<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934.
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998.
Commission file number: 333-51097
COVAD COMMUNICATIONS GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0461529
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
2330 CENTRAL EXPRESSWAY 95050
SANTA CLARA, CALIFORNIA
(Address of principal executive (Zip Code)
offices)
(408) 844-7500
(Registrant's telephone number, including area code)
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
---- ----
As of October 31, 1998, 11,651,324 shares of the Registrants Common Stock,
$0.001 par value, were issued and outstanding.
- --------------------------------------------------------------------------------
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets as of
December 31, 1997 and September 30, 1998............................................ 3
Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 1997 and 1998......................................................... 4
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 1997 and 1998......................................................... 5
Notes to Consolidated Financial Statements........................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.... 11
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................................... 16
Item 2. Changes in Securities................................................................ 16
Item 3. Defaults Upon Senior Securities...................................................... 17
Item 4. Submission of Matters to a Vote of Securities Holders................................ 17
Item 5. Other Information.................................................................... 17
Item 6. Exhibits and Reports on Form 8-K..................................................... 17
SIGNATURES............................................................................................ 18
INDEX TO EXHIBITS..................................................................................... 19
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER
1997 30, 1998
(RESTATED/1/) (UNAUDITED)
------------- ------------
ASSETS
<S> <C> <C>
CURRENT ASSETS:
Cash and cash equivalents..................................................... $4,378 $97,076
Accounts receivable, net...................................................... 25 1,062
Unbilled revenue.............................................................. 4 450
Inventories................................................................... 43 868
Prepaid expenses.............................................................. 52 722
Other current assets.......................................................... 317 446
------- --------
TOTAL CURRENT ASSETS........................................................ 4,819 100,624
PROPERTY AND EQUIPMENT:
Networks and communication equipment.......................................... 2,185 30,321
Computer equipment............................................................ 600 3,660
Furniture and fixtures........................................................ 185 890
Leasehold improvements........................................................ 114 550
------- --------
3,084 35,421
Less accumulated depreciation and amortization................................ (70) (1,418)
------- --------
NET PROPERTY AND EQUIPMENT.................................................. 3,014 34,003
OTHER ASSETS:
Restricted cash............................................................... 210 233
Deposits...................................................................... 31 282
Deferred debt issuance costs (net)............................................ -- 8,304
Other long term assets........................................................ -- 1,176
------- --------
TOTAL OTHER ASSETS.......................................................... 241 9,995
------- --------
TOTAL ASSETS................................................................ $8,074 $144,622
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.............................................................. $ 651 $ 8,777
Unearned revenue.............................................................. 7 290
Accrued network costs......................................................... 58 1,238
Other accrued liabilities..................................................... 77 2,808
Current portion of capital lease obligations.................................. 229 254
------- --------
TOTAL CURRENT LIABILITIES................................................... 1,022 13,367
Long-term debt (net of discount)............................................... -- 137,292
Long-term capital lease obligations............................................ 554 380
------- --------
TOTAL LIABILITIES........................................................... 1,576 151,039
STOCKHOLDERS' EQUITY:
Convertible preferred stock (.001 par value):
Authorized shares--30,000,000
Issued and outstanding shares--17,750,001 and 18,246,162, respectively...... 18 18
Common stock (.001 par value):
Authorized shares--65,000,000
Issued and outstanding shares--11,361,204 and 11,634,149, respectively...... 11 12
Additional paid-in capital.................................................... 9,692 30,732
Deferred compensation......................................................... (611) (6,306)
Retained earnings (deficit)................................................... (2,612) (30,873)
------- --------
TOTAL STOCKHOLDERS' EQUITY..................................................... 6,498 (6,417)
------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY..................................... $8,074 $144,622
======= ========
- -----------------------------
/1/ See Note 4.
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, September 30,
(UNAUDITED) (UNAUDITED)
--------------------------- ---------------------------
1997 1998 1997 1998
------------ ------------ ------------ -----------
<S> <C> <C> <C> <C>
Revenues.............................................. $ -- $ 1,565 $ -- $ 2,560
Operating expenses:
Network and product costs............................ 10 1,355 10 2,316
Sales, marketing, general and administrative......... 783 10,681 1,040 17,231
Amortization of deferred compensation................ 134 1,837 134 2,695
Depreciation and amortization........................ -- 738 -- 1,348
--------- --------- --------- ---------
Total operating expenses............................. 927 14,611 1,184 23,590
--------- --------- --------- ---------
Income (loss) from operations......................... (927) (13,046) (1,184) (21,030)
Interest income (expense):
Interest income...................................... 80 1,526 80 3,673
Interest expense..................................... -- (5,037) -- (10,904)
--------- --------- --------- ---------
Net interest......................................... -- (3,511) -- (7,231)
--------- --------- --------- ---------
Net income (loss)..................................... $ (847) $ (16,557) $ (1,104) $ (28,261)
========= ========= ========= =========
Basic and diluted net income (loss) per common share.. $ (0.24) $ (2.75) $ (0.37) $ (5.26)
Weighted average shares used in computing
net loss per share................................... 3,503,454 6,011,610 3,009,329 5,374,924
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
(UNAUDITED)
-----------------------------
1997 1998
------------- -------------
<S> <C> <C>
NET CASH USED IN OPERATING ACTIVITIES $ (305) $ (4,196)
INVESTING ACTIVITIES:
Purchase of restricted investment...................................... -- (23)
Deposits............................................................... (47) (251)
Long term receivable................................................... -- (887)
Purchase of property and equipment..................................... (1,104) (32,303)
------- --------
Net cash used in investing activities.................................. (1,151) (33,464)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants.............. -- 129,328
Principal payments under capital lease obligations..................... -- (183)
Proceeds from common stock issuance, net of repurchase................. 100 302
Proceeds from preferred stock issuance................................. 8,707 1,200
Offering costs related to common stock offering........................ -- (289)
------- --------
Net cash provided by financing activities.............................. 8,807 130,358
------- --------
Net increase in cash and cash equivalents.............................. 7,351 92,698
Cash and cash equivalents at beginning of period....................... -- 4,378
------- --------
Cash and cash equivalents at end of year............................... $ 7,351 $ 97,076
======= ========
Supplemental disclosures of cash flow information:
Cash paid during the year for interest................................ $ -- $ 78
======= ========
Supplemental schedule of non-cash investing and financing activities:
Equipment purchased through capital leases............................ $ -- $ 34
========= ========
Warrants issued for equity commitment.................................. $ -- $ 2,928
========= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION
The consolidated financial statements of the Company include the accounts
of all of its wholly-owned subsidiaries. There were no intercompany accounts
and transactions which required elimination.
The financial statements at September 30, 1998 and for the three and nine
month periods ended September 30, 1998 and 1997 are unaudited, but include all
adjustments (consisting of normal recurring adjustments) that the Company
considers necessary for a fair presentation of financial position and operating
results. Operating results for the three and nine month periods ended September
30, 1998 and 1997 are not necessarily indicative of results that may be expected
for any future periods.
The consolidated financial statements contained herein should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's annual financial statements included on Form S-1 filed
with the Securities and Exchange Commission ("SEC") on September 21, 1998.
