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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-KSB (Mark One) þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the fiscal year ended December 31, 2004
OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period  to Commission file number 0-27751 WQN, INC.  Delaware
    
    75-2838415(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)
 14911 Quorum Drive, Suite 140, Dallas, Texas
    
    75254(Address of principal executive offices)
    
    (Zip Code)
 Issuers telephone number, including area code: (972) 361-1980 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.01 per share Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the
issuer was required to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. þ o
 Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B
contained herein, and none will be contained, to the best of registrants knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. o The issuers revenues for its most recent fiscal year were: $15,263,806. The aggregate market value of the voting common stock held by non-affiliates of the issuer, based
on the closing sales price of $3.08 per share, was $9,354,413 as of December 31, 2004. At January 31, 2005, the registrant had outstanding 6,878,062 shares of par value $.01 common
stock. DOCUMENTS INCORPORATED BY REFERENCE Part III of this Annual Report on Form 10-KSB incorporates certain information by reference from
the definitive Proxy Statement for the registrants 2005 Annual Meeting of Stockholders. Transitional Small Business Disclosure Format (check one): YES o
    
    NO þ
    1




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TABLE OF CONTENTS PART IITEM 1.
    
    DESCRIPTION OF BUSINESS
    
    
    3ITEM 2.
    
    DESCRIPTION OF PROPERTY
    
    
    14ITEM 3.
    
    LEGAL PROCEEDINGS
    
    
    14ITEM 4.
    
    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    15PART IIITEM 5.
    
    MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
    
    
    15ITEM 6.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
    
    
    17ITEM 7.
    
    FINANCIAL STATEMENTS
    
    
    32ITEM 8.
    
    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
    
    
    32ITEM 8A.
    
    CONTROLS AND PROCEDURES
    
    
    32PART IIIITEM 9.
    
    DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
    
    
    33ITEM 10.
    
    EXECUTIVE COMPENSATION
    
    
    33ITEM 11.
    
    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
    
    
    33ITEM 12.
    
    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    
    
    33ITEM 13.
    
    EXHIBITS AND REPORTS ON FORM 8-K
    
    
    34ITEM 14.
    
    PRINCIPAL ACCOUNTANT FEES AND SERVICES
    
    
    35List of SubsidiariesConsent of Grant Thornton LLPCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906
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WQN, INC. 
 PART I 
 ITEM 1. DESCRIPTION OF BUSINESS Forward Looking Statements This Form 10-KSB includes certain statements that are not historical facts and are deemed to
be forward looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934. See Item 6  Managements Discussion and Analysis of Financial Condition or Plan of
Operation  Forward Looking Statements for a further discussion of these forward looking
statements. General We are a Voice Over Internet Protocol (VoIP) telephony company providing international long
distance services. VoIP enables voice communications over the Internet by compressing voice into
data packets that can be efficiently transmitted over data networks and then converted back into
voice at the receiving end. Our customers utilize our enhanced VoIP services platform to make and
receive calls using their home phone, business phone, personal computer and mobile phone. Our business currently includes the provision of enhanced Internet-based and other telephony
services under various brand names to individual consumers primarily seeking to make international
calls as well as the provision of enhanced Internet-based and other telephony services to
resellers, corporations and service providers under their brand names and carrier transmission
services whereby we sell our excess capacity to other long-distance carriers. We also distribute
telephony services including prepaid long distance and prepaid wireless through a network of over
90 private distributors. Through this network we estimate that our products are sold through over
10,000 retail outlets of which more than 5,000 retail outlets are located in Southern California.
We expect to begin selling our proprietary VoIP products through this distribution channel
beginning in 2005. As of December 31, 2004, Eagle Venture Capital, LLC (Eagle Venture) owned approximately 2.6
million, or 38%, of our outstanding shares of common stock. Eagle Venture is primarily owned by B.
Michael Adler, our founder and Chief Executive Officer. We were incorporated in October 1996 as a Texas corporation. We reincorporated in Delaware in
October 1999. In November 2004, we changed our name to WQN, Inc. from WorldQuest Networks, Inc.
(see Item 3-Legal Proceedings in Part I of this Report). Industry Background Emergence of Internet Telephony.VoIP has emerged as a low cost alternative technology that
can replace services provided by the traditional telephone network. VoIP technology translates
voice into data packets, transmits the packets over data networks and reconverts them into voice at
the destination. Unlike traditional telephone networks, VoIP does not use dedicated circuits for
each telephone call; instead, the same VoIP network can be shared by multiple users for voice, data
and video simultaneously. This type of data network is more efficient than a dedicated circuit
network because the data network is not restricted by the one-call, one-line limitation of a
traditional telephone network. This improved efficiency creates cost savings that can be passed on
to the consumer in the form of lower rates. Also, VoIP technology enables service providers to
offer features and services such as voice-mail to email that traditional telephone networks
cannot provide. Technology research firm JupiterResearch predicts that VoIP telephony services will grow to
about 400,000 U.S. households by the end of 2004, and to 12.1 million U.S. households by 2009. VoIP
has experienced significant growth in recent years due to:  
    Demand for lower cost telephone service;
    Improved quality and reliability of VoIP calls due to technological advances, increased network 3




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development and greater bandwidth capacity;
    New product innovations that allow VoIP providers to offer services not currently
offered by traditional telephone companies; and
    Growing demand for long distance communication services driven by the increased mobility
of the global workforce. As a result of these developments, consumers, enterprises and telecommunications providers are
continuing to embrace offerings from VoIP providers. Consumers, particularly in emerging markets,
are increasingly using VoIP-enabled services to realize significant cost savings on long distance
calls. Enterprises are significantly reducing telephony expenses by using VoIP to link users within
offices and around the world. VoIP enables telecommunications providers to reduce their network
costs and to deliver new products and services. Our Retail Telephony Services We offer various VoIP based telephony services primarily to residential consumers which we
categorize as retail telephony. We focus on the international long distance market of which a
substantial portion of our retail telephony business is currently derived from the sale of services
to customers calling from the United States to India. Our centrally managed enhanced services
platform supports a full range of customer products and services that enhance quality, lower costs
and improve ease of use and management. Our telephony services allow users to access our VoIP
platform to make low cost calls to anywhere in the world. Below are the key products and services
we offer: RocketVoIP.We sell our proprietary next generation VoIP technology service under the brand
name RocketVoIP. With RocketVoIP, subscribers can use their broadband service to make and receive
unlimited domestic and international calls using a home phone, mobile phone or personal computer.
This service is being introduced to WQNs current customer base and other ethnic groups. RocketVoIP
has unique features and advantages over competing products that include:  
    Unlimited local, long distance and international calling to 50 countries, for a low
monthly fee;
    The ability to use a mobile phone to access WQNs network for high quality unlimited
international calls;
    Free in-network calling;
    Free features including Caller-ID, Call-Waiting, Call-Forwarding, 3-Way Calling, Voice
Mail, and more; and
    A total calling solution enabling travelers to make and receive phone calls from
anywhere in the world using a personal computer and high-speed internet access, including
Wi-Fi hotspots. Easy Talk. Our EasyTalk service offers competitively priced long distance services which
allows customers to speak to the party they are calling by the pressing of two designated buttons
from the dial pad of the customers phone. Customers are not required to switch their long distance
service to use EasyTalk. The EasyTalk service offers many features including:  
    Pinless dialing;
    Can be used from registered home, office and mobile phones;
    Access to personal on-line account management tools which enables customers to view
their call history and purchase information 24 hrs a day;
    Recharge their accounts on-line or through our Interactive VoiceResponse System (IVR);
    Update, modify and change their account information including credit card details; and
    Communicate with customer service representative by email, live chat or by calling a
customer service number. My800online.com. Our My800online.com service offers toll free personal 800 numbers that can be
routed to any home, office or cell phone in the world. It allows small businesses to create a
virtual office telephone and lets international companies provide their U.S. based customers a
toll-free number that will ring anywhere in the world. The My800online service offers many feature
including: 4




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
    No monthly fees or contracts;
    International call forwarding;
    The ability to recharge the number on-line at any time; and
    Access to personal on-line account management tools which enables customers to view
account balance and call history 24 hrs a day. Virtual Prepaid Calling Cards.We sell virtual prepaid calling cards over the Internet. They
are virtual because we do not issue a physical card. Our virtual calling cards give us the
flexibility of promptly changing the rates and features to respond to changing consumer demand,
rather than having an inventory of physical cards with set features that cannot be changed until
all are recalled or used. This also allows us to offer and test several different types of virtual
calling cards with varying pricing features, thus providing a greater selection to our customers. Our system functions as follows: A potential customer accesses our Web site, follows the
prompts to enter their credit card information to purchase the virtual calling card, we verify the
credit card within seconds, and we electronically issue a personal identification number, or PIN,
and a toll free number to the customer when the electronic purchase transaction is completed. Once
sold, the virtual calling card can be used immediately to make international and domestic long
distance calls. The customer dials the toll free number and enters the PIN and the telephone number
the customer seeks to reach. Our enhanced services platform determines whether the virtual calling
card is valid and the number of call minutes remaining on it, based on the rate for the country
being called. The platform completes the call and reduces the available credit balance on the
virtual calling card at the conclusion of the call. Resale of Virtual Calling Cards.We also buy virtual calling cards processed through other
companies platforms including prepaid long distance and wireless. We buy them at a discount and
sell them to our customers on our Web sites as our virtual cards. We sell these virtual cards for
calls from the United States to other countries where we have not established our own Internet
network and where our negotiated rates with our international long distance carriers are not as
favorable and to offer other telecom products and services not available on our platform, such as
prepaid wireless. We estimate that less than 1% and 1%, respectively, of our retail telephony
revenues for the fiscal years ended December 31, 2004 and 2003 were generated from these virtual
calling cards processed through other companies platforms. Our Retail Telephony Websites.We have various Websites to allow us to target several ethnic
niches that make international long distance calls. Our Web sites are accessible 24 hours per day,
seven days a week, so we are not constrained by the hours a retail store would be open for
business. Our Web sites may also be reached from the customers home or office. The customer is not
required to physically travel to another location to make a purchase and receive delivery. Our
online purchasing and delivery also allows us to deliver a broad selection of products to customers
worldwide in rural or other locations that do not have convenient access to physical stores. Our
Web sites include the following: Web Site Address
    
    Web Site Descriptionwww.wqn.com
    
    EasyTalk service and Corporate websitewww.rocketvoip.com
    
    RocketVoIP servicewww.my800online.com
    
    Personal 800 servicewww.valucomonline.com
    
    High-end Indian consumerswww.valumaxonline.com
    
    Indian marketwww.card2asia.com
    
    Indian marketwww.supertel.com
    
    Iranian marketwww.metrotelcom.net
    
    Iranian marketwww.wqnwireless.com
    
    Prepaid wireless planswww.rocketmobile.net
    
    International calling for mobile phone users
 Our Web sites have been designed around industry standard architectures to reduce downtime in
the event of outages or catastrophic occurrences. Our Web sites operations staff consists of
systems administrators who 5




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manage, monitor and operate our Web sites. The continued uninterrupted operation of our Web
sites is essential to our business, and it is the job of the site operations staff to ensure, to
the greatest extent possible, the reliability of our Web sites. Our network is built around a
redundant, high availability backbone. In order to achieve maximum redundancy, our network has
several connections to the Internet. We believe these telecommunications and Internet service
facilities are essential to our operation and we anticipate upgrading these facilities as volume
and demand for our services grow. Wholesale Services Our wholesale services consist of the following: Distribution of Telephony Products.We distribute telephony services which primarily consists
of prepaid calling cards through a network of over 90 private distributors. We sell the product or
service to a distributor at a discount who then resells the product or service to a retail outlet.
Through this network we estimate we sell products to over 10,000 retail outlets of which more than
5,000 retail outlets are located in Southern California which gives us access to various large
ethnic communities seeking to make international phone calls. A significant portion of our
distribution business consists of prepaid calling cards used to call from the United States to
Mexico. Through this network we also distribute our products in the Dallas, Houston, Chicago, New
York City, Newark, and Miami markets. We plan to use this network in 2005 to sell our proprietary
VoIP products. Platform Services.We sell our enhanced Internet-based and other telephony services to
resellers, corporations, and service providers who then resell the service under their own brand
name. Many of these resellers are smaller companies which purchase virtual calling cards from us
and then resell the products from their own web sites. For the years ended December 31, 2004 and
2003, approximately 3% and 42%, respectively, of our wholesale revenues were generated from
platform services. Resale of Network Capacity.From time to time we sell our excess network capacity to other
long distance carriers. For the years ended December 31, 2004 and 2003, approximately 4% and 58%,
respectively, of our wholesale revenues were generated from selling our excess network capacity. Our Services Platform and Network Access.Access to our proprietary VoIP Network and enhanced services platform is available by
several methods. Customers can access our network from anywhere in the world through their high
speed Internet connection using a broadband phone (which we supply to RocketVoIP customers) and our
soft phone which is a downloadable software that enables customers to make PC-to-Phone calls.
Customers can also access our network from the United States and Canada using toll-free and local
access numbers. Our Enhanced Services Platform.We have a centrally managed, enhanced services platform
consisting of a reliable and flexible data management, monitoring control and billing systems which
support all of our products and services. We have invested substantial resources to develop and
implement our proprietary real-time call management information system. Key elements include
customer provisioning, customer access, fraud control, network security, call routing, call
monitoring, call reliability and detailed call records. Our enhanced services platform is a specialized telephone switch, soft switch, and software.
It is connected to our Web sites and databases and to our network of outgoing and incoming
telephone lines and Internet lines. It sets up all customer account information when services are
purchased and immediately activates the services so it can be used at the time of purchase. We have
also programmed into the platform a lowest cost routing matrix. This matrix automatically routes
each call over the route most economical to us. This means it will select our international carrier
with the lowest rate or the Internet if we have a gateway in the call destination country. Our enhanced services platform monitors our process of digitizing and compressing voice into
data packets and transmitting these data packets over data networks. We maintain a softswitch,
which is a software-based product that manages call admission, call control, call rating and routes
calls to an appropriate end point. Unless the customer is using an Internet telephony device the
packets (representing a voice call initiated by a customer) are sent to a 6




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gateway belonging to one of our partner telecommunication carriers where the packets are
reassembled and the call is transferred and directed to a regular telephone anywhere in the world.
Our billing and back office systems manage and enroll customers and bill calls as they originate
and terminate on the service. Our enhanced services platform is a specialized telephone switch, soft switch, and software.
It is connected to our Web sites and databases and to our network of outgoing and incoming
telephone lines and Internet lines. It sets up all customer account information when services are
purchased and immediately activates the services so it can be used at the time of purchase. We have
also programmed into the platform a lowest cost routing matrix. This matrix automatically routes
each call over the route most economical to us. This means it will select our international carrier
with the lowest rate or the Internet if we have a gateway in the call destination country.
Focusing on the international market, the use of our platform is spread throughout the day as a
result of the different world time zones. Proprietary Technology.We have developed proprietary customer software that permits a
customer to purchase retail telephony services from our Web sites using a credit card and to have
the services delivered while on our Web sites for immediate use by the customer. We have also
developed proprietary customer software to allow our customers world access to our platform using
their high speed Internet connection to initiate and receive calls, and we have developed various
proprietary credit and fraud management applications which aid us in checking credit and limiting
fraudulent transactions. We historically have developed and expect to continue to develop
proprietary software internally. Our engineering strategy focuses on the development of our Web
sites, which includes the enhancement of features and functionality of our existing software
components, the development of additional new software components, and the integration of
off-the-shelf components into our systems. Operations Support.Our engineering staff consists of software development engineers and
consultants. Our engineering staff monitors all aspects of our network including routers,
databases, switches, leased lines, Internet connections, gate keepers and gateways to ensure that
they are functioning at optimal levels. In the event of failure of these network components, our
engineering staff is provided with real time systems generated notification via an instant
messaging system consisting of pagers, cell phones, and email. Our Internet Gateway Network.As of December 31, 2004, we had international gateways
operational in India and a domestic gateway operational in Dallas, Texas. Our Internet gateways
enable us to route voice quality calls through our enhanced services platform to and from the
country via the public Internet or private intranet networks such as a frame relay network. The
cost of these calls is based on the local telephone rates for the country where the gateway is
located. The cost is not based on international or local long distance rates. Before we place a
gateway in another country, we enter into contractual relationships with local persons or entities
to operate them and to be responsible for procuring local Internet provider connections, local
telephone lines and complying with local law. We pay the local entity a negotiated rate per minute
for terminating or originating calls through the gateway. Interconnection Agreements.We have various telecommunication interconnect and service
agreements with VoIP providers and telecommunication carriers. Pursuant to these agreements, we
can transport VoIP packets to our hubs and terminate calls throughout the world. We typically pay
for these services on a per-minute of use basis. Our agreements are typically one-year agreements
with 30-day cancellation rights by either party. Rates are adjusted approximately every 30 days,
are based on volume and are subject to market price fluctuations. We are dependent on these
carriers to terminate our calls, and the loss of one or more of them as a source for terminating
calls could have a material adverse affect on us. However, we believe there are numerous
international long distance carriers that transport calls to the countries we desire to target and
we believe we could replace any of the carriers we lost. If the rates of any replacement carrier
are higher, or our existing carriers raise their rates, our profit margins would decrease. We also
sell to other long distance carriers any excess line capacity we have. Excess line capacity is the
remaining capacity on our telephone lines not used by us to terminate our own calls during any
given month. We depend on Internet service providers to provide Internet access to us and our customers. As
of December 31, 2004, we had two Internet service providers in Dallas. Our local terminating
parties in foreign countries also rely on local Internet service providers for access to the
Internet in their countries. If we lost our connection with both of our Dallas Internet service
providers, we could not sell our retail telephony products and services through our Web sites,
until the connection was reestablished. If a local terminating party in a foreign 7




