronic instant bingo games, electronic bonanza-style bingo games, electronic skill games and
non house-banked blackjack games. In addition, certain horse tracks in Oklahoma will be allowed to
operate a limited number of instant and bonanzastyle bingo games and electronic skill games.
Four tribes and the state must sign the compact and the Bureau of Indian Affairs must approve it
before it becomes effective. The compact was effective and the tribes began operating the
compacted games in the first quarter of 2005. All vendors placing games at any of the racetracks
under the compact will ultimately be required to be licensed by the State of Oklahoma. Pursuant to
the compacts, vendors placing games at tribal facilities will have to be licensed by each tribe.
All electronic games placed under the compact will have to be certified by independent testing
laboratories to meet technical specifications. These were published by the Oklahoma Horse Racing
Commission and the individual tribal gaming authorities in February 2005. We believe the recently adopted Oklahoma legislation significantly clarifies and expands the
types of gaming permitted by Native America tribes in that state. We currently expect continued
intensified competition from vendors currently operating in Oklahoma as well as new market
entrants. As a result, we anticipate further pressure on our ability to penetrate the market in
Oklahoma. In addition, in the immediate future, we expect continued regulatory uncertainty in
Oklahoma. In particular, although we and other vendors may not begin to offer games enabled by the
new legislation until state and tribal regulations, rules and specifications adopted pursuant to
that legislation become final, certain other vendors and tribes may begin to offer new games prior
to that time. It is unclear what, if any, regulatory enforcement action could or would be taken
against tribes and vendors offering games not authorized by existing law but permitted under the
newly adopted, but not yet effective, legislation. The new legislation requires Oklahoma tribes to develop their own licensing procedures for
their vendors. Our Oklahoma tribal customers are in the early stages of developing these
procedures, and we currently have limited, if any, information regarding the ultimate process or
expenses involved with securing licensure by the tribes. Moreover, tribal policies and procedures,
as well as tribal selection of gaming vendors, are subject to the political and governance
environment within the tribe. Changes in tribal leadership or tribal political pressure can affect
our relationships with our customers. As a result of these and other considerations, it remains
difficult to forecast the short-term impact on our business from the recent Oklahoma gaming
legislation. The Company currently has few required licenses and permits for its gaming business, and has
encountered delays in the permitting and licensing process with tribal authorities.The gaming
industry in the United States is highly regulated, and frequently requires operators of gaming
facilities and manufacturers and distributors of gaming machines and related equipment to acquire
various authorizations, licenses, permits or other forms of approval from governmental, tribal
and/or quasi-governmental agencies or bodies. At this time, we have registered with the U.S.
Department of Justice under the Johnson Act, we possess a manufacturer and distributor registration
from the State of California Gambling Control Commission, twelve 21




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tribal licenses from tribes in
located in the State of California, and one tribal licenses in the State of Oklahoma.
We possess no other authorizations, licenses, permits or other forms of approval that may be
required for us to manufacture, manage and service our anticipated gaming products. We will likely require further approvals from regulatory authorities in the State of
California in order to carry out our current business plans and opportunities in such jurisdiction.
In particular, we will require tribal permits upon each placement of machines in Native American
casinos and facilities, and will likely also require a suitability finding by the California State
Gaming Agency. In addition, we expect to be required to obtain similar permits, licenses and
approvals in the State of Oklahoma. We cannot be certain that we will be able to successfully
obtain any of the foregoing permits, licenses or obtain a suitability finding. Any failure on our
part to obtain required authorizations, licenses, permits or other form of approval may thwart our
business plans significantly or entirely. In addition, in the course of pursuing authorizations, licenses, permits and other forms of
approval for us to manufacture, manage and service our gaming products in California and Oklahoma,
the Company has routinely encountered slower application processes than anticipated, especially
when seeking authorizations, licenses and permits from tribal authorities. We may have a difficult time enforcing our contracts against Native American tribes and the
casinos they own and operate.Native American Tribes generally enjoy sovereign immunity from suit
similar to that of the states and the United States. In order to sue a Native American tribe (or
an agency or instrumentality of a Native American tribe), the Native American tribe must have
effectively waived its sovereign immunity with respect to the matter in dispute. In our contracts with Native American customers, we attempt to provide that any dispute
regarding interpretation, performance or enforcement shall be submitted to, and resolved by,
arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration
Association and that any award, determination, order or relief resulting from such arbitration is
binding and may be entered in any federal court having jurisdiction. Even if we are able to
effectively bargain or negotiate for such a provision, we could be precluded from judicially
enforcing any rights or remedies against a tribe without a waiver, limited or otherwise, of the
tribes sovereign immunity. These rights and remedies include, but are not limited to, our right
to enter Native American lands to retrieve our property in the event of a breach of contract by the
tribe party to that contract, and our right to enforce any arbitration decision in our favor. We will depend upon others for the manufacture of our gaming products, which will subject our
business to the risk that we will be unable to fully control the supply of our products to the
market.Our ability to develop, manufacture and successfully commercialize our proposed products
depends upon our ability to enter into and maintain contractual and collaborative arrangements with
others, such as Bally. We do not intend to manufacture any of our proposed products; but instead
intend to retain contract manufacturers. There can be no assurance that Bally or any other
manufacturers will be able to supply our products in the required quantities, at appropriate
quality levels or at acceptable costs. We may be adversely affected by any difficulties
encountered by such third-party manufacturers that result in product defects, production delays or
the inability to fulfill orders on a timely basis. If a manufacturer cannot meet our quality
standards and delivery requirements in a cost-efficient manner, we would likely suffer
interruptions of delivery while we arrange for alternative manufacturing sources. 22




