KEYNOTE SYSTEMS INC, 10-Q, 2000-08-14

KEYNOTE SYSTEMS INC
10-Q, 2000-08-14
BUSINESS SERVICES, NEC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

----------------

FORM 10-Q

(Mark One)

[X]QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2000

[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER: 000-27241

Keynote Systems, Inc.
(Exact name of registrant as specified in its charter)

DELAWARE 94-3226488
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

2855 Campus Drive, San Mateo, CA 94403
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: (650) 522-1000

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 [_]

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:

Class Shares outstanding at July 31, 2000
----- -----------------------------------
Common Stock, $.001 par value 27,679,664
<PAGE>

Keynote Systems, Inc.

Table of Contents

<TABLE>
<CAPTION>
PART I - FINANCIAL INFORMATION

<S> <C> <C>
Page
----
Item 1. Financial Statements................................................................................... 4
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................. 11
Item 3. Quantitative and Qualitative Disclosures about Market Risk ............................................ 23

PART II - OTHER INFORMATION

Item 1. Legal Proceedings.................................................................................... 24
Item 2. Changes in Securities and Use of Proceeds............................................................... 24
Item 3. Defaults Upon Senior Securities......................................................................... 24
Item 4. Exhibits and Reports on Form 8-K........................................................................ 24
Signatures ........................................................................................................ 26

</TABLE>
<PAGE>

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

KEYNOTE SYSTEMS, INC.

Index to Unaudited Condensed Consolidated Financial Statements

<TABLE>
<CAPTION>
Page
----

<S> <C>
Condensed Consolidated Balance Sheets as of June 30, 2000 and September 30, 1999.................................... 4

Condensed Consolidated Statements of Operations for the three months and nine months ended June 30, 2000 and
1999................................................................................................................ 5

Condensed Consolidated Statements of Cash Flows for the nine months ended June 30, 2000 and 1999.................... 6

Notes to Condensed Consolidated Financial Statements................................................................ 7
</TABLE>
<PAGE>

KEYNOTE SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
June 30, 2000 September 30, 1999
------------------- ---------------------

ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents................................................. $ 356,402 $ 64,647
Accounts receivable, net.................................................. 6,633 2,295
Prepaid and other current assets.......................................... 1,692 333
------------------- ---------------------
Total current assets................................................... 364,727 67,275

Property and equipment, net.................................................. 6,764 3,277
Loans to related parties and other assets.................................... 729 519
Goodwill and other intangible assets......................................... 39,378 -
------------------- ---------------------
Total assets............................................................... $ 411,598 $ 71,071
=================== =====================

</TABLE>
LIABILITIES AND STOCKHOLDERS' EQUITY

<S> <C> <C>
Current liabilities
Notes payable and capital lease obligation - current portion $ 1,316 $ 1,332
Accounts payable and accrued expenses.................................... 6,447 2,578
Deferred revenue......................................................... 5,652 1,087
------------------- ---------------------
Total current liabilities................................................ 13,415 4,987

Notes payable and capital lease obligation, less current portion 1,134 2,842
------------------- ---------------------
Total liabilities........................................................ 14,549 7,829

Stockholders' equity:
Common stock............................................................. 27 23
Additional paid-in capital............................................... 411,343 77,430
Deferred stock-based compensation........................................ (879) (1,135)
Stockholder notes receivable............................................. - (388)
Accumulated deficit...................................................... (13,442) (12,688)
------------------- ---------------------
Total stockholders' equity............................................... 379,049 63,242
------------------- ---------------------
Total liabilities and stockholders' equity............................... $ 411,598 $ 71,071
=================== =====================

</TABLE>

See accompanying notes to the condensed consolidated financial statements
<PAGE>

KEYNOTE SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
Three months ended June 30, Nine months ended June 30,
--------------------------- --------------------------
2000 1999 2000 1999
---- ---- ---- ----

<S> <C> <C> <C> <C>
Revenue:
Subscription services........................................ $ 9,283 $ 1,862 $ 20,733 $ 4,026
Consulting services.......................................... 432 57 956 83
---------- --------- --------- --------
Total revenues............................................. 9,715 1,919 21,689 4,109
---------- --------- --------- --------

Operating Expenses:
Cost of subscription services................................ 2,622 522 6,870 975
Cost of consulting services.................................. 533 167 1,086 254
Research and development..................................... 1,463 634 3,405 1,297
Sales and marketing.......................................... 4,808 1,426 11,617 2,989
Operations................................................... 1,418 475 3,256 1,024
General and administrative................................... 1,346 406 3,503 849
Amortization of goodwill and other intangible
assets....................................................... 1,125 - 1,125 -
Amortization of stock-based compensation..................... 85 88 256 234
---------- --------- --------- --------
Total operating expenses................................... 13,400 3,718 31,118 7,622
---------- --------- --------- --------

Loss from operations....................................... (3,685) (1,796) (9,429) (3,513)

Interest income (expense), net.................................. 5,408 3 8,675 (146)
---------- --------- --------- --------

Net Income (loss).......................................... $ 1,723 $ (1,796) $ (754) $ (3,659)
========= ========= ======== =========

Income (loss) per share:
Basic and diluted.......................................... $ 0.06 $ (0.36) $ (0.03) $ (0.91)
========= ========= ======== =========

Weighted average common shares outstanding used:
Basic...................................................... 26,623 4,965 24,566 4,009
========= ========= ======== =========
Diluted.................................................... 28,569 4,965 24,566 4,009
========= ========= ======== =========

</TABLE>

See accompanying notes to the condensed consolidated financial statements
<PAGE>

KEYNOTE SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

<TABLE>
<CAPTION>
Nine months ended June 30,
---------------------------
2000 1999
---- ----

<S> <C> <C>
Cash flows from operating activities:
Net loss................................................................................... $ (754) $ (3,659)
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
Depreciation and amortization............................................................ 1,750 558
Amortization of goodwill and other intangible assets..................................... 1,125 -
Amortization of stock based compensation................................................. 256 153
Compensation related to performance based stock options.................................. - 81
Changes in operating assets and liabilities
Accounts receivable................................................................... (4,264) (1,237)
Prepaids and other assets............................................................. (1,618) (1,244)
Accounts payable and accrued expenses................................................. 3,152 592
Deferred revenue...................................................................... 4,565 696
--------- --------
Net cash provided by (used for) operating activities................................ 4,212 (4,060)
--------- --------
Cash flows used for investing activities:
Purchases of property and equipment........................................................ (4,819) (1,708)
--------- --------
Cash flows from financing activities
Repayments of notes payable................................................................ (3,739) (227)
Cash acquired as part of Vologic acquisition............................................... 791 -
Proceeds from issuance of notes payable.................................................... - 3,646
Net proceeds from issuance of preferred stock and warrants................................. - 14,851
Proceeds from public offering, net of issuance costs....................................... 294,129 -
Issuance of common stock, net of issuance costs............................................ 723 2,355
Repayments of shareholder notes............................................................ 458 2
--------- --------
Net cash provided by financing activities................................................ 292,362 20,627
--------- --------

Net increase in cash and cash equivalents..................................................... 291,755 14,859
Cash and cash equivalents at beginning of the period.......................................... 64,647 2,293
--------- --------
Cash and cash equivalents at end of the period................................................ $ 356,402 $ 17,152
========= ========
Noncash financing activities:
Issuance of common stock for shareholder notes receivable................................ $ - $ 79
========= ========
Deferred compensation related to stock option grants..................................... $ - $ 1,059
========= ========
Purchase of property and equipment through capital leases................................ $ - $ 418
========= ========
Common stock and options issued in connection with acquisition........................... $ 39,217 $ -
========= ========

</TABLE>

See accompanying notes to the condensed consolidated financial statements
<PAGE>

KEYNOTE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) BASIS OF PRESENTATION

The accompanying interim unaudited condensed consolidated balance sheets
and condensed consolidated statements of operations and cash flows reflect all
normal recurring adjustments that are, in the opinion of management, necessary
for a fair presentation of the financial position of Keynote Systems, Inc. (the
Company) at June 30, 2000, and the results of operations and cash flows for the
interim periods ended June 30, 2000 and 1999.

The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with the instructions on Form 10-Q and, therefore,
do not include all information and footnotes necessary for a complete
presentation of the Company's results of operations, financial position and cash
flows. We filed audited financial statements that included all information and
footnotes necessary for a complete presentation for each of the years in the
three year period ended September 30, 1999 in Keynote's annual report on Form
10-K for the fiscal year ended September 30, 1999.

