March 31 Interim Report - Cover

ePals Corporation March 31, 2012 Interim Report

Condensed Consolidated Interim Financial Report

ePals Corporation (formerly New University Holdings Corp.) For the three months ended March 31, 2012 and 2011 (Unaudited - Prepared by Management)

ePals Corporation (formerly New University Holdings Corp.) Unaudited Condensed Consolidated Interim Financial Report March 31, 2012 and 2011

Contents

Page

Condensed Consolidated Interim Statements of Financial Position Condensed Consolidated Interim Statements of Comprehensive Loss Condensed Consolidated Interim Statements of Changes in Equity (Deficit) Condensed Consolidated Interim Statements of Cash Flows Notes to the Condensed Consolidated Interim Financial Report

1 2 3 4 5 - 15

ePals Corporation (formerly New University Holdings Corp.) Condensed Consolidated Interim Statements of Financial Position March 31, 2012 and December 31, 2011 (Unaudited) March 31, 2012

December 31, 2011

Assets Current assets Cash & cash equivalents Accounts receivable, net of allowance for doubtful accounts (Note 3) Inventory Other current assets Total current assets

$

Property and equipment, net Goodwill Other intangible assets, net Restricted cash (Note 2) Other assets

968,630 1,072,810 383,379 776,588 3,201,407

$

538,068 19,142,054 10,534,093 75,334 89,699

Total assets

6,895,829 1,119,694 366,436 698,557 9,080,516 585,325 19,142,054 10,685,685 75,259 144,748

$

33,580,655

$

39,713,587

$

5,758,966 10,611,684 5,241,256 1,500,000 68,718 38,143 23,218,767

$

6,340,603 10,822,313 6,664,697 1,500,000 55,147 50,444 25,433,204

Liabilities and Stockholders’ Equity Current liabilities Accounts payable and accrued expenses Acquisition consideration liabilities (Note 2) Deferred revenue, current Bank line-of-credit (Note 4) Capital lease obligations, current (Note 10) Other current liabilities Total current liabilities Deferred revenue, less current portion Capital lease obligations, less current portion (Note 10) Other liabilities Total liabilities

852,694 67,790 36,801

1,230,266 55,804 24,948

24,176,052

26,744,222

Commitments and contingencies Stockholders’ equity Share capital (Note 6) Additional paid-in capital Accumulated deficit Unvested restricted common stock (Note 6) Accumulated other comprehensive loss Less: Treasury stock (719,998 shares)

78,135,163 4,277,387 (71,403,953) (3,752) (108,194) (1,492,048)

Total stockholders’ equity

78,098,272 3,951,679 (67,474,961) (6,969) (106,608) (1,492,048)

9,404,603

Total liabilities and stockholders’ equity

$

33,580,655

The accompanying notes are an integral part of these consolidated financial statements.

1

12,969,365 $

39,713,587

ePals Corporation (formerly New University Holdings Corp.) Condensed Consolidated Interim Statements of Comprehensive Loss Three Months Ended March 31, 2012 and 2011 (Unaudited)

Three Months Ended March 31, 2012 2011 Revenue (Note 8)

$

4,588,615

$

494,710

Operating expenses: Technology, development & operational support General & administrative expenses Sales & marketing Stock-based compensation (Note 7) Depreciation & amortization Change in estimated fair value of acquisition share consideration (Note 2) Acquisition investigation expenses (Note 1) Total operating expenses

(3,074,974) (1,760,482) (2,288,893) (349,207) (381,284) (301,429) (336,662) (8,492,931)

(1,174,428) (663,644) (436,108) (87,354) (33,523) (2,395,057)

Loss from operations

(3,904,316)

(1,900,347)

(24,190) (486)

(52,241) -

(3,928,992)

(1,952,588)

(1,586)

(1,292)

Other income (expense): Interest expense, net Net foreign currency exchange losses Net loss Other comprehensive income (loss): Foreign currency translation Total comprehensive loss

$

(3,930,578)

$

(1,953,880)

Net loss per common share: Basic & diluted

$

(0.03)

$

(0.77)

Weighted average number of common shares: Basic & diluted

116,490,803

The accompanying notes are an integral part of these consolidated financial statements.

2

2,528,351

ePals Corporation (formerly New University Holdings Corp.) Condensed Consolidated Interim Statements of Changes in Equity (Deficit) Three Months Ended March 31, 2012 and 2011 (Unaudited)

ePals, Inc. Share Capital

Balance at December 31, 2011 Stock options exercised Vesting of restricted share units Issuance of common stock to consultants Stock compensation: warrants Stock compensation: options & restricted share units Vesting of restricted common stock Net loss Foreign currency translation Total comprehensive loss Balance at March 31, 2012

Series C Convertible Preferred Stock Shares Dollars $ $ -

Balance at December 31, 2010 Vesting of restricted common stock Stock compensation: options Stock compensation: warrants Issuance of convertible notes Transaction costs Share issuance costs Net loss Foreign currency translation Total comprehensive loss Balance at March 31, 2011

15,424,553 $ 15,424,553 $

154,246 154,246

Series B-2 Convertible Preferred Stock Shares Dollars $ $ 14,628,759 $ 14,628,759 $

146,288 146,288

Series B-1 Convertible Preferred Stock Shares Dollars $ $ 2,890,163 $ 2,890,163 $

28,902 28,902

ePals Corporation Share Capital

Series B Convertible Preferred Stock Shares Dollars $ $ 1,559,127 $ 1,559,127 $

15,591 15,591

Series A Convertible Preferred Stock Shares Dollars $ $ 2,366,913 $ 2,366,913 $

23,669 23,669

Common Stock Shares Dollars $ $ 2,616,547 $ 2,616,547 $

26,166 26,166

Voting Common Stock Shares Dollars 67,550,789 $ 45,538,596 56,084 13,391 2,083 67,608,956 $ 45,551,987 -

$

$

-

The accompanying notes are an integral part of these consolidated financial statements.

3

Unvested Restricted Common Stock

Restricted Voting Common Additional Paid-In Accumulated Stock Treasury Stock Capital Deficit Shares Dollars Shares Dollars 48,909,040 $ 32,559,676 (719,998) $ (1,492,048) $ 3,951,679 $ (67,474,961) $ 128,380 75,520 36,153 23,500 5,013 245,175 (3,928,992) 49,073,573 $ 32,583,176 $ (719,998) $ (1,492,048) $ 4,277,387 $ (71,403,953) $ -

$

$

-

(719,998) $ (719,998) $

(1,492,048) $

(1,492,048) $

47,555,250 $ 80,700 6,654 103,490 (28,737) (58,241)

47,659,116 $

Accumulated Other Comprehensive Loss

Total Stockholders' (Deficit) Equity

(6,969) $ 3,217 (3,752) $

(106,608) (1,586) (108,194) $

12,969,365 13,391 75,520 23,500 5,013 245,175 3,217 (3,928,992) (1,586) (3,930,578) 9,404,603

(49,682,098) $ -

(10,186) $ 3,217 -

(96,709) -

(1,952,588) (51,634,686) $

(6,969) $

(3,330,929) 3,217 80,700 6,654 103,490 (28,737) (58,241) (1,952,588) (1,292) (1,953,880) (5,177,726)

(1,292) (98,001) $

ePals Corporation (formerly New University Holdings Corp.) Condensed Consolidated Interim Statements of Cash Flows Three Months Ended March 31, 2012 and 2011 (Unaudited) Three Months Ended March 31, 2012 2011 Cash flows from operating activities: Net loss Adjustments to reconcile net loss to net cash used in operating activities: Restricted share vesting Depreciation and amortization Stock-based compensation Change in estimated fair value of acquisition share consideration (Note 2) Bad debt expense Increase in restricted cash Changes in operating assets and liabilities: Accounts receivable Inventory Other current assets Accounts payable and accrued expenses Deferred revenue Other Total adjustments

$

Net cash used in operating activities Cash flows from investing activities: Cash paid for acquisition of Carus Publishing Company Purchases of equipment Increase in other intangible assets Net cash used in investing activities Cash flows from financing activities: Proceeds from convertible notes payable, net of expenses (Note 5) Proceeds from exercise of stock options (Note 7) Payment of note payable to related party (Note 9) Payments on capital lease obligations (Note 10) Proceeds from capital lease financing (Note 10) Net cash provided by financing activities (Decrease) increase in cash & cash equivalents Effect of exchange rates on cash

(3,928,992)

$

(1,952,588)

3,217 381,284 349,207 301,429 115,341 75

3,217 33,523 87,354 -

(33,556) (16,943) (78,031) (572,187) (1,801,013) 1,349 (1,349,828)

26,393 (44,118) 76,532 (467,271) (7,916) (292,286)

(5,278,820)

(2,244,874)

(512,058) (43,802) (132,950)

(179,967) (47,805)

(688,810)

(227,772)

13,059 (10,178) 38,832

2,571,227 (90,170) (12,061) 116,443

41,713

2,585,439

(5,925,917)

112,793

(1,282)

3,316

-

Cash & cash equivalents at the beginning of the period Cash & cash equivalents at the end of the period

$

6,895,829 968,630

$

309,149 425,258

Non-cash financing activities: Issuance of common shares to consultants for payment of services

$

23,500

$

-

Supplemental disclosures of cash flow information: Cash paid for interest Cash paid for income taxes

$ $

19,716 -

$ $

52,241 -

The accompanying notes are an integral part of these consolidated financial statements.

