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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 o
    
    Transition Report Pursuant to
Section 13 or 15(D) of the Securities Exchange Act of 1934
 For the transition period from _______________ to _______________ Commission File Number 001-15363 ADSTAR, INC. 
  Delaware
    
    22-3666899(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 4553 Glencoe Avenue, Suite 300, Marina del Rey, California 90292 
  Registrants telephone number (310) 577-8255 Securities registered under Section 12(b) of the Exchange Act: Title of Each Class
    
    Name of Each Exchange on Which RegisteredCommon Stock, par value $.0001 per share
    
    Boston Stock ExchangeWarrants
 Securities Registered under Section 12(g) of the Exchange Act: Common Stock, par value $.0001 per share 
  Warrants 
  Indicate by check mark whether the registrant: (1) has 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 registrant was required to file such reports) and (2) has been subject
to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B in this form and no disclosure will be contained, to the best of the 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.
þ For the year ended December 31, 2004, the revenues of the registrant were $4,933,537 The aggregate market value of the voting Common Stock of the registrant held by non-affiliates
of the registrant, based on the closing price on the Nasdaq Market on March 15,2005 of $0.84 per
share, was approximately $12,629,608. As of March 15, 2005, the registrant has a total of 15,216,395 shares of Common Stock
outstanding, including 68,243 shares issuable pursuant to the vendor compensation program. DOCUMENTS INCORPORATED BY REFERENCE NONE




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ADSTAR, INC. AND SUBSIDIARY Form 10-KSB Annual Report  
 TABLE OF CONTENTS PagePART IItem 1. Business
    
    
    3Item 2. Description of Property
    
    
    14Item 3. Legal Proceedings
    
    
    15Item 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 of Financial Condition
and Results of Operation
    
    
    18Item 7. Financial Statements
    
    
    31Item 8. Change in and Disagreements with Accountants on Accounting
and Financial Disclosure
    
    
    31Item 8A. Controls And Procedures
    
    
    31Item 8B. Other Information
    
    
    32PART IIIItem 9. Directors, Executive Officers, Promoters and Control Persons; Compliance With
Section 16(a) of the Exchange Act
    
    
    32Item 10. Executive Compensation
    
    
    34Item 11. Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
    
    
    36Item 12. Certain Relationships and Related Transactions
    
    
    39Item 13. Exhibits
    
    
    39Item 14. Principal Accountant Fees and Services
    
    
    42Exhibit 3.1.eExhibit 23.1Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
  FORWARD-LOOKING STATEMENTS Certain statements made in this Annual Report on Form 10-KSB are forward-looking statements
within the meaning of Section 21E of the Securities and Exchange Act of 1934 regarding the plans
and objectives of management for future operations and market trends and expectations. Such
statements involve known and unknown risks, uncertainties and other factors that may cause our
actual results, performance or achievements to be materially different from any future results,
performance or achievements expressed or implied by such forward-looking statements. The
forward-looking statements included herein are based on current expectations that involve numerous
risks and uncertainties. Our plans and objectives are based, in part, on assumptions involving the
continued expansion of our business. Assumptions relating to the foregoing involve judgments with
respect to, among other things, future economic, competitive and market conditions and future
business decisions, all of which are difficult or impossible to predict accurately and many of
which are beyond our control. Although we believe that our assumptions underlying the
forward-looking statements are reasonable, any of the assumptions could prove inaccurate and,
therefore, there can be no assurance that the forward-looking statements included in this report
will prove to be accurate. In light of the significant uncertainties inherent in the
forward-looking statements included herein, particularly in view of our early stage operations, the
inclusion of such information should not be regarded as a representation by us or any other person
that our objectives and plans will be achieved. The terms we, our, us, or any derivative
thereof, as used herein shall mean AdStar, Inc., a Delaware corporation. 2




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PART I 
 Item 1. BUSINESS General AdStar, Inc., (AdStar) provides technology services within the classified advertising
industry. Our proprietary software is an integrated suite of applications that electronically
connects publishers with the sources of their advertising revenue. Our software applications allow
professional advertising agencies businesses and individuals to electronically send ads to
newspapers. This gives newspapers the ability to electronically receive classified advertising
insertions directly into their sophisticated publishing systems. Our solutions are available in an
application service provider (ASP) model whereby we contract with publishers to design,
implement, host, and manage the on-line ad-taking capabilities of their Web sites. We provide all
the technical and application expertise, customer support, and security measures that the publisher
needs to install our application modules and begin to generate revenue in a short time frame. Our
software solutions afford newspapers the ability to increase revenue and are the application of
choice for advertisers, because it affords them the ability to effortlessly and quickly compose and
format classified ads, price them, schedule them, and electronically send them into the publishing
system at multiple newspapers. Corporate History AdStar was originally incorporated in New York as Ad-Star Services, Inc. a privately held
corporation. In 1999, we incorporated AdStar.com, Inc. in Delaware and merged Ad-Star Services,
Inc. into this entity. We completed an initial public offering of AdStar.com, Inc. Common Stock in
December 1999, receiving net proceeds of approximately $5.4 million. This was followed in September
2000, with another offering of Common Stock, receiving net proceeds of approximately $2.8 million.
In July 2001, we formally changed our name to AdStar, Inc. to more accurately reflect our current
business, products and our plans for future growth. In October 2003, we acquired Edgil Associates,
Inc. for approximately $3.9 million in cash and Common Stock to add their proprietary payment
processing solutions to our suite of application products. The AdStar Software Solution The new AdStar e-business application suite is an enterprise class, integrated software
solution that allows print and on-line publications to electronically receive completed classified
advertising copy using the Internet as the communication channel. This new application suite was
developed in conjunction with our existing customers, and in response to their need for a software
solution supporting both business-to-business (B-to-B) operations and business-to-customer (B-to-C)
operations. These software solutions enable our customers to expand the relationships with their
customers using a single integrated platform, while increasing sales volumes at reduced costs. Our
ASP product provides our customers an opportunity to generate incremental revenue from their
on-line business while increasing the number of visitors to their Web site. Our software allows
newspapers to turn their on-line presence into an e-commerce-enabled, revenue generating Web site. Our new e-business application suite includes four main products that can be purchased
separately or as a fully integrated software solution:  
    Professional software This technology is designed for use by the professional
marketplace. Specifically, the applications accept transmissions from classified
advertising agencies and large corporations using advanced Web-based technology. The
software includes sophisticated 3




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pricing algorithms to provide for maximum flexibility
and intricate design resources to provide unlimited creative capabilities.
    ASP Web site technology This technology is a publisher-specific ad-taking Web site
service designed to enhance a publications Web site by allowing the general public to
execute transactions to purchase classified advertising. Specifically, it is an
integrated application suite that offers visitors to a newspapers Web page the
opportunity to buy classified ads, for both the print and/or on-line editions of the
newspaper, in real-time, on a 24/7 basis. This product allows a publication to
completely outsource the classified ad-taking power of their Web site whereby the
publication receives incremental revenue at a very low incremental cost. We handle all
functions associated with this revenue source. We furnish and host the application
suite, run the technology, monitor the transactions throughout the session, handle the
payment authorization and settlement process, electronically deliver the ad text to the
newspaper, and provide customer service support to the newspapers customers. We
provide all the technical and application expertise, customer support, and security
measures that the publication needs to get an application up and running in a short
time. Typically, we are able to process many more ads and do so much more quickly and
affordably than the publisher could do internally. In addition, this software solution
provides tools to evaluate performance, provide additional customer care, and increase
future revenue opportunities. We provide the means to deliver highly personalized
email communications to existing customers for the purpose of creating additional
revenues and creating a profitable, long-term relationship
    XML Gateway (Application Programming Interface) This technology allows third
parties, internal newspaper applications, and niche Web publishers to facilitate the
processing of classified advertising. Use of AdStars infrastructure and incorporating
Web based ad taking for print, or for print in combination with an online ad, into
their applications.
    Credit Card Processing- With the acquisition of Edgil Associates in October of
2003, we have added the ability to offer to newspapers credit card processing for use
in phone rooms accepting classified ads, subscription departments or for any other
transaction that requires a credit card. Edgil offers system integration services,
installation support, training and customer service. Edgils proprietary EdgCapture
payment processing software processes over 12,000,000 million newspaper advertising and
circulation transactions annually for Tribune Company, Gannett Company, Inc.,
Knight-Ridder, Inc., Copley Press, Inc., the New York Times, Advance Publications,
Inc., Cox Enterprises, Inc., and Village Voice Media, Inc. as well as many independent
daily and specialty publications. Edgils product strategy focuses on providing
newspapers with the financial benefits afforded by reduced labor costs and lower credit
card processing discount rates. Edgils experience with integration services has given
the EdgCapture product line the technical differentiation to meet the specific credit
card processing requirements of the publishing industry. These software products allow transactions to be executed in a secure infrastructure. Our
application suite is designed to be quickly integrated into our customers existing publishing
software and readily expands as our customers needs and business grows. Our Web products use a
single platform to connect and integrate transmissions between multiple browsers and multiple
technology standards. In continually ensuring that our AdStar software solution works with all
available technology standards, we solve the problems created for our customers because advertisers
create and deliver content using ever changing technology with multiple standards, multiple
browsers and evolving network infrastructures. By bridging disparate technologies in a way that
seamlessly allows for communication and transmission of advertising copy, we alleviate this
obstacle for our customers, freeing them to focus on their business. 4




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Our Web-based classified lines of business generate fees to customize the AdStar software
solution to the technical specifications for each publication. In addition, we charge ongoing
monthly fees to manage the ad-taking process, provide technical support, supply a customer service
phone room, and manage the entire e-commerce function. The monthly fees include a small hosting
fee plus a fee based on transaction volumes and are structured in such a way that we are, in
essence, partnering with our customers. Therefore,
when our customers revenue increases, our revenue will also increase. With this structure, we
are able to offer superior service in a manner that is cost effective for publishers of all sizes. Edgils credit card processing application currently operates in a license mode with
installation fees and ongoing license and support fees. We plan to develop a transaction model for
credit card processing hosted on AdStars infrastructure and made available to both existing and
new accounts. Background We began developing the professional software application in 1986, and today have grown to
become the preeminent software solution providing large newspapers with the ability to
electronically receive classified advertising from advertising agencies and large corporations. Our
professional software application has seen numerous technological enhancements over the years, and
is still in place at the majority of installations. This technology enables newspapers to reduce
the amount of manual effort required to publish an ad and eliminates newspaper typographical
errors. Our software allows newspapers to process more ads accurately while under tight time
constraints to meet deadlines and thus realize greater revenue. Our remote entry version of this
software is currently in use at more than 25 large metropolitan newspapers linked to more than
1,500 advertising agencies and numerous large corporations. Our customers include such highly
respected publications as the Los Angeles Times, the Chicago Tribune, The Atlanta
Journal-Constitution, and The Miami Herald. During 1999 and 2000, we designed, engineered, and marketed Advertise123.com, a one-stop
marketplace on the Web for advertisers to buy classified ads. By accessing our Web site, we enable
advertisers to plan, schedule, compose, and purchase classified advertising from a large number of
print and on-line publishers using one simple interface. Our service permitted both advertising
agencies and consumers, including the general public, to create and submit to one or many
publications any number of classified ads, 24 hours a day, seven days a week, using any standard
Web browser. This one-stop marketplace was not especially successful from a business point of view. The
marketing costs associated with its promotion were not justified by the resulting ad volumes.
However, the underlying technology platform and infrastructure that we built enabled us to create a
new e-commerce opportunity for AdStar. We began marketing the technology, in a hosted environment,
directly to newspaper publishers on a private label basis. This enabled newspapers to sell print
classified ad placement on the web. As the web sites of newspapers continued to evolve, AdStars
infrastructure continued to be perfected, and today is a platform offering capabilities leading to
increased revenue opportunities for our customers. In addition to selling classified ads for their print editions, newspaper publishers host
their own web sites and are selling classified ads that are published on those sites. They compete
with the many online only (non-newspaper) websites that sell and publish classified advertising on
the web. AdStars platform enables newspaper publishers to compete very effectively with those
non-newspaper publishers by offering a print ad upsell to purchasers of online ads and an online
upsell to purchasers of print ads. Referred to as reverse publishing, this capability offers the
advertiser maximum coverage, both online and in the newspaper. It also provides the publisher
incremental revenue. This offering is critical to the overall success of classifieds. Newspapers
can compete more effectively with online only websites by offering the power of print as well as
online. 5




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In addition to offering the sale of print ad classifieds, online classifieds and the print ad
upsell to online classifieds, AdStars platform allows for the addition of other functionality. As
auction capabilities, photos, text messaging and the like become more mainstream, we can easily
accommodate the newspapers desire to incorporate them into a robust offering for classifieds. Marketing In 2004 we concentrated on communicating with our customers and prospects on a regular basis
through a monthly newsletter keeping them apprised as to what has been happening with e-commerce
and classifieds. Whether a new technology, real time payment processing or simply reporting on
success stories, it gave newspapers access to what was happening. In addition, we focused on reverse publishing capabilities with special projects for both the
Washington Post and the Atlanta Journal-Constitution. These applications, while specific to those
papers, are built upon our generic technology platform. This allows us to easily build similar
capabilities for other publishers. Attending local, regional and national trade shows during the course of the year kept us
abreast of the needs of the newspapers industry and also offered us a platform to market our
services . We continue to work with Bonafide Classifieds, the online arm of the Newspaper Association of
America (NAA) to help educate and enable their members to offer web-based ad taking. Our goal is to continue to grow transactions with our current customers and enable more
newspapers to get started. There are still many papers who do not offer real time processing for
classifieds. Efforts will take place at the individual paper level and corporate level where appropriate. AdStar Business Strategy In 2004 we focused our e-commerce development efforts to support the industrys move to
reverse publishing: online ads get upsold to print, print ads get upsold to online. The primary
reason for the industrys focus in this area is incremental revenue. In addition we positioned our e- commerce platform comprised of our complete infrastructure as
a solution for publishers in integrating the many and varied e-commerce opportunities coming their
way. As part of this transformation we developed new ASP services supporting high volume
transactions. The XML Gateway (Application Programming Interface) continued to attract large users
of classifieds as well as an acquisition, in late October 2003, of Edgil Associates, Inc. Edgil,
through its EdgCapture product line offers credit card processing for the newspaper industry.
This service enables phone rooms and subscription departments to accept credit card transactions
fully integrated into publishers various systems. In 2002 Edgil processed approximately 12 million
transactions for its customers. While currently operating as a license model we are developing a
hosted solution for publishers that would operate on a transaction model with a monthly fee and per
transaction fee. 6




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Our goal is to become the primary resource for E-Commerce to the newspaper industry, providing
applications for classified ad taking, credit card processing, online subscriptions and any and all
enhancements that can be offered on-line or at the newspapers facilities. To maintain the momentum we created in 2003, we will continue to aggressively pursue the
following:  
    cross selling papers on Web-based ad-taking and credit card processing;
    pursue third parties who can provide ad-taking capability to their customers by using
our XML Gateway;
    expand services to our existing account base with additional AdStar products; and
    acquire technologies that offer enhancements to ad-taking such as text messaging, sound,
auction functions, order fulfillment and virtual tours where we receive fees when
advertisers access these services through our transaction engine. Competition Our classified ad-taking processes compete with phone rooms and other established methods for
ad-taking at newspapers. However, we have not experienced extensive competition from others
offering electronic ad-taking services though many newspapers have established such capabilities on
their own Web sites. As Web-based ad-taking has become more accepted in the industry, other
software vendors, including publishing system vendors have begun to develop technologies that may
compete directly with our products. Many of these potential new competitors have longer operating
histories, greater name recognition, larger customer bases and significantly greater financial,
technical and marketing resources than us. We cannot guarantee that we will be able to compete
successfully against current or future competitors or that competitive pressures will not have a
material and adverse effect on our financial position, results of operations and cash flows. We
also expect that large media companies may decide to design, create, and program software
internally that will allow them to manage the Web-based classified ad-taking process internally. Our ability to compete will also depend upon our ability to continually improve our products
and services, the enhancements we develop, the quality of our customer service, and the ease of
use, performance, price and reliability of our products and services. Intellectual Property We regard our intellectual property as critical to our success, and we rely upon trademark,
and trade secret laws in the United States to protect our proprietary rights. We have established
trademark rights in various forms of the mark AD-STAR, ADSTAR and ADVERTISE123.COM, based on our
use of these marks and our ownership of incontestable United States trademark registrations.
Despite our existing trademark the marks remain susceptible to trademark infringement due to the
frequent illicit use and piracy of trademarks by cybersquatters on the Internet. Although we own
the domain names Advertise123.com and ADSTAR.com, there remains the risk that third parties will
seek to register our marks AD-STAR and Advertise123 in the other top level domains, e.g., .org,
 .net, and .gov, or that they will register close copies of our marks. 7




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We seek to protect our proprietary rights through the use of confidentiality agreements with
employees, consultants, advisors and others. We cannot guarantee that these agreements will provide
adequate protection for our proprietary rights in the event of any unauthorized use or disclosure,
that our employees, consultants, advisors or others will maintain the confidentiality of
proprietary information, or that proprietary information will not otherwise become known, or be
independently developed, by competitors. In the past, we have licensed elements of our trademarks, trade dress and similar proprietary
rights to third parties, and we expect to do so in the future. While we attempt to ensure that the
quality of our name and brand are maintained by our business partners, we cannot guarantee that
these partners will not take
actions that could materially and adversely affect the value of our proprietary rights or the
reputation of our software solutions and technologies. Legal standards relating to the validity, enforceability and scope of protection of certain
proprietary rights in Internet-related industries are uncertain and still evolving, and we cannot
make any guarantees as to the future viability or value of any of our proprietary rights or those
of other companies within the industry. We cannot guarantee that the steps taken by us to protect
our proprietary rights will be adequate or that third parties will not infringe or misappropriate
our proprietary rights. Any infringement or misappropriation, should it occur, could have a
materially adverse effect on our business, our results of operations, and our financial condition.
Furthermore, we cannot guarantee that our business activities will not infringe upon the
proprietary rights of others, or that other parties will not assert infringement claims against us. Employees As of March 15, 2005, we had a total of 28 employees. All but 1 of them are full-time
employees, including 4 in executive management, 9 in engineering, 7 in customer support, 1 in sales
and marketing, 3 in administration and 4 in finance. We are not subject to any collective
bargaining agreements. We believe that we are currently staffed at an appropriate level to
implement and carry out our business plan for the next 12 months. CERTAIN RISK FACTORS THAT MAY AFFECT GROWTH AND PROFITABILITY The following factors may affect the growth and profitability of AdStar and should be
considered by any prospective purchaser of AdStars securities: Our Ability To Sustain Our Operations And Ultimately Attain Profitability Could Be Adversely
Affected If We Are Not Able To Generate New Significant ASP Revenues. It is uncertain as to whether we can transform our business to one generating new significant
revenues from our ASP services. The uncertainty includes risks as to whether we will be able to:  
    attract a sufficient number of publishers for our new publisher specific ASP
ad-taking services to permit profitable operations;
    develop profitable pricing models for our volume related fees;
    respond effectively to competitive pressures; and 8




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
    attract, retain and motivate qualified personnel. Our failure to address these risks successfully could adversely affect our ability to sustain
our operations and ultimately attain profitability. Our Unproven On-Line Business Model May Not Generate Expected Revenues. Because we have limited Internet experience, we cannot accurately forecast the source,
magnitude or timing of our future revenues. Current expectations are that we will generate revenue
from:  
    hosting and transaction fees for ads processed through our ASP product,
    installation fees from publishers installing our new publisher specific ad-taking
Web site services;
    fees from publishers to process classified advertising utilizing our professional
software product. Our expectations with respect to future revenues are principally based on our ability to
attract advertisers and publications. In particular, our assumption that we will not encounter any
significant resistance by publishers to accepting Web-based ads may be wrong. Publishers might view
transactions in which we charge a transaction fee as reducing the amounts they would receive if
they obtained the ads directly. Conversely, advertisers may be reluctant to pay a mark-up to
published classified advertising rates. If because of these factors, the revenues are not generated
in the amounts and within the time periods necessary to sustain our operations, the prospects for
our ASP, on-line business will be seriously compromised. We Have A History Of Losses And Until We Are Able To Significantly Increase ASP Revenues We Expect
Continued Losses. We have incurred significant recurring net losses, and have used substantial funds in our
operations. For the years ended December 31, 2003 and 2004 we had net losses of $2,842,000 and
$3,648,000, respectively. Our 2003 and 2004 net losses were principally attributable to our
continued shift of focus from an on-line business to an ASP business however, our 2004 net loss
includes a $1,203,000 one-time loss from abandoned acquisitions. We expect to continue to incur
losses until we are able to increase our revenues significantly from fees based on the number of ad
purchases transacted through our ASP product. Our operating expenses have been reduced to remain
appropriate in connection with our curtailed activities. Our future profitability will depend on
our ability to increase our transaction and service revenues while controlling or reducing our
costs. We may not be able to achieve profitability. Although there can be no
assurance, we believe that expected cash flow from operations, including cost cutting measures such
as a curtailment of our acquisition strategy and development projects, a reduction in personnel and
other costs during the fourth quarter of 2004 and the additional $597,000 raised through the
exercise of warrants in January 2005, will be sufficient to meet our anticipated working capital
needs through March 31, 2006. In addition we will continue to seek additional financings. The Growth Of Our Historical AdStar Business Is Limited And May Not Be Able To Sustain Our
Operations On Its Own. Our historical AdStar remote ad entry business is limited both in current size and growth
potential due principally to the installation, training and on-going support costs at advertiser
sites and the requirement that advertisers separately dial-up each publication in which they intend
to buy an ad. Our ability to achieve 9




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sufficient revenues to justify the expectations of our
investors is dependent on the success of our professional software product which we believe
eliminates these barriers. Our belief that we can successfully expand our business by migrating to
an Internet delivery system and providing publisher specific site design, customization,
implementation and management services may not be correct. We May Be Unable To Obtain The Additional Capital Required To Grow Our Business Which Would Have An
Adverse Effect On The Successful Implementation Of Our Planned Business Expansion. Our ability to grow depends significantly on our ability to attract publishers to sign-up for
AdStars suite of products, which means having an adequate sales and marketing budget and adequate
funds to continue to enhance our Web sites and ad-taking technology. If the actual cost of
attracting publishers, and enhancing our Web sites and ad-taking technology are higher than
projected or the revenues from our operations fall below our current expectations, we may need
additional financing in the near future. In either event, if our revenues are insufficient to
provide the necessary cash flow for ongoing operations, we will
need to seek additional capital from public or private equity or debt sources to fund our
growth and operating plans and respond to other contingencies. We may not be able to raise needed
cash on terms acceptable to us or at all. Financings may be on terms that are dilutive or
potentially dilutive to our stockholders. If sources of financing are required, but are
insufficient or unavailable, we will be required to modify our growth and operating plans to the
extent of available funding, which would have an adverse effect on the successful implementation of
our planned business expansion. At December 31, 2004 We Have Negative Working Capital Which May
Restrict The Rate Of Our Revenue Growth. At December 31, 2004 we had negative working capital of $1,534,931 compared to $149,000
positive working capital as of December 31, 2003. The deterioration in working capital is
primarily a result of our loss from operations in 2004, including a loss of $1,203,000 with respect
to abandon acquisition cost and an aggregate increase in our current liabilities of $796,000 at
December 31, 2004. We use working capital to increase our sales and marketing efforts, to develop
new or enhance existing products and services, to respond to competitive pressures and to fund
potential acquisitions and expansion. We believe that our cash on hand of $1,093,000 at December
31, 2004, the increase in the cash flows that we are currently generating, which we expect will
continue, from operations through the implementation of cost cutting measures, including a
reduction in staff during the fourth quarter 2004, pay cuts effective January 1, 2005, the
curtailment of our acquisition strategy and development projects, other cost saving measures, the
additional $597,000 raised through the exercise of warrants on January 5, 2005 and an expected
increase in revenues will generate sufficient capital to meet our working capital needs at least
through the next twelve months. Additionally, we currently have no additional borrowings available
to us under any credit arrangement, and we are continuing to look for additional financing.
Adequate funds may not be available or may not be available on terms favorable to us. If
additional funds are raised through the issuance of equity securities, dilution to existing
stockholders may result. If funding is insufficient at any time in the future, we may be unable to
develop or enhance our products or services, take advantage of business opportunities or respond to
competitive pressures, any of which could have a material adverse effect on our financial position,
results of operations and cash flows. We Are Vulnerable To Breakdowns In Service, Which Could Cause Our Customers And Prospective
Customers To Lose Faith In Our Ability To Service Their Needs. As a business delivering certain services via the Internet, we are vulnerable to breakdowns
and interruptions in Internet transmission which could disrupt our ability to provide continued and
sustained support to advertisers and publishers. We have not yet suffered any serious breakdowns in
service. If because of interruptions our customers and prospective customers lose faith in our
ability to service their needs, they may choose more traditional means for placing their classified
ads, may turn to our competition, or may choose to no longer outsource their Web-based ad-taking
functions and instead perform the services in-house. If this were to occur, we would not be
successful in building an on-line business. In March 2003 we entered into an arrangement with
Tribune Company to build out a fully functional back-up site at their AT&T co-location in Redwood
City, California. The site was tested during 2004 and has been deemed to be fully operational. Our Ability To Compete Effectively And Operate Profitably Cannot Be Assured Because Our ASP
Business Competes With Established Methods For Ad-Taking. Our classified ad-taking processes compete with phone rooms and other established methods for
ad taking at newspapers. We are unaware of any major company that provides a centralized publisher
specific ad-taking Web site services for the selection, transaction and processing of classified
ads or to multiple print and on-line publication technology though many newspapers have established
ad-taking capabilities on their own Web sites. Those publishers that accept and process ads by
traditional means like telephone, facsimile transmission and printed copy submissions are potential
competitors. Our ability to compete successfully will depend on the perceived convenience of our
services, ease of use and the amount of fees we charge. In addition, companies not now in the
business of providing on-line remote ad entry but possessing more capital resources than we do may
seek to develop their own technology and enter into the business of offering a similar broad based,
centralized on-line classified ad placement services to ours. Some of these companies could have
longer operating histories, greater name recognition, larger customer bases and significantly
greater technical and marketing resources than we have. As a result, they may be able to 10