The results of operations for any interim period are not necessarily
indicative of the Company's results of operations for any other future interim
period or for a full fiscal year.

(2) REVENUE RECOGNITION POLICY

Subscription services revenue consists of fees from subscriptions to the
Company's Internet measurement and diagnostic services. The majority of our
subscription revenues is deferred upon invoicing and is recognized ratably over
the service period, generally ranging from one to twelve months. Deferred
revenue is comprised entirely of deferred subscription revenue. A small portion
of subscription revenues is invoiced monthly upon completion of measurement
services. Revenue from consulting services is recognized as the services are
performed, typically a period of one month. Revenue related to the Company's
recently acquired load testing services is also included in consulting revenue.
For consulting projects that span multiple months, the Company recognizes
revenue on a percentage of completion basis.

Cost of subscription revenues consists of connection fees to Internet
service providers for bandwidth usage of the Company's computer measurement
agents around the world, depreciation, maintenance and other equipment charges
for the Company's measurement infrastructure. Cost of consulting services
consists of compensation for consulting personnel and related costs, and all
load testing bandwidth costs and related infrastructure costs. Operations
expenses consist primarily of compensation and related costs for management
personnel, and technical support employees who manage and maintain the Company's
measurement data and headquarter infrastructure and support the Company's
customer base.

(3) COMPREHENSIVE LOSS

The Company has no components of other comprehensive loss for any period
presented.

(4) FAIR VALUES OF FINANCIAL INSTRUMENTS

The carrying amounts of cash and cash equivalents, accounts receivable,
loans to related parties, prepaid and other current assets, accounts payable,
notes payable and capital lease obligations approximate their respective fair
values.

<PAGE>

KEYNOTE SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

(5) NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share is computed using the weighted-average
number of outstanding shares of common stock excluding shares of restricted
stock subject to repurchase summarized below. Diluted net income (loss) per
share is computed using the weighted-average number of shares of common stock
outstanding and, when dilutive, potential common shares from options and
warrants to purchase common stock using the treasury stock method and from
convertible securities using the "as-if-converted" basis.

The following potential common shares have been excluded from the
computation of diluted net loss per share because the effect would have been
antidilutive (in thousands):

<TABLE>
<CAPTION>
Nine months ended Three months ended
June 30 June 30
-------------------------------------------------------
<S> <C> <C> <C>
2000 1999 1999
Shares outstanding under stock options 1,995 1,067 1,067
Shares of restricted stock subject to 369 912 912
repurchase
Shares issuable pursuant to warrants to
purchase:
Convertible preferred stock - 537 537
Common stock - 106 106
Shares of convertible preferred stock on an
"as-if-converted" basis - 12,589 12,589
</TABLE>

For the 3 months ended June 30, 2000 the reconciliation of basic to fully
diluted common shares is as follows (in thousands):

Basic shares outstanding 26,623

Shares outstanding under stock options 1,946
-------
Diluted shares outstanding 28,569
=======

The weighted-average exercise price of stock options was $7.24 and $3.20 as
of June 30, 2000 and 1999, respectively. The weighted-average repurchase price
of restricted stock was $0.26, as of June 30, 2000 and 1999. The weighted-
average exercise price of the convertible preferred stock warrants was $1.40 as
of June 30, 1999.

(6) RECENT ACCOUNTING PRONOUNCEMENTS

In March 2000, the FASB's Emerging Issues Task Force (EITF) reached a
consensus on EITF No. 00-2, Accounting for the Costs of Developing a Web Site.
EITF No. 00-2 provides guidance on accounting for web site development costs and
is effective for fiscal quarters beginning after June 30, 2000. The Company is
currently reviewing the impact of EITF No. 00-2 on its financial statements and
results of operations. The Company does not believe the impact of this
statement will have any material adverse effect on the Company's statement of
operations.

In March 2000, the EITF reached a consensus on EITF No. 00-3, Application
of AICPA Statement of Position 97-2, Software Revenue Recognition, to
Arrangements That Include the Right to Use Software Stored on Another Entity's
Hardware. The Company does not expect that the adoption of EITF No. 00-3 will
have a material impact on its financial statements or results of operations.

In March 2000, the Financial Accounting Standards Board issued FASB
Interpretation No. 44, Accounting for Certain Transactions Involving Stock
Compensation (FIN 44), an interpretation of APB Opinion No. 25, Accounting for
Stock Issued to Employees. The application of this interpretation is effective
July 1, 2000. The Company does not believe that the impact of this statement
will have a material effect on the financial position or results of operations
upon the adoption of this interpretation.

In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition in Financial
Statements, as amended by SAB 101A and SAB 101B, which provides guidance on the
recognition, presentation, and disclosure of revenue in financial statements
filed with the SEC. SAB 101 outlines the basic criteria that must be met to
recognize revenue and provides guidance for disclosure related to revenue
recognition policies. In June 2000, the SEC issued SAB 101B, which delays the
implementation of SAB 101. The company must adopt SAB 101 no later than the
fourth quarter of 2000. The SEC has recently indicated that it intends to issue
further guidance with respect to the adoption of specific issues addressed by
SAB 101. Until such time as this additional guidance is issued, the Company is
unable to assess the impact, if any, it may have on its financial position or
results of operations.

Statement No. 133, an Amendment of FASB Statement No. 133 (SFAS 137). SFAS 137
delayed the effective date for SFAS 133 for fiscal years beginning after June
15, 2000. The Company does not believe that the impact of this statement will
have a material effect on the financial position or results of operations upon
the adoption of this accounting standard.

(7) SEGMENT INFORMATION

The Company has determined that it operates in a single operating segment:
developing and selling services to measure, assure and improve the quality of
service of web sites. In December 1999, the Company opened an international
office located in Paris, France. All of the Company's long-lived assets are
located in the United States. To date, there have been no significant operating
revenues or expenses from the Company's international operations. For the three
and nine months ended June 30, 2000, one customer accounted for approximately
10% of the company's total revenues.

(8) ACQUISITION

On June 2, 2000, the Company completed the acquisition of Velogic, Inc., a
California corporation ("Velogic"), through a merger of a wholly-owned
subsidiary of the Company with and into Velogic (the "Merger"), with Velogic
surviving as a wholly-owned subsidiary of the Company. Velogic is a provider of
load testing services for e-Businesses. The Merger is intended to be a tax-free
reorganization and will be accounted for under the purchase method of
accounting.

In connection with the Merger, the Company issued an aggregate of 830,684
shares of its common stock for all of the outstanding capital stock, of
Velogic and assumed all stock options and warrants of Velogic, of which
166,137 shares will be subject to an escrow to ensure certain indemnification
obligations of the former Velogic shareholders. The value of shares issued and
stock options assumed (the purchase consideration) was approximately $39.2
million. In addition, if Velogic achieves certain revenue targets attributed
to Velogic products and services in 2000, the Company will be obligated to
issue to the former Velogic shareholders additional shares of Keynote common
stock or cash having an aggregate value of up to approximately $3.9 million.
The Company will be obligated to issue an additional $3.9 million of Keynote
common stock or cash to the former Velogic shareholders if Velogic achieves
certain revenue targets in 2001. If these revenue goals are met, the Company
could be obligated to issue additional shares of its common stock, or cash,
having an aggregate value of up to approximately $7.8 million. The
determination as to whether cash or stock will be paid, if performance targets
are met is at the sole discretion of the Company.