4

ePals Corporation (formerly New University Holdings Corp.) Notes to the Condensed Consolidated Interim Financial Report (unaudited) March 31, 2012 and 2011

NOTE 1 - Organization and Significant Accounting Policies ePals Corporation (“ePals” or the “Company”), formerly New University Holdings Corp., was incorporated under the laws of the Province of Alberta on July 14, 2010. Previously classified as a Capital Pool Company as defined in Policy 2.4 of the TSX Venture Exchange (“TSX-V”), the Company completed a “qualifying transaction” as defined under the policies of the TSX-V on July 26, 2011 when it acquired ePals, Inc. pursuant to a statutory procedure to form “ePals Corporation” (“the Merger”). ePals is an education media company and the leading provider of safe social learning networks. Focused on the K-12 market, ePals offers elementary and secondary school administrators, teachers, students and parents worldwide a safe and secure platform for building educational communities, providing quality digital content and facilitating collaboration for effective 21st century learning. ePals' award-winning products include: the ePals Global Community™; SchoolMail®365; LearningSpace®; In2Books®; and popular children’s educational publishing brands including Cricket® and Cobblestone®. ePals customers and partners include the International Baccalaureate, Microsoft Corporation, Dell Inc., IBM Corp. and leading school districts across the United States and globally. ePals serves approximately 800,000 educators and reaches millions of teachers, students and parents in approximately 200 countries and territories. Basis of presentation This unaudited consolidated interim financial report and the notes thereto have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board, is presented in United States dollars (unless otherwise noted) and has been prepared on a going concern basis. The disclosures contained in this consolidated interim financial report comply with IAS 34 Interim Financial Reporting and do not include all IFRS requirements for annual financial statements. This unaudited consolidated interim financial report should be read in conjunction with the consolidated audited financial statements of the Company, including the notes thereto, for the year ended December 31, 2011 that are filed under ePals’ SEDAR profile at www.sedar.com. In the opinion of management, the accompanying unaudited consolidated interim financial report includes all adjustments to present fairly the financial position and the results of operations of the Company as at and for the three month periods ended March 31, 2012 and 2011. This unaudited consolidated interim financial report follows the same accounting policies and methods of application as the most recent annual consolidated financial statements of the Company. Interim results are not necessarily indicative of the results that may be expected for a full year. Principles of consolidation Pursuant to the Merger, this unaudited consolidated interim financial report for the three months ended March 31, 2012 and 2011 reflect the assets, liabilities, and results of operations of ePals, Inc. prior to the Merger and the consolidated assets, liabilities, and results of operations of the Company and ePals, Inc. subsequent to the Merger. The consolidated interim financial report is issued under the name of the legal parent, ePals Corporation, but is deemed to be a continuation of the legal subsidiary, ePals, Inc. This unaudited consolidated interim financial report includes the accounts of ePals, its wholly-owned subsidiaries, ePals, Inc., Carus Publishing Company (“Carus”), ePals-Nexify, Inc., ePals Classroom Exchange, Inc. (U.S. subsidiary) and ePals Classroom Exchange, Inc. (Canadian subsidiary), and an entity in which ePals, Inc. holds a controlling financial interest, ePals Foundation. All material intercompany balances and transactions have been eliminated in consolidation.

5

Research and development costs Research costs are expensed as incurred. Development costs are capitalized when a specific product is determined to be technically feasible, when there is an intention to produce the product in a clearly defined future market and adequate resources exist to complete the project. Based on the Company’s product development process, technological feasibility generally occurs on completion of a working model of the Company’s product. To date, development costs incurred between the completion of a working model of the Company’s product and the general release of the product have substantially coincided. As a result, the Company has not capitalized development costs as of March 31, 2012 or 2011. For the three months ended March 31, 2012 and 2011, the Company expensed research and product development costs of $533,273 and $307,993, respectively, as classified in “Technology, development & operational support” on the Consolidated Statements of Comprehensive Loss. Acquisition investigation expenses These expenses represent legal, audit and tax fees related to potential business acquisitions and joint ventures that the Company is considering. Segment reporting The Company aggregates its business into one reporting segment based on the financial results regularly reviewed by the Company's chief operating decision maker and the executive team to determine how resources are allocated. The Company’s geographic area of operation is predominantly the United States. Exports or foreign sales to locations outside the United States are not significant. Earnings (loss) per share ePals Corporation and ePals, Inc.’s outstanding stock options and warrants to acquire shares of the Company, unvested common shares and unvested restricted share units have been excluded in the basic and diluted net loss per common share calculations due to their anti-dilutive effect on earnings per share. The weighted average number of common shares outstanding for the three months ended March 31, 2012 and 2011 excludes 48,253 and 96,506 unvested restricted common shares, respectively. Convertible preferred stock issued by ePals, Inc. prior to the Merger was excluded from the basic and diluted net loss per common share calculations for the three months ended March 31, 2011. Reclassifications Certain immaterial reclassifications have been made to prior periods to conform to the current presentation. Use of estimates In the application of the Company's accounting policies, management is required to make judgments, estimates and assumptions about the carrying amounts of assets and liabilities that are not readily apparent from other sources. The estimates and associated assumptions are based on historical experience and other factors that are considered to be relevant. Actual results may differ from these estimates. The estimates and underlying assumptions are reviewed by the Company on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is revised if the revision affects only that period or in the period of the revision and future periods if the revision affects both current and future periods. New accounting standards There are no new accounting standards effective for the quarter ended March 31, 2012 that had a material effect on the accompanying unaudited condensed consolidated interim financial report. There are no relevant changes in accounting standards applicable to future periods other than those disclosed in the most recent annual financial statements of the Company as at and for the year ended December 31, 2011. 6

Subsequent events The Company evaluated its March 31, 2012 unaudited consolidated interim financial report for subsequent events through the date this financial report was issued and filed with applicable security regulatory authorities in Canada. The Company is not aware of any subsequent events which would require recognition or disclosure in the consolidated financial statements other that those disclosed in Note 11. NOTE 2 – Fair Value Measurements Certain assets and liabilities are recorded at fair value. IAS 32 defines fair value as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Fair value is based on assumptions market participants would make in pricing the asset or liability. Generally, fair value is based on observable quoted market prices or derived from observable market data when such market prices or data are available. When such prices or inputs are not available, the reporting entity should use valuation models. The Company’s assets and liabilities recorded at fair value on a recurring basis are categorized based on the priority of the inputs used to measure fair value. The inputs used in measuring fair value are categorized into three levels under authoritative guidance as follows: 

Level 1 - Inputs that are based upon quoted prices for identical instruments traded in active markets. The Company does not have any Level 1 instruments at March 31, 2012.



Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar investments in markets that are not active, or models based on valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the investment.



Level 3 - Inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques.

