Document:

Exhibit 10.3

-THIRD AMENDMENT TO

NOTE PURCHASE
AGREEMENT

By and Between

ST. CLOUD CAPITAL
PARTNERS L.P.

And

SMALL WORLD KIDS,
INC.

Dated:

As of May 31, 2006

 

 

 

THIRD AMENDMENT TO NOTE
PURCHASE AGREEMENT

This
Third Amendment to Note Purchase Agreement (“Amendment”) is dated as of May 31,
2006 by and between Small World Kids, Inc., a Nevada corporation (the “Company”),
and St. Cloud Capital Partners L.P. (“Purchaser”).

RECITALS

A.            Purchaser and the Company have
entered into that certain Note Purchase Agreement dated as of September 7,
2004 (the “Note Purchase Agreement”) pursuant to which Purchaser purchased from
the Company, and the Company sold to Purchaser a note (the “Initial Note”) in
the principal amount of $2,000,000 (the “Initial Loan Amount”).

B.            Pursuant to an amendment to the Note
Purchase Agreement dated as of July 20, 2005 (the “First Amendment”), the
Initial Loan Amount was increased to $2,500,000 (the “New Loan Amount”) through
a loan to the Company of an additional $500,000. The New Loan Amount was
evidenced by an amended and restated note (the “First Restated Note”).

C.            Pursuant to the Second Amendment to
Note Purchase Agreement dated as of November 9, 2005, (the “Second
Amendment”), the Company issued to Purchaser a new promissory note (the “Second
Restated Note”) to replace the First Restated Note which, among other things,
extended the maturity date of the New Loan Amount to September 15, 2006.

D.            The Company is in the process of
raising additional equity in the form of convertible Preferred Stock, and the
new investors are requiring that the Second Restated Note be restructured on
the terms set forth herein.

AGREEMENTS

NOW,
THEREFORE, in consideration of their respective promises contained herein and
other good and valuable consideration, the receipt and sufficiency of which are
hereby acknowledged by the parties, the Company and Purchaser hereby agree as
follows:

1.                                       ISSUANCE
OF REPLACEMENT NOTE.

(a)           Subject to the terms
and conditions set forth in this Agreement, including the prepayment of $50,000
(the “Prepayment Amount”), and in reliance upon the representations and
warranties contained herein, the Company agrees to issue to Purchaser and
Purchaser agrees to accept in full replacement of the Second Restated Note two
new notes (the “Replacement Notes”) as follows:

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 (the “Note

 

 

 

Shares”) at
$4.00 per share (subject to adjustment). The Replacement Notes shall be
substantially in the form of Exhibits A and B.

(b)           Closing. The
closing of the issuance of the Replacement Notes (the “Closing”) shall be held
at the offices of Troy & Gould in Los Angeles, California, or at such
other location as shall be agreed upon by the parties hereto on or before June 5,
2006. At the Closing, the Company shall deliver the Replacement Notes to
Purchaser, and pay to Purchaser the Prepayment Amount and Purchaser shall
return to the Company the Second Restated Note. The date of the Closing is
referred to herein as the Closing Date.

2.                                       PURCHASER’S
REPRESENTATIONS AND WARRANTIES.

Purchaser
understands, agrees with, and represents and warrants to the Company with
respect to the purchase hereunder that:

(a)           Investment
Purposes; Compliance With Securities Act. Purchaser is acquiring the
Replacement Notes for Purchaser’s own account, for investment only and not with
a view towards, or in connection with, the public sale or distribution thereof,
except pursuant to sales registered under or exempt from the Securities Act of 1933,
as amended (the “Securities Act”).

(b)           Accredited
Purchaser Status. Purchaser is an “accredited Purchaser” as that term is
defined in Rule 501(a) of Regulation D. Purchaser is a
sophisticated purchaser and has such knowledge and experience in financial and
business matters that the Purchaser is capable of evaluating the merits and
risks of an investment made pursuant to this Agreement.

(c)           Reliance on
Exemptions. Purchaser understands the Replacement Notes are being offered
and sold to in reliance on specific exemptions from the registration
requirements of the applicable United States federal and state securities laws
and that the Company is relying upon the truth and accuracy of, and Purchaser’s
compliance with, the representations, warranties, acknowledgments,
understandings, agreements and covenants of the Purchaser set forth herein in
order to determine the availability of such exemptions and the eligibility of
Purchaser to acquire the Replacement Notes.

(d)           Information. Purchaser
and the advisors of the Purchaser, if any, have been furnished with all
material information relating to the business, finances and operations of the
Company and material information relating to the offer and sale of the
Replacement Notes that have been requested by the Purchaser. Purchaser and
Purchaser’s advisors, if any, have been afforded the opportunity to ask all
such questions of the Company as they have in their discretion deemed
advisable.

(e)           Transfer or
Resale. Purchaser understands that:  (i) 
the Note Shares have not been registered under the Securities Act or any state
securities laws, and may not be offered for sale, sold, assigned or transferred
unless either (a) subsequently registered thereunder or (b) Purchaser
shall have delivered to the Company an opinion by counsel reasonably
satisfactory to the Company, in form, scope and substance reasonably
satisfactory to the Company, to the effect that the Note Shares to be sold,
assigned or transferred may be sold, assigned or transferred pursuant to an
exemption from such registration, and (ii) except as expressly provided
herein, neither the Company nor any other person is under any obligation to
register the Note

 

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Shares under the Securities Act or any state securities laws or to
comply with the terms and conditions of any exemption thereunder.

(f)            Legends. The
Note Shares shall bear the following legend:

THE
SECURITIES REPRESENTED HEREBY HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT
OF 1933, AS AMENDED (THE “SECURITIES ACT”), OR ANY STATE SECURITIES LAWS AND MAY NOT
BE OFFERED, SOLD ,PLEDGED, ASSIGNED, OR OTHERWISE TRANSFERRED UNLESS (1) A
REGISTRATION STATEMENT WITH RESPECT THERETO IS EFFECTIVE UNDER THE SECURITIES
ACT AND ANY APPLICABLE STATE SECURITIES LAWS, OR (2) THE COMPANY RECEIVES
AN OPINION OF COUNSEL TO THE HOLDER OF THE SECURITIES, WHICH COUNSEL AND
OPINION ARE REASONABLY SATISFACTORY TO THE COMPANY, THAT SUCH SECURITIES MAY BE
OFFERED, SOLD, PLEDGED, ASSIGNED, OR OTHERWISE TRANSFERRED IN THE MANNER
CONTEMPLATED WITHOUT AN EFFECTIVE REGISTRATION STATEMENT UNDER THE SECURITIES
ACT OR APPLICABLE STATE SECURITIES LAWS.

(g)           This Amendment has
been duly and validly authorized, executed and delivered by Purchaser and is
the valid and binding agreement of Purchaser enforceable in accordance with its
terms, except as enforceability may be limited by bankruptcy, insolvency,
moratorium, liquidation, or similar laws relating to, or affecting, generally
the enforcement of creditors’ rights and remedies or by other equitable
principles of general application.

3.                                       REPRESENTATIONS
AND WARRANTIES OF THE COMPANY.

The
Company understands, agrees with, and represents and warrants to Purchaser
that:

(a)           Organization and
Qualification. The Company and its subsidiaries are duly organized and
existing in good standing under the laws of the respective jurisdictions in
which they are incorporated and have the requisite corporate power to own their
properties and to carry on their business as now being conducted. Each of the
Company and its subsidiaries is duly qualified as a foreign corporation to do
business and is in good standing in every jurisdiction in which the nature of
the business conducted by it makes such qualification necessary and where the
failure so to qualify would have a Material Adverse Effect. “Material Adverse
Effect” as used herein means any material adverse effect on the operations,
properties or financial condition of the Company and its subsidiaries taken as
a whole.

(b)           Authorization;
Enforcement. (i) The Company has the requisite corporate power and
authority to enter into and perform this Amendment and the Replacement Notes in
accordance with the terms hereof, (ii) the execution, delivery and
performance of this Amendment, and the Replacement Notes (the “Transaction
Documents”) by the Company and the consummation by it of the transactions
contemplated hereby and thereby have been duly

 

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authorized by the Company’s Board of Directors and no further consent
or authorization of the Company, its Board of Directors, or its shareholders is
required, (iii) the Transaction Documents have been duly and validly
authorized, executed and delivered by the Company, and (iv) the
Transaction Documents constitute the valid and binding obligations of the
Company enforceable against the Company in accordance with their respective
terms, except as such enforceability may be limited by applicable bankruptcy,
insolvency, reorganization, moratorium, liquidation or similar laws relating
to, or affecting, generally, the enforcement of creditors’ rights and remedies
or by other equitable principles of general application.

(c)           No Conflicts.
The execution, delivery and performance of this Agreement by the Company and
the consummation by the Company of the transactions contemplated hereby will
not (i) result in a violation of the Articles of Incorporation or Bylaws
of the Company or (ii) conflict with, or constitute a default (or an event
which with notice or lapse of time or both would become a default) under, or
give to others any rights of termination, amendment, acceleration or cancellation
of, any agreement, indenture or instrument to which the Company or any of its
subsidiaries is a party, or result in a violation of any law, rule, regulation,
order, judgment or decree (including federal and state securities laws and
regulations) applicable to the Company or any of its subsidiaries or by which
any property or asset of the Company or any of its subsidiaries is bound or
affected (except for such conflicts, defaults, terminations, amendments,
accelerations, cancellations and violations as would not, individually or in
the aggregate, have a material adverse effect).

(d)           Consents. Except
for the filing of a Form D with the Securities and Exchange Commission,
the Company is not required to obtain any consent, authorization or order of,
or make any filing or registration with, any court or governmental agency in
order for it to execute, deliver or perform any of its obligations under the
Transaction Documents.

(e)           SEC Reports. The
Company has filed all proxy statements, reports and other documents required to
be filed by it under the Securities Exchange Act of 1934 as amended (the “Exchange
Act”). The Company has furnished Purchaser with copies of (i) its Annual
Report on Form 10-KSB for the fiscal year ended December 31,
2005, (the “SEC Report”). The SEC Report was in substantial compliance with the
requirements of its respective form and neither the SEC Report, nor the
financial statements (and the notes thereto) included in the SEC Report,
contained any untrue statement of a material fact or omitted to state a
material fact required to be stated therein or necessary to make the statements
therein, in light of the circumstances under which they were made, not
misleading.

(f)            Absence of
Certain Changes. Since December 31, 2005, there has been no material
adverse change in the business, properties, operation, financial condition,
results of operations or prospects of the Company.

(g)           Absence of
Litigation. Except as set forth on Schedule 3(g), there is no action,
suit, proceeding, inquiry or investigation before or by any court, public board
or body pending or, to the knowledge of the Company, threatened against or
affecting the Company, wherein an unfavorable decision, ruling or finding would
have a Material Adverse Effect or which would adversely affect the validity or
enforceability of, or the authority or ability of the Company to perform its
obligations under, this Agreement or any of the documents contemplated herein.