The purchase consideration was allocated to the assets acquired and
liabilities assumed based on estimated fair values at the acquisition date. The
primary purchase adjustments related to recording goodwill of approximately
$36.4 million and other intangible assets of approximately $4.1 million.
Goodwill and other intangible assets are being amortized on a straight-line
basis over thirty-six months. The combined consolidated statement of
operations includes activity of Velogic subsequent to the acquisitions. As a
result of the purchase, the Company assumed the following assets and
liabilities:

<S> <C>
Working capital ($1,679)
Property and equipment, net 392
Goodwill 36,425
Other intangible assets 4,079
-------

Total purchase consideration $39,217
====================
</TABLE>

The following summary, prepared on an unaudited pro-forma basis, reflects
condensed consolidated results of operations for the three and nine months ended
June 30, 2000, and 1999, assuming Velogic had been acquired on October 1, 1998,
(in thousands, except per share data):

<TABLE>
<CAPTION>
Three months ended June 30 Nine months ended June 30
-------------------------- -------------------------
2000 1999 2000 1999
----------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Revenues $ 9,797 $ 1,974 $ 21,832 $ 4,164
Net Loss (1,863) (5,776) (12,942) (14,691)
Basic and diluted net loss per share (0.07) (1.00) (0.51) (3.04)
Shares used in pro-forma per share
computation 27,198 5,796 25,312 4,840
</TABLE>
<PAGE>

(9) Subsequent Event

On July 11, 2000, the Company entered into a lease agreement for an 188,000
square foot office building in San Mateo, California. Payments under this
operating lease are based on LIBOR, which covers a one to six month interest
term. Future minimum payments under this operating lease as of June 30, 2000,
assumes an average interest rate of 7% over a five-year period and includes
a $85.0 million balloon payment at the end of the lease, and are as follows:

<TABLE>
<CAPTION>
Year ended June 30: (000's)
<S> <C>
2001 $ 5,950
2002 5,950
2003 5,950
2004 5,950
2005 90,950
Thereafter ----
-----------

Total minimum lease payments $114,750
===========

</TABLE>
<PAGE>

ITEM 2. Management Discussion and Analysis of Financial Condition and
Results of Operations

You should read the following information in conjunction with the interim
unaudited condensed consolidated financial statements and related notes.

Except for historical information, this Quarterly Report contains forward-
looking statements within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of 1934, as amended. Such
forward-looking statements involve risks and uncertainties, including, among
other things, statements regarding our anticipated costs and expenses, and
revenue mix. Such forward-looking statements include, among others, those
statements including the words "expects," "anticipates," "intends," "believes"
and similar language. Our actual results may differ significantly from those
projected in the forward-looking statements. Factors that might cause or
contribute to such differences include, but are not limited to, those discussed
in the section "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Factors That May Impact Future Operating Results." You
should carefully review the risks described in other documents we file from time
to time with the Securities and Exchange Commission, including the Quarterly
Reports on Form 10-Q that we will file in 2000 and our Annual Report on Form 10-
K, which was filed on December 21, 1999. You are cautioned not to place undue
reliance on the forward-looking statements, which speak only as of the date of
this Quarterly Report on Form 10-Q. We undertake no obligation to publicly
release any revisions to the forward-looking statements or reflect events or
circumstances after the date of this document.

Overview

Keynote provides Internet performance measurement and diagnostic services
that enable electronic commerce, or e-commerce, companies to measure, assure and
improve the quality of service of their web sites. E-commerce web sites face a
different set of challenges than those faced by conventional "bricks and mortar"
stores. In order to discourage customers from "clicking away" to competing web
sites, e-commerce web sites must deliver fast page downloads, efficient
transactions and high reliability of access.

Keynote was founded in June 1995 in California and reincorporated in
Delaware in March 2000. Until we released our Keynote Perspective service in
April 1997, we were engaged in market research and the engineering design of our
services. We have introduced additional versions of the service, most recently
in December 1999, so that Keynote Perspective now includes the ability to
measure Web page download times, secure Web page downloads and multi-page
transactions, and offers our customers a greater ability to personalize their
service through their MyKeynote portal. In July 1999, we introduced our Keynote
Lifeline service. In December 1999, we introduced our Keynote Consumer
Perspective service, which is designed to measure Web-site performance via
various Internet access methods typically used in homes, such as dial-up
connections, cable modems or digital subscriber lines. In April 2000, we
introduced our Diagnostic Perspective service that is designed to enhance the
diagnostic capabilities of our Perspective service and increase the availability
of the diagnostic information on a real-time basis. In January 1999 we formed
our professional services organization.

We market our sales primarily through our direct sales organization. Our
direct sales organization also provides telephone and e-mail sales support,
telemarketing services and pre-sales technical support. We believe our direct
sales approach enables us to focus our resources on ascertaining the needs of
our customers, to devote significant attention to customer satisfaction and to
quickly offer new services to our existing customers. We also distribute our
services through Web-hosting and Internet service providers such as Digex,
GlobalCenter, Exodus Communications, Digital Island/Sandpiper, IBM and UUNET,
which manage e-commerce web sites for other companies. These companies sell or
bundle our services to part of their customer base as a value-added service to
these customers and as a management tool for themselves. We also market our
services through VeriSign and Network Solutions, which was recently acquired
by Verisign, which are companies that sell services complementary to ours. We
recently opened a European office in Paris. We plan to move the office to
London in the near future. In Europe, we have implemented an indirect sales
model and use resellers to sell our services.

On June 2, 2000, we completed the acquisition of Velogic, Inc., a
California corporation, through a merger of our wholly-owned subsidiary with and
into Velogic, with Velogic surviving as our wholly-owned subsidiary. Velogic is
a provider of load testing services for eBusinesses. This merger is intended to
be a tax-free reorganization and has been accounted for under the purchase
method of accounting.

In connection with this merger, we issued an aggregate of 830,684 shares of
our common stock for all of the outstanding capital stock, including stock
options of Velogic, of which 166,137 shares will be subject to an escrow to
ensure certain indemnification obligations of the former Velogic shareholders.
In addition, if Velogic achieves certain revenue targets attributed to Velogic
products and services in 2000, we will be obligated to issue to the former
shareholders of Velogic additional shares of our common stock or cash having an
aggregate value of up to approximately $3.9 million. We will be obligated to
issue an additional $3.9 million of our common stock or cash to the Velogic
shareholders if Velogic achieves certain revenue targets in 2001. As a result,
if these revenue goals related to Velogic are met, we could be obligated to
issue additional shares of our common stock or cash having an aggregate value of
up to approximately $7.8 million. The determination as to whether cash or stock
will be paid if performance targets are met is at our discretion.
<PAGE>

In addition, we are obligated to file, on or about October 2, 2000, a
registration statement with respect to the resale of all of the shares of our
common stock issued to the former security holders of Velogic in connection with
the merger, or issuable upon exercise of the assumed options.

In connection with the Merger, Alberto Savoia, a founder and Chief
Technology Officer of Velogic, and Roongko Doong, a co-founder and the Chief
Scientist of Velogic, entered into employment agreements and non-competition
agreements with us.

We derive and expect to continue to derive all of our subscription revenues
from the sale of our Internet performance measurement, consulting, diagnostic
and load testing services. All of our services are subscription-based services
that our customers purchase for at least an initial three-month term and then
may renew their subscription on a month-to-month basis. Subscription fees vary
based on the number of URLs measured, the number of measurement locations, the
frequency of the measurements, and the additional features ordered. Although
consulting revenues have not been significant to date, we believe that
consulting revenues may become more important in the future as we pursue
additional consulting opportunities. Our international revenues to date have not
been significant. In addition, consulting revenues includes all revenues
derived from our newly-acquired load-testing services.

We recognize revenues ratably as services are performed. We typically
invoice our customers monthly in advance for our services. Any unearned revenue
is recorded as deferred revenue on our balance sheet. As of June 30, 2000, we
had recorded $5.7 million of deferred revenue. Revenues from our consulting
services are recognized as the services are performed; a typical project lasts
one month. For longer consulting projects, we anticipate recognizing revenue on
a percentage-of-completion basis.

Although we experienced net income for the three months ended June 30,
2000, we have otherwise experienced substantial net losses since inception. As
of June 30, 2000, we had an accumulated deficit of $13.4 million. Although our
revenues have grown significantly in recent periods, we may be unable to
sustain this growth. Therefore, you should not consider our historical growth
indicative of future revenue levels or operating results. We also cannot
assure you that we will achieve profitability for the entire current fiscal
year, or that we will achieve profitability in any future quarter.

For the three months ended June 30, 2000, 10 customers accounted for
approximately 38% of our total revenues. We cannot be certain that customers
that have accounted for significant revenues in past periods, individually or
as a group, will renew our services and continue to generate revenue in any
future period. In addition, our customer agreements can generally be
terminated at any time with little or no penalty. If we lose a major customer,
our revenues could decline.

Results of Operations

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------- ------ --------
For the three months ended June 30: (In thousands)
Subscription Services........................................ $ 9,283 $1,862 399%
Consulting Services.......................................... $ 432 $ 57 658%
For the nine months ended June 30:
Subscription Services........................................ $20,733 $4,026 415%
Consulting Services................................. $ 956 $ 83 1052%
</TABLE>

Subscription Services. Revenues from subscription services increased $7.4
million, or 399%, for the three months ended June 30, 2000, as compared to the
same period in 1999. Revenues from subscription services also increased $16.7
million, or 415%, during the nine months ended June 30, 2000, as compared to
1999. Subscription services represented approximately 96% of total revenues for
each of the three months and nine months ended June 30, 2000, and approximately
97% of total revenues for the three months ended June 30, 1999, and 98% of total
revenues for the nine months ender June 30, 1999. The increase in revenue was
attributable to the increase in both the number of new customers and the
increase in revenue from existing customers. For the three months ended June 30,
2000, one customer accounted for approximately 10% of total revenues. For the
three months ended June 30, 1999, no customers accounted for more than 10% of
total revenues.