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Any extended
disruption in the delivery of products could result in our inability to satisfy customer demand for
our products. Consequently, our inability to obtain alternative sources on a timely basis may
have a material adverse effect on our business and results of operations. A number of our products
are manufactured outside of the United States. Our purchase contracts are typically settled in Yen
and we therefore may be subject to currency risk. Our reliance on third-party manufacturers and other third parties in other aspects of our
business will reduce any profits we may earn from our products, and may negatively affect future
product development.As noted above, we currently intend to market and commercialize products
manufactured by others, and in connection therewith we will likely be required to enter into
manufacturing, licensing and distribution arrangements with third parties similar to the licensing
agreement we entered into with Bally. These arrangements will likely reduce our product profit
margins. In addition, the identification of new product candidates for development may require us
to enter into licensing or other collaborative agreements with others. These collaborative
agreements may require us to pay license fees, make milestone payments, pay royalties and/or grant
rights, including marketing rights, to one or more parties. Any such arrangement will likely
reduce our profits. Moreover, these arrangements may contain covenants restricting our product
development or business efforts in the future. We may not be able to enter into manufacturing agreements or other collaborative agreements on
terms acceptable to us, if at all, which failure would materially and adversely affect our
business.We cannot be sure that we will be able to enter into manufacturing or other
collaborative arrangements with third parties on terms acceptable to us, if at all, when and as
required. If we fail to establish such arrangements when and as necessary, we could be required to
undertake these activities at our own expense, which would significantly increase our capital
requirements and may delay the development, manufacture and installation of our gaming machines on
casino floors. If we could not find ways of addressing these capital requirements, we would likely
be forced to sell or abandon our business. We operate in an extremely competitive environment.The market for gaming machines is a
difficult one in which to compete as there are a number of established, well-financed and
well-known companies that compete with our current and planned products. In particular,
International Game Technology (IGT) enjoys a significant domestic and international market
position in the gaming-machine market. Similarly, Multimedia Games, Inc. enjoys a significant
market position in the Class II gaming machine market. Other major gaming-machine companies
include Sigma Gaming, Inc. and Bally Gaming Inc., a subsidiary of Alliance Gaming Corp. All of
these companies have substantially more resources than we do. The development of a successful new
product by a competitor could adversely affect the market demand for our products and impair our
ability to generate sales. Similarly, if well-established companies such as IGT were to focus
their resources on the developing Class II gaming machine market, our ability to capitalize on the
perceived opportunities in that market could be significantly impaired. Our inability to protect our intellectual property could impair our ability to compete.Our
success and ability to compete depend in part upon proprietary intellectual property. Our
proprietary intellectual property currently consists of certain licensed trademark, image and
likeness, and other moral rights, assets acquired pursuant to an asset purchase agreement with
Streamline Development Company, Inc., and a right to acquire copyright and other
intellectual-property rights relating to software that may be developed by MET Games pursuant to
our 23




