Document:

Exhibit 10.5

CONVERSION AGREEMENT

This
Conversion Agreement is dated as of May 26, 2006 (the “Conversion
Agreement”) by and between PCCW Credit Union (the “Lender”), and Small World
Kids, Inc., a Nevada corporation (the “Company”), with reference to the following:

A.            Lender has loaned to the Company the
aggregate principal amount of $115,000 (the “Loan Amount”), all of which is
currently outstanding.

B.            The Company is selling to investors
shares of Class A-1 Convertible Preferred Stock (the “Class A-1
Shares”) with the powers, designation, preferences and relative rights of such
class substantially as set forth on Exhibit A attached hereto.

C.            It is a condition to the closing of
the sale of the Class A-1 Shares that the Loan Amount be converted
into 104,535 Class A-1 Shares.

D.            The Lender is willing to agree to
such conversion on the terms and conditions set forth herein.

NOW
THEREFORE, the parties hereto agree as follows:

1.             Conversion. Upon the terms and conditions set
forth herein, the Lender hereby agrees to convert all of the Loan Amount into
104,535 shares of Class A-1 Shares.

2.             The conversion of the Loan Amount set forth in Section 1
above is conditioned upon the following:

(a)           at least $2,000,000
in gross proceeds from the sale of the Class A-1 Shares shall have
been received;

(b)           the holders of the
Company’s outstanding indebtedness for borrowed money in the aggregate
principal amount of $3,000,000 (exclusive of indebtedness owed to Laurus Master
Fund Ltd., St. Cloud Capital Partners L.P., Horizon Financial Services Group
USA and Eddy Goldwasser) shall have converted such indebtedness into 2,727,278 Class A-1
Shares;

(c)           the outstanding
indebtedness owed to St. Cloud in the principal amount of $2,500,000 shall
have been restructured as follows:

(1)           the Company shall
prepay $50,000

(2)           the remaining
principal amount shall be evidenced by two notes. The first note in the
principal amount of $200,000 will be for twelve months with monthly
amortization payments at a 10% interest rate. The second note will be for
$2,250,000 with interest at 10% per annum, interest only payable on June 30,
2006 and September 15, 2006. Commencing September 16, 2006, payments
will be interest only each month through September 15, 2008 and commencing
October 15, 2008, monthly amortization payments (based on a five-year
amortization) with all interest plus unpaid principal due on September 15,
2011.

 

 

The second
note will be convertible into shares of the Common Stock of the Company at
$4.00 per share (subject to adjustment);

(d)           the Company shall
have amended its Articles of Incorporation to increase the authorized shares of
Preferred Stock to 15,000,000 of which 12,000,000 shares shall be designated Class A-1
Convertible Preferred Stock; and

(e)           SWT, LLC shall have
converted all of the 2,500,000 shares of the Class A Convertible Stock
which it owns into 4,897,261 Class A-1 Shares.

IN
WITNESSWHEREOF, the Lender and the Company have caused this Conversion
Agreement to be executed as of the date first written above.

	
  

  	
  Small World Kids, Inc.

  
	
   

  	
  By

  	
   

  
	
   

  	
   

  	
  Debra Fine, Chief Executive Officer

  
	
   

  	
  PCCW Credit Union

  
	
   

  	
  By

  	
   

  

 

 2

 

 

EXHIBIT A

SMALL WORLD KIDS,
INC.

CERTIFICATE OF DESIGNATION
OF THE

CLASS A-1 CONVERTIBLE PREFERRED STOCK

Pursuant to Section 78.195
of the General

Corporation Law of the
State of Nevada

Small
World Kids, Inc., a corporation organized and existing under the laws of
the State of Nevada (the “Corporation”), hereby certifies that the following
resolution was duly adopted by the Board of Directors of the Corporation by
unanimous written consent effective May 26, 2006:

RESOLVED,
that, Article 3 of the Amended Articles of Incorporation, creates and
authorizes up to 15,000,000 shares of preferred stock (the “Preferred Stock”),
of which there are no shares currently issued and outstanding. The Company has
previously issued 2,500,000 shares of Class A Convertible Preferred Stock
which, concurrently with the filing of this Certificate of Designation
pertaining to Class A-1 Convertible Preferred Stock, are being converted
into such Class A-1 Convertible Preferred Stock pursuant to the
filing of an amendment to Certificate of Designation of the Class A
Convertible Preferred Stock and will no longer be outstanding. Accordingly, as
of the date hereof, there are 15,000,000 shares of Preferred Stock which have
the status of authorized but unissued shares that are available for issuance.

RESOLVED
FURTHER, the Board of Directors of the Corporation hereby establishes a series
of Class A-1 Convertible Preferred Stock to consist of 12,000,000
shares, and hereby fixes the powers, designation, preferences and relative
participating, optional and other rights of such series of Class A-1
Convertible Preferred Stock, and the qualifications, limitations and
restrictions thereof, as follows:

1.             Designation.

(a)           The designation of the series
of Class A-1 Convertible Preferred Stock created by this resolution
shall be “Class A-1 Convertible Preferred Stock” (hereinafter called
the “Class A-1 Preferred Stock”).

(b)           All shares of Class A-1
Preferred Stock shall be identical with each other in all respects.

2.             Liquidation
Rights.

(a)           General. In the event
of any liquidation, dissolution or winding up, whether voluntary or
involuntary, holders of each share of Class A-1 Preferred Stock shall
be entitled to be paid out of the assets or surplus funds of the Corporation
legally available for distribution to holders of the Corporation’s capital
stock of all classes (whether such assets are

 

capital,
surplus, or earnings) before any sums shall be paid or any assets or surplus
funds distributed among the holders of Common Stock or to the holders of any
series of Preferred Stock which may be junior in right of preference to Class A-1
Preferred Stock, an amount equal to $1.65 per share (as adjusted for any stock
dividend, combination or splits with respect to such shares) of Class A-1
Preferred Stock plus any cumulative and or accrued and unpaid dividends thereon
(the “Stated Value”). After payment to the holders of the Class A-1
Preferred Stock of the amount set forth in this Section 2(a), the
remaining assets and funds of the Corporation legally available for
distribution, if any, shall be distributed among the holders of the Common
Stock and the Class A-1 Preferred Stock in proportion to the shares of
Common Stock then held by them and the shares of Common Stock which they have a
right to acquire upon conversion of the shares of the Class A-1
Preferred Stock held by them.

(b)           Distributions Other than Cash.
Whenever the distribution provided for in this Section 2 shall be paid in
property other than cash, the value of such distribution shall be the fair
market value of such property as determined in good faith by the Board of
Directors of the Corporation. In each such case, the holders of the Class A-1
Preferred Stock shall be entitled to a proportionate share of any such
distribution in accordance with the provisions hereof.

If
the assets of the Corporation shall be insufficient to permit the payment in
full to holders of the Class A-1 Preferred Stock of the preferential
amount set forth in this Section 2, then the entire assets of the
Corporation available for such distribution shall be distributed ratably among
the holders of the Class A-1 Preferred Stock in accordance with the
aggregate liquidation preference of the shares of Class A-1
Preferred Stock held by each of them.

The
sale, lease or exchange (for cash, shares of stock, securities or other
consideration) of all or substantially all the property and assets of the
Corporation, or the merger, consolidation or reorganization of the Corporation
into or with any other corporation, or the merger or consolidation of any other
corporation into or with the Corporation or any other transaction or series of
related transactions, in each case where the shareholders of the Corporation do
not continue to hold the majority of the voting power after such merger,
consolidation or reorganization, shall be deemed to be a liquidation for the
purposes of this section.