2. DEBT
On March 11, 1998, the Company completed a private placement (the "1998
Private Offering") through the issuance of 260,000 units (the "Units"), each
unit consisting of $1,000 in principal amount at maturity of 13 1/2% Senior
Discount Notes due 2008 (the "Notes") and one warrant, initially exercisable to
purchase 19.4376 shares of common stock, $0.001 par value, of the Company (the
"Unit Warrants"). Net proceeds from the 1998 Private Offering were
approximately $129.3 million, after transaction costs of approximately $5.8
million.
The principal amount of the Notes will accrete from the date of issuance at
the rate of 13 1/2% per annum through March 15, 2003, compounded semi-annually,
and thereafter bear interest at the rate of 13 1/2% per annum, payable semi-
annually, in arrears on March 15 and September 15 of each year, commencing on
September 15, 2003. The Notes are unsecured senior obligations of the Company
that will mature on March 15, 2008. The Notes will be redeemable at the option
of the Company at any time after March 15, 2003 plus accrued and unpaid interest
thereon, if any, to the redemption date.
The Notes were originally recorded at approximately $126.9 million, which
represents the $135.1 million in gross proceeds less the approximate $8.2
million value assigned to the Unit Warrants, which is included in additional
paid-in capital. The value assigned to the Unit Warrants, representing debt
discount, is being accreted over the life of the Notes. Additional debt
issuance costs were incurred through the issuance of warrants associated with
the commitment of equity by certain investors. The debt issuance costs are also
being amortized over the life of the Notes. For the nine month period ending
September 30, 1998, the accretion of the Notes, debt discount and amortization
of debt issuance costs was $10.8 million and is included in interest expense in
the accompanying consolidated financial statements.
6
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(UNAUDITED)
3. STOCKHOLDERS' EQUITY
Stock Splits:
The consolidated financial statements applicable to the prior periods
have been restated to reflect a two-for-one stock split and a three-for-two
stock split effective in May 1998 and August 1998, respectively, for common
stock ("Common Stock") and preferred stock ("Preferred Stock"). The company has
amended the authorized shares of Common Stock to 65,000,000 and Preferred Stock
to 30,000,000, of which 750,000 are designated Series A Preferred ("Series A"),
17,100,003 are designated Series B Preferred ("Series B"), 11,149,287 are
designated Series C Preferred ("Series C"), and 1,000,710 are undesignated.
Common Stock:
The number of shares of Common Stock authorized for issuance by the Company
is 65,000,000 shares with a par value of $.001 per share. Shares of Common
Stock outstanding at December 31, 1997 and September 30, 1998 were 11,361,204
and 11,634,149 shares, respectively, of which 7,033,107 and 5,375,583 shares,
respectively, remain subject to repurchase provisions which generally lapse over
a four year period from the date of issuance.
Convertible Preferred Stock:
Convertible preferred stock consists of the following:
<TABLE>
<CAPTION>
DECEMBER 31, SEPTEMBER 30,
1997 1998
(IN 000'S) (IN 000'S)
------------ -------------
<S> <C> <C>
Authorized shares--30,000,000
Series A preferred stock (.001 par value);
Authorized shares--750,000
Issued and outstanding shares--750,000 at December 31,
1997 and September 30, 1998........................... $ 1 $ 1
Series B preferred stock (.001 par value);
Authorized shares--17,100,003
Issued and outstanding shares--17,000,001 at December 31,
1997 and 17,100,003 at September 30, 1998............. $17 $17
Series C preferred stock (.001 par value);
Authorized shares--11,149,287
Issued and outstanding shares--None at December 31, 1997
and 396,159 at September 30, 1998..................... -- --
------------ -------------
$18 $18
============ =============
</TABLE>
Equity Commitment
On February 20, 1998, the Company entered into a Series C Preferred Stock
and Warrant Subscription Agreement (the "Subscription Agreement") with certain
of its investors (the "Series C Investors") pursuant to which the Series C
Investors have unconditionally agreed to purchase an aggregate of 5,764,143
shares of Series C Preferred Stock and warrants to purchase an aggregate of
4,729,500 shares of Series C Preferred Stock (the "Series C Warrants") for an
aggregate purchase price of $16.0 million at a date to be determined by the
Company but no later than March 11, 1999. The Company either has agreed to call
this commitment or to complete an alternate equity financing of at least $16.0
million by March 11, 1999. In consideration of this commitment, the
7
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(UNAUDITED)
Company has issued to the Series C Investors warrants to purchase an aggregate
of 1,694,148 shares of the Company's Common Stock at a purchase price of $0.0033
per share (the "Common Warrants"). If an alternative source of equity financing
is used as a replacement for this commitment, no Series C Warrants will be
issued.
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement between the Company, the Series C Investors,
and a director of the Company whereby the Series C Investors assigned to the
director of the Company their obligation to purchase 36,015 shares of Series C
Preferred Stock and 29,559 Series C Warrants for an aggregate purchase price of
$100,000. On the same date, the director purchased 36,015 shares of Series C
Preferred Stock. As a result of this amendment, the aggregate obligation of the
Series C Investors to purchase Series C Preferred Stock and Series C Warrants
was reduced from 5,764,143 shares to 5,728,128 shares, and from 4,729,500 shares
to 4,699,941 shares, respectively, for an aggregate purchase price of $15.9
million, reduced from $16.0 million.
The Stock Purchase
On March 11, 1998, an investor in the Company purchased 360,144 shares of
Series C Preferred Stock and Series C Warrants to purchase an aggregate of
295,500 shares of Series C Preferred Stock for an aggregate purchase price of
$1,000,000. The Company does not have any obligation to issue such Series C
Warrants to this investor until such time as the Equity Commitment is called.
In connection with its agreement to purchase such Series C Preferred Stock and
Series C Warrants, the Company issued to this investor Common Warrants to
purchase an aggregate of 105,852 shares of Common Stock at a purchase price of
$0.0033 per share.
Preferred Stock Attributes
The holders of Series A, Series B and Series C are entitled to receive in
any fiscal year, dividends at the rate of $0.0167 per share, $0.04 per share and
$0.2233 per share, respectively, payable in preference and priority to any
payment of dividends on Common Stock. The rights to such dividends are
cumulative and accrue to the holders to the extent they are not declared or paid
and are payable only in the event of a liquidation, dissolution or winding up of
the Company, or other liquidity event (as defined in the Certificate of
Incorporation). The cumulative dividends at December 31, 1997 for Series A and
Series B were $6,250 and $312,000, respectively, none of which has been declared
or paid.
Subject to certain adjustments as set forth in the Certificate of
Incorporation, each share of Series A, Series B and Series C is convertible into
one share of Common Stock. Each share of Series A, Series B and Series C is
entitled to the number of votes equal to the number of shares of Common Stock in
which such shares of Series A, Series B and Series C, respectively, could be
converted.