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software development agreement with them. We currently rely and intend to rely in the future
on a combination of copyright, trademark, patents, trade secret laws, and nondisclosure
agreements to protect our proprietary technology. Although we have entered into confidentiality,
non-compete and invention assignment agreements with our employees and otherwise limit access to,
and distribution of, our proprietary technology, there can be no assurance that such agreements
will not be breached, that we would have adequate remedies for any breach, or that our trade
secrets will not otherwise become independently developed or discovered by competitors. We are highly dependent on the services provided by certain executives and key personnel.Our
success in the Native American and charitable gaming markets depends in significant part upon the
continued service of certain senior management and other key personnel. In particular, we are
materially dependent upon the services of Russell C. Mix, a director of the Company and our
President and Chief Executive Officer. We have an employment agreement with Mr. Mix, but if Mr.
Mix should no longer serve the Company it would likely have a materially adverse impact on our
business, financial condition and operations. The Company has not secured any key person life
insurance covering the life of Mr. Mix. Our success also depends on our ability to identify, hire, train, retain and motivate highly
skilled technical, managerial, sales and marketing personnel. We intend to hire a full-time Chief
Financial Officer and a number of sales, business development, marketing, technical and
administrative personnel in the future. Competition for such personnel is intense and there can be
no assurance that we will successfully attract, assimilate or retain a sufficient number of
qualified personnel. The failure to retain and attract the necessary technical, managerial, sales
and marketing and administrative personnel could have a material adverse impact on our business,
financial condition and operations. Our officers and directors, together with certain affiliates, possess substantial voting power
with respect to our common stock, which could adversely affect the market price of our common
stock.As of April 27, 2005, our officers and directors collectively possess beneficial ownership
of 520,553 shares of our common stock, which represents approximately 3.8% of our common stock.
Certain other significant shareholders, including Perkins Capital Management, Inc., Ronald E.
Eibensteiner, and Wayne W. Mills, collectively possess beneficial ownership of a total of 5,693,454
shares of common stock, which represents approximately 42.8% of our common stock. When taken
together, our directors, officers and significant shareholders have beneficial ownership of
approximately 45.3% of our common stock. This represents a significant and controlling portion of
the voting power of the Companys shareholders. As a result, our directors and officers, together
with significant shareholders, have the ability to substantially (but not wholly) control our
management and affairs through the election and removal of our entire board of directors, and all
other matters requiring shareholder approval, including the future merger, consolidation or sale of
all or substantially all of our assets. This concentrated control could discourage others from
initiating any potential merger, takeover or other change-of-control transaction that may otherwise
be beneficial to our shareholders. Our stock price is, and we expect it to remain, volatile.The volatile price of our common
stock makes it difficult for investors to predict the value of their investment, to sell shares at
a profit at any given time, or to plan purchases and sales in advance. A variety of factors may
affect the market price of our common stock, including but are not limited to: 24




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
    achievement or rejection of regulatory approvals by us or by the tribes or other
purchasers of our products;
    announcements of technological innovations or new commercial products by our
competitors or us;
    developments concerning proprietary rights, including patents;
    regulatory developments in the United States relating to the gaming industry;
    period-to-period fluctuations in our revenues and other results of operations;
    changes in financial estimates by securities analysts; and
    sales of our common stock. We will not be able to control many of these factors, and we believe that period-to-period
comparisons of our financial results will not necessarily be indicative of our future performance. Our articles of incorporation grant the Companys board of directors with the power to
designate and issue additional shares of common and/or preferred stock.Our authorized capital
consists of 100,000,000 shares of capital stock. Pursuant to authority granted by the Companys
articles of incorporation, our board of directors, without any action by the shareholders, may
designate and issue shares in such classes or series (including classes or series of common stock
and/or preferred stock) as it deems appropriate and establish the rights, preferences, and
privileges of such shares, including dividends, liquidation and voting rights. The rights of
holders of classes or series of common stock or preferred stock that may be issued could be
superior to the rights of the common stock offered hereby. Our board of directors ability to
designate and issue shares could impede or deter an unsolicited tender offer or takeover proposal.
Further, the issuance of additional shares having preferential rights could adversely affect other
rights appurtenant to the shares of common stock offered hereby. Any such issuances will dilute
the percentage of ownership interest of our shareholders and may dilute the book value of the
Company. As of March 31, 2005, we had 12,888,213 shares of common stock outstanding and a further
6,749,888 shares of our common stock had been reserved as follows:  
    2,300,000 shares for issuance under our existing stock option plans, of which
options relating to 904,166 shares were outstanding;
    1,751,942 shares for issuance pursuant to stock option agreements entered into
outside of stock option plans; and
    2,697,946 shares issuable upon the exercise of outstanding warrants. In addition to the shares noted above, our board of directors has designated 466,666 of our
shares for issuance as Series A Convertible Preferred Stock. During the fiscal year ended
December 31, 2001, the Company issued 440,000 shares of Series A Convertible Preferred Stock. As
of March 31, 2005, shareholders holding 266,666 shares of Series A Convertible Preferred Stock had
converted their preferred shares into shares of our common stock. As a result, there remain
173,334 shares of Series A Convertible Preferred Stock outstanding as of March 31, 2005, which
shares are currently convertible into an additional 391,191 shares of our common stock. 25