3.             Conversion.

The
holders of Class A-1 Preferred Stock shall have conversion rights as
follows:

(a)           Right to Convert.
Each share of Class A-1 Preferred Stock shall be convertible, at the
option of the holder thereof, at any time after the date of issuance of such
share, at the office of the Corporation or any transfer agent for the Class A-1
Preferred Stock, into such number of fully paid and non-assessable shares of
Common Stock as is determined by dividing the purchase price ($1.10) of one
share of Class A-1 Preferred Stock by the Conversion Price (the “Conversion
Price”) at the time in effect for a share Class A-1 Preferred Stock.
The Conversion Price per share of Class A-1 Preferred Stock
initially shall be $1.10, subject to adjustment from time to time as provided
below.

(b)           Intentionally
Deleted.

 A-2

 

(c)           Mechanics of
Conversion. No fractional shares of Common Stock shall be issued upon
conversion of the Class A-1 Preferred Stock. In lieu of any
fractional shares to which the holder would otherwise be entitled, the
Corporation shall pay cash equal to such fraction multiplied by the then
applicable Conversion Price of the Class A-1 Preferred Stock. Before
any holder of Class A-1 Preferred Stock shall be entitled to convert
the same into shares of Common Stock pursuant to Section 3(a), such holder
shall surrender the certificate or certificates therefor, duly endorsed, at the
office of the Corporation or of any transfer agent for the Class A-1
Preferred Stock, and shall give written notice by mail, postage prepaid, to the
Corporation at its principal corporate office, of the election to convert the
same, and such conversion shall be deemed to have been made immediately prior
to the close of business on the date of such surrender of the shares of Class A-1
Preferred Stock to be converted. The Corporation shall, as soon as practicable
thereafter, issue and deliver to such address as the holder may direct, a
certificate or certificates for the number of shares of Common Stock to which
such holder shall be entitled. The Corporation shall pay all documentary, stamp,
transfer or other transactional taxes attributable to the issuance or delivery
of shares of Common Stock upon conversion of any shares of Class A-1
Preferred Stock; provided that the Corporation shall not be required to
pay any taxes which may be payable in respect of any transfer involved in the
issuance or delivery of any certificate for such shares in a name other than
that of the holder of the shares of Preferred Stock in respect of which such
shares are being issued.

(d)           Status of
Converted Stock. In the event any shares of Class A-1 Preferred
Stock shall be converted pursuant to this Section 3, the shares so
converted shall be canceled and shall not be reissued as Class A-1
Preferred Stock by the Corporation. All such shares shall upon their cancellation
become authorized but unissued shares of Preferred Stock and may be reissued as
part of a new series of Preferred Stock to be created by resolution or
resolutions of the board of directors, subject to the conditions and
restrictions on issuance set forth herein.

(e)           Certain
Adjustments and Distributions.

(i)            Adjustments for
Subdivisions or Combinations of Common Stock. In the event the outstanding
shares of Common Stock shall be subdivided by stock split, stock dividend or
otherwise, into a greater number of shares of Common Stock, the Conversion
Price of each share of Class A-1 Preferred Stock then in effect
shall, concurrently with the effectiveness of such subdivision, be
proportionately decreased. In the event the outstanding shares of Common Stock
shall be combined or consolidated into a lesser number of shares of Common
Stock, the Conversion Price of each share of Class A-1 Preferred
Stock then in effect shall, concurrently with the effectiveness of such
combination or consolidation, be proportionately increased.

(ii)           Stock Dividends
and Other Distributions. In the event the Corporation makes, or fixes a
record date for the determination of holders of Common Stock entitled to
receive, any distribution (excluding repurchases of securities by the Corporation
not made on a pro rata basis) payable in property or in securities of the
Corporation other than shares of Common Stock, and other than as otherwise
adjusted for in this Section 3 or as provided for in Section 1 in
connection with a dividend, then and in each such event the holders of Class A-1
Preferred Stock shall receive, at the time of such distribution, the amount of
property or the 

 A-3
 

 

number of
securities of the Corporation that they would have received had their Class A-1
Preferred Stock been converted into Common Stock on the date of such event.

(iii)          Reorganizations,
Recapitalizations, Reclassifications or Similar Events. If the Common Stock
shall be changed into the same or a different number of shares of any other
class or classes of stock or other securities or property, whether by capital
reorganization, recapitalization, reclassification or otherwise, then each
share of Class A-1 Preferred Stock shall thereafter be convertible
into the number of shares of stock or other securities or property to which a
holder of the number of shares of Common Stock of the Corporation deliverable
upon conversion of such shares of Class A-1 Preferred Stock shall
have been entitled upon such reorganization, recapitalization,
reclassification, merger, consolidation or other event.

(iv)          Adjustments for
Diluting Issues. In addition to the adjustment of the Conversion Prices
provided above, the Conversion Price of the Class A-1 Preferred
Stock shall be subject to further adjustment from time to time as follows:

(A)          Special Definitions.

(1)           “Options” shall mean rights, options
or warrants to subscribe for, purchase or otherwise acquire either Common Stock
or Convertible Securities.

(2)           “Original Issue Date” shall mean the
date on which the first share of Class A-1 Preferred Stock was first
issued.

(3)           “Convertible Securities” shall mean
securities convertible into or exchangeable for Common Stock, either directly
or indirectly, including the Class A-1 Preferred Stock.

(4)           “Additional Shares of Common Stock”
shall mean all shares of Common Stock issued (or, pursuant to Section 3(e)(iv)(C) deemed
to be issued) by the Corporation after the Original Issue Date.

(B)           No Adjustment of Conversion Price.
No adjustment in the Conversion Price shall be made pursuant to Section 3(e)(iv)(D) unless
the consideration per share for an Additional Share of Common Stock issued (or,
pursuant to Section 3(e)(iv)(C), deemed to be issued) by the Corporation
is less than the Conversion Price in effect on the date of, and immediately
prior to, such issue, and provided that any such adjustment shall not have the
effect of increasing the Conversion Price to an amount which exceeds the
Conversion Price existing immediately prior to such adjustment.

(C)           Deemed Issuance of Additional
Shares of Common Stock. Except as otherwise provided in Section 3(e)(iv)(A) or
3(e)(iv)(B), in the event the Corporation at any time or from time to time
after the Original Issue Date shall issue any Options or Convertible Securities
or shall fix a record date for the determination of any holders of any class of
securities entitled to receive any such Options or Convertible Securities, then
the maximum number of shares (as set forth in the instrument relating thereto
without regard to any provisions contained therein for a subsequent adjustment
of such number) of Common Stock issuable upon 

 A-4
 

 

the exercise of such
Options or, in the case of Convertible Securities and Options therefor, the
conversion or exchange of such Convertible Securities, shall be deemed to be
Additional Shares of Common Stock issued as of the time of such issue or, in
case such a record date shall have been fixed, as of the close of business on
such record date, provided that in any such case in which additional shares of
Common Stock are deemed to be issued:

(1)           no further adjustment in the
Conversion Price shall be made upon the subsequent issue of Convertible
Securities or shares of Common Stock upon the exercise of such Options or
conversion or exchange of such Convertible Securities;

(2)           if such Options or Convertible
Securities by their terms provide, with the passage of time or otherwise, for
any increase or decrease in the consideration payable to the Corporation, or
increase or decrease in the number of shares of Common Stock issuable, upon the
exercise, conversion or exchange thereof, the Conversion Price computed upon
the original issue thereof or upon the occurrence of a record date with respect
thereto, and any subsequent adjustments based thereon, shall, upon any such
increase or decrease becoming effective, be recomputed to reflect such increase
or decrease;

(3)           upon the expiration of any such
Options or any rights of conversion or exchange under such Convertible
Securities which shall not have been exercised, the Conversion Price computed upon
the original issue thereof or upon the occurrence of a record date with respect
thereto, and any subsequent adjustments based thereon, shall, upon such
expiration, be recomputed as if:

(i)            in
the case of Convertible Securities or Options for Common Stock, the only
Additional Shares of Common Stock issued were shares of Common Stock, if any,
actually issued upon the exercise of such Options or the conversion or exchange
of such Convertible Securities, and the consideration received therefor was the
consideration actually received by the Corporation for the issue of all such
Options, whether or not exercised, plus the consideration actually received by
the Corporation upon such exercise, or for the issue of all such Convertible
Securities, whether or not converted or exchanged, plus the additional
consideration, if any, actually received by the Corporation upon such
conversion or exchange; and

(ii)           in
the case of Options for Convertible Securities, only the Convertible
Securities, if any, actually issued upon the exercise thereof were issued at
the time of issue of such Options and the consideration received by the
Corporation for the Additional Shares of Common Stock deemed to have been then
issued was the consideration actually received by the Corporation for the issue
of all such Options, whether or not exercised, plus the consideration deemed to
have been received by the Corporation upon the issue of the Convertible
Securities with respect to which such Options were actually exercised;

(4)           no readjustment pursuant to Section 3(e)(iv)(C)(2) or
(3) above shall have the effect of increasing the Conversion Price to an
amount which exceeds the Conversion Price existing immediately prior to the
original adjustment with respect to the issuance of such Options or Convertible
Securities, as adjusted for any Additional Shares of 

 A-5
 

 

Common Stock issued (or,
pursuant to Section 3(e)(iv)(C), deemed to be issued) between such
original adjustment date and such readjustment date; and

(5)           in the case of any Option or Convertible
Security with respect to which the maximum number of shares of Common Stock
issuable upon exercise or conversion or exchange thereof is not determinable,
the adjustment to the Conversion Price, if any, shall be initially made based
on the minimum number of such shares with a subsequent adjustment once the
maximum number of such shares becomes determinable.

(D)          Adjustment of Conversion Price Upon
Issuance of Additional Shares of Common Stock. Subject to the limitation
set forth in Section 3(e)(iv)(B), above, except for Options issued
pursuant to the Company’s stock option or compensation plans and Additional
Shares of Common Stock issued pursuant to the conversion or exercise of
Convertible Securities outstanding as of the date hereof, if Additional Shares
of Common Stock are issued (or, pursuant to Section 3(e)(iv)(C), deemed to
be issued) for a consideration per share (computed on an as-converted to Common
Stock basis) less than the Conversion Price in effect on the date of, and
immediately prior to, such issue, then and in such event, such Conversion Price
shall be reduced, concurrently with such issue, to a price (rounded to the
nearest cent) determined by multiplying such Conversion Price by a fraction, (x) the
numerator of which shall be the number of shares of Common Stock outstanding
immediately prior to such issue plus the number of shares of Common Stock which
the aggregate consideration received by the Corporation for the total number of
Additional Shares of Common Stock so issued would purchase at such Conversion
Price, and (y) the denominator of which shall be the number of shares of
Common Stock outstanding immediately prior to such issue plus the number of
such Additional Shares of Common Stock so issued. For the purposes of this Section 3(e)(iv)(D),
all shares of Common Stock issuable upon exercise of outstanding Options, upon
conversion of outstanding Convertible Securities and upon conversion of
Convertible Securities following exercise of outstanding Options therefor,
shall be deemed to be outstanding, and immediately after any Additional Shares
of Common Stock are deemed issued pursuant to Section 3(e)(iv)(C), such
Additional Shares of Common Stock shall be deemed to be outstanding.

(E)           Determination of Consideration.
For purposes of this Section 3(e)(iv), the consideration received by the
Corporation for any Additional Shares of Common Stock issued (or, pursuant to Section 3(e)(iv)(C),
deemed to be issued) shall be computed as follows:

(1)           Cash and Property. Such
consideration shall:

(i)            insofar
as it consists of cash, be computed at the aggregate amount of cash received by
the Corporation after deducting any commissions paid by the Corporation with
respect to such issuance, but without deduction of any expenses payable by the
Corporation;

(ii)           insofar
as it consists of property other than cash, be computed at the fair market
value thereof at the time of such issuance, as determined in good faith by the
Board of Directors of the Corporation; and

 

 

 A-6

 

(iii)          if
Additional Shares of Common Stock are issued (or, pursuant to Section 3(e)(iv)(C),
deemed to be issued) together with other shares or securities or other assets
of the Corporation for consideration which covers both, be the proportion of
such consideration so received, computed as provided in clauses (i) and
(ii) above, as determined in good faith by the Board of Directors of the
Corporation.

(2)           Options and
Convertible Securities. The consideration received by the Corporation for
Additional Shares of Common Stock deemed to have been issued pursuant to Section 3(e)(iv)(C),
relating to Options and Convertible Securities, shall be the sum of (x) the
total amount, if any, received or receivable by the Corporation as
consideration for the issue of such Options or Convertible Securities, plus (y) the
minimum aggregate amount of additional consideration (as set forth in the
instruments relating thereto, without regard to any provision contained therein
for a subsequent adjustment of such consideration) payable to the Corporation
upon the exercise of such Options or the conversion or exchange of such
Convertible Securities, or in the case of Options for Convertible Securities,
the exercise of such Options for Convertible Securities and the conversion or
exchange of such Convertible Securities.

(f)            Certificate as
to Adjustments. Upon the occurrence of each adjustment or readjustment of
the Conversion Price pursuant to this Section 3, the Corporation at its
expense shall promptly compute such adjustment or readjustment in accordance
with the terms hereof and furnish to each holder of Class A-1
Preferred Stock to which such adjustment pertains a certificate setting forth
such adjustment or readjustment and showing in detail the facts upon which such
adjustment or readjustment is based. The Corporation shall, upon the written
request at any time of any holder of Class A-1 Preferred Stock,
furnish or cause to be furnished to such holder a like certificate setting
forth (i) such adjustments and readjustments, (ii) the Conversion
Prices at the time in effect, and (iii) the number of shares of Common
Stock and the amount, if any, of other property which at the time would be
received upon the conversion of such holder’s Class A-1 Preferred
Stock.

(g)           No Impairment.
The Corporation will not, through any reorganization, recapitalization,
transfer of assets, consolidation, merger, dissolution, issue or sale of
securities or any other voluntary action, avoid or seek to avoid the observance
or performance of any of the terms to be observed or performed hereunder by the
Corporation, but will at all times in good faith assist in the carrying out of
all the provisions of this Section 3 and in the taking of all such action
as may be necessary or appropriate in order to protect the conversion rights of
the holders of Class A-1 Preferred Stock against impairment. This
provision shall not restrict the Corporation’s right to amend its Amended
Articles of Incorporation with the requisite shareholder consent.

(h)           Notices of Record
Date. In the event of any taking by the Corporation of a record of the
holders of any class of securities for the purpose of determining the holders
thereof who are entitled to receive any dividend or other distribution, any
right to subscribe for, purchase or otherwise acquire any shares of stock of
any class or any other securities or property or to receive any other right,
the Corporation shall mail to each holder of Class A-1 Preferred
Stock at least twenty (20) days prior to such record date, a notice specifying
the date on which any such 

 A-7
 

 

record is to
be taken for the purpose of such dividend or distribution or right, and the
amount and character of such dividend, distribution or right.

(i)            Reservation of
Stock Issuable Upon Conversion. The Corporation shall at all times reserve
and keep available out of its authorized but unissued shares of Common Stock
solely for the purpose of effecting the conversion of the shares of Class A-1
Preferred Stock such number of its shares of Common Stock as shall from time to
time be sufficient to effect the conversion of all outstanding shares of Class A-1
Preferred Stock and if at any time the number of authorized but unissued shares
of Common Stock shall not be sufficient to effect the conversion of all then
outstanding shares of Class A-1 Preferred Stock, the Corporation
will take such corporate action as may be necessary to increase its authorized
but unissued shares of Common Stock to such number of shares as shall be
sufficient for such purpose.

(j)            Notices. Any
notice required by the provisions of this Section 3 to be given to any
holder of Class A-1 Preferred Stock shall be deemed given if
deposited in the United States mail, postage prepaid, and addressed to each
holder of record at such holder’s address appearing on the Corporation’s books.