Consulting Services. Revenues from consulting services increased $375,000,
or 658%, for the three months ended June 30, 2000, as compared to the same
period in 1999. Revenues from consulting services also increased $873,000, or
1052%, during the nine months ended June 30, 2000, as compared to 1999. Our
professional services group was formed in January 1999. Therefore, the
increased growth rate in percentage terms is due to the relatively small base of
consulting services revenues in 1999. We do not expect to experience similar
percentage growth rates in the future.
<PAGE>

Cost of Consulting and Subscription Services

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------ ----- --------
For the three months ended June 30: (In thousands)
Cost of subscription services............................... $2,622 $ 522 402%
Cost of consulting services........................... $ 533 $ 167 219%
For the nine months ended June 30:
Cost of subscription services......................... $6,870 $ 975 605%
Cost of consulting services........................... $1,086 $ 254 328%
</TABLE>

Cost of Subscription Services. Cost of subscription services consists of
connection fees to Internet service providers for bandwidth usage of our
measurement computers around the world and depreciation, maintenance and other
equipment charges for our measurement infrastructure. Cost of subscription
services increased $2.1 million, or 402% for the three months ended June 30,
2000, as compared to 1999. Cost of subscription services increased $5.9
million, or 605% for the nine months ended June 30, 2000, as compared to 1999.
This increase was primarily due to the greater number of measurement computers
deployed and additional bandwidth consumption, resulting in higher connection
fees and more depreciation and equipment charges. In addition, during the nine
months ended June 30, 2000, we continued to increase measurement capacity and
bandwidth at our existing locations, and expand our measurement infrastructure.
Cost of subscription services was 28% of subscription service revenue for the
three months ended June 30, 2000, as compared to 28%, for the three months ended
June 30, 1999. Cost of subscription services was 33% of subscription service
revenue for the nine months ended June 30, 2000, as compared to 24% for the nine
months ended June 30, 1999. In the next couple of quarters we expect cost of
subscriptions to be a greater % of revenue than in the past as we rapidly
increase our bandwidth capacity in anticipation of demand.

Cost of Consulting Services. Cost of consulting services consists of
compensation expenses for consulting personnel and related costs. Cost of
consulting services exceeded consulting services revenue for the three and the
nine months ended June 30, 1999, and the three and nine months ended June 30,
2000 because our professional services group was formed in January 1999. In
addition, we incurred one month of expenses from our recent acquisition of
Velogic. In the future, cost of consulting services will also include network
infrastructure costs associated with our new load testing service. We expect
that the cost of consulting services as a percentage of consulting services
revenues will be greater than the cost of subscription services as a percentage
of subscription services revenues.

Research and Development

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------ ------ --------
For the three months ended June 30: (In thousands)
Research and development.................................... $1,463 $ 634 131%
For the nine months ended June 30:
Research and development.................................... $3,405 $1,297 163%
</TABLE>

Research and development expenses consist primarily of compensation and
related costs for research and development personnel. Research and development
expenses increased from 1999 to 2000 due to the increase in software engineers,
project management and quality assurance personnel. To date, all research and
development expenses have been expensed as incurred. We believe that continued
significant increases in our research and development investment is essential
for us to maintain our market position and to continue to enhance and expand
our services. Accordingly, we anticipate research and development expenses are
likely to increase in the foreseeable future.

Sales and Marketing

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------- ------ --------
For the three months ended June 30: (In thousands)
Sales and marketing.................................... $ 4,808 $1,426 237%
For the nine months ended June 30:
Sales and marketing.................................... $11,617 $2,989 289%
</TABLE>

Sales and marketing expenses consist primarily of salaries, commissions and
bonuses earned by sales and marketing personnel, lead-referral fees, marketing
programs and travel expenses. Our sales and marketing expenses increased from
1999 to 2000 due to our investment in additional personnel in our sales and
marketing organization and marketing programs including our Second Annual
Internet Performance Conference. It also includes salaries and referral fees to
recruit and hire sales
<PAGE>

management, sales representatives and sales engineers. We believe that
continued significant increases in our sales and marketing efforts is essential
for us to maintain our market position and to further increase acceptance of
our services. Accordingly, we anticipate sales and marketing expenses will
continue to increase in the foreseeable future.

Operations

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------ ------ --------
For the three months ended June 30: (In thousands)
Operations.................................................. $1,418 $ 475 199%
For the nine months ended June 30:
Operations.................................................. $3,256 $1,024 218%
</TABLE>

Operations expenses consist primarily of compensation and related costs for
management personnel and technical support employees, who manage and maintain
our measurement and headquarters infrastructure and support our customers. Our
operations personnel also work closely with other departments to assure the
reliability of our services and to support our sales and marketing activities.
The increase in operations expenses from 1999 to 2000 was primarily related to
the hiring of personnel to manage and support our growing customer base. We
believe that continued investment is necessary to support our ability to
successfully develop, deploy and operate our growing Internet measurement
infrastructure, as well as to successfully support our customer base.
Accordingly, we anticipate that operations costs will continue to increase in
the foreseeable future.

General and Administrative

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------ ----- --------
For the three months ended June 30: (In thousands)
General and administrative........................... $1,346 $ 406 232%
For the nine months ended June 30:
General and administrative........................... $3,503 $ 849 313%
</TABLE>

General and administrative expenses consist primarily of salaries and
related expenses, accounting, legal and administrative expenses, insurance,
professional service fees and other general corporate expenses. The increase in
our general and administrative expenses from 1999 to 2000 was primarily related
to hiring additional employees to support the growth of our business, as well as
increases in costs associated with becoming a public company. We believe that
our general and administrative expenses will continue to increase as a result of
the continued expansion of our administrative staff and expenses associated with
being a public company such as annual and other public reporting costs,
directors' and officers' liability insurance and investor relations programs.

Amortization of Goodwill and other Intangible assets.

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
------ ----- --------
For the three months ended June 30: (In thousands)
Amortization of goodwill and other intangible assets $1,125 0 0%
For the nine months ended June 30:
Amortization of goodwill and other intangible assets $1,125 0 0%
</TABLE>

In connection with the purchase of Velogic, we recorded approximately
$40.5 million in goodwill and other intangible assets, which is included in
goodwill and other intangible and other assets on our balance sheet. In the
quarter ended June 30, 2000, we recorded approximately $1.1 million in
amortization of goodwill and other intangible assets, from the acquisition
date of June 2, 2000, until June 30, 2000. We expect the amortization for a
full quarter will increase to approximately $3.3 million. Goodwill and other
intangible assets are being amortized over thirty-six months.

Amortization of Stock-Based Compensation.

<TABLE>
<S> <C> <C> <C>
2000 1999 % Change
----- ----- --------
For the three months ended June 30: (In thousands)
Amortization of stock-based compensation......... $ 85 $ 88 97%
For the nine months ended June 30:
Amortization of stock-based compensation......... $ 256 $ 234 109%
</TABLE>

The amortization expense on stock-based compensation was unchanged from
prior quarters. Some options granted prior to June 30, 1999 have been
considered to be compensatory, as the estimated fair value for accounting
purposes was greater than the stock price as determined by the board of
directors on the date of grant. As a result, we have recorded amortization of
deferred compensation expense and had an aggregate of approximately $879,000 of
deferred compensation remaining to be amortized as of June 30, 2000. Deferred
compensation is amortized on a straight-line basis over the vesting period of
the options.
<PAGE>

We expect amortization of approximately $341,000 in fiscal 2000,
$341,000 in fiscal 2001, $341,000 in fiscal 2002 and $112,000 in fiscal 2003.

Interest Income (Expense), Net

<TABLE>

<S> <C> <C> <C>
2000 1999 % Change
------ ------- --------
For the three months ended June 30: (In thousands)
Interest income, net $5,408 $ 3 180167%
For the nine months ended June 30:
Interest income (expense), net $8,675 ($ 146) 6042%
</TABLE>

Net interest income (expense) increased from 1999 to 2000 primarily due to
higher interest income from our increase in cash and cash equivalents resulting
from the proceeds we received from our initial and follow-on public offerings in
September 1999 and February 2000 respectively.