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respond
more quickly than we can to new or emerging technologies and can devote greater resources than we
can to development, promotion and sale of their services. Faced with this type of competition, our
ability to compete effectively and operate profitably cannot be assured. Our Limited Experience May Affect Our Ability To Deal Effectively With Technological Change Which
Could Materially and Adversely Affect Our Business. Our on-line business is characterized by:  
    rapidly changing technology;
    evolving industry standards;
    frequent new product and service announcements;
    introductions and enhancements; and
    changing customer demands. These market characteristics are heightened by the emerging nature of the Internet, Internet
advertising, Internet transactional activity, and in particular by our limited experience and short
operating history in this market. For these reasons, our future success depends on:  
    our ability to adapt the rapidly changing technologies to the needs of our
advertising and publishing clients; and
    our ability to continually improve the performance, features and reliability of our
on-line services. Furthermore, we do not know if we will have the experience and talent to overcome technical
difficulties that may arise from time to time that could delay or prevent the successful design,
development, testing, introduction or marketing of software solutions, or that any new software
solutions or enhancements to existing software applications will adequately meet the requirements
of our current and prospective customers and achieve any degree of significant market acceptance.
If we are unable, for technological or any other reasons, to develop and introduce new software
solutions or enhancements to existing software solutions in a timely manner or in response to
changing market conditions or customer requirements, or if our software solutions or enhancements
contain errors or do not achieve a significant degree of market acceptance, our financial position,
results of operations and cash flows could be materially and adversely affected. We May Be Unable To Manage Our Growth. Our business plan contemplates a sizable increase in the advertisers and publishers using our
on-line services. In the event we need to increase the number of our employees beyond current
levels, the recruitment, training and integration of these persons into our operations will place a
significant strain on our managerial, operational and financial resources. We cannot guarantee that
we will be able to manage effectively the expansion of our operations, or that our personnel,
systems, procedures and controls will be adequate to meet our anticipated future operations. If
this were to occur, it would materially and adversely affect our business and prospects. 11




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We May Not Be Able To Retain Key Existing Employees Or Attract The Additional Employees Essential
To The Success Of Our Business. Our performance is substantially dependent on the performance of our management and key
technical personnel and on our ability to retain and/or attract the new Internet-oriented employees
required in the implementation of our business plan. The competition for Internet-oriented people
of the type we will be seeking is intense and we may be hard pressed to find the personnel needed
as fast as we need them. If we are unable to retain our key existing employees or to attract, hire
and assimilate the qualified employees we will be seeking, the growth of our on-line business will
be arrested and we will not be able to meet the projected revenue increases within the time period
contemplated in our business plan, if at all. Our Business Could Be Adversely Affected If The Services Of Either Our Chief Executive Officer Or
Chief Technology Officer Become Unavailable To Us. We are dependent on the continuing efforts of our President and Chief Executive Officer,
Leslie Bernhard, and our Executive Vice President and Chief Technology Officer, Eli Rousso. Our
business may be adversely affected if the services of either officer become unavailable to us.
While we have obtained a key-man life insurance policy on the lives of both Leslie Bernhard and Eli
Rousso in the amount of $850,000 each, this amount may not be sufficient to offset the loss of
their services. We Are Vulnerable To Potential Lawsuits Regarding Ad Content Or System Failure. Because we facilitate the placement of advertisements in print and on-line publications,
potential claims may be asserted against us for negligence, defamation or personal injury, or for
reasons based on other theories, due to the nature of the content of these advertisements. Our
technology does not contemplate our reviewing classified advertisement content processed on our Web
sites for libelous or other statements that might give rise to possible liability. This role has
been fulfilled historically by each publication and we expect the publications will continue to
monitor their ads. Although we carry general and professional liability insurance, our coverage may
not cover potential claims or may not be adequate to indemnify us fully. Any imposition of
liability or legal defense expenses that are not covered by insurance or that are in excess of our
insurance coverage could place a strain on our available cash resources, could seriously jeopardize
the success of our business plan and could materially and adversely affect our financial position,
results of operations and cash flows. Our On-Line Businesses Have A Limited History And May Not Be Successful. We did not begin to offer our technology over the Internet until June 1999 and offered only a
limited number of publications from which to purchase classified advertising until March 2000.
Moreover, we know of no other major company that accepts classified ads on-line for publication
both on-line and in print. Accordingly, we cannot guarantee that we will be able to generate the
public interest necessary to sustain our business model. We May Not Be Able To Protect Our Proprietary Rights. We believe that our future success will depend, in part, on our ability to develop and enforce
proprietary rights with respect to our systems and services including domain names, trademarks,
trade names, service marks and copyrights. This is particularly true with respect to our Web-based
service technology. We do not currently own any patents or patent applications on our technology
and we have no assurance that our rights to that technology are patentable or otherwise
protectable. Moreover, there is no assurance that others might not develop alternate technologies
that might be more effective than ours regardless of whether or not we obtain patent protection. 12




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Despite our existing trademark rights in the marks AD-STAR, ADSTAR, and Advertise123.com, the
marks remain susceptible to trademark infringement due to the frequent illicit use and piracy of
trademarks by cybersquatters on the Internet. Although we own the domain names Advertise123.com
and ADSTAR.com, there remains the risk that third parties will seek to register our marks AD-STAR
and Advertise123 in the other top level domains, e.g., .org, .net, and .gov, or that they will
register close copies of our marks.Furthermore, we cannot guarantee that our business activities
will not infringe upon the proprietary rights of others, or that other parties will not assert
infringement claims against us. If for any of the above reasons we are deprived of any proprietary
rights to our technology or trade style, our prospects for success may be seriously and adversely
affected. If Others Develop Alternate Technologies, Or Use Our Technology Without Our Authorization, Our
Business, Results Of Operation And Financial Position Could Be Materially And Adversely Affected. We do not currently own any patents or patent applications on our technology and we have no
assurance that it will not be used by others without our authorization. Moreover, there is no
assurance that others might not develop alternate technologies that might be more effective than
ours whether or not we obtain patent protection. If others develop alternate technologies or use
our technology without our authorization, our results of operations and financial position could be
materially and adversely affected. Natural Disasters Which Disrupt Our Services Could Have An Adverse Effect On Our Business, Results
Of Operations And Financial Condition. Our operations and services depend on the extent to which our computer equipment and the
telecommunications infrastructure of our third-party network providers is protected against damage
from fire, earthquakes, power loss, telecommunications failures, and similar events. A significant
portion of our computer equipment, including critical equipment dedicated to our Internet access is
located in the Los Angeles, California area. Despite precautions taken by us and our third-party
network providers, over which we have no control, a natural disaster or other unanticipated
problems at our network hub, or a third-party network provider point of presence could cause
interruptions in the services that we provide. If disruptions occur, we may have no means of
replacing these network elements on a timely basis or at all. We do not currently maintain back-up
Internet services or facilities or other back-up computing and telecommunications facilities.
Extensive or multiple interruptions in providing users with Internet access is a reason for users
to decide to stop using access services. Accordingly, any disruption of access services in general,
or our service specifically, due to systems failure could have an adverse effect on our business,
results of operations and financial condition. Furthermore, we do not currently have any business
disruption insurance. Our Corporate Documents May Limit Rights Of Stockholders. Our Board of Directors has the authority to issue up to an additional 1,556,543 shares of
Preferred Stock without any further vote or action by our stockholders, and to determine the price,
rights, preferences, privileges and restrictions, including voting rights of these shares. Since
the Preferred Stock could be issued with voting, liquidation, dividend and other rights superior to
the rights accompanying shares of our Common Stock, the rights of the holders of shares of Common
Stock will be subject to, and may be adversely affected by, the superior rights of the holders of
Preferred Stock. The issuance of Preferred Stock could also make it more difficult for a third
party to acquire a majority of our outstanding voting stock. Furthermore, certain provisions of our
Certificate of Incorporation, and certain provisions of our Bylaws and of Delaware law, could have
the effect of delaying or preventing a change in control of the corporation which the stockholders
may deem to be in the best interests of AdStar. 13




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If Our Shares Of Common Stock Are Removed Or Delisted From The Nasdaq Small Cap Market, The Ability
Of Stockholders To Sell Our Common Stock And Warrants In The Secondary Market Could Be Restricted. The Securities and Exchange Commission has adopted regulations which generally define penny
stock to be an equity security that has a market price, as defined, of less than $5.00 per share
or an exercise price of less than $5.00 per share, subject to certain exceptions, including an
exception of an equity security that is quoted on The Nasdaq Stock Market. If our shares of Common
Stock are removed or delisted from The Nasdaq Small Cap Market, the security may become subject to
rules that impose additional sales practice requirements on broker-dealers who sell these
securities. For transactions covered by these rules, the broker-dealer must make a special
suitability determination for the purchaser of such securities and have received the purchasers
written consent to the transactions prior to the purchase. Additionally, for any transaction
involving a penny stock, unless exempt, the rules require the delivery, prior to the transaction,
of a disclosure schedule prepared by the Securities and Exchange Commission relating to the penny
stock market. The broker-dealer also must disclose the commissions payable to both the
broker-dealer and the registered underwriter, current quotations for the securities and, if the
broker-dealer is the sole market maker, the broker-dealer must disclose this fact and the
broker-dealers presumed control over the market. Finally, among other requirements, monthly
statements must be sent disclosing recent price information for the penny stock held in the account
and information on the limited market in penny stocks. As such, the penny stock rules, in the
event our securities are delisted from The Nasdaq Small Cap Market, may restrict the ability of
stockholders to sell our Common Stock and warrants in the secondary market. If We Are Unable To Satisfy Nasdaqs Maintenance Requirements, Our Common Stock May Be Delisted
From Nasdaq Which Could Impair The Liquidity And The Value Of Our Common Stock. While the shares of Common Stock met current Nasdaq listing requirements when initially listed
and are currently included on Nasdaq, there can be no assurance that we will meet the criteria for
continued listing. Continued listing on Nasdaq generally requires that (i) we maintain at least
$2,500,000 in stockholders equity, or $35,000,000 in market capitalization, or $500,000 in net
income for either the last fiscal year, or two out of the last three fiscal years, (ii) the minimum
bid price of the Common Stock be $1.00 per share, (iii) there be at least 500,000 shares in the
public float valued at $1,000,000 or more, (iv) the Common Stock have at least two active market
makers, and (v) the Common Stock be held by at least 300 holders. In February 2005, we received a
letter from Nasdaq putting us on notice that the bid price of our Common Stock had fallen below
their $1.00 per share minimum. Currently, our Common Stock is trading below $1.00. Pursuant
to applicable Nasdaq rules, we have been provided a 180 day grace period until August 17, 2005 to
regain compliance by having the bid price of our Common Stock close at $1.00 per share or more for
a minimum of 10 consecutive business days. If we are unable to satisfy Nasdaqs maintenance
requirements, our securities may be delisted from The Nasdaq Small Cap Market. In that event,
trading, if any, in the Common Stock and warrants would be conducted in the over-the-counter market
in the so-called pink sheets or the NASDs OTC Bulletin Board. Consequently, the liquidity of
our securities could be impaired, not only in the number of securities which could be bought and
sold, but also through delays in the timing of transactions, reduction in security analysts and new
media coverage of AdStar, and lower prices for our securities than might otherwise be obtained. 
 Item 2. Description of Property Our offices are currently located in two separate facilities. The principal office in Marina
del Rey, California consists of an aggregate 5,000 square feet. Offices for our east coast wholly
owned subsidiary, Edgil Associates, Inc., are located in North Chelmsford, Massachusetts,
consisting of approximately 9,000 square feet. In July 2000, we entered into a lease consisting of
approximately 1,700 square feet in Lyndhurst, New Jersey. In May 2001, we assigned all rights in
this lease to Dominion Telecom, Inc., however we 14




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remain secondarily liable on this lease. In December 2002 management executed a plan to
close our east coast offices, in Syosset, New York, and transfer the function performed at that
location to Marina del Rey. In December 2003 we sub-let this 1,400 square foot space. These four
existing leases expire on November 7, 2009, August 31, 2006, November 30, 2005 and April 30, 2005,
respectively. The aggregate monthly rent, net of the current sub-leases and assignment, is
approximately $18,000. We believe that if these leases are not renewed, satisfactory alternative
space will be available. 
 Item 3. Legal Proceedings None. 
 Item 4. Submission of Matters to a Vote of Security Holders On Thursday, November 11, 2004 at 9:00 a.m., Eastern time we held our 2004 Annual Meeting of
Stockholders for the purpose of electing directors, consideration and approval of the AdStar, Inc.
2004 Stock Option Plan, amending AdStars Certificate of Incorporation to increase the number of
authorized shares of Common Stock from 20,000,000 to 40,000,000, and to ratify the selection of the
independent auditors for fiscal 2004. At the meeting,: for which proxies were solicited pursuant
to Regulation 14A under the Exchange Act and there was no solicitation in opposition to any of the
nominees, all of the nominees were elected as directors of AdStar, Inc. for one year terms. The Stockholders also approved the 2004 Stock Option plan with 2,786,017 votes cast in favor,
716,881 against and 37,534 abstaining; the amendment to the Certificate of Incorporation to
increase the number of authorized shares with 10,305,283 votes cast in favor, 481,473 against and
47,600 abstaining; and the appointment of BDO Seidman LLP as our independent auditors for fiscal
2004 was ratified with 10,779,756 votes in favor, 11,000 votes against and 44,000 votes withheld. In January 2004, the holders of a majority of the shares of our Common Stock and Preferred
Stock, voting together as one class, by written consent ratified and approved the issuance of
1,311,350 shares of AdStar Common Stock in connection with our acquisition of all of the assets of
Edgil Associates, Inc., a Massachusetts corporation (Edgil) through the merger of Edgil into our
wholly owned subsidiary. We provided a description of the matter voted upon by filing a Current
Report on Form 8-K with the Securities and Exchange Commission on November 4, 2003 and an
Information Statement further describing the matter voted upon on March 8, 2004 pursuant to the
requirements of Section 14(c) of the Securities Exchange Act of 1934 and Section 228(d) of the
General Corporation Law of the State of Delaware. 
 PART II 
 Item 5. Market for Common Equity and Related Stockholder Matters (a) Market Information AdStars Common Stock is traded on the Boston Stock Exchange and the Nasdaq Small Cap Market
under the symbol ADST. The following table sets forth, for the periods indicated, the high and
low bid information for AdStars Common Stock. Such quotations reflect inter-dealer prices, without
retail mark-up, markdown or commission and may not necessarily represent actual transactions. Bid InformationPrice range of Common Stock
    
    High
    
    
    LowYear Ended December 31, 2003First quarter
    
    $
    1.05
    
    
    $
    0.61
 15




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Bid InformationPrice range of Common Stock
    
    High
    
    
    LowSecond quarter
    
    $
    1.22
    
    
    $
    0.68Third quarter
    
    $
    2.40
    
    
    $
    1.19Fourth quarter
    
    $
    2.24
    
    
    $
    1.50Year Ended December 31, 2004First quarter
    
    $
    2.65
    
    
    $
    1.80Second quarter
    
    $
    3.05
    
    
    $
    2.05Third quarter
    
    $
    2.20
    
    
    $
    1.28Fourth quarter
    
    $
    1.51
    
    
    $
    0.90
 As of March 15, 2005, the closing bid price per share for our Common Stock, as reported on the
Nasdaq Small Cap Market was $0.84. (b) Holders As of March 15, 2005, the number of record holders of the Preferred and Common Stock of AdStar
was one and approximately 48, respectively. AdStar believes that there are more than 1,700
beneficial holders of the Common Stock. (c) Dividends The holders of Common Stock are entitled to receive such dividends as may be declared by
AdStars Board of Directors. During the years ended 2003 and 2004, AdStar did not pay any
dividends, and it does not expect to declare or pay any dividends in the foreseeable future.
Payment of future dividends will be within the discretion of AdStars Board of Directors and will
depend on, among other factors, retained earnings, capital requirements, and the operating and
financial condition of AdStar. Recent Sales of Unregistered Securities. In December 1999, the Company established a vendor compensation plan whereby it may compensate
vendors who are accredited investors, as defined under Rule 215 of the Securities Act of 1933, in
shares of its Common Stock in lieu of cash. Under the plan, 400,000 shares are available for
issuance. AdStar established a vendor payment plan whereby it may pay vendors who are accredited
investors, as defined under Rule 215 of the Securities Act of 1933 (the Act), in shares of its
Common Stock in lieu of cash. Under the plan, 400,000 shares are available for issuance. During
2003 and 2004, 33,279 and 53,217 shares, respectively, were issued to vendors under the plan
relying upon the exemptions under Sections 4(2) and 4(6) of the Securities Act of 1933 which
represented compensation of $42,000 and $96,325,respectively. In December 2002 the Board of Directors approved the sale of shares of its Series B Preferred
Stock to Tribune Company for an aggregate price of $1.5 million. The sale was split into two
funding segments: (i) In December 2002, AdStar sold 1,200,000 shares of its Series B-1 Preferred Stock to
Tribune Company for an aggregate purchase price of $900,000, excluding $86,280 in costs of
financing. These shares currently convert on a 1:1 basis. Shareholders of Series B-1 Preferred
Stock are entitled to vote on all matters submitted to the stockholders for vote and as a single
class with the Common Stock. The holders of Series B-1 Preferred Stock are entitled to one vote for
each share; and (ii) In March 2003, AdStar sold 800,000 shares of its Series B-2 Preferred Stock to Tribune
Company for an aggregate purchase price of $600,000 excluding $71,317 in costs of financing. These
shares currently convert on a 1:1 basis. Shareholders of Series B-2 Preferred Stock are entitled to
vote on all matters submitted to the stockholders for vote and as a single class with the Common
Stock. The holders of 16




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Series B-2 Preferred Stock are entitled to one vote for each share. In addition, on March 28,
2003, in exchange for all of the Series B-1 Preferred Stock plus accrued and unpaid dividends on
those shares, issued in December 2002 to Tribune Company, AdStar issued an additional 1,200,000
shares of its Series B-2 Preferred Stock to Tribune Company. These sales were exempt from registration, as it was a nonpublic offering, made pursuant to
Sections 4(2) and 4(6) of the Act. In March 2003, AdStar issued to Marina Co. a nominee of partners in Morse, Zelnick, Rose and
Lander LLP, AdStars legal counsel, 63,291 shares of restricted Common Stock, issued at fair market
value as payment for $50,000 in legal services accrued at December 31, 2003. This sale was exempt
from registration, as it was a nonpublic offering, made pursuant to Sections 4(2) and 4(6) of the
Act. In September 2003 we sold through a private placement offering 1,590,000 shares of the
Companys authorized but unregistered Common Stock at a price of $1.25 per share. In connection
with this offering the Company paid a commission consisting of $198,750 in cash and issued warrants
to purchase 159,000 shares of its Common Stock, at $1.87. The warrants are exercisable beginning
on March 31, 2004 and expire on March 31, 2009. The Company valued the warrants using the Black
Scholes method, which resulted in a value of $261,169. This amount is being offset against the
proceeds from the private placement as a cost of financing. The sale of these shares was pursuant
to the exemption under sections 4(2) and 4(6) of the Act. On October 21, 2003 in connection with our acquisition of all of the business and assets of
Edgil Associates, Inc., a Massachusetts corporation (Edgil), pursuant to an Agreement and Plan of
Merger, we paid $1,520,000 cash and issued 1,311,530 shares of our restricted Common Stock in
exchange for all the outstanding capital stock of Edgil. The number of shares issued was based upon
the closing price of the Common Stock on the Nasdaq SmallCap Market on October 20, 2003 and was
valued at $2,111,563 based upon the average closing price of the Common Stock on the Nasdaq
SmallCap Market for the 10 trading day period beginning October 14, 2003. A complete description
of the merger and the merger documents can be found on the Current Report on Form 8-K that we filed
with the Securities and Exchange Commission on November 4, 2003. The issuance of these shares was
pursuant to the exemptions under sections 4(2) and 4(6) of the Act. In November 2003, we sold 1,257,692 shares of our Common Stock at a price of $1.30 per share
to accredited investors in a private placement offering raising gross proceeds of approximately
$1,635,000 excluding $56,104 in costs of financing. This sale was exempt from registration, as it
was a nonpublic offering, made pursuant to Sections 4(2) and 4(6) of the Act. In December 2003 and July 2004, AdStar issued to Marina Co. a nominee of the partners of
Morse, Zelnick, Rose and Lander LLP, AdStars legal counsel, 34,615 and 25,000 shares of restricted
Common Stock at fair market value as payment for $45,000 and $32,250, respectively, in legal
services provided during 2003 and 2004. These sales were exempt from registration, as they were nonpublic
offerings, made pursuant to Sections 4(2) and 4(6) of the Act. On April 12, 2004, we closed on a $1.5 million private placement of a 3-year secured
convertible note (the Note) and 7-year warrants to purchase 200,000 shares (the Warrants) of
our Common Stock (the Common Stock) with Laurus Master Fund, Ltd., a New York City based
institutional fund and an accredited investor (Laurus Master Fund). The Note bears interest at the prime rate minus one percentage point and is convertible into
Common Stock at an initial fixed conversion price of $2.25 per share (the Fixed Conversion
Price), 105% of the average closing price of the Common Stock (Average Closing Price) during the
22 trading days preceding 17




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the closing date. The Note has limited anti-dilution protection for capital changes and, on a
weighted average basis, for issuance of Common Stock below the Fixed Conversion Price, excluding
shares issued in mergers, acquisition or strategic relationships, shares underlying compensatory
options, shares issued on conversion or exercise of outstanding securities and other exceptions. The shares underlying the Note are covered by an effective registration statement and subject
to certain limitations based on market volume for the Common Stock and Laurus Master Funds
aggregate holdings, Laurus Master Fund is required to convert all monthly installments of principal
and interest into Common Stock if the Average Closing Price for the 5 trading days immediately
preceding each monthly installment payment date is more than 10 % above the Fixed Conversion Price.
Additionally, we may redeem the Note by paying 125 % of the then outstanding principal balance
plus accrued interest. The Note is secured by a first lien on all of our assets. Of the Warrants, 120,000 are exercisable at $2.58 and 80,000 are exercisable at $2.80 (120%
and 130% of the Average Closing Price during the 22 trading days preceding the closing). Pursuant to the terms of the Note and the Warrants, Laurus Master Fund may not receive shares
of Common Stock on conversion of the Note or exercise of the Warrants to the extent such conversion
or exercise would result in Laurus Master Fund beneficially owning in excess of 4.99% of the issued
and outstanding shares of Common Stock. During May 2004, pursuant to the terms of the Note, Laurus Master Fund elected to convert
$225,000 of the Note into 100,000 shares of Common Stock, at a conversion price of $2.25 per share. 
 Item 6. Managements Discussion and Analysis of Financial Condition and Results of Operation The following discussion of our financial condition and results of operations should be read in
conjunction with the consolidated financial statements and related notes to the consolidated
financial statements included elsewhere in this annual report. Certain statements in this
discussion and elsewhere in this report constitute forward-looking statements within the meaning of
Section 21E of the Securities and Exchange Act of 1934. See Forward-Looking Statements following
the Table of Contents of this 10-KSB. Because this discussion involves risk and uncertainties, our
actual results may differ materially from those anticipated in these forward-looking statements. Overview In 2001 we repositioned our products, moving away from the idea of the Internet as a
stand-alone business category, and moving towards the idea of the Internet as an extremely
efficient and flexible communication channel. We recognized that this technology can be utilized to
greatly enhance the functionality of the software we licensed to our existing customer base, as
well as expand into new areas where our technology can be used to connect advertising outlets with
advertisers. During 2002, we began to execute our business plan and spent virtually the entire year
on successfully enhancing and integrating our existing technology and new products into the
existing and new customers. While some of our historical business has migrated to our new
transaction based model, it continues to be used by hundreds of recruitment agencies and volume
advertisers. During 2003 we continued customer requested enhancements to our existing applications
and expect to monetize the rollouts to a greater extent in 2004 as more publications adapt the new
robust applications available to them. In working with our customers, we recognized there was a great demand for our Web-based
technology within the newspaper industry to run the online classified ad-taking abilities at our
customers 18




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Web sites under a private label branded site concept. Therefore, we revised our business model
to embrace these concepts, and we focused on the immediate needs of our customers. While doing
this, we also made sure that our technology remained flexible to allow for changes as the needs of
our customers change and as we develop product extensions and new lines of business based on our
existing technology and expertise. We adopted our marketing and sales strategies to our new Web-based ad-taking ASP product, and
began marketing the product in September 2001 and found that it was well received by our customers.
During 2001, we implemented our Web-based classified ad-taking ASP product at 14 new metropolitan
newspapers. Given the severe downturn in advertising revenue in 2001, we were told by many
potential customers that implementing our ASP product will need to wait until their advertising
revenue has returned to more normal levels. In 2002, despite a slow economy we contracted with an
additional 16 newspapers to use our Web-based classified ad-taking ASP product. In 2003 we formalized our marketing effort behind our XML Gateway (Application Programming
Interface). With third parties and publishers alike looking to incorporate classified print
advertising into their applications, the Gateway proved to be an easy way to accomplish it. Publishers are beginning to realize the revenue potential of offering print in combination
with online advertising. Being able to accomplish it has been problematic due to old legacy
systems that cannot accommodate this offering. Referred to as reverse publishing, it addresses the
users who currently go online to buy an online ad for a reasonable up-charge they can include a
print ad in their advertising package. The strength of a combination print and online ad assures
the advertiser of maximum exposure. Publishers now receive classified advertising from a myriad of
sources transmitted in a myriad of ways, each offering their own challenges to process in a quick
and efficient way. The XML Gateway allows a newspaper to provide a common, single point of entry to
whoever wants to send ads and easily drive them directly into their publishing systems. In 2003 we also saw the release of our new USER INTERFACE for Web-based ad taking. This new
interface accommodates a variety of customized up-sells for an
advertiser  including our bold
headlines, borders, background shading, pictures and graphic attention getters. The user is able to
create in real time an ad with a unique look and feel. As important as up-sells are to newspapers for additional revenue, what is more important is
the platform we have created that can expand to offer new and unique capabilities. The future of
classifieds rests with the online side of the industry. While print classifieds are two-dimensional
online classifieds will offer all that technology can provide. In the future we will be able to
provide sound, text messaging, voice recognition, auction function and order fulfillment for items
sold etc. All these capabilities will ultimately be provided by our ever-expanding suite of
products. We will partner with these technologies or we will acquire to ensure our leadership role
as the E-Commerce provider to the newspaper industry. In October of 2003 we acquired Edgil Associates, Inc. Edgil provides credit card processing to
the newspaper industry. Key to their service is providing seamless integration of these
transactions into billing systems and circulation systems alike. Historically operating in a
license model we look forward to offering this service in a hosted environment with monthly fees
and transaction fees in line with AdStars current model. Edgils principal product lines include
EdgCapture, a complete payment processing solution and EdgFlow, a content processing and routing
needs solution. EdgCapture -Processing credit card payments has become a way of life for newspapers.
Advertising, circulation, and new media departments need to automate payment processing and
integrate e-commerce programs into day-to-day operations. Using EdgCapture, newspapers have seen a
dramatic improvement in their bottom line. Offering prepayment alternatives to advertisers and
subscribers reduces labor and the costs 19




