10KSB 1 k093004.txt 10-KSB YEAR ENDED SEPTEMBER 30, 2004 U.S Securities and Exchange Commission Washington, D.C. 20549 Form 10-KSB [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the year ended September 30, 2004 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT 0-23545 ------- Commission File Number Ultimate Franchise Systems, Inc. ---------------------- (Exact name of small business issuer as specified in its charter) Nevada 84-1317674 -------- ---------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 300 International Pkwy., Suite 100, Heathrow, Florida, 32746 -------------------------------------------------------------- (Address of principal executive offices) (407) 333-8998 -------------- (Issuer's telephone number including area code) SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: Common Stock, $.001 Par Value Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form and no disclosure will be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB [ ] The Registrant's revenue for the fiscal year ended September 30, 2004: $3,136,377. The aggregate market value of the voting and non-voting common equity held by non-affiliates (computed by reference to the price at which the common equity was sold, or the average bid and asked price of such common equity) as of December 6, 2004 was $4,313,395 (for purposes of the foregoing calculation only, each of the registrant's officers and directors is deemed to be an affiliate). There were 15,023,194 shares of the registrant's common stock outstanding as of December 6, 2004. DOCUMENTS INCORPORATED BY REFERENCE: None Transitional Small Business Disclosure Format: Yes [ ] No [X] PART I This Annual Report on Form 10-KSB contains certain statements concerning the future that are subject to risks and uncertainties. Additional written or oral forward-looking statements may be made by the Company from time to time, in filings with the Securities and Exchange Commission or otherwise. Such statements include, among other things, information concerning possible-future results of operations, capital expenditures, the elimination of losses under certain programs, financing needs or plans relating to products or services of the Company, assessments of materiality, predictions of future events, and the effects of pending and possible litigation, as well as assumptions relating to the foregoing, and those accompanied by the words "believes", "anticipates," "estimates," "expects," "intends," "plans," or similar expressions. For those statements we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You should specifically consider the various factors identified in this 10-KSB, including the matters set forth in "Item 1. Description of Business"; "Item 3. Legal Proceedings"; "Item 6. Management's Discussion and Analysis of Financial Condition and Results of Operations"; and the Notes to Consolidated Financial Statements that could cause actual results to differ materially from those indicated in any forward-looking statements. Other factors that could contribute to or cause such differences include, but are not limited to, unanticipated increases in operating costs, labor disputes, capital requirements, increases in borrowing costs, product demand, pricing, market acceptance, intellectual property rights and litigation, risks in product and technology development and other risk factors detailed in the Company's Securities and Exchange Commission filings. Readers are cautioned not to place undue reliance on any forward-looking statements contained in this 10-KSB, which speak only as of the date hereof. The Company undertakes no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances after the date hereof or to reflect the occurrence of unexpected events. ITEM 1. DESCRIPTION OF BUSINESS. Form and Year of Organization Ultimate Franchise Systems, Inc. (collectively "we" and "our"), was incorporated on July 19, 1995 under the laws of the State of Colorado. In July 2001, a vote of the shareholders approved a change of our corporate domicile from the state of Colorado to Nevada. This change was formally made in April 2002. We are a franchise management and venture company with minority interests in numerous restaurant concepts located throughout the United States. Our headquarters are located in Heathrow, Florida. Currently, we have equity interest in companies controlling approximately 585 franchised restaurant locations and 40 weight loss clinics throughout the United States. Our strategy continues to be one of growth through the acquisition of minority positions in other restaurant franchise companies. This allows us to provide franchise management services to other companies without any increase to operating expenses and provides us with a more diversified portfolio of restaurant brands. In addition, we offer guidance and assistance to the franchisees in areas such as product preparation, equipment purchasing, marketing, administrative support and employee training. 1 Restaurant Brands In total, we have financial investments in 585 restaurants and 40 weight loss clinics. Our equity interests include the following:
State of Ownership Predominant Restaurant Corporation Name Incorporation Percentage Concept ---------------- ------------------ ---------- ---------------------- Central Park of America, Inc. Delaware 100% "Central Park" Obee's Franchise Systems, Inc. Florida 100% "Obee's Soup & Subs" Franchise Management Company, LLC Florida 33.3% N/A Fransaction, Inc. Florida 59% "New York Burrito" Concept Acquisitions II, LLC Florida 25% "Flamers" Jreck Subs, Inc. New York 20% "Jreck Subs" Li'l Dino Corporation North Carolina 20% "Li'l Dino" Quality Restaurant Ventures, Inc. Florida 19% "Sobik's Subs" Concept Acquisitions, Inc. California 18% "Mountain Mike's" Bevery Hills Weight Loss and Wellness, Inc. Colorado 18% "Weight Loss Forever" Famous Food Group, Inc. Delaware 13% "Uncle Al's Famous Hot Dogs" Sea West Subs, Inc. Washington 10% "SeaWest" Piccadilly Restaurant Investment Group, LLC Nevada 1% "Piccadilly's"
Recent Acquisitions Obee's Franchise Systems, Inc. On June 16, 2004, we purchased all issued and outstanding common stock of Obee's Franchise Systems, Inc. ("Obee's"). Obee's is the franchisor of the Obee's Soup & Subs concept based in Port Charlotte, Florida with approximately 55 franchised units located throughout the United States. The purchase price of Obee's consisted of the issuance of 800,000 shares of our common stock valued at $.64 per share ($512,000) as well as cash of $98,377. The transaction was recorded as follows: Total consideration paid $ 610,377 Less fair value of assets acquired $ 203,926 Plus liabilities assumed $ 912,703 ---------- Excess of cost over net assets acquired (goodwill) $1,319,154 ========== The goodwill associated with this transaction was deemed to be impaired and was expensed during the quarter ended June 30, 2004. Recent Dispositions Sobik's International Franchising, Inc. On December 29, 2003, we sold our majority interest in Sobik's International Franchising, Inc. ("Sobik's") to Quality Restaurant Ventures Corp. ("QRVC"). Under the terms of this agreement, we agreed to sell 17,445,664 shares of Sobik's in exchange for $100,000 in cash, a note receivable of $900,000, and 1,000,000 shares of "Series A Convertible Preferred Stock" in Sobik's. This preferred stock is convertible at our option and is anti- dillutive. If all 1,000,000 shares of the Series A Convertible Preferred stock were converted at the same time, we would own 19% of the outstanding common stock of Sobik's. The $900,000 note receivable requires QRVC to pay us quarterly interest only payments of $15,750 until December 2004. At that time QRVC will pay us an additional $100,000 in principal and continue to make quarterly interest payments of $14,000 until December 31, 2005. At that time the remaining principal balance will be amortized and paid in monthly principal and interest installments of $13,489 until 2013. Subsequent to this transaction, an analysis of the QRVC financials indicated inadequate cash flows provided from operations to make payments on this note. As a result, we recorded a $500,000 impairment charge to our note receivable during the year ended September 30, 2004. 2 Our Chief Executive Officer, Christopher Swartz is also a member of the QRVC Board of Directors. The results of operations are included in our consolidated financial statements up until the date of sale. General Description of Business We are a multi-brand franchise management and venture company that invests in and manages franchise concepts predominately in the restaurant industry. Franchise Programs Ultimate Franchise Systems, Inc. is a leading restaurant franchisor with an exclusive focus on growing leading restaurant brands. We provide superior franchise brand management services which has resulted in the creation of numerous regional market leaders. Through the terms of our "Franchise Agreement" we authorize individuals and/or companies to form or establish and operate concept restaurants at approved locations. Under the agreement, we are obligated to provide certain services both for the opening of, and the ongoing support of, each restaurant. Those services generally include: -review and approval of restaurant location -review and approval of plans and layout design -identification of sources of supply of food purveyors and other suppliers -provide an operations manual with respect to service guidelines and restaurant management techniques -provide initial and ongoing training in acceptable methods of operations, food preparation techniques, management controls, accounting functions, legal framework of restaurant operations, human resources, promotional programs and public relations -provide ongoing support with respect to maintaining quality products and insuring such products are offered at competitive prices -perform ongoing consistency and quality inspections of restaurants in order to maintain uniform acceptable standards We obtain prospective franchisees primarily from the ranks of our current and former franchisees and employees, referrals from existing franchisees, affiliations with industry experts and from selected marketing efforts such as restaurant trade shows. We intend to develop new franchise locations primarily through existing franchisees and industry affiliations. The primary selective criteria considered in the review and approval of new franchisees is prior experience in operating restaurants or comparable business acumen and the existence of sufficient capital resources to reasonably insure success. We believe we have a national presence which we intend to strengthen by developing each of our regional concepts. 3 From time to time we will take over the operations of a restaurant from a franchisee before the contract term has expired. We may operate such restaurants until a suitable franchisee can be found, at which time all or part of our investment in such operations may be recovered, or we may choose to close the location. Initial franchise fees are considered to be within industry norms and currently are $12,500 for new locations in the sandwich segment, $20,000 in the hamburger and Fresh-Mex segments, and $25,000 for Casual Dining (Gator's). Initial franchise fees are due upon the execution of the Franchise Agreement. Ongoing royalties are also considered to be within industry norms ranging from 4%-5% of sales. In addition to ongoing royalties, all franchisees are required to contribute 2%-4% of sales to a concept-based pooled marketing fund. We collect weekly and monthly sales and other operating information from each franchisee. We have agreements with most franchisees permitting us to electronically debit the franchisees' bank accounts for the payment of royalties, marketing fund contributions, and other amounts owed to us under the franchise agreement. This system significantly reduces the resources needed to process receivables, improves cash flow and helps to limit past due accounts related to these items. Franchisees generally are required to purchase and install an approved point of sale system that, among other things, allows us to poll sales information daily. The following table sets forth and summarizes certain information about our majority owned concepts and current franchise agreements:
---------------------------------------------------------------------------------------------------------------------------- No. of Avg. Royalty Royalty Franchised Rate on Rate on Currently Units at Avg. Yrs. Existing Current Price of Selling Sept 30, Remaining Franchise Franchise New New Concept 2004 On Contract Agreements Agreement Franchise Franchises ---------------------------------------------------------------------------------------------------------------------------- "Obee's" 62 12.3 7.0% 7.0% 15,000 Yes "Central Park" 42 8.6 4.3% 5.0% 20,000 Yes "New York Burrito" 32 7.3 7.0% 7.0% 15,000 Yes ----------------------------------------------------------------------------------------------------------------------------
In connection with our mandatory monitoring program, all franchisees are required to adhere to our specifications and standards on the selection and purchase of products used in the operation of the restaurant. We provide a detailed "product profile" of acceptable food, paper and supply items for each concept. Franchisees requesting to use products not falling under the concept "product profile" must first receive permission from us. Suppliers Each franchisee is obligated to purchase raw materials, both food and non-food, from authorized and designated distributors who may only sell authorized and approved raw materials purchased from approved manufacturers and suppliers. We negotiate relationships with manufacturers and suppliers on a national level for all products except produce, whether or not they bear our logos. We negotiate and enter into recognition agreements authorizing approved distributors to deliver raw products to our franchisee outlets from approved manufacturers and suppliers. All products purchased by franchisees on a local level must meet our quality standards. Franchisees may request approval of additional manufacturers, suppliers or distributors subject to our approval. We base our approval upon a number of conditions including price, quality, ability to service the system on a national basis and such other reasonable standards as we may promulgate from time to time. Currently, there are no other manufacturers, suppliers or distributors approved by us other than those that we have designated. 