In the event of any liquidation or dissolution or winding up of the
Company, either voluntary or involuntary, the holders of Series A, Series B and
Series C are entitled to receive, in addition to the cumulated and unpaid
dividends, $0.3333, $0.50 and $2.7767 per share, respectively (the "Initial
Preference"), until with respect to Series A and Series B only, a "Liquidation
Preference Threshold" is met based on a formula as set forth in the Certificate
of Incorporation. After payment of these preferences, any remaining amounts are
distributed to the holders of Series A, Series B, Series C and Common Stock on a
pro rata basis based on the number of shares of Common Stock held by each holder
on an as-converted basis. If the "Liquidation Preference Threshold" is met, the
Initial Preference is eliminated with respect to Series A and Series B only.
8
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(UNAUDITED)
4. STOCK OPTIONS
In 1997, the Company adopted the Covad Communications Group, Inc. 1997
Stock Plan (the "Plan"). The Plan provides for the grant of stock purchase
rights and options to purchase shares of Common Stock to employees and
consultants from time to time as determined by the Board of Directors. The
options expire from two to eight years after the date of grant. As of September
30, 1998 the Plan has reserved 13,970,250 shares of the Company's Common Stock
for sale and issuance under the Plan at prices to be determined by the Board of
Directors.
The following table summarizes stock option activity for the nine month
period ending September 30, 1998:
<TABLE>
<CAPTION>
NUMBER OF SHARE OPTION PRICE
OF COMMON STOCK PER SHARE
------------------ ---------------
<S> <C> <C>
Balance as of December 31, 1997................ 3,804,750 $0.033-$0.05
Granted........................................ 8,377,356 $0.10 -$7.93
Exercised...................................... (85,695) $0.033-$0.667
Forfeited...................................... (314,911) $0.05 -$7.38
---------- -------------
Balance as of September 30, 1998............... 11,781,500 $0.033-$7.93
========== =============
</TABLE>
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees," ("APB 25") and related
interpretations in accounting for its employee stock options and the disclosure
only provisions of SFAS No. 123, "Accounting and Disclosure of Stock-Based
Compensation," ("SFAS 123"). Under APB 25, compensation expense is recognized
based on the amount by which the fair value of the underlying common stock
exceeds the exercise price of stock options at the date of grant. As of
December 31, 1997 the Company recorded deferred compensation of $906,000 as a
result of granting stock options and issuing restricted stock with exercise or
issue prices per share below the revised fair value per share of the Company's
Common Stock at the date of grant or issuance. This amount was recorded as a
reduction of stockholders' equity and is being amortized as a charge to
operations over the vesting period of the applicable options. Such amortization
was $295,000 for the year ended December 31, 1997. During the nine months ended
September 30, 1998, the Company recorded additional deferred compensation of
approximately $8.4 million. Amortization of deferred compensation during this
same period was $2.7 million.
5. LEGAL PROCEEDINGS
On March 11, 1998, the Company initiated an arbitration proceeding against
Pacific Bell before the American Arbitration Association seeking damages and
equitable relief from Pacific Bell regarding its collocation practices that have
led to the denial of physical collocation space for the installation of the
Company's equipment in multiple central offices in California. The Company is
also seeking a remedy for Pacific Bell's late loop and transport deliveries. On
May 8, 1998, the Company filed a complaint in Federal Court against Pacific Bell
seeking damages and equitable relief from Pacific Bell regarding its collocation
practices, failures to timely and properly deliver transmission and local loop
facilities, position on local loop spectral interference issues, as well as
other practices. This lawsuit is pending in federal court. However, Pacific
Bell has, during the course of these proceedings, found physical collocation
space in numerous central offices where it had previously denied the Company
such space.
9
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(UNAUDITED)
The Company is also in litigation with U S WEST before the American
Arbitration Association in Seattle, Washington concerning U S WEST's collocation
implementation and other contract related matters. In addition, on August 28,
1998, U S WEST filed a lawsuit and sought a preliminary injunction against the
Company and one of its employees in Federal Court in connection with the
departure of such employee from U S WEST to the Company and the potential
improper disclosure of U S WEST's alleged trade secrets to the Company.
6. YEAR 2000 COMPLIANT
The Company is engaged in the development of information systems to manage
various aspects of the Company's operations. Management believes these
information systems are in compliance with year 2000 requirements, although
there can be no assurance in this regard.
7. FILING OF REGISTRATION STATEMENT
On September 21, 1998, the Company filed Form S-1 with the Securities
Exchange Commission in accordance with the Securities Act of 1933.
10
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Company's
Consolidated Financial Statements and the related Notes thereto included
elsewhere in this Form 10-Q. This discussion contains forward-looking
statements that involve risks and uncertainties. The Company's actual results
could differ materially from those anticipated in the forward-looking statements
as a result of certain factors including, but not limited to, those discussed
herein and in the Company's Registration Statement on Form S-1. The Company
disclaims any obligation to update information contained in any forward-looking
statement. See "-Forward Looking Statements"
OVERVIEW
Covad Communications Group, Inc. is a leading packet-based competitive
local exchange carrier ("CLEC") that provides dedicated high-speed digital
communication services using digital subscriber line ("DSL") technology to
enterprise customers and Internet service providers ("ISPs"). The Company
introduced its services in the San Francisco Bay Area in December 1997. The
Company launched its services in the Los Angeles, New York and Boston
metropolitan areas in August 1998 and expects to introduce its services in the
Seattle and Washington, D.C. metropolitan areas in the first quarter of 1999.
In March 1998, the Company raised approximately $135 million through the
issuance of its 13 1/2% Senior Discount Notes due 2008 (the "Senior Discount
Notes") to fund the deployment of its networks in these initial six regions. In
connection with the Company's expansion within existing regions and into new
regions, it expects to significantly increase its capital expenditures, as well
as its sales and marketing expenditures, to deploy its networks and support
additional subscribers in those regions. Accordingly, the Company expects to
incur substantial and increasing net losses for at least the next several years.
The Company derives revenue from (i) monthly recurring service charges for
connections from the end-user to the Company's facilities and for backhaul
services from the Company's facilities to the enterprise or ISP customer, (ii)
service activation, installation and other non-recurring charges and (iii) the
sale of customer premise equipment ("CPE") which the Company provides to its
customers due to the general unavailability of CPE through retail channels.
The Company's network and product costs include costs of recurring and
nonrecurring circuit fees charged to the Company by incumbent local exchange
companies ("ILECs") and other CLECs, including installation, activation, monthly
line costs, maintenance and repair of circuits between and among the Company's
digital subscriber line access multiplexers ("DSLAMs") and its regional data
centers ("RDCs"), customer backhaul, and subscriber lines. Other costs the
Company incurs include those for materials used by the Company in installation
and the servicing of customers and end-users, and the cost of CPE. As the
Company's end-user base grows, the largest element of network and product cost
is expected to be the ILECs' charges for the Company's leased copper lines.
The development and expansion of the Company's business will require
significant expenditures. The principal capital expenditures incurred during the
buildup phase of any region involve the procurement, design and construction of
the Company's central office ("CO") collocation cages, end-user DSL line cards,
and expenditures for other elements of the Company's network design, which
includes an RDC in each region. Following the buildout of its collocation
facilities, the major portion of the Company's capital expenditures is the
purchase of DSL line cards to support incremental subscribers. Network
expenditures will continue to increase with the number of end-users. However,
once an operating region is fully built out, a substantial majority of the
regional capital expenditures will be tied to incremental customer and end-user
growth. In addition to developing the Company's network, the Company will use
its capital for marketing its services, acquiring enterprise and ISP customers,
and funding its customer care and field service operations.