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associated with taking ads and subscriptions over the phone or Internet. More than just a
piece of software, EdgCapture is an innovative service that allows newspapers and groups of
newspapers to establish their own private payment processing interfaces. With a consistent track
record, EdgCapture effortlessly processes millions of transactions per year. EdgFlow  Data is at the heart of every corporate operation. Managing the distribution of data
among a variety of systems has become an extremely complex task. The EdgFlow system was designed to help organizations cope with their changing data
requirements. The diversity of client/server environments and open database solutions gives a whole
new meaning to the phrase data delivery. Its flexibility is particularly attractive for data
management applications running in a heterogeneous environment encompassing various desktop and
legacy systems. EdgFlow allows organizations to deliver timely information in a format that they need. With
the increasing distribution of information to the Internet, intranets, and a variety of databases,
corporations must be equipped with the high performance tools necessary to meet the
information-specific demands of their customers and their staff. Edgils customer account base offers fertile ground for cross selling opportunities for
Web-based ad taking. In addition to transitioning to a recurring revenue model and expanding our newspaper
customers, we are now in a position to reduce our operating costs on a going forward basis. There
can be no assurance that our new product offerings or the arrangement with Tribune Company will be
successful in generating revenues sufficient to support our operating expenses. Prior to the development of our Web business, revenues had been generally sufficient to
support our historic business. In developing our Web-based system we began to incur significant
losses that could not be offset by the revenues generated by our historic business. These expenses
caused us to incur significant losses from 1998 through 2004. Our future success is dependent upon
our ability to substantially grow revenues and control costs to the point where we can fund the
level of operations necessary to serve the anticipated customer base. To this end, our plans have
included expanding the products and services offered to our customers by building on our
proprietary software processes and unique position within the industry. We feel that there is
significant opportunity to increase revenues by offering the Web software and services that we had
initially developed for ourselves to print publications as an application service provider (ASP).
In addition we have already taken steps to control or in some cases reduce costs on an ongoing
basis. (see Business in part I). 20




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Results of Operations The following table sets forth the results of operations expressed as a percentage of net
revenues. Year Ended December 31,2003
    
    
    2004Net revenues
    
    
    100
    %
    
    
    100
    %Cost of revenues
    
    
    77
    %
    
    
    46
    %Gross Profit
    
    
    23
    %
    
    
    54
    %General and administrative expense
    
    
    47
    %
    
    
    41
    %Selling and marketing expense
    
    
    27
    %
    
    
    27
    %Product maintenance and development costs
    
    
    44
    %
    
    
    28
    %Restructuring expense
    
    
    4
    %
    
    
    -1
    %Amortization of customer list Restructuring
    
    
    4
    %
    
    
    1
    %Abandoned acquisition costs
    
    
    0
    %
    
    
    24
    %Loss from operations
    
    
    -100
    %
    
    
    -67
    %Beneficial interest and amortization of financing fees on convertible note
    
    
    0
    %
    
    
    -6
    %Other income
    
    
    0
    %
    
    
    0
    %Interest income (expense)
    
    
    0
    %
    
    
    -1
    %Loss before taxes
    
    
    -100
    %
    
    
    -74
    %Provision for taxes
    
    
    0
    %
    
    
    0
    %Net loss
    
    
    -100
    %
    
    
    -74
    %
 Years Ended December 31, 2004 and 2003 Revenues Net revenues increased to $4,934,000 in 2004 from $2,834,000 in 2003, a net increase of
$2,100,000 or 74%. The increase in net revenue for 2004 is primarily comprised of a net increase of
$1,181,000 or 109% in licensing and software revenues and a net increase of $702,000 or 254% in
Customization and other revenues. The increase in Licensing and Software revenues is primarily
related to an increase from $245,000 to $1,478,000 or 503% due to the addition of e-commerce
services for the newspaper publishing industry of EdgCapture, an integrated payment processing
solution that interfaces directly with publishers classified and circulation systems; and EdgFlow,
a content processing solution that allows publishers to deliver media content such as articles,
technical documents, advertisements, wire stories, etc., to multiple channels in a variety of
formats. The net increase in these revenues reflects a partial offset for a decrease of $23,000
due to the termination of one licensing and software customer and $28,000 as a result of
termination by 3 customers of the use of our outmoded licensed fax technology as the industry
continues to move toward a Web-based product. We now have only 2 remaining licenses for this
technology. The increase in Customization and other revenue relates primarily to customization services
associated with our new EdgCapture and EdgFlow software lines and to a net $257,000 increase due to
customization services to power a new online recruitment service with The Washington Post (TWP) and
to power a classified Web order entry for the four online vertical classified advertising products,
Recruitment, Autos, Real Estate and Merchandise, for The Atlanta Journal-Constitution (AJC). These
ads will flow through AdStars XML Gateway. The TWP contract was essentially completed during the
second quarter. The AJC contract, which is approximately 67%, complete has been amended to provide
additional services and is expected to continue into the second quarter of 2005. The increase of
$217,000 or 15% in ASP Revenue is primarily comprised of a $145,000 increase in transaction volumes
from existing customers, 21




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$26,000 from the addition of 2 new customers, partially offset by a $14,000 decrease due to
the termination of 3 existing customers. The revenues from EdgCapture or EdgFlow and related
customization services reflected in our 2003 results consist only of activity from October 21
through December 31, since these services for our newspaper customer base were added through our
acquisition of Edgil Associates on October 21, 2003. Cost of revenues Cost of revenues consists primarily of the costs to customize and install software
applications, configure end-user software, install Web-based ad-taking software, provide technical
customer training and end-user support, amortization of internally developed application modules,
depreciation of production servers and related software, royalties, and co-location costs. Cost of
revenues increased to $2,285,000 in 2004 from $2,180,000 in 2003, a net increase of $105,000 or 5%. The increase during 2004 was primarily comprised of a net increase of $468,000 for the cost
underlying our new EdgCapture and EdgFlow services which were part of our service offerings to
publishers for approximately 2 months at the end of 2003. Additionally, a $363,000 increase in
direct labor and overhead associated with one time increased costs from the learning curve caused
by the transferring of the technical support function from the Marina Del Rey offices to the
Chelmsford offices along with the direct costs of customizing our API interface software for the
TWP and AJC service contracts described above, offset by a $61,000 reduction in amortization as a
result of the write-down of capitalized software in the fourth quarter 2003 and an additional
$22,000 reduction in amortization due to the full amortization of a portion of capitalized
software. The net increases described above were offset by a $625,000 decrease in impairment write-downs
of our internally developed software applications from $883,000 in 2003 to $258,000 in 2004. The
impairment recorded during 2003 was primarily related to an $883,000 one time impairment write-down
of our contract Web and FlexAd internally developed software applications and the reserve for
direct costs of contractual obligations to service said software, primarily based on a product line
evaluation undertaken in December 2003 in connection with the integration of AdStars Edgil
acquisition and new information with respect to future revenues from customer utilization of the
FlexAd software. The 2004 impairment was primarily comprised of a $190,000 write-down of 2 uncompleted software
applications primarily designed to deliver the EdgCapture product over the Web or in NT based
environments. In December 2004 we determined that these products had not generated sufficient
market interest to justify continued development with our limited resources. In addition a $53,000
write-down of a limited display ad technology built specifically for the Los Angeles Times
Restaurant Guide was launched in September 2004 but has not generated the anticipated ASP revenues
we originally projected and we have been unsuccessful in selling the product to other publications.
The remaining $14,000 related to 2 older software technologies for which revenues have deteriorated
in recent months to the point where we realized a permanent impairment in value. Our gross profit margin for the year ended December 31, 2004 increased to 54% from 23% for the
year ended December 31, 2003 largely due to the decrease in the net write-down of capitalized
software. If the adjustments related to impairment are excluded, the gross profit margin for 2004
would be 59% compared to 55% in 2003, the 4% improvement is primarily comprised of the reduction in
amortization as described above. 22




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General and administrative expense General and administrative expense consists primarily of the cost of executive,
administrative, professional fees, accounting, and finance personnel. General and administrative
expenses increased to $2,041,000 in 2004 from $1,343,000 in 2003, a net increase of $697,000 or
52%. The net increase was primarily related to a $566,000 increase to support our new EdgCapture
and EdgFlow services and an increase in consulting fees of $131,000 for Sarbanes-Oxley compliance
matters and contractual obligations to obtain Statement on Accounting Standards number 70 (SAS
70) certification as part of our customers compliance with Sarbanes-Oxley requirements. Management believes that our existing executive staffing levels are sufficient to allow for
significant growth without the need to add personnel and related costs for the foreseeable future.
However, the impact of complying with and maintaining Sarbanes-Oxley and SAS 70 has not been fully
analyzed at this time and may require the addition of personnel and/or systems to adequately meet
the requirements. Product maintenance and development costs Product maintenance and development expenses consist of expenses to identify functional
requirements, to plan, identify and conceptually design and test the required technical
infrastructure, and to perform software and Web-site maintenance, and other general routine fixes.
The costs consist primarily of personnel related expenses for technical and design personnel,
equipment maintenance and outside consultants. Product maintenance and development expenses
increased 9% during 2004 to $1,359,000 from $1,242,000 in 2003. The $117,000 increase during 2004
is primarily comprised of a net increase of $330,000, due to our new EdgCapture and EdgFlow
services, offset by a net decrease of $213,000 due to reductions in our technical staffing levels. We monitor technical staffing levels closely and believe that our current level of technical
staffing will be sufficient for the near future. Conversely, we may need to increase technical
staffing in the short term if we obtain additional customers more quickly than currently expected
or an unexpected increase in customer demand for customization projects occurs. However, an
increase in customer demand requiring an increase in technical staffing costs are generally offset
by increased revenues for such services. Selling and marketing expense Selling and marketing expense consists primarily of direct charges for advertising, sales
promotion, marketing, and trade shows, as well as the cost for business development. Selling
expense increased 72% during 2004 to $1,291,000 from $750,000 during 2003. The $540,000 increase
during 2004 is primarily comprised of a net increase of $311,000 or 58% attributable to selling and
marketing expenses for our new EdgCapture and EdgFlow services, a $96,000 net increase in salary,
moving, severance and related expenses, primarily related to the hiring and termination of a senior
vice president of sales during February 2004 through December 2004, a $87,000 commission expense
related to a newly created commission plan and a $45,000 increase in advertising and publicity,
tradeshows and business promotion as anticipated with the increased focus on selling and marketing
our products, offset by a $7,000 reduction in outside consulting fees and other costs. In 2005 we expect our fixed selling and marketing expenses to decrease due to the termination
of our Senior Vice President of Sales and Marketing to start his own sales and marketing company.
The Senior Vice President position is currently not contemplated to be replaced, those duties will
now be shared by, among others our Vice President of Sales and Marketing, Chief Operating Officer
and Chief Executive Officer. Sales Commissions are expected to increase as part of a new
arrangement with our former Senior Vice President of Sales and Marketing which allows him to
continue to sell our products on a contract-by- 23




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contract commission only basis. We will continue the development and implementation of our
strategic marketing plan and continue to build upon our existing relationships with Tribune
Company, Knight-Ridder, Inc., CareerBuilder, L.L.C., Media News Group and other potential strategic
partners. Restructuring costs Restructuring costs consist primarily of direct costs associated with repositioning our
products, moving away from the idea of the Internet as a stand-alone business category, integrating
our products and services with those of Edgil Associates, Inc. our recently acquired wholly owned
subsidiary, and moving towards the idea of the Internet as an extremely efficient and flexible
communication channel. These costs are primarily comprised of direct expensing and reserves for
consolidation of personnel, equipment and associated software, as well as professional fees to more
efficiently service our growing ASP applications and products. During 2004, we adjusted accruals, primarily related to the realization of greater fees
received from subletting the former New York office than originally estimated resulting in a
reduction of the accrual and related expense of $38,000 as compared to restructuring costs of
$125,000 recorded during 2003. Amortization of Customer List Amortization of Customer List consists of straight-line amortization of the Customer List
purchased as part of the acquisition of Edgil on October 21, 2003. The Customer List is recorded
at a valuation of $1,500,000, obtained by use of an independent valuation expert, and is being
amortized over its estimated 17-year life. Amortization during 2004 was approximately $88,000 as
compared to $17,000 for approximately 2 months during 2003. Abandoned Acquisition Costs During 2004, expenses of $1,203,000 were incurred in connection with the abandonment of four
proposed acquisitions and related international expansion plans. On December 31, 2004, an option
to acquire a company expired resulting in a write off of all costs previously recorded as prepaid
costs of the acquisition during 2004, costs incurred during the fourth quarter 2004 and all future
commitments, primarily employee settlement and severance costs and legal and professional fees
associated with the abandoned acquisition. In addition 3 smaller acquisition targets did not meet
our due diligence requirements or turned down our offers during the quarter ended December 31, 2004
for which we expensed all related costs. The charges include approximately $203,000 of prepaid acquisition costs capitalized at
September 30, 2004; approximately $69,000 of costs associated with the international expansion
plans and the related acquisition target which were previously expensed during the nine months
ending September 30, 2004 and included under different operating categories; approximately $391,000
for deposits paid from October 8 through November 29, 2004 lost as a result of the failure to close
one acquisition by December 31, 2004; and approximately $263,000 of employment, consulting, travel,
severance and miscellaneous other expenses recorded during the fourth quarter of 2004 primarily
related to the international acquisition and related expansion plans. A balance of approximately
$277,000 primarily related to two discharged executives specifically hired to promote and
coordinate international expansion, will be paid in 2005. Beneficial interest and amortization of financing fees on Convertible Note On April 12, 2004, we closed a $1.5 million private placement of a 3-year secured convertible
note and 7-year warrants to purchase 200,000 shares of our Common Stock with Laurus Master Fund,
Ltd., a New York City based institutional fund and an accredited investor. 24




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We recorded a debt discount of approximately $734,000 consisting of the intrinsic value of the
beneficial conversion of approximately $467,000 and the portion of the proceeds allocated to the
warrants issued to the lenders of approximately $267,000, using the Black-Scholes option pricing
model, based on the relative fair values of the warrants and the notes. The debt discount is being
amortized as interest expense over the three-year term of the notes using the interest method. During 2004, approximately $299,000 of prepaid financing fees and debt discount were amortized
as interest expense, including a non-cash portion of approximately $263,000. The non-cash portion
was comprised of approximately $156,000 debt discount amortization and an accelerated debt
amortization of approximately $107,000 as a result of the conversion of $225,000 in debt to equity. Other expense During 2003, AdStar paid $10,000 as a termination fee to a financial consultant for a failed
arrangement to secure private financing. Interest income (expense), net Net interest expense was $36,000 during 2004, compared to net interest income of $5,000 during
2003. The interest expense during 2004 consists primarily of $33,000 interest on the Laurus
Convertible Note discussed above with the remainder associated with capitalized leases and notes
payable to the former founders of Edgil. The Convertible Note has an interest rate of Prime minus
1%. Interest income has historically been attained by maintaining excess cash in an overnight
investment sweep account. During 2004, it was determined that the fees to maintain the investment
sweep account exceeded the interest received due the historically low overnight interest rates,
accordingly we temporarily closed the investment sweep account and now only receive interest income
from a minor certificate of deposit account maintained as security on certain credit cards. Provision for taxes The provision for income taxes is comprised primarily of state taxes for Edgil. Federal
income taxes are consolidated and, due to the nature of the merger agreement, AdStar and Edgil are
treated as separate taxable entities for State income taxes. AdStar is currently in a loss
carry-forward position for federal income taxes, primarily due to the operating losses incurred
through December 31, 2004. The federal net operating loss carry-forwards balance as of December
31, 2004 was approximately $16,036,000, compared to $15,431,000 in the prior year. The net
operating loss carry-forward is available to offset future taxable income through 2017. Our net operating loss carry forwards may be limited due to ownership changes as defined under
section 382 of the internal revenue code of 1986. The major temporary tax differences that are expected to reverse next year are deferred
revenue, allowance for doubtful accounts, and accrued vacation. However, we expect new temporary
differences to be established in these years, which will either reduce or exceed the reversing
temporary differences. We evaluate annually the realization of the net deferred tax asset, taking into consideration
prior earnings history, projected operating results, and the reversal of temporary tax differences.
At December 31, 2004, we evaluated the net deferred tax asset, taking into consideration operating
results, and determined that a valuation allowance of $5,720,000 should be maintained. 25




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Liquidity and Capital Resources At December 31, 2004, we had an accumulated deficit of $17,815,000. We have incurred
significant recurring net losses for the years ended December 2003 and 2004 of $2,842,000 and
$3,648,000. Our 2003 and 2004 net losses were principally attributable to our ongoing shift in
focus from an on-line business to an ASP business with an expanded suite of products and our
abandoned acquisition costs of $1,203,000 during 2004. We expect to continue to incur losses until
we are able to increase revenues significantly from fees based on the number of purchases
transacted through our ASP and payment processing products. The revenues from EdgCapture and
related customization services reflected in our 2003 results consist only of activity from October
21 through December 31, since these services for our newspaper customer base were added through our
acquisition of Edgil Associates on October 21, 2003. We expect the deferred revenue to be
realized during 2005. We believe that our cash on hand of $1,093,000
at December 31, 2004, the increase in the cash flows we are currently generating from
operations from cost cutting strategies, which we expect will continue,
including a reduction in staff during the fourth quarter
2004, pay cuts effective January 1, 2005, the curtailment of our acquisition strategy and
development projects, other cost saving measures, the additional $597,000 raised through the exercise of warrants on
January 5, 2005 and an expected increase in revenues will generate sufficient capital to meet our cash needs
through the next twelve months. As a result, we believe that we will be in a position to take advantage of additional strategic acquisitions and revenue
sharing arrangements should they present themselves. We are optimistic that our growing ASP
business will continue to be accepted in the marketplace. However, our ability to sell ASP
business products and service offerings during the current year may be hampered by the current
unstable climate in the advertising market, the geo-political climate, including the war in Iraq,
and state of the economy in general. These factors, coupled with unproven ability of our newly
acquired subsidiary, Edgil, to continue to generate positive cash flow, possible competition from
other vendors, the extended selling cycle in our industry, and customer delays in customization and
implementations, could delay our ability to increase revenue to a level sufficient to cover our
expenses. There is no assurance that management will be successful with its operating plan and, if
events and circumstances occur such that we do not meet our plan as expected, and we are unable to
raise additional financing, we may be required to further reduce certain discretionary spending,
which could have a material adverse effect on Adstars ability to achieve our intended
business objectives. Prior to 1999 we financed our business primarily from cash generated by operations.
Subsequently, we have financed our business through a combination of cash generated from operations
and debt and equity financings. In 2003 we raised net proceeds of $3,831,000 in equity and debt
financings to fund operations and enhance and expand the product line we provide our customers,
including the acquisition of Edgil. In 2004 we raised net proceeds of $1,515,000 which we used
primarily to fund our acquisition and international expansion strategy. At December 31, 2004 we
had negative working capital of $1,534,931 compared to $149,000 positive working capital as of
December 31, 2003. The deterioration in working capital is primarily a result of the 2004 net loss
described above, a net $215,000 increase in Due to publications from $1,084,000 at December 31,
2003 compared to $1,299,000 at December 31, 2004, a $241,000 net increase in Deferred revenues from
$84,000 at December 31, 2003 compared to $325,000 at December 31, 2004, and a $340,000 net increase
in Convertible note from zero at December 31, 2003 compared to $340,000 at December 31, 2004. Due
to publications is a result of contractual customer arrangements whereby we receive net proceeds
daily on behalf of these customers for third party ads placed via credit card. These transactions
are collected reconciled monthly and submitted to the publication, net of processing fees,
generally within 35 days from the month end. We have been providing this service at virtually no
charge to customers since approximately December 2000 without any customer terminations. The
increase in deferred revenues is primarily related to an increase in installation and customization
projects related to our EdgCapture integrated payment processing solution, We expect the deferred
revenues to be realized during 2005 with no incremental increase in operating costs. The
convertible debt was funded in April 2004, see further discussion on the proceeds from and
repayment provisions of the convertible debt below. As of December 31, 2004, we had cash and cash equivalents of approximately $1,093,000 compared
to $2,092,000 as of December 31, 2003 a net decrease of $999,000. The net decrease in cash and cash
equivalents was the result of $1,854,000 used in operating activities of which $926,000 was used to
finance our abandoned acquisitions and international expansion strategies, $531,000 used in
investing activities of which $430,000 was used to enhance our strategic software applications,
offset by net proceeds of $1,386,000 provided by financing activities. Net cash used in operations
during 2004 was approximately $1,834,000 compared with $797,000 during 2003, a $1,037,000 increase. Net cash used in operating activities was primarily the result of a net loss of $3,648,000 less
non-cash charges of $797,000 in depreciation and amortization, $299,000 in beneficial interest and
amortization of financing fees on the convertible note, $258,000 in write-downs of capitalized
software, $13,000 in abandonment of leasehold improvements and trademarks, $12,000 in allowance for
doubtful accounts and $96,000 in stock based vendor payments, net of a $15,000 decrease in prepaids
and other assets, a $215,000 increase in due to publications, $196,000 in accounts payable and accrued expenses, $171,000
in deferred revenue and customer deposits, offset by a $257,000 increase in accounts receivable.
The increase in due to publications was caused by a combination of an unseasonally lower drop-off
in both the quantity and price charged per ad during the fourth quarter 2004 primarily as a result
of a more robust market for employment classified ads. Historically the seasonal nature of the
classified advertising industry is comprised of greater volumes of newspaper ads placed in the
first three quarters of the calendar year with a material drop-off in the fourth quarter. The
fourth quarter drop off was less in 2004 than in 2003. The increase in accounts receivable is
primarily due to an overall increase in ASP and monthly recurring revenues as well as the increase
in revenues from major service contracts such as the Atlanta Journal-Constitution whereby we
perform on the contracts, but in some instances are not paid until certain milestones are met. Net cash used in investing activities decreased to $551,000 during 2004 compared with
$2,281,000 during 2003. The decrease of $1,730,000 is primarily the result of the $1,558,000 spent
for the purchase of Edgil in 2003. Additionally, capitalized and purchased software decreased by
$135,000 in 2004 compared to 2003 as part of a conscious effort to reduce software enhancement
projects to be more in line with a focused marketing based approach, the delay of certain
development projects as a result of shifting certain technical staff from development projects to
servicing major service contracts such as the Washington Post and Atlanta Journal and Constitution
projects, and the overall reduction in our technical staffing levels. We anticipate delayed
development projects to commence late in the first quarter of 2005. 26




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Net cash provided by financing activities decreased to $1,386,000 during 2004 compared
with $4,230,000 during 2003. During 2003 we entered into 2 private placement financings generating
net proceeds of $3,303,000. In addition during 2003 we received $529,000 in net proceeds from the
issuance of Series B-2 Preferred Stock to Tribune Company to complete certain development projects
and received net proceeds of $253,000 from the exercise of options and warrants, due to
historically high stock prices, along with the release of $174,000 of restricted cash. During 2003
the funds from financings were primarily used to acquire and integrate Edgil and promote other
general business objectives. By comparison during 2004 proceeds provided by financing activities
were primarily comprised of approximately, $1,347,000 in net proceeds from securing a convertible
note and $168,000 from the exercise of options and warrants, offset by approximately $45,000 in a
repayment of principal on the convertible note, and $31,000 in costs to convert the Series A
convertible preferred into equivalent shares of Common Stock. On April 12, 2004, we closed on a $1.5 million private placement of a 3-year secured
convertible note and 7-year warrants to purchase 200,000 shares of our common stock. We may redeem
the note at any time by paying 125% of the then outstanding principal balance plus accrued
interest. The note bears interest at the prime rate minus one percentage point and is convertible into
common stock at an initial fixed conversion price of $2.25 per share. In May 2004 $225,000 of the
note was converted into 100,000 shares of Common Stock, at a conversion price of $2.25 per share. The payment of principal and interest on the note are made by monthly installments of cash or
common stock, or a combination of both. However, the holder is required to convert all monthly
installments into common stock if the average closing price for the 5 trading days immediately
preceding each monthly installment payment date is more than 10% above the
conversion price. If the monthly installment is paid in cash, we are required to pay the
holder an amount equal to 102% of the principal portion (as described below) of the installment
payment amount. If the holder converts all or a portion of the monthly installment payment into
shares of common stock the number of shares issuable shall be the number determined by dividing the
monthly installment payment amount, or a portion of it, by the fixed conversion price. On July 1, 2004, and recurring on the first day of each succeeding month thereafter until the
maturity date April 12, 2007, we began making the monthly installment payments consisting of
$45,454.55 of principal and any accrued and unpaid interest. Any outstanding amounts due on the
maturity date will be due and payable on the maturity date. For the past several weeks our common
stock has been trading below $1.00 and there can be no assurance in the near future that it will
reach the conversion price of $2.25 per share or the price requiring mandatory conversion by the
holder. Accordingly, for the near future, we expect to be paying the monthly installments in cash. Pursuant to the terms of the note and the warrants, the holder may not receive shares of
common stock on conversion of the note or exercise of the warrants to the extent such conversion or
exercise would result in it beneficially owning in excess of 4.99% of the issued and outstanding
shares of common stock. We currently have no additional borrowings available to us under any credit arrangement, and
we are continuing to look for additional financing. Adequate funds may not be available or may not
be available on terms favorable to us. If additional funds are raised through the issuance of
equity securities, dilution to existing stockholders may result. If funding is insufficient at any
time in the future, we may be unable to develop or enhance our products or services, take advantage
of business opportunities or respond to competitive pressures, any of which could have a material
adverse effect on our financial position, results of operations and cash flows. Readers should
also read, CERTAIN RISK FACTORS THAT MAY AFFECT GROWTH AND PROFITABILITY under item 1 above. 27