 

 4

 

(h)           Title to Assets
and Liens. Except as set forth on Schedule 3(h), the Company has good
and marketable title to the Assets owned by it and the valid and enforceable
right to receive and/or use each of the Assets in which the Company has any
other interest, free and clear of all Liens. As used herein (i) ”Liens”
shall mean any lien, encumbrance, pledge, mortgage, security interest, lease,
charge, conditional sales contract, option, restriction, reversionary interest,
right of first refusal, voting trust arrangement, preemptive right, claim under
bailment or storage contract, easement or any other adverse claim or right
whatsoever; and (ii) ”Assets” shall mean all of the goodwill, assets,
properties and rights of every nature, kind and description, whether tangible
or intangible, real, personal or mixed, wherever located and whether or not
carried or reflected on the books and records of the Company, which are owned
by the Company or in which the Company has any interest (including the right to
use).

(i)            No Conflicts.
The execution, delivery and performance of this Agreement by the Company and
the consummation by the Company of the transactions contemplated hereby will
not (i) result in a violation of the Articles of Incorporation or Bylaws
of the Company or (ii) conflict with, or constitute a default (or an event
which with notice or lapse of time or both would become a default) under, or
give to others any rights of termination, amendment, acceleration or
cancellation of, any agreement, indenture or instrument to which the Company or
any of its subsidiaries is a party, or result in a violation of any law, rule,
regulation, order, judgment or decree (including federal and state securities
laws and regulations) applicable to the Company or any of its subsidiaries or
by which any property or asset of the Company or any of its subsidiaries is
bound or affected (except for such conflicts, defaults, terminations,
amendments, accelerations, cancellations and violations as would not,
individually or in the aggregate, have a material adverse effect).

(j)            Security
Interest. Pursuant to the attached Exhibit C, the Company hereby
grants a security interest to Purchaser to secure the obligations under the
First Restated Note and the Second Restated Note, and acknowledges that such
security interest shall apply to the obligations of the Company under the
Replacement Notes.

4.                                       COVENANTS.

(a)           Best Efforts.
Each party shall use its best efforts timely to satisfy each of the conditions
to be satisfied by it as provided in Sections 5 and 6 of this Agreement.

(b)           Expenses. Each
party shall pay such party’s expenses in connection with the transactions
contemplated by the Agreement.

(c)           Board Seat. During
the period that the Replacement Notes are outstanding, Robert Lautz will
continue to be appointed to the Company’s board of directors for such period,
and the Company shall continue to provide Mr. Lautz with the same
compensation made available to its other outside directors. In addition, as
long as Purchaser owns in excess of 300,000 shares of the Company (taking into
account the issuance of the Warrant Shares as such term is defined in the
Second Amendment and the Note Shares) (subject to adjustment for stock splits,
recapitalizations, etc.), a designee of Purchaser reasonably acceptable to the
Company shall be entitled to an observer seat on the board of directors.
Mr. Lautz’s undated letter of resignation previously delivered to the
Company in connection with his board of directors’ 

 5
 

 

appointment shall continue in force and effect. Notwithstanding the
foregoing, any stock options available to Mr. Lautz shall be issued to
Purchaser and any fees or other compensation otherwise payable to him shall be
paid to Purchaser.

(d)           Management Fee.
The remaining portion of Purchaser’s management fee of $20,000 shall be paid on
July 1, 2006.

(e)           Lock-up Agreement.
Purchaser agrees that the Lock-up Agreement executed in connection with the
Second Amendment shall be applicable to the Note Shares.

(f)            Negative
Covenants. Without the prior written consent of Purchaser, the Company
shall not:

(i)            Incur any debt for borrowed money
except that the Company may draw down on its credit facilities with Laurus
Master Funds Ltd. (“Laurus”) or Horizon Financial Services Group (USA) (“Horizon”)
as such facilities may exist from time to time, including any extensions or
modifications thereto;

(ii)           Make
any cash payments in respect of its capital stock whether by dividends,
redemption or otherwise;

(iii)          Sell,
transfer, mortgage, assign, pledge, lease, grant a security interest in, or
encumber any of Borrower’s assets or sell with recourse any of Borrower’s
accounts, except to Purchaser;

(iv)          Engage
in any business activities substantially different than those in which Borrower
is presently engaged, or cease operations, liquidate, merge, transfer, acquire,
or consolidate with any other entity, change its name, dissolve or transfer or
sell Collateral out of the ordinary course of business.

5.                                       CONDITIONS
TO THE COMPANY’S OBLIGATION TO ISSUE THE REPLACEMENT NOTES.

The
obligations of the Company hereunder are subject to the satisfaction, on or
before the Closing, unless otherwise specified, of each of the following
conditions, provided that these conditions are for the Company’s sole benefit
and may be waived by the Company at any time in its sole discretion:

(a)           Each of the Company
and Purchaser shall have executed the Transaction Documents as to which it is a
party.

(b)           The representations
and warranties of Purchaser shall be true and correct in all material respects
as of the Closing as though made at that time (except for representations and
warranties that speak as of a specific date). Purchaser shall have performed,
satisfied and complied in all material respects with the covenants, agreements
and conditions required by this Agreement to be performed, satisfied or
complied with by Purchaser at or prior to the Closing.

 6
 

 

(c)           No statute, rule,
regulation, executive order, decree, ruling or injunction shall have been
enacted, entered, promulgated or endorsed by any court or governmental
authority of competent jurisdiction or any self regulatory organization having
authority over the matters contemplated hereby which restricts or prohibits the
consummation of any of the transactions contemplated herein.

(d)           All consents, approval,
authorizations and orders required to be obtained and all registrations,
filings and notices required to be made with or given to any regulatory
authority or person as provided herein shall have been made.

(e)           Purchaser shall
execute such reasonable subordination agreements with Laurus necessary to
affirm that the obligations of the Company under the Replacement Notes continue
to be subordinated to existing indebtedness owed to Laurus.

6.                                       CONDITIONS
TO PURCHASER’S OBLIGATION TO ACCEPT THE REPLACEMENT NOTES.

The
obligations of Purchaser are subject to the satisfaction, on or before the
Closing, unless otherwise specified, of each of the following conditions,
provided that these conditions are for the sole benefit of Purchaser and may be
waived by Purchaser at any time in its sole discretion:

(a)           The Company shall
have executed the Transaction Documents.

(b)           The representations
and warranties of the Company shall be true and correct in all material
respects as of the Closing (except for representations and warranties that
speak as of a specific date). The Company shall have performed, satisfied and
complied in all material respects with the covenants, agreements and conditions
required by this Agreement to be performed, satisfied or complied with by the
Company at or prior to the Closing. The Purchaser may require a certificate,
executed by the Chief Executive Officer of the Company, dated as of the
Closing, to the foregoing effect and as to such other matters as may be
reasonably requested by Purchaser.

(c)           No statute, rule,
regulation, executive order, decree, ruling or injunction shall have been
enacted, entered, promulgated or endorsed by any court or governmental
authority of competent jurisdiction or any self regulatory organization having
authority over the matters contemplated hereby which restricts or prohibits the
consummation of any of the transactions contemplated herein.

(d)           All consents,
approval, authorizations and orders required to be obtained and all
registrations, filings and notices required to be made with or given to any
regulatory authority or person as provided herein shall have been made.

(e)           The Company shall
have received at least $2,000,000 in gross proceeds from the sale of a new
class of the Company’s Convertible Preferred Stock (the “New Preferred Stock”),
the existing holder of the Company’s Preferred Stock shall have converted its
shares into the New Preferred Stock, and the holders of the Company’s
outstanding indebtedness for borrowed 

 7
 

 

money other than Laurus, Horizon or Eddy Goldwasser shall have
converted such outstanding indebtedness into the New Preferred Stock.

7.                                       GOVERNING
LAW; MISCELLANEOUS.

(a)           Governing Law and
Venue. This Agreement shall be governed by and interpreted in accordance
with the laws of the State of California without regard to the principles of
conflict of laws. In the event of any litigation regarding the interpretation
or application of this Agreement, the parties irrevocably consent to
jurisdiction in any of the state or federal courts located in the City of Los
Angeles, State of California and waive their rights to object to venue in any
such court, regardless of the convenience or inconvenience thereof to any party.
Service of process in any civil action relating to or arising out of this
Agreement (including also all Exhibits or Schedules hereto) or the transaction(s) contemplated
herein may be accomplished in any manner provided by law. The parties hereto
agree that a final, non-appealable judgment in any such suit or proceeding
shall be conclusive and may be enforced in other jurisdictions by suit on such
judgment or in any other lawful manner.

(b)           Counterparts.
This Agreement may be executed in two or more identical counterparts, all of
which shall be considered one and the same agreement and shall become effective
when counterparts have been signed by each party and signature pages from
such counterparts have been delivered.

(c)           Headings; Gender,
Etc. The headings of this Agreement are for convenience of reference and
shall not form a part of, or affect the interpretation of this Agreement. As
used herein, the masculine shall refer to the feminine and neuter, the feminine
to the masculine and neuter, and the neuter to the masculine and feminine, as
the context may require. As used herein, unless the context clearly requires
otherwise, the words “herein,” “hereunder” and “hereby,” shall refer to this
entire Agreement and not only to the Section or paragraph in which such
word appears. If any date specified herein falls upon a Saturday, Sunday or
public or legal holidays, the date shall be construed to mean the next business
day following such Saturday, Sunday or public or legal holiday. For purposes of
this Agreement, a “business day” is any day other than a Saturday, Sunday or
public or legal holiday.

(d)           Severability.
If any provision of this Amendment shall be invalid or unenforceable in any
jurisdiction, such invalidity or unenforceability shall not affect the validity
or enforceability of the remainder of this Agreement in that jurisdiction or
the validity or enforceability of any provision of this Agreement in any other
jurisdiction.

(e)           Entire Agreement;
Amendments. This Amendment and the instruments referenced herein contain
the entire understanding of the parties with respect to the matters covered
herein and therein and, except as specifically set forth herein or therein,
neither the Company nor Purchaser makes any representation, warranty, covenant
or undertaking with respect to such matters. No provision of this Amendment may
be waived or amended other than by an instrument in writing signed by the party
to be charged with enforcement. Notwithstanding anything herein to the
contrary, the covenants of the Company pertaining to registration rights and
the release provisions contained in the Second Amendment shall remain in force
and effect.