11
<PAGE>
RESULTS OF OPERATIONS
The Company's operations from inception in October 1996 to December 1997
were limited principally to the development of the technology and activities
related to the commencement of its business operations. As a result, the
Company's revenues and expenditures prior to such period are not indicative of
anticipated revenues which may be attained or expenditures which may be incurred
by the Company in future periods. In particular, the Company's expenditure
levels during the year ended December 31, 1997 do not reflect the issuance of
the Senior Discount Notes in March 1998 and the related interest and
amortization charges, which the Company expects will be approximately $16.0
million during the year ending December 31, 1998 and will increase annually
thereafter up to $36.9 million for the year ending December 31, 2004 and to
remain at that level through the maturity of the Senior Discount Notes in March
2008. The Company did not have any revenue until the fourth quarter of 1997.
As a result, any comparison of the three and nine month periods ended September
30, 1998 with the three and nine month periods ended September 30, 1997 is not
meaningful.
Revenues
For the three and nine month periods ended September 30, 1998, revenues
were $1.6 million and $2.6 million, respectively. For each successive month
during the nine month period ended September 30, 1998, revenues increased
primarily as a result of the Company expanding its network in the San Francisco
Bay Area and the Company increasing its sales and marketing efforts in that
region. The Company expects revenues to increase in future periods as the
Company expands its network within its existing regions, deploys networks in new
regions and increases its sales and marketing efforts in all of its target
regions.
Network and Product Costs
Network and product costs were not incurred until the third quarter of
1997. Total network and product costs increased from $10,000 for the three and
nine month periods ended September 30, 1997 to $1.4 million and $2.3 million for
the three and nine month periods ended September 30, 1998, respectively. This
increase is attributable to the expansion of the Company's network and increased
orders resulting from the Company's sales and marketing efforts. The Company
expects aggregate line costs to increase significantly in future periods due to
increased sales activity and expected revenue growth.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses consist primarily of
salaries, expenses for the development of the Company's business, the
development of corporate identification, promotional and advertising materials,
expenses for the establishment of its management team, and sales commissions.
These expenses increased from $783,000 and $1.0 million for the three and nine
month periods ended September 30, 1997, respectively, to $10.7 million and $17.2
million for the three and nine month periods ended September 30, 1998,
respectively. This increase is attributable to increased headcount in all areas
as the Company expanded its sales and marketing efforts, expanded the deployment
of its network and built operational infrastructure. Sales, marketing, general
and administrative expenses are expected to significantly increase as the
Company continues to expand its business.
Deferred Compensation
Through September 30, 1998, the Company had recorded a total of $9.3
million of deferred compensation, with an unamortized balance of $6.3 million on
its balance sheet as of September 30, 1998. This deferred compensation arose as
a result of the granting of stock options to employees with exercise prices per
share subsequently determined to be below the fair values per share for
accounting purposes of the Company's
12
<PAGE>
Common Stock at the dates of grant. The deferred compensation is being amortized
over the vesting period of the applicable options, and resulted in a charge to
operations of $134,000 for the three and nine month periods ended September 30,
1997 and $1.8 million and $2.7 million, respectively, for the three and nine
month periods ended September 30, 1998, respectively. The total charge to
operations during the year ending December 31, 1998 for amortization of the
deferred compensation associated with the options granted through September 30,
1998 is expected to approximate $4.1 million.
Depreciation and Amortization
Depreciation and amortization includes: (i) depreciation of network
infrastructure equipment, (ii) depreciation of information systems, furniture
and fixtures, (iii) amortization of improvements to COs, RDC and NOC facilities
and corporate facilities and (iv) amortization of capitalized software costs. As
revenue generating operations did not occur until the fourth quarter of 1997,
there was no depreciation charge for the three and nine month periods ending
September 30, 1997. Depreciation and amortization was approximately $738,000
and $1.3 million for the three and nine months ended September 30, 1998,
respectively. The Company expects depreciation and amortization to increase
significantly as the Company increases its capital expenditures to expand its
network.
Net Interest Income and Expense
Net interest income and expense consists primarily of interest income on
the Company's cash balance and interest expense associated with the Company's
debt. Interest income for the three and nine month periods ended September 30,
1997, was $80,000 which was primarily attributable to the interest income earned
from the proceeds raised in the Company's Preferred Stock financing in July
1997. Interest income for the three and nine month periods ended September 30,
1998, was approximately $1.5 million and $3.7 million, respectively, resulting
primarily from investing the proceeds from the Company's Senior Discount Notes.
Interest expense for the three and nine month periods ended September 30, 1998,
was approximately $5.0 million and $10.9 million, respectively, and consisted
primarily of interest on the Senior Discount Notes and capital lease
obligations. The Company expects interest expense to increase significantly as
a result of the issuance of the Senior Discount Notes. The Senior Discount
Notes accrete to $260 million by March 15, 2003, and as a result, the Company
expects that annual interest charges (which includes amortization of debt
discount and debt issuance costs) relating to the accretion of the Senior
Discount Notes will be approximately $16.0 million during the year ending
December 31, 1998, and will increase to approximately $36.9 million for the year
ending December 31, 2004 and will remain at that level through maturity of the
Senior Discount Notes in March 2008.
Income Taxes
Income taxes consist of federal, state and local taxes, when applicable.
The Company expects significant consolidated net losses for the foreseeable
future which should generate net operating loss ("NOL") carryforwards. However,
utilization of NOLs are subject to substantial annual limitations. In addition,
income taxes may be payable during this time due to operating income in certain
tax jurisdictions. Once the Company achieves operating profits and the NOLs
have been exhausted or have expired, the Company may experience significant tax
expense. The Company recognized no provisions for taxes as it operated at a
loss throughout 1997 and through the nine months ended September 30, 1998.
Certain Pro Forma Financial Information
Giving pro forma effect to the issuance of the Senior Discount Notes as if
it had been consummated on January 1, 1997 and the related interest and
amortization charges relating to the Senior Discount Notes accruing from such
date through September 30, 1998, the Company's interest expense would have been
approximately $20.3 million and $17.1 million, net loss would have been
approximately $22.9 million and $34.4 million, and net loss per Common Share
would have been $(7.00) and $(6.40) for the year ended December 31, 1997 and the
13
<PAGE>
nine month period ended September 30, 1998, respectively. For purposes of such
pro forma calculation, the Company has assumed (i) no correlating additional
interest income attributable to interest earned on the cash proceeds of the
issuance of the Senior Discount Notes and (ii) no application of the use of
proceeds from such issuance for the Company's corporate purposes. Therefore, the
interest and amortization charges relating to the Senior Discount Notes would
have had a significant adverse effect on the Company's net loss and net loss per
share had the issuance occurred on January 1, 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company's operations have required substantial capital investment for
the procurement, design and construction of the Company's CO collocation cages,
the purchase of telecommunications equipment and the design and development of
the Company's networks. Capital expenditures were approximately $32.3 million
for the first nine months of 1998. The Company expects that its capital
expenditures will be substantially higher in future periods in connection with
the purchase of infrastructure equipment necessary for the development and
expansion of its network and the development of new markets.