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New accounting pronouncements On December 16, 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123(R)
(revised 2004), Shared-Based Payment, which is a revision of SFAS No. 123. SFAS No. 123(R)
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95,
Statement of Cash Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach
described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income statement based on their
fair values. This revised standard will be effective for the Company beginning with the first
interim period after December 15, 2005. As permitted by SFAS No. 123, the we currently account for share-based payments to employees
according to APB 25 using the intrinsic value method and, as such, generally recognize no
compensation cost for employee stock options. Accordingly, the
adoption of SFAS No. 123(R)s fair
value method will have an impact on our results of operations, although it will have no impact on
our overall financial position. The impact of the modified prospective adoption of SFAS No. 123(R)
cannot be estimated at this time because it will depend on levels of share-based payments granted
in the future. However, had we adopted SFAS No. 123(R) in prior periods, the impact of that
standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma
net income and earnings per share. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets  an amendment
of APB Opinion No. 29. SFAS 153 eliminates the exception from fair value measurement for
nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29,
Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do
not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial
substance if the future cash flows of the entity are expected to change significantly as a result
of the exchange. We are required to adopt this standard as of January 1, 2006 and do not expect
its adoption to have a material impact on our statement of earnings or financial position. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based
upon our financial statements, which have been prepared in accordance with accounting principles
generally accepted in the United States. The preparation of these financial statements requires
that we make estimates and judgments that affect the reported amounts of assets, liabilities,
revenues, expenses, and related disclosure. On an on-going basis, we re-evaluate our estimates,
including those relating to revenue recognition, uncollectible accounts receivable, intangible
assets and contingent expenses and revise reported amounts prospectively. We base our estimates on
historical experiences, combined with anticipated activity and various other assumptions that we
believe to be reasonable under the circumstances. When combined, this 28




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body of knowledge forms the basis for making judgments about the carrying value of assets and liabilities. Actual results may
differ from these estimates under different assumptions or conditions. Financial Reporting Release No. 60, which was recently issued by the Securities and Exchange
Commission, requires all companies to include a discussion of critical accounting policies or
methods used in preparation of financial statements. The following is a brief discussion of our
most critical accounting policies, including those methods affected by our more complex judgments
and estimates. Revenue Recognition We derive revenue from several products and services as follows: ASP revenue  We receive revenue by providing an application service provider (ASP)
product that allows customers to use our software applications on a shared system over the
Internet. This technology is a publisher-specific ad-taking Web site service that offers
visitors to a newspapers Web page the opportunity to buy classified ads, for both the print
and/or on-line editions of the newspaper, in real-time, on a 24/7 basis. We receive monthly
fees for hosting the transactions and providing customer support, and recognize the fees
ratably over the contract period. Web site revenue  We receive revenue from fees charged to customers who transact business
on the Advertise123.com Web site. This site permits the general public to plan, schedule,
compose and purchase advertising from many print and on-line publishers. Under the guidance
provided by the Securities Exchange Commission Staff Accounting Bulletin (SAB) No. 104,
Revenue Recognition and the Emerging Issues Task Force (EITF) Abstract No. 99-19
Reporting Revenue Gross as a Principal versus Net as an Agent (EITF 99-19), we are, in
substance, acting as an agent for the publishers and therefore recognize as revenue only the
net fees realized on the transactions. We recognize revenue on a per-transaction basis when
the ad is placed through their system and collection from the customer is probable. Licensing and Software; Customization and other revenues  We generate revenue from
technology service contracts that generally contain multiple elements such as software
customization services, monthly fees and post-contract customer support (PCS). Revenue from
these arrangements is recognized in accordance with Statement of Position (SOP) 97-2,
Software Revenue Recognition, and SOP 98-9, Software Revenue Recognition with Respect to
Certain Transactions. Accordingly, revenue is allocated to each element within the contract
based on the relative fair values of those elements using vendor specific objective
evidence. Revenue from monthly fees and PCS under software maintenance arrangements is based
upon renewal rates and is recognized ratably over the term of the arrangement. Revenue from
software customization services is recognized as the services are performed, using a
percentage of completion methodology based on labor hours. We also provide customization
services at the customers request and recognize revenue as the services are performed,
using a percentage of completion methodology based on labor hours. Deferred revenue consists primarily of deferred revenues from long-term License and Software
contracts, PCS maintenance arrangements prepaid annually and customization and other
revenues billed and paid in advance. Revenues from upfront license fees, monthly fees and
PCS under software maintenance arrangements is based upon renewal rates and is recognized
ratably over the term of the arrangement, licenses and maintenance generally range from
monthto-month up to 10 years on historical AdStar and 25 years and 3 to 5 years on
historical Edgil, respectively. Deferred revenues on the 25-year license arrangements are
$106,000, PCS contracts paid in advance and prepaid customer deposits are $80,000 for year
ended December 31, 2004. Revenue from software 29




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##### Table of Contents



customization services is recognized upon the completion of services. As part of the integration of Edgil into AdStars business model we
are currently offering new Edgil contracts on terms and conditions similar to AdStar,
generally one year or less in duration. Areas requiring managements judgment includes revenue recognition and cost estimation on
the fixed fee software customization element of the contracts. Revenue is recognized on
these contracts using a percentage-of-completion methodology, based upon labor input
measures and an estimate of time to completion. Monthly, technical management reviews the
estimate of labor hours required to complete the customization and the effect of any change
in estimate is reflected in the period in which the change is first known. Such changes in
estimates have not been material to our results of operation. The corresponding cost of
revenue charge is derived based upon the same labor input measurements and our existing cost
structure. If we do not accurately estimate the resources required under the contract or the
scope of the work to be performed, or if we do not manage our projects properly within the
prescribed timeframe, future margins may be significantly and adversely affected. If
increases in projected costs-to-complete are sufficient to create a loss contract, the
entire estimated loss is charged to operations in the period the loss first becomes known.
The complexity of the estimation process and uncertainties inherent in software
customization activities may affect the percentages derived under the
percentage-of-completion accounting method, which in turn may affect the amounts reported in
the financial statements. Software Development Costs Costs to establish the technological feasibility of software applications developed by
us are charged to expense as incurred. Certain costs incurred subsequent to achieving
technological feasibility are capitalized. Accordingly, we capitalize a portion of the
internal labor costs and external consulting costs associated with essential Web site
development and enhancement activities. Costs associated with conceptual design and
feasibility assessments as well as maintenance and routine changes are expensed as incurred.
Capitalized costs are amortized based on current or future revenue for each product with an
annual minimum equal to the straight-line basis over the estimated economic lives of the
applications, not to exceed 5 years. During the year we capitalized $479,000, amortized
$612,000, and expensed $1,359,000 in capitalized software development and maintenance costs.
In addition during December 2004 we wrote off $258,000 in capitalized software costs. Warranties and Product liability We warrant that our products conform to their respective functional specifications. Our
customized software products, ASP application products and Software License Agreements are
warranted to perform as designed. Such warranties are extended throughout the term of
extended service agreements that clients enter into with us. Direct costs associated with
the initial period of service have been insignificant and are generally covered by upfront
fees. We currently carry product liability insurance. We believe the amount of insurance is
adequate to cover our risks. To further mitigate our risks, our standard service agreement
expressly limits its liabilities and warranties of its products and services in accordance
with accepted provisions of the Uniform Commercial Code as adopted in most states. Allowance for doubtful accounts We maintain an allowance for doubtful accounts using estimates that we make based on factors
we believe appropriate such as the composition of the accounts receivable aging, historical
bad debts, changes in payment patterns, customer creditworthiness and current economic
trends. If we used 30




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##### Table of Contents



different assumptions, or if the financial condition of the customers
were to deteriorate, resulting in an impairment of their ability to make payments,
additional provisions for doubtful accounts would be required and would increase our bad
debt expense. Contractual Obligations, Commitments and Contingencies We have contractual obligations and commitments primarily with regards to employment
agreements for 3 of our executives, certain non-cancelable operating lease obligations for office
space and equipment, and capital lease obligations for computer equipment and office furniture. The following table aggregates our expected contractual obligations and commitments subsequent
to December 31, 2004: Payments due by PeriodBeyondContractual obligations
    
    2005
    
    
    2006
    
    
    2007
    
    
    2007
    
    
    TotalEmployment agreements (1)
    
    $
    712,827
    
    
    $
    212,800
    
    
    $
    
    
    
    $
    
    
    
    $
    925,627Convertible debt
    
    
    644,052
    
    
    
    571,703
    
    
    
    91,993
    
    
    
    
    
    
    
    1,307,748Capital lease commitments
    
    
    19,465
    
    
    
    126
    
    
    
    
    
    
    
    
    
    
    
    19,591Operating lease
commitments (2)
    
    
    256,296
    
    
    
    191,420
    
    
    
    135,097
    
    
    
    258,146
    
    
    
    840,959Loans from stockholders
    
    
    21,000
    
    
    
    21,000
    
    
    
    
    
    
    
    
    
    
    
    42,000$
    1,653,640
    
    
    $
    997,049
    
    
    $
    227,090
    
    
    $
    258,146
    
    
    $
    3,135,925
   (1)
    
    Includes a temporary reduction in compensation for the 3 executives with employment
agreements. On December 31, 2004 as part of a company wide cost cutting strategy, all
employees and officers with annual salaries greater then $50,000 who have been employed for
greater than 1 year agreed to a temporary 5% reduction in compensation, commencing January
1, 2005. It is our intention to reinstate the compensation sometime in the future. For
purposes of the future payments as defined below and elsewhere in this document we assume
the reduction will be reinstated on January 1, 2006 although no formal decision has been
made as to a reinstatement date, if any, at this time.(2)
    
    Excludes sublet office agreement of $2,418 per month through April 2005. 
  Item 7.
    Financial Statements See Index to Financial Statements below, beginning on page F-1. 
  Item 8.
    Change in and Disagreements with Accountants on Accounting and Financial Disclosure None. 
  Item 8A.
    Controls And Procedures a) Evaluation of Disclosure Controls and Procedures. Management, with the participation of
our chief executive officer and the chief financial officer, carried out an evaluation of the
effectiveness of our disclosure controls and procedures (as defined in the Securities Exchange
Act of 1934 (the Exchange Act) Rules 13a-15(e) and 15-d-15(e)) as of the end of the period
covered by this report (the Evaluation Date). Based upon that evaluation, the chief executive
officer and the chief financial officer concluded that, as of the Evaluation Date, our disclosure
controls and procedures are effective, providing them with material 31




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##### Table of Contents



information relating to us as required to be disclosed in the reports we file or submit under the Exchange Act on a timely basis. b) Changes in Internal Control over Financial Reporting. There were no changes in our
internal controls over financial reporting, known to the chief executive officer or the chief
financial officer, that occurred during our fiscal fourth quarter that have materially affected, or
are reasonably likely to materially affect, our internal control over financial reporting. 
  Item 8B.
    Other Information None. 
 PART III 
  Item 9.
    Directors, Executive Officers, Promoters and Control Persons; Compliance WithSection 16(a)of the Exchange Act Our executive officers and directors and their respective ages are as follows: DirectorName
    
    Age
    
    Position
    
    SinceLeslie Bernhard
    
    
    59
    
    
    President, Chief Executive Officer and Director
    
    
    1991Eli Rousso
    
    
    68
    
    
    Executive Vice President, Chief Technology Officer,
Secretary, Treasurer, and Director
    
    
    1991Jeffrey Baudo
    
    
    58
    
    
    Senior Vice President, Chief Operating Officer, and Director
    
    
    2001Anthony J. Fidaleo
    
    
    46
    
    
    Vice President and Chief Financial OfficerRichard Salute (1)(2)
    
    
    59
    
    
    Director
    
    
    2003Arthur Salzfass (3)
    
    
    69
    
    
    Director
    
    
    2004
   (1)
    
    Member of the compensation committee and the audit committee of the Board of Directors.(2)
    
    Mr. Salute was elected to AdStars Board in January 2003.(3)
    
    On November 11, 2004 Arthur Salzfass was elected to the Board of Directors by a majority vote
of the Common Stockholders. Mr. Salzfass previously served on the Board from 2000 to 2002.
On January 19, 2005 Mr. Salzfass resigned due to the press of other matters. Leslie Bernhard, one of our co-founders, has served as our President and Chief Executive
Officer since the organization of our predecessor in 1986. Ms. Bernhard holds a B.S. degree from
St. Johns University. Ms. Bernhard is the sister of Mr. Baudo. Eli Rousso, our other co-founder, has served as our Executive Vice President and Chief
Technology Officer since the organization of our predecessor in 1986. Mr. Rousso holds a B.S.
degree in Electrical Engineering from Massachusetts Institute of Technology (MIT) and has completed
graduate work at the Polytechnic Institute (New York). 32




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##### Table of Contents



Jeffrey Baudo joined us as Chief Operating Officer in January 2001 and became a director in
February 2001. Prior to joining AdStar, Mr. Baudo, served as president and COO of the publishing
division of United Advertising Publications. Mr. Baudo holds a B.A. degree from St. Johns University.
Mr. Baudo is the brother of Ms. Bernhard. Anthony J. Fidaleo joined us as Chief Financial Officer in June 2002 and became Vice President
of Finance in September 2002. Prior to joining AdStar, Mr. Fidaleo served in a consulting capacity,
as acting Chief Financial Officer or Vice President Controller, over the past 5 years primarily
servicing the technology sector with companies such as Autobytel,Inc. and L90, Inc. Between 1992
and 1997 Mr. Fidaleo served as Chief Financial Officer of privately held national companies
American Dawn, Inc. and Vagabond Inns, Inc. Mr. Fidaleo was in public accounting from 1982 through
1992, primarily with BDO Seidman, LLP where he attained the level of audit senior manager. Mr.
Fidaleo is a CPA and holds a B.S. degree in Accounting from California State University at Long
Beach. Richard Salute, a director, has been a partner in J. H. Cohn, a public accounting firm, since
February 2004. Previously, since January 2002, he was a private investor. Prior thereto he was a
partner with Arthur Andersen, LLP for more than five years. Mr. Salute has been nominated to the
Board of Directors of Copytel, Inc., a developer and distributor of flat panel displays and
encryption devices. He is a Certified Public Accountant, licensed to practice in New York, New
Jersey and Connecticut. Mr. Salute holds a B.A. degree from Adelphi University. All directors hold office until the next annual meeting of stockholders and until their
successors are duly elected and qualified. Officers are elected to serve, subject to the discretion
of the Board of Directors, until their successors are appointed. AdStars Board of Directors has established compensation and audit committees. The
Compensation Committee reviews and recommends to the Board of Directors the compensation and
benefits of all the officers of AdStar, reviews general policy matters relating to compensation and
benefits of employees of AdStar, and administers the issuance of stock options to AdStars
officers, employees, directors and consultants. The Audit Committee meets with management and
AdStars independent auditors to determine the adequacy of internal controls and other financial
reporting matters. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 requires AdStars officers and directors,
and persons who own more than ten percent (10%) of a registered class of AdStars equity securities
to file reports of ownership and changes in ownership with the Securities and Exchange Commission
(SEC). Officers, directors and greater than ten percent (10%) stockholders are required by SEC
regulations to furnish AdStar with copies of all Section 16(a) forms they file. To the best of AdStars knowledge, based solely on review of the copies of such forms
furnished to it, or written representations that no other forms were required, AdStar believes that
all Section 16(a) filing requirements applicable to its officers, directors and greater than ten
percent (10%) stockholders were complied with during 2004. With respect to any former directors,
officers, and ten percent (10%) stockholders of AdStar, AdStar does not have any knowledge of any
known failures to comply with the filing requirements of Section 16(a). Audit Committee Financial Expert The Board has determined that Richard Salute qualifies as our Audit Committee financial

expert, as that term is defined in Item 401(e) of Regulation S-B, and independent as that term
is used in Item 7 (d) 33




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##### Table of Contents



(3)(iv) of schedule 14A under the Securities Exchange Act of 1934. Code of Ethics We have adopted a code of ethics that applies to our principal executive officer, principal
financial officer and other persons performing similar functions. This code of ethics is posted on
our Website at www.AdStar.com and is filed as Exhibit 14.1 to this report. 
  Item 10.
    Executive Compensation The following Summary Compensation Table sets forth all compensation earned, in all
capacities, during the fiscal years ended December 31, 2002, 2003 and 2004 by our (i) Chief
Executive Officer, and (ii) executive officers, other than the CEO, whose salary for the 2004
fiscal year as determined by Regulation S-B, Item 402, exceeded $100,000 (the individuals falling
within categories (i) and (ii) are collectively referred to as the Named Executives). Summary Compensation Table Annual
    
    
    Long-Term CompensationCompensation
    
    
    Awards
    
    
    PayoutsCommon Stock
    
    
    All OtherUnderlying Options
    
    
    CompensationName and Principal Position
    
    Year
    
    
    Salary ($)
    
    
    (#)
    
    
    ($)Leslie Bernhard,
    
    
    2004
    
    
    $
    212,800
    
    
    
    0
    
    
    $
    0President & Chief Executive
    
    
    2003
    
    
    $
    212,800
    
    
    
    0
    
    
    
    0Officer
    
    
    2002
    
    
    $
    211,250
    
    
    
    150,000
    
    
    
    0Eli Rousso
    
    
    2004
    
    
    $
    212,800
    
    
    
    0
    
    
    $
    0Executive Vice President &
    
    
    2003
    
    
    $
    212,800
    
    
    
    0
    
    
    
    0Chief Technology Officer
    
    
    2002
    
    
    $
    209,450
    
    
    
    150,000
    
    
    
    0Jeffrey Baudo
    
    
    2004
    
    
    $
    191,700
    
    
    
    0
    
    
    $
    0Chief Operating Officer
    
    
    2003
    
    
    $
    191,700
    
    
    
    0
    
    
    
    02002
    
    
    $
    191,700
    
    
    
    150,000
    
    
    
    0Anthony J. Fidaleo
    
    
    2004
    
    
    $
    140,000
    
    
    
    0
    
    
    $
    0Vice President Finance &
    
    
    2003
    
    
    $
    125,000
    
    
    
    20,000
    
    
    
    0Chief Financial Officer
    
    
    2002
    (1)
    
    $
    65,104
    
    
    
    30,000
    
    
    
    0
   (1)
    
    Since commencement of employment on June 24, 2002. Stock Options No options were granted to any of the Named Executives for the year ended December 31, 2004
and none of the options referred to in the table below have been exercised as of December 31, 2004.
The following table provides the number and aggregate value of unexercised options held by Named
executives as of December 31, 2004. The per share exercise price of all options was equal to, or
above, the estimated fair market value of a share of Common Stock on the date of grant. 34




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##### Table of Contents



Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values Number of Shares Underlying
    
    
    Dollar Value of UnexercisedNumber of Shares
    
    
    Dollar Value
    
    
    Unexercised Options at fiscal
    
    
    In-the-Money Options at fiscalUnderlying
    
    
    Realized on
    
    
    Year-End (1)
    
    
    Year-End (1)Name
    
    Options Exercised
    
    
    Exercise
    
    
    Exercisable
    
    
    Nonexercisable
    
    
    Exercisable
    
    
    NonexercisableLeslie Bernhard
    
    
    
    
    
    $
    
    
    
    
    250,000
    
    
    
    
    
    
    $
    92,500
    
    
    $
    Eli Rousso
    
    
    
    
    
    $
    
    
    
    
    250,000
    
    
    
    
    
    
    $
    92,500
    
    
    $
    Jeffrey Baudo
    
    
    
    
    
    $
    
    
    
    
    250,000
    
    
    
    
    
    
    $
    19,000
    
    
    $
    Anthony J. Fidaleo
    
    
    
    
    
    $
    
    
    
    
    26,667
    
    
    
    23,333
    
    
    $
    600
    
    
    $
    300
   (1)
    
    Based on the closing price of the AdStars Common Stock on December 31, 2004 of $1.09. For
the purposes of this calculation, value is based upon the difference between the exercise
price of the options and the per share price at December 31, 2004. On July 1, 2002, AdStar entered into four-year employment agreements with each of Leslie
Bernhard and Eli Rousso. Their prior agreements expired on June 30, 2002. Pursuant to her
employment agreement, Leslie Bernhard was retained as our Chief Executive Officer and her total
annual compensation was reduced to $212,800. Pursuant to his employment agreement, Eli Rousso was
retained as our Executive Vice President and his total annual compensation was reduced to $212,800.
Each agreement provides, among other things, for participation in an equitable manner in any
profit-sharing or retirement, separation and disability plans for employees or executives and for
participation in other employee benefits applicable to employees and executives of AdStar. Each
agreement further provides for fringe benefits which are commensurate with the executives duties
and responsibilities. Under each agreement, employment may be terminated by us with cause or by the
executive with good reason. Termination by us without cause, or by the executive for good reason,
would subject us to liability for liquidated damages in an amount equal to the terminated
executives base salary for the remaining term of his or her employment agreement or 12 months,
whichever is greater. In January 2001, AdStar entered into a 2-year employment contract with Mr. Jeffrey Baudo.
Pursuant to his employment agreement, Mr. Baudo was retained as our Chief Operating Officer at an
annual rate of $213,000 per year, and granted options to purchase 100,000 shares of AdStars Common
Stock. Subsequently, as of July 1, 2002, Mr. Baudo agreed to an amendment to his employment
agreement reducing his annual rate of compensation to $191,700. Mr. Baudos contract was extended
for one year with successive one-year terms for the same salary under essentially the same terms
and conditions, effective January 22, 2003. Mr. Baudo is the brother of Leslie Bernhard. On December 31, 2004, as part of a global cost cutting strategy, all employees and officers
with annual salaries greater then $50,000 who have been employed for greater then 1 year received a
temporary 5% reduction in compensation. It is AdStars intention to reinstate the compensation
sometime in the future. For purposes of the future payments as defined below and elsewhere in this
document we assume the reduction will be reinstated on January 1, 2006. Compensation of Directors As of November 11, 2004, we granted Arthur Salzfass,
a non-employee director, options covering 50,000 shares of Common
Stock, exercisable at $1.29 per share for
services rendered. Options for 25,000 shares vested immediately upon grant with the remaining
25,000 due to vest 35




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##### Table of Contents



on November 11, 2005. However, as a result of his resignation the remaining
option will not vest. The options are exercisable at anytime up to the amounts vested on the date of exercise until
their expiration on November 11, 2009. Limitation of Directors Liability and Indemnification The Delaware General Corporation Law (the DGCL) authorizes corporations to limit or
eliminate the personal liability of directors to corporations and their shareholders for monetary
damages for breach of directors fiduciary duty of care. The AdStar Certificate of Incorporation
limits the liability of its directors to AdStar or its stockholders to the fullest extent permitted
by Delaware law. AdStars Certificate of Incorporation provides mandatory indemnification rights to any officer
or director of AdStar who, by reason of the fact that he or she is an officer or director of
AdStar, is involved in a legal proceeding of any nature. Such indemnification rights include
reimbursement for expenses incurred by such officer or director in advance of the final disposition
of such proceeding in accordance with the applicable provisions of the DGCL. Insofar as
indemnification for liabilities under the Act may be provided to officers and directors or persons
controlling AdStar, AdStar has been informed that in the opinion of the Securities and Exchange
Commission such indemnification is against public policy as expressed in the Act and is, therefore,
unenforceable. 
 Item 11. Security
Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters The following table, together with the accompanying footnotes, sets forth information, as of March
8,2005, regarding stock ownership of all persons known by AdStar to own beneficially more than 5%
of AdStars outstanding Common Stock, Named Executives, all directors, and all directors and
officers of AdStar as a group: Shares ofCommon StockBeneficially
    
    
    Percentage ofName of Beneficial Owner (1)
    
    Owned (2)
    
    
    OwnershipLeslie Bernhard (3)
    
    
    889,205
    
    
    
    5.7
    %Eli Rousso (3)
    
    
    917,127
    
    
    
    5.9
    %Jeffrey Baudo (4)
    
    
    280,060
    
    
    
    1.8
    %Anthony J. Fidaleo (6)
    
    
    45,845
    
    
    
    *Richard Salute (7)
    
    
    75,000
    
    
    
    *Tribune Company (5)
    
    
    3,443,457
    
    
    
    20.1
    %All Directors and Officers (4 persons) as a group
    
    
    2,207,237
    
    
    
    14.2
    %
   *
    
    less than 1%(1)
    
    The addresses of the persons named in this table are as follows: Leslie Bernhard, Eli
Rousso, Jeffrey Baudo, and Anthony Fidaleo, c/o AdStar, Inc., 4553 Glencoe Avenue, Suite
300, Marina del Rey, CA 90292; Richard Salute, 7 Lori Court, Woodbury, New York, 11797; and
Tribune Company, 435 N. Michigan Ave. Chicago IL, Attn: General Counsel;(2)
    
    A person is deemed to be a beneficial owner of securities that can be acquired by such
person within 60 days from the filing of this report upon the exercise of options and
warrants or conversion of convertible securities. Each beneficial owners percentage
ownership is determined by assuming that options, warrants and convertible securities that
are held by such person (but not held by any 36




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##### Table of Contents



other person) and that are exercisable or convertible within 60 days from March 08, 2005 have been
exercised or converted. Except as otherwise indicated, and subject to applicable community
property and similar laws, each of the persons named has sole voting and investment power
with respect to the shares shown as beneficially owned. On March 8, 2005, 15,216,395 shares
of Common Stock were outstanding.(3)
    

    Includes an aggregate of 110,054 shares in respect of which Ms. Bernhard and Mr. Rousso
have voting power. Additionally, Ms. Bernhard and Mr. Rousso each have options to purchase
100,000, 150,000, and 29,151 shares of AdStar Common Stock at $0.81, $.060, and $0.73 per
share, respectively, exercisable within 60 days.(4)
    

    Includes options to purchase 100,000, 150,000, and 26,260 shares of AdStar Common
Stock, at $1.25, $0.60, and $0.73 per share, exercisable within 60 days.(5)
    

    Includes 2,000,000 shares of Series B-2 Preferred Stock, which currently convert into
Common Stock on a 1 for 1 basis.(6)
    

    Consists of options to purchase 20,000, 6,667, and 19,178 shares of AdStar Common
Stock, at $1.06, $2.06, and $0.73 per share, exercisable within 60 days.(7)
    