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country loses its Internet connection, we could not route calls over the Internet to that
destination until the connection was re-established. These failures could cause us to lose
customers and our ability to sell retail telephony products and services would be affected. Our Third Party Contracts.Our success depends, in part, on our ability to continue to use
long distance telephone and Internet capacity from third parties at cost-effective rates to serve
the foreign countries we target. It also depends, in part, on our ability to maintain our
contractual relationships with local terminating parties in those countries where we have Internet
gateways. If we lose our contracts or if these parties are unable to provide these services, we
believe we could replace them. However, it would cause a disruption of our business until they are
replaced. Also, any replacement contracts may not be at rates or on terms as favorable to us. Credit Card Processing Arrangements.All sales of our retail telephony services are billed to
customers through credit cards. We use processing companies to verify credit cards. These
companies are connected to our platform and database and verification or denial is usually
accomplished within seconds. We pay these processing companies a percentage of sales and a fee per
transaction as their fee for processing our credit card transactions. Sales and Marketing Our sales and marketing strategy efforts utilize the following on-line and off-line channels: Internet Advertising.We have taken a selective approach in our online advertising strategy.
We attempt to maximize the return from promotional expenditures by choosing advertising media based
on the cost relative to the likely audience and ability to generate increased traffic for our Web
sites. We generally identify a country and customer group to whom we desire to market our telephony
services. We place advertisements on various Web sites and Internet portals frequently visited by
this customer group in the United States and abroad. These advertisements usually take the form of
banner ads that encourage readers to click through directly to our Web sites. We believe banner
advertising on these Web sites and portals significantly increase our targeted exposure to
prospective customers. We also use Search Engine Optimization (SEO) and Pay-Per-Click advertising services through
Google and Overture to drive traffic to our Web sites. Our SEO programs work to build our online
presence in the major search engines by content building and key word optimizations. The SEO
programs research search phrases and criteria and make sure our sites have the content to support
the search programs as they navigate the Internet searching for results to search queries. Our
Pay-Per-Click advertising campaigns are similar to SEO programs, in that our results are displayed
on search engines, but the difference is that our advertisement displays as a sponsored link next
to the search results on various search engines versus a search result. Our Pay-Per-Click programs
are based on daily budgets or cost per clicks and can be edited and targeted to various specific
key word searches. Customer Electronic Mail Broadcasts.We actively market to our base of customers through
email broadcasts. All new opt-in purchasers are automatically added to our electronic mailing list.
We email messages to our customers on a periodic basis announcing new rates new products and new
features. Our customer database allows us to introduce new products and services to a targeted
audience without the significant customer acquisition costs normally associated with introducing
new products or services. Telemarketing.During 2004 we developed an outsourced Indian based call center to make
outbound telemarketing calls to our customers. The call center currently has 24 seats and is
operated seven days a week, 10 hours a day. We use third party predictive dialers and call center
management software and pay for monthly Internet and telecommunication usage. The call center
agents contact our existing customer base to promote special offers and incentives, new products
and services, rate changes and other promotions. The call center agents also make courtesy calls to
inquire about customer satisfaction, service quality and recommendations for new features and
services. Bricks and Mortar Distribution.We distribute telephony services which primarily consists of
prepaid calling cards through a network of over 90 private distributors. Through this network we
estimate our products are sold through over 10,000 retail outlets of which more than 5,000 retail
outlets are located in Southern California 8




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which gives us access to various large ethnic communities seeking to make international phone
calls. Through this network we also distribute our products in the Dallas, Houston, Chicago, New
York City, Newark, and Miami markets. We plan to use this network in 2005 to sell our proprietary
VoIP products. Affiliates and Resellers.We offer individuals and businesses the opportunity to become
resellers of our services through our reseller program. Resellers are able to purchase at reseller
specific rates and are then able to resell these accounts to private individuals under their own
brand. Other Methods.During 2004, we placed advertisements in certain Indian foreign national based
periodicals and television channels to market our telephony products and services. We will continue
to use these methods during 2005, as we deem necessary. We will continually review other potential
cost-effective methods of advertising and marketing our products and services through the Internet
and other channels. Such methods may include the use of chat rooms, video email, ethnic movie
houses, ethnic cable television, direct mail, and other methods. 9




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Customer Support and Service We believe our ability to establish and maintain long-term relationships with our customers
and encourage repeat purchases is dependent, in part, on the strength of our customer support and
service operations and staff. Our retail telephony products come with a 100% satisfaction
guarantee. If a customer is unhappy with their service, we will refund the remaining balance on
their virtual calling card or plan. Our primary multilingual customer support team in Dallas, Texas
provides email, live-chat, and telephone customer support. We also provide customer service and
technical support directly to our resellers and to the customers of our resellers. Also, we have an
outsourced New Delhi, India customer service team which answers sales related questions seven days
a week. We estimate we resolve 95% of all email inquiries within 24 hours and that on average, we
respond to customer calls within 60 seconds. Government Regulation Regulation of the Internet.The United States Congress and the Federal courts have adopted
legislation that regulates certain aspects of the Internet, including online content, user privacy,
taxation, liability for third-party activities, and jurisdiction. In addition, a number of
initiatives pending in Congress and state legislatures would prohibit or restrict advertising of or
sale of certain products and services on the Internet, which may have the effect of raising the
cost of doing business generally on the Internet. The European Union has also enacted several
directives relating to the Internet, one of which addresses online commerce. In addition, federal,
state, local and foreign governmental organizations are considering other legislative and
regulatory proposals that would regulate the Internet. Increased regulation of the Internet may
decrease growth, which may negatively impact the cost of doing business via the Internet or
otherwise materially adversely affect our business, financial condition, and results of operation. Potential Regulation of Internet Telephony.To our knowledge, there are currently no
domestic and few international laws or regulations that prohibit the transmission of voice
communications over the Internet. If Congress, the FCC, state regulatory agencies or governments
of other countries impose substantial regulations relating to Internet telephony, the growth of our
business could be adversely affected. In the United States, several efforts have been made to enact
federal legislation that would either regulate or exempt from regulation telecommunication services
provided over the Internet. State public utility commissions may also attempt to regulate the
provision of intrastate Internet telephony services. However, the FCC has issued two decisions that
suggest that all transmissions over the Internet may be jurisdictionally interstate, and these
decisions may restrict the ability of state public utility commissions to regulate Internet
telephony. Recently, however, a Colorado court ruled that Internet telephony companies would be
subject to payment of originating and terminating access charges to the incumbent provider.
Imposition of such charges on our services would increase our costs. Internationally, a number of
countries that currently prohibit competition in the provision of voice telephony have also
prohibited Internet telephony. Other countries permit but regulate Internet telephony. On April 10, 1998, the FCC issued a Report to Congress concerning its implementation of the
universal service provisions of the Telecommunications Act. In the Report, the FCC indicated that
it would examine the question of whether any forms of phone-to-phone Internet Protocol telephony
are information services, which are unregulated, or telecommunications services, which are fully
regulated. The Report noted that the FCC did not have, as of the date of the Report, an adequate
record on which to make any definitive pronouncements. The FCC did, however, note that the record
before it suggested that some forms of phone-to-phone Internet telephony appear to have the same
functionality as non-Internet Protocol telecommunications services. While the FCC found that it needed a more complete record to establish new rules, it
tentatively concluded that providers of phone-to-phone Internet telephony services should be
treated like other providers of telephone service. This means they should be required to make
payments into Federal universal service subsidy programs. To date, the FCC has taken no further
action, and has not imposed this obligation on Internet telephony providers. It may do so at some
time in the future, however, and such a decision could have a material adverse effect on our
business, increasing our costs and the price at which we can offer our Internet telephony services. 10




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There are several proceedings pending before the FCC that may affect the regulatory status of
Internet telephony. On October 18, 2002, AT&T filed a petition with the FCC seeking a declaratory
ruling that would prevent incumbent local exchange carriers, or ILECs, from imposing traditional
circuit-switched access charges on phone-to-phone IP services. On February 5, 2003, pulver.com
filed a petition with the FCC seeking a declaratory ruling that its Free World Dialup, which
facilitates point-to-point broadband Internet protocol voice communications, is neither
telecommunications nor a telecommunications service as these terms are defined in section 153 of
the Telecommunications Act of 1996. On February 19, 2004 the FCC issued an order holding that Free
Wrold Dialup is more properly classified as an information service and not subject to regulations
governing traditional telecommunications providers. Vonage has filed a petition for declaratory
ruling requesting that the FCC find an Order of the Minnesota Public Utilities Commission (MNPUC)
requiring Vonage to comply with state laws governing providers of traditional telephone service to
be preempted because Vonages broadband Internet telephony service is an information service. In
November 2004, the FCC concluded that Vonages DigitalVoice service is not subject to
certification, tariffing and E911 requirements that the MNPUC otherwise imposes on intrastate
telecommunications carriers. The Commission, however, limited its decision to Vonages DigitalVoice
service and services similar to DigitalVoice and certain state regulatory obligations. Outstanding
questions regarding the regulatory classification of VoIP and other IP-enabled services and whether
these services are subject to universal service obligations, intercarrier compensation, public
safety requirements, access to services by disabled persons, and the Communications Assistance for
Law Enforcement Act (CALEA) will be addressed in other pending FCC proceedings. These
petitions and subsequent industry reactions may exert pressure on the FCC to render a decision
regarding the regulation of phone-to-phone IP services. The FCC could determine that certain types
of Internet telephony should be regulated like basic interstate telecommunications services. Thus,
Internet telephony would no longer be exempt from the access charge regime that permits local
telephone companies to charge long distance carriers for the use of the local telephone networks to
originate and terminate long-distance calls. Recently one of our Internet telephony competitors was sued by a state government for
providing false, misleading and confusing information regarding how 911 services work for broad
band phone service. We cant predict what impact this will make on our RocketVoIP service which
currently does not include 911 service. The FCC could also conclude that Internet telephony providers should contribute to the
Universal Service Fund, which provides support to ensure universal access to telephone service. The
imposition of interstate access charges or universal service contributions would substantially
increase our costs of serving our customers in the U.S. and may diminish the incentives for
companies to continue to develop IP technologies to offer VoIP services. We cannot predict what
regulations, if any, the FCC will impose. In July 2004, the Internal Revenue Service issued an Advance Notice of Proposed Rulemaking to
examine proposing regulations that would revise the existing Federal Excise Tax requirements to
reflect changes in communications technologies that could impact us. Additionally, there are
several amendments to the Internet Tax Freedom Act, or ITFA, pending in the federal legislature
that aim to expressly exclude VoIP from the tax freedom enjoyed by Internet services under the
ITFA. There are also at least two states that have passed legislation that could be interpreted to
impose taxes on VoIP services such as ours. Regulation of Telecommunication Carriers.When we purchase long distance telephone capacity
from third-party carriers, we rely on them to comply with local laws and regulations. We have no
control over the manner in which these companies operate in these countries. Foreign regulatory,
judicial, legislative or political entities may raise issues regarding the compliance of these
companies with local laws or regulations, or limit their ability to carry our calls. State Laws.Several states have also proposed legislation that would limit the uses of
personal user information gathered online or require online services to establish privacy policies.
Changes to existing laws or the passage of new laws intended to address these issues could reduce
demand for our services or increase the cost of doing business. In addition, because our services
are accessible worldwide, and we facilitate the sale of goods to users worldwide, other
jurisdictions may claim that we are required to comply with their laws. We are qualified to do
business in the United States, and failure by us to qualify as a foreign corporation in a
jurisdiction where we are required to do so could subject us to taxes and penalties for the failure
to qualify and could result in our inability to 11




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enforce contracts in such jurisdictions. Any such new legislation or regulation, or the application
of laws or regulations from jurisdictions whose laws do not currently apply to our business, could
have a material adverse effect on our business, financial condition and operating results. Sales Taxes.We do not currently collect sales or other similar taxes for telephony services
or other services sold through our Web sites, other than for telephony services sold to Texas
residents. However, one or more states may seek to impose sales tax or similar collection
obligations on out-of-state companies, such as ours, which engage in Internet commerce. A number of
proposals have been made at the state and local level that would impose additional taxes on the
sale of goods and services through the Internet. Such proposals, if adopted, could substantially
impair the growth of online commerce, and could adversely affect our opportunity to derive
financial benefit from such activities. Moreover, a successful assertion by one or more states or
any foreign country that we should collect sales or other taxes on the sale of telephony services
or services on our system could have a material adverse effect on our operations. Competition The market for enhanced VoIP services is new and rapidly evolving. An increasing number of
large, well-capitalized companies are entering the market for Internet telephony products and
services. As a result, we may not be able to compete effectively with our competitors in this
market, or to increase our customer base. Various major long distance providers, including AT&T,
Verizon and Deutsche Telekom AG, as well as other major companies, including Comcast and AOL-Time
Warner, Inc., have all entered or plan to enter the Internet telephony market, in some cases by
investing in companies engaged in the development of Internet telephony products. These and other
competitors may be able to bundle services and products that are not offered by us together with
VoIP communication services that could place us at a significant competitive disadvantage. Many of
our competitors enjoy economies of scale that can result in lower cost structure for transmission
and related costs that could cause significant pricing pressures. Our competitors also include a number of companies that have introduced services that make
Internet telephony solutions available to businesses and consumers. Net2Phone, AT&T, Delta Three,
ITXC Corp., Packet8, Inc. and Vonage Holdings provide a range of Internet telephony services to
consumers and businesses that are similar to the ones we offer. We also compete in the growing market of discounted international telecommunication services,
including calling cards, prepaid cards, dial around calling and other calling services. We compete
with many of the largest telecommunications providers, including AT&T, MCI WorldCom and Sprint.
These companies are substantially larger and have greater financial, technical, engineering,
personnel and marketing resources, longer operating histories, greater name recognition and larger
customer bases than we do. We also compete with smaller, emerging carriers in the prepaid calling
card market, and with various smaller companies who resell virtual calling cards provided by other
carriers through their web sites. We may also compete with large operators in other countries.
These companies may have larger, more established customer bases and other competitive advantages. We cannot be certain we will be able to compete successfully against current and future
competitors. As a strategic response to changes in the competitive environment, we may, from time
to time, make pricing, service or marketing decisions that could have a material adverse effect on
our business, financial condition and operating results. New technologies and the expansion of existing technologies may increase competitive pressures
by enabling our competitors to offer lower-cost services. Certain Web-based applications that
direct Internet traffic to other Web sites may channel users to services which compete with us. In
addition, companies that control access to transactions through network access or Web browsers
could promote our competitors or charge us substantial fees for inclusion. The occurrence of any of
these events could have a material adverse effect on our business, financial condition and
operating results. 12