 

 8

 

(f)            Notices. Any
notices required or permitted to be given under the terms of this Amendment
shall be sent by U.S. Mail or delivered personally or by courier or via
facsimile (if via facsimile, to be followed within three (3) business days
by an original of the notice document via U.S. Mail or courier) and shall be
effective five (5) days after being placed in the mail, if mailed,
certified or registered, return receipt requested, or upon receipt, if
delivered personally or by courier or by facsimile, in each case properly
addressed to the party to receive the same. The addresses for such
communications shall be:

	
  If to the Company:

  	
   

  	
  Small World
  Kids, Inc.

  5711 Buckingham Parkway

  Culver City, California 90230

  Attention:                            Debra
  Fine

  Fax Number:                 310-258-1194

  
	
   

  	
   

  	
   

  
	
  With a copy to:

  	
   

  	
  Troy & Gould

  1801 Century Park East, 16th Floor

  Los Angeles, California 90067

  Attention:                            David
  L. Ficksman

  Fax Number:                 310-789-1490

  
	
   

  	
   

  	
   

  
	
  If to Purchaser:

  	
   

  	
  St. Cloud Capital
  Partners L.P.

  10866 Wilshire Boulevard, Suite 1450

  Los Angeles, California 90024

  Attention:                            Robert
  Lautz

  Fax Number:                 310-553-0257

  
	
   

  	
   

  	
   

  
	
  With a copy to:

  	
   

  	
  Latham and Watkins, LLP

  633 West Fifth Street, Suite 4000

  Los Angeles, California 90071

  Attention:                            Alex
  Voxman

  Fax Number:                 213-891-8763

  

 

Each
party shall provide written notice to the other party of any change in address.

(g)           Successors and
Assigns. This Amendment shall be binding upon and inure to the benefit of
the parties and their respective successors and assigns. Neither the Company
nor Purchaser shall assign this Amendment or any rights or obligations
hereunder without the prior written consent of the other (which consent shall
not be unreasonably withheld), and in any event any assignee of Purchaser shall
be an accredited investor (as defined in Regulation D), in the written
opinion of counsel who is reasonably satisfactory to Company, and such
assignment shall be in form, substance and scope reasonably satisfactory to the
Company. Notwithstanding anything herein to the contrary, Purchaser may pledge
the Replacement Notes as collateral for a bona fide loan with a third party
lender, and such pledge shall not be considered an assignment in violation of
this Agreement so long as it is made in compliance with all applicable law.

 9
 

 

(h)           No Third Party
Beneficiaries. This Amendment is intended for the benefit of the parties
hereto and their respective permitted successors and assigns, and is not for
the benefit of, nor may any provision hereof be enforced by, any other person.

(i)            Survival. The
representations and warranties of the Company and Purchaser contained in
Sections 2 and 3 and the agreements and covenants set forth in Section 4
shall survive the final Closing of the purchase and sale of the Replacement
Notes purchased and sold hereby.

(j)            Further
Assurance. Each party shall do and perform, or cause to be done and
performed, all such further acts and things, and shall execute and deliver all
such other agreements, certificates, instruments and documents, as the other
party may reasonably request in order to carry out the intent and accomplish
the purposes of this Agreement and the consummation of the transactions
contemplated hereby.

(k)           Remedies. No
provision of this Amendment providing for any specific remedy to a party shall
be construed to limit such party to the specific remedy described, and any
other remedy that would otherwise be available to such party at law or in
equity shall be so available. Nothing in this Agreement shall limit any rights
a party may have with any applicable federal or state securities laws with
respect to the transactions contemplated hereby.

IN
WITNESS WHEREOF, Purchaser and the Company have caused this Third Amendment to
Note Purchase Agreement to be duly executed as of the date first written above.

	
  

  	
  THE COMPANY:

  
	
   

  	
   

  	
   

  	
   

  
	
   

  	
  SMALL WORLD KIDS, INC.

  
	
   

  	
   

  
	
   

  	
  By:

  	
   

  	
   

  
	
   

  	
   

  	
   

  	
  Name:     Debra Fine

  Title:       Chief Executive
  Officer

  
	
   

  	
   

  	
   

  	
   

  
	
   

  	
  PURCHASER:

  
	
   

  	
   

  	
   

  	
   

  
	
   

  	
  ST. CLOUD CAPITAL PARTNERS L.P.

  
	
   

  	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  	
  SCGP, LLC.

  
	
   

  	
  Its:

  	
   

  	
  General Partner 

  
	
   

  	
   

  	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
   

  	
   

  	
  Name:     Robert Lautz
Title:       Senior Managing
  Member

  

 

 10
 

 

 

Schedule 3(g)

Litigation

·                                          The
Company has received a letter from an attorney claiming that Small World Kids
owes $180,000 as a finder’s fee in connection with the acquisition of Small
World Toys which claim is subject to indemnification by Eddy Goldwasser.

·                                          The
Company has been sued by Small Play Inc. in United States District Court for
the Southern District of New Jersey that Small World Kids owes $1,000,000 in
damages from not executing a licensing agreement. The license only contemplated
a $12,000 guaranteed royalty payment so $1,000,000 in alleged damages is
believed excessive.

·                                          The
Company has been sued by Gemini Partners claiming a finder’s fee in connection
with the reverse merger and the financing with St. Cloud.

·                                          The
Company’s former controller has filed a complaint with the US Department of
Labor alleging he was terminated in violation of the Sarbanes-Oxley Act.

 11
 

 

Schedule 3(h)

Pledged Assets

·                                          Credit
Facility between Small World Toys, as Borrower and Laurus Capital Fund as
Lender is secured by all of the assets of Small World Toys.

·                                          1,667
shares of Small World Toys have been pledged to Eddy Goldwasser to secure one
promissory note dated May 20, 2004 to Mr. Goldwasser.

·                                          Promissory
Notes dated July 20, 2005 issued to various holders in the aggregate
principal amount of $500,000.

 12
 

 

Schedule 3(i)

Capitalization Table

Beneficial Ownership

	
   

  	
   

  	
  Shares

  	
   

  	
   

  	
   

  	
  Fully

  Diluted

  	
   

  	
   

  	
   

  
	
   

  	
   

  	
  Outstanding

  	
   

  	
  %

  	
   

  	
  Shares

  	
   

  	
  %

  	
   

  
	
  Russell and
  Debra Fine, as trustees of FFT

  	
   

  	
  1,721,543

  	
   

  	
  31.8

  	
  %

  	
  2,151,825

  	
   

  	
  24.8

  	
  %

  
	
  SWT Investments,
  LLC / Shelly Singal

  	
   

  	
  1,297,673

  	
   

  	
  24.0

  	
  %

  	
  2,056,010

  	
   

  	
  23.7

  	
  %

  
	
  Phoenix Capital
  Opportunity, LLC

  	
   

  	
  754,521

  	
   

  	
  13.9

  	
  %

  	
  1,045,338

  	
   

  	
  12.1

  	
  %

  
	
  David
  Marshall, Inc.

  	
   

  	
  1,078,599

  	
   

  	
  19.9

  	
  %

  	
  1,085,870

  	
   

  	
  12.5

  	
  %

  
	
  Sid Marshall
  Enterprises

  	
   

  	
  206,500

  	
   

  	
  3.8

  	
  %

  	
  210,000

  	
   

  	
  2.4

  	
  %

  
	
  Sid Marshall as
  trustee of Memorial Gift Trust

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  247,194

  	
   

  	
  2.9

  	
  %

  
	
  David L.
  Ficksman and Maxine B. Ficksman, as trustees of the Ficksman Family
  Trust

  	
   

  	
  37,726

  	
   

  	
  0.7

  	
  %

  	
  37,726

  	
   

  	
  0.4

  	
  %

  
	
  Michael Rubin

  	
   

  	
  65,000

  	
   

  	
  1.2

  	
  %

  	
  65,000

  	
   

  	
  0.7

  	
  %

  
	
  Other Holders

  	
   

  	
  97,700

  	
   

  	
  1.8

  	
  %

  	
  97,700

  	
   

  	
  1.1

  	
  %

  
	
  St. Cloud

  	
   

  	
  81,250

  	
   

  	
  1.5

  	
  %

  	
  125,000

  	
   

  	
  1.4

  	
  %

  
	
  Strome

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  134,400

  	
   

  	
  1.5

  	
  %

  
	
  John Nelson

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  70,000

  	
   

  	
  0.8

  	
  %

  
	
  Bob Rankin

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  52,000

  	
   

  	
  0.6

  	
  %

  
	
  Alex Gerstenzang

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  David Swartz

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  Carey Fitchey

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  Gary Adelson

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  Lane Nemeth

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  John Matise

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  4,000

  	
   

  	
  0.0

  	
  %

  
	
  All other
  employees

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  225,000

  	
   

  	
  2.6

  	
  %

  
	
  Consultants

  	
   

  	
  16,000

  	
   

  	
  0.3

  	
  %

  	
  208,000

  	
   

  	
  2.4

  	
  %

  
	
  Conversion of
  $5M Note to Convertible Preferred - Other

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  87,245

  	
   

  	
  1.0

  	
  %

  
	
  $.5 Bridge Note

  	
   

  	
  4,063

  	
   

  	
  0.1

  	
  %

  	
  6,250

  	
   

  	
  0.1

  	
  %

  
	
  Imagiix Purchase

  	
   

  	
  50,000

  	
   

  	
  0.9

  	
  %

  	
  50,000

  	
   

  	
  0.6

  	
  %

  
	
  Bushido Capital
  Partners LTD

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  328,125

  	
   

  	
  3.8

  	
  %

  
	
  Gamma
  Opportunity Partners LP

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  328,125

  	
   

  	
  3.8

  	
  %

  
	
  Cambria Funds -
  warrants

  	
   

  	
   

  	
   

  	
   

  	
   

  	
  37,500

  	
   

  	
  0.4

  	
  %

  
	
  Total Shares

  	
   

  	
  5,410,575

  	
   

  	
  100.0

  	
  %

  	
  8,672,307

  	
   

  	
  100.0

  	
  %

  
	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  	
   

  
	
  Officers &
  Directors

  	
   

  	
  3,100,466

  	
   

  	
  57.3

  	
  %

  	
  4,478,835

  	
   

  	
  51.6

  	
  %

  
	
  Employees

  	
   

  	
  0

  	
   

  	
  0.0

  	
  %

  	
  225,000

  	
   

  	
  2.6

  	
  %

  
	
  Consultants

  	
   

  	
  16,000

  	
   

  	
  0.3

  	
  %

  	
  208,000

  	
   

  	
  2.4

  	
  %

  
	
  Existing
  Investors

  	
   

  	
  2,077,347

  	
   

  	
  38.4

  	
  %

  	
  2,760,527

  	
   

  	
  31.8

  	
  %

  
	
  Public Share
  Investors

  	
   

  	
  162,700

  	
   

  	
  3.0

  	
  %

  	
  162,700

  	
   

  	
  1.9

  	
  %

  
	
  New

  	
   

  	
  54,063

  	
   

  	
  1.0

  	
  %

  	
  837,245

  	
   

  	
  9.7

  	
  %

  
	
  Total

  	
   

  	
  5,410,575

  	
   

  	
  100.0

  	
  %

  	
  8,672,307

  	
   

  	
  100.0

  	
  %

  

 

 

 13

 

EXHIBIT A

PROMISSORY NOTE

THIS
NOTE HAS NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED OR,
IF APPLICABLE, STATE SECURITIES LAWS. THIS NOTE MAY NOT BE SOLD, OFFERED
FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION
STATEMENT AS TO THIS NOTE UNDER SAID ACT OR AN OPINION OF COUNSEL REASONABLY
SATISFACTORY TO SMALL WORLD KIDS, INC. THAT SUCH REGISTRATION IS NOT REQUIRED.