    Consists of options to purchase 75,000 shares of Common Stock of AdStar at $0.94 per
share exercisable within 60 days. Securities Authorized for Issuance Under Equity Compensation Plans 2004 Stock Option Plan In 2004 our stockholders approved the 2004 Stock Option Plan adopted by our Board (the 2004
Plan), which provides for the grant to our employees, directors and consultants of incentive and
non-qualified stock options to purchase 1,200,000 shares of our Common Stock. The purpose of the
2004 Plan is to provide incentives to employees, directors and consultants whose performance will
contribute to our long-term success and growth, to strengthen our ability to attract and retain
employees, directors and consultants of high competence, to increase the identity of interests of
such people with those of our stockholders and to help build loyalty to AdStar through recognition
and the opportunity for stock ownership. The Compensation Committee of the Board will administer
the 2004 Plan. The 2004 Plan will expire 10 years from the date of stockholder approval.
Generally, the option price of both incentive stock options and non-qualified stock options must be
at least equal to 100% of the fair market value of the shares on the date of grant. The maximum
term of each option is ten years. For any participant who owns shares possessing more than 10% of
the voting rights of our outstanding Common Stock, the exercise price of any incentive stock option
must be at least equal to 110% of the fair market value of the shares subject to such option on the
date of grant and the term of the option may not be longer than five years. 1999 Stock Option Plan To attract and retain the personnel necessary for our success, we adopted our 1999 Stock
Option Plan (the 1999 Plan) and reserved 1,500,000 shares of stock for future grants under it.
Pursuant to the 1999 Plan, our officers, directors and key employees and consultants are eligible
to receive grants of incentive and/or non-incentive stock options covering up to 1,500,000 shares
of our Common Stock. The purpose of the 1999 Plan is to provide a flexible framework that permits
the Board to develop and implement stock-based incentive compensation programs based on changing
needs in our competitive market. In addition, the 1999 Plan provides that the maximum term for
options granted under the plan is 10 years and that the exercise price for the options may not be
less than the fair market value of our Common 37




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Stock on the date of grant. Options granted to stockholders owning more than 10% of our
outstanding Common Stock must be exercised within five years from the date of grant and the
exercise price must be at least 110% of the fair market value of our Common Stock on the date of
the grant. The following table summarizes as of December 31, 2004 the (i) options granted under both of
our option plans and (ii) all other securities subject to contracts, options, warrants and rights
or authorized for future issuance outside the plans. The shares covered by outstanding options or
authorized for future issuance are subject to adjustment for changes in capitalization stock
splits, stock dividends and similar events. As of December 31, 2004, no options were granted under
the 2004 Plan. Equity Compensation Plan TableNumber of securitiesremaining availablefor future issuanceunder equityNumber of securities
    
    
    
    
    
    
    compensation plansto be
    
    
    Weighted-average
    
    
    (excludingissued upon exercise of
    
    
    exercise price of
    
    
    securitiesoutstanding options,
    
    
    outstanding options,
    
    
    reflected in columnwarrants and rights
    
    
    warrants and rights
    
    
    (a))(a)
    
    
    (b)
    
    
    (c)Equity
Compensation Plans
Approved By
Security Holders
(the 2004 plan and
the 1999 Plan)
    
    
    1,118,563
    
    
    $
    1.00
    
    
    
    1,448,632Equity Compensation
Plans Not Approved
By Security Holders
    
    
    851,770
    
    
    $
    2.00
    
    
    
    148,665
    (1)Total
    
    
    1,970,333
    
    
    $
    1.43
    
    
    
    1,597,297
   (1)
    
    Reflects shares of AdStar Common Stock under the Vendor Plan described below.The equity compensation not approved by security holders referred to in the table above
includes: 
Grants of an aggregate of 230,000 non-qualified Common Stock purchase options to
certain consultants for Investor Relation services and to our non-employee directors for their
services. The details of the grants are as follows: (1) 25,000 options to a consultant exercisable
at $10.00 per share, expiring in March 2005, (2) 30,000 options to a consultant exercisable at
$1.99 per share, expiring in November 2008, (3) 50,000 options exercisable at $0.60 per share,
expiring on the earlier of thirty days from such directors termination of his position or January
27, 2007, (4) 75,000 options exercisable at $0.94 per share, expiring on the earlier of thirty days
from such directors termination of his position or on January 28, 2008 and (5) As of November 11, 2004
we granted options covering 50,000 shares of Common Stock, exercisable at $1.29 per share were
granted to a non-employee director, for services rendered. Options for 25,000 shares vested
immediately upon grant with the remaining 25,000 due to vest on November 11, 2005. However, as a
result of this directors resignation the remaining option will not vest. The options are
exercisable at anytime up to the amounts vested on the date of exercise until their expiration on
November 11, 2009.  Issuances of an aggregate of 421,770 Common Stock purchase warrants for services
rendered by the Underwriter in our public offerings, and the Placement Agent in our private
offerings, of securities. The details of the warrants are as follows: (1) 200,000 Common Stock
Purchase warrants exercisable at 38




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##### Table of Contents



$1.80 per share, expiring on September 25, 2005; (2) 67,450 Common Stock purchase warrants
exercisable at $0.75 per share, expiring on January 16, 2007; and (3) 154,320 Common Stock purchase
warrants exercisable at $1.87 per share, expiring on March 31, 2009.  Issuance of 200,000 Common Stock purchase warrants as part of a private placement for
a convertible note with a institutional fund.  In addition we established a plan (the Vendor Plan) to pay vendors, who are
accredited investors (as defined under Rule 215 of the Securities Act of 1933), in shares of our
Common Stock, valued at fair market value, for goods or services. Up to 400,000 shares may be
issued under the Vendor Plan. Under the Vendor Plan, as of December 31, 2004, an aggregate of
251,335 shares of Common Stock had been issued leaving 148,665 shares available for future
issuance. 
 Item 12. Certain Relationships and Related Transactions In March 2002, our Board of Directors approved the sale of 1,443,457 shares of our Series A
Preferred Stock to Tribune Company for an aggregate purchase price of approximately $1.8 million.
These shares carry a liquidation preference that includes a dividend of 7% per year available only
upon liquidation and currently convert on a 1:1 basis. The holders of Series A Preferred Stock are
entitled to vote on all matters submitted to the stockholders for vote and vote as a single class
with the holders of our Common Stock. The holders of Series A Preferred Stock are entitled to one
vote for each share of Common Stock issuable upon conversion. In December 2002 our Board of Directors approved the sale of shares of its Series B Preferred
Stock to Tribune Company for an aggregate price of $1.5 million. The sale was split into two
funding segments: (i) In December 2002, we sold 1,200,000 shares of our Series B-1 Preferred Stock to Tribune
Company for an aggregate purchase price of $900,000. These shares currently convert on a 1:1 basis.
The holders of Series B-1 Preferred Stock are entitled to vote on all matters submitted to
stockholders for vote and as a single class with our Common Stock. The holders of Series B-1
Preferred Stock are entitled to one vote for each share; and (ii) In March 2003, we sold 800,000 shares of our Series B-2 Preferred Stock to Tribune
Company for an aggregate purchase price of $600,000. These shares currently convert on a 1:1 basis.
The holders of Series B-2 Preferred Stock are entitled to vote on all matters submitted to
stockholders for vote and as a single class with our Common Stock. The holders of Series B-2
Preferred Stock are entitled to one vote for each share. In addition, on March 28, 2003, in
exchange for all of the Series B-1 Preferred Stock plus accrued and unpaid dividends on those
shares, issued in December 2002 to Tribune Company, we issued an additional 1,200,000 shares of our
Series B-2 Preferred Stock to the Tribune Company. 
 Item 13. Exhibits, List and Reports on Form 8-K (a) Exhibits: ExhibitNo.
    
    Description2.1
    
    Agreement and Plan of Merger dated October 21, 2003(1)3.1
    
    Certificate of Incorporation of AdStar (2)3.1a
    
    Amendment to Certificate of Incorporation, as filed with the Secretary of State of Delaware
on July 11, 2001 (3)
 39




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##### Table of Contents



ExhibitNo.
    
    Description3.1b
    
    Series A Preferred Stock Certificate of Designation as filed with the Secretary of State of
Delaware on March 15, 2002 (4)3.1c
    
    Series B-1 Preferred Stock Certificate of Designation as filed with the Secretary of State of
Delaware on December 20, 2002, effective December 23, 2002 (5)3.1d
    
    Series B-2 Preferred Stock Certificate of Designation as filed with the Secretary of State of
Delaware on March 28, 2003, effective March 28, 2003(6)3.1e
    
    Amendment to Certificate of Incorporation, as filed with the Secretary of State of Delaware
on November 11, 2004 *3.2
    
    By-Laws of AdStar (2)4.1
    
    Specimen Stock Certificate (2)4.2
    
    Revised Form of Underwriters Warrant (7)4.3
    
    Form of 5-year warrant issued in the Private Placement of units on April 6, 2001 (8)4.4
    
    Form of 5-year warrant issued in connection with the Private Placement of AdStar Common Stock
during the period of October 2001 through January 2002(9)4.5
    
    Form of 3-year warrant issued to C.C.R.I. Corporation in connection with an agreement between
it and AdStar, dated as of October 2, 2001(9)4.6
    
    Form of 5-year warrant issued in connection with the Private Placement of AdStar Common Stock
in September 2003 (10)4.7
    
    Registration Rights Agreement by and among the Company and the Edgil Stockholders, dated
October 21, 2003 (11)10.1
    
    1999 Stock Option Plan (2)10.2
    
    Employment Agreement between AdStar and Leslie Bernhard (6)10.3
    
    Employment Agreement between AdStar and Eli Rousso (6)10.4
    
    Employment Agreement between AdStar and Jeffrey Baudo (6)10.5
    
    Series A Preferred Stock Purchase Agreement, dated March 18, 2002, by and between AdStar,
Inc. and Tribune Company (4)10.6
    
    Software Development and Deployment Agreement, dated March 18, 2002, by and between AdStar,
Inc. and Tribune Company (4)10.7
    
    Registration Rights Agreement, dated March 18, 2002, by and between AdStar, Inc. and Tribune
Company (4)10.8
    
    Governance Agreement, dated March 18, 2002, by and among AdStar, Inc., Leslie Bernhard, Eli
Rousso and Tribune Company (4)10.9
    
    Series B Preferred Stock Purchase Agreement, dated December 23, 2002, by and between AdStar,
Inc. and Tribune Company (5)10.10
    
    Second Software Development and Deployment Agreement, dated December 23, 2002, by and
between AdStar, Inc. and Tribune Company (5)10.11
    
    Amended and Restated Registration Rights Agreement, dated December 23, 2002, by and between
AdStar, Inc. and Tribune Company (5)10.12
    
    Amended and Restated Governance Agreement, dated December 23, 2002, by and among AdStar,
Inc., Leslie Bernhard, Eli Rousso and Tribune Company (5)10.13
    
    2004 Stock Option Plan (14)14.1
    
    Code of Ethics (15)16.1
    
    Letter from PricewaterhouseCoopers LLP dated February 20, 2003 (12)
 40




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##### Table of Contents



ExhibitNo.
    
    Description20.1
    
    Notification to AdStar, Inc. stockholders of action taken by written consent of the holders
of a majority of outstanding shares (13)21.1
    
    Subsidiaries(15)22.1
    
    Published reports containing information called for by Item 4 of Part I of this report (See
Exhibit 20.1 above)(15)23.1
    
    Consent of BDO Seidman, LLP *31.1
    
    Chief Executive Officer Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002*31.2
    
    Chief Executive Officer Certification pursuant to section 302 of the Sarbanes-Oxley Act of 2002*32.1
    
    Chief Executive Officer Certification pursuant to section 906 of the Sarbanes-Oxley Act of 2002*32.2
    
    Chief Executive Officer Certification pursuant to section 906 of the Sarbanes-Oxley Act of 2002*Notes to exhibits
   *
    
    Filed herewith(1)
    
    Filed on November 4, 2003 as an exhibit with the same number to Current Report on Form 8-K
and incorporated herein by reference.(2)
    
    Filed on October 1999 as an exhibit with the same number to Registration Statement on Form
SB-2 (No. 333-84209), and incorporated herein by reference.(3)
    
    Filed as an exhibit to Quarterly Report on Form 10QSB for the period ended September 30, 2001
and incorporated herein by reference.(4)
    
    Filed on March 25, 2002 as an exhibit to the Current Report on Form 8-K filed and
incorporated herein by reference.(5)
    
    Filed on December 31, 2003 as an exhibit to the Current Report on Form 8-K filed and
incorporated herein by reference.(6)
    
    Filed as an exhibit to the Annual Report on Form 10KSB for the period ended December 31, 2003
and incorporated herein by reference.(7)
    
    Filed in September 2000 as an exhibit with the same number to Registration Statement on Form
SB-2 (No. 333-43408) and incorporated herein by reference.(8)
    
    Filed on May 10, 2001 as an exhibit to Registration Statement on Form S-3 No. 333-60664 and
incorporated herein by reference.(9)
    
    Filed on January 24, 2002 as an exhibit to Registration Statement on Form S-3 No. 333-81338
and incorporated herein by reference.(10)
    
    Filed on October 16, 2003 as an exhibit with the same number to Registration Statement on
Form S-3 (No. 333-109757) and incorporated herein by reference.(11)
    
    Filed on November 4, 2003 as an exhibit to the Current Report on Form 8-K and incorporated
herein by reference.(12)
    
    Filed on February 24, 2003 as an exhibit to the Current Report on Form 8-K filed and
incorporated herein by reference.(13)
    
    Filed on March 9, 2004 by a Schedule 14C Information Statement.(14)
    
    Filed on October 13, 2004 as Appendix A to the Schedule 14A Proxy Statement and incorporated
herein by reference.(15)
    
    Filed as an exhibit to the Annual Report on Form 10KSB for the period ended December 31, 2003
and incorporated herein by reference. 41




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##### Table of Contents



Item 14. Principal Accountant Fees and Services The aggregate fees billed by our principal accounting firm, BDO Seidman, LLP, for fees billed
for fiscal years ended December 31, 2004 and 2003 are as follows: 2004
    
    
    2003Audit fees
    
    $
    100,500
    
    
    $
    90,611Audit related fees
    
    
    52,426
    
    
    
    41,586
    (1)Total audit and audit related fees
    
    $
    152,926
    
    
    $
    132,197Tax fees
    
    
    19,477
    
    
    
    6,900All other fees
    
    
    
    
    
    
    Total fees
    
    $
    172,403
    
    
    $
    139,097
   (1)
    
    Includes fees paid to PricewaterhouseCoopers LLP. Audit-Related Fees The Audit-Related Fees set forth in the table above consist primarily of consulting on
regulatory filings, acquisition audits of Edgil, and consulting and research on specific accounting
issues that pertained to our on-going operations and the audit, including, technical research
associated with revenue recognition, Preferred Stock and Common Stock financings, and purchase
accounting rules. Tax Fees The Tax Fees set forth in the table above are the aggregate fees paid by us for tax services
including, the preparation of corporate tax returns. All Other Fees There were no Other Fees for the periods presented. Each of the permitted non-audit services has been pre-approved by the Audit Committee or the
Audit Committees Chairman pursuant to delegated authority by the Audit Committee, other than de
minimus non-audit services for which the pre-approval requirements are waived in accordance with
the rules and regulations of the SEC. Audit Committee Pre-Approval Policies and Procedures The Audit Committee charter provides that the Audit Committee will pre-approve audit services
and non-audit services to be provided by our independent auditors before the accountant is engaged
to render these services. The Audit Committee may consult with management in the decision-making
process, but may not delegate this authority to management. The Audit Committee may delegate its
authority to pre-approve services to one or more committee members, provided that the designees
present the pre-approvals to the full committee at the next committee meeting. 42




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. AdStar, Inc.By:
    
    /s/ Leslie BernhardLeslie Bernhard,President and Chief Executive Officer
 Date: March 31, 2005 In accordance with the Exchange Act, this report has been signed below by the following
persons on behalf of the Registrant and in the capacities indicated on March 31, 2005. Signature
    
    TitlePrincipal Executive Officer/s/ Leslie Bernhard
    
    President and Chief Executive Officer and DirectorLeslie BernhardPrincipal Financial Officer/s/ Anthony J. Fidaleo
    
    Chief Financial OfficerAnthony J. FidaleoDirectors/s/ Eli Rousso
    
    DirectorEli Rousso/s/ Jeffrey Baudo
    
    DirectorJeffrey Baudo/s/ Richard Salute
    
    DirectorRichard Salute
 43




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##### Table of Contents



Index To Financial Statements PageReports of Independent Registered Public Accounting Firm
    
    
    F-2Financial Statements:Consolidated Balance Sheet as of December 31, 2004
    
    
    F-3Consolidated Statements of Operations for the two years ended December 31, 2004
    
    
    F-4Consolidated Statements of Stockholders Equity for the two
years ended December 31, 2004
    
    
    F-5Consolidated Statements of Cash Flows for the two years ended December 31, 2004
    
    
    F-6Notes to Consolidated Financial Statements
    
    
    F-7
 F-1




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##### Table of Contents



Report of Independent Registered Public Accounting Firm Board of Directors
AdStar, Inc.
Marina del Rey, California We have audited the accompanying consolidated balance sheet of AdStar, Inc. and Subsidiary (the
Company) as of December 31, 2004 and the related consolidated statement of operations,
stockholders equity, and cash flows for the two 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 auditing standards generally accepted in the United
States of America. Those standards require that we plan and perform the audits 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 audits 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 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 financial statements referred to above present fairly, in all material
respects, the financial position of AdStar, Inc. and Subsidiary at December 31, 2004, and the
results of its operations and its cash flows for the two years then ended in conformity with
accounting principles generally accepted in the United States of America. /s/ BDO Seidman, LLP
Los Angeles, California
March 11, 2005 F-2




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##### Table of Contents



AdStar, Inc. and Subsidiary 
 Consolidated Balance Sheet
 As of December 31, 2004
 AssetsCurrent assets:Cash and cash equivalents
    
    $
    1,093,006Accounts receivable, net of allowance for doubtful accounts of $72,000
    
    
    584,652Notes receivable from officers  current portion
    
    
    8,022Prepaid and other current assets
    
    
    170,459Total current assets
    
    
    1,856,139Notes receivable from officers, net of current portion
    
    
    224,334Property and equipment, net
    
    
    142,423Capitalized and purchased software, net
    
    
    1,543,478Intangible assets, net
    
    
    1,395,285Goodwill
    
    
    2,132,219Other assets
    
    
    117,957Total assets
    
    $
    7,411,835Liabilities and Stockholders EquityCurrent liabilities:Due to publications
    
    $
    1,298,929Accounts payable and accrued expenses
    
    
    1,389,149Deferred revenue and customer deposits  current portion
    
    
    324,139Loans from stockholders  current portion
    
    
    21,000Capital lease obligations  current portion
    
    
    18,161Convertible note  current portion
    
    
    339,692Total current liabilities
    
    
    3,391,070Deferred revenues, net of current portion
    
    
    36,179Loans from stockholders, net of current portion
    
    
    21,000Capital lease obligations, net of current portion
    
    
    124Convertible note, net of current portion
    
    
    413,114Total liabilities
    
    
    3,861,487Commitments and contingenciesStockholders equity:Convertible Preferred Stock series B-2, par value $0.0001; authorized
5,000,000 shares; 2,000,000 issued and outstanding; liquidation
preference of $1,708,594
    
    
    1,342,404Common Stock, par value $0.0001; authorized 20,000,000 shares;
14,513,416 issued and outstanding
    
    
    1,451Additional paid-in capital
    
    
    20,088,890Treasury stock; 67,796 shares
    
    
    (67,796
    )Accumulated deficit
    
    
    (17,814,601
    )Total stockholders equity
    
    
    3,550,348Total liabilities and stockholders equity
    
    $
    7,411,835
 The accompanying notes are an integral part of these consolidated financial statements. F-3




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##### Table of Contents



AdStar, Inc. and Subsidiary 
 Consolidated Statements of Operations
 For the Two Years
 Ended December 31, 2004
 2003
    
    
    2004ASP, net
    
    $
    1,470,260
    
    
    $
    1,687,468Licensing and software
    
    
    1,087,097
    
    
    
    2,268,274Customization and other
    
    
    276,168
    
    
    
    977,795Net revenues
    
    
    2,833,525
    
    
    
    4,933,537Cost of revenues, including of amortization of $683,300 and $649,095
    
    
    1,296,883
    
    
    
    2,027,446Loss on write-down of capitalized software
    
    
    883,060
    
    
    
    257,820Total cost of revenues
    
    
    2,179,943
    
    
    
    2,285,266Gross profit
    
    
    653,582
    
    
    
    2,648,271General and administrative expense
    
    
    1,343,395
    
    
    
    2,053,018Product maintenance and development costs
    
    
    1,241,957
    
    
    
    1,359,029Selling and marketing expense
    
    
    750,128
    
    
    
    1,290,578Restructuring expenses
    
    
    124,774
    
    
    
    (37,592
    )Amortization of customer list
    
    
    17,315
    
    
    
    88,231Abandoned acquisition costs
    
    
    
    
    
    
    1,203,140Loss from operations
    
    
    (2,823,987
    )
    
    
    (3,308,133
    )Beneficial interest and amortization of financing fees on
convertible note
    
    
    
    
    
    
    (298,653
    )Other expense
    
    
    (10,000
    )
    
    
    Interest income (expense), net
    
    
    5,472
    
    
    
    (36,477
    )Loss before income taxes
    
    
    (2,828,515
    )
    
    
    (3,643,263
    )Provision for income taxes
    
    
    (13,850
    )
    
    
    (4,900
    )Net loss
    
    $
    (2,842,365
    )
    
    $
    (3,648,163
    )Loss per share  basic and diluted
    
    $
    (0.31
    )
    
    $
    (0.26
    )Weighted average number of shares  basic and diluted
    
    
    9,030,764
    
    
    
    14,043,221
 The accompanying notes are an integral part of these consolidated financial statements. F-4




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##### Table of Contents



AdStar, Inc. and Subsidiary 
 Consolidated Statements of Stockholders Equity
 For the Two Years
 Ended December 31, 2004
 TotalCommon Stock
    
    
    Preferred Stock Series A
    
    
    Preferred Stock Series B-1
    
    
    Preferred Stock Series B-2
    
    
    Treasury Stock
    
    
    Additional
    
    
    Accumulated
    
    
    StockholdersShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    PaidIn Capital
    
    
    Deficit
    
    
    EquityBalance,
January 1, 2003
    
    
    8,260,928
    
    
    $
    826
    
    
    
    1,443,457
    
    
    $
    1,697,840
    
    
    
    1,200,000
    
    
    $
    813,720
    
    
    
    
    
    
    $
    
    
    
    
    67,796
    
    
    
    ($67,796
    )
    
    $
    11,294,075
    
    
    $
    (11,324,073
    )
    
    $
    2,414,592Conversion of Preferred
Series B-1 to B-2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,200,000
    )
    
    
    (813,720
    )
    
    
    1,200,000
    
    
    
    813,720
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net Proceeds from
Preferred Series B-2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    800,000
    
    
    
    528,683
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    528,684Common Stock and warrants
issued in private
placement
    
    
    1,590,000
    
    
    
    159
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,723,511
    
    
    
    
    
    
    
    1,723,670Common Stock issued for
purchase of Edgil
Associates, Inc.
    