4.             Covenants. The
Corporation is prohibited from taking any actions to amend or repeal any
provision of, or add any provision to, the Corporation’s Amended Articles of
Incorporation, Bylaws or this Certificate of Designation, if such action would
change adversely the preferences, rights, privileges or powers of, or
restrictions provided for the benefit of, the Class A-1 Preferred.

5.             Dividends.

(a)           The holders of the outstanding
Class A-1 Preferred Stock shall be entitled to receive, out of funds
legally available therefore, cumulative dividends at the annual rate of 6%
per annum of the per share purchase price ($1.10) of the Class A-1
Preferred Stock. Such dividends shall be payable in shares of the Company’s Class A-1
Preferred Stock quarterly, on the fifteenth day of October, January, April and
July (each of such dates being a “Dividend Payment Date”) commencing on
the date of issuance, and shall be pro-rated for the first such quarterly
period if the same is less than 91 (ninety-one) days. All shares of common
stock shall be valued at the Fair Market Value thereof.  As used herein Fair Market Value shall mean in
the case of stock on a given date, the average of the closing bid prices for
the Company’s common stock for the ten trading days immediately preceding the
Dividend Payment Date. Such dividends shall accrue on each such share
commencing on the date of issue, and shall accrue from day to day, whether or
not earned or declared. Such dividends shall be cumulative so that if such dividends
in respect of any previous quarterly dividend period shall not have been paid
on, the deficiency shall be fully paid on or declared and set apart for such
shares before the Corporation makes any distribution (as hereinafter defined)
to the holders of Common Stock. Accrued but unpaid dividends shall not bear
interest. “Distribution” in this section 5 means the transfer of cash or
property without consideration, whether by way of  dividend or otherwise (except a dividend in
shares of the Corporation) or the purchase or redemption of shares of the
Corporation for cash or property (except for an exchange of shares of the
Corporation or shares acquired by the Corporation from employees pursuant to
the terms of any employee incentive plan, agreement or arrangement) including
any such transfer, purchase or redemption by a

 A-8
 

 

 subsidiary of the Corporation. The time of any
distribution by way of dividend shall be the date of declaration thereof and
the time of any distribution by purchase or redemption of shares shall be the
day cash or property is transferred by the Corporation, whether or not pursuant
to a contract of an earlier date; provided that where a negotiable debt
security is issued in exchange for shares the time of the distribution is the
date when the Corporation acquires the shares in such exchange. The Board of
Directors may fix a record date for the determination of holders of Class A-1
Preferred Stock entitled to receive payment of a dividend declared thereon,
which record date shall be no more than sixty (60) days.

(b)           In addition to the dividends
specified in subparagraph (a) above, if dividends are declared or paid on
the Common Stock, then such dividends shall be declared and paid pro rata on the Common Stock and the Class A-1
Preferred Stock, treating each share of Class A-1 Preferred Stock as
the greatest whole number of shares of Common Stock then issuable upon
conversion thereof pursuant to Section 3 above.

(c)           If full cash dividends are not
paid or made available to the holders of all outstanding shares of Class A-1
Preferred Stock, and funds available shall be insufficient to permit payment in
full in cash to all such holders of the preferential amounts to which they are
then entitled, the entire amount available for payment of cash dividends shall
be distributed among the holders of the Class A-1 Preferred Stock
ratably in proportion to the full amount to which they would otherwise be
respectively entitled, and any remainder not paid in cash to the holders of the
Class A-1 Preferred Stock shall cumulate as provided in
subparagraph 5(d) below.

(d)           Dividends shall be paid to the
holders of record of the Preferred Stock as their names appear on the share
register of the Corporation upon a liquidation, dissolution or winding up
pursuant to Section 2 above. If, on any dividend payment date, the holders
of the Class A-1 Preferred Stock shall not have received the full
dividends provided for in the other provisions of this Section 5, then
such dividends shall cumulate, whether or not earned or declared, with
additional dividends thereon for each succeeding full dividend period during
which such dividends shall remain unpaid. Unpaid dividends for any period less
than a full dividend period shall cumulate on a day-to-day basis and shall be
computed on the basis of a 360-day year.

6.             Voting Rights.

(a)           General. Each
holder of shares of Class A-1 Preferred Stock shall be entitled to
the number of votes equal to the number of shares of Common Stock into which
the Class A-1 Preferred Stock could be converted and shall have
voting rights and powers equal to the voting rights and powers of the Common
Stock

(b)           Approval by
Holders of Class A-1 Preferred Stock. The Corporation shall not,
without first obtaining the approval of the holders of a majority of the then
outstanding shares of Class A-1 Preferred Stock:

(i)            Amend, waive or
repeal any provision of, or add any provision to, the Corporation’s Amendment
Articles of Incorporation or Bylaws if such action would 

 A-9
 

 

adversely
alter or change in any way in any material respect the rights, preferences,
privileges, or restrictions of the Class A-1 Preferred Stock;

(ii)           Issue any
Additional Shares of Common Stock, except in connection with or pursuant to (x) an
equity financing of not less that $10,000,000 for capital raising purposes,
provided that the majority of such financing is provided by investors who are
not shareholders of the Company at the time of such financing (a “Qualified
Financing”); (y) a debt financing that does not require a series vote
under subsection (v) below; (z) an acquisition or merger
approved by a majority of the Board of Directors where part or all of the
consideration for such acquisition or merger is paid in capital stock of the
Company; (xx) Options issued in connection with the Company’s stock option
or stock compensation plans; or (yy) the exercise or conversion of
Convertible Securities outstanding as of the date hereof.

(iii)          Authorize, create
and/or issue any class or series of equity or equity-linked securities that is
senior to the Class A-1 Preferred Stock in any respect whether by
reclassification or otherwise;

(iv)          Pay, declare or set
aside for payment any dividends or distributions on or pursuant to the
redemption of any capital stock of the Company except as set forth in Section 5
above;

(v)           Authorize, create
and/or issue any debt securities in one transaction or series of related
transactions in the aggregate amount in excess of $10,000,000 other than in
connection with the Company’s credit facilities with Laurus Master Fund Ltd. as
such facilities may exist from time to time;

(vi)          Alter the authorized
number of the Company’s board of directors, other than (i) increases to
give an investor in a Qualified Financing a board seat or (ii) increases
to give a board seat to a shareholder who has acquired Preferred Stock or
Common Stock in connection with a merger or acquisition which is valued at
least $30,000,000 and that does not require a vote under subsection (ii) above;

(vii)         Effect any
consolidation, sale or merger of the Company or other transaction in which
control of the Company is transferred except for transactions in which the Class A-1
Preferred Stock will receive at least the Stated Value multiplied by the number
of shares of Class A-1 Preferred Stock than outstanding in cash or
registered and freely tradable securities valued at the fair market value;

(viii)        Alter, amend or
change any of the provisions of this Certificate of Designation; and

(ix)           Redeem, repurchase
or declare a dividend with respect to any security of the Corporation, except
that the Corporation may repurchase shares of its capital stock issued pursuant
to the Corporation’s stock compensation plans.

(c)           Election of
Director. The holders of a majority of the outstanding shares of Class A-1
Preferred Stock shall have the right voting as a class to elect one member of
the Company’s board of directors (the “Preferred Director”), including to fill
a vacancy as to the 

 A-10
 

 

Preferred
Director. Any Preferred Director may be removed, with or without cause, by the
affirmative vote of the holders of a majority of the then outstanding shares of
Class A-1 Preferred Stock.

(d)           Expiration of
Voting Rights. The provisions of paragraph (b),
subsections (ii)-(vi) and paragraph (c) of this
Section 6 shall no longer be in force and effect at such time as the
aggregate Stated Value of the shares of Class A-1 Preferred Stock
outstanding is less than $250,000.