Provision for Income Taxes

No provision for federal and state income taxes has been recorded because
we have experienced net losses since inception that has resulted in deferred tax
assets. Although we achieved profitability in this quarter, no provision was
required because we do not expect to be profitable for the entire fiscal year.
In light of our recent history of operating losses, we have provided a valuation
allowance for all of our net deferred tax assets, as we are presently unable to
conclude that it is more likely than not that the deferred tax asset will be
realized.

As of September 30, 1999, we had net operating loss carryforwards for
federal income tax reporting purposes of approximately $10.6 million available
to reduce future income subject to income taxes. As of September 30, 1999, we
had net operating loss carryforwards for state income tax purposes of
approximately $6.2 million available to reduce future income subject to income
taxes. The federal net operating loss carryforwards expire in various periods
through 2019. State net operating loss carryforwards expire in various periods
through 2004. In addition, as of September 30, 1999, we had federal research and
development tax credit carryforwards of approximately $154,000. The federal
credit carryforwards expire in various periods through 2019. As of September 30,
1999, we had California research and development tax credit carryforwards of
approximately $140,000. The California credit may be carried over indefinitely.
The U.S. Tax Reform Act of 1986 contains provisions that limit the net operating
loss carryforwards and research and development credits available to be used in
any given year upon the occurrence of certain events, including a significant
change in ownership.

Liquidity and Capital Resources

Since our inception, we have funded our operations primarily through public
sale and private placements of our common stock and convertible redeemable
preferred stock with strategic investors, venture capital firms and private
investors. Prior to our initial public offering, in September 1999, we had
raised approximately $25.8 million, net of offering costs, from the sale of
common stock and preferred stock. In our initial public offering, we raised
$56.7 million, net of issuance costs, including $7.8 million raised from the
exercise of the underwriter's over-allotment option, which occurred in October
1999. In a public offering in February 2000, we raised $286.6 million, net of
issuance costs, including $86.5 million, net of issuance costs, raised from the
exercise of the underwriter's over-allotment option, which occurred at the end
of February 2000. In addition, we financed our operations through subordinated
and other debt, equipment loans and a capital lease. The principal balance
outstanding at June 30, 2000 for these loans and leases was approximately $2.5
million. At June 30, 2000, we had approximately $356 million in cash and cash
equivalents.

Net cash provided by operating activities was $4.2 million in the nine
months ended June 30, 2000. Net cash provided by operating activities was
primarily the result of an increase in deferred revenue and accounts payable and
accrued expenses and amortization of goodwill, resulting from the merger in June
2000. The increase was partially offset by an increase in accounts receivable
and our net operating loss. Net cash used for operating activities was $4.1
million in the nine months ended June 30, 1999. Net cash used for operating
activities was primarily due to our net operating loss.

Since inception, our investing activities have been purchases of property
and equipment. Capital expenditures totaled $4.8 million in the nine months
ended June 30, 2000, and $1.7 million in the nine months ended June 30, 1999.

Our financing activities provided $292.4 million in the nine months ended
June 30, 2000 and approximately $20.6 million in the nine months ended June 30,
1999. In the nine months ended June 30, 2000, we raised $7.8 million in
October 1999 from the exercise of the underwriters' over-allotment option from
our initial public offering and $286.6 million, net of issuance costs from a
public offering in February 2000. During the nine months ended June 30, 1999,
we raised $14.8 million from the issuance of preferred stock in April of 1999.
In addition, we received $3.6 million in proceeds from our equipment loans.
<PAGE>

As of June 30, 2000, our principal commitments consisted of $2.5 million in
loans and obligations under leases. We have granted a security interest in
substantially all of our assets to secure these loans. The interest rate on our
loans in the form of equipment notes ranged from 5.60% to 10.25% per year and
the interest rate on the loans in the form of a promissory note bore interest at
a rate of 8.25% per year. As of June 30, 2000, we also had commitments of
approximately $29.8 million in future lease payments for our headquarters
facility. We had no material commitments for capital expenditures as of June 30,
2000. Because we expect to continue to increase the number of our measurement
computers and increase their measurement capacity, we expect that we will make
additional capital expenditures to purchase this equipment. We anticipate that
we will also experience an increase in our capital expenditures and lease
commitments consistent with our anticipated growth in operations, infrastructure
and personnel.

We believe our existing cash and cash equivalents will be sufficient to
meet our anticipated cash needs for working capital and capital expenditures for
at least the next 12 months. After that time, if cash generated from operations
is insufficient to satisfy our liquidity requirements, we may seek to sell
additional equity or debt securities or to obtain a credit facility. If
additional funds are raised through the issuance of debt securities, these
securities could have rights, preferences and privileges senior to holders of
common stock, and the term of this debt could impose restrictions on our
operations. The sale of additional equity or convertible debt securities could
result in additional dilution to our shareholders, and we may not be able to
obtain additional financing on acceptable terms, if at all. If we are unable to
obtain this additional financing, our business may be harmed.

Year 2000 Compliance

To date, we have not experienced any year 2000-related problems with our
internally developed software or our third party supplied software and computer
systems, and we are not aware of any failure of our systems or of our third
party suppliers systems to be year 2000 compliant that could impact our business
operations.

Recent Accounting Pronouncements

In March 2000, the FASB's Emerging Issues Task Force (EITF) reached a
consensus on EITF No. 00-2, Accounting for the Costs of Developing a Web Site.
EITF No. 00-2 provides guidance on accounting for web site development costs and
is effective for fiscal quarters beginning after June 30, 2000. The Company is
currently reviewing the impact of EITF No. 00-2 on its financial statements and
results of operations. The Company does not believe that the impact of this
statement will have a material effect on the financial position or results of
operations upon the adoption of this interpretation.

In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, Accounting for Derivative Instruments
and Hedging Activities (SFAS 133), and in July 1999 issued Financial Accounting
Standard No. 137, Accounting For Derivative Instruments and Hedging Activities -
Deferral of the Effective Date of FASB Statement No. 133, an Amendment of FASB
Statement No. 133 (SFAS 137). SFAS 137 delayed the effective date for SFAS 133
for fiscal years beginning after June 15, 2000. The Company does not believe
that the impact of this statement will have a material effect on the financial
position or results of operations upon the adoption of this accounting standard.
<PAGE>

Factors That May Impact Future Operating Results

We are an early stage company with an unproven business model that makes it
difficult to evaluate our current business and future prospects.

We have only a limited operating history upon which to base an evaluation
of our current business and future prospects. We began offering our Internet
performance measurement services in May 1997. We introduced our Transaction
Perspective service in April 1999, our Lifeline service in July 1999, the most
recent version of our Perspective service in December 1999, our Consumer
Perspective service in December 1999, our Diagnostic Perspective in April 2000,
and our Streaming Perspective in June 2000. We formed our professional services
organization in January 1999 and acquired Velogic, Inc. in June 2000. The
revenue and income potential of our business and the related market are
unproven. In addition, because of our limited operating history and because the
market for Internet performance measurement and diagnostic services is
relatively new and rapidly evolving, we have limited insight into trends that
may emerge and affect our business. Before investing, you should evaluate the
risks, expenses and problems frequently encountered by companies such as ours
that are in the early stages of development and that are entering new and
rapidly changing markets such as Internet performance measurement.

We have incurred losses, we expect to incur future losses and we may never
achieve profitability.

We have experienced operating losses in each quarterly and annual period
since inception and we expect to incur significant losses in the future. We
incurred net losses of $754,000 for the nine months ended June 30, 2000, and as
of June 30, 2000, we had an accumulated deficit of $13.4 million. We believe
that our operating expenses will continue to increase as we grow our business.
As a result, although our recent initial and secondary public offering provided
us with cash for our working capital, we will need to significantly increase our
revenues to achieve and maintain profitability, as reflected in our financial
statements. We may not be able to sustain our recent revenue growth rates. In
fact, we may not have any revenue growth, and our revenues could decline.

The success of our business depends on customers renewing their subscriptions
for our services and purchasing additional services.

We depend on achieving high customer renewal rates for our revenues. Our
customers have no obligation to renew our services and therefore, they could
cease using our services at any time. We cannot assure you that we will continue
to experience high renewal rates. Our customer renewal rates may decline as a
result of a number of factors, including consolidations in the Internet industry
or if a significant number of our customers cease operations. Further, because
of the relatively small size of initial orders, we depend on sales to new
customers and sales of additional services to our existing customers.