4 We believe that if such regional and national distributors could no longer provide such goods and services, adequate alternate suppliers or distributors are available to provide such goods and services without a significant increase in costs. Government Regulation Our principal activity of selling restaurant franchises is regulated by the Federal Trade Commission (the "FTC") and various states. Such regulations govern disclosure, performance and procedure in the sale and transfer of new and existing franchises. In general the FTC's regulations require us to timely furnish a franchise offering circular to prospective franchisees containing prescribed information. Certain state laws also require registration of the franchise offering circular with applicable state authorities. Other states monitor or regulate the franchise relationship, particularly the sale, renewal and termination of an agreement. In October 1999, the FTC issued proposed changes to the FTC Rule that would effect certain disclosure obligations in connection with franchise sales. These proposed changes are still subject to public comment, and even if adopted as proposed, we do not think the changes would materially effect our franchise sales or other operations. We are not aware of any other probable pending franchise legislation that in our view is likely to affect our operations significantly. We believe that our operations comply in all material respects with the FTC Rule and the applicable state franchise laws. We are also subject to "Federal Fair Labor Standards Act", which governs minimum wages, overtime, working conditions and other matters as well as the "Americans With Disabilities Act". From time to time we will operate company owned restaurants. While operating the restaurants, we are subject to a variety of federal, state and local laws regarding minimum wage standards, sanitation, health, fire, alcoholic beverage and safety codes. While we believe we are in compliance with all applicable federal, state and local laws and regulations, there can be no assurance that we will continue to meet the requirements of such laws and regulations. Such a default could result in a withdrawal of approval to market franchises in one or more jurisdictions. Any such loss of approval may have a material adverse effect upon our ability to successfully market our franchises. Violations of federal and state franchising laws and/or regulations regulating substantive aspects of our business activity could subject us and our affiliates to rescission offers, monetary damages, penalties or injunctive proceedings. In addition, under court decisions in certain states, absolute and vicarious liability may be imposed upon franchisors based upon the facts and circumstances of the claim. Current expected changes in federal and individual state laws and regulations concerning the sale, termination and non-renewal of franchises are not expected to have a material impact on our operation. There can be no assurance that existing or future franchise regulations will not have an adverse effect on our ability to maintain and expand our franchise program. Competition We compete in the quick service and casual dining segments of the restaurant industry. As a franchisor of restaurants, we compete on two fronts. First we must attract successful franchisees; and, second, we must assist our franchisees in attracting customers in each of those two niches of the restaurant industry. We compete with an increasing number of national chains of quick service outlets, several of which have dominant market positions, and possess substantially greater financial resources and longer operating histories than us. 5 The segments of the restaurant industry that we compete in are highly competitive with respect to price, service, outlet location, and food quality and are often affected by changes in consumer taste, local and national economic conditions, population trends and local traffic patterns. The three most prolific submarine sandwich chains we compete with are Subway, Blimpie and Quiznos. Subway currently has approximately 19,000 units while Blimpie and Quiznos each have about 1,700 and 2,500 units respectively. Both Subway and Blimpie offer a low cost product in a fast food style environment while Quiznos is positioned between the traditional fast food style of Subway and Blimpie and full service dining. Through its regional concepts, the Company offers a comfortable, fast food style, family atmosphere in which to dine on higher quality food products. Competitors of our Central Park hamburger chain include Checkers Drive-In Restaurants and Back Yard Burgers. Checkers currently has approximately 410 units while Back Yard Burgers has about 105 units. Both Checkers and Back Yard Burgers offer a drive-thru format, with a low cost product in a fast food style environment. A number of companies have adopted "value pricing" strategies in response to flattening growth rates and/or declines in average sale per restaurant. Such strategies could draw customers away from companies that do not engage in "value pricing", or discount pricing, and could also negatively impact the operating margins by attempting to match competition pricing points. In addition to competing with these chains as restaurants, we also compete with these and other fast food chains for qualified franchisees. Many franchisors, including but not limited to, those in the restaurant industry, have greater market recognition and financial resources than us. We believe our well established regional concepts offer prospective franchisees the balance of a moderately priced alternative with which to enter the fast food restaurant industry and the pride of ownership in well established and recognized brands. Employees As of September 30, 2004 we had approximately 36 employees consisting of 16 administrative employees, and 20 employees at our one corporately owned Central Park location. Copy of Report A copy of this report is available for review at the SEC Public Reference Room located at 450 Fifth Street, N.W., Washington, DC 20549. You may obtain more information regarding the operation of the Public Reference Room by calling 1-800-SEC-0330. You may also obtain a copy of this report via the internet at . ITEM 2. DESCRIPTION OF PROPERTY Our office space is leased at various terms up to September 2009. A summary of all real estate locations owned or leased by us at September 30, 2004 are as follows: 6
Owned Base Lease or Square Monthly Expiration Address of Property Type Leased Footage Rent Date ============================================================================================== Leases not assigned to third parties 300 International Pkwy. Suite 100 Office Leased 2,833 4,778 02/11/06 Heathrow, FL 32746 300 International Pkwy., Suite 180 Office Leased 747 1,276 02/11/06 Hewthrow, FL 32746 300 International Pkwy., Suite 104 Office Leased 712 1,187 10/31/06 Hewthrow, FL 32746 5751 Uptain Rd., Suite 301 Office Leased 1,129 1,200 05/31/07 Chattanooga, TN 37402 1376 Highland Avenue Land Leased N/A 1,614 02/28/06 Selma, AL 1777 Tamiami Tr., Suite 206 Office Leased 2,454 4,080 11/30/08 Port Charlotte, FL 7205 Waters Ave. Land Leased N/A 2,650 09/09/06 Savanah, GA 31406 ------ -------- 7,875 $16,785 Owned Base Lease or Square Monthly Expiration Address of Property Type Leased Footage Rent Date ============================================================================================== Leases that have been assigned to franchisee's, but which we remain contingently liable 6204 Lee Highway Land Leased N/A 1,600 04/01/08 Chattanooga, TN West Broadway Street Land Leased N/A 750 06/06/06 West Memphis, AR 395 Inman St. SW Land Leased N/A 601 12/31/04 Cleveland, TN 3717 Mercer Blvd. Land Leased N/A 1,650 03/01/05 Macon, GA -------- $ 4,601 ========
We believe we have obtained, and currently carry, adequate liability insurance on all the properties we own or lease. ITEM 3. LEGAL PROCEEDINGS We are involved in various other lawsuits and litigation matters on an ongoing basis as a result of our day-to-day operations. However, we do not believe that any of these legal matters will have a material adverse effect on our financial position or results of operations. 7 ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS On April 19, 2004, the shareholders voted in favor of amending our employee incentive plan. This increased the maximum allowable shares of our common stock to be issued under this plan from 1,500,000 shares to 3,000,000 shares. In addition, the shareholders voted in favor of electing Harold L. Kestenbaum to our Board of Directors. Mr. Kestenbaum served as franchise and general counsel to Sbarro, Inc., the national franchisor of over 900 family-style Italian restaurants and, since March 1985, he has been a director of Sbarro, whose securities were formerly listed on the New York Stock Exchange. In addition, he currently sits on the Board of Directors of RezConnect Technologies, Inc., NYB Foods Inc., Desert Moon Cafe Franchise Corp., GarageTek, Inc. and Wall Street Deli Systems, Inc. From September 1983 to October 1989, he served as President and Chairman of the Board of FranchiseIt Corporation, the first publicly traded company specializing in providing franchise marketing and consulting services and equity financing to emerging franchise companies, which he co-founded. 8 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our Common Stock is listed on the OTC Bulletin Board under the symbol "UFSY". The prices reported below reflect inter-dealer prices and are without adjustments for retail markups, markdowns or commissions, and may not necessarily represent actual transactions. High Bid Low Bid -------- ------- Fiscal Year Ended September 30, 2003 First Quarter $ .22 $ .16 Second Quarter .18 .14 Third Quarter .20 .10 Fourth Quarter .15 .12 Fiscal Year Ended September 30, 2004 First Quarter $ .20 $ .12 Second Quarter .60 .16 Third Quarter .95 .44 Fourth Quarter .85 .41 Stockholders As of December 6, 2004 there were approximately 2,700 holders of record of our common stock. Dividends We have never paid any dividends on our Common Stock and do not expect to pay any dividends on our common stock in the foreseeable future. Management currently intends to retain all available funds for working capital and the development of its business. Dividends, if declared, must be from funds legally available after dividends are first paid to any senior series of equity securities such as our Preferred Stock. Currently no surplus exists. Recent Sale of Unregistered Securities The following table sets forth information with respect to the sale or issuance of unregistered securities over the last three fiscal years.
Exempt From 1933 Act Value or Registration Shares Type of Consider- To Whom In Issued Security Date ation Issued Business Purpose Reliance of: ------------------------------------------------------------------------------------------------------------------------------------ 51,852 Common Aug 07, 2002 500,000 TAS, LLC Sale of Common Stock Section 4(2) 226,699 Common Mar 31, 2002 34,004 5 Individuals Restructuring of Debt Section 4(2) 100,000 Common Feb 20, 2002 25,000 Gary Pereira Conversion of Debt Section 4(2) 500,000 Common Jul 23, 2002 50,000 Agricola Coco Conversion of Debt Section 4(2) 500,000 Common Jul 23, 2002 50,000 Bain Investments Conversion of Debt Section 4(2) 250,000 Common Jul 23, 2002 25,000 John Mitchell Conversion of Debt Section 4(2) 250,000 Common Jul 23, 2002 25,000 James Spratt Conversion of Debt Section 4(2) 400,000 Common Dec 11, 2002 100,000 Allor Trust Sale of Stock for Cash Section 4(2) 100,000 Common Jan 24, 2003 14,000 4 Individuals Consulting Services Section 4(2) 50,000 Common Feb 12, 2003 8,000 Gary Pereira Consulting Services Section 4(2) 100,000 Common Mar 24, 2003 14,000 JAS Investments Interest on Long-Term Debt Section 4(2) 200,000 Common Mar 31, 2003 28,000 Wall Street Group Consulting Services Section 4(2) 100,000 Common Apr 17, 2003 15,000 Barka Mat S.A. Interest on Long-Term Debt Section 4(2) 100,000 Common Sep 25, 2003 12,000 CLD IR, Inc. Consulting Services Section 4(2) 100 Common Oct 20, 2003 20 Fred Pilon Interest on Long-Term Debt Section 4(2) 25,000 Common Jan 16, 2004 4,250 4 Individuals Consulting Services Section 4(2) 25,000 Common Jan 30, 2004 4,250 4 Individuals Consulting Services Section 4(2) 200,000 Common Mar 31, 2004 120,000 Mitch Day Settlement of Redeemable Common Stock Section 4(2) 50,000 Common Apr 06, 2004 47,500 Barka Mat S.A. Interest on Long-Term Debt Section 4(2) 25,000 Common Apr 06, 2004 23,750 4 Individuals Consulting Services Section 4(2) 50,000 Common May 13, 2004 27,000 James Skalko Interest on Long-Term Debt Section 4(2) 800,000 Common Jun 16, 2004 512,000 8 Individuals Acquisition of Obee's Franchise Systems Section 4(2) 31,650 Common Jul 08, 2004 25,320 James Skalko Interest on Long-Term Debt Section 4(2) 25,000 Common Aug 02, 2004 15,500 4 Individuals Consulting Services Section 4(2) 42,094 Common Aug 03, 2004 25,256 James Skalko Interest on Long-Term Debt Section 4(2)
9 Options and Warrants In February 1999, we approved the 1998 Incentive Plan ("Incentive Plan") to enable us to offer employees and consultants equity interests. There are 3,000,000 shares designated under the Incentive Plan and are fully vested upon grant. Since January, 1997 we have issued options and warrants to purchase our common stock outside of the Incentive Plan. The following table describes selected data with respect to unexercised options and warrants at September 30, 2004:
1998 Incentive Plan As of September 30, 2004 there were no outstanding options under the Incentive Plan. Outside of the Incentive Plan ---------------------------------------------------------------------------------------------------------------------------- Date Expiration Number of Exercise of Grant Date Name Shares Price Business Purpose ---------------------------------------------------------------------------------------------------------------------------- Sep 30, 1998 Sep 30, 2006 Wall St. Group 11,429 5.00 Investment Banking Services Oct 15, 1999 Oct 15, 2004 Blaine Quick 64,500 2.90 Business Expansion Consulting Services Oct 15, 1999 Oct 15, 2004 Dr. Sol Lizerbram 12,500 5.00 Business Expansion Consulting Services Oct 15, 1999 Oct 15, 2007 Wall St. Group 12,500 5.00 Business Expansion Consulting Services Oct 15, 1999 Oct 15, 2004 Richard Silberman 60,000 2.90 Business Expansion Consulting Services Oct 15, 1999 Oct 15, 2004 Bradley Gordon 100,000 2.90 Employee Compensation Oct 15, 1999 Oct 15, 2004 Michael Cronin 100,000 2.90 Employee Compensation Oct 15, 1999 Oct 15, 2004 Richard Huey 50,000 2.90 Employee Compensation Oct 15, 1999 Oct 15, 2004 Kelly Swartz 3,500 1.60 Business Expansion Consulting Services Oct 15, 1999 Oct 15, 2004 Linda Patterson 3,500 1.60 Business Expansion Consulting Services Jul 31, 2000 Jul 31, 2007 Lloyd, Benton & Taylor 20,000 2.29 Business Expansion Consulting Services Nov 30, 2000 Nov 30, 2005 Olympus Capital #1 10,000 1.00 Investment Relations Services Nov 30, 2000 Nov 30, 2005 Olympus Capital #2 10,000 1.20 Investment Relations Services Nov 30, 2000 Nov 30, 2005 Olympus Capital #3 10,000 1.50 Investment Relations Services Dec 05, 2001 Dec 05, 2006 Noble International 429,791 .10 Investment Relations Services Oct 01, 2002 Oct 01, 2007 Christopher Swartz 250,000 .08 Employee Compensation Oct 01, 2002 Oct 01, 2008 Christopher Swartz 250,000 .08 Employee Compensation Oct 01, 2002 Oct 01, 2007 Michael Cronin 250,000 .08 Employee Compensation Oct 01, 2002 Oct 01, 2008 Michael Cronin 250,000 .08 Employee Compensation Oct 01, 2002 Oct 01, 2007 14 Employees 400,001 .08 Employee Compensation Oct 01, 2002 Oct 01, 2008 14 Employees 400,001 .08 Employee Compensation ------------ TOTAL 2,697,722 ------------------------------------------------------------------------------------------------------------------------------
The weighted average exercise price of these outstanding options is $.53 outside of the Incentive Plan. The aggregate of all options has a weighted average life until expiration of 32.88 months. No options expired in 2004. No options were granted in 2004. 10 The following table provides information about the Company's equity compensation plans as of September 30, 2004 and including the Ultimate Franchise System's, Inc. 1998 Stock Option Plan.