    
    1,311,530
    
    
    
    131
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,111,432
    
    
    
    
    
    
    
    2,111,563Options issued as
replacement options in
purchase of Edgil
Associates, Inc.
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    68,926
    
    
    
    
    
    
    
    68,926Common Stock issued in
private placement
    
    
    1,257,693
    
    
    
    127
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,578,769
    
    
    
    
    
    
    
    1,578,896Warrants exercised
    
    
    152,501
    
    
    
    15
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    197,362
    
    
    
    
    
    
    
    197,377Options issued for services
    
    
    131,185
    
    
    
    13
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    136,987
    
    
    
    
    
    
    
    137,000Options exercised
    
    
    74,694
    
    
    
    7
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    55,477
    
    
    
    
    
    
    
    55,484Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,842,365
    )
    
    
    (2,842,365
    )Balance, December 31, 2003
    
    
    12,778,531
    
    
    
    1,278
    
    
    
    1,443,457
    
    
    
    1,697,840
    
    
    
    
    
    
    $
    
    
    
    
    2,000,000
    
    
    
    1,342,404
    
    
    
    67,796
    
    
    
    (67,796
    )
    
    
    17,166,539
    
    
    
    (14,166,438
    )
    
    
    5,973,827Conversion of Preferred
Series A net of associated
costs and fees
    
    
    1,443,457
    
    
    
    144
    
    
    
    (1,443,457
    )
    
    
    (1,697,840
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,666,997
    
    
    
    
    
    
    
    (30,699
    )Beneficial conversion of
warrants issued with
convertible debt
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    734,231
    
    
    
    
    
    
    
    734,231Common Stock issued to
legal council for finders
fee on convertible debt
    
    
    25,000
    
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    32,247
    
    
    
    
    
    
    
    32,250Conversion of convertible
debt to Common Stock
    
    
    100,000
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    224,990
    
    
    
    
    
    
    
    225,000Common Stock issued for
services
    
    
    53,217
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    96,320
    
    
    
    
    
    
    
    96,325Warrants exercised
    
    
    55,230
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    109,158
    
    
    
    
    
    
    
    109,163Options exercised
    
    
    58,111
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    58,408
    
    
    
    
    
    
    
    58,414Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,648,163
    )
    
    
    (3,648,163
    )Balance, December 31, 2004
    
    
    14,513,546
    
    
    $
    1,451
    
    
    
    
    
    
    $
    
    
    
    
    
    
    
    $
    
    
    
    
    2,000,000
    
    
    $
    1,342,404
    
    
    
    67,796
    
    
    $
    (67,796
    )
    
    $
    20,088,890
    
    
    $
    (17,814,601
    )
    
    $
    3,550,348
 The accompanying notes are an integral part of these consolidated financial statements. F-5




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##### Table of Contents



AdStar, Inc. and Subsidiary 
 Consolidated Statements of Cash Flows
 For the Two Years
 Ended December 31, 2004
 2003
    
    
    2004Cash flows from operating activities:Net loss
    
    $
    (2,842,365
    )
    
    $
    (3,648,163
    )Adjustments to reconcile net loss to net cash used in operating
activities:Depreciation and amortization
    
    
    877,947
    
    
    
    797,023Beneficial interest and amortization of financing fees on
convertible note
    
    
    
    
    
    
    298,653Loss on write-down of capitalized software
    
    
    883,060
    
    
    
    257,820Loss on disposal of equipment and purchased software
    
    
    
    
    
    
    12,910Stock based charges
    
    
    137,000
    
    
    
    96,325Allowance for doubtful accounts
    
    
    (15,202
    )
    
    
    12,000Changes in assets and liabilities:Accounts receivable
    
    
    63,211
    
    
    
    (256,780
    )Prepaids and other assets
    
    
    3,459
    
    
    
    15,269Due to publications
    
    
    59,298
    
    
    
    214,956Accounts payable and accrued expenses
    
    
    (39,992
    )
    
    
    195,722Deferred revenue and customer deposits
    
    
    76,202
    
    
    
    170,545Net cash used in operating activities
    
    
    (797,382
    )
    
    
    (1,833,720
    )Cash flows from investing activities:Purchase of Edgil Associates, Inc., net of cash received
    
    
    (1,558,388
    )
    
    
    29,235Additions to capitalized and purchased software
    
    
    (634,145
    )
    
    
    (498,677
    )Purchase of property and equipment
    
    
    (95,406
    )
    
    
    (83,400
    )Notes from officers
    
    
    
    
    
    
    (6,003
    )Repayment of officer receivable
    
    
    7,179
    
    
    
    7,589Net cash used in investing activities
    
    
    (2,280,760
    )
    
    
    (551,256
    )Cash flows from financing activities:Decrease in restricted cash
    
    
    174,918
    
    
    
    Net proceeds from issuance of convertible debt
    
    
    
    
    
    
    1,346,794Repayment of convertible debt
    
    
    
    
    
    
    (45,454
    )Net proceeds from sale of stock in private placements
    
    
    3,302,566
    
    
    
    Proceeds from issuance of notes payable
    
    
    200,000
    
    
    
    Repayment of notes payable
    
    
    (200,000
    )
    
    
    Net proceeds from issuance of series B Preferred Stock
    
    
    528,683
    
    
    
    Proceeds from exercise of options and warrants
    
    
    252,861
    
    
    
    167,579Cost of conversion of series A Preferred Stock
    
    
    
    
    
    
    (30,699
    )Principal repayments on loans from shareholders
    
    
    
    
    
    
    (21,000
    )Principal repayments on capital leases
    
    
    (28,787
    )
    
    
    (31,715
    )Net cash provided by financing activities
    
    
    4,230,241
    
    
    
    1,385,505Net increase (decrease) in cash and cash equivalents
    
    
    1,152,099
    
    
    
    (999,471
    )Cash and cash equivalents at beginning of period
    
    
    940,378
    
    
    
    2,092,477Cash and cash equivalents at end of period
    
    $
    2,092,477
    
    
    $
    1,093,006
 The accompanying notes are an integral part of these consolidated financial statements. F-6




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##### Table of Contents



AdStar, Inc. and Subsidiary 
 Notes to Consolidated Financial Statements
  1.
    Organization and BusinessAdStar, Inc. (the Company or AdStar) (formerly AdStar.com, Inc. and AdStar-Services,
Inc.) was incorporated in the State of New York on June 29, 1991 as an S-Corporation under
the Internal Revenue Code. In 1999, the Company reincorporated as a C-Corporation in
Delaware.The Companys core business has been licensing proprietary software systems and supplying
the related support and maintenance. This professional software system allows large
commercial advertising agencies and corporations to directly enter classified advertisements
into the publishing systems at the Companys customers, through modems on a dial-up basis.
The Companys customers are principally located in the United States. In June 1999, the
Company commenced offering a one-stop marketplace on the World Wide Web for advertisers to
buy classified ads. This service enables advertisers to plan, schedule, compose and
purchase classified advertising from many print and on-line publishers, using one interface.In 2001, the Company formally introduced its new AdStar e-business application suite. This
is an enterprise class, integrated software solution that allows print and on-line
publications to electronically receive completed classified advertising copy using the
Internet as the communication channel. These software solutions enable customers to expand
the relationships with their customers using a single integrated platform, while increasing
sales volumes at reduced costs. This suite includes an updated version of the Companys core
professional software product that utilizes the Internet as the communication channel. In
addition, the Company has added an application service provider (ASP) product that
provides its customers an opportunity to generate incremental revenue from classified ad
sale transactions completed on-line, while increasing the number of visitors to the
customers Web site.On October 21, 2003 (the Effective Date), AdStar acquired all of the business and assets
of Edgil Associates, Inc. (Edgil) pursuant to an Agreement and Plan of Merger (the Merger
Agreement), dated as of the Effective Date, by and among AdStar, Edgil, EDG, and Edward P.
Hopey and Gilbert Wolsky  the stockholders of Edgil (collectively, the Edgil
Stockholders). Edgil was incorporated in the State of Massachusetts on February 22, 1984 as
a C-Corporation under the Internal Revenue Code. Edgil, based in North Chelmsford,
Massachusetts, is a provider of complete automated payment processing systems and content
processing solutions for the publishing industry. Edgils core business has been licensing
proprietary software systems and supplying the related support and maintenance.Edgil develops software applications primarily for the newspaper publishing industry. Its
management and personnel combine extensive knowledge of newspaper publishing systems with
technical expertise in database management systems, electronic commerce, and Web application
development. Edgil offers system integration services, installation support, training, and
customer service. Edgils proprietary EdgCapture payment processing software processes over
10,000,000 newspaper advertising and circulation transactions annually for Tribune Company,
Gannett Company, Inc., Knight-Ridder, Inc., Copley Press, Inc., New York Times Company,
Advance Publications, Inc., Cox Enterprises, Inc., and Village Voice Media, Inc., as well as
many independent daily and specialty publications. F-7




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##### Table of Contents



Edgils product strategy focuses on providing newspapers with the financial benefits
afforded by reduced labor costs and lower credit card processing discount rates. Edgils
experience with integration services has given the EdgCapture product line the technical
differentiation to meet the specific credit card processing requirements of the publishing
industry.2.
    Basis of Presentation and Summary of Significant Accounting PoliciesBasis of Presentation and Managements PlanThe accompanying financial statements have been prepared assuming the Company will have
liquidity to maintain its required minimum level of operations. At December 31, 2004, we had
an accumulated deficit of $17,815,000. We have incurred significant recurring net losses.
For the years ended December 2003 and 2004 we had net losses of $2,842,000 and $3,648,000.
Our 2003 and 2004 net losses were principally attributable to our continued shift of focus
from an on-line business to an ASP business; in addition our 2004 net losses included a
one-time $1,203,000 loss from abandoned acquisitions. At December 31, 2004, the Company had negative working capital of $1,534,931. The
deterioration in working capital is primarily a result of the 2004 net loss described above
including, a $215,000 net increase in Due to publications expense, a $241,000 net increase
in Deferred revenues and a $340,000 net increase in Convertible note expense. The Due to
publications expense is a result of contractual customer arrangements whereby the Company
receives net proceeds daily on behalf of these customers for third party ads placed via
credit card. These transactions are collected, reconciled monthly and submitted to the
publication, net of processing fees, generally within 35 days from the month end. The
Company has been providing this service at virtually no charge to customers since
approximately December 2000 without any customer terminations. The increase in deferred
revenues is primarily related to an increase in installation and customization projects
related to our EdgCapture integrated payment processing solution. The Company expects the
deferred revenues to be realized during 2005 with no incremental increase in operating
costs.We expect to continue to incur losses
until we are able to increase revenues significantly from fees based on the number of
purchases transacted through our ASP product. Although there can be no assurance, we
believe that cash on hand of $1,093,000 at December 31, 2004, the increase in the cash
flows we are currently generating, which we expect will continue, from operations from cost cutting strategies, including a
reduction in staff during the fourth quarter 2004, pay cuts effective January 1, 2005,
curtailment of our acquisition strategy and development projects, other cost saving measures
combined with an expected increase in revenues and the additional $597,000 raised through the exercise of 702,850 warrants on
January 5, 2005 will be sufficient to meet our anticipated working capital needs through
December 31, 2005. In addition the Company continues to seek additional financings.Although the Company is optimistic that its growing ASP business will continue to be accepted in the
marketplace, timing is not assured. The Companys ability to sell ASP business products and service
offerings during the current year may be hampered by continued sluggishness in the
advertising market, the geo-political climate, including the war in Iraq, and state of the
economy in general. These factors, coupled with the extended selling
cycle in the Companys industry
and customer delays in customization and implementations, could delay
its ability to
increase revenue to a level sufficient to cover our expenses. There is no assurance that
management will be successful with its operating plan and, if events and circumstances occur
such that the Company does not meet its the plan as expected, and the Company is unable to
raise additional financing, the Company may be required to further reduce certain
discretionary spending, which could have a material adverse effect on the Companys ability
to achieve its intended business objectives.Principles of ConsolidationThe accompanying consolidated financial statements include the accounts of AdStar, Inc. and
its wholly owned subsidiary Edgil Associates, Inc. All intercompany transactions and
balances have been eliminated in consolidation.Use of EstimatesThe preparation of financial statements in conformity with generally accepted accounting
principles requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from those estimates. F-8




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##### Table of Contents



Cash and Cash EquivalentsThe Company considers all highly liquid investments purchased with an initial maturity of
three months or less to be cash equivalents. Cash and cash equivalents are carried at cost,
which approximates fair value. At December 31, 2004, the company has cash balances held at a
financial institution which exceed FDIC insurance limits by $993,006.Restricted cashIn August 2002, AdStar was informed by Chase Merchant Services, L.L.C. (Chase), a merchant
bank that provides credit card processing services for AdStar, that it required the Company
to maintain a restricted cash balance of $175,000. During 2003 the Company entered into a
new arrangement with another merchant banker whereby the terms and conditions do not require
AdStar to maintain a reserve.Supplemental schedule of noncash investing and financing activities for the two years ended
December 31, 2004: 2003
    
    
    2004Supplemental cash flow disclosure:Taxes paid
    
    $
    7,643
    
    
    $
    7,661Interest paid
    
    $
    14,558
    
    
    $
    38,813Noncash investing and financing activities:Conversion of 1,443,457 shares of Series A
Preferred Stock to equivalent shares of Common
net of expenses
    
    $
    
    
    
    $
    1,697,840Beneficial conversion feature on warrants issued
in conjunction with convertible debt
    
    $
    
    
    
    $
    734,231Conversion of $225,000 of convertible debt into
100,000 shares of Common Stock
    
    $
    
    
    
    $
    225,000Issuance of Common Stock to legal council as a
finders fee for securing convertible debt
    
    $
    
    
    
    $
    32,250Issuance of Common Stock for legal expenses
    
    $
    95,000
    
    
    $
    Issuance of Common Stock to technical consultants
    
    $
    
    
    
    $
    95,807
  The Company purchased all of the Common Stock of Edgil. Pursuant to the Merger
Agreement, the Company paid $1,520,000 cash and issued 1,311,530 shares of Common Stock, in
exchange for the business and assets of Edgil. Based upon the average closing price of the
Common Stock on the Nasdaq SmallCap Market for the 10 trading day period beginning October
14, 2003 the value of our Common Stock used to acquireEdgil was $2,111,563. In addition the
Company issued 63,397 AdStar options valued at $68,926 using the Black-Scholes method as
replacement options for fully vested Edgil employee options (Note 13) and recorded an
estimated $285,000 in legal, accounting and other fees as part of the cost of the
acquisition. In conjunction with the acquisition, liabilities were assumed as follows: Fair value of assets acquired
    
    $
    5,166,721Issuance of Common Stock for purchase of Edgil Associates, Inc.
    
    
    (2,111,563
    )Issuance of Common Stock to replace Edgil vested employee options
    
    
    (68,928
    )Cash paid for the Common Stock
    
    
    (1,520,000
    )Professional fees and other costs of the acquisition
    
    
    (285,002
    )Liabilities assumed
    
    $
    1,181,232
 F-9




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##### Table of Contents



Concentration of Credit Risk and Major CustomersFinancial instruments that potentially subject the Company to significant concentrations of
credit risk are principally comprised of trade accounts receivable and shareholder loans.For the year ended December 31, 2003, one customer accounted for 11% and two different
customers accounted for 7% of net revenues. As of December 31, 2003, twelve customers, in
the aggregate, accounted for 52% of the Companys accounts receivable.For the year ended December 31, 2004, one customer accounted for 10% of net revenues. As of
December 31, 2004, one customer accounted for 30% of the Companys accounts receivable.The majority of the Companys customers have historically consisted of newspapers and
publishers of classified advertisements. The Companys customers on its Web site are the
general public.Accounts Receivable and Allowance for Doubtful AccountsWe regularly evaluate the collectibility of our trade receivables based on a combination of
factors. When a customers account become past due, we initiate dialogue with the customer
to determine the cause. If it is determined that the customer will be unable to meet its
financial obligation to us, due to a bankruptcy filing, deterioration in the customers
operating results or financial position or other material events impacting their business,
we record a specific reserve for bad debt to reduce the related receivable to the amount we
expect to recover given all information presently available. We also record reserves for bad
debts for all other customers based on certain other factors including length of time the
receivables are past due and historical collection experience with individual customers. If
circumstances related to specific customers change, our estimates of the recoverability of
receivables could materially change.Property and EquipmentProperty and equipment are stated at cost less accumulated depreciation and amortization.
When such items are retired or otherwise disposed of, the cost and related accumulated
depreciation and amortization are relieved from the accounts and the resulting gain or loss
is reflected in operations. Depreciation and amortization are provided using the
straight-line method over the estimated useful lives of the assets. The depreciation and
amortization periods by asset category are as follows: Furniture and fixtures
    
    7 yearsComputer equipment
    
    3 yearsComputer Software
    
    3 to 5 yearsLeasehold improvements
    
    Shorter of useful life or remaining lease term
  Maintenance and minor replacements are charged to expense as incurred while renewals and
improvements are capitalized. Leasehold improvements are amortized over their estimated
useful lives or the remaining lives of the related leases, whichever is shorter.Software Development CostsIn March 2000, the Financial Accounting Standards Boards Emerging Issue Task Force (EITF)
issued EITF No. 00-2 Accounting for Web Site Development Costs, which provides guidance
with respect to capitalization of certain costs incurred in connection with Web development
activities and references Statement of Financial Accounting Standards (SFAS) No. 86 F-10




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##### Table of Contents



Accounting for the Cost of Computer Software to be Sold, Leased or Otherwise Marketed. In
accordance with these pronouncements, costs to establish the technological feasibility of
software applications developed by the Company are charged to expense as incurred. Certain
costs incurred subsequent to achieving technological feasibility are capitalized.
Accordingly, the Company capitalizes a portion of the internal labor costs and external
consulting costs associated with essential Web site development and enhancement activities.
Costs associated with conceptual design and feasibility assessments as well as maintenance
and routine changes are expensed as incurred. Capitalized costs are amortized based on
current or future revenue for each product with an annual minimum equal to the straight-line
basis over the estimated economic lives of the applications, not to exceed 5 years. In
accordance with this policy, the Company has capitalized expenditures incurred to enhance
the AdStar ASP application suite of products. At December 31, 2004, the Company has
capitalized software development costs of $2,767,504, net of a write down to net realizable
value, with associated accumulated amortization of $1,563,285.As part of the ongoing internal review of the carrying value of capitalized software, in
conjunction with an overall product line evaluation undertaken as part of the integration of
our newly acquired subsidiary, Edgil Associates, Inc., management determined that certain
internally developed software products had impairment losses. In December 2003 the Company
recognized $883,060 in impairment losses on capitalized software and related service
contracts of which $698,060 relates to the write-down of two software applications to their
net realizable value. The write-down is comprised of $381,598 and $316,462 for our contract
Web and FlexAd software applications, respectively.Contract Web is a Web-based application developed over the past 3 years to replace our
legacy software which is still being used, via stand-alone servers. The application was
carried on the balance sheet at a total cost of $626,633 with accumulated amortization of
$245,036. The application was based on old technology and had latency issues that we
unsuccessfully continued to attempt to correct through November 2003. Contract Web was
never fully adopted by our customers and we received minimal incremental revenues from it.
While we have essentially abandoned this version of the software we still believe the future
of our legacy software resides on a Web-based application. As such and in conjunction with
the acquisition of Edgil we now have access to additional software engineering experts and
are in the process of leveraging Edgils expertise in re-engineering this product for
re-introduction in the future. In addition to the write- down of the capitalized software
we reserved an additional $15,000 as estimated costs to support this application under
existing maintenance contracts until we can move customers to a new version or back to the
old application.FlexAd software is a Web-based application that allows certain Tribune Company Newspapers to
accept real print and online versions of the same ad simultaneously into the News Paper and
CareerBuilder Website. In addition to the write down of the capitalized software we recorded
an additional $170,000 estimated loss on the related customer contract. (Notes 7 and 19).In December 2004 the Company recognized $257,820 in impairment losses and wrote-down five
software applications to their net realizable value. The impairment was primarily comprised
of a $190,294 write-down of 2 uncompleted software applications primarily designed to
deliver the EdgCapture product over the Web or in NT based environments. During December
2004 our Senior Vice President of Sales left the Company and our current Vice President of
Sales and Chief Operating Officer, assumed overall revenue responsibility, and indicated
these products have not generated sufficient market interest to justify continued
development with our limited resources. In addition a $52,837 write-down of a limited
display ad technology built specifically for the Los Angeles Times Restaurant Guide was
launched in September 2004 and had not generated the anticipated ASP revenues we originally
projected and we have been unsuccessful in selling the product to other publications. The
remaining $14,689 related to 2 older software technologies for F-11




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##### Table of Contents



which revenues have deteriorated in recent months to the point where a permanent
impairment in value was indicated. Intangible Assets Intangible assets are comprised of purchased customer list, trademarks, license agreements
and proprietary technology and are carried at cost less accumulated amortization.
Amortization is calculated on a straight-line basis over the estimated useful lives of the
intangible assets of 5 and 17 years. Long-Lived Assets The carrying value of long-lived assets, as defined under SFAS 144, is periodically reviewed
by management and impairment losses, if any are recognized when the expected undiscounted
future operating cash flows derived from such assets are less than their carrying value. As part of this policy management determined that two internally developed software products
were permanently impaired and required a write down to net realizable value. (Notes 2, 7
and 19.) Goodwill Goodwill represents the excess of the purchase price for acquisitions over the fair value of
identifiable assets and liabilities acquired. We use estimates and make assumptions to
determine the fair value of acquired assets and liabilities. If estimates or assumptions
change in the future, we may be required to record goodwill impairment charges. In future
periods, if goodwill is determined to be impaired we will recognize a non-cash charge equal
to the excess of the carrying value over the determined fair value. There can be no
assurance that future goodwill impairment tests will not result in a charge to earnings. In accordance with the requirements of SFAS 142 the Company completed its annual impairment
analysis including obtaining an independent outside appraisal and such analysis indicated
that the amount of goodwill is fairly stated. Fair Value of Financial Instruments Cash and cash equivalents, accounts receivable, shareholder notes receivable, accounts
payable, deferred revenue, notes payable, capital leases and accrued expenses are carried at
cost which approximates their fair value because of the short-term maturity or the current
lending rates of these instruments. Revenue Recognition The Company derives revenue from several products and services as follows: ASP revenue  The Company receives revenue from providing an application service provider
(ASP) product that allows customers to use the Companys software applications on a
shared system over the Internet. This technology is a publisher-specific ad-taking Web
site service that offers visitors to a newspapers Web page the opportunity to buy
classified ads, for both the print and/or on-line editions of the newspaper, in real-time,
on a 24/7 basis. The Company receives monthly fees for hosting the transactions and
providing customer support, and recognizes the fees ratably over the contract period. F-12




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##### Table of Contents



Web site revenue  The Company receives revenue from fees charged to customers who transact
business on the Advertise123.com Web site. This site permits the general public to plan,
schedule, compose and purchase advertising from many print and on-line publishers. Under the
guidance provided by the Securities Exchange Commission Staff Accounting Bulletin (SAB)
No. 104, Revenue Recognition and the Emerging Issues Task Force (EITF) Abstract No.
99-19 Reporting Revenue Gross as a Principal versus Net as an Agent (EITF 99-19), the
Company is, in substance, acting as an agent for the publishers and therefore recognizes as
revenue only the net fees realized on the transactions. The Company recognizes revenues on a
per-transaction basis when the ad is placed through their system and collection from the
customer is probable. Licensing and Software; Customization and other revenues  The Company generates revenue
from technology service contracts that generally contain multiple elements such as software
customization services, monthly fees and post-contract customer support (PCS). Revenue from
these arrangements is recognized in accordance with Statement of Position (SOP) 97-2,
Software Revenue Recognition, and SOP 98-9, Software Revenue Recognition with Respect to
Certain Transactions. Accordingly, revenue is allocated to each element within the contract
based on the relative fair values of those elements using vendor specific objective
evidence. Revenue from monthly fees and PCS under software maintenance arrangements is based
upon renewal rates and is recognized ratably over the term of the arrangement. Revenue from
software customization services is recognized as the services are performed, using a
percentage of completion methodology based on labor hours. The Company also provides
customization services at the customers request and recognizes revenue as the services are
performed, using a percentage of completion methodology based on labor hours. Deferred
revenue consists primarily of License and Software prepaid annually and customization and
other revenues billed and paid in advance. Deferred revenue consists primarily of deferred revenues from long-term License and Software
contracts, PCS maintenance arrangements prepaid annually and customization and other
revenues billed and paid in advance. Revenues from upfront license fees, monthly fees and
PCS under software maintenance arrangements is based upon renewal rates and is recognized
ratably over the term of the arrangement, licenses and maintenance generally range from
month  to-month up to 10 years on AdStar and 1 year up to 25 on Edgil, respectively.
Deferred revenues on the 25-year license arrangements are $32,000, revenues from PCS
contracts paid in advance and prepaid customer deposits are $328,000 for year ended December
31, 2004. Revenue from software customization services is recognized upon the completion of
services. Areas requiring managements judgment includes revenue recognition and cost estimation on
the fixed fee software customization element of the contracts. Revenue is recognized on
these contracts using a percentage-of-completion methodology, based upon labor input
measures and an estimate of time to completion. Monthly, technical management reviews the
estimate of labor hours required to complete the customization and the effect of any change
in estimate is reflected in the period in which the change is first known. Such changes in
estimates have not been material to our results of operation. The corresponding cost of
revenue charge is derived based upon the same labor input measurements and our existing cost
structure. If the Company does not accurately estimate the resources required under the
contract or the scope of the work to be performed, or if the Company does not manage its
projects properly within the prescribed timeframe, future margins may be significantly and
adversely affected. If increases in projected costs-to-complete are sufficient to create a
loss contract, the entire estimated loss is charged to operations in the period the loss
first becomes known. The complexity of the estimation process and uncertainties inherent in
software customization activities may affect the percentages derived under the
percentage-of-completion accounting method, which in turn may affect the amounts reported in
the financial statements. F-13




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##### Table of Contents



Income Taxes The Company utilizes the liability method of accounting for income taxes. Under this
method, deferred tax liabilities and assets are determined based on the difference between
the financial statement and tax bases of assets and liabilities using enacted tax rates in
effect for the period in which the differences are expected to reverse. Valuation allowances
are established, when necessary, to reduce the deferred tax assets to the amounts expected
to be realized. Advertising Costs The Company expenses the costs of advertising in the periods in which those costs are
incurred. Advertising expense was approximately $29,000 and $72,000 for the years ended
December 31, 2003 and 2004, respectively. Earnings (Loss) Per Share Basic earnings (loss) per share is computed by dividing the net income (loss) applicable to
Common Stockholders by the weighted average number of shares of Common Stock outstanding
during the period. Diluted earnings (loss) per share is computed by dividing the net income
(loss) applicable to Common Stockholders by the weighted average number of common shares
outstanding plus the number of additional common shares that would have been outstanding if
all dilutive potential common shares had been issued, using the treasury stock method.
Potential common shares are excluded from the computation when their effect is antidilutive. For the years ended December 31, 2003 and 2004, diluted earnings (loss) per share does not
include 7,009,576 and 4,389,833, respectively of options and warrants to purchase Common
Stock, and Preferred Stock as their inclusion is antidilutive. Comprehensive Income The Company discloses comprehensive income in accordance with the provisions of SFAS No.
130, Reporting Comprehensive Income. This statement establishes standards for reporting
and disclosing comprehensive income and its components in a full set of general-purpose
financial statements. Comprehensive income generally represents all changes in
stockholders equity (deficit) during the period except those resulting from investments by,
or distributions to, stockholders. The Company has no other comprehensive income or loss
items and, accordingly, net loss equals comprehensive loss for all periods presented. Segment Reporting The Company determines and discloses its segments in accordance with SFAS No. 131,
Disclosures About Segments of an Enterprise and Related Information, which uses a
management approach for determining segments. The management approach designates the
internal organization that is used by management for making operating decisions and
assessing performance as the source of a companys reportable segments. SFAS No. 131 also
requires disclosures about products or services, geographic areas and major customers. The
Companys management reporting structure provides for only one reportable segment and
accordingly, no separate segment information is presented. Warranties and Product liability The Company warrants that its products conform to their respective functional
specifications. The Companys customized software products, ASP application products and
Software License F-14




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##### Table of Contents



Agreements are warranted to perform as designed. Such warranties are extended throughout
the term of extended service agreements that clients enter into with the Company. Direct
costs associated with the initial period of service have been insignificant and are
generally covered by upfront fees. At December 31, 2003 and 2004 all costs associated with
contract service were recorded directly into cost of revenues. We currently carry product liability insurance. We believe the amount of insurance is
adequate to cover our risks. To further mitigate our risks, our standard service agreement
expressly limits its liabilities and warranties of its products and services in accordance
with accepted provisions of the Uniform Commercial Code as adopted in most states. Accounting for Stock-Based Compensation The Company accounts for stock-based employee compensation arrangements in accordance with
the provisions of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock
Issued to Employees, and has elected the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-Based Compensation. Under APB No. 25, compensation expense is based
on the difference, if any, on the date of grant, between the fair value of the Companys
stock for financial reporting purposes and the exercise price of the option. The Company
accounts for equity instruments issued to non-employees in accordance with the provisions of
SFAS No. 123 or EITF 96-18 at fair value. Fair Value Disclosures The fair value of each option grant was determined using the Black-Scholes option-pricing
model. The Company calculated the fair value of each option granted on the date of grant
using the minimum value method or Black-Scholes model as prescribed by SFAS No. 123 using
the following assumptions: Year Ended December 31,2003
    
    
    2004Risk-free interest rate
    
    
    1.75
    %
    
    
    0.99
    %Expected lives (years)
    
    
    3.5
    
    
    
    3.5Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Expected volatility
    
    
    68.5
    %
    
    
    70.7
    %
 The Company has adopted the disclosure only provisions of SFAS No. 123. If compensation cost
associated with the Companys stock-based compensation plan had been determined using the
fair value prescribed by SFAS No. 123, the Companys net loss for 2003 and 2004 would have
increased to the pro forma amounts indicated below: Year Ended December 31,2003
    