NOTE

FOR
VALUE RECEIVED, Small World Kids, Inc. a Nevada corporation (the “Borrower”)
with principal offices located at 5711 Buckingham Parkway, Culver City,
California 90230, hereby promises to pay to St. Cloud Capital Partners L.P.
(the “Holder”) or order, without demand, the sum of Two Million Two Hundred and
Fifty Thousand Dollars ($2,250,000) with interest at the rate of 10% per annum.
The principal amount of the Note shall be due and payable on the Maturity Date
(as hereinafter defined). Capitalized terms used herein but not otherwise
defined shall have the meaning assigned to those terms in that certain Third
Amendment to Note Purchase Agreement dated as of May 31, 2006, between the
Borrower and the Holder (the “Amendment”).

The
following terms shall apply to this Note:

ARTICLE I

PAYMENT

1.1           Payment. The Borrower shall
make payments of interest hereunder on June 30, 2006 and September 15,
2006. Commencing October 15, 2006 on the 15th day of each month through and including September 15,
2008, the Borrower shall make interest payments. Commencing on October 15,
2008 through September 15, 2011, the Borrower shall make monthly
amortization (principal and interest) payments of Forty Seven Thousand Eight
Hundred and Five Dollars and Eighty-Five Cents ($47,805.85). During the
occurrence and continuation of an Event of Default the interest rate shall be increased
by five (5%) per annum commencing on the date when the Event of Default was
declared by Holder, and the applicable payments shall be increased accordingly.

1.2           Maturity Date. On the Maturity
Date, the entire principal amount and any accrued and unpaid interest shall be
paid to the Holder without offset or deduction of any kind. The Maturity Date
shall be September 15, 2011.

1.3           Prepayment. The Note may be
prepaid in whole or in part. If paid in part, such prepayment shall be applied
against the principal payment due on the Maturity Date.

1.4           Priority. The Note shall be
subordinated to Laurus Master Funds, Ltd., pursuant to that certain
Subordination Agreement dated February 28, 2006 and the Amended and
Restated Subordination Agreement dated as of May 31, 2006.

 A-1
 

 

 

ARTICLE II

CONVERSION RIGHTS

The
Holder shall have the right to convert the principal amount under this Note
into shares of the Borrower’s Common Stock as set forth below.

2.1           Conversion into the Borrower’s
Common Stock.

(a)           The Holder shall have the right from
and after the issuance of this Note and then at any time until this Note is
fully paid, to convert any outstanding and unpaid principal portion of this
Note by delivering to Borrower a Notice of Conversion substantially in the form
of Exhibit A (the date of giving of such notice of conversion being a “Conversion
Date”) into fully paid and nonassessable shares of common stock of Borrower as
such stock exists on the date of issuance of this Note, or any shares of
capital stock of Borrower into which such stock shall hereafter be changed or
reclassified (the “Common Stock”) at the conversion price as defined in Section 2.1(b) hereof
(the “Conversion Price”), determined as provided herein. Upon delivery to the
Company of a Notice of Conversion of the Holder’s written request for
conversion, Borrower shall issue and deliver to the Holder within three
business days from the Conversion Date that number of shares of Common Stock
for the portion of the Note converted in accordance with the foregoing. The
number of shares of Common Stock to be issued upon each conversion of this Note
shall be determined by dividing that portion of the principal of the Note to be
converted, by the Conversion Price.

(b)           Subject to adjustment as provided in Section 2.1(c) hereof,
the Conversion Price per share shall be $4.00.

(c)           The Conversion Price described in Section 2.1(b) above
and the number and kind of shares or other securities to be issued upon
conversion determined pursuant to Section 2.1(a) shall be subject to
adjustment from time to time upon the happening of certain events while this
conversion right remains outstanding, as follows:

A.            Merger, Sale of Assets, etc. If the Borrower at any time
shall consolidate with or merge into or sell or convey all or substantially all
its assets to any other corporation, this Note, as to the unpaid principal
portion thereof, shall thereafter be deemed to evidence the right to purchase
such number and kind of shares or other securities and property as would have
been issuable or distributable on account of such consolidation, merger, sale
or conveyance, upon or with respect to the securities subject to the conversion
or purchase right immediately prior to such consolidation, merger, sale or
conveyance. The foregoing provision shall similarly apply to successive
transactions of a similar nature by any such successor or purchaser. Without
limiting the generality of the foregoing, the anti-dilution provisions of this Section shall
apply to such securities of such successor or purchaser after any such
consolidation, merger, sale or conveyance.

B.            Reclassification, etc. If the Borrower at any time shall,
by reclassification or otherwise, change the Common Stock into the same or a
different number of securities of any class or classes, this Note, as to the
unpaid principal portion thereof, shall thereafter be deemed to evidence the
right to purchase an adjusted number of such securities and kind of securities
as would have been issuable as the result of such change with respect to the
Common Stock immediately prior to such reclassification or other change.

 A-2
 

 

C.            Stock Splits, Combinations and Dividends. If the shares
of Common Stock are subdivided or combined into a greater or smaller number of
shares of Common Stock, or if a dividend is paid on the Common Stock in shares
of Common Stock, the Conversion Price shall be proportionately reduced in case
of subdivision of shares or stock dividend or proportionately increased in the
case of combination of shares, in each such case by the ratio which the total
number of shares of Common Stock outstanding immediately after such event bears
to the total number of shares of Common Stock outstanding immediately prior to
such event.

D.            Borrower will reserve from its authorized and unissued
Common Stock a sufficient number of shares to provide for the issuance of
Common Stock upon the full conversion of this Note. Borrower represents that
upon issuance, such shares will be duly and validly issued, fully paid and
non-assessable. Borrower agrees that its issuance of this Note shall constitute
full authority to its officers, agents, and transfer agents who are charged
with the duty of executing and issuing stock certificates to execute and issue
the necessary certificates for shares of Common Stock upon the conversion of
this Note.

2.2           Method of Conversion. This
Note may be converted by the Holder in whole or in part as described in Section 2.1(a) hereof.
Upon partial conversion of this Note, a new Note containing the same date and
provisions of this Note shall, at the request of the Holder, be issued by the
Borrower to the Holder for the principal balance of this Note which shall not
have been converted or paid.

ARTICLE III

EVENTS OF DEFAULT

3.1           Events of Default. The
occurrence of any of the following events of default (“Event of Default”)
shall, at the option of the Holder hereof, make the principal balance then
remaining unpaid hereon and all other amounts payable hereunder immediately due
and payable:

(a)           Failure to Pay Principal and/or
Interest. The Borrower fails to pay any installment of principal or
interest hereon when due and such failure continues for a period of ten (10) days
after the due date.

(b)           Breach of Covenant. The
Borrower breaches any material covenant or other term or condition of this Note
or the Amendment in any material respect and such breach, if subject to cure,
continues for a period of thirty (30) days after written notice to the Borrower
from the Holder.

(c)           Breach of Representations and
Warranties. Any material representation or warranty of the Borrower made
herein or in any Transaction Document shall be false or misleading in any
material respect.

(d)           Receiver or Trustee. The
Borrower shall make an assignment for the benefit of creditors, or apply for or
consent to the appointment of a receiver or trustee for it or for a substantial
part of its property or business; or such a receiver or trustee shall otherwise
be appointed.

 A-3
 

 

(e)           Judgments. Any money judgment,
writ or similar final process, shall be entered or filed against Borrower or
any of its property or other assets for more than $500,000, and shall remain
unvacated, unbonded or unstayed for a period of forty-five (45) days.

(f)            Bankruptcy. Bankruptcy,
insolvency, reorganization or liquidation proceedings or other proceedings or
relief under any bankruptcy law or any law for the relief of debtors shall be
instituted by for against the Borrower and if instituted against Borrower are
not dismissed within 60 days of initiation.

3.2           Enforcement. Upon the
occurrence of any Event of Default, the Holder may thereupon proceed to protect
and enforce its rights either by suit in equity and/or by action at law or by
other appropriate proceedings whether for the specific performance (to the
extent permitted by law) of any covenant or agreement contained in this Note or
in aid of the exercise of any power granted in this Note, and proceed to
enforce the payment of this Note held by it, and to enforce any other legal or
equitable right of the Holder.

ARTICLE IV

MISCELLANEOUS

4.1           Failure or Indulgence Not Waiver.
No failure or delay on the part of Holder hereof in the exercise of any power,
right or privilege hereunder shall operate as a waiver thereof, nor shall any
single or partial exercise of any such power, right or privilege preclude other
or further exercise thereof or of any other right, power or privilege. All
rights and remedies existing hereunder are cumulative to, and not exclusive of,
any rights or remedies otherwise available.

4.2           Notices. Any notice herein
required or permitted to be given shall be in writing and may be personally
served or sent by fax transmission (with copy sent by certified or registered
mail or by overnight courier). For the purposes hereof, the address and fax
number of the Holder is set forth on the signature page hereto. The
address and fax number of the Borrower is 5711 Bunkingham Parkway, Culver City,
California 90230, facsimile (310) 258-1194. Both Holder and Borrower
may change the address and fax number for service by service of notice to the
other as herein provided.

4.3           Amendment Provision. The term “Note”
and all reference thereto, as used throughout this instrument, shall mean this
instrument as originally executed, or if later amended or supplemented, then as
so amended or supplemented.

4.4           Assignability. This Note shall
be binding upon the Borrower and its successors and assigns, and shall inure to
the benefit of the Holder and its successors and assigns, and may be assigned
by the Holder.

4.5           Cost of Collection. If default
is made in the payment of this Note, Borrower shall pay the Holder hereof
reasonable costs of collection, including reasonable attorneys’ fees.

4.6           Maximum Payments. Nothing
contained herein shall be deemed to establish or require the payment of a rate
of interest or other charges in excess of the maximum permitted by applicable
law. In the event that the rate of interest required to be paid or other
charges hereunder exceed the maximum permitted by such law, any payments in
excess of such 

 A-4
 

 

maximum shall be credited against amounts owed by the Borrower to the
Holder and thus refunded to the Borrower.