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Intellectual Property and Other Proprietary Rights Our success depends in part upon our ability to protect our proprietary technology and other
intellectual property rights. We rely on a combination of copyright, trademark, service mark and
trade secret laws and contractual restrictions to establish and protect our proprietary rights in
our products and services. We protect our proprietary software through United States copyright
laws, and the source code for our proprietary software is protected under trade secret laws.
Effective trademark, service mark, copyright and trade secret protection may not be available in
every country in which our services are made available online, and thus, the steps that we take may
be inadequate to protect our rights. We cannot assure you that we will be issued any of these
trademarks and may find that such marks are unavailable. We have entered into confidentiality and assignment agreements with our employees and
contractors, and nondisclosure agreements with parties with whom we conduct business. We do this in
order to limit access to and disclosure of our proprietary information. These agreements are
designed to make it clear that we own any technology developed by our employees and contractors
during their engagement by us and to protect us against unauthorized disclosure of our proprietary
information. We cannot assure you that these contractual arrangements or the other steps taken by
us to protect our intellectual property will prove sufficient. To date, we have not actively
policed unauthorized use of our technology. This is because the global nature of the Internet makes
it difficult to control the ultimate destination or security of software or other data transmitted. We rely upon certain technology, including hardware and software, licensed from third parties.
There can be no assurance that the technology licensed by us will continue to provide competitive
features and functionality or that licenses for technology currently utilized by us or other
technology which we may seek to license in the future will be available to us on commercially
reasonable terms or at all. The loss of, or inability to maintain existing licenses could result in
shipment delays or reductions until equivalent technology or suitable alternative products could be
developed, identified, licensed and integrated, and could harm our business. These licenses are on
standard commercial terms made generally available to us by the companies providing the licenses.
The cost of these licenses individually are not material to our business. In the future, we may license certain of our proprietary rights to third parties. While we
will attempt to ensure the quality of the WQN brand is maintained by such licensees, we cannot
assure you that such licensees will not take actions that might materially adversely affect the
value of our proprietary rights or reputation, and have a material adverse effect on our business,
financial condition and operating results. We also rely on certain technologies that we license
from third parties. These may include suppliers of key database technology, enhanced services
platforms, gateway server platforms, operating systems and specific hardware components for our
service. We cannot assure you that these third-party technology licenses will continue to be
available to us on commercially reasonable terms. The loss of such technology could require us to
obtain substitute technology of lower quality or performance standards or at greater cost, which
could materially adversely affect our business, financial condition and operating results. Research and Development We consider the amounts spent by us for research and development during 2004 and 2003 to be
immaterial. Environmental Matters Environmental contingencies are not expected to have a material adverse effect on our results
of operations or financial condition. Employees As of December 31, 2004, we had 22 full-time employees. None of our employees are represented
by a labor union. We have not experienced any work stoppages and consider our employee relations to
be good. 13




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ITEM 2. DESCRIPTION OF PROPERTY Our executive offices are located in Dallas, Texas, where we lease approximately 6,200 square
feet under a lease at a monthly rental of approximately $9,400 that expires August 31, 2006. We
also have a network hub in Dallas, Texas under a co-location arrangement at a monthly rental of
approximately $10,400. We believe our space is adequate for our current needs. As we expand, we
expect that suitable additional space will be available on commercially reasonable terms, although
no assurance can be made in this regard. We also believe our property is adequately covered by
insurance. 
 ITEM 3. LEGAL PROCEEDINGS In December 1996, the Company applied to the United States Patent and Trademark Office to
register the trademarks: WorldQuest and WorldQuest Networks. We received a registration for
the trademark WorldQuest from the U.S. Patent and Trademark Office on November 23, 1999. In
October 1997, the Patent and Trademark Office issued a notice of publication regarding our
application to register WorldQuest Networks as a trademark. In response to that notice, Qwest
Communications filed a notice of opposition in September 1998. Qwest Communications instituted a
cancellation proceeding in the Patent and Trademark Office for the registered trademark
WorldQuest. In December 2001, a judgment was made in the Companys favor whereby Qwests motion
to cancel our WorldQuest trademark was dismissed, however, Qwest filed a motion appealing the
judgment. In December 2002, Qwest filed a separate complaint stating that the Companys prepaid
cash card product infringes on the Qwest trademark. In February 2003, the companies settled all
outstanding claims whereby WorldQuest received a cash payment and telecommunication services
(primarily long distance termination) from Qwest and Qwest retained all rights to the trademarks in
question. Pursuant to the term of a settlement agreement with Qwest Communications arising out of
a trademark dispute, on November 9, 2004 the Company changed its name to WQN, Inc. from WorldQuest
Networks, Inc. In September 2004, the Company settled a dispute with a vendor from which it had purchased
telecommunication services. Under the terms of the settlement, the Company agreed to purchase from
the vendor a total of $960,000 in telecommunication services at rates less than the Company is
paying for similar services over a fourteen month period. The Company must purchase a minimum of
$80,000 per month in services beginning in the month that is four months after the settlement date. The Company is a defendant from time to time in lawsuits and disputes arising in the ordinary
course of business. The Company believes that resolution of all known contingencies is uncertain,
and there can be no assurance that future costs related to such litigation would not be material to
the Companys financial position or results of operations. 14




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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The annual meeting of WQNs stockholders was held on November 11, 2004. The following matters
were submitted to our stockholders for their vote and the results of the vote taken at the meeting
were as follows: 1. At the meeting, the directors named below were elected to hold office until the 2005
annual meeting of stockholders or until their successors are elected and qualified. Following is a
tabulation of the votes relating to the election of directors: Shares voted
    
    
    Shares voted
    
    
    SharesName
    
    for
    
    
    against
    
    
    withheldB. Michael Adler
    
    
    3,810,293
    
    
    
    
    
    
    
    14,800Robert A. Farmer
    
    
    3,807,083
    
    
    
    
    
    
    
    18,010E. Denton Jones
    
    
    3,810,293
    
    
    
    
    
    
    
    14,800Elizabeth M. Buchler
    
    
    3,810,293
    
    
    
    
    
    
    
    14,800Hal H. Bibee
    
    
    3,810,293
    
    
    
    
    
    
    
    14,800
 2. The amendment of the Companys Certificate of Incorporation to change the name from
WorldQuest Networks, Inc. to WQN, Inc. was ratified by a vote of 3,814,117 for ratification,
15,876 against and 9,900 abstaining. 3. The appointment of Grant Thornton LLP as the Companys independent public accountants was
ratified by a vote of 3,821,692 shares for ratification, 12,201 against and 6,000 abstaining. 
 PART II 
 ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS WQNs Common Stock trades on the NASDAQ National Market under the symbol WQNI. The
following table sets forth the per share range of high and low sales prices of our Common Stock for
the periods indicated: High
    
    
    LowYear ended December 31, 2004First Quarter
    
    $
    7.65
    
    
    $
    3.01Second Quarter
    
    $
    5.38
    
    
    $
    2.35Third Quarter
    
    $
    3.70
    
    
    $
    1.84Fourth Quarter
    
    $
    3.80
    
    
    $
    1.98Year ended December 31, 2003First Quarter
    
    $
    2.40
    
    
    $
    1.86Second Quarter
    
    $
    2.75
    
    
    $
    1.85Third Quarter
    
    $
    4.00
    
    
    $
    2.16Fourth Quarter
    
    $
    3.55
    
    
    $
    2.79
 As of February 28, 2005, there were approximately 28 stockholders of record of our Common
Stock and approximately 1,200 additional beneficial owners of our Common Stock. 15




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Equity Compensation Plan Information Shown below is information concerning all equity compensation plans and individual
compensation arrangements in effect as of December 31, 2004. Equity Compensation Plan InformationNumber ofSecuritiesNumber of
    
    
    
    
    
    
    RemainingSecurities To Be
    
    
    Weighted
    
    
    Available ForIssued Upon
    
    
    Average Exercise
    
    
    Future IssuanceExercise of
    
    
    Price of
    
    
    Under EquityOutstanding
    
    
    Outstanding
    
    
    CompensationPlan Category
    
    Options
    
    
    Options
    
    
    PlansEquity compensation
plans approved by
security
holders
    
    
    852,984
    
    
    $
    4.11
    
    
    
    611,020
 Dividend Policy We have never paid cash dividends on our Common Stock and anticipate that we will continue to
retain our earnings, if any, to finance the growth of our business. Use of Proceeds of Initial Public Offering The effective date of our first registration statement, filed on Form SB-2 under the
Securities Act of 1933 (no. 333-93019) relating to our initial public offering of our Common Stock,
was February 4, 2000. A total of 3,162,500 shares of our Common Stock were sold at a price of
$13.00 per share. Net proceeds to WQN were $36.3 million. From the time of receipt through
December 31, 2004 the net proceeds were applied toward:  
    repayment of indebtedness, $4,498,000;
    equipment purchases including additional back-up systems, $4,598,000;
    software development, $990,000; and
    investments, $3,000,000;
    merger and acquisition related, $3,232,000;
    general corporate purposes, including payment of outstanding payables, payoffs
of capital leases, liability insurance premiums, development of strategic
relationships and research and development of new products, $10,040,000. The remaining proceeds are being used as working capital or are being held in high quality,
short-term investment instruments such as short-term corporate investment grade or United States
Government interest-bearing securities. Of the $4,498,000 paid for repayment of indebtedness, $1,440,000 was paid to Eagle Venture
Capital, LLC, which owns approximately 38% of our Common Stock and is controlled by B. Michael
Adler, our former Chairman of the Board and current Chief Executive Officer and President. 16




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ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS The following discussion of the financial condition and results of operations of WQN, Inc.
should be read in conjunction with the Managements Discussion and Analysis or Plan of Operation
(including Risk Factors That May Affect Results of Operations and Financial Condition) and the
Consolidated Financial Statements and the Notes thereto included in the Companys Annual Report on
Form 10-KSB for the year ended December 31, 2004. Forward-Looking Statements Certain statements in this report, including statements of WQNs and managements
expectations, intentions, plans and beliefs, including those contained in or implied by
Managements Discussion and Analysis or Plan of Operation and the Notes to Condensed Consolidated
Financial Statements, are forward-looking statements, within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended (the Exchange Act), that are subject to certain
events, risks and uncertainties that may be outside WQNs control. These forward-looking statements
include statements of managements plans and objectives for WQNs future operations and statements
of future economic performance, information regarding our expansion and possible results from
expansion, our expected growth, our capital budget and future capital requirements, the
availability of funds and our ability to meet future capital needs, the realization of our deferred
tax assets, and the assumptions described in this report underlying such forward-looking
statements. Actual results and developments could differ materially from those expressed in or
implied by such statements due to a number of factors, including, without limitation, those
described in the context of such forward-looking statements, our expansion and acquisition
strategy, our ability to achieve operating efficiencies, our dependence on network infrastructure,
capacity, telecommunications carriers and other suppliers, industry pricing and technology trends,
evolving industry standards, domestic and international regulatory matters, general economic and
business conditions, the strength and financial resources of our competitors, our ability to find
and retain skilled personnel, the political and economic climate in which we conduct operations and
the risk factors described from time to time in our other documents and reports filed with the
Securities and Exchange Commission (the Commission). Overview We are a Voice Over Internet Protocol (VoIP) telephony company providing international long
distance services. VoIP enables voice communications over the Internet by compressing voice into
data packets that can be efficiently transmitted over data networks and then converted back into
voice at the receiving end. Our customers utilize our enhanced VoIP services platform to make and
receive calls using their home phone, business phone, personal computer and mobile phone. Our business currently includes the provision of enhanced Internet-based and other telephony
services under various brand names to individual consumers primarily seeking to make international
calls; the provision of enhanced Internet-based and other telephony services to resellers,
corporations and service providers under their brand names and carrier transmission services
whereby we sell our excess capacity to other long-distance carriers. We also distribute telephony
services including prepaid long distance and prepaid wireless through a network of over 90 private
distributors. Through this network we estimate that our products are sold through over 10,000
retail outlets of which more than 5,000 retail outlets are located in Southern California. We
expect to begin selling our proprietary VoIP products through this distribution channel beginning
in 2005. As of December 31, 2004, Eagle Venture Capital, LLC (Eagle Venture) owned approximately 2.6
million, or 38%, of our outstanding shares of common stock. Eagle Venture is primarily owned by B.
Michael Adler, our founder and Chief Executive Officer. In November 2004, we changed our name to WQN, Inc. from WorldQuest Networks, Inc. (see Item
3-Legal Proceedings in Part I of this Report). Our primary source of revenue is the fees that we receive from our telephony customers for
completing calls over our network and from the sale of telephony products to our network of
distributors. Our Internet telephony 17




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revenue is dependent on the volume of voice traffic carried over the network, which is measured in
terms of minutes of voice traffic and the fees per minute of traffic we charge our customers. We
recognize this revenue in the period in which the call is completed. We bill our retail customers
on a prepaid basis through credit cards. Our revenue from the sale of telephony products to our
distributors is included as wholesale telephony revenue. We provide some of our credit worthy
wholesale customers with terms that generally allow them to pay for our products within two weeks.
All other wholesale customers pay for our products upfront. Cost of telephony revenue consists primarily of data communication and telecommunication
expenses to terminate long distance traffic over our networks, which vary proportionately with the
volume of traffic carried over our network. These costs include Internet related expenses to send
voice traffic over the Internet, fees we pay to terminate calls, fees we pay to utilize the
traditional telephone network to terminate our calls, expenses incurred to connect our customers to
our network, and fees we pay to other service providers for the purchase of telecom and other
products which we distribute. Selling, general and administrative expenses consist of advertising and promotional
expenditures including telemarketing services of the Indian based call center, payroll and related
expenses for executive and administrative personnel, facilities expenses, professional services
expenses, travel and other general corporate expenses. Factors Affecting Future Results Industry and Economic Factors:Our operations and earnings are affected by local, regional and
global events or conditions that affect supply and demand for telecommunications products and
services. These events or conditions are generally not predictable and include, among other things,
general economic growth rates and the occurrence of economic recessions; the development of new
supply sources; supply disruptions; technological advances, including advances in
telecommunications technology and advances in technology relating to telecommunications usage;
changes in demographics, including population growth rates and consumer preferences; and the
competitiveness of alternative telecommunications sources or product substitutes. Currently, the
economy in general and the telecommunications industry in particular are suffering. A number of the
leading telecommunications companies have seen their market capitalizations decrease dramatically
and some have filed for bankruptcy protection. As a result, raising capital has become extremely
difficult, there is extreme pressure on the pricing of telecommunications services and potential
customers and partners have sharply cut back on expenditures, all of which impact us. Competitive Factors:The telecommunications industry is highly competitive. There is
competition within the traditional telecommunications marketplaces (landline and wireless) and also
with other emergent next generation telecommunications providers, including IP telecommunications
providers in supplying the overall telecommunications needs of businesses and individual consumers.
We compete with other telecommunications firms in the sale and purchase of various products and
services in many national and international markets and employ all methods of competition which are
lawful and appropriate for such purposes. A key component of our competitive position, particularly
given the commodity-based nature of many of our products, is our ability to manage operating
expenses successfully, which requires continuous management focus on reducing unit costs and
improving efficiency. Political Factors:Our operations and earnings have been, and may in the future be, affected
from time to time in varying degree by political instability and by other political developments
and laws and regulations, such as forced divestiture of assets; restrictions on production, imports
and exports; war or other international conflicts; civil unrest and local security concerns that
threaten the safe operation of company facilities; price controls; tax increases and retroactive
tax claims; expropriation of property; cancellation of contract rights; and telecommunications
regulations. Both the likelihood of such occurrences and their overall effect upon us vary greatly
from country to country and are not predictable Project Factors:In addition to the factors cited above, the advancement, cost and results of
particular projects depend on the outcome of negotiations with potential partners, governments,
suppliers, customers or others; changes in operating conditions or costs; and the occurrence of
unforeseen technical difficulties. 18