Since inception, the Company has financed its operations primarily through
private placements of $10.3 million of equity securities, $865,000 of lease
financings and $129.3 million in net proceeds raised from the issuance of the
Senior Discount Notes. In conjunction with the offering of the Senior Discount
Notes, certain investors of the Company have agreed to purchase shares and
warrants of Series C Preferred Stock for an aggregate price of $16.0 million at
a date to be determined by the Company but no later than March 11, 1999. The
Company has either agreed to call this commitment or to complete an alternate
equity financing of at least $16.0 million by March 11, 1999. As of September
30, 1998, the Company had an accumulated deficit of $30.9 million, and cash and
cash equivalents of $97.1 million.
Net cash used in the Company's operating activities was approximately
$305,000 and $4.2 million for the nine month period ended September 30, 1997 and
September 30, 1998, respectively. The net cash used for operating activities
during this period was primarily due to net losses and increases in current
assets, offset by noncash expenses, increases in accounts payable and accrued
liabilities. Net cash used by the Company for acquisitions of property and
equipment was $1.1 million for the nine month period ended September 30, 1997
and $32.3 million during the nine month period ended September 30, 1998. Net
cash provided by financing activities for the nine month period ended September
30, 1997 was $8.8 million which primarily related to the issuance of Series B
Preferred Stock. Net cash provided by financing activities for the nine month
period ended September 30, 1998 was $130.4 million which primarily related to
the issuance of the Senior Discount Notes (including amounts attributable to the
related warrants to purchase Common Stock) and Series C Preferred Stock.
The Company expects to experience substantial negative cash flow from
operating activities and negative free cash flow before financing activities for
at least the next several years due to continued development, commercial
deployment and expansion of its networks. The Company's future cash
requirements for developing, deploying and enhancing its networks and operating
its business, as well as the Company's revenues, will depend on a number of
factors including (i) the number of regions entered, the timing of entry and
services offered; (ii) network development schedules and associated costs due to
issues including the physical requirements of the CO collocation process; (iii)
the rate at which customers and subscribers purchase the Company's services and
the pricing of such services; (iv) the level of marketing required to acquire
and retain customers and to attain a competitive position in the marketplace;
and (v) the rate at which the Company invests in engineering and development and
intellectual property with respect to existing and future technology.
The Company will require additional financing to support the continued
development, commercial deployment, and expansion of its network. The Company
expects to raise additional capital prior to the end of 1999 through the
issuance of debt or equity securities.
14
<PAGE>
YEAR 2000 ISSUES
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code field and cannot distinguish
21st century dates from 20th century dates. These date code fields will need to
distinguish 21st century dates from 20th century dates and, as a result, many
companies' software and computer systems may need to be upgraded or replaced in
order to comply with such "Year 2000" requirements. The Company has reviewed
its internally developed information technology systems and programs and
believes that its systems are Year 2000 compliant and that there are no
significant Year 2000 issues within the Company's systems or services. The
Company has not reviewed its non-information technology systems for Year 2000
issues relating to embedded microprocessors. To the extent that such issues
exist, these systems may need to be replaced or upgraded to become Year 2000
compliant. The Company believes that its non-information technology systems
will not present any significant Year 2000 issues. In addition, the Company
utilizes third-party equipment and software that may not be Year 2000 compliant.
Failure of such third-party equipment or software to operate properly with
regard to the year 2000 and thereafter could require the Company to incur
unanticipated expenses to remedy any problems, which could have a material
adverse effect on the Company's business, prospects, operating results and
financial condition. Furthermore, the purchasing patterns of the Company's
enterprise and ISP customers may be affected by Year 2000 issues as companies
expend significant resources to correct their current systems for Year 2000
compliance. These expenditures may result in reduced funds available for the
Company's services, which could have a material adverse effect on the Company's
business, prospects, operating results and financial condition. The Company, to
date, has not made any assessment of the Year 2000 risks associated with its
third-party equipment or software or with its enterprise and ISP customers, has
not determined the risks associated with the reasonably likely worst-case
scenario and has not made any contingency plans to address such risks. However,
the Company intends to devise a Year 2000 contingency plan prior to December 31,
1999.
FORWARD LOOKING STATEMENTS
The statements contained in this Report that are not historical facts are
"forward-looking statements" (as such term is defined in Section 27A of the
Securities Act of 1933 and section 21E of the Securities Exchange Act of 1934),
which can be identified by the use of forward-looking terminology such as
"estimates," "projects," "anticipates," "expects," "intends," "believes," or the
negative thereof or other variations thereon or comparable terminology, or by
discussions of strategy that involve risks and uncertainties. These forward-
looking statements, such as the Company's plans to expand its existing network
or to commence service in new areas, estimates regarding the timing of launching
its service in new regions, statements regarding development of the Company's
business, future operating results, the Company's anticipated capital
expenditures, the effect of regulatory reform and regulatory litigation, the
Company's expectations as to its use of the capital resources and the
availability of additional financing, and other statements contained in this
Report regarding matters that are not historical facts, are only estimates or
predictions and cannot be relied upon. No assurance can be given that future
results will be achieved; actual events or results may differ materially as a
result of risks facing the company or actual results differing from the
assumptions underlying such statements. Such risks and assumptions include, but
are not limited to, the Company's ability to successfully market its services to
current and new customers, generate customer demand for its services in the
particular regions where it plans to market services, access additional debt
or equity financing in the future, achieve acceptable pricing for its services,
respond to increasing competition, manage growth of the Company's operations,
access regions and negotiate suitable interconnection agreements with the ILECs,
all in a timely manner, at reasonable costs and on satisfactory terms and
conditions, as well as regulatory, legislative, and judicial developments that
could cause actual results to vary materially from the future results indicated,
expressed or implied in such forward-looking statements. All written and oral
forward-looking statements made in connection with this Report which are
attributable to the company or persons acting on its behalf are expressly
qualified in their entirety by the "Risk Factors" and other cautionary
statements included in the Company's Registration Statement on Form S-1
(Commission File No. 333-63899). The company disclaims any obligation to
update information contained in any forward-looking statement.