4.7           Governing Law and Venue. This
Note shall be governed by and interpreted in accordance with the laws of the
State of California without regard to the principles of conflict of laws. In
the event of any litigation regarding the interpretation or application of this
Note, the parties irrevocably consent to jurisdiction in any of the state or
federal courts located in the City of Los Angeles, State of California and
waive their rights to object to venue in any such court, regardless of the
convenience or inconvenience thereof to any party. Service of process in any
civil action relating to or arising out of this Agreement or the transaction(s) contemplated
herein may be accomplished in any manner provided by law. The parties hereto
agree that a final, non-appealable judgment in any such suit or proceeding
shall be conclusive and may be enforced in other jurisdictions by suit on such
judgment or in any other lawful manner.

4.8           Replacement. This Note
together with that certain promissory note to Holder dated the date hereof in
the principal amount of $200,000 replace that certain Promissory Note to Holder
dated November 9, 2005.

IN
WITNESS WHEREOF, Borrower has caused this Note to be signed in its name by its
President on this 31st day of May 2006.

 

	
  

  	
  SMALL WORLD KIDS, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
  By: 

  	
   

  
	
   

  	
   

  	
  Name:Debra Fine

  Title:President

  

 

 

 A-5

 

EXHIBIT B

PROMISSORY NOTE

NOTE

FOR
VALUE RECEIVED, Small World Kids, Inc. a Nevada corporation (the “Borrower”)
with principal offices located at 5711 Buckingham Parkway, Culver City,
California 90230, hereby promises to pay to St. Cloud Capital Partners L.P.
(the “Holder”) or order, without demand, the sum of Two Hundred Thousand
Dollars ($200,000) with interest at the rate of 10% per annum. The principal
amount of the Note shall be due and payable on the Maturity Date (as
hereinafter defined). Capitalized terms used herein but not otherwise defined
shall have the meaning assigned to those terms in that certain Third Amendment
to Note Purchase Agreement dated as of May 31, 2006, between the Borrower
and the Holder (the “Amendment”).

The
following terms shall apply to this Note:

ARTICLE I

PAYMENT

1.1           Payment. Commencing June 30,
2006, the Borrower shall make monthly amortization payments (principal and
interest) of Seventeen Thousand Five Hundred and Eighty Three Dollars and
Eighteen Cents ($17,583.18).

1.2           Maturity Date. On the Maturity
Date, the entire principal amount and any accrued and unpaid interest shall be
paid to the Holder without offset or deduction of any kind. The Maturity Date
shall be May 31, 2007.

1.3           Prepayment. The Note may be
prepaid in whole or in part. If paid in part, such prepayment shall be applied
to the principal payment due on the Maturity Date.

1.4           Priority. The Note shall be
subordinated to Laurus Master Funds, Ltd., pursuant to that certain
Subordination Agreement dated February 28, 2006 and the Amended and
Restated Subordination Agreement dated as of May 31, 2006.

ARTICLE II

EVENTS OF DEFAULT

2.1           Events of Default. The
occurrence of any of the following events of default (“Event of Default”)
shall, at the option of the Holder hereof, make the principal balance then
remaining unpaid hereon and all other amounts payable hereunder immediately due
and payable:

(a)           Failure to Pay Principal and/or
Interest. The Borrower fails to pay any installment of interest hereon when
due and such failure continues for a period of ten (10) days after
the due date.

 B-1
 

 

(b)           Breach of Covenant. The
Borrower breaches any material covenant or other term or condition of this Note
or the Amendment in any material respect and such breach, if subject to cure,
continues for a period of thirty (30) days after written notice to the Borrower
from the Holder.

(c)           Breach of Representations and
Warranties. Any material representation or warranty of the Borrower made
herein or in any Transaction Document shall be false or misleading in any
material respect.

(d)           Receiver or Trustee. The
Borrower shall make an assignment for the benefit of creditors, or apply for or
consent to the appointment of a receiver or trustee for it or for a substantial
part of its property or business; or such a receiver or trustee shall otherwise
be appointed.

(e)           Judgments. Any money judgment,
writ or similar final process, shall be entered or filed against Borrower or
any of its property or other assets for more than $500,000, and shall remain
unvacated, unbonded or unstayed for a period of forty-five (45) days.

(f)            Bankruptcy. Bankruptcy,
insolvency, reorganization or liquidation proceedings or other proceedings for
relief under any bankruptcy law or any law for the relief of debtors shall be
instituted by or against the Borrower and if instituted against Borrower are
not dismissed within 60 days of initiation.

2.2           Enforcement. Upon the
occurrence of any Event of Default, the Holder may thereupon proceed to protect
and enforce its rights either by suit in equity and/or by action at law or by
other appropriate proceedings whether for the specific performance (to the
extent permitted by law) of any covenant or agreement contained in this Note or
in aid of the exercise of any power granted in this Note, and proceed to
enforce the payment of this Note held by it, and to enforce any other legal or
equitable right of the Holder.

ARTICLE III

MISCELLANEOUS

3.1           Failure or Indulgence Not Waiver.
No failure or delay on the part of Holder hereof in the exercise of any power,
right or privilege hereunder shall operate as a waiver thereof, nor shall any
single or partial exercise of any such power, right or privilege preclude other
or further exercise thereof or of any other right, power or privilege. All
rights and remedies existing hereunder are cumulative to, and not exclusive of,
any rights or remedies otherwise available.

3.2           Notices. Any notice herein
required or permitted to be given shall be in writing and may be personally
served or sent by fax transmission (with copy sent by certified or registered
mail or by overnight courier). For the purposes hereof, the address and fax
number of the Holder is set forth on the signature page hereto. The
address and fax number of the Borrower is 5711 Buckingham Parkway, Culver City,
California 90230, facsimile (310) 258-1194. Both Holder and Borrower
may change the address and fax number for service by service of notice to the
other as herein provided.

 B-2
 

 

 

3.3           Amendment Provision. The term “Note”
and all reference thereto, as used throughout this instrument, shall mean this
instrument as originally executed, or if later amended or supplemented, then as
so amended or supplemented.

3.4           Assignability. This Note shall
be binding upon the Borrower and its successors and assigns, and shall inure to
the benefit of the Holder and its successors and assigns, and may be assigned
by the Holder.

3.5           Cost of Collection. If default
is made in the payment of this Note, Borrower shall pay the Holder hereof
reasonable costs of collection, including reasonable attorneys’ fees.

3.6           Maximum Payments. Nothing
contained herein shall be deemed to establish or require the payment of a rate
of interest or other charges in excess of the maximum permitted by applicable
law. In the event that the rate of interest required to be paid or other
charges hereunder exceed the maximum permitted by such law, any payments in
excess of such maximum shall be credited against amounts owed by the Borrower
to the Holder and thus refunded to the Borrower.

3.7           Governing Law and Venue. This
Note shall be governed by and interpreted in accordance with the laws of the
State of California without regard to the principles of conflict of laws. In
the event of any litigation regarding the interpretation or application of this
Note, the parties irrevocably consent to jurisdiction in any of the state or
federal courts located in the City of Los Angeles, State of California and
waive their rights to object to venue in any such court, regardless of the
convenience or inconvenience thereof to any party. Service of process in any
civil action relating to or arising out of this Agreement or the transaction(s) contemplated
herein may be accomplished in any manner provided by law. The parties hereto
agree that a final, non-appealable judgment in any such suit or proceeding
shall be conclusive and may be enforced in other jurisdictions by suit on such
judgment or in any other lawful manner.

3.8           Replacement. This Note
together with that certain promissory note to Holder dated the date hereof in
the principal amount of $2,250,000 replace that certain Promissory Note to
Holder dated November 9, 2005.

IN
WITNESS WHEREOF, Borrower has caused this Note to be signed in its name by its
President on this 31st day of May 2006.

 

	
  

  	
  SMALL WORLD KIDS, INC.

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
  By:

  	
   

  
	
   

  	
   

  	
  Name:   Debra Fine

  Title:   President

  

 

 B-3

 

EXHIBIT C

COMMERCIAL SECURITY
AGREEMENT

	
  Borrower/Grantor:

  	
   

  	
  Lender:

  
	
   

  	
   

  	
   

  
	
  SMALL WORLD KIDS, INC.

  5711 Buckingham Parkway

  Culver City, CA 90230

  	
   

  	
  ST. CLOUD CAPITAL PARTNERS, L.P.

  10866 Wilshire Blvd., Suite 1450

  Los Angeles, CA 90024

  

 

THIS
COMMERCIAL SECURITY AGREEMENT is entered into between SMALL WORLD KIDS, INC., a
Nevada corporation (referred to below as “Grantor”); and ST. CLOUD CAPITAL
PARTNERS, L.P., a federally licensed Small Business Investment Company
(referred to below as “Lender”). For valuable consideration, Grantor grants to
Lender a security interest in the Collateral to secure the Indebtedness and
agrees that Lender shall have the rights stated in this Agreement with respect
to the Collateral, in addition to all other rights which Lender may have by
law.

1.             DEFINITIONS. The
following words shall have the following meanings when used in this Agreement. Terms
not otherwise defined in this Agreement shall have the meanings attributed to
such terms in that certain Business Loan Agreement entered into on even date
herewith by and between Borrower and Lender or as otherwise may be set forth
under the California Uniform Commercial Code, as defined herein. All references
to dollar amounts shall mean amounts in lawful money of the United States of
America.

1.1           Agreement.
The word “Agreement” means this Commercial Security Agreement, as
this Commercial Security Agreement may be amended or modified from time to
time, together with all exhibits and schedules attached to this Commercial
Security Agreement from time to time.

1.2           Collateral.
The word “Collateral” means the following described property of
Grantor, whether now owned or hereafter acquired, whether now existing or
hereafter arising, and wherever located:

All
inventory, equipment, accounts (including but not limited to all health-care-insurance
receivables), chattel paper, instruments (including but not limited to all
promissory notes), letter-of-credit rights, letters of credit,
documents, deposit accounts, investment property, money, other rights to
payment and performance, and general intangibles (including but not limited to
all software and all payment intangibles); all oil, gas and other minerals
before extraction; all oil, gas, other minerals and accounts constituting as-extracted
collateral; all fixtures; all timber to be cut; all attachments, accessions,
accessories, fittings, increases, tools, parts, repairs, supplies, and
commingled goods relating to the 

 C-1
 

 

foregoing
property, and all additions, replacements of, 
and substitutions for all or any part of the foregoing property; all
insurance refunds relating to the foregoing property; all good will relating to
the foregoing property; all records and data and embedded software relating to
the foregoing property, and all equipment, inventory and software to utilize,
create, maintain and process any such records and data on electronic media; and
all supporting obligations relating to the foregoing property; all whether now
existing or hereafter arising, whether now owned or hereafter acquired or
whether now or hereafter subject to any rights in the foregoing property; and
all products and proceeds (including but not limited to all insurance payments)
of or relating to the foregoing property.