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Risk Factors:See Risk Factors below for discussion of the impact of market risks,
financial risks and other uncertainties 2004 Developments Discontinued Operations In July 2004, the Company sold all of the outstanding capital stock in its wholly-owned
subsidiary buyindiaonline.com, Inc. (Cash2India) to a private company for approximately
$1,552,000. Under the terms of the transaction, the Company received $852,000 in cash, a
promissory note for $700,000, and a warrant to purchase common stock in the acquiring company.
The cash payment included consideration for $352,000 in working capital associated with Cash2India
at the time of the sale. The promissory note bears interest at 5% per annum, is secured by the
capital stock of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of
$29,167 plus accrued interest. The balance of the promissory note and accrued interest was $554,167
as of December 31, 2004. Cash2India is accounted for as a discontinued operation in the
accompanying consolidated financial statements. Merger Agreement with Ntera Holdings On March 16, 2004, the Company entered into an Agreement and Plan of Merger (the Agreement)
with Ntera Holdings, Inc., a Delaware corporation (Ntera), providing for a transaction that would
have resulted in a change of control of WQN. In connection with the Agreement, WQN extended to
Ntera a bridge loan in the principal amount of $2 million bearing interest of 7% per annum, which
is secured by the assets of Ntera. On September 2, 2004 the Company terminated the Agreement with
Ntera. Under the terms of the loan agreement, the full amount of the loan and accrued interest are
due and payable within six months of the termination of the Agreement. The Company and Ntera have
amended the repayment provisions of the loan agreement whereby Ntera will make installment payments
to repay the loan and accrued interest by March 31, 2005. The balance of the note and accrued
interest at December 31, 2004 was $2,058,679, which is net of a payment of approximately $56,000
received during 2004 in the form of telecommunication services. During the first quarter of 2005
the Company received debt payments from Ntera totaling $1,650,000. The unpaid principal and
interest as of March 1, 2005 from Ntera was $408,679 and is expected to be collected on its due
date. The loan is secured by the assets of Ntera. Value Communications Transaction In April 2004, the Company purchased from Value Communications Corporation (ValuCom), a
wholly owned subsidiary of Rediff.com India Limited, certain assets consisting primarily of
ValuComs customer list, brand, trademarks, web sites, internally built software, and certain
hardware for $500,000. The Company paid $200,000 of the total consideration at closing with the
remaining $300,000 to be paid in twelve monthly installments of $25,000 commencing May 2004. In
addition, the Company entered into an advertising agreement with Rediff.com, Inc. (Rediff)
entitling WorldQuest to marketing services including exclusive rights to prominent online
advertising space on the Rediff.com U.S website, the premier online destination for Indians in
North America. Under the terms of the advertising agreement, the Company will pay Rediff $50,000
for twelve consecutive months commencing in May 2004 for the advertising services. The Company
provided both ValuCom and Rediff irrevocable letters of credit for the Companys remaining
obligation under the agreements. The letters of credit are secured by deposits in money market
funds and the amount of the letters of credit and the security deposits are reduced as the monthly
installments are paid. At December 31, 2004, the Companys obligation under both the agreements
totaled $300,000. Substantially all of the ValuCom purchase consideration was allocated to
customer lists, which is included in other long-term assets. Distribution and Marketing Agreement In September 2004, we entered into a distribution and marketing agreement with a privately
held company. As a result of the agreement, the Companys products will be sold in more than 5,000
retail outlets in the Southern California market. We sell telephony and other products to a
network of distributors who then re-sell the product to the retail outlets. The revenues generated
through this agreement are included in wholesale telephony revenues. 19




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Critical Accounting Policies Financial Reporting Release No. 60 recommends that all companies include a discussion of
critical accounting policies used in the preparation of their financial statements. The Companys
significant accounting policies are summarized in Note 2 of its consolidated financial statements
included in the Companys Annual Report on Form 10-KSB for the year ended December 31, 2004. While
all these significant accounting policies impact its financial condition and results of operations,
the Company views certain of these policies as critical. Policies determined to be critical are
those policies that have the most significant impact on the Companys financial statements and
require management to use a greater degree of judgment and/or estimates. Actual results may differ
from those estimates. The Company believes that given current facts and circumstances, it is
unlikely that applying any other reasonable judgments or estimate methodologies would cause a
material effect on the Companys consolidated results of operations, financial position or
liquidity for the periods presented in this report. The accounting policies identified as critical
are as follows: Revenue Recognition The Company recognizes revenues in accordance with generally accepted accounting principles as
outlined in SAB No. 101 which requires that four basic criteria be met before revenue can be
recognized: (1) persuasive evidence of an arrangement exists, (2) product delivery, including
customer acceptance, has occurred or services have been rendered, (3) the price is fixed or
determinable and (4) collectibility is reasonably assured.
Retail telephony revenue is recorded net of estimated returns and
allowances and is recognized as calling services are used. Wholesale
traffic revenue is recognized as calls are processed. Revenue on the
distribution of telephony products is included in wholesale telephony
revenue, is recorded net of estimated returns and allowances and is
recognized when the products are shipped to the customer. A substantial portion of the Companys revenues is derived from the sale of
prepaid phone cards that terminate in India. Property and Equipment Property and equipment are depreciated over their useful lives. Useful lives are based on
managements estimates of the period that the assets will generate revenue. Any change in
conditions that would cause management to change its estimate as to the useful lives of a group or
class of assets may significantly impact the Companys depreciation expense on a prospective
basis. Web Site Development Costs Our products and services are sold predominantly through our web sites. We incur costs to
maintain and add new functionality to our existing web sites and to develop new web sites. Costs
related to the planning and post implementation phases of our web site development efforts are
expensed. Direct costs incurred in the development phase are capitalized and amortized over the
products estimated useful life of one to three years, which is included in depreciation expense.
Costs associated with minor enhancements and maintenance for web sites are expensed. Income Taxes As of December 31, 2004, we had approximately $25,104,000 of net operating loss carry forwards
for federal income tax purposes, which expire beginning in 2011. We have not recognized an income
tax benefit for our losses because of uncertainty regarding future realizability and we have
provided a full valuation allowance on our deferred tax assets. Off-Balance Sheet Arrangements The Company does not have any off-balance sheet arrangements to report for the years ended
December 31, 2004 and 2003. 20




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Results of Operations Year Ended December 31, 2004 Compared to Year Ended December 31, 2003 Revenue Revenue increased approximately 63% to $15,264,000 for the year ended December 31, 2004 from
$9,359,000 for the year ended December 31, 2003. This $5,905,000 increase is attributable to a
$6,021,000 increase in wholesale telephony revenue partially offset by a $116,000 decrease in
retail telephony revenue. The increase in wholesale telephony revenue is primarily attributable to
a distribution and marketing agreement we entered into in September 2004 giving the Company
distribution to more than 5,000 retail locations in Southern California. During 2004, the majority
of the wholesale telephony revenue was from the sale of telephony product we purchased from other
providers. In 2005 we expect to purchase less products from these providers as we begin selling our
proprietary VoIP telephony products through this distribution channel. The decrease in retail
telephony is primarily attributable to a decrease in the average price per minute we charge our
customers reflecting an overall market decrease in price charged for calls to international
destinations partially offset by an increase in the minutes of use for our services. Overall, our
minutes of use have increased approximately 10% to 55.7 million minutes for the year ended December
31, 2004, up from 50.6 million minutes for the year ended December 31, 2003. A substantial portion of our retail telephony customers are calling from the United States to
India. The Indian international telephony market continues to experience downward pricing pressures
and it is unlikely that this trend will reverse in the near future. Cost of Revenue Cost of revenue increased approximately 91% to $13,388,000 for the year ended December 31,
2004 from $7,009,000 for the year ended December 31, 2003. This $6,379,000 increase is due
primarily to a shift in revenue mix whereby lower margin wholesale revenue comprised 41% of total
revenues in 2004 compared to 2% in 2003. Our gross profit percentage was approximately 12% during
the year ended December 31, 2004, a decrease from approximately 25% in the year ago
period. The decrease in gross profit percentage during the 2004 period was primarily due to the
addition of lower margin wholesale telephony revenue. During the year ended December 31, 2004,
wholesale telephony revenue consisted primarily of reselling other carriers products. In the next
few months we will be selling our higher margin proprietary VoIP telephony products through this
distribution channel. Excluding the wholesale operations, our gross profit margin for the year
ending December 31, 2004 was approximately 19%. The decrease in
our retail gross profit margin from approximately 25% in 2003 was
primarily attributable to a decrease in the average selling price per minute without a
corresponding decrease in the average termination price per minute. Selling, General and Administrative Selling, general and administrative expenses decreased approximately 18% to $3,717,000 for the
year ended December 31, 2004 from $4,518,000 for the year ended December 31, 2003. This $801,000
decrease is due primarily to lower personnel costs associated with the Companys efforts to
concentrate on its core Internet telephony business. Selling, general and administrative expenses
for the year ended December 31, 2004 include a benefit of $139,000 in connection with the
settlement of various disputes and an impairment charge of approximately $60,000 related to certain
stored value equipment that is no longer in use. Selling, general and administrative expenses for
the 2003-period include a benefit of $421,000 in connection with the Companys Qwest (see Item
3-Legal Proceedings in Part I of this Report) and other legal settlements. Excluding the impact of
these items, our selling, general and administrative expenses decreased by
approximately 22% or $1,083,000 from 2003. We expect selling, general and administrative expenses
to increase in absolute dollars, but decrease as a percentage of revenue, as we continue to pursue
advertising and marketing efforts and incur additional costs related to the growth of our business. 21




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Merger Expenses For the year ended December 31, 2004 we incurred merger expenses of approximately $1,312,000
primarily for: legal fees ($519,000), investment banking fees ($134,000), severance and other
personnel cost ($574,000), accounting fees ($27,000), and other administrative expenses ($58,000)
associated with the previously announced Ntera Holdings, Inc. merger agreement (see Item 6 - Merger
Agreement with Ntera Holdings). Depreciation and Amortization Depreciation and amortization decreased approximately 14% to $796,000 for the year ended
December 31, 2004 from $922,000 for the year ended December 31, 2003. This $126,000 decrease in
depreciation and amortization is primarily attributable to certain depreciable assets becoming
fully depreciated in 2003 partially offset by higher depreciation due to an increase in
depreciable assets in the second quarter of 2004 in connection with the acquisition of the ValuCom
assets. Interest Income, Net Interest income, net consists of interest earned on cash and cash equivalents and notes less
interest expense on borrowings. Interest earned on cash and cash equivalents and notes was $293,000
for the year ended December 31, 2004 and $207,000 for the year ended December 31, 2003. The
increase is due primarily to interest income earned on the bridge loan made to Ntera Holdings, Inc.
in March 2004 and interest income earned on the Companys note receivable from the sale of its
financial services subsidiary. Interest expense for the 2004 period totaled $5,000 compared to
$5,000 in the comparable 2003 period. Loss From Investment In Partnership The Company accounts for its partnership interest under the equity method of accounting and
for the year ended December 31, 2004 recorded a loss from its equity investment of $56,000. Loss From Continuing Operations We incurred a loss from continuing operations of $3,717,000 for the year ended December 31,
2004 compared to a loss of $2,888,000 for the year ended December 31, 2003. The increase in loss
from continuing operations in the 2004 period is primarily attributable to the expenses associated
with the Ntera Holdings, Inc. merger agreement of approximately $1,312,000, a $474,000 decrease in
gross profit, and a loss from its equity investment of $56,000 partially offset by a $801,000
decrease in selling, general and administrative expenses, a $126,000 decrease in depreciation and
amortization, and a $86,000 increase in net interest income. Income/(Loss) From Discontinued Operations The income/(loss) from discontinued operations is due to the sale of the Companys financial
services subsidiary, which comprised the financial services segment (see Discontinued Operations in
Note 3 to the financial statements). For the periods presented, the loss from discontinued
operations were attributable to the loss from operations of the entity. As a result of this
transaction, the Company recorded a gain on the disposition of approximately $777,000 and a loss
from discontinued operations of $234,000 resulting in income from discontinued operations of
$543,000. In 2003, the Company had a loss of $458,000 from
discontinued operations. The reduction in the 2004 year is primarily
because the business was sold during July 2004 and was operated for the
full year in 2003. Liquidity and Capital Resources As of December 31, 2004, we had approximately $9,942,000 of cash and cash equivalents and
working capital of approximately $14,292,000. We generated negative cash flow from operating
activities of approximately $4,232,000 for the year ended December 31, 2004, compared with negative
cash flow from operating activities of approximately $2,384,000 during the year ended December 31,
2003. Net cash used in operating activities for the 2004 and 2003 periods primarily consisted of
net operating losses as well as changes in working capital. The 22




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increase in net cash used in operating activities for the year ended December 31, 2004 is
primarily attributable to the Ntera merger expenses. Net cash used in investing activities was $4,873,000 for the year ended December 31, 2004
compared to $405,000 for the year ended December 31, 2003. The increase in net cash used in
investing activities for the 2004 period is primarily attributable to a $2,000,000 loan made to
Ntera Holdings in connection with the merger agreement, a $3,000,000 investment in a partnership
interest and capital expenditures partially offset by cash proceeds received from the sale of the
financial services subsidiary and note repayments. Net cash used in investing activities for the
year ended December 31, 2003 were attributable to additions to property and equipment. Additions to
property and equipment for the years ended December 31, 2004 and 2003 include $244,000 and
$190,000, respectively of capitalized web site development costs. On September 2, 2004 the Company terminated the Agreement with Ntera. Under the terms of the
loan agreement, the full amount of the loan and accrued interest are due and payable within six
months of the termination of the Agreement. The Company and Ntera have amended the repayment
provisions of the loan agreement whereby Ntera will make installment payments to repay the loan and
accrued interest by March 31, 2005. The balance of the note and accrued interest at December 31,
2004 was $2,058,679, which is net of a payment of approximately $56,000 received during 2004 in the
form of telecommunication services. During the first quarter of 2005 the Company received debt
payments from Ntera totaling $1,650,000. The unpaid principal and interest as of March 1, 2005
from Ntera was $408,679 and is expected to be collected on its due date. The loan is secured by the
assets of Ntera. The $700,000 note received in connection with the sale of the outstanding capital stock of our
wholly-owned subsidiary Cash2India bears interest at 5% per annum, is secured by the capital stock
of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of $29,167 plus
accrued interest. The balance of the promissory note and accrued interest was $554,167 as of
December 31, 2004. In November 2004, the Company invested $3 million in a partnership managed by an affiliate of
a director of the Company. The majority of the partnership assets are to be invested in Private
Investments in Public Entities. The partnership investments will take the form of common equity,
preferred equity, convertible debt and/or equity or debt securities. Although the partnership will
endeavor to engage in hedging transactions in order to mitigate downside risk, there can be no
assurance that the partnerships investments will be successful and, as a result, the Company may
lose all or some of its investment. The partnership agreement contains certain restrictions,
including limits on the Companys ability to withdraw capital from the partnership and limits on
the transferability of the Companys interests in the
partnership. The Company can receive a distribution on its partner
capital account by giving the partnership 60 days written notice. The Company accounts for its
partnership interest under the equity method of accounting and for the year ended December 31, 2004
recorded a loss from its equity investment of $55,757. For the year ended December 31, 2004, the Company has generated cash from financing activities
of $1,115,000 related to the exercise of stock options. The Company has borrowed $300,000 from a financial institution under a term promissory note
agreement (the Note). The Note bears interest at the financial institutions prime rate as
adjusted from time to time (5.25% at December 31, 2004) less 2.25% per annum. The Note is due in
October 2005 and is collateralized by a $300,000 certificate of deposit bearing interest of 1.47%
per annum. The Company provided ValuCom and Rediff irrevocable letters of credit in connection with the
Companys purchase of certain assets from ValuCom and the Companys advertising agreement with
Rediff. The letters of credit are secured by deposits in a money market fund and the amount of the
letters of credit and security deposits are reduced as the monthly installments are paid. At
December 31, 2004, the Companys obligation under both agreements was $300,000. 23




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We believe our existing cash resources will be sufficient to meet our anticipated needs for
working capital and capital expenditure requirements through at least the next 18 months. We may
need to raise additional funds prior to the expiration of such period if, for example, we pursue
business or technology acquisitions or experience operating losses that exceed our current
expectations. If we raise additional funds through the issuance of equity, equity-related or debt
securities, such securities may have rights, preferences or privileges senior to those of the
rights of our common stock and our stockholders may experience additional dilution. We cannot be
certain that additional financing will be available to us on favorable terms or at all. Income Taxes As of December 31, 2004, we had approximately $25,104,000 of net operating loss carry-forwards
for federal income tax purposes, which expire beginning in 2011. We have not recognized an income
tax benefit for our losses because of uncertainty regarding future profitability; therefore, at
December 31, 2004, we have provided a full valuation allowance on our deferred tax assets of
approximately $9,564,000. Limitations on the utilization of these carry-forwards may result if we
experience a change of control, as defined in the Internal Revenue Code of 1986, as amended, as a
result of changes in the ownership or our common stock. Recent Accounting Pronouncements In December 2004, FASB issued statement of Financial Accounting standards No. 123 (revised
2004), Share-Based Payment (SFAS 123R), which will be effective in our first quarter of fiscal
2006. This standard sets forth the revised rules for the accounting treatment of employee stock
options and other share-based payments. SFAS 123(R) requires the adoption a fair value-based
method for measuring the compensation expense related to employee stock awards; this will lead to
additional compensation expense. We currently use the intrinsic value method to measure
compensation expense for stock-based awards to our employees. Under this standard, we do not
recognize any compensation related to stock option grants we issue under our stock option plans.
Note 2 to our Consolidated Financial Statements in this report provides our pro forma net loss and
loss per share as if we had used a fair value-based method prescribed under
SFAS 123 to measure the compensation expense for employee stock awards during fiscal 2004 and
2003. We have not determined the impact of SFAS 123R on these
computations. In addition, the adoption of this standard could limit our ability to continue to use stock
options as an incentive and retention tool, which could, in turn, hurt our ability to recruit
employees and retain existing employees. 24