The following section describes the valuation methodologies the Company uses to measure its financial assets and liabilities at fair value. Assets and liabilities measured at fair value on a recurring basis are summarized below: As of March 31, 2012

Description Restricted cash - certificate of deposit $ Acquisition consideration liabilities - Consideration Shares (defined below) Acquisition consideration liabilities - cash earn out

Asset Measured at Fair Value

Level 1

Fair Value Hierarchy Level Level 2

75,334

-

8,636,871 986,871

7

$

Level 3

75,334

-

-

8,636,871

-

-

-

986,871

As of December 31, 2011 Asset Measured at Fair Value

Description Restricted cash - certificate of deposit $ Acquisition consideration liabilities - Consideration Shares (defined below) Acquisition consideration liabilities - cash earn out

Level 1

Fair Value Hierarchy Level Level 2

75,259

-

8,335,442 986,871

$

Level 3

75,259

-

-

8,335,442

-

-

-

986,871

The acquisition of Carus included as consideration the right to receive restricted common voting shares of the Company (the “Consideration Shares”) in an amount of up to $10 million (calculated as 15,625,000 shares based on the agreed value of Cdn$0.64 per share in the purchase agreement), subject to certain adjustments. At March 31, 2012, the Company increased the liability for the fair value of the Consideration Shares by $301,429 to $8,636,871, which is recorded in the Consolidated Statements of Comprehensive Loss. A third party specializing in business valuations estimated the fair value of the Consideration Shares at March 31, 2012 using a binomial lattice model that calculated the range of the Company’s potential stock prices using the starting stock price of Cdn$0.55 (the Company’s stock price on March 31, 2012) and based on the following assumptions:

Expected volatility Expected term (years) Risk-free interest rate

Share Payment on July 1, 2012 60% 0.25 0.07%

Share Payment on September 30, 2012 55% 0.50 0.15%

The liability for the Consideration Shares will continue to be adjusted each reporting period based on changes in the Company’s stock price and fluctuations from currency translation until the final Consideration Shares are issued on September 30, 2012. As additional purchase consideration, and subject to meeting or exceeding revenue growth targets in the Company’s “At Home” business, in each of 2012, 2013 and 2014, the Company is required to pay to the Carus sellers a cash earn out payment of up to a maximum of $3.5 million (up to $10.5 million in the aggregate). A third party specializing in business valuations estimated the fair value of the earn out portion of the purchase price at the acquisition date based on probabilities of the Company’s “At Home” business achieving specific gross revenue targets for 2012, 2013 and 2014. No adjustment was made at March 31, 2012 to the $986,871 liability for the fair value of the cash earn out payments since the Company’s estimate of the probability of meeting those targets did not change from the acquisition date or December 31, 2011. The acquisition consideration liabilities on the Condensed Consolidated Interim Statements of Financial Position at March 31, 2012 and December 31, 2011, respectively, also include $987,942 and $1,500,000 of cash due to the sellers of Carus. These cash payments were deferred and payable in six equal monthly installments which commenced 30 days after closing of the acquisition of Carus. The Company is required to maintain a security deposit for one of its office leases, which it holds in the form of a letter-of-credit. At March 31, 2012 and December 31, 2011, the Company has a certificate of deposit held at a bank as collateral for an irrevocable standby letter-of-credit totaling $75,334 and $75,259, respectively. The fair value of the certificate of deposit is based on quotes from the bank.

8

NOTE 3 – Financial Instruments Credit risk Details about the Company’s accounts receivable are as follows:

Accounts receivable, gross Allowance for doubtful accounts Accounts receivable, net

March 31, 2012 $1,199,920 (127,110) $1,072,810

December 31, 2011 $1,163,478 (43,784) $1,119,694

The rollforward of the allowance for doubtful accounts consisted of the following for the three months ended March 31, 2012: Balance at December 31, 2011 Provision Write-offs Balance at March 31, 2012

$43,784 115,341 (32,015) $127,110

The details of the March 31, 2012 gross accounts receivable balance are shown below:  60% due from customers for the sale of subscriptions of children’s magazines, educational books and consumer products;  28% due from school systems and educational institutions located in the United States of America; and  12% due from Newstogram customers. The details of the December 31, 2011 gross accounts receivable balance are shown below:  47% due from customers of Carus which was acquired in December 2011; represents receivables for the sale of subscriptions of children’s magazines, educational books and consumer products;  43% due from school systems and educational institutions located in the United States of America, with 37% of the total gross accounts receivable due from one educational institution; and  9% due from Newstogram customers. The allowance for doubtful accounts at March 31, 2012 for the sale of subscriptions of children’s magazines, educational books and consumer products is $117,914, compared to $2,573 at December 31, 2011. The allowance for doubtful accounts for receivables from subscription license agreements, support and professional services, and contract work at March 31, 2012 is $9,196, compared to $41,211 at December 31, 2011. Newstogram customers have historically paid their respective balances due in a timely manner so there is no allowance for doubtful accounts for these receivables at March 31, 2012 and December 31, 2011. At March 31, 2012, one educational institution accounted for 25% of the Company’s gross accounts receivable balance. During the three months ended March 31, 2012, no one customer accounted for more than 10% of the Company’s revenue. Liquidity risk At March 31, 2012, the Company had $968,630 in cash, while successfully lowering its accounts payables and accrued liabilities by $581,637 from December 31, 2011. The Company was exposed to liquidity risk at March 31, 2012 because of its cash balance; however a private placement described in “Financing” under Note 11 was completed subsequent to March 31, 2012. In December 2011, the Company assumed $4,549,590 of accounts payable and accrued expenses in a business acquisition, which have been reduced to $4,076,053 at March 31, 2012. The Company’s future obligations under leases are discussed in Note 10. 9

NOTE 4 – Bank Line-of-Credit On March 18, 2012, the Company renewed the $1,500,000 bank line-of-credit agreement with the same local bank for a one-year term. The line-of-credit agreement was renewed under terms that were substantially similar to the previous agreement, including the interest rate at the Wall Street Journal Prime rate minus 0.50%, but not less than 4.5% per annum. This line-of-credit is personally guaranteed by two members of ePals Corporation’s Board of Directors. At March 31, 2012, the Company is in compliance with all covenants related to its bank line-of-credit agreement. NOTE 5 – Convertible Notes Payable During the three months ended March 31, 2011, ePals, Inc. obtained bridge financing from investors through convertible notes totaling $2,584,722, with $1,678,400 of notes issued to either affiliates of or members of the ePals, Inc.’s Board of Directors. These notes were ultimately converted into restricted voting common shares and voting common shares of the Corporation as part of the Merger. The note and warrant purchase agreement also gave the investors a warrant to purchase a certain number of shares of ePals, Inc.’s common stock. The certain number of shares was equal to 20% of the principal amount of the promissory note divided by $0.495, the purchase price per share of the preferred stock, as stated in the note and warrant purchase agreement. See “Stock Warrants” in Note 7 for details about the warrants issued in connection with these notes. NOTE 6 – Share Capital The Company’s equity structure after the Merger reflects the equity structure of the legal parent, ePals, including the equity instruments issued by ePals to effect the Merger. Authorized share capital An unlimited number of voting common shares and an unlimited number of restricted voting common shares without par value are authorized at March 31, 2012. An unlimited number of preferred shares without par value are authorized at March 31, 2012, issuable in series. Issued and outstanding share capital Escrow Holders of voting common shares and restricted voting common shares who were former shareholders of ePals, Inc., the holders of options and warrants issued by ePals, Inc. prior to the completion of the Merger, and holders of options, warrants and vested restricted share units issued by the Company after the Merger are subject to escrow restrictions imposed by the Company, with 25% of securities initially scheduled to be released from escrow on January 27, 2012, 25% initially to be released on July 27, 2012 and 50% to be released on January 27, 2013. In the long term interests of the Company, in May 2012, the Board of Directors postponed the release of 25% of the shares originally scheduled for release on January 27, 2012 and 25% originally scheduled for release on July 27, 2012 to be released from escrow on September 4, 2012. See Note 11 for more details about the delay of the release of shares in escrow. Restricted common stock During the three months ended March 31, 2012, 24,127 voting common shares of ePals Corporation were released from restriction in accordance with the Company’s February 2009 cooperative agreement with Gabriel Piedrahita Uribe Foundation, thereby leaving 48,253 voting common shares that are unvested at March 31, 2012. The unvested portion of this restricted common stock at March 31, 2012 and December 31, 2011 was $3,752 and $6,969, respectively, and is classified as a contra-equity account on the accompanying Consolidated Statements of Financial Position and the Consolidated Statements of Changes in Equity.