 

 A-11Exhibit 10.6

CONVERSION AGREEMENT

This
Conversion Agreement is dated as of May 26, 2006 (the “Conversion
Agreement”) by and between Hong Kong League Central Credit Union (the “Lender”),
and Small World Kids, Inc., a Nevada corporation (the “Company”), with
reference to the following:

A.            Lender has loaned to the Company the
aggregate principal amount of $565,000 (the “Loan Amount”), all of which is
currently outstanding.

B.            The Company is selling to investors
shares of Class A-1 Convertible Preferred Stock (the “Class A-1
Shares”) with the powers, designation, preferences and relative rights of such
class substantially as set forth on Exhibit A attached hereto.

C.            It is a condition to the closing of
the sale of the Class A-1 Shares that the Loan Amount be converted
into 513,636 Class A-1 Shares.

D.            The Lender is willing to agree to
such conversion on the terms and conditions set forth herein.

NOW
THEREFORE, the parties hereto agree as follows:

1.             Conversion. Upon the terms and conditions set
forth herein, the Lender hereby agrees to convert all of the Loan Amount into
513,636 shares of Class A-1 Shares.

2.             The conversion of the Loan Amount set forth in Section 1
above is conditioned upon the following:

(a)           at least $2,000,000
in gross proceeds from the sale of the Class A-1 Shares shall have
been received;

(b)           the holders of the
Company’s outstanding indebtedness for borrowed money in the aggregate
principal amount of $3,000,000 (exclusive of indebtedness owed to Laurus Master
Fund Ltd., St. Cloud Capital Partners L.P., Horizon Financial Services Group
USA and Eddy Goldwasser) shall have converted such indebtedness into 2,727,278 Class A-1
Shares;

(c)           the outstanding
indebtedness owed to St. Cloud in the principal amount of $2,500,000 shall
have been restructured as follows:

(1)           the Company shall
prepay $50,000

(2)           the remaining
principal amount shall be evidenced by two notes. The first note in the
principal amount of $200,000 will be for twelve months with monthly
amortization payments at a 10% interest rate. The second note will be for
$2,250,000 with interest at 10% per annum, interest only payable on June 30,
2006 and September 15, 2006. Commencing September 16, 2006, payments
will be interest only each month through September 15, 2008 and commencing
October 15, 2008, monthly amortization payments (based on a five-year
amortization) with all interest plus unpaid principal due on September 15,
2011.

 

The second
note will be convertible into shares of the Common Stock of the Company at
$4.00 per share (subject to adjustment);

(d)           the Company shall
have amended its Articles of Incorporation to increase the authorized shares of
Preferred Stock to 15,000,000 of which 12,000,000 shares shall be designated Class A-1
Convertible Preferred Stock; and

(e)           SWT, LLC shall have
converted all of the 2,500,000 shares of the Class A Convertible Stock
which it owns into 4,897,261 Class A-1 Shares.

IN
WITNESSWHEREOF, the Lender and the Company have caused this Conversion
Agreement to be executed as of the date first written above.

	
  

  	
  Small World Kids, Inc.

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
  By

  	
   

  
	
   

  	
  Debra Fine, Chief Executive Officer

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
  Hong Kong League Central Credit Union

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
  By

  	
   

  

 

 2

EXHIBIT A

SMALL WORLD KIDS, INC.

CERTIFICATE OF DESIGNATION

OF THE

CLASS A-1 CONVERTIBLE PREFERRED STOCK

 

Pursuant to Section 78.195 of the General

Corporation Law of the State of Nevada

 

Small
World Kids, Inc., a corporation organized and existing under the laws of
the State of Nevada (the “Corporation”), hereby certifies that the following
resolution was duly adopted by the Board of Directors of the Corporation by
unanimous written consent effective May 26, 2006:

RESOLVED,
that, Article 3 of the Amended Articles of Incorporation, creates and
authorizes up to 15,000,000 shares of preferred stock (the “Preferred Stock”),
of which there are no shares currently issued and outstanding. The Company has
previously issued 2,500,000 shares of Class A Convertible Preferred Stock
which, concurrently with the filing of this Certificate of Designation
pertaining to Class A-1 Convertible Preferred Stock, are being
converted into such Class A-1 Convertible Preferred Stock pursuant
to the filing of an amendment to Certificate of Designation of the Class A
Convertible Preferred Stock and will no longer be outstanding. Accordingly, as
of the date hereof, there are 15,000,000 shares of Preferred Stock which have
the status of authorized but unissued shares that are available for issuance.

RESOLVED
FURTHER, the Board of Directors of the Corporation hereby establishes a series
of Class A-1 Convertible Preferred Stock to consist of 12,000,000
shares, and hereby fixes the powers, designation, preferences and relative
participating, optional and other rights of such series of Class A-1
Convertible Preferred Stock, and the qualifications, limitations and
restrictions thereof, as follows:

1.             Designation.

(a)           The designation of the series
of Class A-1 Convertible Preferred Stock created by this resolution
shall be “Class A-1 Convertible Preferred Stock” (hereinafter called
the “Class A-1 Preferred Stock”).

(b)           All shares of Class A-1
Preferred Stock shall be identical with each other in all respects.

2.             Liquidation
Rights.

(a)           General. In the event
of any liquidation, dissolution or winding up, whether voluntary or involuntary,
holders of each share of Class A-1 Preferred Stock shall be entitled
to be paid out of the assets or surplus funds of the Corporation legally
available for distribution to holders of the Corporation’s capital stock of all
classes (whether such assets are 

 

capital,
surplus, or earnings) before any sums shall be paid or any assets or surplus
funds distributed among the holders of Common Stock or to the holders of any
series of Preferred Stock which may be junior in right of preference to Class A-1
Preferred Stock, an amount equal to $1.65 per share (as adjusted for any stock
dividend, combination or splits with respect to such shares) of Class A-1
Preferred Stock plus any cumulative and or accrued and unpaid dividends thereon
(the “Stated Value”). After payment to the holders of the Class A-1
Preferred Stock of the amount set forth in this Section 2(a), the
remaining assets and funds of the Corporation legally available for
distribution, if any, shall be distributed among the holders of the Common Stock
and the Class A-1 Preferred Stock in proportion to the shares of
Common Stock then held by them and the shares of Common Stock which they have a
right to acquire upon conversion of the shares of the Class A-1
Preferred Stock held by them.

(b)           Distributions Other than Cash.
Whenever the distribution provided for in this Section 2 shall be paid in
property other than cash, the value of such distribution shall be the fair
market value of such property as determined in good faith by the Board of
Directors of the Corporation. In each such case, the holders of the Class A-1
Preferred Stock shall be entitled to a proportionate share of any such
distribution in accordance with the provisions hereof.

If
the assets of the Corporation shall be insufficient to permit the payment in
full to holders of the Class A-1 Preferred Stock of the preferential
amount set forth in this Section 2, then the entire assets of the
Corporation available for such distribution shall be distributed ratably among
the holders of the Class A-1 Preferred Stock in accordance with the
aggregate liquidation preference of the shares of Class A-1
Preferred Stock held by each of them.

The
sale, lease or exchange (for cash, shares of stock, securities or other
consideration) of all or substantially all the property and assets of the
Corporation, or the merger, consolidation or reorganization of the Corporation
into or with any other corporation, or the merger or consolidation of any other
corporation into or with the Corporation or any other transaction or series of
related transactions, in each case where the shareholders of the Corporation do
not continue to hold the majority of the voting power after such merger,
consolidation or reorganization, shall be deemed to be a liquidation for the
purposes of this section.