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Risk Factors That May Effect Results of Operations and Financial Condition You should carefully consider the risks and uncertainties described below and the other
information in this Form 10-KSB. Additional risks and uncertainties not presently known to us or
those we currently deem immaterial may also impair our business, financial condition and operating
results. We have a history of losses and we anticipate future losses and negative cash flow. Since inception, we have incurred operating losses, and as of December 31, 2004, we had an
accumulated deficit of $27,183,000. We incurred net losses of $3,174,000 and $3,345,000 for the
years ended December 31, 2004 and 2003, respectively. We generated negative cash flow of $7,990,000
during 2004 and $2,789,000 during 2003. Our revenues may not grow or even continue at their current level. We will need to increase
our revenues significantly to become profitable or significantly increase our gross profit margins,
however, if our revenues do not increase as much as we expect or if our expenses increase at a
greater pace then revenues, we may not achieve profitability or, if we became profitable, we may
not be able to sustain or increase profitability on a quarterly or annual basis. We may incur
additional costs and expenses in 2005 related to:  
    marketing and advertising related to traffic generation and brand development;
    purchases of equipment for our operations and network infrastructure;
    the continued development of our Web site transaction processing and network infrastructure;
    development and improvement of additional products and services;
    the hiring of additional personnel; and
    evaluating and completing potential acquisitions of other companies. Our financial results could suffer if we are unable to maintain or grow sales levels of
telephony services. We have a significant dependence on key markets. We depend on the sale of telephony services to customers calling from the United States to
India for a significant percentage of our sales volume. For the years ended December 31, 2004 and
2003, 80% and 77% respectively of our total retail telephony sales were to customers calling from
the United States to India. A decrease in the number of our customers calling from the United
States to India, or a decrease in the price per minute charged to these customers could materially
adversely offset our business, financial condition and operating results. We have a limited operating history with which to judge our performance. We were incorporated in October 1996. We began selling prepaid virtual calling cards on our
Web site in May 1998. We began routing calls over our enhanced services platform in August 1998.
Accordingly, we have a limited operating history. We may also encounter risks and difficulties
frequently encountered by early stage companies in new and rapidly evolving markets. We cannot
assure stockholders that our business strategy will be successful or that we will successfully
address these risks. Our failure to do so could materially adversely affect our business, financial
condition and operating results. 25




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Our quarterly operating results are subject to significant fluctuations and our future
operating results are unpredictable. Our operating results are unpredictable and have fluctuated significantly on a quarterly
basis. We expect to continue to experience significant fluctuations in our quarterly results of
operations due to a variety of factors, many of which are outside of our control. As a result,
period-to-period comparisons of our results of operations are not necessarily meaningful and should
not be relied upon as indications of future performance. Because of our limited operating history, we cannot accurately forecast our net sales. We rely
upon limited historical financial data to predict our future operating results. Sales and operating
results are difficult to forecast because they generally depend on the volume of traffic on our
network and the volume and timing of sales of our virtual calling cards. Because of these factors,
we may be unable to adjust our spending in a timely manner to adjust for any unexpected revenue
shortfall. If we do not increase the number visitors to our Web sites we may not be able to grow our
business. We market our telephony services on third-party Web sites, portals and search engines. If we
cannot continue to cost effectively market our telephony services through these channels, our
ability to expand our customer base would be adversely affected. The telecommunications and Internet telephony markets are highly competitive and our failure
to compete effectively could adversely affect us. With respect to prepaid calling cards, we compete with the largest telecommunications
providers in the United States, as well as smaller, emerging carriers. We may also compete with
large operators in other countries. An increasing number of large, well-capitalized companies are
entering the market for Internet telephony products and services. These competitors include a
number of companies that have introduced services that make Internet telephony solutions available
to businesses and consumers, and that permit voice communications over the Internet. Many of our
competitors are substantially larger and have greater financial, technical, engineering, personnel
and marketing resources, longer operating histories, greater name recognition and larger customer
bases than we do. Competition from existing or new competitors could reduce our revenues from the
sale of our virtual prepaid calling cards and other services. A general decrease in
telecommunication rates charged by international long distance carriers could also have a negative
effect on our operations. Our ability to compete also depends on our ability to anticipate and
adapt to rapid technological and other changes occurring in the telecommunications industry. We may not be able to compete with providers that can bundle long distance services with other
offerings. Our competitors may be able to bundle services and products that we do not offer together with
long distance or Internet telephony services. These services could include wireless
communications, voice and data services, Internet access and cable television. This form of
bundling would put us at a competitive disadvantage if these providers can combine a variety of
service offerings at a single attractive price. In addition, some of the telecommunications and
other companies that compete with us may be able to provide customers with lower communications
costs or other incentives with their services reducing the overall cost of their communications
packages, and significantly increasing pricing pressures on our services. This form of competition
could significantly reduce our revenues. 26




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We may be vulnerable to technical malfunctions which could adversely affect our
operations. We depend upon our software systems, communications hardware and enhanced services platform to
conduct our telephony sales and telephone routing, manage our network, track account balances and
perform other vital functions. If we experience substantial technical difficulties with our
hardware or software, we may not succeed in routing traffic effectively, or in tracking account
balances accurately, which could adversely affect our operations. We have experienced periodic
system interruptions, which we believe will continue to occur from time-to-time. Since our
operations depend on our ability to successfully expand our network and to integrate new
technologies and equipment into our network, there is an increased risk of system failure as well
as a natural strain on the system. Our systems may not accommodate significant growth in the number of users which could have a
negative effect on our operations. Our success depends on our ability to handle a large number of simultaneous calls. We expect
that the volume of simultaneous calls will increase significantly as we expand our operations. If
this occurs, additional stress will be placed upon the network hardware and software that manages
our traffic. We cannot assure stockholders of our ability to efficiently manage a large number of
simultaneous calls. If we are not able to maintain an appropriate level of operating performance,
or if our service is disrupted, then we may develop a negative reputation and our business, results
of operations and financial condition would be materially adversely affected. If the Internet telephony and prepaid calling card markets do not gain market acceptance by
potential customers, our business will be adversely affected. We cannot be certain that Internet telephone service will gain market acceptance or prove to
be a viable alternative to traditional telephone service. If the Internet telephony market fails to
develop or develops more slowly than we expect, then our future revenues would be adversely
affected. The market for prepaid calling cards is an emerging business with a large number of market
entrants. Therefore, it is difficult to accurately determine what the demand will be for our
products and services in this area. Substantial markets may not continue to develop for prepaid
calling cards, and we may not be able to sustain or increase our sales of these products and
services. If the e-commerce market does not continue to develop and gain market acceptance, our revenues
may be negatively affected. We anticipate that e-commerce will continue to account for substantially all of our future
revenues. Our business will suffer if e-commerce does not grow or grows more slowly than expected.
A number of factors could prevent acceptance of e-commerce, including:  
    e-commerce is at an early stage and buyers may be unwilling to shift their
purchasing from traditional vendors to online vendors;
    increased government regulation or taxation may limit the growth of e-commerce; and
    adverse publicity and consumer concern about the security of e-commerce
transactions may discourage its acceptance and growth. These factors could impair our ability to generate revenues from our online sales of virtual
calling cards, online transmission of telephone calls and other e-commerce activities. 27




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If the Internet and Internet infrastructure do not continue to develop as anticipated, our
operations will be negatively affected. For the Internet to be commercially viable in the long-term, the size of the network
infrastructure, enabling technologies, necessary performance improvements and user security will
need to be continually addressed. To the extent that the Internet continues to experience an
increased number of users, frequency of use or increased bandwidth requirements, we cannot assure
stockholders that the performance or reliability of the Internet will not be adversely affected.
Furthermore, the Internet has experienced a variety of outages and other delays as a result of
damage to portions of its infrastructure, and could face such outages and delays in the future.
These outages and delays could adversely affect the level of Internet usage and affect the level of
traffic, the processing of orders and the transmission of calls on our Web site. We cannot assure stockholders that the infrastructure or complementary products or services
necessary to make the Internet a viable commercial marketplace for the long term will be developed.
Even if these products and services are developed, we cannot assure stockholders that the Internet
will become a viable commercial marketplace for our virtual calling cards and services. If not
developed, our business, financial condition and operating results will be materially adversely
affected. Also, we may be required to incur substantial expenditures in order to adapt our products
and services to changing Internet technologies, which could have a material adverse effect on our
business, financial condition and operating results. The failure to manage our growth in operations and hire additional qualified employees could
have a material adverse effect on us. The expected growth of our operations places a significant strain on our current management
resources. To manage this expected growth, we will need to improve our:  
    transaction processing methods;
    operations and financial systems;
    procedures and controls; and
    training and management of our employees. Competition for personnel is intense, and we cannot assure stockholders that we will be able
to successfully attract, integrate or retain sufficiently qualified personnel. Our failure to
attract and retain the necessary personnel or to effectively manage our employee and operations
growth could have a material adverse effect on our business, financial condition and operating
results. Operating internationally exposes us to additional risks. International operations are subject to inherent risks including: potentially weaker
protection of intellectual property rights; political instability; changes in regulations and
tariffs; fluctuations in prices; varying tax consequences and other factors. Decreasing telecommunication rates may diminish or negatively impact the pricing of our
services. International and domestic telecommunication rates have decreased significantly over the last
few years in most of the markets in which we operate and we anticipate that this trend will
continue. Users who select our services to take advantage of our current pricing differential
between our rates and traditional telecommunications rates may switch to traditional
telecommunications carriers as our pricing differential diminishes and we may be unable to attract
new customers in the future. Continued rate decreases could require us to lower our rates to remain
competitive and could reduce our gross profit margins. 28




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Our potential customers may have concerns about Internet commerce security which could inhibit
our growth and we may incur losses resulting from credit card fraud. Consumer concerns over the security of transactions conducted on the Internet or the privacy
of users may inhibit the growth of the Internet and online commerce. To securely transmit
confidential information, such as customer credit card numbers, we rely on encryption and
authentication technology that we license from third parties. We cannot predict whether events or
developments will compromise or breach the technology that protects our customer transaction data.
If our security measures do not prevent security breaches, this could have a material adverse
effect on our business, financial condition and operating results. To date, we have suffered minimal losses as a result of orders placed with fraudulent credit
card data even though the associated financial institution approved payment of the orders. Under
current credit card practices, a merchant is liable for fraudulent credit card transactions where
the merchant does not obtain a cardholders signature. We do not obtain the signature of the
cardholder when we process orders. Although we have implemented mechanisms to try to detect credit
card fraud, we cannot assure you that our efforts will be successful. Our inability to adequately
detect credit card fraud could materially adversely affect our business, financial condition and
operating results. To the extent that our activities involve the storage and transmission of proprietary
information, such as credit card numbers, security breaches could expose us to a risk of loss or
litigation and possible liability. We do not presently carry insurance policies to reimburse us for
losses caused by security breaches. We cannot assure stockholders that our security measures will
prevent security breaches. Our failure to prevent security breaches could have a material adverse
effect on our business, financial condition and operating results. The market price for our common stock may be volatile, which could cause stockholders to lose
substantial portions of their investment. The market prices of the securities of Internet-related and online commerce companies have
been especially volatile. We cannot assure stockholders that these trading prices will not continue
to be volatile or that valuations will be sustained. Broad market and industry factors may
materially and adversely affect the market price of our common stock, regardless of our operating
performance. Our business may be adversely affected if we are not able to protect our intellectual property
and other proprietary rights from infringement. Our success depends in part upon our ability to protect our proprietary technology and other
intellectual property rights. We rely on a combination of copyright, trademark, service mark and
trade secret laws and contractual restrictions to establish and protect our proprietary rights.
Effective trademark, service mark, copyright and trade secret protection may not be available in
every country in which our services are made available online. Therefore, the steps that we take
may be inadequate to protect our rights. Failure to adequately protect our intellectual property
could harm our brand, devalue our proprietary content and affect our ability to compete
effectively. Further, defending intellectual property rights could result in the expenditure of
significant financial and managerial resources. Government regulation and legal uncertainties relating to IP telephony could harm our
business. Historically, voice communications services have been provided by regulated telecommunications
common carriers. We offer voice communications to the public for international and domestic calls
using IP telephony, and we do not operate as a licensed telecommunications common carrier in any
jurisdiction. Based on specific regulatory classifications and recent regulatory decisions, we
believe we qualify for certain exemptions from telecommunications common carrier regulation in many
of our markets. However, the growth of IP telephony has led
to close examination of its regulatory treatment in many jurisdictions making the legal status of
our services uncertain and subject to change as a result of future regulatory action, judicial
decisions or legislation in any of the
jurisdictions in which we operate. Established regulated telecommunications carriers have sought
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to seek regulatory actions to restrict the ability of companies such as ours to provide services or
to increase the cost of providing such services. In addition, our services may be subject to
regulation if regulators distinguish phone-to- phone telephony service using IP technologies over
privately-managed networks such as our services from integrated PC-to-PC and PC-originated voice
services over the Internet. Some regulators may decide to treat the former as regulated common
carrier services and the latter as unregulated enhanced or information services. Recently one of our Internet telephony competitors was sued by a state government for
providing false, misleading and confusing information regarding how 911 services work for broad
band phone service. We cant predict what impact this will make on our RocketVoIP service which
currently does not include 911 service. Application of new regulatory restrictions or requirements to us could increase our costs of
doing business and prevent us from delivering our services through our current arrangements. In
such event, we would consider a variety of alternative arrangements for providing our services,
including obtaining appropriate regulatory authorizations for our local network partners or
ourselves, changing our service arrangements for a particular country or limiting our service
offerings. Such regulations could limit our service offerings, raise our costs and restrict our
pricing flexibility, and potentially limit our ability to compete effectively. Further, regulations
and laws which affect the growth of the Internet could hinder our ability to provide our services
over the Internet. For a more detailed discussion of the regulation of IP telephony (see
Description of Business  Potential Regulation of Internet Telephony). We may not be able to keep pace with rapid technological changes in the communications
industry. Our industry is subject to rapid technological change. We cannot predict the effect of
technological changes on our business. In addition, widely accepted standards have not yet
developed for the technologies we use. We expect that new services and technologies will emerge in
the market in which we compete. These new services and technologies may be superior to the services
and technologies that we use, or these new services may render our services and technologies
obsolete. To be successful, we must adapt to our rapidly changing market by continually improving and
expanding the scope of services we offer and by developing new services and technologies to meet
customer needs. Our success will depend, in part, on our ability to license leading technologies and respond to technological
advances and emerging industry standards on a cost-effective and timely basis. We will need to
spend significant amounts of capital to enhance and expand our services to keep pace with changing
technologies. The Internet industry may become subject to increased government regulation which could have a
negative effect on our operations. Various actions have been taken by the United States Congress and the Federal courts that, in
some cases impose some forms of regulation on the Internet, and in other cases protect the Internet
from regulation. Domestic and international authorities regularly consider proposed legislation
that could result in new regulations on the Internet. It is impossible to say at this time whether
and to what extent the Internet may ultimately be regulated domestically or internationally.
Increased regulation of the Internet may decrease its growth, which may negatively impact the cost
of doing business via the Internet or otherwise materially adversely affect our business, results
of operations and financial condition. In addition, because our services are accessible worldwide, and we facilitate the sale of
goods to users worldwide, other jurisdictions may claim that we are required to comply with their
laws and could subject us to taxes and penalties for the failure to comply. Sales tax collection by states may adversely affect our growth. We do not currently collect sales or other similar taxes for calling cards or services sold
through our Web site, other than for calling cards sold to Texas residents. However, one or more
states may seek to impose sales tax or similar collection obligations on out-of-state companies,
such as ours, which engage in Internet commerce. A 30