15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is engaged in negotiations, arbitration and litigation
proceedings with several ILECs concerning their denial of physical collocation
space to the Company in certain central offices ("COs") and other matters. For
example, the Company has filed a suit against Pacific Bell in Federal Court on
these issues on antitrust and other grounds. Since commencement of the suit,
Pacific Bell has found space for the Company in numerous COs where Pacific Bell
had previously denied the Company space. In addition, the Company is asserting
a variety of breach of contract claims against Pacific Bell and U S WEST
Communications, Inc. on collocations issues in American Arbitration Association
proceedings in California and Washington. Failure to resolve these controversies
and obtain space in COs without undue delay or expense could have a material
adverse effect on the Company's business, prospects, operating results and
financial condition. In addition, on August 28, 1998, U S WEST Communications
sued the Company and one of its employees and sought a preliminary injunction in
federal court in connection with such employee's departure from U S WEST
Communications to join the Company and the potential improper disclosure of U S
WEST Communications' alleged trade secrets to the Company. The Company is not
currently engaged in any other legal proceedings that it believes could have a
material adverse effect on the Company's business, prospects, operating results
and financial condition. The Company is, however, subject to state commission,
FCC and court decisions as they relate to the interpretation and implementation
of the Telecommunications Act of 1996, the interpretation of CLEC
interconnection agreements in general and the Company's interconnection
agreements in particular. In some cases, the Company may be deemed to be bound
by the results of ongoing proceedings of these bodies or the legal outcomes of
other contested interconnection agreements that are similar to the Company's
agreements. The results of any of these proceedings could have a material
adverse effect on the Company's business, prospects, operating results and
financial condition.
ITEM 2. CHANGES IN SECURITIES
During the three month period ended September 30, 1998, the Company has
issued and sold unregistered securities as follows:
(1) A Warrant for the purchase of an aggregate of 135,000 shares of
Common Stock with an exercise price of $1.00 per share was issued in July
1998 to Heidrick & Struggles in connection with the payment of a fee for
executive search services.
(2) An aggregate of 40,000 shares of Common Stock was issued in a
private placement pursuant to a Restricted Stock Purchase Agreement in
August 1998 to Mr. Hawk, a member of the Company's Board of Directors. The
consideration received for such shares was $230,000.
(3) An aggregate of 40,000 shares of Common Stock was issued in a
private placement pursuant to a Restricted Stock Purchase Agreement in
September 1998 to Mr. Grant. The consideration received for such shares
was $230,000.
No underwriters were used in connection with these sales and issuances.
The sales and issuances of these securities were exempt from registration under
the Securities Act pursuant to Rule 701 promulgated thereunder on the basis that
these options were offered and sold either pursuant to a written compensatory
benefit plan or pursuant to written contracts relating to consideration, as
provided by Rule 701, or pursuant to Section 4(2) thereof on the basis that the
transactions did not involve a public offering.
16
<PAGE>
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On July 23, 1998, a majority of the holders of the Company's outstanding
Common Stock and Preferred Stock approved by written consent an amendment to the
Company's Bylaws which increased the number of authorized directors from a range
of four to seven directors to a range of five to nine directors, with the number
of directors set at eight.
On August 28, 1998, a majority of the holders of the Company's outstanding
Common Stock and Preferred Stock approved by written consent (A) an amendment to
the company's Certificate of Incorporation which (i.) effected a three-for-two
stock split of the Company's Common Stock and Preferred Stock, and (ii.)
increased the number of shares of authorized Common Stock to 65,000,000 and the
number of shares of authorized Preferred Stock to 30,000,000, and (B) an
amendment to the Company's 1997 Stock Plan which increased the number of shares
received for issuance hereunder to a total of 13,970,250 post-split shares.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a. Exhibits:
<TABLE>
<CAPTION>
Exhibit Number Description of Exhibit
- -------------- ----------------------
<C> <S>
3.1 Bylaws of the company as currently in effect (incorporated by reference to the
Company's Registration Statement on Form S-1 (File No. 333-63899)).
10.1 Employment Agreement dated August 3, 1998 between the Company and Robert E.
Knowling.
10.2 Note Secured by Deed of Trust dated August 14, 1998 between the Company and Robert
E. Knowling.
10.3 1997 Stock Plan, as amended.
27.1 Financial Data Schedule
</TABLE>
b. Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
September 30, 1998.
17
<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.
COVAD COMMUNICATIONS GROUP, INC.
Date: November 13, 1998 By: /s/ Timothy P. Laehy
-----------------------------------------
Timothy P. Laehy
Chief Financial Officer and Vice President,
Finance (Principal Financial and Accounting
Officer)
18
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
- ------------
<C> <S>
3.1 Bylaws of the Company, as currently in effect (incorporated by
reference to the Company's Registration Statement on Form S-1 (file No.
333-63899)).
10.1 Employment Agreement dated August 3, 1998 between the Company and
Robert E. Knowling.
10.2 Note Secured by Deed of Trust dated August 14, 1998 between the Company
and Robert E. Knowling.
10.3 1997 Stock Plan of the Company, as amended.
27.1 Financial Data Schedule
</TABLE>
19
<PAGE>
EXHIBIT 10.1
August 3, 1998
Mr. Bob Knowling
[Address]
Dear Bob:
The Board of Directors (the "Board") of Covad Communications Group, Inc.
("Covad" or the "Company") is pleased to extend to you this agreement to be
employed by Covad on the terms described below. You will join Covad as a full
time employee in the role of President and Chief Executive Officer, reporting to
the Board. While you are employed by the Company, you will also be a member of
the Board. You will be covered by the Company's Change in Control Policy (as
defined below). Your monthly salary will be thirty three thousand three hundred
thirty three dollars ($33,333).
You will also receive a signing bonus of one million five hundred thousand
dollars ($1,500,000), one half of which will be paid on commencement of your
employment and the remaining one half of which will be paid on your one year
anniversary or, if earlier, the date on which a Change in Control (as defined
below) occurs, if you are employed by the Company at that time. If your
employment terminates prior to such one-year anniversary or, if earlier, the
date of a Change in Control, the remaining one-half will be paid at the time of
such employment termination if such termination occurs by reason of your death
or your being Disabled, for Good Reason, or by the Company other than for Cause
(as those terms are defined below). If your employment with the Company
terminates for any other reason prior to such one-year anniversary or, if
earlier, the date of a Change in Control, you will forfeit the remaining one-
half of your signing bonus.
In addition you will be offered a stock option to purchase one million four
hundred thousand (1,400,000) shares of Covad Common Stock at the price of $1.50
per share. The option will be designated as an incentive stock option, as that
term is defined in Code section 422, to the extent that it can qualify as an
incentive stock option based on the following vesting schedule. To the extent
that the full 1.4 million shares cannot be made subject to an incentive stock
option, the remainder will be granted as a non-qualified stock option. The
option will become exercisable based on Covad's standard vesting schedule (six
forty eighth's of the shares vested on your six month anniversary with the
Company and one forty eighth per month for the next forty two months).
Notwithstanding the foregoing, (i) the option will become fully exercisable one
year from the date of a Change in Control, if you are employed by the Company on
that date; (ii) the
<PAGE>
Page 2
option will become fully exercisable at any time following the date of a Change
in Control if your employment terminates by reason of your death or your being
Disabled, for Good Reason, or by the Company other than for Cause; and (iii) if
your employment terminates prior to the occurrence of a Change in Control, by
reason of your death or your being Disabled, for Good Reason, or by the Company
other than for Cause, the exercisability of the option on your date of
termination shall be determined under the regular vesting schedule of the
option, but applied as though you had been employed through the six-month
anniversary following your actual date of termination. After the option becomes
exercisable, it will remain exercisable for the period continuing until the
eight-year anniversary of the date of grant, provided that you are employed by
the Company through that date. Notwithstanding the preceding sentence, the
option, or portion thereof, that is exercisable (or becomes exercisable) upon
your termination of employment shall remain exercisable for a period of one year
following your date of termination, if your termination occurs by reason of your
death or your being Disabled, and shall remain exercisable for a period of 90
days following your date of termination if your termination occurs for any other
reason, provided that in no event will the option be exercisable later than the
eight-year anniversary of the date of grant of the option.