10

NOTE 7 – Share-Based Compensation Presented below is a summary of the stock option activity for the three months ended March 31, 2012 and 2011: Weighted Average Exercise Price

Number of Shares

Weighted Average Remaining Contractual Term (Years)

Outstanding at January 1, 2011 Granted Exercised Forfeited or expired

10,206,913 3,043,892 (116,836)

$

0.10 0.10 0.10

Outstanding at March 31, 2011

13,133,969

$

0.10

8.02

Exercisable at March 31, 2011

4,743,980

$

0.10

7.33

Outstanding at January 1, 2012 Granted Exercised Forfeited or expired

8,719,519 182,000 (56,084) (564,050)

$

0.22 0.51 0.25 0.26

Outstanding at March 31, 2012

8,281,385

$

0.22

8.62

Exercisable at March 31, 2012

4,225,726

$

0.16

8.20

At March 31, 2012, the aggregate intrinsic value of the Company’s total outstanding and total exercisable stock options is $2,407,289 and $1,462,938, respectively. The fair value of options granted during the three months ended March 31, 2012 was approximately $29,000, which will be expensed over the vesting period. The Company charged stock compensation expense related to stock options of $139,006 and $80,700 to operations for the three months ended March 31, 2012 and 2011, respectively. The fair value of each stock option award to employees is estimated from the date of grant using the Black-Scholes Option Pricing Model with assumption ranges for the three months ended March 31, 2012 and 2011 noted in the following table: Expected volatility Expected dividends Expected term (in years) Risk-free interest rate

March 31, 2012 51.00 - 55.00% 0.00% 1.25 – 4.0 0.17 – 0.61%

March 31, 2011 57.00 - 58.00% 0.00% 5.0 – 6.1 1.99 – 2.33%

The expected term for options granted during the three months ended March 31, 2012 that vest on a graded/step basis used in the Black-Scholes calculation is derived from analyzing the options as separate tranches based on increments in which they vest. The expected term for options granted during the three months ended March 31, 2011 was based on the “Simplified Method”, which produced results that were not materially different than the method prescribed by IFRS 2. Restricted share units A share-based compensation cost of $129,995 for the restricted share units (“RSUs”) granted during the three months ended March 31, 2012 will be amortized over the vesting period, of which $25,900 was recognized during the period. Share-based compensation of $155,789 was recognized during the three months ended March 31, 2012 for the restricted share units granted in 2011. The $181,689 share-based compensation recorded for RSUs granted during the three months ended March 31, 2012 includes $75,520 of compensation expense for RSUs vested during the quarter.

11

Presented below is a summary of the restricted share unit activity for the three months ended March 31, 2012: Weighted Average Grant Date Fair Value

Number of RSUs Outstanding at January 1, 2012 Granted Vested Forfeited

1,335,778 252,875 (130,463) (5,806)

$

0.53 0.55 0.48 0.39

Outstanding at March 31, 2012

1,452,384

$

0.53

Stock warrants Warrants issued by ePals Corporation No warrants were issued by ePals Corporation during the three months ended March 31, 2012. Stockbased compensation expense for warrants of $5,013 was recorded during the three months ended March 31, 2012 for the vesting of the warrants issued to Nexify, Inc. in August 2011 to acquire 307,000 restricted voting common shares. Those warrants vest at eight and one-third percent per quarter provided that certain former key Nexify, Inc. employees continue to provide services to the Company or its affiliates. During the three months ended March 31, 2012, one of the employees left the Company, thereby cancelling the respective warrants tied to his employment. Warrants issued by ePals, Inc. During the three months ended March 31, 2012, the Company did not record any expense for the performance warrant granted to Dell Products L.P. in 2011 for the right to purchase 7,830,917 of the Company’s voting common shares and/or restricted voting common shares because Dell Products L.P. did not meet the vesting provisions for the quarter. During the three months ended March 31, 2011, ePals, Inc. issued warrants to investors participating in the bridge financing disclosed in Note 5 to purchase 1,044,326 shares of ePals, Inc. common stock at an exercise price of $0.495 per share. The exercise price of these warrants equaled the price these investors’ bridge investment converted into Series C preferred stock. These warrants were exercisable at the option of the holder and expired at the earlier of the ten year anniversary of the date of issuance, the effective date of the first registration statement filed with the Securities and Exchange Commission under the Securities Act of 1933, or the consummation of an asset sale or acquisition where ePals, Inc. was the legal acquiree.

12

Presented below is a summary of the stock warrant activity for the three months ended March 31, 2012 and 2011: Number of Warrant Shares

Weighted Average Exercise Price

Outstanding at January 1, 2011 Granted Exercised Forfeited or expired

3,235,365 1,044,326 -

$

0.62 0.50 -

Outstanding at March 31, 2011

4,279,691

$

0.59

Outstanding at January 1, 2012 Granted Exercised Forfeited or expired

15,602,628 (112,102)

$ $

0.31 1.90

Outstanding at March 31, 2012

15,490,526

$

0.30

Weighted Average Remaining Contractual Term (Years)

7.90

5.64

There are 7,500,609 warrants exercisable at March 31, 2012. At March 31, 2012, the aggregate intrinsic value of the Company’s total outstanding and exercisable warrants is $4,282,071 and $746,333, respectively. The Company valued non-service warrants issued during the three months ended March 31, 2011 using the Black-Scholes Option Pricing Model with assumption ranges noted in the following table: 2011 Expected volatility Expected dividends Expected term (in years) Risk-free interest rate

57.00% 0.00% 5.0 2.33%

The fair value of warrants issued and vested during the three months ended March 31, 2011 totaled $6,654 which was expensed during that period. NOTE 8 – Revenue Presented below are the details of the Company’s revenue for the three months ended March 31, 2012 and 2011: Three months ended March 31, 2012 2011 $3,671,699 $ 4,447 916,916 490,263 $4,588,615 $494,710

Media subscriptions & commerce revenue Services revenue (subscription products & licensing) Total revenue

NOTE 9 – Transactions with Related Parties As discussed in Note 10, the Company has a short-term agreement to reimburse ZG Ventures, LLC, an affiliate of two members of the Company’s Board of Directors, for a percentage of the rent on shared office space up to $5,000 per month through the end of September 2012. In December 2010, ePals, Inc. entered into a loan agreement with an officer for $90,000 with interest of 2.75% per annum. The loan was repaid on January 4, 2011. The Company’s $1,500,000 bank line-of-credit at March 31, 2012 and December 31, 2011 is personally guaranteed by two members of the Company’s Board of Directors. 13

NOTE 10 – Commitments In March 2012, the Company entered into a noncancelable capital lease agreement for computer equipment for a 36 month term and a $1 end of lease purchase option. In June 2011, ePals, Inc. entered into a short-term agreement through December 31, 2011 to reimburse ZG Ventures, LLC for a percentage of the rent on shared office space in Washington, D.C. The agreement is for a reimbursement of up to $5,000 per month. The Company extended this agreement under the same terms in January 2012 and again in March 2012 through the end of September 2012. The option for future extensions is available upon mutual agreement of ZG Ventures, LLC and the Company. The following table is a schedule by year of the future minimum lease payments required under the noncancelable capital and operating leases, which have an initial or remaining term in excess of one year at March 31, 2012. This table also includes the Company’s future obligation for the June 2011 short-term agreement to reimburse ZG Ventures, LLC for a percentage of the rent on shared office space in Washington D.C for up to $5,000 per month as that lease was extended to September 2012. The Company’s obligation is calculated based on its portion of the future minimum lease payments required by ZG Ventures, LLC for this lease. Capital Leases

Years ending December 31, 1

2012 2013 2014 2015 Total future minimum lease payments Less: interest Present value of minimum lease payments Less: current portion of obligations under capital leases Noncurrent portion of obligations under capital leases

$ 57,602 69,410 17,177 3,491 $ 147,680 (11,172) 136,508 (68,718) $ 67,790

Operating Leases $ 516,567 355,778 55,294 2,228 $ 929,867

(1) Remainder due as of March 31, 2012.

Rent expense aggregated $198,733 and $92,124 for the three months ended March 31, 2012 and 2011, respectively. NOTE 11 – Subsequent Events Joint Venture Contract In April 2012, the Company announced the signing of a definitive Joint Venture Contract (the “JVC”) with NeuEdu Tianjin (“NeuEdu”) for a 20 year term whereby the parties agreed to create a partnership (“NeuPals”) to create and launch a Chinese language platform in China that enables school-safe communications. The joint venture will become effective on approval by the Chinese Government and the JVC is subject to all necessary regulatory and government approvals. Based on the structure of the organization, the parties will not have joint control over NeuPals. The Company will have significant influence over NeuPals and will account for NeuPals using the equity method of accounting. The total amount of the registered capital of NeuPals will be $5,000,000, of which the contributions from ePals and NeuEdu are expected to be $2,450,000 and $2,550,000, respectively, accounting for 49% and 51%, respectively, of the registered capital. NeuEdu and ePals are required to fund at least 50% of their share of the registered capital within 90 days of the date NeuPals’ business license is issued (expected to occur during the second half of 2012) and the remaining share are required to be funded within 24 months after the date the business license is issued. NeuEdu purchased 2,439,024 voting common shares of ePals on a private placement basis at a price of Cdn$0.41 per share for total gross proceeds to ePals of Cdn$1,000,000 as part of the April 2012 14