    
    2004Net loss - applicable toCommon Stockholders
    
    As Reported
    
    $
    (2,842,365
    )
    
    $
    (3,648,163
    )Add: Stock based employee
compensation included in   reported loss
    
    
    -0-
    
    
    
    -0-Deduct: Employee compensation expense
    
    
    (286,877
    )
    
    
    (279,732
    )Pro Forma
    
    
    (3,129,242
    )
    
    
    (3,927,895
    )
 F-15




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##### Table of Contents



Year Ended December 31,2003
    
    
    2004Loss per share -
    
    As Reported
    
    $
    (0.31
    )
    
    $
    (0.26
    )Pro Forma
    
    $
    (0.35
    )
    
    $
    (0.28
    )
 Because additional stock options are expected to be granted each year, the above pro forma
disclosures are not representative of pro forma effects on reported financial results for
future years. Reclassifications Certain reclassifications have been made to prior year balances in order to conform to the
current year presentation. New accounting pronouncements On
December 16, 2004, the FASB issued SFAS No. 123® (revised 2004), Shared-Based
Payment, which is a revision of SFAS No. 123. SFAS No. 123(R) supersedes APB Opinion No.
25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash
Flows. Generally, the approach in SFAS No. 123(R) is similar to the approach described in
SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees,
including grants of employee stock options, to be recognized in the income statement based
on their fair values. This revised standard will be effective for the Company beginning with
the first interim period after December 15, 2005. As permitted by SFAS No. 123, the Company currently accounts for share-based payments to
employees according to APB 25 using the intrinsic value method and, as such, generally
recognizes no compensation cost for employee stock options. Accordingly, the adoption of
SFAS No. 123(R)s fair value method will have an impact on the Companys result of
operations, although it will have no impact on the Companys overall financial position. The
impact of the modified prospective adoption of SFAS No. 123(R) cannot be estimated at this
time because it will depend on levels of share-based payments granted in the future.
However, had the Company adopted SFAS No. 123(R) in prior periods, the impact of that
standard would have approximated the impact of SFAS 123 as described in the disclosure of
pro forma net income and earnings per share. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets  an
amendment of APB Opinion No. 29. SFAS 153 eliminates the exception from fair value
measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB
Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception
for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary
exchange has commercial substance if the future cash flows of the entity are expected to
change significantly as a result of the exchange. The Company is required to adopt this
standard as of January 1, 2006 and does not expect its adoption to have a material impact on
the Companys statement of earnings or financial position. F-16




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3. Property and Equipment Property and equipment consisted of the following at December 31, 2004: Computer equipment
    
    $
    555,393Furniture and fixtures
    
    
    63,508Leasehold improvements
    
    
    6,593625,494Less: Accumulated depreciation and amortization
    
    
    (483,071
    )Property and equipment, net
    
    $
    142,423
 Computer equipment and furniture and fixtures include equipment held under capital leases of
$76,943. Depreciation and amortization expense for December 31, 2003 and 2004 was
approximately $180,000 and $76,000 including amortization of computer equipment and
furniture and fixtures held under capital leases of approximately $47,000 and $23,000. 4. Capitalized and Purchased Software Capitalized and purchased software consisted of the following at December 31, 2004: Capitalized software
    
    $
    2,767,504Purchased software
    
    
    513,6323,281,136Less: Accumulated depreciation and amortization
    
    
    (1,737,658
    )Capitalized and purchased software, net
    
    $
    1,543,478
 Amortization expense for capitalized and purchased software for the years ended December 31,
2003 and 2004 was approximately $641,000 and $612,000, respectively. During 2003 and 2004,
the Company wrote off capitalized software totaling approximately $883,000 and $258,000,
respectively. (Notes 2, 7 and 18.) 5. Intangible Assets Intangible assets are comprised of the following at December 31, 2004: Customer list
    
    $
    1,500,000Trademarks
    
    
    197,9581,697,958Less: Accumulated amortization
    
    
    (302,673
    )Intangible assets, net
    
    $
    1,395,285
 Amortization expense for the years ended December 31, 2003 and 2004 was approximately
$57,000 and $96,000, respectively. Amortization of intangibles is as follows for the years
ending December 31,: 2005
    
    $
    88,7472006
    
    
    88,4842007
    
    
    88,2392008
    
    
    88,2352009
    
    
    88,235
 F-17




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##### Table of Contents



Thereafter
    
    
    953,345Total
    
    $
    1,395,285
 6. Goodwill In accordance with SFAS No. 142, the Company recorded goodwill of $2,132,219 from the
purchase of Edgil. In accordance with SFAS 142, the Company does not amortize goodwill.
However, the Company evaluates goodwill at least on an annual basis for impairment. The
Company performed an impairment test of goodwill using the public company market multiple
method and concluded that goodwill was not impaired. In future periods if goodwill is
determined to be impaired, the Company will recognize a non-cash charge equal to the excess of the
carrying value over the fair value. There can be no assurance that future evaluations of
goodwill will not result in impairment and a charge to earnings. The Company completed its annual impairment analysis including obtaining an independent
outside appraisal and such analysis indicated that the amount of goodwill is fairly stated. 7. Significant Contracts On March 18, 2002, the Company entered into a series of agreements with Tribune Company
(Tribune) and sold 1,443,457 shares of Series A convertible Preferred Stock for
approximately $1.8 million. The Company recorded the the $1.8 million investment in Series A
convertible Preferred Stock at cost which approximated fair value. The Company converted
the Series A convertible Preferred Stock into an equivalent number of the Companys Common
Stock on April 1, 2004. (Note 8.) As of December 31, 2003, $294,063 in development and customization costs associated with the
FlexAds application have been capitalized net of a write down of $316,462. (Notes 2 and 19.)
As of December 31, 2003 the Company had launched the FlexAds service on eight Tribune
newspapers and commenced full amortization of the cost of the development and customization
effort over the maximum 5 year period of the contract. Under the terms of the agreement the
Company receives $7,500 minimum monthly payments for up to 60 months comprised of a 36-month
contract with two 12-month options which automatically renew unless Tribune provides 180-day
notice. The Company commenced recognition of revenue from the $7,500 minimum monthly fee
under the agreement on a straight-line basis during August 2002. In October, 2004 the
company received formal notification from CareerBuilder indicating that it is preserving its
rights to terminate the contract at the end of the initial contract period, August 2005. The monthly transactions have not exceeded the contracted minimums during any month since
inception and have essentially stabilized at less than 20% of the guaranteed minimum
resulting in amortization exceeding revenues recognized by $13,778. In November 2003
Tribune Company indicated to AdStar that a significant change in the programming was
required to meet their internal requirements. Under the terms of the agreement, AdStar has
to provide up to 2 full time equivalent programmers for such modifications at no additional
charge. In accordance with Company policy management determined the carrying value of the
FlexAd software application (Notes 2 and 19) and the related service contract have a
permanent impairment in value. As such during December 2003 management estimated that the
expected future revenues were never likely to exceed total costs, and that under the
existing transaction levels there is no assurance that Tribune would exercise its options to
extend the contract. As such, we recorded an additional $170,000 in estimated costs to
complete the additional programming requirement. The write-down is included in the 2003
statement of operations under cost of revenues as part of the loss on write down of
capitalized F-18




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##### Table of Contents



software. (Notes 2 and 19.)In October, 2004 the Company received formal
notification from CareerBuilder indicating that it is preserving its rights to terminate the
contract at the end of the initial contract period, August 2005. In December 2002 the Company entered into an agreement with Tribune Company for an
additional investment by Tribune of $1,500,000. As part of the transaction, AdStar developed
additional features that expand the capabilities of its generic service and the customized
services that were launched in August 2002. The investment is in the form of an initial
purchase by Tribune of 1,200,000 shares of Series B-1 Preferred Stock for $900,000 funded in
December 2002 and a subsequent purchase of 800,000 shares of Series B-2 Preferred Stock for
$600,000. In addition, on the second closing, the series B-1 shares, plus additional shares
issued for accrued dividends on Series B-1 converted to series B-2. The purchase price for
each share of the Series B-1 and Series B-2 Preferred Stock was $0.75 at or below the fair market value of AdStar Common Stock at the
time of the respective closing. These shares carry a liquidation preference that includes a
dividend of 7% per year available only upon liquidation and currently convert on a 1:1
basis. Shareholders of Series B Preferred Stock are entitled to vote on all matters
submitted to the stockholders for vote and vote as a single class with the shareholders of
our Common Stock. The holders of Series B Preferred Stock are entitled to one vote for each
share of common issuable upon conversion. 8. Convertible Preferred Stock The Company has authorized 5,000,000 shares of Preferred Stock, par value $0.0001 per share,
of which 1,443,457 shares have been designated as Series A, convertible Preferred Stock
(Series A Preferred Stock), 1,200,000 shares have been designated as Series B-1,
convertible Preferred Stock and 800,000 shares have been designated as Series B-2,
convertible Preferred Stock (Series B Preferred Stock). The remaining authorized shares
have not been designated. Pursuant to automatic conversion provisions in the Tribune Company agreement, all 1,443,457
shares of Series A Preferred Stock automatically converted to an equivalent number of shares
of Common Stock on April 1, 2004. At December 31, 2004, the Company has reserved 2,000,000 shares of Common Stock for issuance
upon the conversion of the Series B Preferred Stock. The Series A and B Preferred Stock have
the following characteristics: Voting Rights- Each holder of the Series B Preferred Stock is entitled to the number of
votes equal to the number of shares of Common Stock into which such holders shares are
convertible. The Company cannot amend its Certificate of Incorporation amending the rights
of the Series B Preferred Stockholders, enter into any capital stock or equity agreements
with rights ranking the same or above the rights of the Series B Preferred Stock or
liquidate the Company without the approval of at least a majority of the holders of the
Series B Preferred Stock then outstanding. Liquidation Preference- In the event of any liquidation, dissolution or winding up of the
affairs of the Company, the holders of the Series B Preferred Stock will be entitled to
receive in preference to the holders of the Common Stock, an amount per share equal to $0.75
accrued and unpaid dividends, respectively. After such payment, the Series B Preferred
Stockholders share equally with the Common Stockholders in any remaining assets or funds of
the Company. Conversion Each share of the Series B Preferred Stock is convertible at anytime at the
option of the holder into shares of Common Stock pursuant to a ratio of one share of Common
Stock for each share of Series B Preferred Stock, subject to certain stock split and stock
dividend adjustments. In addition, the conversion ratio is subject to adjustment, as defined
in the agreement, in the event that the Company issues Common Stock at a per share price
less than $0.75. All Series B Preferred F-19




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##### Table of Contents



Stock will automatically convert to Common Stock
on the first day after December 23, 2005 for which the market price of the Companys Common
Stock exceeds $1.50 per share Dividends Dividends on the Series B Preferred Stock shall accrue cumulatively at 7% per
annum through the date of liquidation or conversion. In the event of conversion all accrued
and unpaid dividends will be waived. The 7% cumulative dividend has not been shown as a
deduction from net loss applicable to common shareholders, since the dividends are only to
be paid if a liquidation event occurs and the dividends would be accrued from the original
issuance date to the date of the liquidating event. If the Series B Preferred Stock is
converted into Common Stock, the right to the cumulative dividends will be waived. 9. Convertible Debt On April 12, 2004, the Company closed a $1.5 million private placement of a 3-year secured
convertible note (the Note) and 7-year warrants to purchase 200,000 shares (the
Warrants) of our Common Stock (the Common Stock) with Laurus Master Fund, Ltd., a New
York City based institutional fund and an accredited investor (Laurus Master Fund). The Note bears interest at the prime rate minus one percentage point and is convertible into
Common Stock at an initial fixed conversion price of $2.25 per share (the Fixed Conversion
Price), 105% of the average closing price of the Common Stock (Average Closing Price)
during the 22 trading days preceding the closing date. The Note has limited anti-dilution
protection for capital changes and, on a weighted average basis, for issuance of Common
Stock below the Fixed Conversion Price, excluding shares issued in mergers, acquisition or
strategic relationships, shares underlying compensatory options, shares issued on conversion
or exercise of outstanding securities and other exceptions. The shares underlying the Note are covered by an effective registration statement and
subject to certain limitations based on market volume for the Common Stock and Laurus Master
Funds aggregate holdings, Laurus Master Fund is required to convert all monthly
installments of principal and interest into Common Stock if the Average Closing Price for
the 5 trading days immediately preceding each monthly installment payment date is more than
10 percent above the Fixed Conversion Price. Additionally, we may redeem the Note by paying
125 % of the then outstanding principal balance plus accrued interest. The Note is secured
by a first lien on all of AdStars assets. Of the Warrants, 120,000 are exercisable at $2.58 and 80,000 are exercisable at $2.80 (120%
and 130% of the Average Closing Price during the 22 trading days preceding the closing). Pursuant to the terms of the Note and the Warrants, Laurus Master Fund may not receive
            shares of Common Stock on conversion of the Note or exercise of the Warrants to the extent
such conversion or exercise would result in Laurus Master Fund beneficially owning in excess
of 4.99% of the issued and outstanding shares of Common Stock. During May 2004, pursuant to the terms of the Note, Laurus Master Fund elected to convert
$225,000 of the Note into 100,000 shares of Common Stock, at a conversion price of $2.25 per
share. The Company recorded a debt discount of approximately $734,000 consisting of the intrinsic
value of the beneficial conversion of approximately $467,000 and the portion of the proceeds
allocated to the warrants issued to the lenders of approximately $267,000, using the
Black-Scholes option pricing model, based on the relative fair values of the warrants and
the notes. The debt discount is being amortized as interest expense over the three-year term
of the notes using the interest method. F-20




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##### Table of Contents



During the year ended December 31, 2004, approximately $299,000 of prepaid financing fees
and debt discount was amortized as interest expense, including a non-cash portion of
approximately $263,000. The non-cash portion was comprised of approximately $156,000 debt
discount amortization for the period and an accelerated debt amortization of approximately
$107,000, as a result of the conversion of $225,000 in debt to equity. The future non-cash
debt discount and prepaid finder fees to be amortized as interest expense over the remaining
33 months of the note are approximately $270,000 for 2005, $270,000 in 2006, and $80,000 in
2007. In the event the investors convert additional amounts of the debt or exercise all or
part of the warrants, the Company will be required to amortize the remaining debt discount
in the period in which the conversion or exercise occurs. In addition, the Company is
exploring the possibility of refinancing this debt. Certain of the refinancing
alternatives, if concluded prior to the end of the fiscal year, could require the
accelerated amortization of the prepaid financing fees and debt discount. Payment will be made monthly in Cash or Common Stock. Each month the holder shall deliver
to the Company a written notice converting the monthly amount payable on the next repayment
date in either cash or Common Stock, or a combination of both. If a repayment notice is not
delivered by the holder on or before the applicable notice date the Company shall pay the
monthly amount due in cash. Any portion of the note paid in cash shall be paid to the
Holder an amount equal to 102% of the principal portion of the monthly amount due. If the
Holder converts all or a portion of the monthly Amount in shares of Common Stock as provided
by the note, the number of such shares to be issued by the Company to the holder on such
date shall be the number determined by dividing the portion of the monthly amount to be paid
in shares of Common Stock, by the fixed conversion price of $2.25 per share. Payments in
Common Stock conversions will be applied to monthly principal payments until fully applied. Beginning on July 1, 2004 and recurring on the first day of each succeeding month
thereafter, until the maturity date April 12, 2007, the Company will make minimum monthly
payments of $45,454.55, together with any accrued and unpaid interest that are due. Any
Principal Amount that remains outstanding on the Maturity Date shall be due and payable on
the Maturity Date.The net proceeds from the financing were primarily used to pursue the
Companys strategic acquisition strategy. The strategy was abandoned in December 2004.
(Note 19.)  10.
    Notes PayableDuring March 2003, the Company entered into a 7% $200,000 unsecured bridge note payable
agreement with Tribune Company pending the closing of the $600,000 funding on the Series B-2
Preferred Stock transaction. During March 2003 the note was repaid out of the proceeds from
the $600,000, (Note 7.)Pursuant to the Merger agreement the notes payable to the two former stockholders of Edgil
were restated whereby each Stockholder received $51,500 in principal payments upon the
closing and the remaining $31,500 note balance, for each Stockholder, is to be repaid in six
equal payments of principal along with all interest at a rate of 8% per annum, with the
first payment to be made on the six month anniversary of the Effective Date (October 21,
2003) and each of the next five payments to be paid each six months thereafter, with the
final payment to be made on the third anniversary of the Closing Date. Accordingly $21,000
in minimum principal pay-downs are due during each of the years ending December 31, 2005,
and 2006.  11.
    Due to publicationsThe Company processes credit cards on behalf of certain of its customers as part of ASP
services provided. The Company receives net proceeds daily on behalf of these customers for
third party ads F-21




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##### Table of Contents



placed via credit card. These transactions are reconciled monthly and
submitted to the publication, net of processing fees, generally within 35 days from the
month end. Due to publications is a result of contractual customer arrangements whereby
we receive net proceeds daily on behalf of these customers for third party ads
placed via credit card. These transactions are collected, reconciled monthly
and submitted to the publication, net of processing fees, generally
within 35 days from the month end. We have been providing this service at virtually no charge
to customers since approximately December 2000 without any customer terminations.  12.
    Income TaxesProvision for income taxes consist of the following: December 31,2003
    
    
    2004Current taxesFederal
    
    $
    
    
    
    $
    State
    
    
    13,850
    
    
    
    4,900DeferredFederal
    
    
    348,200
    
    
    
    (378,800
    )State
    
    
    100,700
    
    
    
    (39,300
    )Total deferred taxes
    
    
    448,900
    
    
    
    (418,100
    )Change in valuation allowance
    
    
    (448,900
    )
    
    
    418,100Income tax provision
    
    $
    13,850
    
    
    $
    4,900
 Prior to June 30, 1999, the Company was taxed as an S-Corporation. Deferred 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 for the Companys deferred taxes at December 31, consisted of the
following: 2004Deferred tax assets:Net operating loss carry forwards
    
    $
    5,906,000Depreciation and amortization
    
    
    132,000Deferred revenue
    
    
    0-Other
    
    
    335,000Gross deferred tax asset
    
    
    6,373,000Deferred tax liabilityDepreciation and amortization
    
    
    (653,000
    )Gross deferred tax liabilities
    
    
    (653,000
    )Net Deferred tax asset
    
    
    5,720,000Less: Valuation allowance
    
    
    (5,720,000
    )Gross deferred tax asset
    
    $
    
 In assessing the realizability of deferred tax assets, management considers whether it is
more likely than not that some portion or all of the deferred tax assets will be realized.
Based upon the level of historical losses and projections of future taxable income over the
periods in which the deferred tax F-22




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##### Table of Contents



assets are deductible, a full valuation allowance has been
provided as management believes that it is more likely than not, based upon available
evidence, that the deferred tax assets will not be realized. As of December 31, 2004, the Company has federal net operating loss carry forwards of
approximately $16,036,000. As of December 31, 2004, the Company has state net operating loss
carry forwards of approximately $7,776,000. The federal and state net operating loss carry
forwards will begin to expire in 2017 and 2005, respectively. The Companys ability to
utilize net operating loss carry forwards may be limited in the event that a change in
ownership, as defined in the Internal Revenue Code, occurs in the future. The provision for income taxes for the years ended December 31, 2003 and 2004 differs from
the amount that would result from applying the federal statutory rate as follows: 2003
    
    
    2004Statutory regular federal income tax rate
    
    
    (34.0
    %)
    
    
    (34.0
    %)Change in valuation allowance
    
    
    33.4
    %
    
    
    33.4
    %State taxes, net of federal benefit
    
    
    (0.1
    %)
    
    
    (3.0
    %)Other
    
    
    .6
    %
    
    
    .2
    %(0.1
    %)
    
    
    (0.0
    %)
  13.
    CapitalizationCommon StockIn June 2001, the shareholders approved an increase to the number of authorized shares of
the Companys Common Stock from 10,000,000 to 20,000,000. In November 2004, the shareholders
approved an increase to the number of authorized shares of the Companys Common Stock from
20,000,000 to 40,000,000.In December 1999, the Company established a vendor compensation plan whereby it may
compensate vendors who are accredited investors, as defined under Rule 215 of the Securities
Act of 1933, in shares of its Common Stock in lieu of cash. Under the plan, 400,000 shares
are available for issuance. AdStar established a vendor payment plan whereby it may pay
vendors who are accredited investors, as defined under Rule 215 of the Securities Act of
1933 (the Act), in shares of its Common Stock in lieu of cash. Under the plan, 400,000
shares are available for issuance. During 2003 and 2004, 33,279 and 53,217,shares,
respectively, were issued to vendors under the plan relying upon the exemptions under
Sections 4(2) and 4(6) of the Securities Act of 1933 which represented compensation of
$42,000 and $96,325, respectively.In March 2002, the Board of Directors approved the sale of 1,443,457 shares of our Series A
Preferred Stock to Tribune Company for an aggregate purchase price of
$1.8 million. These shares currently convert on a 1:1 basis. Shareholders of Series A Preferred Stock are
entitled to vote on all matters submitted to the stockholders for vote and as a single class
with the Common Stock. The holders of Series A Preferred Stock are entitled to one vote for
each share of Common Stock issuable upon conversion. This sale was exempt from registration,
as it was a nonpublic offering, made pursuant to Sections 4(2) and 4(6) of the Act. Pursuant
to automatic conversion provisions in the Tribune Company agreement, all 1,443,457 shares of
Series A Preferred Stock automatically converted to an equivalent number of shares of Common
Stock on April 1, 2004.In December 2002 the Board of Directors approved the sale of shares of its Series B
Preferred Stock to Tribune Company for an aggregate price of $1.5 million. The sale was
split into two funding segments: F-23




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##### Table of Contents



(i) In December 2002, AdStar sold 1,200,000 shares of its Series B-1 Preferred Stock
to Tribune Company for an aggregate purchase price of $900,000 excluding $86,200 in
costs of financing. These shares currently convert on a 1:1 basis. Shareholders of
Series B-1 Preferred Stock are entitled to vote on all matters submitted to the
stockholders for vote and as a single class with the Common Stock. The holders of
Series B-1 Preferred Stock are entitled to one vote for each share; and (ii) In March 2003, AdStar sold 800,000 shares of its Series B-2 Preferred Stock to
Tribune Company for an aggregate purchase price of $600,000 excluding $71,317 in
costs of financing. These shares currently convert on a 1:1 basis. Shareholders of
Series B-2 Preferred Stock are entitled to vote on all matters submitted to the
stockholders for vote and as a single class with the Common Stock. The holders of
Series B-2 Preferred Stock are entitled to one vote for each share. In addition, on
March 28, 2003, in exchange for all of the Series B-1 Preferred Stock plus accrued
and unpaid dividends on those shares, issued in December 2002 to Tribune Company,
AdStar issued an additional 1,200,000 shares of its Series B-2 Preferred Stock to the
Tribune Company. These sales were exempt from registration, as it was a nonpublic offering, made pursuant to
Sections 4(2) and 4(6) of the Act. In March 2003, AdStar issued to Marina Co. a nominee of the partners of Morse, Zelnick, Rose
and Lander LLP, AdStars legal counsel, 63,291 shares of restricted Common Stock, issued at
fair market value as payment for $ 50,000 in legal services accrued at December 31, 2003.
This sale was exempt from registration, as it was a nonpublic offering, made pursuant to
Sections 4(2) and 4(6) of the Act. In September 2003 the Company sold through a private placement offering 1,590,000 shares of
the Companys authorized but unregistered Common Stock at a price of $1.25 per share. In
connection with this offering the Company paid a commission consisting of $198,750 in cash
and issued warrants to purchase 159,000 shares of its Common Stock, at $1.87. The Company
also incurred costs of $65,080 related to the private placement. The commission of $198,750
and costs of $65,080 are being offset against the proceeds of the private placement as a
cost of financing. The warrants are exercisable beginning on March 31, 2004 and expire on
March 31, 2009. The Company valued the warrants using the Black Scholes method, which
resulted in a value of $261,169On October 21, 2003 (the Effective Date), AdStar acquired
all of the business and assets of Edgil pursuant to an Agreement and Plan of Merger (the
Merger Agreement), dated as of the Effective Date, by and among AdStar, Edgil, EDG, and
Edward P. Hopey and Gilbert Wolsky, the stockholders of Edgil (collectively, the Edgil
Stockholders). Pursuant to the Merger Agreement, we paid $1,520,000 cash and issued 1,311,530 shares of
Common Stock, in exchange for the business and all of the assets of Edgil. Based upon the
average closing price of the Common Stock on the Nasdaq SmallCap Market for the 10 trading
day period beginning October 14, 2003 the value of the Edgil Shares was $2,111,563. The
Company issued authorized but previously unissued shares of Common Stock in the acquisition. In November 2003 the Company sold through a private placement offering 1,257,693 shares of
the Companys authorized but unregistered Common Stock at a price of $1.30 per share, less
costs of $56,104, for a net amount of $1,578,896. In December 2003, AdStar issued to Marina Co. a nominee of the partners of Morse, Zelnick,
Rose and Lander LLP, AdStars legal counsel, 34,615 shares of restricted Common Stock,
issued at fair market value as payment for $45,000 in legal services provided during 2003.
This sale was exempt from registration, as it was a nonpublic offering, made pursuant to
Sections 4(2) and 4(6) of the Act. F-24