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Our common stock trades only in an illiquid trading market.Trading of our common stock is
conducted on the over-the-counter bulletin board. This has an adverse effect on the liquidity of
our common stock, not only in terms of the number of shares that can be bought and sold at a given
price, but also through delays in the timing of transactions and reduction in security analysts
and the medias coverage of our Company and its common stock. This may result in lower prices for
our common stock than might otherwise be obtained and could also result in a larger spread between
the bid and asked prices for our common stock. There is currently little trading volume in our common stock, which may make it difficult to
sell shares of our common stock.In general, there has been very little trading activity in our
common stock. Over the past three months, the average daily trading volume (as reported by
BigCharts.com and Yahoo Finance) has been approximately 20,000 shares. The relatively small
trading volume will likely make it difficult for our shareholders to sell their shares as and when
they choose. Furthermore, small trading volumes generally depress market prices. As a result, you
may not always be able to resell shares of our common stock publicly at the time and prices that
you feel are fair or appropriate. Because it is a penny stock, you may have difficulty selling shares of our common stock.
Our common stock is a penny stock and is therefore subject to the requirements of Rule 15g-9
under the Securities and Exchange Act of 1934, as amended (the Exchange Act). Under this rule,
broker-dealers who sell penny stocks must provide purchasers of these stocks with a standardized
risk-disclosure document prepared by the Securities and Exchange Commission. Under applicable
regulations, our common stock will generally remain a penny stock until and for such time as its
per-share price is $5.00 or more (as determined in accordance with SEC regulations), or until we
meet certain net asset or revenue thresholds. These thresholds include the possession of net
tangible assets (i.e., total assets less intangible assets and liabilities) in excess of $2,000,000
in the event we have been operating for at least three years or $5,000,000 in the event we have
been operating for fewer than three years, and the recognition of average revenues equal to at
least $6,000,000 for each of the last three years. We do not anticipate meeting any of the
foregoing thresholds in the foreseeable future. The penny-stock rules severely limit the liquidity of securities in the secondary market, and
many brokers choose not to participate in penny-stock transactions. As a result, there is
generally less trading in penny stocks. If you become a holder of our common stock, you may not
always be able to resell shares of our common stock publicly at the time and prices that you feel
are fair or appropriate. We have no intention of paying dividends on our common stock.To date, we have not paid any
cash dividends and do not anticipate the payment of cash dividends in the foreseeable future.
Accordingly, the only return on an investment in shares of our common stock, if any, may occur upon
a subsequent sale of such shares. Off-Balance-Sheet Arrangements The Company has no off-balance-sheet arrangements. 26




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Critical Accounting Estimates Our critical accounting policies are those both having the most impact to the reporting of our
financial condition and results, and requiring significant judgments and estimates. Our critical
accounting policies include those related to (a) revenue recognition, (b) property, plant and
equipment, (c) inventory and (d) the valuation of stock-based compensation awarded. The Company
derives its gaming revenues in primarily two ways, outright sales of machines to customers, and
participation arrangements with its Native American customers. Revenue for machine sales is
recorded upon shipment. Under the participation arrangements, the Company retains ownership of the
equipment installed at a customer site and receives revenue based on a percentage of the hold per
day generated by each gaming system, which is generally considered both realizable and earned at
the end of each gaming day. The Company accounts for the participation agreements as operating
leases. Property, equipment and leasehold improvements and leased gaming equipment were stated at
cost. Depreciation of an asset was recognized on the straight-line basis over the assets
estimated useful life ranging from three to five years. Leasehold improvements were amortized
using the straight-line method over the shorter of the lease term or the estimated useful life.
Maintenance, repairs and minor renewals are expensed when incurred. Inventory, which consists
principally of gaming products and related materials, are stated at the lower of cost (determined
on the first-in, first-out method) or market. The Company uses the intrinsic value-based method
prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for employee stock options and stock based
compensation. The Company uses Emerging Issues Task Force 96-18 (EITF 96-18), Accounting for
Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling, Goods or Services, to value options and warrants issued to non-employees. Managements
estimates of the fair value of each option and warrant granted is calculated using the
Black-Scholes pricing model with weighted-average assumptions including risk free interest rate,
expected life of options granted, expected volatility range, and expected dividend yield. Forward-Looking Statements This Form 10-QSB contains certain forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934,
as amended. Statements made in this report which are not historical in nature, including but not
limited to statements using the terms may, expect to, believe, should, anticipate, and
other language employing a future aspect, are referred to as forward-looking statements, should be
viewed as uncertain and should not be relied upon. Although our management believes that the
results reflected in or suggested by these forward-looking statements are reasonable, all
forward-looking statements involve risks and uncertainties and our actual future results may be
materially different from the expectations expressed in such forward-looking statements. In
particular, all statements included herein regarding activities, events or developments that the
Company expect, believe or anticipate will or may occur in the future, including such things as
future capital expenditures (including the amount and nature thereof), business strategy and
measures to implement strategy, competitive strengths, goals, expansion and other such matters are
forward-looking statements. The foregoing list is not exhaustive, and the Company disclaims any
obligation to subsequently revise any forward-looking statements to reflect events or circumstances
after the date of such statements. 27