In addition, initial sales of our services and subsequent customer follow-
up are conducted almost exclusively by telephone. A few customers have, in the
past, expressed a preference for more personal, face-to-face customer service.
Dissatisfaction by a customer with the nature or quality of our services could
lead that customer to elect not to renew its subscription to our services. If
our renewal-rate percentage declines, our revenues could decline unless we are
able to obtain additional customers or sources of revenues, sufficient to
replace lost revenues.

Our quarterly financial results are subject to significant fluctuations, and if
our future results are below the expectations of public-market analysts and
investors, the price of our common stock may decline.

Our results of operations could vary significantly from quarter to quarter.
We expect to incur significant sales and marketing expenses to promote our brand
and our services, as well as additional expenses to expand our presence
worldwide. If revenues fall below our expectations, we will not be able to
reduce our spending rapidly in response to the shortfall.

Other factors that could affect our quarterly operating results include
those described below and elsewhere in this report:

. the renewal rate of subscriptions to our Internet performance measurement
services;

. changes relating to goodwill and other intangibles;

. our ability to increase the number of web sites we measure for our
existing customers in a particular quarter;

. our ability to attract new customers in a particular quarter;

. the amount and timing of operating costs and capital expenditures
relating to expansion of our operations infrastructure, including our planned
international expansion; and

. the amount and timing of professional services revenues.
<PAGE>

Due to these and other factors, we believe that period-to-period
comparisons of our results of operations are not meaningful and should not be
relied upon as indicators of our future performance. It is possible that in some
future periods, our results of operations may be below the expectations of
public-market analysts and investors. If this occurs, the price of our common
stock may decline.

The success of our business depends on the widespread adoption of the Internet
by business and consumers for e-commerce and communications.

Because our business is based on providing performance measurement and
diagnostic services for web sites, the Internet must be widely adopted, in a
timely manner, as a means of electronic commerce, or e-commerce, and
communications. Because e-commerce and communications over the Internet are new
and evolving, it is difficult to predict the size of this market and its
sustainable growth rate. In addition, we believe that the use of the Internet
for conducting business transactions could be hindered for a number of reasons,
including, but not limited to:

. security concerns including the potential for fraud or theft of stored
data and information communicated over the Internet;

. inconsistent quality of service, including well-publicized outages of
popular web sites;

. lack of availability of cost-effective, high-speed service;

. limited numbers of local access points for corporate users;

. delay in the development of enabling technologies or adoption of new
standards;

. inability to integrate business applications with the Internet;

. the need to operate with multiple and frequently incompatible products;
and

. a lack of tools to simplify access to and use of the Internet.

Our operating results depend on sales of our Keynote Perspective service.

Because we have only recently begun to offer professional services and we
only recently introduced our Keynote Consumer Perspective, Keynote Lifeline,
Keynote Transaction Perspective, Keynote Diagnostic Perspective, and Keynote
Streaming Perspective services, the success of our business currently depends,
and for the immediate future will continue to substantially depend, on the sale
of our Keynote Perspective service. Therefore, we believe that initial sales and
renewals of our Keynote Perspective service will account for substantially all
of our revenues for the immediate future. A decline in the price of, or
fluctuation in the demand for, Keynote Perspective, or our inability to maintain
or increase sales, would cause our revenues to decline.

If one of our competitors' Internet performance measurement service is adopted
as the industry standard for measuring the speed and reliability of web sites,
we may lose existing customers or encounter difficulties in attracting new
customers.

To date, no Internet performance measurement service has been adopted as an
accepted industry standard for measuring the speed and reliability of web sites.
As a result, if one of our current or potential competitors develops an Internet
performance measurement service that is adopted as the industry standard, our
customers may turn to the services provided by these competitors. In addition,
it would be more difficult for us to attract the additional customers for our
Internet performance measurement services that are necessary for our business to
grow. If this were to occur, our business would be harmed.

Improvements to the infrastructure of the Internet could reduce or eliminate
demand for our Internet performance measurement services.

The demand for our Internet performance measurement services could be
reduced or eliminated if future improvements to the infrastructure of the
Internet lead companies to conclude that measuring and evaluating the
performance of their web sites is no longer important to their business. The
Internet is a complex, heterogeneous network of communications networks with
multiple operators and vendors supplying and managing the underlying
infrastructure as well as connections to this infrastructure. Because the
inherent complexity of the Internet currently causes significant e-commerce
quality of service problems for companies, the vendors and operators that supply
and manage the underlying infrastructure are continuously
<PAGE>

seeking to improve the speed, availability, reliability and consistency of the
Internet. If these vendors and operators succeed in significantly improving the
performance of the Internet, which would result in corresponding improvements in
the performance of companies' web sites, demand for our services would likely
decline.

It would be more difficult for us to deliver our services and therefore earn
revenues if we cannot expand and manage our computer infrastructure
successfully.

We will need to continue to deploy a large number of measurement computers
if we continue to experience an increase in our customer base or if we expand
our operations and measurement capabilities on a worldwide basis. These
computers are responsible for measuring the performance of web sites and
collecting performance data and it is critical to our ability to deliver our
services that they operate effectively. We currently measure the performance of
and receive revenue for approximately 13,000 web-site addresses for our
customers. Based on the number of measurement computers we currently have
deployed and the communications capacity available to these computers, we
believe we are able to measure the performance of an even greater number of web-
site addresses. We are in the process of deploying additional measurement
computers and upgrading the underlying infrastructure so that we will have the
ability by the end of fiscal 2000 to measure in excess of 50,000 web-site
addresses. With more measurement computers deployed and measurements conducted,
we will need to monitor and maintain a larger and more geographically dispersed
computer network, and manage an ever increasingly complex database, requiring us
to devote significant additional resources for these tasks. In addition, if we
experience increases in the number of our customers prior to deploying
additional measurement computers, our existing infrastructure may not have the
capacity to accommodate the additional customers. This could result in outages,
interruptions or slower response times, any of which could impair our ability to
retain and attract customers.

The inability of our services to perform properly could result in loss of or
delay in revenues, injury to our reputation or other harm to our business.

Services as complex as those we offer may not perform as we expect. We have
given credits to a limited number of customers as a result of past problems with
our service, though we do not believe that any customers failed to renew their
subscription to our services due to these problems. Despite our testing, our
existing or future services may not perform as expected due to unforeseen
problems, which could result in loss of or delay in revenues, loss of market
share, failure to achieve market acceptance, diversion of development resources,
injury to our reputation, increased insurance costs or increased service costs.

These problems could also result in tort or warranty claims. Although we
attempt to reduce the risk of losses resulting from any claims through warranty
disclaimers and liability-limitation clauses in our customer agreements, these
contractual provisions may not be enforceable in every instance. Furthermore,
although we maintain errors and omissions insurance, this insurance coverage may
not adequately cover us for claims. If a court refused to enforce the liability-
limiting provisions of our contracts for any reason, or if liabilities arose
that were not contractually limited or adequately covered by insurance, we could
be required to pay damages.

If we do not continually improve our services in response to technological
changes, including changes to the Internet, we may encounter difficulties
retaining existing customers and attracting new customers.

The ongoing evolution of the Internet requires us to continually improve
the functionality, features and reliability of our Internet performance
measurement and diagnostic services, particularly in response to competitive
offerings. If we do not succeed in developing and marketing new services that
respond to competitive and technological developments and changing customer
needs, we may encounter difficulties retaining existing customers and attracting
new customers. We must also introduce any new Internet services as quickly as
possible. The success of new services depends on several factors, including
properly defining the scope of the new services and timely completion,
introduction and market acceptance of our new services. If new Internet,
networking or telecommunication technologies or standards are widely adopted or
if other technological changes occur, we may need to expend significant
resources to adapt our services.

Our services and brand name might not attain the brand awareness necessary for
our business to succeed.

We believe that maintaining and strengthening the Keynote brand is an
important aspect of our business and an important element in attracting new
customers. Our efforts to build our brand will involve significant expense. To
promote our brand, we may increase our marketing budget or increase our
financial commitment to building our brand. If our brand-building strategy is
unsuccessful, we may fail to attract enough new customers or retain our existing
customers to the extent necessary to realize a sufficient return on our brand-
building efforts.

We face growing competition that could make it difficult for us to acquire and
retain customers.