In
addition, the word “Collateral” includes all the following, whether now owned
or hereafter acquired, whether now existing or hereafter arising, and wherever
located:

(a)           All attachments, accessions,
accessories, tools, parts, supplies, increases, and additions to and all
replacements of and substitutions for any property described above.

(b)           All products and produce of any of
the property described in this Collateral section.

(c)           All accounts, general intangibles,
instruments, rents, monies, payments, and all other rights, arising out of a
sale, lease, or other disposition of any of the property described in this
Collateral section.

(d)           All proceeds (including, without
limitation, insurance proceeds) from the sale, destruction, loss, or other
disposition of any of the property described in this Collateral section.

(e)           All records and data relating to any
of the property described in this Collateral section, whether in the form of a
writing, photograph, microfilm, microfiche, or electronic media, together with
all of Grantor’s right, title, and interest in and to all computer software
required to utilize, create, maintain, and process any such records or data on
electronic media.

The
Collateral and fixtures are located on the following described real
estate:  5711
Buckingham Parkway, Culver City,
CA  90230.

1.3           Event
of Default. The words “Event of Default” mean and include without
limitation any of the Events of Default set forth below in the section titled “Events
of Default.”

1.4           Grantor.
The word “Grantor” means SMALL WORLD KIDS, INC.,
its successors and assigns.

1.5           Indebtedness.
The word “Indebtedness” means the indebtedness and obligations of
performance evidenced by the Note, including all principal and interest,
together with all other indebtedness, obligations of performance, and costs,
fees and expenses for which Borrower or any Grantor is responsible under this
Agreement or under any of the Related 

 C-2
 

 

Documents. In addition, the word “Indebtedness” includes all other
obligations, debts and liabilities, plus interest thereon, of Grantor, or any
one or more of them, to Lender, as well as all claims by Lender against
Grantor, or any one or more of them, whether existing now or later; whether
they are voluntary or involuntary, due or not due, direct or indirect, absolute
or contingent, liquidated or unliquidated; whether Grantor may be liable
individually or jointly with others; whether Grantor may be obligated as
guarantor, surety, accommodation party or otherwise; whether recovery upon such
indebtedness may be or hereafter may become barred by any statute of
limitations; and whether such indebtedness may be or hereafter may become
otherwise unenforceable.

1.6           Lender.
The word “Lender” means ST. CLOUD
CAPITAL PARTNERS, L.P., its respective successors and assigns.

1.7           Note.
The word “Note means the Replacement Notes executed by Borrower
dated May __, 2006, in favor of ST. CLOUD CAPITAL PARTNERS, LP, in the
principal amounts of Two Million Dollars Two Hundred Fifty Thousand Dollars
($2,250,000.00) and Two Hundred Thousand Dollars ($200,000.00) as well as any
other promissory notes executed in connection with this Agreement, together
with all renewals of, extensions of, modifications of, refinancings of,
consolidations of, and substitutions for the notes or credit agreements.

1.8           Related
Documents. The words “Related Documents” mean and include without
limitation all promissory notes, credit agreements, loan agreements, royalty
agreements, warrant agreements, environmental agreements, guaranties, security
agreements, mortgages, deeds of trust, and all other instruments, agreements
and documents, whether now or hereafter existing, executed in connection with
the Indebtedness, together with all renewals of, extensions of, modifications
of, refinancings of, consolidations of, and substitutions thereof.

2.             OBLIGATIONS OF GRANTOR.
Grantor warrants and covenants to Lender as follows:

2.1           Perfection
of Security Interest. Grantor agrees to execute such
financing statements and to take whatever other actions are reasonably
requested by Lender to perfect and continue Lender’s security interest in the
Collateral. Upon request of Lender, Grantor will deliver to Lender any and all
of the documents evidencing or constituting the Collateral, and Grantor will
note Lender’s interest upon any and all chattel paper if not delivered to
Lender for possession by Lender. Grantor hereby appoints Lender as its
irrevocable attorney-in-fact for the purpose of executing any
documents necessary to perfect or to continue the security interest granted in
this Agreement. Lender may at any time, and without further authorization from
Grantor, file a carbon, photographic or other reproduction of any financing
statement or of this Agreement for use as a financing statement. Grantor will
reimburse Lender for all expenses for the perfection and the continuation of
the perfection of Lender’s security interest in the Collateral. Grantor
promptly will notify Lender before any change in Grantor’s name including any
change to the assumed business names of Grantor.

 

 C-3

 

2.2           No
Violation. The execution and delivery of this Agreement will not
violate any law or agreement governing Grantor or to which Grantor is a party,
and its charter documents do not prohibit any term or condition of this
Agreement.

2.3           Enforceability
of Collateral. To the extent the Collateral consists of accounts,
chattel paper, or general intangibles, the Collateral is enforceable in
accordance with its terms, is genuine, and complies with applicable laws
concerning form, content and manner of preparation and execution, and all
persons appearing to be obligated on the Collateral have authority and capacity
to contract and are in fact obligated as they appear to be on the Collateral. At
the time any account becomes subject to a security interest in favor of Lender,
the account shall be a good and valid account representing an undisputed, bona
fide indebtedness incurred by the account debtor, for merchandise held subject
to delivery instructions or theretofore shipped or delivered pursuant to a
contract of sale, or for services theretofore performed by Grantor with or for
the account debtor; there shall be no setoffs or counterclaims against any such
account; and no agreement under which any deductions or discounts may be
claimed shall have been made with the account debtor except those disclosed to
Lender in writing.

2.4           Removal
of Collateral. Grantor shall keep the Collateral (or to the extent
the Collateral consists of intangible property such as accounts, the records
concerning the Collateral) at Grantor’s address shown above, or at such other
locations as are acceptable to Lender. Some or all of the Collateral may be
located at the real property described above. Except in the ordinary course of
its business, including the sales of inventory, Grantor shall not remove the
Collateral from its existing locations without the prior written consent of
Lender. To the extent that the Collateral consists of vehicles, or other titled
property, Grantor shall not take or permit any action which would require
application for certificates of title for the vehicles outside the State of
California, without the prior written consent of Lender.

2.5           Transactions
Involving Collateral. Except for inventory sold or accounts
collected in the ordinary course of Grantor’s business, Grantor shall not sell,
offer to sell, or otherwise transfer or dispose of the Collateral, except in
the ordinary course of Grantor’s business. Grantor shall not pledge, mortgage,
encumber, or otherwise permit the Collateral to be subject to any lien, security
interest, encumbrance, or charge, other than the security interest provided for
in this Agreement, without the prior written consent of Lender. This includes
security interests even if junior in right to the security interests granted
under this Agreement. Unless waived by Lender, all proceeds from any
disposition of the Collateral (for whatever reason) shall be held in trust for
Lender and shall not be commingled with any other funds; provided however, this
requirement shall not constitute consent by Lender to any sale or other
disposition. Upon receipt, Grantor shall immediately deliver any such proceeds
to Lender.

2.6           Title.
Grantor represents and warrants to Lender that it holds good and marketable
title to the Collateral, free and clear of all liens and encumbrances except
for the lien of this Agreement and a lien granted to Laurus Master Funds, Ltd. No
financing statement covering any of the Collateral is on file in any public
office other than those which reflect the security interest created by this
Agreement or to which Lender has specifically consented. Grantor shall defend
Lender’s rights in the Collateral against the claims and demands of all other
persons.

 C-4
 

 

2.7           Collateral
Schedules and Locations. As often as Lender shall require, and
insofar as the Collateral consists of accounts and general intangibles, Grantor
shall deliver to Lender schedules of such Collateral, including such
information as Lender may require, including without limitation names and
addresses of account debtors and agings of accounts and general intangibles. Insofar
as the Collateral consists of equipment, Grantor shall deliver to Lender, as
often as Lender shall require, such lists, descriptions, and designations of
such Collateral as Lender may require to identify the nature, extent, and
location of such Collateral. Such information shall be submitted for Grantor
and each of its subsidiaries or related companies.

2.8           Maintenance
and Inspection of Collateral. Grantor shall maintain all tangible
Collateral in good condition and repair. Grantor will not commit or permit
damage to or destruction of the Collateral or any part of the Collateral. Lender
and its designated representatives and agents shall have the right at all
reasonable times to examine, inspect, and audit the Collateral wherever located.
Grantor shall immediately notify Lender of all cases involving the return,
rejection, repossession, loss or damage of or to any Collateral in excess of a
single occurrence in the sum of $20,000.00; of any other dispute arising with
respect to the Collateral; and generally of all happenings and events
materially affecting the Collateral or the value or the amount of the
Collateral.

2.9           Taxes,
Assessments and Liens. Grantor will pay when due, subject to
allowable extensions, all taxes, assessments and liens upon the Collateral, its
use or operation, upon this Agreement, upon any promissory note or notes
evidencing the Indebtedness, or upon any of the other Related Documents. Grantor
may withhold any such payment or may elect to contest any lien, upon written
notice to Lender, if Grantor is in good faith conducting an appropriate
proceeding to contest the obligation to pay and so long as Lender’s interest in
the Collateral is not jeopardized in Lender’s sole opinion. If the Collateral
is subjected to a lien which is not discharged within fifteen (15) days,
Grantor shall deposit with Lender cash, a sufficient corporate surety bond or
other security satisfactory to Lender in an amount adequate to provide for the
discharge of the lien plus any interest, costs, attorneys’ fees or other
charges that could accrue as a result of foreclosure or sale of the Collateral.
In any contest Grantor shall defend itself and Lender and shall satisfy any
final adverse judgment before enforcement against the Collateral. Grantor shall
name Lender as an additional obligee under any surety bond furnished in the
contest proceedings.

2.10         Compliance
With Governmental Requirements. Grantor shall comply promptly with
all laws, ordinances, rules and regulations of all governmental
authorities, including without limitation all environmental laws, ordinances, rules and
regulations, now or hereafter in effect, applicable to the ownership,
production, disposition, or use of the Collateral. Grantor may contest in good
faith any such law, ordinance or regulation and withhold compliance during any
proceeding, including appropriate appeals, so long as Lender’s interest in the
Collateral, in Lender’s opinion, is not jeopardized.