financing described below. These securities are subject to a four month hold period under applicable Canadian securities laws which commenced on the date of issuance. The parties are working to finalize ancillary agreements relating to intellectual property, stock purchase, warrants and operational services. Financing In April 2012, the Company completed a best efforts private placement and issued a total of 24,390,000 voting common shares (the “Shares") at a purchase price of Cdn$0.41 per Share for gross proceeds of Cdn$9,999,900 (the “Offering”). The Offering was conducted through a syndicate of agents led by Cormark Securities Inc. (“Cormark”) and including National Bank Financial Inc. and Canaccord Genuity Corp. (collectively, the “Agents”) pursuant to an agency agreement dated April 19, 2012 (the “Agency Agreement”). In connection with the Offering, the Agents received a cash commission equal to 6% of the gross proceeds of the Offering, subject to a reduced commission in respect of certain subscribers as agreed to between Cormark and the Company. The net proceeds of the Offering will be used for working capital and general corporate purposes. The Shares issued pursuant to the Offering are subject to a four month hold period which commenced on the closing date of the Offering. Delay of Release of Shares in Escrow Holders of voting common shares and restricted voting common shares who were former shareholders of ePals, Inc., the holders of options and warrants issued by ePals, Inc. prior to the completion of the Merger, and holders of options, warrants and vested restricted share units issued by the Company after the Merger are subject to escrow restrictions imposed by the Company, with 25% of securities initially scheduled to be released from escrow on January 27, 2012, 25% initially to be released on July 27, 2012 and 50% to be released on January 27, 2013. In May 2012, the Board of Directors postponed the release of 25% of the shares originally scheduled for release on January 27, 2012 and 25% originally scheduled for release on July 27, 2012 to be released from escrow on September 4, 2012. Although the Company had made progress in building a presence on the TSX-V, ePals’ stock remains thinly traded and therefore highly volatile. A small number of shares offered by existing investors as they come off lock-up has the potential to significantly and adversely impact ePals’ ability to execute its business plan. Vested options can be exercised at any point, but the resulting shares would be included in escrow and released according to its release schedule. Carus Acquisition As of March 31, 2012, the Company had paid $512,058 of the $1,500,000 deferred cash due from the 2011 acquisition of Carus. The remaining $987,942 of the deferred cash was paid by the Company in April 2011.

15

MANAGEMENT’S DISCUSSION AND ANALYSIS OF EPALS CORPORATION (FORMERLY NEW UNIVERSITY HOLDINGS CORP.) FOR THE THREE MONTHS ENDED MARCH 31, 2012 DATE OF REPORT: MAY 29, 2012 The Management’s Discussion and Analysis (“MD&A”) of ePals Corporation (“ePals”, “Company”, “we”, “us” and “our”), formerly New University Holdings Corp., was prepared by management of ePals and should be read in conjunction with the unaudited condensed consolidated interim financial report and accompanying notes of ePals for the three months ended March 31, 2012 and the audited consolidated financial statements and accompanying notes of ePals for the years ended December 31, 2011 and 2010. Previously classified as a Capital Pool Company as defined in Policy 2.4 of the TSX Venture Exchange (“TSX-V”), the Company completed a “qualifying transaction” as defined under the policies of the TSX-V on July 26, 2011 when it acquired ePals, Inc. pursuant to a statutory procedure to form “ePals Corporation” (“Merger”). Additional information about the Company and the Merger may be found under the Company’s SEDAR profile at www.sedar.com. The Company’s unaudited condensed consolidated interim financial report for the three months ended March 31, 2012 and 2011 and this MD&A are presented in United States dollars (unless otherwise noted) and were prepared in accordance with International Financial Reporting Standards (“IFRS”). Forward-Looking Statements Certain statements contained in this MD&A constitute forward-looking information within the meaning of applicable securities laws, including statements with respect to customers, ventures such as ePals China and ePals Europe (“ePals Ventures”), partnerships; ePals' strategy, prospects and success in pursuing domestic or international markets and the composition of its leadership teams to be established in connection therewith; and ePals' anticipated plans to increase its registered users, subscriptions, average revenue per user (“ARPU”), including through its media and platform businesses. These statements relate to future events or future performance. Often, but not always, forward-looking information can be identified by the use of words such as “plans”, “expects”, “is expected”, “budget”, “scheduled”, “estimates”, “forecasts”, “intends”, “anticipates”, or “believes” or variations (including negative variations) of such words and phrases, or statements formed in the future tense or indicating that certain actions, events or results “may”, “could”, “would”, “might” or “will” (or other variations of the forgoing) be taken, occur, be achieved, or come to pass. Forward-looking information is necessarily based upon a number of assumptions and factors that, while considered reasonable, are subject to known and unknown risks, uncertainties, and other factors which may cause the actual results and future events to differ materially from those expressed or implied by such forward-looking information. Those assumptions and factors are based on information currently available to ePals. Such material factors and assumptions include, but are not limited to: ePals' ability to execute on its business plan, including the successful launch of ePals ventures; the acceptance of ePals' products and services by customers globally; that ePals affiliated entities will be able to secure distribution partners for sale of ePals' products and services; ePals' subjective assessment of the likelihood of success of a sales lead or opportunity; that sales will be completed at or above ePals' estimated margins; that the demand for webhosting and secure email communication, as well as education media related products domestically, in Europe, in China and elsewhere will continue to grow; that the demand for ePals' products and services globally will develop and grow; the receipt of all requisite regulatory approvals including throughout venture territories for the sale of ePals' products and services; the availability of additional financing, if and when required, and market conditions generally. Although ePals has attempted to identify factors that could cause actual actions, events or results to differ materially from those described in forward-looking information, there may be other factors that cause actions, events or results to differ from those anticipated, estimated or intended. The Company expressly disclaims any intention or obligation to update or revise any forwardlooking information, whether as a result of new information, future events or otherwise, except as required by applicable securities laws. Because of the risks, uncertainties and assumptions contained herein,

1

investors should not place undue reliance on forward-looking information. The foregoing statements expressly qualify any forward-looking information contained herein. Any and all forward-looking information contained in this MD&A is expressly qualified by this cautionary statement. Many factors could cause the actual results of the Company to differ materially from the results, performance, achievements or developments expressed or implied by such forward-looking statements, including, without limitation, those factors under the heading “Risk Factors” which are further discussed in the Company’s filing statement dated July 19, 2011, a copy of which is available under the Company’s SEDAR profile at www.sedar.com. Business Overview ePals is an education media company connecting K-12 schools, students, teachers and parents around st the world for shared, 21 century learning. ePals operates a global social learning network, connecting over 8,000,000 members in over 200 countries for collaboration around high quality content and educational projects. ePals also publishes electronic and physical versions of industry-leading children’s magazines, books and mobile apps, subscribed to by hundreds of thousands of families and approximately one-third of all US middle schools. ePals' award-winning products include: the ePals Global Community™; its Schoolsafe Product Suite (SchoolMail®365; LearningSpace®); In2Books®; and popular children’s educational publishing brands including Cricket® and Cobblestone®. ePals customers and partners include the International Baccalaureate, Microsoft Corporation, Dell Inc., IBM Corp. and leading school districts across the United States and globally. Business Strategy ePals’ mission is to create engaging and safe online services that empower students, inspire self-directed and collaborative learning, and transform outcomes. ePals’ vision is to create the opportunity for every student to build the skills and gain the knowledge needed for success in a networked, global economy and to assist educators and parents in helping students achieve those goals. The cornerstone of ePals’ business strategy is to deliver safe, social learning communities infused with high quality content and tailored to the specific needs of K-12 schools, educators, and parents. Specifically, ePals’ products and services aim to: 

deliver rigorous student safety and compliance using sophisticated policy management technologies usually absent from consumer and higher education social networks;



combine group-based, social learning communities with tools to create, publish and consume quality educational content (professional and user-generated) in ways that can be aligned to learning standards and served adaptively;



produce and distribute high-quality, children’s digital media and interactive learning apps for sale in home and school markets;



save time and money, recognizing that K-12 environments are both student-facing and mediated by administrators, educators and parents that are overburdened and have tight budgets;



facilitate formative and summative assessments;



create network effects across a “federation” of communities, each with their own unique safety and collaboration policies tailored to their local environment; and



provide a platform upon which partners, publishers and developers can build and distribute new online learning products and services to ePals’ users.