Equity Compensation Plan Information Number of Number of securities securities to be remaining available issued upon for future issuance exercise of Weighted-average under equity outstanding exercise price of compensation plans options, outstanding (excluding warrants and options, warrants securities reflected Plan Category rights and rights in column (a)) ----------------------------------- ------------------ -------------------- ---------------------- (a) (b) (c) Equity compensation plans approved by security holders - $ - 150,000 Equity compensation plans not approved by security holders - $ - - ------------------ -------------------- ---------------------- Total - 150,000 ------------------ -------------------- ----------------------
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview As described in Item 1, management has significantly changed the direction of the Company and the way its on-going revenue will be derived in the future. Currently, we derive our revenue from several sources: sale of investment securities, royalties, franchise fees, developer fees, company owned restaurants sales and other franchise related activities. In the future, the Company's revenue will be derived predominately from dividends, interest income, management fees and the gain on disposition of assets. Royalties Royalties are based on a percentage of franchisees' net sales and are recognized in the same period that the franchise store sales occur. Generally royalties are earned at the rate of 4%-7% of sales. Royalties earned under newer franchise agreements are paid by means of weekly automatic drafts by us drawn on franchisee bank accounts. Royalties earned under older agreements are generally paid by the remittance of a check payable to us on a weekly, bi-weekly or monthly basis. A portion of the royalties received are paid to our area developers as royalty service costs for providing on-going services to franchisees in their respective territories (see Item 1. Business-Franchising-Area Developers). Franchise Fees Franchise Fees are payments received from franchisees and are recognized as revenue in the period in which the store opens. The franchise fee for a franchisee's initial store is currently $10,000-$12,500 for submarine sandwich restaurants and $20,000 for hamburger restaurants. Expenses associated with the sale of franchises also include area developer fees and are included in franchise servicing costs. Generally, area developers are paid one-half of the franchise fees received or collected in their territory. 11 Area Developer Fees We charge area developers a non refundable fee for the exclusive right to develop and market a defined territory for a specified period of time. Typically, a portion of the developer fee is paid in cash and the balance is paid with a promissory note (see Item 1. Business-Franchising-Area Developers). When we have fulfilled substantially all of our contractual obligations such as training, providing manuals, and reasonable efforts to obtain and retain trademark registrations, we recognize, as revenue, the cash portion of the fee and the value of the promissory note. Certain performance obligations are ongoing. On these the income has been deferred to future periods in which the services will be substantially performed. Restaurant Sales Restaurant sales are reported from our one Company owned Central Park store located in Selma Alabama. Management does not believe that the operating costs of its Company owned stores are indicative of costs for franchised stores on a systemwide basis. Store sales are expected to vary widely from year to year and reflect the uncertainty of when, where and how long a store may be operated by us before being returned to the franchising system. Management Services The management services segment is comprised of equity securities from other restaurant concepts. These securities are issued to our company in exchange for franchise services such as: purchasing, marketing, and general franchise management. Year Ended September 30, 2004 Compared to Year Ended September 30, 2003 Revenue Total revenue increased $676,692 in 2004 over 2003 from $2,459,685 to $3,136,377. Franchise operations revenue increased $593,604, or 44.4%, from $1,335,858 in 2003 to $1,929,462 in 2004. The primary reason for this increase resulted from the acquisition of Obee's Franchise Systems, Inc. in June 2004. As a result of this acquisition, we realized approximately $512,000 in revenue from the sale of restricted territories in Northern California to several development agents. Retail restaurant sales in Company owned stores decreased $228,345 or 30.2% from $756,213 in 2003 to $527,868 in 2004. This decrease resulted from the operation of one company owned location in 2004 compared to two locations in 2003. Management services revenue increased $170,830 or 46.5% from $367,614 in 2003 to $538,444 in 2004. This increase primarily relates to our equity earnings in the COAC II partnership. During 2004 we recognized $122,282 in revenue from earnings generated by this partnership. Equipment revenue for the year ended September 30, 2004 was $140,603. This was the result of revenue generated from the sale of restaurant equipment to franchisee's of the Obee's Soup and Sub Concept. Since this business does not meet with our core business model we are currently evaluating other means to source restaurant equipment to our franchisees'. In early 2005, we will decide whether we will continue this segment of the Obee's franchise business. 12 Costs and Expenses We segregate our operating expenses into six general categories as follows: Ongoing Franchise Servicing Retail Company Owned Store Cost of Sales and Expenses General Corporate Operating Expenses Consulting and Investor Relations Non-Cash Other Franchise servicing costs, increased $323,706 or 43.5% from $743,498 in 2003 to $1,067,204 in 2004. This increase resulted from three factors. First, franchise servicing costs associated with our acquisition of Obee's Franchise Systems, Inc. were $568,657 during the year ended September 30, 2004. Additionally, our disposition of the Sobik's Subs concept in December 2003 resulted in a decrease in franchise servicing costs of approximately $155,000 during 2004. Finally, franchise servicing costs for our Central Park hamburger concept decreased $106,488 in 2004 as a result of the formation of Franchise Management Company, LLC. This partnership was formed in March 2004 in an effort to leverage human resources with other franchise companies in the quick service hamburger segment. The result of this partnership allowed us to eliminate three positions while maintaining the same level of service for our franchisees'. Retail cost of sales and operating expenses from company owned stores decreased from $804,228 in 2003 to $532,211 in 2004. Retail cost of sales and operating expenses as a percentage of retail sales decreased from 106.4% in 2003 to 100.1% in 2004. This decrease was the result of operating only one company owned location in 2004 compared to two locations in 2003. General corporate operating expenses generally include: officers and office support staff payroll and payroll costs; legal, audit and other professional fees; office occupancy costs and other general administrative costs. These administrative costs decreased $66,591 or 5.3% from $1,249,354 in 2003 to $1,182,763 in 2004. This decrease was primarily the result of reduced salaries and wages from the resignation of our Chief Operating Officer in February 2004. Consulting and investor relations costs decreased $14,594 or 6.9% from $210,044 in 2003 to $195,450 in 2004. Routine or recurring non-cash charges such as depreciation and amortization was $15,324 in 2003 compared to $8,595 in 2004. The primary reason for the decrease was the elimination of trademark amortization associated with the Sobik's Subs concept. This concept was sold in December 2003 and as a result our trademark amortization expense was reduced by $6,100 in 2004. Interest expense increased $182,052 or 98.7% from $184,412 in 2003 to $366,464 in 2004. This increase is a direct result of an increase in borrowings of long-term debt. Due to cash flow constraints and our cash investments into other restaurant concepts, we borrowed $1,510,000 in new long-term debt in 2004. Additionally, we assumed $308,209 in long-term debt from the acquisition of Obee's Franchise Systems, Inc. Finally, we entered into new long-term debt agreements totaling $91,861 in 2004 for the settlement of other outstanding liabilities. These three factors increased our interest expense approximately $200,000 in 2004. Impairment of notes receivable and investment securities increased $471,943 or 75.6% from $624,500 in 2003 to $1,096,443 in 2004. During 2004 we agreed to an early settlement of our $1.3 million dollar note receivable due from Grace Ventures, LLC. This note was originally to be paid in quarterly installments through 2011, however due to cash flow constraints we agreed to accept a lump sum payment of $475,000 in August 2004 and continue to hold an additional note receivable in the amount of $125,000. This note requires Grace Ventures, LLC to pay us $25,000 in November 2004 and the remaining balance will be due in August 13 2008. As a result of this agreement the remaining balance on the original note of $1.3 million dollars was expensed in 2004. Additionally, in 2004 we recorded impairment charges for two notes receivable totaling $372,440. During 2003, we recorded a valuation allowance on our note receivable from CFB Enterprises, Inc. in the amount of $274,500. This valuation allowance represents 25% of the carrying value of the note receivable and was recorded based on the possibility that CFB will lack sufficient cash to be able to make payments on this debt. Finally, in June 2003 we sold a note receivable with a carrying value of $500,000 for $225,000 in cash. The difference between the cash received and the carrying value was expensed at that time. Impairment of goodwill increased $1,097,450 from $221,704 in 2003 to $1,319,154 in 2004. During 2004 we evaluated the goodwill associated with the acquisition of Obee's Franchise Systems, Inc. This evaluation indicated that all the goodwill associated with this acquisition was impaired. As a result, we recorded goodwill impairment expense of $1,319,154 in 2004. During 2003 our analysis of the Sobik's Subs goodwill suffered impairment. As a result, an impairment expense of $221,704 was recorded in 2003. Equity of losses from our ownership interests in other restaurant concepts increased $53,294 from $789 in 2003 to $54,083 in 2004. This increase in loss was the result of increased losses from our ownership interest in Fransaction, Inc. In 2004 we were issued an additional 6 million shares of common stock in this company. This increased our ownership percentage in the company from 29% to 59%. We continue to account for this investment under the equity method of accounting. During 2004 we agreed to sell our remaining Central Park restaurant located in Selma, Alabama. The sale of this location will be completed in November 2004. The sale of this location will result in a loss as this location has continued to suffer diminishing sales revenue. As a result, we incurred an impairment expense of $149,797 in 2004 to reduce the assets of this location to fair market value. Liquidity and Capital Resources Net cash used in operating activities was $1,015,083 in 2004 compared to $811,598 in 2003, an increase of $203,485. Net cash of $141,818 was provided by investing activities in 2004 compared to $328,458 in 2003, an increase of $186,640. This change is primarily the result of two factors: First, our collections on notes receivable decreased $376,503 from $897,000 in 2003 to $520,497 in 2004. Second our cash investments into other restaurant concepts decreased $206,979 from $650,000 in 2003 to $443,021 in 2004. Net cash provided by financing activities was $956,838 in 2004 compared to $195,011 used by financing activities in 2003. The change of $1,151,849 primarily results from our increased borrowings of long-term debt. In 2004 we had new borrowings of long-term debt of $1,910,070 compared to $300,000 in 2003, a change of $1,610,070. Additionally, payments on long-term debt increased $342,621 from $588,511 in 2003 to $931,132 in 2004. Working capital at September 30, 2004 was a deficit of $2,430,418 compared with a deficit of $1,603,821 on September 30, 2003. Two significant items contributed to the increase in our working capital deficit. The first was the increase in our current portion of long-term debt which increased $885,988 from $788,489 in 2003 to $1,674,477 in 2004. This increase resulted from our acquisition of Obee's Franchise Systems, Inc which increased current debt by $308,209. Additionally, we entered into several short term debt agreements totaling approximately $1,050,000. The second reason for the increase in our working capital deficit relates to an increase in accounts payable and accrued expenses which increased $252,390 and $147,442. respectively. These increases relates primarily to the acquisition of Obee's Franchise Systems, Inc. in June 2004. 14 These issues have resulted in substantial doubt about our ability to continue as a going concern. To address this deficiency we have sourced three opportunities for large equity investments into the company. This could enable us to continue as a going concern. The first opportunity is in the form of a 2.5 million ($2,500,000) dollar equity investment. This investment would be in exchange for approximately thirty percent (30%) of the company. This investment would also call for the creation of a new Board of Director's seat as well as a stock option program. The stock option program is being negotiated at the present time. We expect this equity investment to be complete by the end of February 2005. We contemplate the use of proceeds to be the following: 1. Five Hundred Thousand Dollars ($500,000) in working capital; 2. Two Million Dollars ($2,000,000) for acquisitions of new franchise systems. We believe the acquisitions of the new revenue streams will allow us to reach levels of operational profitability that coupled with infusion of working capital, will allow us to grow exponentially in the coming year. If this 2.5 million ($2,500,000) Dollar equity investment does not occur, then we have two other sources to obtain one million dollars ($1,000,000) in equity infusion respectively. In each case, these investments would be in exchange for approximately ten percent (10%) of the company. We would contemplate only accepting one of these equity investments. The company has also made significant changes in how it will oversee and operate its investments. The operating systems and, therefore, the cash flow have been streamlined with all division Presidents now reporting to a newly hired Chief Operating Officer. We believe this streamlining and the maturation of revenue streams will now allow us to operate those entities profitably. The vast majority of the initial cash requirements to oversee these investments are behind us and in the coming years, we should now see the return on the capital that was invested in these entities. Most specifically, we have consummated the transaction which allowed us to facilitate the reverse merger of Obee's Franchise Systems into a new publicly traded entity. This transaction, once again, highlights our capabilities in creating transactions that create significant value for our shareholders and the value of our venture partners. A significant portion of our negative working capital pertains to the Obee's acquisition and through this "spin off", this working capital deficit will no longer be the obligation of Ultimate Franchise Systems, Inc. Furthermore, with Obee's new position as a stand alone publicly traded company, they have sourced the appropriate amount of capital in order to take care of their cash requirements. With the imminent resolution of our business transformation being complete, we feel that we have addressed or will be addressing the financial challenges to allow us to continue as a going concern. There is no assurance that additional funding will be available, or if available, it can be obtained on terms favorable to us. Failure to obtain such funding could adversely affect our financial condition. Off-Balance Sheet Arrangements and Aggregate Contractual Obligations Off-Balance Sheet Arrangements. In accordance with the definition under the new Securities and Exchange Commission rules, the following qualify as off-balance sheet arrangements: 15 o Any obligation under certain guarantees or contracts; o A retained or contingent interest in assets transferred to an unconsolidated entity or similar arrangement that serves as credit, liquidity or market risk support to that entity for such assets; o Any obligation under certain derivative instruments; o Any obligation under a material variable interest held by the registrant in an unconsolidated entity that provides financing, liquidity, market risk or credit risk support to the registrant, or engages in leasing, hedging or research and development services with the registrant. During 2004, we sold our majority interest in the Sobik's International Franchising, Inc. restaurant concept. Under the terms of this agreement, we agreed to sell 17,445,664 shares of Sobik's in exchange for $100,000 in cash, a note receivable of $900,000, and 1,000,000 shares of "Series A Convertible Preferred Stock" in Sobik's. This preferred stock is convertible at our option and is anti- dillutive. If all 1,000,000 shares of the Series A Convertible Preferred stock were converted at the same time, we would own 19% of the outstanding common stock of Sobik's. The $900,000 note receivable requires QRVC to pay us quarterly interest only payments of $15,750 until December 2004. At that time QRVC will pay us an additional $100,000 in principal and continue to make quarterly interest payments of $14,000 until December 31, 2005. At that time the remaining principal balance will be amortized and paid in monthly principal and interest installments of $13,489 until 2013. Subsequent to this transaction, an analysis of the QRVC financials indicated inadequate cash flows provided from operations to make payments on this note. As a result, we recorded a $500,000 impairment charge to our note receivable during the year ended September 30, 2004. Our Chief Executive Officer, Christopher Swartz is also a member of the QRVC Board of Directors. The results of operations are included in our consolidated financial statements up until the date of sale. Quantitative and Qualitative Disclosures About Market Risk The Company believes that its revenues and results of operations have not been significantly affected by inflation during the two years ended September 30, 2004. One of the Company's long-term debt loans is subject to variable interest rates. Significant fluctuations in interest rates therefore could have an adverse effect on the Company and its ability to fund working capital requirements. ITEM 7. FINANCIAL STATEMENTS Attached hereto and filed as part of this Form 10-KSB are the consolidated financial statements listed in the index to the Consolidated Financial Statements at page F-1. ITEM 8. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None 16 ITEM 8A. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures. Within the 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with participation of our management, including the Chief Executive Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting members of the management to material information relating to the Company required to be included in our periodic SEC filings. (b) Changes in internal controls. No significant changes were made in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. 17 PART III ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT Executive Officers and Directors of the Company The following table sets forth certain information with respect to the executive officers and directors. Each director holds such position until the next annual meeting of our shareholders and until his successor has been duly qualified and elected. Any of our officers may be removed, with or without cause, by the board of directors. -------------------------------------------------------------------------------- Name Age Director/Date Office or Position Elected -------------------------------------------------------------------------------- Christopher M. Swartz 34 Yes/ Apr 1996 Chairman, President and Chief Executive Officer Eric T. Swartz 38 Yes/ Apr 1996 Secretary * Michael F. Cronin 48 No / Apr 2000 Chief Financial Officer/Treasurer and Chief Operating Officer Richard Beattie 40 Yes/ Oct 2002 Director Harold L. Kestenbaum 46 Yes/ Apr 2004 Director -------------------------------------------------------------------------------- * Mr. Cronin resigned from the board of directors on February 29, 2004. Christopher M. Swartz, Chairman, President and CEO has been Chairman, President and Chief Executive Officer of the Company since April 1996 and Chairman, President and Chief Executive Officer of JRECK Subs, Inc. since September 1994. Mr. Swartz is on the Board of Directors of the Florida Restaurant Association and has won multiple National leadership awards from the National Republican Committee. Mr. Swartz is also a member of the board of our affiliate company Weight Loss Forever International, Inc. Mr. Swartz is a 1992 honors graduate from Syracuse University. Eric T. Swartz has been a Director and Secretary since April, 1996. He was awarded his J.D. degree and undergraduate degree from Syracuse University College of Law and Syracuse University, respectively. From October 1993 to the present he has been a partner in the Swartz Law Firm, P.C. and was associated with the law firm of Pease and Willer after graduating from law school in 1992. Mr. Swartz is the brother of Christopher M. Swartz. Richard P. Beattie has had a very long and successful career as a developer and operator of some of the largest and most respected restaurant chains in the country. He is currently the largest franchisee of the Denny's corporation, operating over 65 units and in November 2000 was presented with the award for Developer of the Year for Denny's Inc. Mr. Beattie has been involved with the Franchise Advisory Council for Denny's for nine years and served on several corporate committees. He is also one of only eight Chili's franchisees with ownership rights for the states of Washington and Oregon. In addition to the eight Chili's restaurants he presently operates, there are two more under development. Mr. Beattie is considered to be one of the top fifty franchise operators in the country by most industry publications. Mr. Kestenbaum served as franchise and general counsel to Sbarro, Inc., the national franchisor of over 900 family-style Italian restaurants and, since March 1985, he has been a director of Sbarro, whose securities were formerly listed on the New York Stock Exchange. In addition, he currently sits on the Board of Directors of RezConnect Technologies, Inc., NYB Foods Inc., Desert Moon Cafe Franchise Corp., GarageTek, Inc. and Wall Street Deli Systems, Inc. From September 1983 to October 1989, he served as President and Chairman of the Board of FranchiseIt Corporation, the first publicly traded company specializing in providing franchise marketing and consulting services and equity financing to emerging franchise companies, which he co-founded. 18 Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934 requires executive officers and directors, and persons who beneficially own more than 10% of the Company's common stock, to file initial reports of ownership and reports of changes in ownership with the Securities and Exchange Commission. Executive officers, directors and greater than 10% beneficial owners are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms they file. Based solely on the Company's review of copies of such reports and written representations from the Company's executive officers and directors, the Company believes that its executive officers and directors complied with all Section 16(a) filing requirements during the fiscal year ended September 30, 2004. ITEM 10. EXECUTIVE AND DIRECTOR COMPENSATION Summary Compensation Table The following table sets forth the cash compensation of our executive officers and directors during each of the last three fiscal years. The remuneration described in the table does not include the cost to the company of benefits such as health insurance premiums, and other benefits, furnished to the named executive officers, that are extended in connection with the ordinary conduct of our business. The value of such benefits cannot be precisely determined, however no executive officer named below received any such benefits in excess of the lesser of $25,000 or 10% of such officer's cash compensation.
Summary Compensation Table ----------------------------------------------------------------------------------------------------------------------- Annual Compensation Long Term Compensation ----------------------------------------------------------------------------------------------------------------------- Name & Principal Other Annual Awards Awards Payouts All Other Position Year Salary Bonus Compensation ---------------------------------------------- Restricted Options LTIP Stock in $ SARS (#) Payouts ($) ----------------------------------------------------------------------------------------------------------------------- 2004 $ 175,000 $ 0 $ 0 $ 0 0 $ 0 $ 0 Christopher M. Swartz 2003 $ 175,000 $ 0 $ 0 $ 0 0 $ 0 $ 0 President & CEO 2002 $ 175,000 $ 0 $ 0 $ 0 500,000 $ 0 $ 0 ----------------------------------------------------------------------------------------------------------------------- Michael F. Cronin 2004 $ 58,333 $ 0 $ 0 $ 0 0 $ 0 $ 0 Chief Financial Officer 2003 $ 140,000 $ 0 $ 0 $ 0 0 $ 0 $ 0 & Chief Operating Officer 2002 $ 140,000 $ 0 $ 0 $ 0 500,000 $ 0 $ 0 -----------------------------------------------------------------------------------------------------------------------
(a) Mr. Cronin resigned from his position of Chief Financial Officer and Chief Operating Officer on February 29, 2004. 19 Employment Contracts None Options and Rights Granted to Purchase Common Stock The following table summarizes options and rights to purchase common stock that were granted or issued to executive officers and directors over each of the last three fiscal years:
--------------------------------------------------------------------------------------------------------------------------- Number Percent of of Number of Total Options Shares of Date of Exercise Options Granted Common Grant Price of Granted to (in Stock or Expiration Purchase Employees Name Position Shares) Purchased Purchase Date Price During Year --------------------------------------------------------------------------------------------------------------------------- Christopher M. Swartz President and 250,000 Oct 01, 2001 Oct 01, 2007 $ 0.08 13.9% Chief Executive 250,000 Oct 01, 2001 Oct 01, 2008 $ 0.08 13.9% Officer Michael F. Cronin Chief Financial 250,000 Oct 01, 2001 Oct 01, 2007 $ 0.08 13.9% Officer and Chief 250,000 Oct 01, 2001 Oct 01, 2008 $ 0.08 13.9% Operating Officer --------------------------------------------------------------------------------------------------------------------------- Stock Appreciation Rights granted to our officers during 2004 The following table sets forth information regarding the value of Options and ---------------------------------------------------------------------------------------------------------------------------- Number of Securities Underlying Value of In-The-Money Unexercised Options and SAR's Options and SAR's at September 30, 2004 at September 30, 2004 ---------------------------------------------------------------------------------------------------------------------------- Shares Acquired Name and Position on Exercise Value Realized Exercisable Unexercisable Exercisable Unexercisable ---------------------------------------------------------------------------------------------------------------------------- Christopher M. Swartz None None 500,000 None $215,000 None President and Chief Executive Officer Michael F. Cronin None None 600,000 None $215,000 None Chief Financial Officer and Chief Operating Officer ----------------------------------------------------------------------------------------------------------------------------
20 Other We do not carry officers & directors liability insurance or disability benefits in excess of statutorily mandated amounts. Directors receive no compensation for their duties. ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information relating to the beneficial ownership of the Company's Common Stock by those persons beneficially holding more than 5% of the Company's common stock or held by our executive officers and directors, and by all our officers and directors as a group as of September 30, 2004. The address of each person is in care of the Company unless noted. As used in the table, the term "beneficial ownership" means the sole or shared power to vote, or to direct the voting of a security, or the sole or shared investment power with respect to a security (i.e. the power to dispose of, or to direct the disposition of, a security). In addition, for purposes of this table, a person is deemed to have "beneficial ownership" of any security if such person has the right to acquire such security within sixty days. -------------------------------------------------------------------------------- Name and Amount and Address of Officer Nature of Title of Beneficial or Beneficial Percent of Class Owner Director Owner Class -------------------------------------------------------------------------------- Common Stock Christopher M. Swartz Yes (a) 2,556,709 17.21% Common Stock Eric Swartz Yes 42,500 0.05 % Common Stock Richard Beattie Yes (b) 100,000 0.07 % All Officers and Directors as a Group 2,699,209 24.30 % (a) Includes 1,537,037 shares of common stock owned by TAS LLC. Mr. Swartz is an 83% partner in TAS, and as such, is deemed to have beneficial ownership of 83% of the shares owned by TAS. It also includes 374,421 shares of common stock owned by Tri-Emp Enterprises, a limited family partnership. Mr. Swartz is the general partner of Tri-Emp Enterprises, and as such, is deemed to have beneficial ownership of the shares owned by Tri-Emp Enterprises. It also includes 500,000 shares subject to options exercisable by Mr Swartz. (b) Includes 400,000 shares of common stock owned by The Allor Trust In October 2002, pursuant to a stock purchase agreement we issued 400,000 shares of our common stock to The Allor Trust, ("Allor") in exchange for $100,000. In addition, Richard Beattie was appointed to our Board of Directors as a result of this transaction. 21 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Formation of Joint Venture In October 2002, we formed a joint venture with Concept Acquisitions, LLC., ("COAC") The joint venture has purchased 100% of the assets in the Flamers hamburger concept with 55 units throughout the Mid-Atlantic United States. The purchase price consisted of $1,000,000 in cash and a note payable for $1,600,000 which will require principal and interest payments over a three year period with a balloon payment due thereafter. The transaction was funded as follows:
UFSI COAC Total ----------- ------------ ------------- Cash for equity position in Joint Venture 350,000 350,000 700,000 Cash for note receivable 300,000 - 300,000 ----------- ------------ ------------- Total cash used for acquisition 650,000 350,000 1,000,000 ======================================
Conversion of Note Receivable to Equity Subsequent to the formation of the COAC joint venture, in March 2003 we converted our $300,000 note receivable issued to form the joint venture with COAC into equity. Under the terms of the agreement, Ultimate Franchise Systems, Inc. will receive the greater of $15,000 per month or 50% of the cash distributions or sales proceeds of COAC II until December 31, 2005. Thereafter, Ultimate Franchise Systems will be entitled to a 25% interest in cash distributions and sales proceeds. In addition, and in connection with this transaction we converted our note receivable of $265,000 due from COAC into an equity interest in COAC. This equity interest provides for UFSI to receive 18% of the cash distributions and sales proceeds of COAC commencing after repayment by COAC of all outstanding debt obligations which is expected to occur in April 2007. Management Agreements In December 2002, we entered into a letter agreements with Topper's Brick Oven Pizza, Inc. ("Topper's") and Weight Loss Forever, International Inc. ("Weight Loss Forever") whereby we will offer our expertise in purchasing, marketing, franchise legal services, franchise sales, and general management to each company in exchange for 6,000,000 shares of common stock of each company. The value of these services is $500,000 and will be amortized over a 24 month period beginning in December 2002. In August 2004, we received 6,000,000 shares of common stock from Fransaction, Inc in exchange for franchise management services we plan to provide this company. As a result of this transaction we now own 59% of the issued and outstanding shares of Fransaction, Inc. 22 Item 13. Exhibits and Reports on Form 8-K. a) Exhibits. The following exhibits are included as part of this report at the location indicated: SEC Exhibit Reference Number Number Title of Document Location ---------- --------- ---------------------------------------- ---------------- Item 31 Certifications ---------- --------- ---------------------------------------- ---------------- 31.1 31 Certification of Chief Executive Officer This filing of Periodic Report pursuant to Rule 13a-14a and Rule 15d-14(a). 32.1 32 Certification pursuant to 18 U.S.C. This filing Section 1350. (b) Reports on Form 8-K. During the year ended September 30, 2004, Ultimate Franchise Systems, Inc. did not file any reports on Form 8-K. Item 14. Principal Accountant Fees and Services The following table sets forth the aggregate fees for professional services billed to us by our principal accounting firm, Berman Hopkins Wright & LaHam, LLP, for the past two fiscal years. Such information is provided as of December 6, 2004 and, accordingly, the information for Fiscal 2004 may be subject to change: Year Ended September 30, 2004 2003 ----------- ----------- Audit Fees...................... $ 76,343 $ 62,852 Tax Fees........................ 26,452 22,354 ----------- ----------- $ 102,795 $ 85,206 =========== =========== Tax fees are for the preparation of our U.S. corporate federal and state tax returns. All work performed by our independent registered certified public accountants must be pre-approved by our Audit Committee to ensure that all such work is compatible with maintaining the principal accountant's independence. 23 SIGNATURES In accordance with all the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Ultimate Franchise Systems, Inc. ------- ------------------------ (Registrant) President, Chief Financial Officer & Duly Authorized Officer Member of 01/13/05 Christopher M. Swartz Board of Directors /s/ Christopher M. Swartz -------- --------------------- ------------------- ------------------------- Date Print Name Title Signature 24 Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 Contents Independent Auditors' Report on Consolidated Financial Statements............F-1 Consolidated Financial Statements: Consolidated Balance Sheets.......................................F-2 - F-3 Consolidated Statements of Operations...................................F-4 Consolidated Statements of Cash Flows.............................F-5 - F-6 Consolidated Statements of Stockholders' Equity.........................F-7 Notes to Consolidated Financial Statements.......................F-8 - F-34 25 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Ultimate Franchise Systems, Inc. Heathrow, Florida We have audited the accompanying consolidated balance sheets of Ultimate Franchise Systems, Inc. and subsidiaries as of September 30, 2004, and 2003, and the related consolidated statements of operations, stockholders' equity and cash flows for the years then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the Standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Ultimate Franchise Systems, Inc. and subsidiaries as of September 30, 2004, and 2003 and the consolidated results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Berman Hopkins Wright & LaHam, CPA's, LLP Berman Hopkins Wright & LaHam, CPA's, LLP Melbourne, Florida November 17, 2004 F-1