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successful assertion by one or more states or any other country that we should collect sales or
other taxes on the sale of cards or services on our system could have a material adverse effect on
our operations. The loss of key personnel could adversely affect our business. We believe that our success will depend on the continued services of our senior management
team. The loss of the services of any of our senior management team or other key employees could
adversely affect our business, financial condition and operating results. We may not be able to raise needed additional capital in the future. We require substantial working capital to fund our business. Our working capital requirements
and cash flow provided by operating activities can vary from quarter to quarter depending on
revenues, operating expenses, capital expenditures and other factors.
We anticipate that our cash and working capital will be sufficient to meet our anticipated needs through at
least the next 18 months. Thereafter, we may need to raise additional funds. We may also need to raise additional funds sooner than anticipated to:  
    fund more rapid expansion;
    develop new or enhanced services or products; and
    respond to competitive pressures. If additional funds are raised through the issuance of equity or convertible debt
securities, the rights and ownership in our company by existing stockholders may be reduced. We cannot assure stockholders that additional financing will be available on terms favorable
to us or at all. If adequate funds are not available, or are not available on acceptable terms, we
may not be able to fund planned expansion, take advantage of available opportunities, develop or
enhance services or products or respond to competitive pressures. Such inabilities could have a
material adverse effect on our business, financial condition and operating results. 31




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ITEM 7. FINANCIAL STATEMENTS The financial statements required by this item begin at Page F-1 hereof. 
 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 8A. CONTROLS AND PROCEDURES Based on the evaluation conducted by management of the Company with the participation of the
Companys Chief Executive Officer and Chief Financial Officer, regarding the Companys disclosure
controls and procedures as of the end of the fiscal quarter ended December 31, 2004, the Companys
Chief Executive Officer and Chief Financial Officer have concluded that the Companys disclosure
controls and procedures (as defined in Rules 13a-15 and 15d-15 under the Securities Exchange Act of
1934) are effective. There have been no changes in internal controls or in other
factors that could significantly affect these controls subsequent to the date of their evaluation,
including any corrective actions with regard to significant deficiencies and material weaknesses. In addition, during the fiscal quarter ended December 31, 2004, there have been no
changes in internal control over financial reporting that have materially affected, or that are
reasonably likely to materially affect, the Companys internal control over financial reporting. 32




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PART III 
 ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
SECTION 16(a) OF THE EXCHANGE ACT Except for information with respect to our Code of Ethics and Business Conduct discussed
below, the information regarding the directors and executive officers of WQN in the Proxy Statement
relating to WQNs 2005 Annual Meeting, which will be filed with the Commission within 120 days
after December 31, 2004, is incorporated herein by reference. WQN has adopted a Code of Ethics and Business Conduct that applies to directors, officers and
employees, including WQNs principal executive officer, principal financial officer and principal
accounting officer. WQNs Code of Ethics and Business Conduct can be obtained free of charge by
contacting the company at 972-361-1980. Changes to and waivers granted with respect to WQNs Code
of Ethics and Business Conduct related to officers identified above, and other executive officers
and directors of WQN that we are required to disclose pursuant to applicable rules and regulations
of the SEC will be posted on our website at http://www.wqn.com. 
 ITEM 10. EXECUTIVE COMPENSATION The information regarding executive compensation in the Proxy Statement relating to WQNs 2005
Annual Meeting, which will be filed with the Commission within 120 days after December 31, 2004, is
incorporated herein by reference. 
 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information regarding the security ownership of certain beneficial owners and management
in the Proxy Statement relating to WQNs 2005 Annual Meeting, which will be filed with the
Commission within 120 days after December 31, 2004, is incorporated herein by reference. 
 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information regarding certain relationships and related transactions in the Proxy
Statement relating to WQNs 2005 Annual Meeting, which will be filed with the Commission within 120
days after December 31, 2004, is incorporated herein by reference. 33




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ITEM 13. EXHIBITS  The following documents are filed as part of this Annual Report on Form 10-KSB:1.
    Financial Statements: The financial statements filed
as part of this report are listed in the Index to Financial
Statements on Page F-1 hereof.2.
    Exhibits required to be filed by Item 601 of Regulation S-B: ExhibitNumber
    
    Description of Exhibits2.1
    
    Agreement and Plan of Merger, dated as of March 16, 2004, among WorldQuest, Ntera Holdings, Inc.
and Engin Yesil, filed as exhibit 2.1 to WorldQuests Current Report on Form 8-K/A dated March 19,
2004, as amended, and incorporated herein by this reference.2.2
    
    Stock Purchase Agreement dated as of July 26, 2004, by and among Xoom Corporation, Inc., WorldQuest
Networks, Inc., and WQN Mercury Inc., filed as exhibit 2.2 to WorldQuests Quarterly Report as
Form 10-QSB
for the quarter ended June 30, 2004.2.3
    
    Promissory Note dated as of July 26, 2004, by and between Xoom Corporations, Inc. and WorldQuest
Networks,
Inc. filed as exhibit 2.3 to WorldQuests Quarterly Report as Form 10-QSB for the quarter ended
June 30, 2004.2.4
    
    Stock Pledge Agreement dated as of July 26, 2004 by and between Xoom Corporation, Inc. and
WorldQuest Networks, Inc., filed as exhibit 2.4 to WorldQuests Quarterly Report as Form 10-QSB
for the quarter ended June 30, 2004.2.5
    
    Stock Purchase Warrant dated as of July 26, 2004 by and between Xoom Corporation, Inc. and
WorldQuest Networks, Inc., filed as exhibit 2.5 to WorldQuests Quarterly Report as Form 10-QSB
for the quarter ended June 30, 2004.3.1
    
    Certificate of Incorporation of WorldQuest, filed as Exhibit 3.1 to WorldQuests Form SB-2
Registration Statement, File No. 333-82721 (the Prior Registration Statement), and incorporated
herein by reference.3.2
    
    Bylaws of WorldQuest, filed as Exhibit 3.2 to the Prior Registration Statement, and incorporated
herein by this reference.4.1
    
    Specimen common stock certificate, filed as Exhibit 4.1 to the Prior Registration Statement, and
incorporated herein by this reference.4.2.1
    
    Representatives Warrant dated February 4, 2000 granted to John G. Kinnard and Company
Incorporated for 68,750 shares of common stock, filed as Exhibit 4.3.1 to WorldQuests Annual
Report on Form 10-KSB for the fiscal year ended December 31, 1999, and incorporated herein by
reference.4.2.2
    
    Representatives Warrant dated February 4, 2000 granted to Kaufman Bros., L.P. for 178,750 shares
of common stock, filed as Exhibit 4.3.2 to WorldQuests Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1999, and incorporated herein by reference.4.2.3
    
    Representatives Warrant dated February 4, 2000 granted to WestPark Capital, Inc. for 27,500
shares of common stock, filed as Exhibit 4.3.3 to WorldQuests Annual Report on Form 10-KSB for
the fiscal year ended December 31, 1999, and incorporated herein by reference.4.3
    
    Form of Unsecured Subordinated Convertible Promissory Note issued in the private placement closed
in December 1999 (the Private Placement), filed as Exhibit 4.5 to WorldQuests Form SB-2
Registration Statement, file no. 333-93019 (the Second Registration Statement), and incorporated
herein by this reference.4.4
    
    Form of Warrant issued in the Private Placement, filed as Exhibit 4.4 to the Second Registration
Statement, and incorporated herein by this reference.4.5
    
    Warrant to purchase 50,000 shares of common stock granted to Advanced Multimedia Group, Inc. on
March 16, 2000, filed as Exhibit 4.7 to WorldQuests Annual Report on Form 10-KSB for the fiscal
year ended December 31, 2000, and incorporated herein by this reference.4.6
    
    Warrant to purchase 50,000 shares of common stock granted to Advanced Multimedia Group, Inc. on
April 26, 2000, filed as Exhibit 4.8 to WorldQuests Annual Report on Form 10-KSB for the fiscal
year ended December 31, 2000, and incorporated herein by this reference.10.1
    
    Amended 1997 Stock Option Plan, filed as Exhibit 10.2 to the Prior Registration Statement, and
incorporated herein by this reference.
 34




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##### Table of Contents



ExhibitNumber
    
    Description of Exhibits10.2
    
    Stock Option Agreement dated December 7, 1998 granted to Michael R. Lanham by WorldQuest, filed as
Exhibit 10.3 to the Prior Registration Statement, and incorporated herein by this reference.10.3
    
    Form of Registration Rights Agreement executed in connection with the Private Placement, filed as
Exhibit 10.6 to the Second Registration Statement, and incorporated herein by this reference.10.4
    
    2001 Stock Option Plan, filed as Exhibit 4.8 to WorldQuests Form S-8 Registration Statement, File
No. 333-54498, and incorporated herein by this reference.10.5
    
    Employment agreement by and between WorldQuest Networks, Inc. and B. Michael Adler effective as of
April 14, 2003 filed as exhibit 10.10 to WorldQuests Quarterly Report as Form 10-QSB for the
quarter ended June 30, 2003.10.6
    
    Employment agreement by and between WorldQuest Networks, Inc. and Victor E. Grijalva effective as
of April 14, 2003 filed as exhibit 10.12 to WorldQuests Quarterly Report as Form 10-QSB for the
quarter ended June 30, 2003.10.7
    
    2002 Stock Option Plan.*21.1
    
    List of Subsidiaries.*23.1
    
    Consent of Grant Thornton LLP.*31.1
    
    Certification of the Companys Chief Executive Officer, pursuant to Rule 13a-14(a) and 15d-14(a),
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*31.2
    
    Certification of the Companys Chief Financial Officer, pursuant to Rule 13a-14(a) and 15d-14(a),
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*32.1
    
    Certification of the Companys Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of the Companys Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Filed herewith. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information regarding certain principal accountant fees and services in the Proxy
Statement relating to WQNs 2005 Annual Meeting, which will be filed with the Commission within 120
days after December 31, 2004, is incorporated herein by reference. 35




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SIGNATURES In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly
caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. WQN, INC.March 31, 2005
    /s/ B. Michael AdlerB. Michael AdlerPresident and Chief Executive Officer (Principal Executive Officer)March 31, 2005
    /s/ Victor E. GrijalvaVictor E. GrijalvaVice President, Chief Financial Officer,
Secretary and Treasurer (Principal Financial
and Accounting Officer) In accordance with the Securities Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the Company and in the capacities and on the dates indicated. March 31, 2005
    /s/ B. Michael AdlerB. Michael AdlerDirectorMarch 31, 2005
    /s/ E. Denton JonesE. Denton JonesDirectorMarch 31, 2005
    /s/ Elizabeth H. BuchlerElizabeth H. BuchlerDirectorMarch 31, 2005
    /s/ Hal H. BibeeHal H. BibeeDirectorMarch 31, 2005
    /s/ Robert A. FarmerRobert A. FarmerDirector (Chairman of the Board) 36




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WQN, Inc. and Subsidiaries Index to Consolidated Financial Statements Contents Report of Independent Registered Public Accounting Firm
    
    
    F-2Consolidated Balance Sheets as of December 31, 2004 and 2003
    
    
    F-3Consolidated Statements of Operations for the years ended December 31, 2004 and 2003
    
    
    F-4Consolidated Statements of Changes in Stockholders Equity for the years ended December 31, 2004 and 2003
    
    
    F-5Consolidated Statements of Cash Flows for the years ended December 31, 2004 and 2003
    
    
    F-6Notes to Consolidated Financial Statements
    
    
    F-7
 F-1




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Report of Independent Registered Public Accounting Firm Board of Directors
WQN, Inc. and Subsidiaries We have audited the accompanying consolidated balance sheets of WQN, Inc. (a Delaware
corporation) formerly known as WorldQuest Networks, Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated
statements of operations, changes in stockholders equity, and cash flows for the years then ended.
These financial statements are the responsibility of the Companys management. Our responsibility
is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. The Company is not required to have, nor were we engaged to perform an audit of its
internal control over financial reporting. Our audit included consideration of internal control
over financial reporting as a basis for designing audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion on the effectiveness of the
Companys internal control over financial reporting. Accordingly, we express no such opinion. An
audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements,assessing the accounting principles used and significant estimates made
by management, as well as evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all
material respects, the financial position of WQN, Inc. and subsidiaries as of December 31, 2004 and
2003, and the results of its operations and its cash flows for the years then ended in conformity
with accounting principles generally accepted in the United States of America. /s/ Grant Thornton LLP Dallas, Texas
March 28, 2005 F-2




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WQN, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS December 31,2004
    
    
    2003ASSETSCurrent assets:Cash and cash equivalents
    
    $
    9,942,280
    
    
    $
    17,931,820Investment in partnership
    
    
    2,944,243
    
    
    
    Accounts receivable, net of allowances of $25,000 in 2004 and 2003
    
    
    874,219
    
    
    
    553,251Notes receivable
    
    
    2,408,679
    
    
    
    Prepaid expenses and other current assets
    
    
    806,068
    
    
    
    557,577Total current assets
    
    
    16,975,489
    
    
    
    19,042,648Property and equipment, net
    
    
    597,522
    
    
    
    1,039,783Note receivable
    
    
    204,167
    
    
    
    Other assets, net
    
    
    972,794
    
    
    
    101,192Total assets
    
    $
    18,749,972
    
    
    $
    20,183,623LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,481,188
    
    
    $
    1,108,152Accrued expenses
    
    
    457,459
    
    
    
    471,746Deferred revenue
    
    
    444,988
    
    
    
    254,121Promissory note
    
    
    300,000
    
    
    
    Total current liabilities
    
    
    2,683,635
    
    
    
    1,834,019Promissory note
    
    
    
    
    
    
    300,000Commitments and contingenciesStockholders equity:Preferred stock, par value $0.01 per share:Authorized shares10,000,000; none issued and outstanding
    
    
    
    
    
    
    Common stock, par value $.01 per share:Authorized shares50,000,000; issued and outstanding shares 
6,830,062 at December 31, 2004 and  6,386,199 at December 31,
2003
    
    
    68,301
    
    
    
    63,862Additional capital
    
    
    43,180,859
    
    
    
    41,994,594Accumulated deficit
    
    
    (27,182,823
    )
    
    
    (24,008,852
    )Total stockholders equity
    
    
    16,066,337
    
    
    
    18,049,604Total liabilities and stockholders equity
    
    $
    18,749,972
    
    
    $
    20,183,623
 The accompany notes are an integral part of these consolidated financial statements. F-3




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WQN, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS Year ended December 31,2004
    
    
    2003Retail telephony revenue
    
    $
    9,036,354
    
    
    $
    9,152,320Wholesale telephony revenue and other
    
    
    6,227,452
    
    
    
    206,572Total revenue
    
    
    15,263,806
    
    
    
    9,358,892Cost of revenue
    
    
    13,387,986
    
    
    
    7,008,908Gross profit
    
    
    1,875,820
    
    
    
    2,349,984Operating expenses:Selling, general and administrative
    
    
    3,716,711
    
    
    
    4,517,784Merger expenses
    
    
    1,311,945
    
    
    
    Depreciation and amortization
    
    
    796,426
    
    
    
    921,900Total operating expenses
    
    
    5,825,082
    
    
    
    5,439,684Operating loss
    
    
    (3,949,262
    )
    
    
    (3,089,700
    )Interest income, net
    
    
    287,709
    
    
    
    202,187Income (loss) from partnership investment
    
    
    (55,757
    )
    
    
    Loss from continuing operations
    
    
    (3,717,310
    )
    
    
    (2,887,513
    )Income (loss) from discontinued operations
    
    
    543,339
    
    
    
    (457,879
    )Net loss
    
    $
    (3,173,971
    )
    
    $
    (3,345,392
    )Income
(loss) per share - basic and diluted:Continuing operations
    
    $
    (0.56
    )
    
    $
    (0.45
    )Discontinued operations
    
    
    0.08
    
    
    
    (0.07
    )Income (loss) per share
    
    $
    (0.48
    )
    
    $
    (0.52
    )Weighted-average common shares outstanding - basic and diluted
    
    
    6,642,005
    
    
    
    6,386,199
 The accompany notes are an integral part of these consolidated financial statements. F-4




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WQN, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY Common Stock
    
    
    Additional
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Deficit
    
    
    EquityBalance at December 31, 2002
    
    
    6,386,199
    
    
    $
    63,862
    
    
    $
    41,994,594
    
    
    $
    (20,663,460
    )
    
    $
    21,394,996Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,345,392
    )
    
    
    (3,345,392
    )Balance at December 31, 2003
    
    
    6,386,199
    
    
    $
    63,862
    
    
    $
    41,994,594
    
    
    $
    (24,008,852
    )
    
    $
    18,049,604Issuance of
warrants
    
    
    
    
    
    
    
    
    
    
    76,000
    
    
    
    
    
    
    
    76,000Exercise of stock options
    
    
    443,863
    
    
    
    4,439
    
    
    
    1,110,265
    
    
    
    
    
    
    
    1,114,704Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,173,971
    )
    
    
    (3,173,971
    )Balance at December 31, 2004
    
    
    6,830,062
    
    
    $
    68,301
    
    
    $
    43,180,859
    
    
    $
    (27,182,823
    )
    
    $
    16,066,337
 The accompany notes are an integral part of these consolidated financial statements. F-5




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WQN, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS Year ended December 31,2004
    
    
    2003Operating ActivitiesNet loss
    
    $
    (3,173,971
    )
    
    $
    (3,345,392
    )Adjustments to reconcile net loss to net cash used in operating activities:Gain on
sale of operations
    
    
    (777,114
    )
    
    
    Depreciation and amortization
    
    
    796,426
    
    
    
    921,900Loss on disposition of property and equipment, net
    
    
    76,522
    
    
    
    18,541(Income) loss in investment in partnership
    
    
    55,757
    
    
    
    Changes in operating assets and liabilities net of effects of acquisitions:Accounts receivable and notes receivable
    
    
    (411,919
    )
    
    
    4,243Accounts payable and accrued expenses
    
    
    134,749
    
    
    
    237,297Deferred revenue
    
    
    190,867
    
    
    
    15,185Other assets
    
    
    (1,122,886
    )
    
    
    (235,772)Net cash used in operating activities of continuing operations
    
    
    (4,231,569
    )
    
    
    (2,383,998
    )Investing ActivitiesAdditions to property and equipment
    
    
    (436,423
    )
    
    
    (405,389
    )Proceeds from the sale of subsidiary net of disposed cash
    
    
    417,915
    
    
    
    Payments received on note from the sale of subsidiary
    
    
    145,833
    
    
    
    Loan to Ntera Holdings, Inc.
    