2

We deliver a variety of free and premium, online and offline media and platform products and services that contribute to the core metrics of registered users, subscriptions and revenue. ePals’ “Media Business” is comprised of subscriptions for children’s print and digital magazines and books, content licensing, e-commerce, sponsorship/advertising, and learning apps. We sell or license these media products and services to schools, libraries, teachers, parents, grandparents and students worldwide through a variety of direct and indirect channels, including the ePals Global Community™ and partners such as First Book, K-12, Inc. McGraw Hill and New York City schools. In late 2011, we significantly expanded the number of home-based consumers in our Media Business. A significant percentage of our Media Business in 2012 has been, and is expected to continue to be, from these home-based consumers. The Company is actively developing new digital, interactive app and magazine formats for distribution on iPhone, iPad, Kindle and other platforms. We use premium and subscription models both as cross-sales to existing print customers and for new customers who are consuming both electronic and print formats or shifting away from print products altogether. ePals’ “Platform Business” is currently comprised of a K-12 social learning product suite sold directly and indirectly to schools on a subscription basis and licensed to third party organizations. This SchoolSafe product suite provides schools with student-safe communication and with collaboration tools that are integrated into the ePals Global Community™ and to other popular cloud services such as Google Apps. The Platform Business products are generally sold through direct or indirect channels to schools seasonally on an academic year basis and, until late 2011, most of our revenue was derived from these products. The Company’s Platform Business faces a variety of market pressures in North America due to: funding and appropriation issues; and the speed at which schools and districts shift use of government subsidies, such as from the Schools and Libraries Program of the Universal Service Fund (“E-Rate”) in the US, to purchase collaborative products for use in the classroom, as opposed to solutions aimed at administrative staff and informational products such as public facing websites, that schools continue to fund with these government subsidies. The markets for our collaborative media and platform products are still at an early stage of development in North America and globally. Adaptation of pricing and product strategies for different markets will be necessary both in our Media and Platform businesses in order to respond effectively to identified market opportunities and changing competitive landscapes. In particular, and because growth in registered users is extremely important at this stage in the market, management is constantly assessing what portion of our platform we provide free as part of the ePals Global Community in order to maximize product adoption and registered user growth, and how to balance that against subscription- based or licensing based revenue. It is important to note that education market conditions in North America are not generally characteristic of market conditions in other countries at this juncture, where, for example, viral growth may be less likely and paid platform subscriptions more likely to be the predominate method for penetration into schools and homes. The ePals Global Community™ is believed to be the world’s largest K-12 learning network, enabling students, teachers and parents to safely connect and collaborate with classrooms locally, nationally and around the world for shared learning. Offered at no cost, individuals from around the world can freely join the ePals Global Community™ to safely connect their classrooms with others from around the world, participate in discussions, find and share projects, practice language skills, take part in educational contests, and explore quality content from both ePals and leading providers such as National Geographic and the Smithsonian Institution. At March 31, 2012, ePals Global Community™ had approximately 8 million registered users in approximately 200 countries, with about 50% of visits coming from international users. We expect to see more growth in international users in 2012 as globalization and English language learning continue to grow and Internet online use expands globally including on tablets and other mobile platforms. Our expectation is that the ePals Global Community™ will grow virally through “word-of-mouth”, adoption of our platform by large, educational communities, and cross-marketing to our home-based consumers and customers of our international joint ventures. We plan to launch an enhanced version of our global community platform in the second quarter of 2012 that we believe will set a new standard in collaborative learning, further differentiating ePals from its competitors. Due to its increased functionality, we expect this enhanced version of the global community platform to increase growth in new user registrations. We plan to monetize the Global Community™ through

3

sponsorships/advertising and distribution of premium digital and physical content, products and services generated by ePals in its Media Business, as well as by third party partners. Our objectives in 2012 include international expansion through the launch of regional, native language ePals communities that distribute premium social learning content, products and services for both consumers and schools. International markets present a significant growth opportunity for ePals to reach approximately 1.5B students worldwide. Initially, ePals plans to target large markets that invest heavily in K-12 education and plans to launch ePals China and ePals Europe this year. ePals is also focusing on introducing our products to additional international markets through both new and existing global channel partners. Overall Performance

Financial Highlights

Three months ended March 31, 2012 2011

Increase (Decrease)

%

(dollars in thousands, except share and per share data)

Revenue—media Revenue—platform Total revenue Operating expenses Loss from operations Other income (expense) Net loss Basic and diluted net loss per share Weighted average shares outstanding-Basic

$

4,127 462 4,589 (8,493) (3,904) (25) $ (3,929) $ (0.03)

$

91 404 495 (2,395) (1,900) (53) $ (1,953) $ (0.77)

116,490,803

2,528,351

$ 4,036 58 4,094 6,098 2,004 (28) $ 1,976

4435% 14% 827% 255% 105% (53%) 101%

Revenue for the three months ended March 31, 2012 was $4,588,615, an increase of $4,093,905 or 827% over the prior-year period. While revenue increased 827%, operating expenses increased at a slower rate of 255%, from $2,395,057 for the three months ended March 31, 2011 to $8,492,931 for the three months ended March 31, 2012. The net loss for the three months ended March 31, 2012 was $3,928,992, a loss of $0.03 per share and an increase of $1,976,404, or 101%, over the net loss for the three months ended March 31, 2011 of $1,952,588, a loss of $0.77 per share. Operating results for the three months ended March 31, 2012 include revenues and expenses from the establishment of our home subscription market in late 2011. Below is an update on our key operating objectives, which include growth in registered users, monetizing users of our free and premium products, revenue diversification and international expansion. 

Registered User and Subscription Growth – During the three months ended March 31, 2012, registered users of ePals products grew to over 8 million users, an increase of 31% on a year over year basis. The net registered users added in Q1 2012 for the ePals Global Community, typically a lower growth period than the second half of the year, were over 10 times greater than the net registered users added in Q1 2011. Growth in registered users continues to originate primarily from increasing product awareness and interest in collaboration around the world. International registrations are increasingly driving user growth. Based on historical rates, we expect the overall registered user growth to accelerate in the second half of 2012 due to back-toschool seasonality in the Northern Hemisphere, introduction of the enhanced version of the Global Community, ePals’ international expansion, and effective cross-marketing of the community to school and home-customers of our media products and services. Year-over-year subscription growth increased by 310,000, or 177%, as ePals added new school customers for its products, converting free to paid users. Subscriptions to ePals SchoolMail365® more than doubled over the same period. Platform subscriptions are anticipated to grow faster in

4

international markets as ePals launches ePals Europe and ePals China under its international initiatives in 2012. Year-over-year, first quarter subscriptions as a percentage of registered users increased from 3% to 6%. During the three months ended March 31, 2012, subscriptions decreased by 18%, to 485,000. The decline in subscriptions during the quarter is caused primarily by the non-renewal of customers due to lack of available financing for schools and districts, a focus by school districts on administrative rather than classroom based products for initial cloud based purchases with e-rate dollars, and the continued decline of physical magazine publications. Also effecting subscription growth were changing strategies in our indirect channel partners requiring different product integration strategies that are underway. The Company is currently developing digital versions of its magazines and working on other key initiatives to enhance digital and hybrid media subscriptions. Based on historical analysis, we expect greater than 70% of our annual growth in subscriptions to be in the second half of the year because of the seasonality of the North American education system, with new school years traditionally starting in August/September (platform) and the holiday season (media). 

Business Operations and Acquisitions – In May 2012, ePals announced the completion of its integration of Carus Publishing Company (“Carus”) following a number of activities to accelerate synergies between the various operating units of the combined business. In addition to aligning operational processes and accounting procedures, the Company launched key initiatives aimed at driving user registration and new subscriptions, including the completion of its first digital magazines that combine engaging content from the publications with the collaboration tools on the ePals Global Community™ to extend learning opportunities for children between home and school. The Company also executed a number of agreements with digital distribution partners and organizations such as First Book that have high penetration of institutional markets and continued scaling of digital marketing efforts to accelerate broad consumer uptake of its offerings and better retain customers with enhanced lifetime value.



Expand International Operations – ePals China: The previously announced joint venture with NeuEdu Tianjin (“NeuEdu”) is expected to launch in 2012, subject to regulatory approvals. A definitive agreement with NeuEdu was executed in April 2012, and a host of regulatory approval filings have been undertaken based on which we expect to start launching products and services in 2012, targeting approximately 205 million Chinese students aged 6-15. ePals Europe: With Dr. Thomas Middelhoff as Chairman of ePals Europe, ePals continues its focus on building a European management team, establishing key content and distribution partnerships, and launching local language versions of the ePals Global Community™ in 2012.