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On April 12, 2004, we closed on a $1.5 million private placement of a 3-year secured
convertible note (the Note) and 7-year warrants to purchase 200,000 shares (the
Warrants) of our Common Stock (the Common Stock) with Laurus Master Fund, Ltd., a New
York City based institutional fund and an accredited investor (Laurus Master Fund).
During May 2004, pursuant to the terms of the Convertible Note, Laurus Master Fund elected
to convert $225,000 of the Note into 100,000 shares of Common Stock. At a conversion price
of $2.25 per share. (Note 9.) In July 2004, AdStar issued to Marina Co. 25,000 shares of restricted Common Stock, issued
at fair market value as payment for $32,250 in legal services provided during 2004. This
sale was exempt from registration, as it was a nonpublic offering,
made pursuant to Sections 4(2) and 4(6) of the Act. Stock Options In 1999, the Board of Directors adopted the 1999 Stock Option Plan (the Plan) in order to
attract and retain officers, other key employees, consultants and non-employee directors of
the Company. The plan as amended during 2002 has an aggregate of 1,500,000 shares of Common
Stock that have been authorized for issuance under the Plan. In 2004, the Board of
Directors adopted the 2004 Stock Option Plan (the 2004 Plan) in order to have adequate
options available to continue to attract and retain officers, other key employees,
consultants and non-employee directors of the Company. The 2004 Plan as approved by
shareholders during 2004 has an aggregate of 1,200,000 shares of Common Stock authorized for
issuance under the Plan. The Plans provide for issuance of nonqualified and incentive stock options to officers, key
employees, consultants and non-employee directors to the Company. Each nonqualified stock
option shall have an exercise price not less than 100% of the fair value of the Common Stock
on the date of grant, unless as otherwise determined by the committee that administers the
Plans. Incentive stock options shall have an exercise price equal to or greater than the fair value
of the Common Stock on the date of grant provided that incentive stock options granted to a
10% holder of the Companys voting stock shall have an exercise price equal to or greater
than 110% of the fair market value of the Common Stock on the date of grant. Each option
generally has a term of five to ten years from the date of grant unless otherwise determined
by the committee that administers the Plans. All options granted in from 1999 through 2004
have a five-year term. Upon the occurrence of a change in control, as defined in the Plans, each option granted
under the Plans shall thereupon become fully vested and exercisable. Pursuant to the Merger agreement, at the Closing, AdStar replaced each Edgil vested option
with a corresponding AdStar option (based on the merger consideration received by the Edgil
Stockholders) as follows: (a) each holder of an option to purchase shares of Edgil Common
Stock at $0.92 per share received in replacement therefore an option to purchase that number
of shares of AdStar Common Stock as equaled the number of shares of Edgil Common Stock which
such optionee had a right to purchase, multiplied by 0.4858, at a price per share of $0.73;
(b) each holder of an option to purchase shares of Edgil Common Stock at $1.02 per share
received in replacement therefore an option to purchase that number of shares of AdStar
Common Stock as equaled the number of shares of Edgil Common Stock which such optionee had a
right to purchase, multiplied by 0.4858, at a price per share of $0.94; (c) each holder of
an option to purchase shares of Edgil Common Stock at $1.16 per share received in
replacement therefore an option to purchase that
number of shares of AdStar Common Stock as equaled the number of shares of Edgil Common
Stock which such optionee had a right to purchase, multiplied by 0.4858, at a price per
share of $1.23. A total of 63,397 AdStar options were issued as replacements. The AdStar
replacement options were valued at $68,926 using the Black-Scholes method and were included
in the purchase price of Edgil. (Note 18.) F-25




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##### Table of Contents



During the year ended December 31, 2004 option holders exercised 58,111 options for which
the company received net proceeds of $58,414. The following table summarizes all stock option activity and includes all options under the
Plan and 205,000 non-qualified options for the years ended December 31, 2003 and 2004: AverageWeightedExerciseShares
    
    
    PriceOutstanding at January 1, 2003
    
    
    1,133,474
    
    
    $
    0.95Granted
    
    
    369,173
    
    
    $
    1.38Exercised
    
    
    (74,694
    )
    
    $
    0.78Forfeited
    
    
    (133,334
    )
    
    $
    1.29Outstanding at December 31, 2003
    
    
    1,294,619
    
    
    $
    1.05Granted
    
    
    353,687
    
    
    $
    1.54Exercised
    
    
    (58,111
    )
    
    $
    1.01Forfeited
    
    
    (266,632
    )
    
    $
    1.95Outstanding at December 31, 2004
    
    
    1,323,563
    
    
    $
    1.00Options exercisable at December 31, 2003
    
    
    986,118
    
    
    $
    0.94Options exercisable at December 31, 2004
    
    
    1,169,401
    
    
    $
    0.90Options available for future grant (1)
    
    
    1,448,632Weighted average fair value of options granted in 2003
    
    
    
    
    
    $
    1.33Weighted average fair value of options granted in 2004
    
    
    
    
    
    $
    1.54
 (1) Excludes the 205,000 non-qualified options issued to the outside directors and consultants.
The 205,000 is comprised of 50,000 options issued to Steve Zelnick for services rendered as an
outside member of the board of directors, exercisable at $0.60 per share, expiring on January 27,
2007, 50,000 and 25,000 options issued to Richard Salute for services rendered as an outside member
and as an independent financial expert for the Board of Directors, exercisable at $0.94 per share,
expiring on January 28, 2008, 50,000 options issued to Arthur Salzfass for services rendered as an
outside member of the Board of Directors, exercisable at $1.29 per share, expiring on November 11,
2009 respectively, and 30,000 options issued to an Investor Relations firm for services rendered,
exercisable at $1.99 per share, expiring on November 24, 2008. The following table summarizes information about stock options outstanding at December 31,
2004: Options Exercisable atOptions Outstanding at December 31, 2004
    
    
    December 31, 2004WeightedAverage
    
    
    Weighted
    
    
    
    
    
    
    WeightedNumber of
    
    
    Remaining
    
    
    Average
    
    
    Number of
    
    
    AverageRange of
    
    Shares
    
    
    Contractual Life
    
    
    Exercise
    
    
    Shares
    
    
    ExerciseExercise Price
    
    Outstanding
    
    
    (years)
    
    
    Price
    
    
    Exercisable
    
    
    Price$0.01 - $0.99
    
    
    821,595
    
    
    
    1.93
    
    
    $
    0.69
    
    
    
    816,596
    
    
    $
    0.69$1.00 - $1.99
    
    
    390,468
    
    
    
    3.34
    
    
    $
    1.34
    
    
    
    316,138
    
    
    $
    1.30$2.00 - $2.40
    
    
    111,500
    
    
    
    4.14
    
    
    $
    2.06
    
    
    
    36,667
    
    
    $
    2.061,323,563
    
    
    
    
    
    
    
    
    
    
    
    1,169,401
 F-26




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##### Table of Contents



Warrants The following table summarizes activity for the years ended December 31, 2003 and 2004: WeightedAverageExerciseShares
    
    
    PriceOutstanding at January 1, 2003
    
    
    2,281,668
    
    
    $
    5.83Issued
    
    
    159,000
    
    
    $
    1.87Exercised
    
    
    (152,501
    )
    
    $
    1.29Forfeited
    
    
    (16,667
    )
    
    $
    6.00Outstanding at December 31, 2003
    
    
    2,271,500
    
    
    $
    5.85Issued
    
    
    200,000
    
    
    $
    2.67Exercised
    
    
    (55,230
    )
    
    $
    1.98Forfeited
    
    
    (1,350,000
    )
    
    $
    8.27Outstanding at December 31, 2004
    
    
    1,066,270
    
    
    $
    1.81Warrants exercisable at December 31, 2003
    
    
    2,271,500
    
    
    $
    5.85Warrants exercisable at December 31, 2004
    
    
    1,066,270
    
    
    $
    1.81Weighted average fair value of warrants issued
in 2003
    
    
    
    
    
    $
    0.98Weighted average fair value of warrants issued
in 2004
    
    
    
    
    
    $
    1.63
 The following table summarizes the outstanding warrants, all of which are currently
exercisable, to purchase Common Stock at December 31, 2004: Number
    
    Exercise Price
    
    Expiration Date25,000
    
    $10.00
    
    March 2005200,000
    
    $  1.80
    
    September 2005400,000
    
    $  1.07
    
    April 200686,950
    
    $  0.75
    
    January 2007159,000
    
    $  1.87
    
    March 2009120,000
    
    $  2.58
    
    April 211180,000
    
    $  2.88
    
    April 2111
 During the year ended December 31, 2004 warrant holders exercised 55,230 warrants for which
the company received net proceeds of $109,164. In January the Company raised $597,423 from the exercise of 702,850 warrants at $0.85 per
warrant. The warrants had been issued to Paulson Investment Company, or certain of its
officers and employees, primarily as compensation for their services in prior securities
offerings and originally had exercise prices ranging from $0.75 to $1.87 and expiration
dates ranging from September 25, 2005 to March 31, 2009. (Note 20.)  14.
    Shareholder receivableIn July 2002, AdStar entered into a loan transaction with Leslie Bernhard, President and
Chief Executive Officer and Eli Rousso, Executive Vice President and Chief Technical Officer
for $110,434 and $100,000, respectively. As part of the transaction, Ms. Bernhard and Mr.Rousso each F-27




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##### Table of Contents



issued to AdStar an unsecured, non-negotiable promissory note bearing interest at 5.56% with
monthly principal and interest payments of $763 and $691, respectively. The notes are
payable on a monthly basis, with all remaining outstanding principal and interest amounts
due on July 31, 2022. Concurrently, an outstanding note from Ms. Bernhard in the amount of
$39,566 was restructured under the same terms and conditions as the aforementioned new note.
The loans are forgiven if there is a change in control in AdStar or if the loan holder is
dismissed for other than cause as defined by the loan and employment agreements. At December
31, 2004 the balance outstanding on the notes receivable was $232,356. (Note 16.)  15.
    Restructuring costsDuring 2001, the Company contemplated a restructuring plan which among other things,
contemplated the closure of the New York office within approximately nine months, a related
reduction in force of the 4 technology staff as of December 31, 2001 and the abandonment of
an externally created customized billing software module. During December 2001 the Company
hired a seasoned industry executive to transfer the software programs and intellectual
knowledge from the New York office to the corporate office, identify and begin training
existing personnel in anticipation of the reduction-in-force, and abandoned the billing
software system. The corporate office assumed full revenue responsibilities concurrently
with the closing of the New York office.During 2003 the Company completed the major enhancement of its products and the major
requirements under the terms of the Tribune Agreements. In addition the Company acquired
Edgil Associates, Inc., and immediately commenced an overall product line evaluation as part
of the integration. In December 2003 management approved a reduction-in-force during the
fourth quarter, evaluated excess computer equipment and paid a bonus associated with the
successful transfer of various functions of the New York office to the Los Angeles office.
During 2004, we adjusted accruals, primarily related to the realization of greater fees
received from subletting the former New York office than originally estimated resulting in a
reduction of the accrual and related expense of $38,000.Restructuring costs for the year-ended December 31, 2004 are included in accrued expenses on
the balance sheet and are summarized below: Bonus and
    
    
    Office
    
    
    Legal andAccrued restructuring
    
    Severance
    
    
    Lease
    
    
    Other
    
    
    TotalBalance December 31, 2003
    
    $
    25,311
    
    
    $
    58,608
    
    
    $
    15,653
    
    
    $
    99,572Net charges during 2004
    
    
    (25,311
    )
    
    
    (43,608
    )
    
    
    (15,653
    )
    
    
    (84,572
    )Balance December 31, 2004
    
    $
    
    
    
    $
    15,000
    
    
    $
    
    
    
    $
    15,000
  16.
    Commitments and ContingenciesOperating and Capital Lease CommitmentsThe Company has certain non-cancelable operating lease obligations for office space and
equipment, and capital lease obligations for computer equipment and office furniture. The
operating leases are for office space located in New York, California, Massachusetts, and
New Jersey and expire through November 2009. The leases contain certain escalation clauses
based on certain charges that the landlords of the properties may incur over the base year, as defined in the
lease agreements. F-28




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##### Table of Contents



In June 2001, the Company assigned the lease for its New Jersey office to a third party,
whereby that party would be primarily responsible and the Company would be secondarily
liable for lease payments through November 30, 2005, the end of the lease agreement. Future minimum lease payments under the non-cancelable operating and capital leases as of
December 31, 2004 are as follows: Operating
    
    
    CapitalYears Ending December 31,
    
    Leases
    
    
    Leases2005
    
    $
    256,296
    
    
    $
    19,4652006
    
    
    191,420
    
    
    
    1242007
    
    
    135,097
    
    
    
    2008
    
    
    138,156
    
    
    
    2009
    
    
    119,990
    
    
    
    Total minimum obligations
    
    $
    840,959
    
    
    
    19,589Less: Amounts representing interest
    
    
    
    
    
    
    (1,304
    )Present value of minimum obligations
    
    
    
    
    
    
    18,285Less: Current portion
    
    
    
    
    
    
    (18,161
    )Non-current portion
    
    
    
    
    
    $
    124
 Rent expense for the years ended December 31, 2003 and 2004 was approximately $154,700 and
$220,900, respectively, including month-to-month rentals. Beginning in March 2001, the
Company entered in an agreement to sub-lease a portion of its corporate office space to a
third party for $10,750 per month for the first 18-months which increased to $11,012 for the
remaining 30 months. Beginning in December 2003 the Company entered into an agreement to
sub-lease its New York office space for $2,418 per month through April 2005. For the years
ended December 31, 2003 and 2004, the Company received approximately $143,300 and $151,100,
respectively, of sublease income, which is included in general and administrative expense on
the statement of operations. In the normal course of business, various claims and lawsuits may, from time-to-time, be
filed against the Company. There are no claims or lawsuits outstanding at December 31,
2004. Employment Agreements On July 1, 2002, AdStar entered into four-year employment agreements with each of Leslie
Bernhard and Eli Rousso. Their prior agreements expired on June 30, 2002. Pursuant to her
employment agreement, Leslie Bernhard was retained as our Chief Executive Officer and her
total annual compensation was reduced to $212,800. Pursuant to his employment agreement, Eli
Rousso was retained as our Executive Vice President and his total annual compensation was
reduced to $212,800. Each agreement provides, among other things, for participation in an
equitable manner in any profit sharing or retirement, separation and disability plans for
employees or executives and for participation in other employee benefits applicable to
employees and executives of AdStar. Each agreement further provides for fringe benefits
which commensurate with the executives duties and responsibilities. Under each agreement,
employment may be terminated by us with cause or by the executive with good reason.
Termination by us without cause, or by the executive for good reason, would subject us to
liability for liquidated damages in an amount equal to the terminated executives base
salary for the remaining term of his or her employment agreement or 12 months, whichever is
greater. In January 2001, AdStar entered into a 2-year employment contract with Mr. Jeffrey Baudo.
Pursuant to his employment agreement, Mr. Baudo was retained as our Chief Operating Officer
at F-29




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an annual rate of $213,000 per year, and granted options to purchase 100,000 shares of
AdStars Common Stock. Subsequently, as of July 1, 2002, Mr. Baudo agreed to an amendment to
his employment agreement reducing his annual rate of compensation to $191,700. Mr. Baudos
contract was extended for one year with successive one-year terms for the same salary under
essentially the same terms and conditions, effective January 22, 2003. Mr. Baudo is the
brother of Leslie Bernhard. Pursuant to the Merger agreement the two stockholders of Edgil entered into employment
agreements whereby each receives a monthly salary of $7,000 for six months from the
effective date, October 31, 2003. In November 2004, AdStar entered into a 1-year employment contract with Mr. Max Coeberg.
Pursuant to his employment agreement, Max Coeberg was retained as our Senior Vice President,
International Operations at an annual rate of $150,000 per year plus certain bonus
provisions providing for bonuses of up to $36,000 on an annual basis, and granted options to
purchase 100,000 shares of AdStars Common Stock. Under the agreement employment may be
terminated by us with cause. Termination by us without cause would subject us to liability
for liquidated damages in an amount equal to the terminated executives base salary per his
employment agreement for 12 months. On December 31, 2004 Mr. Coeberg resigned and he and
AdStar agreed to a settlement arrangement whereby Mr. Coeberg is to receive a $121,392 in 12
monthly installments commencing in January 2004 and $5,000 bonus to be paid in January 2004.
All amounts payable to Mr. Coeberg are included on the balance sheet in accrued expenses
and were expensed in the 2004 statement of operations as part of the cost of abandoned
acquisitions. (Note 19.) On December 31, 2004, as part of a global cost cutting strategy, all employees and officers
with annual salaries greater than $50,000 who have been employed for greater then 1 year
received a temporary 5% reduction in compensation. It is AdStars intention to reinstate
the compensation sometime in the future. For purposes of the future payments as defined
below and elsewhere in this document we assume the reduction will be reinstated on January
1, 2006. Employment contract Payments due by Period2005
    
    2006
    
    Total$712,800
    
    $
    212,800
    
    
    $
    925,600
 License Agreement In April 1996, the Company entered into an exclusive license agreement with a software
company that developed the facsimile technology available as a feature within the Companys
historical software product. This agreement provides that the Company pays royalties of up
to 50% of net revenues generated by the Company on license fees, implementation fees and
maintenance fees. This agreement is for an initial term of 20 years, though it can be
terminated by the Company upon six months notice or by the software company in certain
circumstances. For the years ended December 31, 2003 and 2004, the Company paid royalties of
approximately $47,000 and $24,000, respectively.  17.
    Related party transactionsDuring the years ended December 31, 2003 and 2004 the Companys total revenues derived from
Tribune Company agreements were $510,836 and $556,890 respectively.  18.
    Acquisition of Edgil Associates, Inc. F-30




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On October 21, 2003 (the Effective Date), the Company acquired Edgil Associates, Inc.
(Edgil) through a forward triangular merger pursuant to an Agreement and Plan of Merger
(the Merger Agreement), dated as of the Effective Date, by and among AdStar, Edgil, EDG,
and Edward P. Hopey and Gilbert Wolsky  the stockholders of Edgil (collectively, the Edgil
Stockholders). Pursuant to the Merger Agreement, the Company paid $1,520,000 cash and issued 1,311,530
shares of Common Stock, in exchange for the business and assets of Edgil. Based upon the
average closing price of the Common Stock on the Nasdaq SmallCap Market for the 10 trading
day period beginning October 14, 2003 the value of the Edgil Shares was $2,111,563. In
addition the Company issued 63,397 AdStar options valued at $68,926 using the Black-Scholes
method as replacement options for fully vested Edgil employee options (Note 13) and recorded
an estimated $285,000 in legal, accounting and other fees as part of the cost of the
acquisition. The Company issued authorized but previously unissued shares of Common Stock
in the acquisition. The cash and number of shares of Common Stock issued to the Edgil
Stockholders was determined in an arms-length negotiation and the transaction was
unanimously approved by the Board of Directors. Prior to the Effective Date, neither we nor
any of our affiliates, nor any of our officers or directors nor any of their associates had
any material relationship with Edgil, except that AdStar was a customer of Edgil. In connection with the Merger Agreement we and the Edgil Stockholders entered into a
Registration Rights Agreement, dated as of October 21, 2003, pursuant to which we agreed to
file a Registration Statement on Form S-3, for the purposes of registering under the
Securities Act of 1933 the re-sale by the Edgil Stockholders of the Edgil Shares, and AdStar
entered into six-month employment agreements with each of the Edgil Stockholders effective
as of the Effective Date. REASONS FOR THE ACQUISITION OF EDGIL The acquisition of Edgil adds to AdStars suite of e-commerce services; Edgils EdgCapture,
an integrated payment processing solution that interfaces directly with publishers
classified and circulation systems, and EdgFlow, a content processing solution that allows
publishers to deliver media content such as articles, technical documents, advertisements,
wire stories, etc., to multiple channels in a variety of formats. Edgils products and
services will continue to be offered under the Edgil brand, and AdStar will maintain Edgils
Massachusetts-based headquarters. ACCOUNTING TREATMENT The acquisition of Edgil is accounted for as a purchase business combination in accordance
with SFAS No. 141, Business Combinations. The total purchase price related to the
acquisition of Edgil was $3,899,859. Edgil operates as a wholly owned subsidiary of AdStar
and the Companys financial statements include the results of Edgil from the closing date of
the acquisition (October 21, 2003). The following table summarizes the estimated fair values of the assets acquired and
liabilities assumed at the date of acquisition. The allocation of the purchase price is
based in part on independent third-party valuation of certain intangible assets. The excess
purchase price over the estimated fair value of the assets acquired and liabilities assumed
is recorded as goodwill At October 21, 2003 Current assets
    
    $
    535,322Purchased software
    
    
    311,000Customer list
    
    
    1,500,000Goodwill
    
    
    2,820,399
 F-31




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##### Table of Contents



Total assets acquired
    
    
    5,166,721Current liabilities
    
    
    430,052Deferred tax liability
    
    
    688,180Notes payable Shareholders
    
    
    63,000Total liabilities assumed
    
    
    1,181,232Net assets acquired
    
    $
    3,985,489
 The purchased software is comprised of internally created software which was valued by the
independent third-party who assigned an expected useful life of 5 years. The customer list of $1,500,000 is primarily comprised of value of the recurring revenue
stream associated with long-term customers, valued by the independent third-party who
assigned an expected life of 17 years. The excess of the purchase price over the estimated fair value of the assets acquired and
the liabilities assumed was recorded as goodwill. There is no step up in basis of the
assets for tax purposes therefore the goodwill is not deductible for tax purposes. Since there is no step up in basis of the acquired Edgil assets for tax purposes,
amortization of the purchased software and customer list is not deductible for tax purposes.
The $688,180 deferred tax liability is calculated at Edgils 38% blended tax rate assigned
by the independent third-party appraiser and applied to the $311,000 purchased software and
$1,500,000 customer list. In accordance with SFAS 141, at December 31, 2004 the deferred tax
liability is expected to be realized over the term as the deferred tax asset, therefore the
deferred tax liability was offset against the deferred tax asset on AdStar as part of the
consolidated income tax provision. As a result of this transaction, AdStars deferred tax
asset valuation allowance was reduced. In accordance with SFAS 109, the change in the
valuation allowance was offset against goodwill. Accordingly, a 100% valuation allowance
has been recorded for the deferred tax assets and liabilities of the Company. The following summarized pro forma consolidated results of operations are presented as if
the acquisition of Edgil had occurred on January 1, 2003. The unaudited pro forma results
are not necessarily indicative of future earnings or earnings that would have been reported
had the acquisition been completed as presented. December 31,2003Revenue
    
    $
    4,878,051Net Loss
    
    
    (2,537,610
    )Loss per share  basic and diluted
    
    $
    (0.28
    )
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19.
    Significant fourth quarter adjustmentsDuring the fourth quarter of fiscal 2003 the Company recorded a $883,060 one time impairment
write-down of our contract Web and FlexAd internally developed software applications and a related reserve for direct costs of contractual obligations to service
said software, primarily based on a product line evaluation undertaken in December 2003 in
connection with the integration of AdStars Edgil acquisition and new information supplied
by the customer for FlexAds in November 2003 with respect to its future utilization of that
software. A summary of the composition of the write-down is as follows:In December 2003 the Company recognized $698,060 in impairment losses and wrote-down two
software applications to their net realizable value. The write down is comprised of $381,598
and $316,462 for our contract Web and FlexAd software applications, respectively. In
addition in November 2003 we entered into discussions with Tribune Company to materially
modify the FlexAd application. As a result of information provided by Tribune in these
conversations management estimated that the expected future revenues from the FlexAd
application were never likely to exceed total costs. As such, we recorded an additional
$170,000 estimated loss to service the related customer contract. An additional $15,000 in
estimated costs was recorded to support the contract Web application under existing
maintenance contracts until we can move customers to a new version or back to the old
application. (Notes 2 and 7).The above adjustments increased the 2003 loss per common share from $0.21 to $0.31.During 2004, expenses of $1,203,000 were incurred in connection with the abandonment of four
proposed acquisitions and related international expansion plans. On December 31, 2004, an
option to acquire a company expired resulting in a write off of all costs previously
recorded as prepaid costs of the acquisition during 2004, costs incurred during the forth
quarter 2004 and all future commitments, primarily employee settlement and severance costs
and legal and professional fees associated with the abandoned acquisition. In addition 3
smaller acquisition targets did not meet our due diligence requirements or turned down our
offers during the quarter ended December 31, 2004 for which we expensed all related costs.The charges include approximately $203,000 of prepaid acquisition costs capitalized at
September 30, 2004; approximately $69,000 of costs associated with the international
expansion plans and the related acquisition target which were previously expensed during the
nine months ending September 30, 2004 and included under different operating categories,
approximately $391,000 for deposits paid from October 16 through November 29, 2004 lost as a
result of the failure to close one acquisition by December 31, 2004; and approximately
$263,000 of employment, consulting, travel, severance and miscellaneous other expenses
recorded during the fourth quarter 2004 primarily related to the international acquisition
and related expansion plans. A balance of approximately $277,000 primarily related to two
discharged executives specifically hired to promote and coordinate international expansion,
will be paid in 2005.In December 2004 the Company recognized $257,820 in impairment losses and wrote-down five
software applications to their net realizable value. The impairment was primarily comprised
of a $190,294 write-down of 2 uncompleted software applications primarily designed to
deliver the EdgCapture product over the Web or in NT based environments. During December
2004 our Senior Vice President of Sales left the Company and our current Vice President of
Sales and Chief Operating Officer, with overall revenue responsibility, indicated these
products have not generated sufficient market interest to justify continued development with
our limited resources. In addition a $52,837 write-down of a limited display ad technology
built specifically for the Los Angeles Times Restaurant Guide was launched in September 2004
and had not generated the anticipated ASP revenues we originally projected and we have been
unsuccessful in selling the product to other F-33




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publications. The remaining $14,689 related to 2 older software technologies for which
revenues have deteriorated in recent months to the point where a permanent impairment in
value was indicated. The above adjustments increased the 2004 loss per common share from $0.16 to $0.26.  20.
    Subsequent EventIn January the Company raised $597,423 from the exercise of 702,850 warrants at $0.85 per
warrant. The warrants had been issued to Paulson Investment Company, or certain of its
officers and employees, primarily as compensation for their services in prior securities
offerings and originally had exercise prices ranging from $0.75 to $1.87 and expiration
dates ranging from September 25, 2005 to March 31, 2009.In February 2005, we received a letter from Nasdaq putting us on notice that the bid price
of our Common Stock had fallen below their $1.00 per share minimum. Currently, our Common
Stock is trading below $1.00. Pursuant to applicable Nasdaq rules, we have been
provided a 180 day grace period until August 17, 2005 to regain compliance by having the bid
price of our Common Stock close at $1.00 per share or more for a minimum of 10 consecutive
business days. If we are unable to satisfy Nasdaqs maintenance requirements, our
securities may be delisted from The Nasdaq Small Cap Market. If we are unable to satisfy
Nasdaqs maintenance requirements, our securities may be delisted from Nasdaq. In that
event, trading, if any, in the Common Stock and warrants would be conducted in the
over-the-counter market in the so-called pink sheets or the NASDs OTC Bulletin Board.
Consequently, the liquidity of our securities could be impaired, not only in the number of
securities which could be bought and sold, but also through delays in the timing of
transactions, reduction in security analysts and new media coverage of AdStar, and lower
prices for our securities than might otherwise be obtained. F-34