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Balance Sheets September 30, September 30, 2004 2003 --------------------------------------------------------------------------------------------------------------------- Assets Current assets: Cash $ 104,656 $ 21,083 Accounts receivable 38,746 56,059 Prepaid expenses 4,547 6,014 Current portion of notes receivable 192,213 132,796 --------------------------------------------------------------------------------------------------------------------- Total current assets 340,162 215,952 --------------------------------------------------------------------------------------------------------------------- Property and equipment, net 94,780 63,449 --------------------------------------------------------------------------------------------------------------------- Other assets: Goodwill 2,625,773 3,531,057 Deferred loan costs, net 49,103 114,563 Notes receivable, net of current portion and allowance of $1,146,940 and $274,500, respectively 1,161,596 2,275,952 Investment securities 293,947 749,816 Other Investments 1,368,989 1,041,719 --------------------------------------------------------------------------------------------------------------------- Total other assets 5,499,408 7,713,107 --------------------------------------------------------------------------------------------------------------------- Total assets $ 5,934,350 $ 7,992,506 ===================================================================================================================== Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-2
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Balance Sheets, Continued September 30, September 30, 2004 2003 --------------------------------------------------------------------------------------------------------------------- Liabilities and Stockholders' Equity Current liabilities: Current portion of long-term debt $ 1,595,960 $ 788,489 Accounts payable 451,657 199,267 Deferred revenue 41,673 291,669 Accrued expenses 667,965 520,523 Accrued preferred stock dividends 13,325 19,825 --------------------------------------------------------------------------------------------------------------------- Total current liabilities 2,770,580 1,819,773 --------------------------------------------------------------------------------------------------------------------- Long-term debt, less current portion 2,229,511 2,037,073 --------------------------------------------------------------------------------------------------------------------- Total liabilities 5,000,091 3,856,846 --------------------------------------------------------------------------------------------------------------------- Minority interest - 202,902 --------------------------------------------------------------------------------------------------------------------- Redeemable common stock - 293,000 --------------------------------------------------------------------------------------------------------------------- Stockholders' equity: Series C convertible preferred stock, no par value, 120 shares authorized, issued and outstanding 120,000 120,000 Common stock, $.001 par value, 100,000,000 shares authorized, 15,023,194, and 13,749,350 shares issued and outstanding, respectively 31,131,059 30,611,215 Accumulated deficit (30,088,841) (27,305,884) Accumulated other comprehensive (loss) income (227,959) 214,427 --------------------------------------------------------------------------------------------------------------------- Total stockholders' equity 934,259 3,639,758 --------------------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 5,934,350 $ 7,992,506 ===================================================================================================================== Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-3
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Statements of Operations Year Year Ended Ended September 30, September 30, 2004 2003 ---------------------------------------------------------------------------------------------------- Revenues: Franchise operations $ 1,929,462 $ 1,335,858 Retail sales - company-owned stores 527,868 756,213 Equipment sales 140,603 - Management services 538,444 367,614 ---------------------------------------------------------------------------------------------------- 3,136,377 2,459,685 Operating costs and expenses: Franchise servicing costs 1,067,204 743,498 Cost of retail sales and operating costs - stores 532,211 804,228 Cost of sales - equipment 224,674 - General and administrative 1,182,763 1,249,354 Consulting and investor relations 195,450 210,044 Amortization and depreciation 8,595 15,324 ---------------------------------------------------------------------------------------------------- 3,210,897 3,022,448 ---------------------------------------------------------------------------------------------------- Income (loss) from operations (74,520) (562,763) Other income (expense): Interest, net (366,464) (184,412) Impairment of notes receivable and investment securities (1,096,443) (624,500) Impairment of goodwill (1,319,154) (221,704) Equity of earnings/(losses) of unconsolidated subsidiary (54,083) (789) Gain on disposal of consolidated subsidiary 243,340 - Minority interest in income of subsidiary - 40,008 Loss on the sale of company owned restaurant (149,797) - Other, net 49,764 40,000 ---------------------------------------------------------------------------------------------------- (2,692,837) (951,397) ---------------------------------------------------------------------------------------------------- Net income (loss) (2,767,357) (1,514,160) ---------------------------------------------------------------------------------------------------- Preferred stock dividends (15,600) (15,600) ---------------------------------------------------------------------------------------------------- Net income (loss) applicable to common stock $ (2,782,957) $ (1,529,760) ==================================================================================================== Weighted average number of common shares outstanding 14,188,789 13,335,826 Earnings (loss) per basic and diluted common share: Net income (loss) per common share - basic $ (.20) $ (.11) Net income (loss) per common share - diluted N/A N/A ==================================================================================================== Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-4
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Statements of Cash Flows Year Year Ended Ended September 30, September 30, 2004 2003 ------------------------------------------------------------------------------------------------- Operating activities: Net income (loss) $ (2,767,357) $ (1,514,160) Adjustments to reconcile net loss to net cash used by operating activities: Amortization and depreciation 8,595 15,324 Allowance for notes receivable 150,820 274,500 Impairment of long-lived assets 1,246,240 277,635 Permanent impairment of goodwill - 221,704 Gain on settlement of long-term debt - (40,000) Discount on early settlement of notes receivable 1,274,796 - Gain on sale of consolidated subsidiaries (243,340) - Stock and stock options issued for services 47,750 65,000 Stock of majority owned subsidiary issued for services - 8,563 Stock issued for interest on long-term debt 125,096 Stock issued for restructuring of long-term debt - 29,000 Minority interest in income (loss) of subsidiary - (40,008) Amortized discounts on financial instruments 11,796 - Loss on settlement of redeemable common stock (23,517) - Amortization of deferred loan costs to interest expense 65,460 65,460 Capitalized interest on notes receivable (131,130) (136,109) Unrealized gain on equity earnings of joint venture (122,282) - (Increase) decrease in: Accounts receivable (60,566) 101 Prepaid expenses 1,465 21,333 Other assets - - Increase (decrease) in: Accounts payable (274,576) 38,853 Deferred revenue (233,631) (210,344) Accrued liabilities (90,702) 111,550 ------------------------------------------------------------------------------------------------- Net cash used by operating activities (1,015,083) (811,598) ------------------------------------------------------------------------------------------------- Investing activities: Purchase of property and equipment (2,690) (2,550) Proceeds from sale of marketable securities - 57,000 Issuance of notes receivable (18,667) - Proceeds from collection of dividends - 27,008 Cash used for investment in restaurant concepts (438,582) - Cash from sale of majority owned subsidiary 96,260 - Cash used for formation of joint venture - (650,000) Cash used for formation of management company (30,000) - Return of capital from managment company 15,000 - Proceeds from collection of notes receivable 520,497 897,000 ------------------------------------------------------------------------------------------------- Net cash provided by investing activities 141,818 328,458 ------------------------------------------------------------------------------------------------- Financing activities: Borrowings on long-term debt 1,910,070 300,000 Proceeds from sale of common stock - 100,000 Dividends paid on preferred stock (22,100) (6,500) Payments on long-term debt (931,132) (588,511) ------------------------------------------------------------------------------------------------- Net cash provided (used) by financing activities 956,838 (195,011) ------------------------------------------------------------------------------------------------- Net increase (decrease) in cash and cash equivalents 83,573 (678,151) Cash and cash equivalents, beginning of period 21,083 699,234 ------------------------------------------------------------------------------------------------- Cash and cash equivalents, end of period $ 104,656 $ 21,083 ================================================================================================= Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-5
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Statements of Cash Flows, Continued Certain supplemental disclosure of cash flow information and non-cash investing and financing activities is as follows: Year Year Ended Ended September 30, September 30, 2004 2003 ---------------------------------------------------------------------------------------------------------------------------- Cash paid for interest $ 227,131 $ 184,508 ---------------------------------------------------------------------------------------------------------------------------- Conversion of note receivable into joint venture equity $ - $ 543,083 Accrued preferred stock dividends relieved - 32,917 Acquisition of investment securities for services 600,000 500,000 Write down of non-refundable deposit of potential acquisition - 75,000 Unrealized gain / (loss) on marketable securities (442,386) 214,427 Preferred stock dividends accrued 15,600 15,600 Stock returned to treasury for cancellation of subscription receivable - 687,500 Common stock issued for settlement of redeemable common stock (120,000) - Stock adjustment for sale of Sobik subsidiary (285,002) - Note receivable received from sale of Sobik subsidiary (900,000) - Adjustment of majority interests from sale of Sobik subsidiary (202,902) - Receipts of Series A preferred stock from sale of Sobik subsidiary (8,058) - Note payable from settlement of redeemable common stock 60,000 - Stock issued for acquisiton of Obee's subsidiary 512,000 - Debt acquired in acquisiton of Obee's subsidiary 196,154 - Fixed assests acquired from Obee's subsidiary (87,427) - ============================================================================================================================ Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-6
Ultimate Franchise Systems, Inc. and Subsidiaries Consolidated Statements of Stockholders' Equity Accumulated Other Preferred Compre- Common Series C Subscrip- hensive ---------------------- ----------------- Accumulated tion Income Total Shares Amount Shares Amount Deficit Notes (Loss) Equity ------------------------------------------------------------------------------------------------------------------------------------ Balance, September 30, 2002 12,749,415 $31,096,152 120 $120,000 $(25,809,041) $(687,500) $ - $4,719,611 Issuance of common stock as payment of interest on long-term debt 200,000 29,000 - - - - - 29,000 Excess of par value of subsidiary common stock issued for services 8,563 - - - - - 8,563 Stock returned to the treasury of the company (50,065) (687,500) - - - 687,500 - - Issuance of common stock for cash 400,000 100,000 - - - - - 100,000 Stock issued for services 450,000 65,000 - - - - - 65,000 Write off of preferred Series F dividends - - - - 32,917 - - 32,917 Preferred dividends - - - - (15,600) - - (15,600) Net loss - - - - (1,514,160) - - (1,514,160) Unrealized gain on investment securities - - - - - - 214,427 214,427 ------------------------------------------------------------------------------------------------------------------------------------ Balance, September 30, 2003 13,749,350 $30,611,215 120 $120,000 $(27,305,884) $ - $214,427$ 3,639,758 Excess of par value of subsidiary common stock sold for cash and note receivable - (285,002) - - - - - (285,002) Stock issued as interest on long-term debt 173,844 125,096 - - - - - 125,096 Stock issued for settlement of redeemable common stock 200,000 120,000 - - - - - 120,000 Stock issued for acquisition of subsidiary 800,000 512,000 - - - - - 512,000 Stock issued for services 100,000 47,750 - - - - - 47,750 Preferred dividends - - - - (15,600) - - (15,600) Net loss - - - - (2,767,357) - - (2,767,357) Unrealized loss on investment securities - - - - - - (442,386) (442,386) Balance, September 30, 2004 15,023,194 $31,131,059 120 $120,000 $(30,088,841) $ - $(227,959)$ 934,259 ==================================================================================================================================== Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-7
Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 1. Background Information Ultimate Franchise Systems, Inc. (collectively "we" and "our"), was incorporated on July 19, 1995 under the laws of the State of Colorado. On April 25, 2002, we changed our state of domicile from the State of Colorado to the State of Nevada. We are a franchise management and venture company with minority interests in numerous restaurant concepts located throughout the United States. Our headquarters are located in Heathrow, Florida. Currently, we have equity interest in companies controlling approximately 585 franchised restaurant locations and 40 weight loss clinics throughout the United States. Our strategy continues to be one of growth. The majority of which is through the acquisition of minority positions in other restaurant franchise companies. This allows us to provide franchise management services to other companies without any increase to operating expenses and provides us with a more diversified portfolio of restaurant brands. In addition, we offer guidance and assistance to the franchisees in areas such as product preparation, equipment purchasing, marketing, administrative support and employee training. 2. Liquidity and Capital Resources The accompanying consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America, which contemplates continuation of the Company as a going concern. However, the Company has sustained substantial losses from operations in recent years. In addition, the Company has used, rather than provided, cash in its operations. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainity. The Company has incurred losses in each of the past two years. As of September 30, 2004, it had an accumulated deficit of $30,088,841. During the fiscal year ended September 30, 2004, the Company incurred a loss of $2,767,357 and used cash in operations of $1,015,083. The Company's working capital deficit as of September 30, 2004 was 2,430,418. To address this deficiency, we have a signed commitment from an individual to contribute $2.5 million dollars in the form of a convertible debenture. This individual has expressed an interest to convert this debenture into common stock immediately and as a result an addendum to this agreement is currently being negotiated. We expect that this will require us to issue approximately five million shares of our common stock and allow this individual to become a member of our Board of Directors. The proceeds from this investment will be used to fund our working capital deficit, fund our ongoing operations, and to make additional acquisitions of other restaurant concepts. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-8 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 2. Liquidity and Capital Resources (continued) The company has also made significant changes in how it will oversee and operate its investments. The operating systems and, therefore, the cash flow have been streamlined with all division Presidents now reporting to a newly hired Chief Operating Officer. We believe this streamlining and the maturation of revenue streams will now allow us to operate those entities profitably. The vast majority of the initial cash requirements to oversee these investments are behind us and in the coming years, we should now see the return on the capital that was invested in these entities. With the imminent resolution of our business transformation being complete, we feel that we have addressed or will be addressing the financial challenges to allow us to continue as a going concern. 3. Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Ultimate Franchise Systems, Inc. and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-9 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 3. Significant Accounting Policies (continued) Use of Estimates The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates. Cash and Cash Equivalents For financial presentation purposes, we consider those short-term, highly liquid investments with original maturities of three months or less to be cash and cash equivalents. Property and Equipment Property and equipment are recorded at cost. Maintenance and repairs are charged to operations as incurred. Betterments and renewals are capitalized. When property and equipment are sold or otherwise disposed of, the asset account and the related accumulated depreciation accounts are relieved, and any gain or loss is included in operations. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, generally ranging from five to 40 years. For the years ended September 30, 2004 and 2003, depreciation expense amounted to $6,562 and $7,191 respectively. Asset Impairment We regularly examine our long-lived assets for possible impairment indicators. If an impairment indicator is noted, the estimated undiscounted future cash flows of these assets are compared to the recorded value of the assets. If the net recorded value cannot be recouped, the assets are written down to their fair market value. For the years ended September 30, 2004 and 2003, we determined that certain investments and notes receivable had incurred impairment (see notes 5 & 6). As a result, the accompanying consolidated statements of operations reflects a write-down of long-lived assets in the amount of $1,096,443 and $624,500 respectively. Deferred Loan Costs Deferred loan costs are amortized ratably over the terms of the related loans. For the years ended September 30, 2004 and 2003, amortization of deferred loan costs amounted to $65,460 for both years. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-10 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 3. Significant Accounting Policies (continued) Goodwill Goodwill represents the excess of cost over the fair value of net assets acquired and is being examined regularly for impairment using the discounted future cash flows method. If any such impairment exists, the related assets are written down to fair value. During the year ended September 30, 2004 we reviewed the goodwill associated with our acquisition of Obee's Franchise Systems, Inc. This analysis indicated an immediate impairment of all goodwill associated with the acquisition. As a result, we recorded a $1,319,154 impairment charge during the third quarter of this year. Additionally, we agreed to sell our one remaining Central Park hamburger restaurant. This transaction will be consummated in November 2004, and will result in an impairment of the goodwill associated with this location. As a result, an impairment charge of $97,573 was recorded during the fourth quarter of 2004. Revenue Recognition Continuing franchise royalty revenue is recognized monthly as earned. Initial franchise royalty revenue is recognized when all services or conditions relating to the sale of the individual franchise has been substantially performed. Revenues from company-owned stores and bakery products are recognized upon the sale of products. Advertising Costs Advertising costs are charged to operations as incurred. Advertising expenses were $15,440 and $13,219 for the years ended September 30, 2004 and 2003, respectively. Accounting for Stock-Based Compensation The Financial Accounting Standards Board issued Statement 123 ("FAS 123"), "Accounting for Stock-Based Compensation", which provides that expense equal to the fair value of all stock-based awards on the date of the grant be recognized over the vesting period. Alternatively, this statement allows entities to continue to apply the provisions of Accounting Principles Board Opinion No. 25 ("APB 25"), "Accounting for Stock Issued to Employees", whereby compensation expense is recorded on the date the options are granted equal to the excess of the market price of the underlying stock over the exercise price. We apply APB 25 and related interpretations in accounting for employee stock options. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-11 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 3. Significant Accounting Policies (continued) Investment Securities Our investment securities have been classified entirely as available-for-sale securities. Available-for-sale securities are recorded at cost and adjusted to fair market value on each subsequent balance sheet date. Any change in fair market value between the purchase date and all subsequent balance sheet dates is excluded from earnings. Rather, this amount is included as a component of other comprehensive income. It is our intention to hold investment securities for an indefinite period of time. Therefore, we have classified our investment securities as non-current assets. Upon disposal, the entire amount of a security's accumulated other comprehensive gain or loss is reclassified into the statement of operations as a component of the realized gain or loss on disposal. Realized gains or losses on the sale of investment securities are determined on the first-in, first-out ("FIFO") basis. A permanent impairment in value of equity securities classified as available for sale is an impairment that is other than temporary. If a permanent impairment is deemed to exist, the decline in value is reflected in current operations and the reduced carrying amount becomes the new cost basis from which other increases or decreases in value are measured. Fair Value of Financial Instruments Financial Accounting Standards Board Statement No. 107 ("FAS 107"), "Disclosures about Fair Value of Financial Instruments," requires disclosure of fair value information about financial instruments. Fair value estimates discussed herein are based upon certain market assumptions and pertinent information available to management as of September 30, 2004. The respective carrying value of on-balance-sheet financial instruments approximates their fair values. These financial instruments include cash and equivalents, accounts receivables, prepaid expenses, accounts payable, deferred revenue, accrued liabilities and accrued preferred stock dividends. Fair values were assumed to approximate carrying values for these financial instruments since they are short term in nature and their carrying amounts approximate fair values or they are receivable or payable on demand. The fair values of our notes receivable and long-term debt are estimated based upon the quoted market prices for the same or similar issues or on the current rates offered for instruments of the same remaining maturities. The carrying value of our notes receivable and long-term debt approximates their fair market value. Investment securities are stated at fair market value which are determined by quoted market prices or other valuation indicators. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-12 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 3. Significant Accounting Policies (continued) Earnings Per Common Share We have adopted the provisions of Financial Accounting Standards Board Statement No. 128 ("FAS 128"), "Earnings per Share". FAS 128 replaces the previously reported primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share exclude any dilutive effects of options, warrants and convertible securities. Diluted earnings per share are computed similarly to fully diluted earnings per share. Contingently issuable shares are included in basic earnings per share as of the date all necessary conditions have been satisfied. Contingently issued shares are included in diluted earnings per share based on the number of shares, if any, that would be issuable under the terms of the acquisition agreements if the end of the reporting period were the end of the contingency period. Potential common shares at September 30, 2004 and 2003 include 2,229,794 stock options and warrants and approximately 450,000 shares from convertible notes payable, for both years. We also have a liability to issue 25,000 shares of common stock as of September 30, 2004 and 2003, respectively. This liability to issue common stock of $58,650 is included as a component of accrued expenses on the accompanying consolidated balance sheets. Income Taxes We account for income taxes using the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities. Measurement of deferred income tax is based on enacted tax rates and laws that will be in effect when the differences are expected to reverse, with the measurement of deferred income tax assets being reduced by available tax benefits not expected to be realized. Recent Accounting Pronouncements In January 2003, the FASB issued Interpretation 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or entitled to receive a majority of the entity's residual returns or both. The consolidation requirements of Interpretation 46 apply immediately to Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-13 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 3. Significant Accounting Policies (continued) Recent Accounting Pronouncements (continued) variable interest entities created after January 31, 2003. The consolidation requirements apply to transactions entered into prior to February 1, 2003 in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of the Interpretation on July 1, 2003 did not have a material impact on our financial statements. In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. The Statement is effective (with certain exceptions) for contracts entered into or modified after June 30, 2003. The adoption of this Statement has had no material impact on our financial statements. In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of this Statement has had no material impact on our financial statements. Risk and Uncertainties The primary uncertainty which we face is our ability to locate knowledgeable franchisees who also have the financial resources to successfully operate the stores. In addition, we need to be able to identify appropriate locations for our newly franchised stores. We believe that we have taken the steps necessary to minimize these risks. Reclassifications Certain amounts in the 2003 financial statements have been reclassified to conform to the 2004 presentation. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-14 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 4. Disposition of Subsidiaries and Company Owned Restaurant Location Changes in goodwill and accumulated amortization for the years ended September 30, 2004 and 2003 are as follows:
Accumulated Net Goodwill Amortization Goodwill --------------------------------------------------------------------------------------------------------- Balance, September 30, 2002 $ 4,175,853 $ (423,092) $ 3,752,761 Impairment of Sobik's Subs (221,704) - (221,704) --------------------------------------------------------------------------------------------------------- Balance, September 30, 2003 $ 3,954,149 $ (423,092) $ 3,531,057 Acquisition of Obee's 1,319,154 - 1,319,154 Impairment of Obee's (1,319,154) - (1,319,154) Sale of Sobik's (1,053,897) 246,186 (807,711) Impairment of Central Park restaurant (97,573) - (97,573) --------------------------------------------------------------------------------------------------------- Balance, September 30, 2004 2,802,679 (176,906) 2,625,773 =========================================================================================================
Sobik's International Franchising, Inc. On December 29, 2003, we sold our majority interest in Sobik's International Franchising, Inc. ("Sobik's") to Quality Restaurant Ventures Corp. ("QRVC"). Under the terms of this agreement, we agreed to sell 17,445,664 shares of Sobik's in exchange for $100,000 in cash, a note receivable of $900,000, and 1,000,000 shares of "Series A Convertible Preferred Stock" in Sobik's. This preferred stock is convertible at our option and is anti- dillutive. If all 1,000,000 shares of the Series A Convertible Preferred stock were converted at the same time, we would own 19% of the outstanding common stock of Sobik's. The $900,000 note receivable requires QRVC to pay us quarterly interest only payments of $15,750 until December 2004. At that time QRVC will pay us an additional $100,000 in principal and continue to make quarterly interest payments of $14,000 until December 31, 2005. At that time the remaining principal balance will be amortized and paid in monthly principal and interest installments of $13,489 until 2013. Subsequent to this transaction, an analysis of the QRVC financials indicated inadequate cash flows provided from operations to make payments on this note. As a result, we recorded a $500,000 impairment charge to our note receivable during the year ended September 30, 2004. Our Chief Executive Officer, Christopher Swartz is also a member of the QRVC Board of Directors. The results of operations are included in our consolidated financial statements up until the date of sale. Central Park Company Owned Store In September 2004, we agreed in principle to a sale of our corporately owned Central Park store located in Selma, Alabama. The sale was finalized in November 2004 and as a result Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-15 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 4. Disposition of Subsidiaries (continued) Central Park Company Owned Store (continued) the goodwill associated with this location has been determined to be impaired. A charge to earnings in the amount of $97,573 was taken in the fourth quarter of 2004. 5. Acquisitions of Restaurant Concepts & Other Equity Investments Obee's Franchise Systems, Inc. On June 16, 2004, we purchased all issued and outstanding common stock of Obee's Franchise Systems, Inc. ("Obee's"). Obee's is the franchisor of the Obee's Soup & Subs concept based in Port Charlotte, Florida with approximately 55 franchised units located throughout the United States. The purchase price of Obee's consisted of the issuance of 800,000 shares of our common stock valued at $.64 per share ($512,000) as well as cash of $98,377. The transaction was recorded as follows: Total consideration paid $ 610,377 Less fair value of assets acquired $ 203,926 Plus liabilities assumed $ 912,703 ---------- Excess of cost over net assets acquired (goodwill) $1,319,154 ========== The goodwill associated with this transaction was deemed to be impaired and was expensed during the quarter ended June 30, 2004. Franchise Management Company, LLC. In January 2004, we completed the formation of Franchise Management Company, LLC. ("FMC"), whereby our Central Park brand will combine franchising revenues and expenses with other regional quick service restaurant concepts. The benefit of this type of partnership is twofold; first, we have been able to significantly reduce our overhead costs by spreading these costs over multiple brands. Second, we expect an increase in franchising revenue by increasing our purchasing power associated with the aggregation of these concepts. FMC began operations on March 1, 2004. Our initial investment in FMC was $30,000 which represents a 33.3% interest in this partnership. In June 2004, the Members of FMC elected to redistribute a portion of our initial investment. As a result, in June 2004 we received $15,000 as a partial return of our equity in this partnership. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-16 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 5. Acquisitions of Restaurant Concepts & Other Equity Investments Piccadilly Restaurant Investment Group, LLC In March 2004, we invested $350,000 in exchange for an ownership interest in Bristol Equity Partners, LLC. Bristol Equity Partners, LLC is a private investment Florida limited liability company that was formed for the purpose of purchasing units of Piccadilly Restaurant Investment Group, LLC. Piccadilly Restaurant Investment Group, LLC purchased the assets of the Piccadilly Cafeteria restaurant concept on March 15, 2004. Piccadilly operates 136 cafeterias in 15 states primarily in the Southeast and Mid Atlantic regions. Our $350,000 investment represents a 1% interest in Piccadilly Restaurant Investment Group, LLC. Concept Acquisitions II In October 2002, we formed a joint venture with Concept Acquisitions, LLC., ("COAC") The joint venture has purchased 100% of the assets in the Flamers hamburger concept that has 55 units throughout the Mid-Atlantic United States. The purchase price consisted of $1,000,000 in cash and a note payable for $1,600,000 which will require principal and interest payments over a three year period with a balloon payment due thereafter. The transaction was funded as follows:
UFSI COAC Total ----------- ------------ ------------- Cash for equity position in Joint Venture 350,000 350,000 700,000 Cash for note receivable 300,000 - 300,000 ------- ------- --------- Total cash used for acquisition 650,000 350,000 1,000,000 ======= ======= =========
Subsequent to this transaction, in March 2003, we converted our $300,000 note receivable issued to form the joint venture into a reduced equity position in this joint venture. Under the terms of the agreement, Ultimate Franchise Systems, Inc. receives a guaranteed payment in the joint venture equal to the greater of $15,000 per month or 50% of the cash distributions or sales proceeds of COAC II until December 31, 2005. Thereafter, Ultimate Franchise Systems will be entitled to a 25% interest in cash distributions and sales proceeds. In addition, and in connection with this transaction we converted our note receivable of $265,000 due from COAC into an equity interest in COAC. This equity interest provides for UFSI to receive 18% of the cash distributions and sales proceeds of COAC commencing after repayment by COAC of all outstanding debt obligations which is expected to occur in October 2006. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-17 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 6. Notes Receivable Notes receivable are comprised of the following at September 30, 2004 and 2003:
2004 2003 --------------------------------------------------------------------------------------------------------- $900,000 note receivable from Quality Restaurant Ventures, LLC; interest is 7%. Interest only payments made quarterly until December 2005, Thereafter, monthly principal and interest payments until paid in full in 2013. (Net of allowance of $500,000, see note 4) 415,750 - $1,300,000 note receivable from Grace Ventures Group, LLC; This note was paid at a discount under a early settlement agreement (see note 6 below) 125,000 1,320,000 $260,682 non-interest bearing note receivable from Mahar Partnership from sale of building that was used in the Pastry Products Bakery operation. Payable in full by March 2009, net of $110,000 allowance and unamortized discount of $38,230 at September 30, 2004. A 7% discount rate was used for this computation. (Mahar Partnership is a related party as our CEO Christopher Swartz is a Managing Member of Mahar Partnership) 112,452 210,248 $1,000,000 notes receivable from CFB Enterprises from sale of Pastry Products; $90,000, interest-free, due in March 2003, and $900,000, accruing interest at 8%, due in equal quarterly payments from April 2005 through March 2012. Net of $536,940 allowance. (CFB Enterprises is a related party as our CEO Christopher Swartz is a Managng Member of CFB Enterprises) 626,940 823,500 $55,000 note receivable from Clark from sale of Seawest; due September 2004 55,000 55,000 Various notes receivable from related franchise concepts; with interest of 8% to 10%, payable in monthly principal and interest installments with maturity dates through September 2005. 18,667 - --------------------------------------------------------------------------------------------------------- 1,353,809 2,408,748 Less current portion (192,213) (132,796) --------------------------------------------------------------------------------------------------------- $ 1,161,596 $ 2,275,952 =========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-18 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 7. Permanent Impairment of Note Receivable & Related Party Transaction During the year ended September 30, 2004 we entered into an agreement with Grace Ventures, LLC to accept a discounted payment on their note to us. The note originally required Grace Ventures, LLC to pay us $1.3 million dollars through 2011. Under this agreement we were paid $500,000 in August 2004 and continue to hold a note receivable for $125,000 which is due in 2008. As a result, we recorded a permanent impairment of this note in the amount of $724,003 during the year ended September 30, 2004. Our Chief Executive Officer Christopher Swartz is also a managing member of Grace Ventures, LLC. 8. Concentrations and Credit Risk As indicated in the table above, we have several notes receivable with related parties. While we fully anticipate timely collection of these notes, their nature causes a possible credit risk. 9. Investment Securities The following details an itemized list of our investment securities as of September 30, 2004.
Current Market Number of Bid Price on Value of Valuation Book Value Corporation Name Percentage Shares Owned 9/30/04 Investment Allowance on 9/30/04 -------------------------------------------------------------------------------------------------------------------------------- Beverly Hills Weight Loss and Wellness, Inc. 18% 8,697,368 $ 0.02 $ 173,947 $ $173,947 Famous Food Group, Inc. 13% 6,000,000 $ 0.02 $ 120,000 - $120,000 ---------------- ----------------- ---------------- ------------ 14,697,368 $ 293,947 $ $293,947 The following summarizes our portfolio of investment securities as of September 30, 2004 and 2003: -------------------------------------------------------------------------------------- Carrying value at September 30, 2002 $ 95,024 Acquisition of investment securities 500,000 Recognition of impairment in value of investment securities due to other than temporary decline in market value (2,635) Sale of investment securities for cash (57,000) Cumulative unrealized gains on investment securities 214,427 --------------------------------------------------------------------------------------
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-19 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003
-------------------------------------------------------------------------------------- Carrying value at September 30, 2003 $ 749,816 Securities issued in settlement of redeemable common stock liability (13,483) Cumulative unrealized gains on investment securities (442,386) -------------------------------------------------------------------------------------- Carrying value at September 30, 2004 $ 293,947 ====================================================================================== 10. Other Investments The following table summarizes our other long-term assets as of September 30, 2004 and 2003: 2004 2003 -------------------------------------------------------------------------------------------- Equity in COAC II Joint Venture (See note 4) $ 772,282 $ 650,000 Equity in Mountain Mike's (See note 4) 243,084 243,084 Investment in Uptown Restaurant Group - 38,554 Investment in Gators Franchising, LLC. 30,565 35,864 Investment in QRVC (See note 3) 8,058 - Investment in Franchise Management Company (See note 4) 15,000 - Investment in Piccadilly's (See note 4) 300,000 - Trademarks, net of accumulated amortization - 74,217 -------------------------------------------------------------------------------------------- $1,368,989 $1,041,719
Our ownership interest in these companies is as follows: Method of Corporation Name Percentage Accounting Used ----------------------------------------------------------------------- Concept Acquisitions II, LLC 25% Equity Method Mountain Mike's 18% Cost Method Uptown Restaurant Group 59% Equity Method Gator's Dockside Int'l Franchising, Inc. 10% Cost Method Quality Restaurant Ventures, LLC 19% Cost Method Piccadilly Restaurant Investment Group, LLC >1% Cost Method Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-20 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 11. Property and Equipment Property and equipment are comprised of the following at September 30, 2004 and 2003:
2004 2003 --------------------------------------------------------------------------------------------------------- Land and buildings $ - $ 34,554 Machinery and equipment 78,026 13,241 Office and computer equipment 18,923 11,261 Leasehold improvements 17,343 17,343 --------------------------------------------------------------------------------------------------------- 114,292 76,399 Less accumulated depreciation (19,512) (12,950) --------------------------------------------------------------------------------------------------------- Net property and equipment $ 94,780 $ 63,449 ========================================================================================================= 12. Accrued Expenses Accrued expenses are comprised of the following at September 30, 2004 and 2003: 2004 2003 ---------------------------------------------------------------------------------------------------------- Accrued payroll and payroll-related items 4,885 3,219 Accrued interest 259,624 197,405 Liability to issue common stock 58,650 58,650 Accrued payroll taxes 256,223 - Accrued credit card payables 78,518 - Accrued fountain incentive due to related companies - 249,482 Other accrued expenses 10,065 11,767 ---------------------------------------------------------------------------------------------------------- $ 667,965 $ 520,523 ==========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-21 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 13. Long-Term Debt Long-term debt consists of the following at September 30, 2004 and 2003:
2004 2003 --------------------------------------------------------------------------------------------------------- Note payable to former owners of acquired Central Park subsidiary, payable in monthly installments at the prime lending rate less 0.5% (5.25% at September 30, 2004) of $6,670 through July 2005; collateralized by certain accounts receivable, real and personal property and inventory. $ 63,933 $ 133,250 Note payable to former owner of acquired Central Park subsidiary. Paid in February 2004. - 231,739 Note payable to former owner of acquired Central Park subsidiary. Paid in February 2004. - 62,632 Convertible note payable to individuals in the face amount of $950,000; monthly principal and interest payments at 7% until July 2010 of $12,952. The note is convertible into Company common stock at $1.00 per share beginning July 2001. This note is uncollateralized. 922,698 934,608 Convertible note payable to former owners of acquired Central Park subsidiary, interest accrues at 7% until July 2005 and then monthly principal and interest payments of $3,960 until July 2010. The note is convertible into Company common stock at $1.00 per share beginning July 2001. This note is uncollateralized. 200,000 200,000 Three notes payable in the cumulative face amount of $600,000 issued in connection with the Central Park acquisition for non-compete agreements, these notes bear interest at 7% until July 2005 and then payable in equal aggregate monthly payments until July 2010. These notes are uncollateralized. One note with a face amount of $80,000 was retired in January 2003 for $40,000. 520,000 520,000 Note payable to former owner of acquired subsidiary; monthly principal and interest payments at 7% of $3,019 are due through July 2007; collateralized by royalty revenues generated by the Sobik's franchises. This note was assigned to Quality Restaurant Ventures Corp. in connection with our sale of the Sobik's Subs Concept in December 2003. - 126,054 Four notes payable to individuals with an aggregate face amount of $350,000; all unpaid principal and interest at 8% currently past-due; collateralized by a personal guarantee of our chief executive officer. 80,000 80,000 Two notes payable to individuals with an aggregate face amount of $150,000; quarterly interest at 15%; principal and interest payments of $10,840 continue through July 2006. Non-collateralized 73,587 102,935 Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-22 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 Three notes payable to individuals; monthly interest-only payments at 15% due through November 2004, at which time any remaining unpaid principal and interest is due; these notes are uncollateralized and are net of unamortized loan costs of $162,000 and $138,000 respectively. We are in arrears with respect to the interest payments and thus have classified these notes as currently due. 162,000 138,000 Note payable to a corporation; monthly interest only payments at 12% until September 2003; thereafter quarterly principal and interest payments of $77,000 until fully paid in June 2004. This note was restructured in June 2004. - 226,000 Note payable to a corporation; monthly principal and interest payments at 13% until October 2005. 280,840 - Note payable to several individuals; monthly interest only payments at 12.5% until July 2006; thereafter monthly principal and interest payments of $12,043 until fully paid in July 2009. 360,000 - Note payable to an individual in settlement of our redeemable common stock liability. Requires quarterly payments of $7,500 until June 2006. This note does not require us to pay interest. 52,500 - Note payable to five individuals with an aggregate face amount of $85,000; monthly interest only payments at 15% due through March 11, 2003, at which time principal is due; upon mutual agreement between parties the note may be extended for an additional twelve month period; this note is collateralized by a personal guaranty and a UCC-1 filing on the royalty stream of Sobik's. Two of these notes payable with a face value of $25,000 were paid in 2003. The remaining three notes were paid in 2004. - 60,000 Note payable to an individual; monthly interest only payments at 15% until March 2004; at that time the entire principal balance will be due. 200,000 - Note payable to three individuals with an aggregate face amount of $800,000; interest on these notes is 15%. Monthly principal and interest payments of $22,265 are required until paid in full in November 2007. These notes are secured through a security agreement that pledge the assets and royalty stream of our Central Park hamburger concept as collateral. These notes are also personally guaranteed by our CEO Christopher Swartz. 670,220 - Note payable to a bank which was due in July 2004. Interest rate on this note is 6%. This note was paid in full in November 2004 96,154 - Note payable to an individual. Due in December 2004. Interest rate is 8%. 100,000 - Various uncollateralized notes payable; due with various monthly principal and interest payments; maturing at various dates through July 2004. 43,539 10,344 --------------------------------- 3,825,471 2,825,562 Less current portion (1,595,960) (788,489) --------------------------------------------------------------------------------------------------------- Total long-term debt $ 2,229,511 $ 2,037,073 =========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-23 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 13. Long-Term Debt (continued) Interest expense on long-term debt during the years ended September 30, 2004 and 2003 amounted to $541,298 and $344,574, respectively. The annual maturities of long-term debt for the five years subsequent to September 30, 2004 are as follows: Total ------------------------------------------------------- 2005 $ 1,595,960 2006 893,861 2007 508,169 2008 320,185 2009 286,054 Thereafter 221,242 ------------------------------------------------------- $ 3,825,471 ======================================================= 14. Stockholders' Equity The following is a synopsis of significant transactions involving stockholders' equity accounts: Preferred Series C In September 1997, we designated and issued 120 shares of no par value Series C convertible preferred stock ("Preferred Series C") in connection with the acquisition of Quality Franchise Systems, Inc.. The preferred series C stock is entitled to cumulative dividends at a rate of $32.50 per share per quarter and is convertible into common stock at a rate of 13.32 shares of common stock for each preferred share with a face amount of $1,000. The stock is redeemable at our option or in liquidation at a rate of $1,000 per share. Redeemable Common Stock In connection with our acquisition of Seawest, the prior owner of Seawest had the right to require us to repurchase 9,000 shares at a purchase price of $32.55 per share for a total repurchase value of $293,000. In March 2004, we settled this obligation by issuing a note payable of $60,000, 200,000 shares of our common stock, and investment securities we hold in other restaurant companies. The note payable requires us to make eight quarterly payments of $7,500 beginning in April 2004. This resulted in a gain of $23,517 calculated as follows: Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-24 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 14. Stockholders' Equity (continued)