The following table highlights our key business metrics for March 31, 2012 compared to March 31, 2011. March 31, Key Business Metrics

2012

2011

Increase

8,035

6,148

31%

485

175

177%

$4,589

$495

827%

$ 0.59

$ 0.08

638%

(amounts in thousands, except per user data)

Registered users Subscriptions Revenue Average revenue per user (ARPU)

5

Results of Operations Revenue In 2011 we established our Media Business, expanded our Platform Business and put together core parts of an international footprint that we believe will make us a unique international educational media company. The Media Business accounted for 90% of total revenue for the three months ended March 31, 2012. The over $4 million increase in Media Business revenue in the first quarter of 2012 was primarily due to the addition of magazine sales and other consumer-based revenues in 2011. During the three months ended March 31, 2012, no one customer accounted for more than 10% of the Company’s revenue. Platform revenue increased 14% for the three months ended March 31, 2012 compared to the prior-year quarter. As part of its revenue from the Platform Business, ePals recognized $250,000 of revenue during each of the three months ended March 31, 2012 and 2011 related to the delivery of milestones specified in the April 2010 two-year strategic technical collaboration agreement between Microsoft and ePals, Inc. As of March 31, 2012, all of the revenue from this collaboration agreement has been recognized. The Company also recognized $54,000 from services during the three months ended March 31, 2012, an increase of approximately $44,000, or 419%, predominantly from being more deeply integrated into customer environments. During the three months ended March 31, 2012, the Company did not record any expense for the performance warrant granted to Dell Products L.P. (“Dell”) in 2011 for the right to purchase 7,830,917 of the Company’s voting common shares and/or restricted voting common shares because Dell did not meet the vesting provisions for the quarter. Dell must meet certain revenue targets from their resale of ePals products and services for the warrants to vest during the quarter. We continue to work with the Dell channel to fully integrate our products into their educational offering as they shift from a device-centric sales model to a solution sales model. We continue to provide training and other resources to enhance the partner relationship. While this MD&A segregates revenue into the Platform Business and the Media Business, the Company currently operates in only one reportable segment. Deferred Revenue To better understand the Company’s operations, investors should consider revenues and deferred revenues. Advance payments for the sale of subscriptions of children’s magazines are deferred and included in revenue on a pro-rata basis over the term of the subscriptions as issues are delivered. The revenue is recognized as earned when the subscription orders are shipped. Of the $5,241,256 in current deferred revenue at March 31, 2012, $4,741,905 is for advance payments of magazine subscriptions. The Company had $852,694 in long-term deferred revenue at March 31, 2012, with $643,373 for advance payments of magazine subscriptions. The remainder of the deferred revenue is from the Company’s contracts for platform licensing and professional services where it builds and licenses access to the ePals platform. Deferred revenue is initially recorded upon invoicing of the sale, and licensing revenue is recognized ratably in subsequent periods over the term of the contract, whereas professional services revenue is recognized in the period earned.

6

Operating Expenses

Operating Expense Detail

For the three months ended March 31, 2012 2011

Increase

%

(dollars in thousands)

Technology, development & operational support General & administrative expenses Sales & marketing Stock-based compensation Depreciation & amortization Change in estimated fair value of acquisition share consideration Acquisition investigation expenses Total operating expenses

$3,075 1,761 2,289 349 381

$1,175 664 436 87 33

$1,900 1,097 1,853 262 348

162% 165% 425% 301% 1055%

301 337 $8,493

$2,395

301 337 $6,098

N/A N/A 255%

Technology, development & operational support expenses increased $1,900,546, or 162% for the three months ended March 31, 2012, of which $1,594,166 was from the establishment of our home-based business to consumers. The remaining increase of $306,380 was due to additional consulting expenses and staffing in 2012 to develop and support ePals’ expanding platform and media products. The Company’s product development costs have not met the criteria for capitalization under IFRS because the technologically feasibility and the general release of Company’s products have substantially coincided. For the three months ended March 31, 2012 and 2011, the Company expensed research and product development costs of $533,273 and $307,993, respectively, as classified in “Technology, development & operational support” on the Consolidated Statements of Comprehensive Loss. The establishment of our home-based business to consumers accounted for $569,725 of the $1,096,838 increase in general and administrative expenses for the three months ended March 31, 2012, with the remaining increase of $527,113 due to human resources and accounting consultants for the integration of the businesses acquired in 2011, new senior management hires, additional travel expenses in anticipation of expanding business opportunities in Europe and China, and increased fees for legal, audit, tax and corporate insurance associated with ePals’ new public corporate structure. Sales and marketing expenses for the three months ended March 31, 2012 increased $1,852,785, of which $1,027,057 was from the establishment of our home-based business to consumers. The remaining increase of $825,728 was due to increased staffing in marketing, business development and education media, and additional marketing and travel expenses due to a greater presence at tradeshows in the first quarter of 2012. Stock-based compensation expense increased by $261,853 for the three months ended March 31, 2012 compared to the prior-year period primarily because of restricted share units (“RSUs”) granted to the Company’s new hires between August 2011 and March 2012 (including new hires in senior management) which are being expensed over the vesting period. Acquisition investigation expenses represent legal, audit and tax fees related to potential business acquisitions and joint ventures that the Company is considering. Financial Condition Total assets at March 31, 2012 compared to December 31, 2011 decreased $6,132,932 primarily due to the $5,927,199 decrease in cash, mainly consisting of cash used in operating activities which totaled $5,278,820 during the three months ended March 31, 2012. Liabilities decreased by $2,568,170 from December 31, 2011 to March 31, 2012 due to the $1,801,013 reduction in deferred revenue and the $581,637 reduction in accounts payable and accrued expenses.

7

Stockholders’ equity decreased by $3,564,762 from $12,969,365 at December 31, 2011 to $9,404,603 at March 31, 2012 primarily due to the net loss of $3,928,992 for the three months ended March 31, 2012, which was partially offset by the $325,708 increase in additional paid-in capital. This increase was due to stock-based compensation from stock options and warrants. Liquidity and Capital Resources ePals’ cash at March 31, 2012 was $968,630. In April 2012, ePals completed a private placement of 24,390,000 voting common shares at a price of Cdn$0.41 per share for total gross proceeds of Cdn$9,999,900. These net proceeds will be used for working capital and general corporate purposes. See Subsequent Events below for more information about this financing. The Company renewed its $1,500,000 bank line-of-credit outstanding in March 2012 for an additional year under terms substantially similar to the previous agreement. Holders of voting common shares and restricted voting common shares who were former shareholders of ePals, Inc., the holders of options and warrants issued by ePals, Inc. prior to the completion of the Merger, and holders of options, warrants and vested restricted share units issued by the Company after the Merger are subject to escrow restrictions imposed by the Company, with 25% of securities initially scheduled to be released from escrow on January 27, 2012, 25% initially to be released on July 27, 2012 and 50% to be released on January 27, 2013. In the long term interests of the Company, in May 2012, the Board of Directors postponed the release of 25% of the shares originally scheduled for release on January 27, 2012 and 25% originally scheduled for release on July 27, 2012 to be released from escrow on September 4, 2012. Operating Activities for the Three Months Ended March 31, 2012 versus March 31, 2011 Cash flows used in operating activities for the three months ended March 31, 2012 compared to the three months ended March 31, 2011 reflect an increase of $3,033,946 or 135%. The increase in cash flows used in operating activities was primarily due to the increased expenses during the current period which are explained above. Investing Activities for the Three Months Ended March 31, 2012 versus March 31, 2011 Cash flows used in investing activities for the three months ended March 31, 2012 were $688,810 compared to $227,772 for the three months ended March 31, 2011. The increase of $461,038 or 202% is due to the $512,058 in payments made during the three months ended March 31, 2012 for the Carus acquisition. Financing Activities for the Three Months Ended March 31, 2012 versus March 31, 2011 Cash flows provided by financing activities for the three months ended March 31, 2012 decreased by $2,543,726 because of the $2,571,227 proceeds from convertible notes during the three months ended March 31, 2011. The Company did not receive additional financing during the first quarter of 2012. Bank Line-of-Credit Covenants At March 31, 2012, the Company is in compliance with all covenants related to its bank line-of-credit agreement. Future Working Capital and Capital Expenditure Needs In April 2012, ePals completed a private placement of 24,390,000 voting common shares at a price of Cdn$0.41 per share for total gross proceeds of Cdn$9,999,900. These net proceeds will be used for working capital and general corporate purposes. See Subsequent Events below for more information about this financing. The Company obtained additional financing in part to replenish the funds used for the acquisition of Carus. The launch of ePals’ Ventures such as ePals China and ePals Europe also