Also, as we discussed, you will participate in an annual bonus program that will
pay a cash bonus based on your performance to the objectives the Board will set
for the Company. However, for 1998, you are guaranteed a minimum bonus of two
hundred fifty thousand dollars ($250,000). For subsequent years, the bonus will
vary from this amount depending on your actual performance to the objectives,
provided that your annual bonus opportunity will be not less than $250,000.
To assist in your relocation to California, the Company will loan you five
hundred thousand dollars ($500,000) in a full recourse note toward the purchase
of a home in the Bay area secured by your stock option. This loan will be
forgiven at the rate of 25% per year on your employment anniversary date with
the Company. It will become immediately due and payable should you voluntarily
leave the Company or are terminated for Cause. Covad will also pay the interest
on this loan while you are an employee. If a Change in Control occurs while you
are employed by the Company, or if your employment with the Company is
terminated by reason of death, your being Disabled, for Good Reason, or by the
Company other than for Cause, any unpaid principal and interest on the loan will
be forgiven.
In the event that your employment with the Company is terminated for Good
Reason, or by the Company other than for Cause, the Company will continue your
base salary plus targeted bonus for an additional two years from your
termination date, provided that you do not become employed by a company directly
competing with Covad.
<PAGE>
Page 3
You shall not be required to mitigate the amount of any payment provided for in
this letter by seeking other employment or otherwise. The Company shall be
entitled to set off against the amounts payable to you under this letter, any
amounts owed to the Company by you, but shall not be entitled to set off against
the amounts payable to you under this letter any amounts earned by you in other
employment after termination of your employment with the Company, or any amounts
which might have been earned by you in other employment had you sought such
other employment.
As with all employees, you will be responsible for paying all applicable taxes
related to your employment with Covad including income and other taxes on your
salary, bonus, signing bonus, real estate loan, debt forgiveness and interest
payments, capital gains taxes on Covad stock and stock options and any income or
excise taxes that apply to severance or change of control payments that may be
made to you. The Company will pay for the one-time consulting services of a
compensation attorney for you to use to review this agreement and its tax
implications.
At Covad, benefits are also an important part of your total compensation. These
programs are: comprehensive health coverage under either an HMO or PPO option,
dental coverage, also under either a PPO or HMO option, vision care, a tax-
advantaged 401(k) plan, a flexible spending plan account, disability insurance,
group life insurance and three weeks of paid vacation/sick leave per year. As a
Covad employee you will be eligible to participate in these benefit programs
starting on the first day of your employment. Additionally, Covad will continue
your current split life insurance policy or put in place an equivalent policy.
For purposes of this letter, the terms listed below shall be defined as
indicated:
(1) Your employment shall be considered to have been terminated for "Cause"
only if the termination is because of:
(a) the willful and continued failure by you to substantially perform your
duties with the Company (other than any such failure resulting from your
being Disabled), within a reasonable period of time after a written demand
for substantial performance is delivered to you by the Board, which demand
specifically identifies the manner in which the Board believes that you
have not substantially performed your duties;
(b) the willful engaging by you in conduct which is demonstrably and
materially injurious to the Company, monetarily or otherwise; or
<PAGE>
Page 4
(c) the engaging by you in egregious misconduct involving serious moral
turpitude to the extent that, in the reasonable judgment of the Board, your
credibility and reputation no longer conform to the standard of the
Company's executives.
For purposes of this letter, no act, or failure to act, on your part shall
be deemed "willful" unless done, or omitted to be done, by you not in good
faith and without reasonable belief that your action or omission was in the
best interest of the Company.
(2) "Change in Control" is defined as set forth in the Change in Control
Policy. The "Change in Control Policy" shall be the change in control
policy as in effect on the date you are initially employed by the Company,
a copy of which is attached to this letter.
(3) Your employment shall be considered to have been terminated for "Good
Reason" if you resign from the employ of the Company after any of the
following circumstances:
(a) The assignment to you of any duties inconsistent with your position
and status as President and Chief Executive Officer of the Company, or a
material adverse change in the nature or status of your responsibilities or
reporting relationship with the Board.
(b) You fail to be elected or reelected to the Board.
(c) A reduction by the Company in your annual base salary to an amount
that is less than required under this agreement.
(d) The relocation of your base office to an office that is more than 50
highway miles of your base office on the Effective Date.
(e) The failure of the Company to obtain a satisfactory agreement from any
successor to assume and agree to perform this agreement.
(f) Any material breach of this agreement by the Company not described in
paragraphs (a) through (e) next above.
<PAGE>
Page 5
Your right to terminate your employment for Good Reason shall not be
affected by your incapacity due to physical or mental illness. Your
continued employment shall not constitute consent to, or a waiver of rights
with respect to, any circumstance constituting Good Reason hereunder for a
period of 90 days following the occurrence of such circumstance.
(4) You shall be considered "Disabled" during any period in which you have a
physical or mental disability which renders you incapable, after reasonable
accommodation, of performing your duties under this letter and you shall
not be required to perform your duties for the Company, as described under
this letter, during any period you are Disabled.
This agreement is contingent on the completion of the following requirements:
1) You sign Covad's Employee Confidentiality and Inventions Agreement, a copy
of which is attached, and which, among other things, obligates you not to
reveal any Covad confidential information, not to bring with you to Covad
any non-public, proprietary information of your previous employer or any
other party, not to disclose such information to Covad, and to continue to
honor any existing confidentiality obligations you have to your previous
employer or any other company. It also assigns Covad any rights you may
have in work related inventions you may develop while at Covad.
2) You sign Covad's Restricted Stock Option Agreement which among other things
requires you to acknowledge that your shares of Covad are not currently
marketable, may never become marketable, and are subject to restrictions
and prohibitions on sales and other transfers until they become marketable.
Please sign and return this agreement acknowledging the employment terms
contained here, including our mutual understanding that these terms constitute
your entire compensation package, that your employment is "at will" and not
subject to any employment agreement other than this agreement and the agreements
referred in paragraph (1) and (2) above, that you will devote your full time to
Covad and that you will not engage in any other employment or contracting
without the prior written consent of Covad.
<PAGE>
Page 6
Sincerely, Agreed and Accepted
/s/ Charles J. McMinn
Charles J. McMinn /s/ Robert E. Knowling, Jr.
---------------------------
Chief Executive Officer Robert E. Knowling
Covad Communications Group, Inc.
Date: ________________, 1998
<PAGE>
EXHIBIT 10.2
COVAD COMMUNICATIONS, INC.