3.             Conversion.

The
holders of Class A-1 Preferred Stock shall have conversion rights as
follows:

(a)           Right to Convert.
Each share of Class A-1 Preferred Stock shall be convertible, at the
option of the holder thereof, at any time after the date of issuance of such
share, at the office of the Corporation or any transfer agent for the Class A-1
Preferred Stock, into such number of fully paid and non-assessable shares of
Common Stock as is determined by dividing the purchase price ($1.10) of one
share of Class A-1 Preferred Stock by the Conversion Price (the “Conversion
Price”) at the time in effect for a share Class A-1 Preferred Stock.
The Conversion Price per share of Class A-1 Preferred Stock
initially shall be $1.10, subject to adjustment from time to time as provided
below.

(b)           Intentionally
Deleted.

 

 A-2

 

(c)           Mechanics of
Conversion. No fractional shares of Common Stock shall be issued upon
conversion of the Class A-1 Preferred Stock. In lieu of any
fractional shares to which the holder would otherwise be entitled, the
Corporation shall pay cash equal to such fraction multiplied by the then
applicable Conversion Price of the Class A-1 Preferred Stock. Before
any holder of Class A-1 Preferred Stock shall be entitled to convert
the same into shares of Common Stock pursuant to Section 3(a), such holder
shall surrender the certificate or certificates therefor, duly endorsed, at the
office of the Corporation or of any transfer agent for the Class A-1
Preferred Stock, and shall give written notice by mail, postage prepaid, to the
Corporation at its principal corporate office, of the election to convert the
same, and such conversion shall be deemed to have been made immediately prior
to the close of business on the date of such surrender of the shares of Class A-1
Preferred Stock to be converted. The Corporation shall, as soon as practicable
thereafter, issue and deliver to such address as the holder may direct, a
certificate or certificates for the number of shares of Common Stock to which
such holder shall be entitled. The Corporation shall pay all documentary, stamp,
transfer or other transactional taxes attributable to the issuance or delivery
of shares of Common Stock upon conversion of any shares of Class A-1
Preferred Stock; provided that the Corporation shall not be required to
pay any taxes which may be payable in respect of any transfer involved in the
issuance or delivery of any certificate for such shares in a name other than
that of the holder of the shares of Preferred Stock in respect of which such
shares are being issued.

(d)           Status of
Converted Stock. In the event any shares of Class A-1 Preferred
Stock shall be converted pursuant to this Section 3, the shares so
converted shall be canceled and shall not be reissued as Class A-1
Preferred Stock by the Corporation. All such shares shall upon their cancellation
become authorized but unissued shares of Preferred Stock and may be reissued as
part of a new series of Preferred Stock to be created by resolution or
resolutions of the board of directors, subject to the conditions and
restrictions on issuance set forth herein.

(e)           Certain
Adjustments and Distributions.

(i)            Adjustments for
Subdivisions or Combinations of Common Stock. In the event the outstanding
shares of Common Stock shall be subdivided by stock split, stock dividend or
otherwise, into a greater number of shares of Common Stock, the Conversion
Price of each share of Class A-1 Preferred Stock then in effect
shall, concurrently with the effectiveness of such subdivision, be
proportionately decreased. In the event the outstanding shares of Common Stock
shall be combined or consolidated into a lesser number of shares of Common
Stock, the Conversion Price of each share of Class A-1 Preferred
Stock then in effect shall, concurrently with the effectiveness of such
combination or consolidation, be proportionately increased.

(ii)           Stock Dividends
and Other Distributions. In the event the Corporation makes, or fixes a
record date for the determination of holders of Common Stock entitled to
receive, any distribution (excluding repurchases of securities by the Corporation
not made on a pro rata basis) payable in property or in securities of the
Corporation other than shares of Common Stock, and other than as otherwise
adjusted for in this Section 3 or as provided for in Section 1 in
connection with a dividend, then and in each such event the holders of Class A-1
Preferred Stock shall receive, at the time of such distribution, the amount of
property or the

 A-3
 

 

 

number of
securities of the Corporation that they would have received had their Class A-1
Preferred Stock been converted into Common Stock on the date of such event.

(iii)          Reorganizations,
Recapitalizations, Reclassifications or Similar Events. If the Common Stock
shall be changed into the same or a different number of shares of any other
class or classes of stock or other securities or property, whether by capital
reorganization, recapitalization, reclassification or otherwise, then each
share of Class A-1 Preferred Stock shall thereafter be convertible
into the number of shares of stock or other securities or property to which a
holder of the number of shares of Common Stock of the Corporation deliverable
upon conversion of such shares of Class A-1 Preferred Stock shall
have been entitled upon such reorganization, recapitalization,
reclassification, merger, consolidation or other event.

(iv)          Adjustments for
Diluting Issues. In addition to the adjustment of the Conversion Prices
provided above, the Conversion Price of the Class A-1 Preferred
Stock shall be subject to further adjustment from time to time as follows:

(A)          Special Definitions.

(1)           “Options” shall mean rights, options
or warrants to subscribe for, purchase or otherwise acquire either Common Stock
or Convertible Securities.

(2)           “Original Issue Date” shall mean the
date on which the first share of Class A-1 Preferred Stock was first
issued.

(3)           “Convertible Securities” shall mean
securities convertible into or exchangeable for Common Stock, either directly
or indirectly, including the Class A-1 Preferred Stock.

(4)           “Additional Shares of Common Stock”
shall mean all shares of Common Stock issued (or, pursuant to Section 3(e)(iv)(C) deemed
to be issued) by the Corporation after the Original Issue Date.

(B)           No Adjustment of Conversion Price.
No adjustment in the Conversion Price shall be made pursuant to Section 3(e)(iv)(D) unless
the consideration per share for an Additional Share of Common Stock issued (or,
pursuant to Section 3(e)(iv)(C), deemed to be issued) by the Corporation
is less than the Conversion Price in effect on the date of, and immediately
prior to, such issue, and provided that any such adjustment shall not have the
effect of increasing the Conversion Price to an amount which exceeds the
Conversion Price existing immediately prior to such adjustment.

(C)           Deemed Issuance of Additional
Shares of Common Stock. Except as otherwise provided in Section 3(e)(iv)(A) or
3(e)(iv)(B), in the event the Corporation at any time or from time to time
after the Original Issue Date shall issue any Options or Convertible Securities
or shall fix a record date for the determination of any holders of any class of
securities entitled to receive any such Options or Convertible Securities, then
the maximum number of shares (as set forth in the instrument relating thereto
without regard to any provisions contained therein for a subsequent adjustment
of such number) of Common Stock issuable upon

 A-4
 

 

 

the exercise of such
Options or, in the case of Convertible Securities and Options therefor, the
conversion or exchange of such Convertible Securities, shall be deemed to be
Additional Shares of Common Stock issued as of the time of such issue or, in
case such a record date shall have been fixed, as of the close of business on
such record date, provided that in any such case in which additional shares of
Common Stock are deemed to be issued:

(1)           no further adjustment in the
Conversion Price shall be made upon the subsequent issue of Convertible
Securities or shares of Common Stock upon the exercise of such Options or
conversion or exchange of such Convertible Securities;

(2)           if such Options or Convertible
Securities by their terms provide, with the passage of time or otherwise, for
any increase or decrease in the consideration payable to the Corporation, or
increase or decrease in the number of shares of Common Stock issuable, upon the
exercise, conversion or exchange thereof, the Conversion Price computed upon
the original issue thereof or upon the occurrence of a record date with respect
thereto, and any subsequent adjustments based thereon, shall, upon any such
increase or decrease becoming effective, be recomputed to reflect such increase
or decrease;

(3)           upon the expiration of any such
Options or any rights of conversion or exchange under such Convertible
Securities which shall not have been exercised, the Conversion Price computed upon
the original issue thereof or upon the occurrence of a record date with respect
thereto, and any subsequent adjustments based thereon, shall, upon such
expiration, be recomputed as if:

(i)            in
the case of Convertible Securities or Options for Common Stock, the only
Additional Shares of Common Stock issued were shares of Common Stock, if any,
actually issued upon the exercise of such Options or the conversion or exchange
of such Convertible Securities, and the consideration received therefor was the
consideration actually received by the Corporation for the issue of all such
Options, whether or not exercised, plus the consideration actually received by
the Corporation upon such exercise, or for the issue of all such Convertible
Securities, whether or not converted or exchanged, plus the additional
consideration, if any, actually received by the Corporation upon such
conversion or exchange; and

(ii)           in
the case of Options for Convertible Securities, only the Convertible
Securities, if any, actually issued upon the exercise thereof were issued at
the time of issue of such Options and the consideration received by the
Corporation for the Additional Shares of Common Stock deemed to have been then
issued was the consideration actually received by the Corporation for the issue
of all such Options, whether or not exercised, plus the consideration deemed to
have been received by the Corporation upon the issue of the Convertible
Securities with respect to which such Options were actually exercised;

(4)           no readjustment pursuant to Section 3(e)(iv)(C)(2) or
(3) above shall have the effect of increasing the Conversion Price to an
amount which exceeds the Conversion Price existing immediately prior to the
original adjustment with respect to the issuance of such Options or Convertible
Securities, as adjusted for any Additional Shares of

 A-5
 

 

 

Common Stock issued (or,
pursuant to Section 3(e)(iv)(C), deemed to be issued) between such
original adjustment date and such readjustment date; and

(5)           in the case of any Option or Convertible
Security with respect to which the maximum number of shares of Common Stock
issuable upon exercise or conversion or exchange thereof is not determinable,
the adjustment to the Conversion Price, if any, shall be initially made based
on the minimum number of such shares with a subsequent adjustment once the
maximum number of such shares becomes determinable.

(D)          Adjustment of Conversion Price Upon
Issuance of Additional Shares of Common Stock. Subject to the limitation
set forth in Section 3(e)(iv)(B), above, except for Options issued
pursuant to the Company’s stock option or compensation plans and Additional
Shares of Common Stock issued pursuant to the conversion or exercise of
Convertible Securities outstanding as of the date hereof, if Additional Shares
of Common Stock are issued (or, pursuant to Section 3(e)(iv)(C), deemed to
be issued) for a consideration per share (computed on an as-converted to Common
Stock basis) less than the Conversion Price in effect on the date of, and
immediately prior to, such issue, then and in such event, such Conversion Price
shall be reduced, concurrently with such issue, to a price (rounded to the
nearest cent) determined by multiplying such Conversion Price by a fraction, (x) the
numerator of which shall be the number of shares of Common Stock outstanding
immediately prior to such issue plus the number of shares of Common Stock which
the aggregate consideration received by the Corporation for the total number of
Additional Shares of Common Stock so issued would purchase at such Conversion
Price, and (y) the denominator of which shall be the number of shares of
Common Stock outstanding immediately prior to such issue plus the number of
such Additional Shares of Common Stock so issued. For the purposes of this Section 3(e)(iv)(D),
all shares of Common Stock issuable upon exercise of outstanding Options, upon
conversion of outstanding Convertible Securities and upon conversion of
Convertible Securities following exercise of outstanding Options therefor,
shall be deemed to be outstanding, and immediately after any Additional Shares
of Common Stock are deemed issued pursuant to Section 3(e)(iv)(C), such
Additional Shares of Common Stock shall be deemed to be outstanding.

(E)           Determination of Consideration.
For purposes of this Section 3(e)(iv), the consideration received by the
Corporation for any Additional Shares of Common Stock issued (or, pursuant to Section 3(e)(iv)(C),
deemed to be issued) shall be computed as follows:

(1)           Cash and Property. Such
consideration shall:

(i)            insofar
as it consists of cash, be computed at the aggregate amount of cash received by
the Corporation after deducting any commissions paid by the Corporation with
respect to such issuance, but without deduction of any expenses payable by the
Corporation;

(ii)           insofar
as it consists of property other than cash, be computed at the fair market
value thereof at the time of such issuance, as determined in good faith by the
Board of Directors of the Corporation; and

 A-6

 

(iii)          if
Additional Shares of Common Stock are issued (or, pursuant to Section 3(e)(iv)(C),
deemed to be issued) together with other shares or securities or other assets
of the Corporation for consideration which covers both, be the proportion of
such consideration so received, computed as provided in clauses (i) and
(ii) above, as determined in good faith by the Board of Directors of the
Corporation.

(2)          Options and
Convertible Securities. The consideration received by the Corporation for
Additional Shares of Common Stock deemed to have been issued pursuant to Section 3(e)(iv)(C),
relating to Options and Convertible Securities, shall be the sum of (x) the
total amount, if any, received or receivable by the Corporation as
consideration for the issue of such Options or Convertible Securities, plus (y) the
minimum aggregate amount of additional consideration (as set forth in the
instruments relating thereto, without regard to any provision contained therein
for a subsequent adjustment of such consideration) payable to the Corporation
upon the exercise of such Options or the conversion or exchange of such
Convertible Securities, or in the case of Options for Convertible Securities,
the exercise of such Options for Convertible Securities and the conversion or
exchange of such Convertible Securities.

(f)            Certificate as
to Adjustments. Upon the occurrence of each adjustment or readjustment of
the Conversion Price pursuant to this Section 3, the Corporation at its
expense shall promptly compute such adjustment or readjustment in accordance
with the terms hereof and furnish to each holder of Class A-1
Preferred Stock to which such adjustment pertains a certificate setting forth
such adjustment or readjustment and showing in detail the facts upon which such
adjustment or readjustment is based. The Corporation shall, upon the written
request at any time of any holder of Class A-1 Preferred Stock,
furnish or cause to be furnished to such holder a like certificate setting
forth (i) such adjustments and readjustments, (ii) the Conversion
Prices at the time in effect, and (iii) the number of shares of Common
Stock and the amount, if any, of other property which at the time would be
received upon the conversion of such holder’s Class A-1 Preferred
Stock.

(g)           No Impairment.
The Corporation will not, through any reorganization, recapitalization,
transfer of assets, consolidation, merger, dissolution, issue or sale of
securities or any other voluntary action, avoid or seek to avoid the observance
or performance of any of the terms to be observed or performed hereunder by the
Corporation, but will at all times in good faith assist in the carrying out of
all the provisions of this Section 3 and in the taking of all such action
as may be necessary or appropriate in order to protect the conversion rights of
the holders of Class A-1 Preferred Stock against impairment. This
provision shall not restrict the Corporation’s right to amend its Amended
Articles of Incorporation with the requisite shareholder consent.

(h)           Notices of Record
Date. In the event of any taking by the Corporation of a record of the
holders of any class of securities for the purpose of determining the holders
thereof who are entitled to receive any dividend or other distribution, any
right to subscribe for, purchase or otherwise acquire any shares of stock of
any class or any other securities or property or to receive any other right,
the Corporation shall mail to each holder of Class A-1 Preferred
Stock at least twenty (20) days prior to such record date, a notice specifying
the date on which any such 

 

 A-7
 

 

 

record is to
be taken for the purpose of such dividend or distribution or right, and the
amount and character of such dividend, distribution or right.

(i)            Reservation of
Stock Issuable Upon Conversion. The Corporation shall at all times reserve
and keep available out of its authorized but unissued shares of Common Stock
solely for the purpose of effecting the conversion of the shares of Class A-1
Preferred Stock such number of its shares of Common Stock as shall from time to
time be sufficient to effect the conversion of all outstanding shares of Class A-1
Preferred Stock and if at any time the number of authorized but unissued shares
of Common Stock shall not be sufficient to effect the conversion of all then
outstanding shares of Class A-1 Preferred Stock, the Corporation
will take such corporate action as may be necessary to increase its authorized
but unissued shares of Common Stock to such number of shares as shall be
sufficient for such purpose.

(j)            Notices. Any
notice required by the provisions of this Section 3 to be given to any
holder of Class A-1 Preferred Stock shall be deemed given if
deposited in the United States mail, postage prepaid, and addressed to each
holder of record at such holder’s address appearing on the Corporation’s books.