The market for Internet performance measurement and diagnostic services is
new and rapidly evolving. We expect competition in this market to intensify in
the future. Our competitors vary in size and in the scope and breadth of the
products
<PAGE>

and services that they offer. Our principal competitors today include Freshwater
Software, Internet Resources Group, Inverse Network Technology, a unit of Visual
Networks and Service Metrics a unit of Exodus Communications. We also indirectly
compete with WebCriteria, MIDS Matrix IQ Service, and INS INSoft Division, and
free services such as the WebSite Garage unit of Netscape, NetMechanic and
Internet Weather Report. While the free services are not as comprehensive as
ours, as they only take measurements from one location, they do not measure the
speed of transactions and they only measure simple download time, customers
could still choose to use these less comprehensive services.

If we expand the scope of our products and services, we may encounter many
additional, market-specific competitors. These potential competitors include
companies that sell network management software such as CompuWare, HP-Openview
and IBM's Tivoli Unit, and companies that sell load-testing software such as
Mercury Interactive and Segue Software. Mercury Interactive has a service that
competes with our Transaction Perspective service. Some of our competitors have,
and our future competitors may have:

. longer operating histories;

. larger customer bases;

. greater brand recognition in similar businesses; and

. significantly greater financial, marketing, technical and other
resources.

In addition, some of our competitors may be able to:

. devote greater resources to marketing and promotional campaigns;

. adopt more aggressive pricing policies; and

. devote substantially more resources to technology and systems
development.

Increased competition may result in price reductions, increased costs of
providing our services and loss of market shares, any of which could seriously
harm our business. We may not be able to compete successfully against our
current and future competitors.

A limited number of customers account for a significant portion of our revenues,
and the loss of a major customer could harm our operating results.

For the three months ended June 30, 2000, 10 customers accounted for
approximately 38% of our total revenues, and this trend may continue in the
future. We cannot be certain that customers that have accounted for significant
revenues in past periods, individually or as a group, will renew our services
and continue to generate revenue in any future period. In addition, our
customer agreements can generally be terminated at any time with little or no
penalty. If we lose a major customer, our revenues could decline.

In order to grow our business, we need to establish and maintain relationships
with other companies to help market our Internet performance measurement and
diagnostic services.

In order to increase sales of our Internet performance measurement and
diagnostic services worldwide, we must complement our direct sales force with
relationships with companies to market and sell our services to their customers.
If we are unable to maintain our existing contractual marketing and distribution
relationships, or fail to enter into additional relationships, we will have to
devote substantially more resources to the direct sale and marketing of our
services. We would also lose anticipated revenues from customer referrals and
other co-marketing benefits. Our success depends in part on the ultimate success
of these relationships and the ability of these companies to market and sell our
services. Our existing relationships do not, and any future relationships may
not, afford us any exclusive marketing or distribution rights. Therefore, they
could reduce their commitment to us at any time in the future. Many of these
companies have multiple relationships and they may not regard us as significant
for their business. In addition, these companies may terminate their
relationships with us, pursue other relationships with our competitors or
develop or acquire products or services that compete with our services. Even if
we succeed in entering into these relationships, they may not result in
additional customers or revenues.

In addition, growth in the sales of our services depends on our ability to
obtain domestic and international resellers, distributors and integrators who
will market and sell our services on our behalf. In the future, we intend to
increase our indirect distribution channels through distribution arrangements.
We may not be successful in establishing relationships with these companies, and
any of these relationships, if established, may not increase our revenue.
<PAGE>

In order to grow our business, we must attract and retain qualified personnel
while competition for personnel in our industry is intense.

We may be unable to retain our key employees, namely our management team
and experienced engineers, or to attract, assimilate or retain other highly
qualified employees. We have from time to time in the past experienced, and we
expect in the future to continue to experience, difficulty in hiring and
retaining highly skilled employees with experience in the Internet industry, a
complex industry that requires a unique knowledge base. In addition, there is
significant competition for qualified employees in the Internet industry. Umang
Gupta, our chief executive officer, is our only key employee with whom we have
entered into an employment agreement. Our other key employees are not bound by
employment agreements that could prevent them from terminating their employment
at any time.

In addition, because we sell our Internet performance measurement and
diagnostic services primarily through our telesales force, we believe that we
will need to attract additional sales personnel to grow our revenues. Our
ability to deliver our services also depends on our ability to attract and
retain operations personnel. There is a shortage of qualified sales and
operations personnel and competition for personnel in our industry is intense.
If we are unable to hire, train, motivate or retain qualified employees,
including sales and operations personnel, our business could be harmed.

If the market does not accept our professional services, our results of
operations could be harmed.

We formed our professional services organization in January 1999. As a
result, we have little experience in delivering consulting services and we may
not be able to successfully introduce additional consulting services. We will
also need to successfully market these services to potential customers. There
are many experienced firms which offer computer network and Internet-related
consulting services. These consulting services providers include the consulting
groups of "Big Five" accounting firms, such as Andersen Consulting and Ernst &
Young, as well as consulting divisions of large technology companies such as
IBM. Because we do not have an established reputation for delivering consulting
services, because this area is very competitive, and due to our general
inexperience in delivering consulting services, we may not succeed in selling
these services.

The growth of our business depends on the continued performance of and future
improvements to the Internet.

The growth in Internet traffic has caused frequent periods of decreased
performance, requiring Internet service providers and web sites on the Internet
to upgrade their infrastructures. Our ability to increase the speed with which
we provide services to our customers and to increase the scope of these services
is limited by and depends upon the speed and reliability of the Internet.
Consequently, the emergence and growth of the market for our services and,
consequently our revenues, depends on the performance of and future improvements
to the Internet.

Because we have expanded our operations, our success will depend on our ability
to manage our growth, improve our existing systems and implement new systems,
procedures and controls.

We are expanding, and we intend to continue to expand, our operations by
deploying additional measurement computers, both domestically and
internationally, hiring new personnel and implementing and integrating new
accounting and control systems to manage this expansion. We may encounter
difficulties in managing this growth. Our ability to compete effectively and to
manage any future expansion of our operations will require us to continue to
improve our financial and management controls, reporting systems and procedures
on a timely basis. We may not succeed in these efforts and a disruption could
impair our ability to retain existing customers or attract new customers.

Our network infrastructure could be disrupted by a number of different
occurrences, which could impair our ability to retain existing customers or
attract new customers.

All data collected from our measurement computers are stored in and
distributed from our operations center. Therefore, our operations depend upon
our ability to maintain and protect our computer systems, most of which are
located at our corporate headquarters in San Mateo, California, which is an area
susceptible to earthquakes. If we experience outages at our operations center,
we would not be able to receive data from our measurement computers and we would
not be able to deliver our services to our customers. We currently do not have a
redundant system for computer-network and other services at an alternate site.
Therefore, our operations systems are vulnerable to damage from break-ins,
computer viruses, unauthorized access, vandalism, fire, floods, earthquakes,
power loss, telecommunications failures and similar events. Although we maintain
insurance against fires, floods, earthquakes and general business interruptions,
the amount of coverage may not be adequate in any particular case. If our
operations center is damaged, causing a disruption in our services, this could
impair our ability to retain existing customers or attract new customers.

If our computer infrastructure is not functioning properly, we may not be
able to deliver our services in a timely or accurate manner. We have
occasionally experienced outages of our service in the past, the last of which
occurred approximately six months ago. The outages that we have experienced have
lasted no more than a few hours, with the longest outage that occurred in the
fall of 1998 having lasted approximately 12 hours. These outages have been
caused by a variety of factors
<PAGE>

including operator error, the failure of a back-up computer to operate when the
primary computer ceased functioning and power outages due to our previous
facility's being inadequately equipped to house our operations center. Although
we do not believe we have lost any customers due to these prior outages, any
outage for any period of time could cause us to lose customers.

Hackers or individuals that attempt to breach our network security, could,
if successful, misappropriate proprietary information or cause interruptions in
our services. Although we have not yet experienced any breaches of our network
security or sabotage, we might be required to expend significant capital and
resources to protect against, or to alleviate, problems caused by hackers. We
may not have a timely remedy against a hacker who is able to breach our network
security. In addition to purposeful security breaches, the inadvertent
transmission of computer viruses could expose us to litigation or to a material
risk of loss.

Our measurement computers are located at sites, which we do not own or operate
and it could be difficult for us to maintain or repair them if they do not
function properly.