    
    (2,000,000
    )
    
    
    Purchase of partnership interest
    
    
    (3,000,000
    )
    
    
    Net cash used in investing activities
    
    
    (4,872,675
    )
    
    
    (405,389
    )Financing ActivitiesProceeds from exercise of stock options
    
    
    1,114,704
    
    
    
    Decrease in cash and cash equivalents
    
    
    (7,989,540
    )
    
    
    (2,789,387
    )Cash and cash equivalents at beginning of year
    
    
    17,931,820
    
    
    
    20,721,207Cash and cash equivalents at end of year
    
    $
    9,942,280
    
    
    $
    17,931,820Supplemental Disclosures of Cash Flow Information:Interest paid
    
    $
    4,538
    
    
    $
    4,692Non-cash note receivable from sale of subsidiary
    
    $
    700,000
    
    
    $
    
 The accompany notes are an integral part of these consolidated financial statements. F-6




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WQN, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Years ended December 31, 2004 and 2003 1. Organization and Description of Business We are a Voice Over Internet Protocol (VoIP) telephony company providing international long
distance services. VoIP enables voice communications over the Internet by compressing voice into
data packets that can be efficiently transmitted over data networks and then converted back into
voice at the receiving end. Our customers utilize our enhanced VoIP services platform to make and
receive calls using their home phone, business phone, personal computer and mobile phone. Our business currently includes the provision of enhanced Internet-based and other telephony
services under various brand names to individual consumers primarily seeking to make international
calls; the provision of enhanced Internet-based and other telephony services to resellers,
corporations and service providers under their brand names and carrier transmission services
whereby we sell our excess capacity to other long-distance carriers. We also distribute telephony
services including prepaid long- distance and prepaid wireless through a network of over 90 private
distributors. Through this network we estimate that our products are sold through over 10,000
retail outlets of which more than 5,000 retail outlets are located in Southern California. We
expect to begin selling our proprietary VoIP products through this distribution channel beginning
in 2005. As of December 31, 2004, Eagle Venture Capital, LLC (Eagle Venture) owned approximately 2.6
million, or 38%, of our outstanding shares of common stock. Eagle Venture is primarily owned by B.
Michael Adler, our founder and Chief Executive Officer. In November 2004, we changed our name to WQN, Inc. from WorldQuest Networks, Inc. (see Note
18). 2. Significant Accounting Policies Use of Estimates The preparation of financial statements in conformity with generally accepted accounting
principles in the United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities
at the date of the financial statements and the reported amounts of revenues and expenses during
the reporting period. Management believes the estimates used in preparing the financial statements
are reasonable; however, actual results could differ from these estimates. Principles of Consolidation The consolidated financial statements include the accounts of the Company, its subsidiaries
and joint ventures in which the Company owns a controlling interest. Investments in 20% to 50%
owned partnerships and affiliates are accounted for on the equity method. All significant
intercompany balances and transactions have been eliminated in consolidation. Reclassifications Certain reclassifications have been made to the 2003 financial statements to conform to the
2004 presentation. F-7




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WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) Cash Equivalents Cash equivalents include money market mutual funds and other highly liquid investments
purchased with maturities of three months or less. Depreciation and Amortization Property and equipment are recorded at cost and depreciated using the straight-line method
over the estimated useful lives of the assets. Amortization of capital leases and leasehold
improvements is provided on a straight line basis over the lives of the related assets or the life
of the lease, whichever is shorter, and is included with depreciation expense. Maintenance repairs
are charged to operations as incurred. Gains and losses on the disposition of property and
equipment are recorded in the period incurred. Depreciation expense totaled $500,778 and $820,709 for 2004 and 2003, respectively.
Amortization expense totaled $295,648 for 2004 and $101,191 for 2003
for continuing operations and $107,297 for 2004 and $153,863 for
2003 for discontinued operations. Impairment of Long-lived Assets The Company evaluates long-lived assets, including intangible assets, for impairment whenever
events or changes in circumstances indicate the carrying amount of an asset may not be recoverable
and the undiscounted cash flows to be generated by these assets are less than the carrying amounts
of these assets. For the year ended December 31, 2004 the
Company determined that certain stored value equipment could no
longer be used and recorded a non-cash impairment
charge of approximately $60,000. Website Development Costs Costs related to the planning and post implementation phases of our website development
efforts are expensed. Direct costs incurred in the development phase are capitalized and amortized
over the products estimated useful life of one to three years and are included in depreciation
expense. Costs associated with minor enhancements and maintenance for the website are expensed.
Website development costs capitalized for the years ended December 31, 2004 and 2003 were $243,986
and $190,000, respectively. Income Taxes Income taxes are determined using the liability method, which gives consideration to the
future tax consequences associated with differences between the financial accounting and tax basis
of assets and liabilities. This method also gives immediate effect to changes in income tax laws. Revenue Recognition Retail telephony revenue is recorded net of estimated returns and allowances and is recognized
as calling services are used. Wholesale traffic revenue is recognized as calls are processed.
Revenue on the distribution of telephony products is included in
wholesale telephony revenue, is recorded net of estimated returns and
allowances and is recognized when the products are shipped to the customer. Distribution products
are processed by other carriers therefore no future service is provided by the Company. F-8




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WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) Intangible Assets Intangible assets consist primarily of acquired customer lists and are included in other
assets. Amortization is provided for by the straight-line method over the assets estimated life
ranging from 2 to 4 years. At December 31, 2004 intangible
assets totaled $972,794 net of accumulated amortization of $337,136. The estimated aggregate amortization for
each of the succeeding years is as follows: 2005 - $362,395, 2006 -
$295,269, 2007 - $253,711, 2008 - $61,419. Investment in Partnership The Companys investment in partnership is accounted for on the partnership basis of
accounting. Gains and losses are included in income (loss) from partnership investment. The Company
can receive a distribution on its partner capital account by giving the partnership 60 days written
notice. Notes Receivable Notes receivable represent balances due from third parties related to the sale of its
wholly-owned subsidiary buyindiaonline.com, Inc. and the merger agreement with Ntera Holdings.
Interest earned on notes receivable are recognized over the term of the note and is included in
interest income, net. Advertising Costs The Company expenses advertising costs as incurred. Advertising expense for the years ended
December 31, 2004 and 2003 was $467,000 and $334,000, respectively. Stock-Based Compensation The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees, in the primary financial statements and has provided supplemental
disclosures required by Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation and by Statement of Financial Accounting Standards No. 148, Accounting
for Stock-Based Compensation  Transition and Disclosure an amendment of FASB Statement No. 123. Statement of Financial Accounting Standards No. 123, Accounting for Stock Based
Compensation, (SFAS 123) requires the disclosure of pro forma net loss and loss per share
computed as if the Company had accounted for its employee stock options under the fair value method
set forth in SFAS 123. The Companys reported and pro forma net loss for the years ending December
31, 2004 and 2003 are as follows: Year ended December 31,2004
    
    
    2003Net loss as reported
    
    $
    (3,173,971
    )
    
    $
    (3,345,392
    )Pro forma stock-based employee
compensation expense
    
    
    (202,499
    )
    
    
    (170,863
    )Pro forma net loss
    
    $
    (3,376,470
    )
    
    $
    (3,516,255
    )Net loss per share:As reported  basic and diluted
    
    $
    (0.48
    )
    
    $
    (0.52
    )Pro forma  basic and diluted
    
    $
    (0.51
    )
    
    $
    (0.55
    )
 F-9




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##### Table of Contents



WQN, INC. AND SUBSIDIAIRES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) The fair value of options granted was estimated at the date of grant using the Black-Scholes
option pricing model. The following weighted average assumptions used in the December 31, 2004
calculation were as follows: risk free interest rate of 3.5%, dividend yield of zero, volatility
factor of 1.1, and average expected life of 4 years. The weighted average assumptions used in the
December 31, 2003 calculation were as follows: risk free interest rate of 3.25%, divided yield of
zero, volatility of .85 and average expected life of 5 years. The options granted during 2004 and
2003 had a weighted average fair value of $1.50 and $1.40 per share, respectively. Net Loss per Share Basic and diluted net loss per share is computed using the Companys net loss for each period
presented divided by the average common shares outstanding during the period. Stock options and
warrants convertible into 1,267,759 and 1,790,556 shares of the Companys common stock for the
years ended December 31, 2004 and 2003, respectively, are excluded from the calculation of diluted
earning per share because the Company reported losses from continuing operations in those periods
and their effect would be antidilutive. Comprehensive Income Comprehensive income is defined as the change in equity of a business enterprise during a
period from transactions and other events and circumstances from non-owner sources. For the years
ended December 31, 2004 and 2003, the Company had no transactions other than those reported in its
statement of operations. Fair Value of Financial Instruments The Companys financial instruments consist primarily of cash equivalents, accounts and notes
receivable, accounts payable and long-term debt. At December 31, 2004 and 2003, the carrying amount
of the Companys financial instruments approximates their fair values. Management believes the
Companys debt approximates fair value due to its short maturity and its variable interest rate. Concentration of Credit and Business Risks Financial instruments that potentially subject the Company to concentrations of credit risk
consist primarily of cash equivalents, accounts receivable and notes receivable. Accounts
receivable consist of amounts owed by credit card processing companies relating to retail telephony
sales, amounts owed by distributors for the purchase of telephony products and money transfer
services. We bill our retail customers on a prepaid basis through
credit cards. Credit is extended to some wholesale customers with terms that generally allow them to pay for our products
within two weeks. All other wholesale customers pay for our products upfront. Customers purchase the Companys retail telephony products using major credit cards, which are
reimbursed by credit card processing companies. The Company does not routinely perform on-going
credit evaluations of its retail customers but does evaluate its credit card processors. The
Company performs credit evaluations and establishes credit limits for its wholesale traffic and
whole sale distribution customers, including requiring deposits when applicable. F-10




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##### Table of Contents



WQN, INC. AND SUBSIDIAIRES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) For the years ended December 31, 2004 and 2003, a substantial portion of our retail customers
were calling from the United States to India. The India international telephony market continues to
experience downward pricing pressures, which has resulted in a decrease in our average selling price
to our retail customers. It is unlikely that this trend will reverse in the near future. At December 31, 2004, one customer accounted for 15% of total accounts receivable and no
receivables from credit card processing companies accounted for more than 10% of total accounts
receivable. At December 31, 2003, three credit card processing companies accounted for 35%, 13%,
and 10% of total accounts receivable. At December 31, 2004 and 2003, accounts receivable are
stated net of an allowance for doubtful accounts of $25,000. Bad debt expense for the years ended
December 31, 2004 and 2003 was $5,000 and $83,000, respectively. For the year ended December 31,
2004, the Company purchased data communication and telecommunication services from three suppliers,
which accounted for 18%, 13% and 11% of cost of goods sold for telecommunication services. For the
year ended December 31, 2003, the Company purchased data communication and telecommunication
services from three suppliers, which accounted for 35%, 18%, and 11% of cost of goods sold for
telecommunication services. New Accounting Pronouncements In December 2004, FASB issued statement of Financial Accounting standards No. 123 (revised
2004), Share-Based Payment (SFAS 123R), which will be effective in our first quarter of fiscal
2006. This standard sets forth the revised rules for the accounting treatment of employee stock
options and other share-based payments. SFAS 123(R) requires the adoption a fair value-based
method for measuring the compensation expense related to employee stock awards; this will lead to
additional compensation expense. We currently use the intrinsic value method to measure
compensation expense for stock-based awards to our employees. Under this standard, we do not
recognize any compensation related to stock option grants we issue under our stock option plans.
Note 2 to our Consolidated Financial Statements in this report provides our pro forma net loss and
loss per share as if we had used a fair value-based method required under
SFAS 123 to measure the compensation expense for employee stock awards during fiscal 2004 and
2003. The Company has not yet determined the full effect of
implementing SFAS 123R on the financial statements. F-11




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##### Table of Contents



WQN, INC. AND SUBSIDIAIRES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 3. Discontinued Operations In July 2004, the Company sold all of the outstanding capital stock of its wholly-owned
subsidiary buyindiaonline.com, Inc. (Cash2India) to a private company for approximately
$1,552,000. The Cash2India business comprised the Companys previously reported financial services
segment and is accounted for as a discontinued operation in the accompanying condensed consolidated
financial statements. Under the terms of the transaction, the Company received $852,000 in cash, a
promissory note for $700,000, and a warrant to purchase common stock in the acquiring company. The
cash payment included consideration for $352,000 in working capital associated with Cash2India at
the time of the sale. The promissory note bears interest at 5% per annum, is secured by the capital
stock of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of $29,167
plus accrued interest. The balance of the promissory note and accrued interest was $554,167 as of
December 31, 2004. As a result of the transaction the Company
recorded a gain on the disposition of
Cash2India of approximately $777,000 in the third quarter of 2004. The net gain/(loss) from
discontinued operations is comprised as follows: Year ended December 31,2004
    
    
    2003Revenue
    
    $
    340,027
    
    
    $
    556,462Cost of revenue
    
    
    (134,969
    )
    
    
    (200,880
    )Gross profit
    
    
    205,058
    
    
    
    355,582Operating expenses
    
    
    (438,833
    )
    
    
    (813,461
    )Net loss
    
    
    (233,775
    )
    
    
    (457,879
    )Gain on disposal
    
    
    777,114
    
    
    
    Income (loss) from discontinued operations
    
    $
    543,339
    
    
    $
    (457,879
    )
 The components of assets and
liabilities of discontinued operations are as follows: December 31,
    
    
    December 31,2004
    
    
    2003Cash and cash equivalents
    
    $
    
    
    
    $
    514,635Accounts receivable
    
    
    
    
    
    
    409,717Prepaid expenses and other current assets
    
    
    
    
    
    
    71,988Property and equipment, net
    
    
    
    
    
    
    236,308Accounts payable and accrued expenses
    
    
    
    
    
    
    (210,658
    )$
    
    
    