4.             Covenants. The
Corporation is prohibited from taking any actions to amend or repeal any
provision of, or add any provision to, the Corporation’s Amended Articles of
Incorporation, Bylaws or this Certificate of Designation, if such action would
change adversely the preferences, rights, privileges or powers of, or
restrictions provided for the benefit of, the Class A-1 Preferred.

5.             Dividends.

(a)           The holders of the outstanding
Class A-1 Preferred Stock shall be entitled to receive, out of funds
legally available therefore, cumulative dividends at the annual rate of 6%
per annum of the per share purchase price ($1.10) of the Class A-1
Preferred Stock. Such dividends shall be payable in shares of the Company’s Class A-1
Preferred Stock quarterly, on the fifteenth day of October, January, April and
July (each of such dates being a “Dividend Payment Date”) commencing on
the date of issuance, and shall be pro-rated for the first such quarterly
period if the same is less than 91 (ninety-one) days. All shares of common
stock shall be valued at the Fair Market Value thereof.  As used herein Fair Market Value shall mean in
the case of stock on a given date, the average of the closing bid prices for
the Company’s common stock for the ten trading days immediately preceding the
Dividend Payment Date. Such dividends shall accrue on each such share
commencing on the date of issue, and shall accrue from day to day, whether or
not earned or declared. Such dividends shall be cumulative so that if such
dividends in respect of any previous quarterly dividend period shall not have
been paid on, the deficiency shall be fully paid on or declared and set apart
for such shares before the Corporation makes any distribution (as hereinafter
defined) to the holders of Common Stock. Accrued but unpaid dividends shall not
bear interest. “Distribution” in this section 5 means the transfer of cash
or property without consideration, whether by way of  dividend or otherwise (except a dividend in
shares of the Corporation) or the purchase or redemption of shares of the
Corporation for cash or property (except for an exchange of shares of the
Corporation or shares acquired by the Corporation from employees pursuant to
the terms of any employee incentive plan, agreement or arrangement) including
any such transfer, purchase or redemption by a 

 

 A-8
 

 

 

subsidiary of
the Corporation. The time of any distribution by way of dividend shall be the
date of declaration thereof and the time of any distribution by purchase or
redemption of shares shall be the day cash or property is transferred by the
Corporation, whether or not pursuant to a contract of an earlier date; provided
that where a negotiable debt security is issued in exchange for shares the time
of the distribution is the date when the Corporation acquires the shares in
such exchange. The Board of Directors may fix a record date for the
determination of holders of Class A-1 Preferred Stock entitled to
receive payment of a dividend declared thereon, which record date shall be no more
than sixty (60) days.

(b)           In addition to the dividends
specified in subparagraph (a) above, if dividends are declared or paid on
the Common Stock, then such dividends shall be declared and paid pro rata on the Common Stock and the Class A-1
Preferred Stock, treating each share of Class A-1 Preferred Stock as
the greatest whole number of shares of Common Stock then issuable upon
conversion thereof pursuant to Section 3 above.

(c)           If full cash dividends are not
paid or made available to the holders of all outstanding shares of Class A-1
Preferred Stock, and funds available shall be insufficient to permit payment in
full in cash to all such holders of the preferential amounts to which they are
then entitled, the entire amount available for payment of cash dividends shall
be distributed among the holders of the Class A-1 Preferred Stock
ratably in proportion to the full amount to which they would otherwise be
respectively entitled, and any remainder not paid in cash to the holders of the
Class A-1 Preferred Stock shall cumulate as provided in
subparagraph 5(d) below.

(d)           Dividends shall be paid to the
holders of record of the Preferred Stock as their names appear on the share
register of the Corporation upon a liquidation, dissolution or winding up
pursuant to Section 2 above. If, on any dividend payment date, the holders
of the Class A-1 Preferred Stock shall not have received the full
dividends provided for in the other provisions of this Section 5, then
such dividends shall cumulate, whether or not earned or declared, with
additional dividends thereon for each succeeding full dividend period during
which such dividends shall remain unpaid. Unpaid dividends for any period less
than a full dividend period shall cumulate on a day-to-day basis and shall be
computed on the basis of a 360-day year.

6.             Voting Rights.

(a)           General. Each
holder of shares of Class A-1 Preferred Stock shall be entitled to
the number of votes equal to the number of shares of Common Stock into which
the Class A-1 Preferred Stock could be converted and shall have
voting rights and powers equal to the voting rights and powers of the Common
Stock

(b)           Approval by
Holders of Class A-1 Preferred Stock. The Corporation shall not,
without first obtaining the approval of the holders of a majority of the then
outstanding shares of Class A-1 Preferred Stock:

(i)            Amend, waive or
repeal any provision of, or add any provision to, the Corporation’s Amendment
Articles of Incorporation or Bylaws if such action would

 

 A-9
 

 

 

adversely
alter or change in any way in any material respect the rights, preferences,
privileges, or restrictions of the Class A-1 Preferred Stock;

(ii)           Issue any
Additional Shares of Common Stock, except in connection with or pursuant to (x) an
equity financing of not less that $10,000,000 for capital raising purposes,
provided that the majority of such financing is provided by investors who are
not shareholders of the Company at the time of such financing (a “Qualified
Financing”); (y) a debt financing that does not require a series vote
under subsection (v) below; (z) an acquisition or merger
approved by a majority of the Board of Directors where part or all of the
consideration for such acquisition or merger is paid in capital stock of the
Company; (xx) Options issued in connection with the Company’s stock option
or stock compensation plans; or (yy) the exercise or conversion of
Convertible Securities outstanding as of the date hereof.

(iii)          Authorize, create
and/or issue any class or series of equity or equity-linked securities that is
senior to the Class A-1 Preferred Stock in any respect whether by
reclassification or otherwise;

(iv)          Pay, declare or set
aside for payment any dividends or distributions on or pursuant to the
redemption of any capital stock of the Company except as set forth in Section 5
above;

(v)           Authorize, create
and/or issue any debt securities in one transaction or series of related
transactions in the aggregate amount in excess of $10,000,000 other than in
connection with the Company’s credit facilities with Laurus Master Fund Ltd. as
such facilities may exist from time to time;

(vi)          Alter the authorized
number of the Company’s board of directors, other than (i) increases to
give an investor in a Qualified Financing a board seat or (ii) increases
to give a board seat to a shareholder who has acquired Preferred Stock or
Common Stock in connection with a merger or acquisition which is valued at
least $30,000,000 and that does not require a vote under subsection (ii) above;

(vii)         Effect any
consolidation, sale or merger of the Company or other transaction in which
control of the Company is transferred except for transactions in which the Class A-1
Preferred Stock will receive at least the Stated Value multiplied by the number
of shares of Class A-1 Preferred Stock than outstanding in cash or
registered and freely tradable securities valued at the fair market value;

(viii)        Alter, amend or
change any of the provisions of this Certificate of Designation; and

(ix)           Redeem, repurchase
or declare a dividend with respect to any security of the Corporation, except
that the Corporation may repurchase shares of its capital stock issued pursuant
to the Corporation’s stock compensation plans.

(c)           Election of
Director. The holders of a majority of the outstanding shares of Class A-1
Preferred Stock shall have the right voting as a class to elect one member of
the Company’s board of directors (the “Preferred Director”), including to fill
a vacancy as to the

 

 A-10
 

 

 

Preferred
Director. Any Preferred Director may be removed, with or without cause, by the
affirmative vote of the holders of a majority of the then outstanding shares of
Class A-1 Preferred Stock.

(d)           Expiration of
Voting Rights. The provisions of paragraph (b), subsections (ii)-(vi) and
paragraph (c) of this Section 6 shall no longer be in force and
effect at such time as the aggregate Stated Value of the shares of Class A-1
Preferred Stock outstanding is less than $250,000.

 

 A-11

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