Our measurement computers are located at facilities that are not owned by our
customers or us. Instead, these computers are installed at locations near
various Internet access points worldwide. Because we do not own or operate
these facilities, we have little control over how these computers are maintained
on a day-to-day basis. We do not have long-term contractual relationships with
the companies that operate the facilities where are measurement computers are
located. We may have to find new locations for these computers if we are unable
to develop relationships with these companies or if these companies cease their
operations. In addition, if our measurement computers were not functioning
properly, we may not be able to repair or service these computers on a timely
basis as we may not have immediate access to our measurement computers. Our
ability to collect data in a timely manner could be impaired if we are unable to
maintain and repair our computers should performance problems arise.

Others might bring infringement claims against us or our suppliers that could
harm our business.

In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We expect that we
could become subject to intellectual property infringement claims as the number
of our competitors grows and our services overlap with competitive offerings.
These claims, even if not meritorious, could be expensive and divert
management's attention from operating our company. If we become liable to others
for infringing their intellectual property rights, we would be required to pay a
substantial damage award and to develop noninfringing technology, obtain a
license or cease selling the services that contain the infringing intellectual
property. We may be unable to develop noninfringing technology or to obtain a
license on commercially reasonable terms, if at all.

As we expand our international activities, our business will be susceptible to
additional risks associated with international operations.

We believe we must expand the sales of our services outside the United
States and hire additional international personnel. Therefore, we expect to
commit significant resources to expand our international sales and marketing
activities, which were less than approximately 3% of our total revenues for the
three months ended June 30, 2000 and for our prior periods. In addition, we
intend to deploy additional measurement computers worldwide, which would require
us to maintain and service computers over larger distances. Conducting
international operations would subject us to risks we do not face in the United
States. These include:

. currency exchange rate fluctuations;

. seasonal fluctuations in purchasing patterns;

. unexpected changes in regulatory requirements;

. maintaining and servicing computer hardware in distant locations;

. longer accounts receivable payment cycles and difficulties in collecting
accounts receivable;

. difficulties in managing and staffing international operations;

. potentially adverse tax consequences, including restrictions on the
repatriation of earnings;

. the burdens complying with a wide variety of foreign laws; and

. reduced protection for intellectual property rights in some countries.
<PAGE>

The Internet may not be used as widely in other countries and the adoption
of e-commerce may evolve slowly or may not evolve at all. As a result, we may
not be successful in selling our services to customers in markets outside the
United States.

Future sales of our common stock may cause our stock price to decline.

Sales of a large number of shares of our common stock in the market in the
future, or the belief that these sales could occur, could cause a drop in the
market price of our common stock. At June 30, 2000, we had outstanding
27,634,836 shares of common stock. All of these shares including the 4,600,000
shares sold in our initial public offering as well as the 6,612,500 shares sold
in our secondary offering are freely tradable without restriction or further
registration under the Securities Act, unless the shares are sold by or
purchased by our "affiliates". As of June 30, 2000 there were outstanding
options to purchase 3,002,573 shares of our common stock. Sales of a
substantial number of these shares could cause our stock price to fall.

We may face difficulties assimilating our recent acquisition of Velogic and may
incur costs associated with any future acquisitions.

As a part of our business strategy, we may seek to acquire or invest in
businesses, products or technologies that we feel could complement or expand our
business, augment our market coverage, enhance our technical capabilities or
that may otherwise offer growth opportunities. In June 2000, we acquired
Velogic, Inc., a provider of load testing services for eBusinesses.
Acquisitions could create risks for us, including:

. difficulties in assimilation of acquired personnel, operations and
technologies;

. unanticipated costs associated with the acquisition;

. diversion of management's attention from other business concerns;

. adverse effects on existing business relationships with resellers of our
service and our customers; and

. use of substantial portions of our available cash to consummate the
acquisition.

Item 3. Qualitative and Quantitative Disclosures about Market Risks.

Interest Rate Sensitivity. Our interest income and expense could be
sensitive to changes in the general level of U.S. interest rates, particularly
because most of our cash equivalents are invested in short-term debt
instruments. If market interest rates were to change immediately and uniformly
by ten percent from levels at June 30, 2000, the interest earned on those cash
equivalents could increase or decrease by approximately $2.2 million on an
annualized basis.

Foreign Currency Fluctuations. We have not had any significant
transactions in foreign currencies, nor do we have any significant balances that
are due or payable in foreign currencies at June 30, 2000.
<PAGE>

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

We are not a party to any material legal proceedings.

Item 2. Changes in Securities and Use of Proceeds

The effective date of our registration statement on Form S-1 filed
under Securities Act of 1933 (No. 333-82781) relating to our initial public
offering of our common stock was September 24, 1999. A total of 3,875,000 shares
of our common stock were sold by us and 125,000 shares of common stock were sold
on behalf of a selling stockholder, each at a price of $14.00 per share to an
underwriting syndicate led by FleetBoston Robertson Stephens Inc., Chase
Securities, Inc., and Dain Rauscher Incorporated. The offering commenced on
September 24, 2000 and closed on September 29, 2000. On October 15, 1999, we
sold an additional 600,000 shares of common stock at a price of $14.00 per share
to this underwriting syndicate upon their exercise of the over-allotment option.

As a result of the initial public offering, we received proceeds of
$56.7 million, net of issuance costs, including proceeds of $7.8 million, net of
issuance costs, from the exercise of the underwriters' over-allotment option. A
portion of the proceeds was applied toward continuing operations. The remaining
proceeds are being used as working capital or are included in cash and cash
equivalents. We did not receive any proceeds from the sale of shares by the
selling stockholder.

The effective date of our registration statement on Form S-1 filed
under Securities Act of 1933 (No. 333-94651) relating to our secondary public
offering of our common stock was February 17, 2000. A total of 2,000,000 shares
of our common stock were sold by us and 3,750,000 shares of common stock were
sold on behalf of selling stockholders, each at a price of $105.00 per share to
an underwriting syndicate led by FleetBoston Robertson Stephens Inc., Chase
Securities, Inc., Dain Rauscher Incorporated, and Soundview Technology Group,
Inc. The offering commenced on February 18, 2000 and closed on February 24,
2000. On February 29, 2000, we sold an additional 862,500 shares of common stock
under this registration statement at a price of $105.00 per share to the same
underwriting syndicate as a result of their exercise of the underwriter's over-
allotment option.

The secondary public offering resulted in gross proceeds of $286.6
million, net of issuance costs. A portion of the proceeds was applied toward
continuing operations. The remaining proceeds are being used as working capital
or are included in cash and cash equivalents. We did not receive any proceeds
from the sale of shares by the selling stockholders.

On June 2, 2000, the Company acquired all of the issued and outstanding
common stock of Velogic, Inc. pursuant to a merger of a newly formed wholly
owned subsidiary of the Company with and into Velogic, in exchange for 830,684
shares of the company's common stock. In addition, the Company assumed options
to purchase common stock of Velogic, which options are exercisable for an
aggregate of 29,280 shares of the Company's common stock. The issuance of shares
of the Company's common stock and the assumption of options were made in
reliance on Section 4(2) and/or Regulation D promulgated under the Securities
Act.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Exhibits and Reports on Form 8-K.

(a) Index to Exhibits
<PAGE>

Exhibit No. 2.01 - Agreement and Plan of Reorganization, dated as of
May 9, 2000, by and between us and Velogic, Inc. (incorporated herein
by reference to Exhibit 2.01 and our Current Report on Form 8-K filed
with the Securities Exchange Commission on June 16, 2000).

Exhibit No. 10.01 - Synthetic Lease

Exhibit No. 27.01 - Financial Data Schedule (Available in EDGAR format
only)

(b) Reports on Form 8-K

We filed a current report on Form 8-K on June 16, 2000, in connection
with the completion of our acquisition of Velogic, Inc. The only
exhibit filed with the report was the Agreement and Plan of
Reorganization, dates as of May 9, 2000, by and between us and Velogic,
Inc. We intend to file by amendment the required Pro Forma Financial
Statements reflecting the acquisition of all of the issued and
outstanding capital stock, including stock options and warrants of
Velogic, no later than August 16, 2000.
<PAGE>

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of San Mateo, State of
California, on this 14th day of August 2000.

KEYNOTE SYSTEMS, INC.

By: /s/ Umang Gupta
-----------------------------------------
Umang Gupta
Chairman of the Board and Chief Executive
Officer (Principal Executive Officer)

By: /s/ John J. Flavio
-----------------------------------------
John J. Flavio
Chief Financial Officer (Principal
Financial Officer and Principal Accounting
Officer)