2.11         Hazardous
Substances.   Except as
disclosed to and acknowledged by Lender in writing or as set forth in the
Purchase Agreement (as that term is defined in the Business Loan Agreement,
Grantor represents and warrants that:  (1) During
the period of Grantor’s ownership of the Collateral, there has been no use,
generation, manufacture, storage, 

 C-5
 

 

treatment, disposal, release or threatened release of any Hazardous
Substance (as defined in the Business Loan Agreement of even date herewith) by
any person on, under, about or from any of the Collateral. (2) Grantor has
no knowledge of, or reason to believe that there has been (a) any
breach or violation of any Environmental Laws (as defined in the Business Loan
Agreement of even date herewith); (b) any use, generation,
manufacture, storage, treatment, disposal, release or threatened release of any
Hazardous Substance on, under, about or from the Collateral by any prior owners
or occupants of any of the Collateral; or (c) any actual or
threatened litigation or claims of any kind by any person relating to such matters.
(3) Neither Grantor nor any tenant, contractor, agent, or other authorized
user of any of the Collateral shall use, generate, manufacture, store, treat,
dispose of or release any Hazardous Substance on, under, about or from any of
the Collateral; and any such activity shall be conducted in compliance with all
applicable federal, state, and local laws, regulations, and ordinances,
including without limitation all Environmental Laws. Grantor authorizes Lender
and its agents to enter upon the Collateral to make such inspections and tests
as Lender may deem appropriate to determine compliance of the Collateral with
this section of the Agreement. Any inspections or tests shall be at Grantor’s
expense and for Lender’s purposes only and shall not be construed to create any
responsibility or liability on the part of Lender to Grantor or to any other
person. Any such inspections or tests shall not unreasonably interfere with
Grantor’s business. The representations and warranties contained herein are
based on Grantor’s due diligence in investigating the Collateral for hazardous
waste and Hazardous Substances. Grantor hereby (1) releases and waives any
future claims against Lender for indemnity or contribution in the event Grantor
becomes liable for cleanup or other costs under any such laws, and (2) agrees
to indemnify and hold harmless Lender against any and all claims, losses,
liabilities, damages, penalties, and expenses (including attorneys fees
incurred before trial, at trial, on appeal or in any bankruptcy or arbitration
proceeding) which Lender may directly or indirectly sustain or suffer resulting
from a breach of this section of the Agreement or as a consequence of any use,
generation, manufacture, storage, disposal, release or threatened release of a
hazardous waste or a Hazardous Substance on the Collateral. The provisions of
this section of the Agreement, including the obligation to indemnify, shall
survive the payment of the Indebtedness and the termination, expiration or
satisfaction of this Agreement and shall not be affected by Lender’s
acquisition of any interest in any of the Collateral, whether by foreclosure or
otherwise.

2.12         Maintenance
of Casualty Insurance. Grantor shall procure and maintain all risks
insurance, including without limitation fire, theft and liability coverage
together with such other insurance as Lender may require with respect to the
Collateral, in form, amounts, coverages and basis reasonably acceptable to
Lender and issued by a company or companies acceptable to Lender. Grantor, upon
request of Lender, will deliver to Lender from time to time the policies or
certificates of insurance in form satisfactory to Lender, including
stipulations that coverages will not be cancelled or diminished without at
least thirty (30) days’ prior written notice to Lender and not including any
disclaimer of the insurer’s liability for failure to give such a notice. Each
insurance policy also shall include an endorsement providing that coverage in
favor of Lender will not be impaired in any way by any act, omission or default
of Grantor or any other person. In connection with all policies covering assets
in which Lender holds or is offered a security interest, Grantor will provide
Lender with such loss payable or other endorsements as Lender may require. If
Grantor at any time fails to obtain or maintain any insurance as required under
this Agreement, Lender may (but shall not be obligated to) obtain 

 C-6
 

 

such insurance as Lender deems appropriate, including if it so chooses “single
interest insurance,” which will cover only Lender’s interest in the Collateral.

2.13         Application
of Insurance Proceeds. Grantor shall promptly notify Lender of any
loss or damage to the Collateral. Lender may make proof of loss if Grantor
fails to do so within fifteen (15) days of the casualty. All proceeds of any
insurance on the Collateral, including accrued proceeds thereon, shall be held
by Lender as part of the Collateral. If Lender consents to repair or
replacement of the damaged or destroyed Collateral, Lender shall, upon
satisfactory proof of expenditure,  pay
or reimburse Grantor from the proceeds for the reasonable cost of repair or
restoration. If Lender does not consent to repair or replacement of the
Collateral, Lender shall retain a sufficient amount of the proceeds to pay all
of the Indebtedness, and shall pay the balance to Grantor. Any proceeds which
have not been disbursed within six (6) months after their receipt and
which Grantor has not committed to the repair or restoration of the Collateral
shall be used to prepay the Indebtedness.

2.14         Insurance
Reserves. Lender may require Grantor to maintain with Lender
reserves for payment of insurance premiums, which reserves shall be created by
monthly payments from Grantor of a sum estimated by Lender to be sufficient to
produce, at least fifteen (15) days before the premium due date, amounts at
least equal to the insurance premiums to be paid. If fifteen (15) days before
payment is due, the reserve funds are insufficient, Grantor shall upon demand
pay any deficiency to Lender. The reserve funds shall be held by Lender as a
general deposit and shall constitute a non-interest-bearing account
which Lender may satisfy by payment of the insurance premiums required to be
paid by Grantor as they become due. Lender does not hold the reserve funds in
trust for Grantor, and Lender is not the agent of Grantor for payment of the
insurance premiums required to be paid by Grantor. The responsibility for the
payment of premiums shall remain Grantor’s sole responsibility.

2.15         Insurance
Reports. Grantor, upon request of Lender, shall furnish to Lender
reports on each existing policy of insurance showing such information as Lender
may reasonably request including the following: 
(a) the name of the insurer; (b) the risks insured; (c) the
amount of the policy; (d) the property insured; (e) the then current
value on the basis of which insurance has been obtained and the manner of
determining that value; and (f) the expiration date of the policy. In
addition, Grantor shall upon request by Lender have an independent appraiser
satisfactory to Lender determine, as applicable, the cash value or replacement
cost of the Collateral.

3.             GRANTOR’S RIGHT TO
POSSESSION AND TO COLLECT ACCOUNTS. Until default and except as
otherwise provided below with respect to accounts, Grantor may have possession
of the tangible personal property and beneficial use of all the Collateral and
may use it in any lawful manner not inconsistent with this Agreement or the
Related Documents, provided that Grantor’s right to possession and beneficial
use shall not apply to any Collateral where possession of the Collateral by
Lender is required by law to perfect Lender’s security interest in such
Collateral. Until otherwise notified by Lender, Grantor may collect any of the
Collateral consisting of accounts. At any time an Event of Default exists,
Lender may exercise its rights to collect the accounts and to notify account
debtors to make payments directly to Lender for application to the
Indebtedness. If Lender at any time has possession of any Collateral, whether
before or after an Event of Default, Lender shall be 

 C-7
 

 

deemed to have exercised reasonable care in the custody and
preservation of the Collateral if Lender takes such action for that purpose as
Grantor shall request or as Lender, in Lender’s sole discretion, shall deem
appropriate under the circumstances, but failure to honor any request by
Grantor shall not of itself be deemed to be a failure to exercise reasonable
care. Lender shall not be required to take any steps necessary to preserve any
rights in the Collateral against prior parties, nor to protect, preserve, or
maintain any security interest given to secure the Indebtedness.

4.             EXPENDITURES BY LENDER.
If not discharged or paid when due, Lender may (but shall not be
obligated to) discharge or pay any amounts required to be discharged or paid by
Grantor under this Agreement, including without limitation all taxes, liens,
security interests, encumbrances, and other claims, at any time levied or
placed on the Collateral. Lender also may (but shall not be obligated to) pay
all costs for insuring, maintaining and preserving the Collateral. All such
expenditures incurred or paid by Lender for such purposes will then bear
interest at the default interest rate charged under the Note from the date
incurred or paid by Lender to the date of repayment by Grantor. All such
expenses shall become a part of the Indebtedness and, at Lender’s option,
will  (a) be payable on demand,  (b) be added to the balance of the Note
and be apportioned among and be payable with any installment payments to become
due during either  (i) the term of
any applicable insurance policy or  (ii) the
remaining term of the Note, or  (c) be
treated as a balloon payment which will be due and payable at the Note’s
maturity. This Agreement also will secure payment of these amounts. Such right
shall be in addition to all other rights and remedies to which Lender may be
entitled upon the occurrence of an Event of Default.

5.             EVENTS OF DEFAULT. The
occurrence of any of the following events of default (“Event of Default”)
shall, at the option of the Holder hereof, make the principal balance then
remaining unpaid hereon and all other amounts payable hereunder immediately due
and payable:

5.1           Failure to Pay Principal
and/or Interest. The Borrower fails to pay any installment of
interest hereon when due and such failure continues for a period of ten (10) days
after the due date.

5.2           Breach of Covenant. The
Borrower breaches any material covenant or other term or condition of this Note
or the Amendment in any material respect and such breach, if subject to cure,
continues for a period of thirty (30) days after written notice to the Borrower
from the Holder.

5.3           Breach of Representations
and Warranties. Any material representation or warranty of the
Borrower made herein in any Transactional Document shall be false or misleading
in any material respect.

5.4           Receiver or Trustee. The
Borrower shall make an assignment for the benefit of creditors, or apply for or
consent to the appointment of a receiver or trustee for it or for a substantial
part of its property or business; or such a receiver or trustee shall otherwise
be appointed.

 

 C-8

 

5.5           Judgments. Any
money judgment, writ or similar final process, shall be entered or filed
against Borrower or any of its property or other assets for more than $500,000,
and shall remain unvacated, unbonded or unstayed for a period of forty-five
(45) days.

5.6           Bankruptcy. Bankruptcy,
insolvency, reorganization or liquidation proceedings or other proceedings or
relief under any bankruptcy law or any law for the relief of debtors shall be
instituted by or against the Borrower and if instituted against Borrower are
not dismissed within 60 days of initiation.

6.             RIGHTS AND REMEDIES ON
DEFAULT. If an Event of Default occurs under this Agreement, and at
any time thereafter, Lender shall have all the rights of a secured party under
the California Uniform Commercial Code. In addition and without limitation,
Lender may exercise any one or more of the following rights and remedies:

6.1           Accelerate
Indebtedness. Lender may declare the entire Indebtedness, including
any prepayment penalty which Grantor would be required to pay, immediately due
and payable, without notice.

6.2           Assemble
Collateral. Lender may require Grantor to deliver to Lender all or
any portion of the Collateral and any and all certificates of title and other
documents relating to the Collateral. Lender may require Grantor to assemble
the Collateral and make it available to Lender at a place to be designated by
Lender. Lender also shall have full power to enter upon the property of Grantor
to take possession of and remove the Collateral. If the Collateral contains
other goods not covered by this Agreement at the time of repossession, Grantor
agrees Lender may take such other goods, provided that Lender makes reasonable
efforts to return them to Grantor after repossession.