Number of Shares Bid Price on Company Issued Settlement Date Total Market Value ------- ------ --------------- ------------------ Ultimate Franchise Systems, Inc. 200,000 $ 0.60 $ 120,000 Quality Restaurant Ventures, Inc. 1,000,000 0.04 40,000 Weight Loss Forever, Inc. 300,000 0.27 81,000 Fransaction, Inc. 200,000 0.18 36,000 ------------ 277,000 Plus note payable 60,000 ------------ Total consideration 337,000 Less carrying value of redeemable option 293,000 Plus realized gain on investment securities 67,517 ------------ Gain on settlement of redeemable common stock $ 23,517 ============
In addition, the value of the securities listed above will be evaluated on April 1, 2005. If at that time the aggregate value of these securities is below $293,000, we are required to issue additional securities to compensate for this difference. At this time it is not possible to estimate the market price of these securities and no additional liability has been recorded at this time. Stock Issued for Settlement of Redeemable Common Stock Liability In March 2004, we issued 200,000 shares of common stock as part of the settlement agreement of our redeemable common stock. The fair market value of these shares at the time of the settlement was $120,000. Stock Issued for Services For the years ended September 30, 2004 and 2003, we issued 100,000 and 450,000 shares of common stock, respectively, in exchange for consulting and legal services. The aggregate fair value of these shares was $47,750 and $65,000, respectively, based on the market value of the stock on the date of issuance. Stock Issued as Interest on Long-Term Debt For the years ended September 30, 2004 and 2003, we issued 173,844 and 200,000 shares of common stock, respectively, as payment of interest on Long-Term debt. The aggregate fair Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-25 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 14. Stockholders' Equity (continued) Stock Issued as Interest on Long-Term Debt (continued) value of these shares was $125,096 and $29,000, respectively, based on the market value of the stock on the date of issuance. Stock Issued for Acquisition of Obee's Franchise Systems, Inc. In June 2004, we issued 800,000 shares of our common stock to acquire all the outstanding common stock of Obee's Franchise Systems, Inc. The fair market value of these shares at the time of the transaction was $512,000. Authorized Number of Common Shares We have currently authorized 100,000,000 shares of our common stock to be issued. Common Stock Options and Warrants In February 1999, we approved the 1998 Incentive Plan ("Incentive Plan") to enable us to offer our employees and consultants' equity interests. There are 3,000,000 shares designated under the Incentive Plan and are fully vested upon grant. The Company had 2,697,723 options outstanding at September 30, 2004 all of these options are issued outside of the Incentive Plan. Changes in options outstanding for the years ended September 30, 2004 and 2003 under the Incentive Plan and options outstanding outside of the Incentive Plan are summarized as follows: Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-26 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 14. Stockholders' Equity (continued) Options Within the Incentive Plan There are no outstanding options within the Incentive Plan. Options Outside of the Incentive Plan
Weighted- Weighted- Average Average Fair Value Exercise of Options Shares Price Granted --------------------------------------------------------------------------------------------------------- Balance, September 30, 2002 2,834,151 $ 1.94 - Granted - - - Less options expired (136,429) $ 27.95 - --------------------------------------------------------------------------------------------------------- Balance, September 30, 2003 2,697,723 $ .65 - Granted - - - Less options expired - $ - - --------------------------------------------------------------------------------------------------------- Balance, September 30, 2004 2,697,723 $ .53 - =========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-27 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 14. Stockholders' Equity (continued) The following table summarizes information about options outstanding at September 30, 2004:
Options Outstanding and Exercisable --------------------------------------------------------- Weighted- Weighted- Average Average Range of Remaining Exercise Exercise Prices Shares Contractual Life Price --------------------------------------------------------------------------------------------------------- $08 to $2.00 2,290,723 38.3 months $.10 $2.01 to $38.40 407,000 2.1 months $2.95 --------------------------------------------------------------------------------------------------------- 2,697,723 32.88 months $.53 =========================================================================================================
The Financial Accounting Standards Board issued Statement No. 123 ("FAS 123"), "Accounting for Stock-Based Compensation", which provides that expense equaled to the fair value of all stock based awards on the date of the grant over the testing period be recognized. Pursuant to APB 25, however, no compensation cost has been recognized for options granted to employees at exercise prices which equal or exceed the market price of our common stock at the date of grant. Options granted at exercise prices below market prices are recognized as compensation cost measured as the difference between market price and exercise price at the date of grant. No options were issued in 2004, therefore no proforma presentation of net income and earning per share is required. 15. Commitments and Contingencies Operating Leases We lease office space and restaurant land space under certain operating leases which expire on various dates through September 2009. Total rent expense for the years ended September 30, 2004 and 2003 was $178,255 and $150,133, respectively. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-28 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 15. Commitments and Contingencies (continued) Future annual minimum lease payments due under these operating leases for the five year subsequent to September 30, 2004 are as follows: 2005 $ 187,635 2006 106,267 2007 63,578 2008 56,677 2009 9,919 -------------------------------------------------------- $ 424,076 ======================================================== Management Agreements In December 2002, we entered into letter agreements with Topper's Brick Oven Pizza, Inc. ("Topper's") and Weight Loss Forever, International Inc. ("Weight Loss Forever") whereby we will offer our expertise in purchasing, marketing, franchise legal services, franchise sales, and general management to each company in exchange for 6,000,000 shares of common stock of each company. The value of these services is $500,000 and is being amortized over a 24 month period which began in December 2002. In August 2004, we entered into a letter agreement with Fransaction Inc. Whereby Fransaction, Inc. issued us 6 million shares of their common stock in exchange for ongoing franchise services we will provide them. This increased our ownership in Fransaction, Inc. from 29% to 59% of all issued and outstanding stock in the company. Legal Issues We are involved in various other lawsuits and litigation matters on an ongoing basis as a result of our day-to-day operations. However, we do not believe that any of these legal matters will have a material adverse effect on our financial position or results of operations. Franchise Agreements Under the terms of the various franchise agreements, which are for terms ranging from 10 to 15 years and contain various renewal options, the franchisees are obligated for the payment of the following fees. o Franchise Fees - In accordance with the terms of the franchise agreements, the Company receives an initial franchise fee of $10,000 to $25,000. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-29 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 15. Commitments and Contingencies (continued) Franchise Agreements (continued) o Royalties - The Company receives royalties ranging from 4% to 7% of gross sales from the franchisees' operations of the restaurants. o Advertising Fund - The franchise agreements require the franchisees to contribute to an advertising fund based upon 2% to 4% of gross sales. The funds are maintained in separate bank accounts, and their use is restricted solely for advertising, marketing and public relations programs and materials to develop the goodwill and public image of each of the respective franchises. 16. Income Taxes The components of income tax expense (benefit) for the years ended September 30, 2004 and 2003 are as follows:
2004 2003 --------------------------------------------------------------------------------------------------------- Current: Federal $ - $ - State - - --------------------------------------------------------------------------------------------------------- - - --------------------------------------------------------------------------------------------------------- Deferred: Federal 573,075 346,000 State 63,675 42,000 --------------------------------------------------------------------------------------------------------- 636,750 388,000 --------------------------------------------------------------------------------------------------------- Total current and deferred income taxes 636,750 388,000 --------------------------------------------------------------------------------------------------------- Increase / (Decrease) in valuation allowance (636,750) (388,000) --------------------------------------------------------------------------------------------------------- Total income taxes $ - $ - =========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-30 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 16. Income Taxes (continued) Our net deferred tax asset is comprised of the following at September 30, 2004 and 2003:
2004 2003 --------------------------------------------------------------------------------------------------------- Current deferred tax asset: Allowance for doubtful accounts $ - $ - Prepaid interest - - --------------------------------------------------------------------------------------------------------- - - Less, valuation allowance - - --------------------------------------------------------------------------------------------------------- Net current deferred tax asset $ - $ - --------------------------------------------------------------------------------------------------------- Non-current deferred tax asset: Net operating loss carryforwards $ 5,576,000 $ 4,500,000 Prepaid interest - 218,000 Stock and stock options issued for services 577,750 530,000 Investment securities 59,000 328,000 --------------------------------------------------------------------------------------------------------- 6,212,750 5,576,000 Less, valuation allowance (6,212,750) (5,576,000) --------------------------------------------------------------------------------------------------------- Net non-current deferred tax asset $ - $ - --------------------------------------------------------------------------------------------------------- Net deferred tax asset $ - $ - ========================================================================================================= The following summary reconciles differences from taxes at the federal statutory rate with the effective rate: 2004 2003 --------------------------------------------------------------------------------------------------------- Income taxes at federal statutory rates 34.0% 34.0% Operating loss with no tax benefit (34.0) (34.0) --------------------------------------------------------------------------------------------------------- Income tax at effective rates 0.0% 0.0% =========================================================================================================
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-31 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 16. Income Taxes (continued) At September 30, 2004, we had net operating loss carryforwards of approximately $15,200,000 for federal income tax purposes that expire as follows: 2012 $ 3,400,000 2018 1,700,000 2019 700,000 2020 2,800,000 2021 3,100,000 2022 3,500,000 -------------------------------------------------------- $ 15,200,000 ======================================================== 17. Operating Segments We define segments as each separate franchising concept we operate. We clearly view each business as a separate segment and makes decisions based on the activity and profitability of that particular segment. The reportable segments are defined as follows: o The franchise operations segment is engaged in the franchising of various quick-service restaurants located throughout the United States. These restaurants feature submarine sandwiches, hamburgers, soups and hot and cold side order items. We assist the franchisees with selecting suitable locations, assist on the negotiation of lease terms and store design, and assist with securing of food product supply and purchase of furniture and fixtures. o The restaurant operations segment is comprised of franchise concept stores that we operate on a temporary basis until a new franchise is located. o The management services segment is comprised of equity securities from other restaurant concepts. These securities are issued to our company in exchange for franchise services such as: purchasing, marketing, and general franchise management. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-32 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 17. Operating Segments (continued) The table below shows certain financial information by business segment for the years ended September 30, 2004 and 2003:
Segment Reporting Franchise Restaurant Management Consolidated September 30, 2004 Operations Operations Services Total ----------------------------------------------------------------------------------------------------------------------- Revenue from external customers $ 1,929,462 $ 668,471 $ 538,444 $ 3,136,377 Interest- net 366,464 - - 394,094 Permanent impairment of long-lived assets 2,265,800 149,797 - 2,415,597 Depreciation and amortization 2,138 6,457 - 8,595 Segment income / (loss) (3,227,698) (78,103) 538,444 (2,767,357) Segment assets 93,797 983 - 94,780 ----------------------------------------------------------------------------------------------------------------------- Segment Reporting Franchise Restaurant Management Consolidated September 30, 2003 Operations Operations Services Total ----------------------------------------------------------------------------------------------------------------------- Revenue from external customers $ 1,335,858 $ 756,213 367,614 $ 2,419,058 Interest- net 344,574 - - 344,574 Permanent impairment of long-lived assets 184,412 - - 350,000 Depreciation and amortization 8,867 6,457 - 15,324 Segment income / (loss) (1,834,966) (46,808) 367,614 (1,514,160) Segment assets 7,907,211 167,072 - 8,074,283 -----------------------------------------------------------------------------------------------------------------------
Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-33 Ultimate Franchise Systems, Inc. and Subsidiaries Notes to Consolidated Financial Statements For the Years Ended September 30, 2004 and 2003 18. Subsequent Events Acquisition of Juicy Lucy Restaurant Concept In November 2004, we acquired the Juicy Lucy Hamburger concept and real property for $890,000 in cash. Juicy Lucy is an eight unit double drive-thru hamburger concept based in Ft. Myers Florida. The purchase price consisted of two parcels of real property valued at $540,000 with the remaining portion of the purchase price allocated to the business. In connection with this acquisition, we entered into long-term debt agreements with private investors to raise the capital necessary to fund this purchase. This debt requires us to pay monthly principal and interest payments of $24,769 until November 2008. The interest rate on this note is 15% and the note is secured through UCC-1 filings on the assets of Juicy Lucy. Additionally, we are required to pay ongoing semi-annual interest payments equal to $13,350 to these note holders in perpetuity. Sale of Central Park Company Owned Restaurant In November 2004, we refranchised our one company owned Central Park restaurant located in Selma, Alabama. The new owner is a current franchisee with four restaurant locations in Tennessee. The sale will allow us to earn ongoing royalties from this location while eleminating losses we experienced while operating this location. The transaction resulted in one-time charges of $149,797 from the write down of assets in the fourth quarter of 2004. Spin Off of Obee's Franchise Systems, Inc. In October 2004, we entered into an agreement to spin off our Obee's Franchise Systems, Inc. subsidiary into it's own public company. As a result, of this transaction our ownership interest in this new public entity represents approximately 79% of the issued and outstanding shares of this new company. This will allow Obee's the ability to raise capital and restructure certain debt obligations that would not be possible as a wholly owned subsidiary of Ultimate Franchise Systems, Inc. Read independent auditors' report. The accompanying notes are an integral part of the consolidated financial statements F-34