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Actual events may differ materially from those anticipated in the forward-looking statements.
Important factors that may cause such a difference include those risk factors summarized above.
For additional information regarding these and other factors, see our Annual Report on Form 10-KSB
for the year ended December 31, 2004 and other recent filings with the SEC. 
 Item 3. Controls and Procedures The Company carried out an evaluation, with the participation of our Chief Executive and Chief
Financial Officers, of the effectiveness, as of March 31, 2005, of our disclosure controls and
procedures (as defined in Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934).
Based upon that evaluation, made at the end of the period, our Chief Executive Officer and Chief
Financial Officer concluded that our disclosure controls and procedures are effective in alerting
them on a timely basis to material information required to be disclosed in our periodic reports to
the SEC, and that there has been no significant change in such internal controls, or other factors
which could significantly affect such controls including any corrective actions with regard to
significant deficiencies or material weaknesses, since our evaluation. However, due to the limited
number of Company employees engaged in the authorization, recording, processing and reporting of
transactions, there is inherently a lack of segregation of duties. During the course of their
audit of our consolidated financial statements for fiscal 2004, our independent registered public
accounting firm, Virchow, Krause & Company, LLP, advised management and the audit committee of our
Board of Directors that they had identified a deficiency in internal control. The deficiency is
considered to be a material weakness as defined under standards established by the American
Institute of Certified Public Accountants. The material weakness relates to the lack of
segregation of duties within the financial processes in the Company. The Company periodically
assesses the cost versus benefit of adding the resources that would remedy or mitigate this
situation, and currently does not consider the benefits to outweigh the costs of adding additional
staff in light of the limited number of transactions related to the Companys operations. 
 PART II Other Information 
 Item 2. Changes in Securities and Small Business Issuer Purchases of Equity Securities The disclosures made in Note 10 of the financial statements (see Item 1 of Part I of this
report) regarding sales and issuances of the Companys securities during the period beginning
January 1, 2005 and ending March 31, 2005 are hereby incorporated into this Item 2 of Part II by
this reference. On January 24, 2005, the Company issued options to purchase up to 150,000 shares of the
Companys common stock to Mr. Witcher upon his appointment to the Companys Board of Directors. 28




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On February 9, 2004, the Company issued options to purchase up to 250,000 shares of the
Companys common stock to Mr. Brimmer upon his appointment to the Companys Board of Directors. During the three months ended March 31, 2005, the Company issued an aggregate of 37,691 shares
of the Companys common stock to Pandora, in lieu of payments of $ 75,728 in principal and
interest, under the promissory note issued to Pandora in connection with the May 20, 2004 borrowing
described in Note 5 of the financial statements (see Item 1 of Part I of this report). 
 Item 6. Exhibits (a) Exhibits 31.1
    
    Rule 13a-14(a) Certification of Chief Executive Officer.31.2
    
    Rule 13a-14(a) Certification of Chief Financial Officer.32
    
    Section 1350 Certification.
 
 SIGNATURES Pursuant to the registration requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly
authorized. SPECTRE GAMING, INC.Date: May 12, 2005
    
    By:
    
    /s/ Russell C. MixTitle:
    
    President and Chief Executive OfficerDate: May 12, 2005
    
    By:
    
    /s/ Brian D. NieburTitle:
    
    Chief Financial Officer(Principal Accounting Officer)
 29