8

increase the expected future funding needs. The Company is required to contribute registered capital of $2,450,000 in NeuPals (as hereinafter defined) with at least 50% of this amount required to be funded within 90 days of the date NeuPals’ business license is issued. The remaining registered capital is required to be funded within 24 months after the date the business license is issued. Future capital requirements will depend on many factors, including the rate of revenue growth, the expansion of marketing and sales activities, the timing and extent of spending to support product development efforts and expansion into new territories, the timing of the release of new services and enhancements to existing services, acquisition activity, the timing of capital expenditures and expenses associated with web hosting and the continuing market acceptance of our services. To the extent that available funds are insufficient to fund future activities, the Company may need to raise additional funds through public or private equity or debt financing. Off-Balance Sheet Arrangements The Company’s off-balance sheet arrangements are comprised of operating leases entered into in the normal course of business. The Company has no other off-balance sheet arrangements and does not anticipate entering into any such arrangements other than in the normal course of business. Transactions with Related Parties The Company has a short-term agreement to reimburse ZG Ventures, LLC, an affiliate of two members of the Company’s Board of Directors, for a percentage of the rent on shared office space up to $5,000 per month through the end of September 2012. In December 2010, ePals, Inc. entered into a loan agreement with an officer for $90,000 with interest of 2.75% per annum. The loan was repaid on January 4, 2011. The Company’s $1,500,000 bank line-of-credit at March 31, 2012 and December 31, 2011 is personally guaranteed by two members of the Company’s Board of Directors. Changes in Accounting Policies There are no new accounting standards effective for the quarter ended March 31, 2012 that had a material effect on the accompanying unaudited condensed consolidated interim financial report. There are no relevant changes in accounting standards applicable to future periods other than those disclosed in the most recent annual financial statements of the Company as at and for the year ended December 31, 2011. Financial Instruments and Other Instruments The Company holds various forms of financial instruments, including cash, certificates of deposit, accounts receivable, accounts payable, capital leases and a bank line-of-credit. The nature of these instruments and its operations expose ePals to credit risk, interest rate risk and liquidity risk. ePals manages its exposure to these risks by operating in a manner that minimizes this exposure. While management monitors and administers these risks, the Company’s Board of Directors has the overall responsibility for the establishment and oversight of ePals’ risk management framework.

9

Summary of Quarterly Results The following table sets forth certain unaudited information for each of the eight most recent quarters. The quarterly information has been derived from the unaudited interim consolidated financial statements of ePals, Inc. and the Company that have been prepared in accordance with IFRS and include all adjustments necessary for the fair presentation of the information presented.

2010 (unaudited) (dollars in thousands, except share and per share data) Revenue Net loss Net loss per common share Weighted average common shares (1) (2)

Q21

2011 Q12

Q21

2012

Q3

Q4

Q3

Q4

Q1

429 (2,426)

380 (2,395)

477 (1,735)

495 (1,953)

485 (2,323)

612 (8,696)

2,009 (4,821)

4,589 (3,929)

(0.96)

(0.95)

(0.69)

(0.77)

(0.82)

(0.11)

(0.04)

(0.03)

2,520,124 2,520,123 2,520,069

2,528,351

2,829,677

82,721,996

116,123,674

116,490,803

From ePals, Inc.’s Consolidated Interim Statement of Comprehensive Loss for the three and six months ended June 30, 2011 and 2010. These quarters were prior to the Merger. From ePals, Inc.’s Consolidated Interim Statement of Comprehensive Loss for the three months ended March 31, 2011. This quarter was prior to the Merger.

Subsequent Events Joint Venture Contract In April 2012, the Company announced the signing of a definitive Joint Venture Contract (the “JVC”) with NeuEdu for a 20 year term whereby the parties agreed to create a partnership (“NeuPals”) to create and launch a Chinese language platform in China that enables school-safe communications. The joint venture will become effective on approval by the Chinese Government and the JVC is subject to all necessary regulatory and government approvals. Based on the structure of the organization, the parties will not have joint control over NeuPals. The Company will have significant influence over NeuPals and will account for NeuPals using the equity method of accounting. The parties are working to finalize ancillary agreements relating to intellectual property, stock purchase, warrants and operational services. The total amount of the registered capital of NeuPals will be $5,000,000, of which the contributions from ePals and NeuEdu are expected to be $2,450,000 and $2,550,000, respectively, accounting for 49% and 51%, respectively, of the registered capital. NeuEdu and ePals are required to fund at least 50% of their share of the registered capital within 90 days of the date NeuPals’ business license is issued (expected to occur during the second half of 2012) and the remaining share are required to be funded within 24 months after the date the business license is issued. NeuEdu purchased 2,439,024 voting common shares of ePals on a private placement basis at a price of Cdn$0.41 per share for total gross proceeds to ePals of Cdn$1,000,000 as part of the April 2012 financing described below. These securities are subject to a four month hold period under applicable Canadian securities laws which commenced on the date of issuance. Financing In April 2012, the Company completed a best efforts private placement and issued a total of 24,390,000 voting common shares (the “Shares") at a purchase price of Cdn$0.41 per Share for gross proceeds of Cdn$9,999,900 (the “Offering”). The Offering was conducted through a syndicate of agents led by Cormark Securities Inc. (“Cormark”) and including National Bank Financial Inc. and Canaccord Genuity Corp. (collectively, the “Agents”) pursuant to an agency agreement dated April 19, 2012 (the “Agency

10

Agreement”). In connection with the Offering, the Agents received a cash commission equal to 6% of the gross proceeds of the Offering, subject to a reduced commission in respect of certain subscribers as agreed to between Cormark and the Company. The Shares issued pursuant to the Offering are subject to a four month hold period which commenced on the closing date of the Offering. The net proceeds of the Offering will be used for working capital and general corporate purposes. Delay of Release of Shares in Escrow Holders of voting common shares and restricted voting common shares who were former shareholders of ePals, Inc., the holders of options and warrants issued by ePals, Inc. prior to the completion of the Merger, and holders of options, warrants and vested restricted share units issued by the Company after the Merger are subject to escrow restrictions imposed by the Company, with 25% of securities initially scheduled to be released from escrow on January 27, 2012, 25% initially to be released on July 27, 2012 and 50% to be released on January 27, 2013. In May 2012, the Board of Directors postponed the release of 25% of the shares originally scheduled for release on January 27, 2012 and 25% originally scheduled for release on July 27, 2012 to be released from escrow on September 4, 2012. Although the Company had made progress in building a presence on the TSX-V, ePals’ stock remains thinly traded and are therefore highly volatile. Thus the Company’s Board of Directors unanimously decided in light of prevailing market conditions and its business plans as concerns its financial affairs to extend such “lock up” provision. Vested options can be exercised at any point, but the resulting shares would be included in escrow and released according to its release schedule. Carus Acquisition As of March 31, 2012, the Company had paid $512,058 of the $1,500,000 deferred cash due from the 2011 acquisition of Carus. The remaining $987,942 of the deferred cash was paid by the Company in April 2011. Outstanding Share Data The Company is authorized to issue an unlimited number of voting common shares, an unlimited number of restricted voting common shares and an unlimited number of preferred shares, issuable in series. The following table sets forth the details of voting common shares and restricted voting common shares outstanding as of May 15, 2012 and securities that are exercisable or convertible into voting common shares or restricted voting common shares. No preferred shares of the Company are outstanding as of May 15, 2012.

11

Type Voting common shares (1) Restricted voting common shares Outstanding securities convertible into voting common shares and/or restricted voting common shares: ePals, Inc. stock options Number of voting common shares and/or restricted voting common shares issuable upon exercise of stock options ePals Corporation stock options Number of voting common shares and/or restricted voting common shares issuable upon exercise of stock options Total ePals Corporation common shares that would be issued upon conversion of ePals, Inc.’s stock options and ePals Corporation’s stock options

Number of Shares 92,001,039 49,794,533

6,698,600

3,466,989 10,165,589

(2)

ePals, Inc. warrants Number of voting common shares and/or restricted voting common shares issuable upon exercise of warrants ePals Corporation warrants Number of voting common shares and/or restricted voting common shares issuable upon exercise of warrants Total ePals Corporation common shares that would be issued upon conversion of ePals, Inc.’s common and preferred warrants and ePals Corporation’s warrants Restricted stock units

12,213,700

3,274,756 15,488,456

1,474,935

Notes: (1) (2)

Each restricted voting common share is convertible into one voting common share. Common and preferred stock warrants issued by ePals, Inc. are convertible into common shares of the Company on a one-for-one basis, subject to adjustment based on stock splits, etc. These warrants are exercisable at the option of the holder and expire at various dates, depending on when they were issued, or the effective date of the first registration statement filed with the Securities and Exchange Commission under the Securities Act of 1933, or the consummation of an acquisition or asset sale. The warrants to purchase common shares includes a performance warrant for the right to purchase 7,830,917 shares of ePals, Inc. common shares, subject to specific vesting provisions which may or may not be met.

Consideration for the purchase of Carus included the right to receive ePals’ restricted voting common shares in an amount of up to $10 million (calculated as 15,625,000 shares based on the agreed value of Cdn$0.64 per share), subject to certain adjustments. These shares will be issued in two equal tranches on July 1, 2012 and September 30, 2012 and are not included in the Outstanding Share Data table above.

12

ePals Corporation Corporate Headquarters 13625-A Dulles Technology Dr. Herndon, VA 20171 Phone: 703-885-3400 Fax: 703-885-3490 www.corp.epals.com