    $
    1,021,990
 F-12




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##### Table of Contents



WQN, INC. AND SUBSIDIAIRES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 4. Merger Agreement with Ntera Holdings On March 16, 2004, the Company entered into an Agreement and Plan of Merger (the Agreement)
with Ntera Holdings, Inc., a Delaware corporation (Ntera), providing for a transaction that would
have resulted in a change of control of WQN. In connection with the Agreement, WQN extended to
Ntera a bridge loan in the principal amount of $2 million bearing interest of 7% per annum, which
is secured by the assets of Ntera. On September 2, 2004, the Company terminated the Agreement with
Ntera. Under the terms of the loan agreement, the full amount of the loan and accrued interest are
due and payable within six months of the termination of the Agreement. The Company and Ntera have
amended the repayment provisions of the loan agreement whereby Ntera will make installment payments
to repay the loan and accrued interest by March 31, 2005. The balance of the note and accrued
interest at December 31, 2004 was $2,058,679, which is net of a payment of approximately $56,000
received during 2004 in the form of telecommunication services.
During the first quarter of 2005,
the Company received debt payments from Ntera totaling $1,650,000. The unpaid principal and
interest as of March 1, 2005 from Ntera was $408,679 and is expected to be collected on its due
date. The loan is secured by the assets of Ntera. 5. Value Communications Transaction In April 2004, the Company purchased from Value Communications Corporation (ValuCom), a
wholly owned subsidiary of Rediff.com India Limited, certain assets consisting primarily of
ValuComs customer list, brand, trademarks, web sites, internally built software, and certain
hardware for $500,000 in order to increase its customer base. The Company paid $200,000 of the
total consideration at closing with the remaining $300,000 to be paid in twelve monthly
installments of $25,000 commencing May 2004. In addition, the Company entered into an advertising
agreement with Rediff.com, Inc. (Rediff) entitling WQN to marketing services including exclusive
rights to prominent online advertising space on the Rediff.com U.S. website, the premier online
destination for Indians in North America. Under the terms of the advertising agreement, the Company
will pay Rediff $50,000 for twelve consecutive months commencing in May 2004 for the advertising
services. The Company provided both ValuCom and Rediff irrevocable letters of credit for the
Companys remaining obligation under the agreements. The letters of credit are secured by deposits
in money market funds and the amount of the letters of credit and the deposits are reduced as the
monthly installments are paid. At December 31, 2004, the Companys obligation under both the
agreements totaled $300,000. Substantially all of the ValuCom purchase consideration was allocated
to customer lists, which is included in other assets and is being amortized over four years. 6. Distribution and Marketing Agreement In September 2004, we entered into a distribution and marketing agreement with a privately
held company. As a result of the agreement, the Companys products will be sold in more than 5,000
retail outlets in the Southern California market. We sell telephony and other products to a
network of distributors who then re-sell the product to the retail outlets. The revenues generated
through this agreement are included in wholesale telephony revenues. In connection with the
agreement, we paid the private company $50,000 and issued a warrant to purchase 40,000 shares of
our common stock for a total consideration of approximately $126,000
as valued with the Black-Scholes pricing model which is included in other
assets and is being amortized over the three year term of the
agreement. The warrants exercise price is .01. F-13




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##### Table of Contents



WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 7. Investment in partnership In November 2004, the Company invested $3 million in a partnership managed by an affiliate of
a director of the Company. The majority of the partnership assets are to be invested in private
investments in public entities. The partnership investments will take the form of common equity,
preferred equity, convertible debt and/or equity or debt securities. Although the partnership will
endeavor to engage in hedging transactions in order to mitigate downside risk, there can be no
assurance that the partnerships investments will be successful and, as a result, the Company may
lose all or some of its investment. The partnership agreement contains certain restrictions,
including limits on the Companys ability to withdraw capital from the partnership and limits on
the transferability of the Companys interests in the partnership. The Company can receive a
distribution on its partner capital account by giving the partnership 60 days written notice. The
Company records its proportionate share of earnings and losses from
the partnership based on its share of the partnership and for the
year ended December 31, 2004 recorded a loss from its partnership investment of $55,757. 8. Notes Receivable Components of notes receivable are as follows: 2004
    
    
    2003Loan to Ntera Holdings, Inc.
    
    $
    2,058,679
    
    
    $
    Note from sale of Cash2India subsidiary
    
    
    554,167
    
    
    
    Less amounts classified as current
    
    
    (2,408,679
    )
    
    
    Long-term portion
    
    $
    204,167
    
    
    $
    
 During 2004, in connection with the Agreement and plan of merger with Ntera Holding Inc., WQN
extended to Ntera a bridge loan in the principal amount of $2 million bearing interest of 7% per
annum (see Note 4). The balance of the note and accrued interest at December 31, 2004 was
$2,058,679. The full amount of the loan and accrued interest are to be repaid in
installments by March 31, 2005. During the first quarter of 2005 the Company has received debt
payments from Ntera totaling $1,650,000. The unpaid principal and interest as of March 1, 2005 from
Ntera was $408,679. The loan is secured by the assets of Ntera. In July 2004, the Company sold all of the outstanding capital stock of its wholly-owned
subsidiary Cash2India and received as a component of the purchase price a promissory note for
$700,000 (See Note 3). The promissory note bears interest at 5% per annum, is secured by the
capital stock of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of
$29,167 plus interest. During 2004, the Company received principal and interest payments of
$159,290 and the balance of the promissory note and accrued interest was $554,167 as of December
31, 2004. 9. Prepaid Expenses and Other Current Assets Prepaid expenses and other current assets consist of the following as of December 31: 2004
    
    
    2003Prepaid telecommunication services
    
    $
    534,181
    
    
    $
    33,222Deposits
    
    
    151,781
    
    
    
    316,936Prepaid expenses
    
    
    120,106
    
    
    
    207,419$
    806,068
    
    
    $
    557,577
 F-14




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##### Table of Contents



WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 10. Property and Equipment Property and equipment consists of the following as of December 31: EstimatedUseful Life(Years)
    
    
    2004
    
    
    2003Leasehold improvements
    
    
    2 to 5
    
    
    $
    78,134
    
    
    $
    78,134Computers and network equipment
    
    
    2 to 5
    
    
    
    3,871,060
    
    
    
    3,797,148Furniture and fixtures
    
    
    5
    
    
    
    86,308
    
    
    
    87,196Purchased software and website development
costs
    
    
    1 to 5
    
    
    
    865,755
    
    
    
    1,315,622Total
    
    
    
    
    
    
    4,901,257
    
    
    
    5,278,100Less: accumulated depreciation and amortization
    
    
    
    
    
    
    (4,303,735
    )
    
    
    (4,238,317
    )Net property and equipment
    
    
    
    
    
    $
    597,522
    
    
    $
    1,039,783
 Property and equipment balances at December 31, 2003 are inclusive of assets of our
discontinued operation, Cash2India (See note 3 for a detail of the components of net assets of
discontinued operations). For the years ended December 31, 2004 and 2003 the Company recorded
losses of $16,522 and $18,541, respectively on the disposal of certain fixed assets. 11. Accrued Expenses Accrued expenses consist of the following as of December 31: 2004
    
    
    2003Accrued franchise, property and sales taxes
    
    $
    44,471
    
    
    $
    130,608Accrued payroll expenses
    
    
    67,467
    
    
    
    62,115ValuCom
payable
    
    
    300,000
    
    
    
    Other accrued expenses
    
    
    121,521
    
    
    
    279,023$
    533,459
    
    
    $
    471,746
 12. Debt Long-term debt consists of the following as of December 31: 2004
    
    
    2003Promissory note
    
    $
    300,000
    
    
    $
    300,000Less current portion
    
    
    (300,000
    )
    
    
    Long term debt net of current portion
    
    $
    
    
    
    $
    300,000
 In 2001, the Company borrowed $300,000 from a financial institution under a term promissory
note agreement (the Note). The Note bears interest at the financial institutions prime rate as
adjusted from time to time (5.25% at December 31, 2004) less 2.25% per annum. The Note, originally
due in October 2003 was extended and is now due in October 2005. The Note is collateralized by a
$300,000 certificate of deposit bearing interest of 1.47 % per annum. F-15




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##### Table of Contents



WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 13. Related Party Transactions The Companys founder, Chief Executive Officer and President holds a controlling interest in
Eagle Venture Capital, which owns approximately 2.6 million outstanding shares of the common stock
of the Company as of December 31, 2004 and 2003. A consulting company managed by one of the Companys directors holds warrants to acquire
100,000 shares of the Companys common stock. The warrants have an exercise price of $6.00 per
share and expire in 2005. In November 2004, the Company invested $3 million in a partnership managed by an affiliate of
a director of the Company (see Note 7). Certain other company directors and officers have also
invested separately in the partnership. 14. Income Taxes Deferred income taxes reflect the net tax effects of temporary differences between the
carrying amounts of assets and liabilities for financial reporting purposes and the amounts used
for income tax purposes. Significant components of deferred tax assets and liabilities are as
follows as of December 31: 2004
    
    
    2003Deferred tax assets/(liability):Property and equipment
    
    $
    21,265
    
    
    $
    (35,341
    )Capital loss carry forward
    
    
    195,941
    
    
    
    195,941Other
    
    
    66,162
    
    
    
    29,075Net operating loss carry forwards
    
    
    9,281,128
    
    
    
    9,292,073Total deferred tax assets
    
    
    9,564,496
    
    
    
    9,481,748Valuation allowance
    
    
    (9,564,496
    )
    
    
    (9,481,748
    )Net deferred tax assets
    
    $
    
    
    
    $
    
 The Company has U.S. net operating loss carry forwards of approximately $25,104,000 as of
December 31, 2004. The Company has not recognized a deferred tax asset in the accompanying balance
sheets due to the uncertainty of future realization. Accordingly, no tax benefit has been
recognized in the accompanying consolidated statements of operations. Net operating loss carry
forwards associated with the sale of our Cash2India subsidiary of
approximately $2,900,000 have not been included in the
deferred tax assets at December 31, 2004. No other significant reconciling items exist between the
actual effective tax rate and the expected effective tax rate. During 2004 and 2003, the valuation
allowance increased by approximately $83,000 and $1,232,000, respectively. If unused, accumulated
net operating losses expire as follows: 2011 - $214,000; 2012 - $1,531,000; 2018 - $1,447,000; 2019
- $1,999,000; 2020 - $4,628,000; 2021 - $8,210,000; 2022 - $3,828,000; 2023 - $3,247,000. F-16




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##### Table of Contents



WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) 15. Stockholders Equity Common and Preferred Stock The Companys authorized share capital consists of 50,000,000 shares of common stock with par
value of $0.01 per share, and 10,000,000 shares of preferred stock with par value of $0.01 per
share. Warrants At December 31, 2004 and 2003, the Company had outstanding warrants to purchase 414,775 and
720,775 shares of its common stock, respectively. These warrants expire March 2005 through July
2006 and have a weighted average exercise price of $16.98 per share. At December 31, 2004, all of
the warrants were exercisable. The warrants outstanding include warrants granted to a consulting
company managed by one of the Companys directors to acquire 100,000 shares of common stock (see
Note 13); warrants granted to representatives of the Companys underwriters in connection with the
Companys initial public offering to acquire 275,000 shares of common stock; and warrants granted
to various service providers and others to acquire 39,775 shares of
common stock. In 2004, we issued warrants to
purchase 40,000 shares of our common stock to a privately held company in connection with a
distribution and marketing agreement (See Note 6). Stock Options The Company has stock option plans (the Plans) under which the Company may grant Directors
and key employees options to purchase up to 1,750,000 shares of the Companys common stock at an
amount at least equal to the fair value of the Companys common stock on the date of grant. The
exercise and vesting period of each option is determined by the Companys Board of Directors, but
no option shall have a term longer than 10 years. Options granted under the Plans are
non-qualified stock options. The following table summarizes the employee stock option transactions
for the years ended December 31, 2004 and 2003 under the Plans: Weighted AverageNumber of Shares
    
    
    Exercise PriceOutstanding at December 31, 2002
    
    
    886,080
    
    
    $
    4.05Granted
    
    
    55,000
    
    
    
    2.04Exercised
    
    
    
    
    
    
    0.00Cancelled
    
    
    (39,166
    )
    
    
    3.82Outstanding at December 31, 2003
    
    
    901,914
    
    
    $
    3.93Granted
    
    
    265,500
    
    
    
    2.65Exercised
    
    
    (275,996
    )
    
    
    2.51Cancelled
    
    
    (38,434
    )
    
    
    2.10Outstanding at December 31, 2004
    
    
    852,984
    
    
    $
    4.11Options exercisable:December 31, 2003
    
    
    794,258
    
    
    $
    4.18December 31, 2004
    
    
    662,486
    
    
    $
    4.57
 F-17




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##### Table of Contents



WQN, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued) A summary of stock options under the Plans outstanding as of December 31, 2004 are as follows: Options Outstanding
    
    
    
    
    
    
    
    Options ExercisableWeighted-
    
    
    Weighted-
    
    
    
    
    
    
    Weighted-Range of
    
    
    
    
    
    
    Average
    
    
    Average
    
    
    
    
    
    
    AverageExercise
    
    
    
    
    
    
    Remaining
    
    
    Exercise
    
    
    
    
    
    
    ExercisePrices
    
    Shares
    
    
    
    Life (years)
    
    
    Price
    
    
    Shares
    
    
    Price$
    
    
    1.00 -$1.99
    
    
    145,000
    
    
    
    
    6.59
    
    
    $
    1.31
    
    
    
    95,000
    
    
    $
    0.992.00 - 2.99
    
    
    426,984
    
    
    
    
    5.02
    
    
    
    2.25
    
    
    
    341,486
    
    
    
    2.193.00 - 3.99
    
    
    155,500
    
    
    
    
    3.46
    
    
    
    3.16
    
    
    
    100,500
    
    
    
    3.215.00 - 11.00
    
    
    25,000
    
    
    
    
    2.60
    
    
    
    5.75
    
    
    
    25,000
    
    
    
    5.7513.00 -14.00
    
    
    35,000
    
    
    
    
    1.90
    
    
    
    13.00
    
    
    
    35,000
    
    
    
    13.0019.00 -20.00
    
    
    60,000
    
    
    
    
    2.24
    
    
    
    19.13
    
    
    
    60,000
    
    
    
    19.1321.00 -22.00
    
    
    5,500
    
    
    
    
    2.22
    
    
    
    21.63
    
    
    
    5,500
    
    
    
    21.63Total
    
    
    
    852,984
    
    
    
    
    4.59
    
    
    $
    4.11
    
    
    
    662,486
    
    
    $
    4.57
 In December 1998, the Company issued options outside of the option plans to purchase 167,867
shares of its common stock to a former officer of the Company at an exercise price of $3.33 with a
seven-year term. During 2004 all of these options were exercised. 16. Benefit Plan The Company has a 401(k) benefit plan. The plan provides for voluntary employee
contributions and the Company matches 15% of the first 8% of payroll contributed by the employee.
Employees become 100% vested in employment contributions after 2 years of service accruing 50% per
year of service. For the years ended December 31, 2004 and 2003, the Companys plan contributions
were $3,400 and $5,400, respectively. 17. Commitments The Company has operating leases relating principally to office facilities, which expire in
2006 and have future minimum lease commitments under operating leases with remaining non-cancelable
lease terms in excess of one year at December 31, 2004: 2005
 $112,500; 2006 - $75,000. Rental
expense under operating leases was approximately $113,000 and $138,000 for the years ended December
31, 2004 and 2003, respectively. In September 2004, the Company settled a dispute with a vendor from which it had previously
purchased telecommunication services. Under the terms of the settlement, the Company agreed to
purchase from the vendor a total of $960,000 in telecommunication services at rates less than the
Company is paying for similar services over a fourteen month period. The Company must purchase a
minimum of $80,000 per month in services beginning four months after the settlement date. F-18




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WQN, INC. AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued) 18. Contingencies In December 1996, the Company applied to the United States Patent and Trademark Office to
register the trademarks: WorldQuest and WorldQuest Networks. We received a registration for
the trademark WorldQuest from the U.S. Patent and Trademark Office on November 23, 1999. In
October 1997, the Patent and Trademark Office issued a notice of publication regarding our
application to register WorldQuest Networks as a trademark. In response to that notice, Qwest
Communications filed a notice of opposition in September 1998. Qwest Communications instituted a
cancellation proceeding in the Patent and Trademark Office for the registered trademark
WorldQuest. In December 2001, a judgment was made in the Companys favor whereby Qwests motion
to cancel our WorldQuest trademark was dismissed, however, Qwest filed a motion appealing the
judgment. In December 2002, Qwest filed a separate complaint stating that the Companys prepaid
cash card product infringes on the Qwest trademark. In February 2003, the companies settled all
outstanding claims whereby WorldQuest received a cash payment and telecommunication services
(primarily long distance termination) from Qwest and Qwest retained all rights to the trademarks in
question. Pursuant to the term of a settlement agreement with Qwest Communications arising out of
a trademark dispute, on November 9, 2004 the Company changed its name to WQN, Inc. from WorldQuest
Networks, Inc. The Company is a defendant from time to time in lawsuits and disputes arising in the ordinary
course of business. The Company believes that resolution of all known contingencies is uncertain,
and there can be no assurance that future costs related to such litigation would not be material to
the Companys financial position or results of operations. 19. Interest Income, Net Interest income for the years ended December 31, 2004 and 2003 was $293,000 and $207,000,
respectively. Interest income includes $114,778 interest on the Ntera loan and $13,457 interest on
the loan received in connection with the sale of the Companys financial service subsidiary.
Interest expense for the years ended December 31, 2004 and 2003 was $5,000 and $5,000,
respectively. F-19