6.3           Sell
the Collateral. Lender shall have full power to sell, lease,
transfer, or otherwise deal with the Collateral or proceeds thereof in its own
name or that of Grantor. Lender may sell the Collateral at public auction or
private sale. Unless the Collateral threatens to decline speedily in value or
is of a type customarily sold on a recognized market, Lender will give Grantor
reasonable notice of the time after which any private sale or any other
intended disposition of the Collateral is to be made. The requirements of
reasonable notice shall be met if such notice is given at least ten (10) days,
or such lesser time as required by state law, before the time of the sale or
disposition. All expenses relating to the disposition of the Collateral,
including without limitation the expenses of retaking, holding, insuring,
preparing for sale and selling the Collateral, shall become a part of the
Indebtedness secured by this Agreement and shall be payable on demand, with
interest at the Note rate from date of expenditure until repaid.

6.4           Appoint
Receiver. To the extent permitted by applicable law, Lender shall
have the following rights and remedies regarding the appointment of a
receiver:  (a) Lender may have a
receiver appointed as a matter of right, 
(b) the receiver may be an employee of Lender and may serve without
bond, and  (c) all fees of the
receiver and his or her attorney shall become part of the Indebtedness secured
by this Agreement and shall be payable on demand, with interest at the Note
rate from date of expenditure until repaid.

 C-9
 

 

6.5           Collect
Revenues, Apply Accounts. Lender, either itself or through a
receiver, may collect the payments, rents, income, and revenues from the
Collateral. Lender may at any time in its discretion transfer any Collateral
into its own name or that of its nominee and receive the payments, rents,
income, and revenues therefrom and hold the same as security for the
Indebtedness or apply it to payment of the Indebtedness in such order of
preference as Lender may determine. Insofar as the Collateral consists of
accounts, general intangibles, insurance policies, instruments, chattel paper,
choices in action, or similar property, Lender may demand, collect, receipt
for, settle, compromise, adjust, sue for, foreclose, or realize on the
Collateral as Lender may determine, whether or not Indebtedness or Collateral
is then due. For these purposes, Lender may, on behalf of and in the name of
Grantor, receive, open and dispose of mail addressed to Grantor; change any
address to which mail and payments are to be sent; and endorse notes, checks,
drafts, money orders, documents of title, instruments and items pertaining to
payment, shipment, or storage of any Collateral. To facilitate collection,
Lender may notify account debtors and obligors on any Collateral to make payments
directly to Lender.

6.6           Obtain
Deficiency. If Lender chooses to sell any or all of the Collateral,
Lender may obtain a judgment against Grantor for any deficiency remaining on
the Indebtedness due to Lender after application of all amounts received from
the exercise of the rights provided in this Agreement. Grantor shall be liable
for a deficiency even if the transaction described in this subsection is a sale
of accounts or chattel paper.

6.7           Other
Rights and Remedies. Lender shall have all the rights and remedies
of a secured creditor under the provisions of the Uniform Commercial Code, as
may be amended from time to time. In addition, Lender shall have and may
exercise any or all other rights and remedies it may have available at law, in
equity, under the Note, the Related Documents, or otherwise.

6.8           Cumulative
Remedies. All of Lender’s rights and remedies, whether evidenced by
this Agreement, by the Note, or the Related Documents or by any other writing,
shall be cumulative and may be exercised singularly or concurrently. Election
by Lender to pursue any remedy shall not exclude pursuit of any other remedy,
and an election to make expenditures or to take action to perform an obligation
of Grantor under this Agreement, after Grantor’s failure to perform, shall not
affect Lender’s right to declare a default and to exercise its remedies.

7.             CALIFORNIA UNIFORM COMMERCIAL
CODE DEFINITIONS. All terms used herein, if not otherwise
specifically defined, shall have the meaning defined by the current or any
future version of the California Uniform Commercial Code, and as revised,
amended or modified.

8.             NO CHANGE IN
JURISDICTION. Borrower or any Grantor will not change its
jurisdiction of organization without prior notice  to Lender.

9.             OTHER DEFAULT WITH
LENDER. In the event Borrower or any Grantor defaults under any
loan, extension of credit, security agreement, purchase or sales agreement, or
any other agreement in favor of Lender or the other holders of the Note that
may affect any of 

 C-10
 

 

Borrower’s property or Borrower’s ability to repay the Note or any of
the related documents, it shall be considered an event of default (“Event of
Default”) under the Note.

10.           MISCELLANEOUS
PROVISIONS. The following miscellaneous provisions are a part of
this Agreement:

10.1         Amendments.
This Agreement, together with the Note and any Related Documents,
constitutes the entire understanding and agreement of the parties as to the
matters set forth in this Agreement. No alteration of or amendment to this
Agreement shall be effective unless given in writing and signed by the party or
parties sought to be charged or bound by the alteration or amendment.

10.2         Governing Law and Venue. This
Agreement will be governed by, construed, and enforced in accordance with
federal law and the laws of the State of California. This Agreement has been
delivered to Lender and accepted by Lender in the State of California. If there
is a lawsuit, Grantor agrees upon Lender’s request to submit to the
jurisdiction of the Courts of Los Angeles County, State of California.

10.3         Waiver
of Jury Trial. Lender and Grantor hereby waive the right to any jury
trial in any action, proceeding, or counterclaim brought by either Lender or
Grantor against the other.

10.4         Attorneys’
Fees; Expenses. Grantor agrees to pay upon demand all of Lender’s
costs and expenses, including attorneys’ fees and Lender’s legal expenses,
incurred in connection with the enforcement of this Agreement. Lender may pay
someone else to help enforce this Agreement, and Grantor shall pay the costs
and expenses of such enforcement. Costs and expenses include Lender’s attorneys’
fees and legal expenses whether or not there is a lawsuit, including attorneys’
fees and legal expenses for bankruptcy proceedings (and including efforts to
modify or vacate any automatic stay or injunction), appeals, and any
anticipated post-judgment collection services. Grantor also shall pay all
court costs and such additional fees as may be directed by the court.

10.5         Caption
Headings. Caption headings in this Agreement are for convenience
purposes only and are not to be used to interpret or define the provisions of
this Agreement.

10.6         Multiple
Parties. All obligations of Grantor under this Agreement shall be
joint and several, and all references to Grantor shall mean each and every
Grantor. This means that each of the persons signing below is responsible for
all obligations in this Agreement.

10.7         Notices.
All notices required to be given under this Agreement shall be given
in writing, may be sent by telefacsimile (unless otherwise required by law),
and shall be effective when actually delivered or when deposited with a
nationally recognized overnight courier or deposited in the United States mail,
first class, postage prepaid, addressed to the party to whom the notice is to be
given at the address shown above. Any party may change its address for notices
under this Agreement by giving formal written notice to the other parties,
specifying that the purpose of the notice is to change the party’s address. To
the extent permitted by applicable law, if there is more than one Grantor,
notice to any Grantor will constitute notice to 

 C-11
 

 

all Grantors. For notice purposes, Grantor will keep Lender informed at
all times of Grantor’s current address(es).

10.8         Power
of Attorney. Grantor hereby appoints Lender as its true and lawful
attorney-in-fact, irrevocably, with full power of substitution to
do the following:  (a) to demand,
collect, receive, receipt for, sue and recover all sums of money or other
property which may now or hereafter become due, owing or payable from the
Collateral;  (b) to execute, sign
and endorse any and all claims, instruments, receipts, checks, drafts or
warrants issued in payment for the Collateral; 
(c) to settle or compromise any and all claims arising under the
Collateral, and, in the place and stead of Grantor, to execute and deliver its
release and settlement for the claim; and 
(d) to file any claim or claims or to take any action or institute
or take part in any proceedings, either in its own name or in the name of
Grantor, or otherwise, which in the discretion of Lender may seem to be
necessary or advisable. This power is given as security for the Indebtedness,
and the authority hereby conferred is and shall be irrevocable and shall remain
in full force and effect until renounced by Lender.

10.9         Preference
Payments. Any monies Lender pays because of an asserted preference
claim in Borrower’s bankruptcy will become a part of the Indebtedness and, at
Lender’s option, shall be payable by Borrower as provided above in the “EXPENDITURES
BY LENDER” paragraph.

10.10       Severability.
If a court of competent jurisdiction finds any provision of this
Agreement to be invalid or unenforceable as to any person or circumstance, such
finding shall not render that provision invalid or unenforceable as to any
other persons or circumstances. If feasible, any such offending provision shall
be deemed to be modified to be within the limits of enforceability or validity;
however, if the offending provision cannot be so modified, it shall be stricken
and all other provisions of this Agreement in all other respects shall remain
valid and enforceable.

10.11       Successor
Interests. Subject to the limitations set forth above on transfer of
the Collateral, this Agreement shall be binding upon and inure to the benefit
of the parties, their successors and assigns.

10.12       Waiver.
Lender shall not be deemed to have waived any rights under this
Agreement unless such waiver is given in writing and signed by Lender. No delay
or omission on the part of Lender in exercising any right shall operate as a
waiver of such right or any other right. A waiver by Lender of a provision of
this Agreement shall not prejudice or constitute a waiver of Lender’s right
otherwise to demand strict compliance with that provision or any other
provision of this Agreement. No prior waiver by Lender, nor any course of
dealing between Lender and Grantor, shall constitute a waiver of any of Lender’s
rights or of any of Grantor’s obligations as to any future transactions. Whenever
the consent of Lender is required under this Agreement, the granting of such
consent by Lender in any instance shall not constitute continuing consent to
subsequent instances where such consent is required and in all cases such
consent may be granted or withheld in the sole discretion of Lender.

10.13       Waiver
of Co-obligor’s Rights. If more than one person is obligated
for the Indebtedness, Borrower irrevocably waives, disclaims and relinquishes
all claims against 

 C-12
 

 

such other person which Borrower has or would otherwise have by virtue
of payment of the Indebtedness or any part thereof, specifically including but
not limited to all rights of indemnity, contribution or exoneration.

10.14       Miscellaneous. The
terms “include”, Includes”, or “including” shall mean “include”, Includes”, or “including”
without limitation.

GRANTOR ACKNOWLEDGES HAVING READ ALL THE PROVISIONS OF
THIS COMMERCIAL SECURITY AGREEMENT, AND GRANTOR AGREES TO ITS TERMS. THIS
AGREEMENT IS DATED MAY __, 2006

 

	
  GRANTOR:

  	
  SMALL WORLD KIDS, INC.

  a Nevada corporation

  
	
   

  	
   

  	
   

  
	
   

  	
  By: 

  	
   

  
	
   

  	
   

  	
  Debra Fine, Chief Executive Officer

  

 

 

 

 C-13Exhibit 10.4

CONVERSION AGREEMENT

This
Conversion Agreement is dated as of May 26, 2006 (the “Conversion
Agreement”) by and between HIT 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 $320,000 (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 290,909 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
290,909 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

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
   

  
	
   

  	
   

  	
  HIT 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

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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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