--------------------------
NOTE SECURED BY DEED OF TRUST
-----------------------------
$500,000 August 14, 1998
Santa Clara, California
FOR VALUE RECEIVED, Robert E. Knowling Jr. ("Maker") promises to pay
to the order of Covad Communications, Inc. (the "Company"), at its corporate
offices at 2330 Central Expressway, Building B, Santa Clara, California 95050,
the principal sum of Five Hundred Thousand Dollars ($500,000.00), together with
any accrued interest thereon, upon the terms and conditions specified below.
1. PRINCIPAL. The entire principal balance of this Note shall become
---------
due and payable in one lump sum on August 14, 2002.
2. INTEREST. No interest shall accrue under the Note while the Maker
--------
continues in employment with the Company.
3. PAYMENT. Payment shall be made in lawful tender of the United
-------
States and shall be applied first to the payment of all accrued and unpaid
interest and then to the payment of principal. Prepayment of the principal
balance of this Note may be made in whole or in part at any time without
penalty.
4. SECURITY; FULL RECOURSE. The proceeds of the loan evidenced by
-----------------------
this Note shall be applied solely to the purchase of the Maker's principal
residence in the City of [_], County of [_], State of California. Payment of
this Note shall be secured by a Deed of Trust on such principal residence, as
such property is more particularly described in Exhibit "A" to the Deed of
Trust, a copy of which Deed is attached hereto as Exhibit A. However, Maker
shall remain personally liable for payment of this Note, and assets of the
Maker, in addition to the collateral under the Deed of Trust, may be applied to
the satisfaction of the Maker's obligations hereunder.
5. EVENTS OF ACCELERATION. The entire unpaid principal balance of
----------------------
this Note shall become immediately due and payable upon:
A. the earlier of: (i) the date Maker voluntary resigns from the
-------
Company's employ or (ii) the date Maker is terminated by the
Company for cause; or
B. the sale, transfer, mortgage, assignment, encumbrance or lease,
whether voluntarily or involuntarily or by operation of law or
otherwise, of the property covered by the Deed of Trust, or any
portion thereof or interest therein, without the prior written
consent of the Company; or
C. the insolvency of the Maker, the commission of any act of
bankruptcy by the Maker, the execution by the Maker of a general
assignment for the benefit of creditors, the filing by or against
the Maker of any petition in
- -----------------------------------------------------------------------------
<PAGE>
bankruptcy or any petition for relief under the provisions of the
federal bankruptcy act or any other state or federal law for the
relief of debtors and the continuation of such petition without
dismissal for a period of thirty (30) days or more, the
appointment of a receiver or trustee to take possession of any
property or assets of the Maker, or the attachment of or execution
against any property or assets of the Maker; or
D. the occurrence of any event of default under the Deed of Trust
securing this Note or any obligation secured thereby.
For purposes of applying the provisions of this Note, "cause" shall
mean (i) the repeated failure of Maker to perform the duties of the President
and Chief Executive Officer in any substantial respect following thirty (30)
days prior notification in writing, (ii) Maker's conviction of a felony (other
than a traffic violation) or other criminal conduct involving fraud or theft, or
(iii) breach of any duty of loyalty to the Company that has a material adverse
effect on the Company.
6. EMPLOYMENT REQUIREMENT. The benefits of the interest arrangements
----------------------
under this Note are not transferable by Maker and are conditioned on the future
performance of substantial services by the Maker.
Upon Maker's cessation of employment with the Company, interest shall
accrue on the unpaid balance of this Note at the minimum per annum rate,
compounded semi-annually, required to avoid the imputation of compensation
income to Maker under the Federal tax laws.
For purposes of applying the provisions of this Note, the Maker shall
be considered to remain in the Company's employ for so long as the Maker renders
services as a full-time employee of the Company, any successor entity of the
Company or one or more subsidiaries of the Company in which the Company has at
least a fifty percent (50%) direct or indirect ownership interest.
7. CERTIFICATION. The Maker certifies that Maker reasonably expects
-------------
to be entitled to and will itemize deductions for Federal income tax purposes
for each year the Note is outstanding.
8. SPECIAL FORGIVENESS. The principal amount of this Note shall be
-------------------
forgiven by the Company in accordance with the terms of the offer letter from
the Corporation to the Maker dated August 3, 1998.
9. COLLECTION. If action is instituted to collect this Note, the
----------
Maker promises to pay all costs and expenses (including reasonable attorney
fees) incurred in connection with such action.
10. WAIVER. No previous waiver and no failure or delay by the
------
Company in acting with respect to the terms of this Note or the Deed of Trust
shall constitute a waiver of any breach, default, or failure of condition under
this Note, the Deed of Trust or the obligations secured thereby. A waiver of any
term of this Note, the Deed of Trust or of any of the
<PAGE>
obligations secured thereby must be made in writing and shall be limited to the
express terms of such waiver.
The Maker waives presentment, demand, notice of dishonor, notice of
default or delinquency, notice of acceleration, notice of protest and
nonpayment, notice of costs, expenses or losses and interest thereon, notice of
interest on interest, and diligence in taking any action to collect any sums
owing under this Note or in proceeding against any of the rights or interests in
or to properties securing payment of this Note.
11. CONFLICTING AGREEMENTS. In the event of any inconsistencies
----------------------
between the terms of this Note and the terms of any other document related to
the loan evidenced by the Note, the terms of this Note shall prevail.
12. GOVERNING LAW. This Note shall be construed in accordance with
-------------
the laws of the State of California without resort to that State's conflict-of-
laws rules.
13. DUE ON SALE. If the Maker shall sell, convey or alienate the
-----------
property covered by the Deed of Trust, or any part thereof, or any interest
therein, or shall be divested of his title or any interest therein in any manner
or way, whether voluntarily or involuntarily, without the written consent of the
Company being first had and obtained, the Company, shall have the right, at its
option, except as prohibited by law, to declare an indebtedness or obligations
secured hereby, irrespective of the maturity date specified in any note
evidencing the same, immediately due and payable. Consent to one such
transaction shall not be deemed to be a waiver of the right to require such
consent to future successive transactions.
MAKER
/s/ Robert E. Knowling Jr.
--------------------------
ROBERT E. KNOWLING JR.
<PAGE>
EXHIBIT A
LEGAL DESCRIPTION
-----------------
[Technical description of property]
<PAGE>
RECORDING REQUESTED BY |
Escrow No. 710-756 |
AND WHEN RECORDED MAIL TO |
| SPACE ABOVE THIS LINE FOR RECORDER'S USE
- --------------------------------------------------------------------------------
SHORT FORM DEED OF TRUST AND ASSIGNMENT OF RENTS
(INDIVIDUAL)
(DUE ON SALE CLAUSE) A.P.N._____________
- --------------------------------------------------------------------------------
THIS DEED OF TRUST, made this 14th day of August, 1998, between
Robert E. Knowling Jr. and Angela Denise Knowling, husband and wife, herein
called TRUSTOR,
whose address is [_] [_] [_] [_]
number and street city state zip
North American Title Company, a California corporation, herein called
TRUSTEE, and
Covad Communications Group, Inc. herein called BENEFICIARY,
WITNESSETH: That Trustor IRREVOCABLY GRANTS, TRANSFERS AND ASSIGNS TO TRUSTEE IN
TRUST, WITH POWER OF SALE, that property , described as:
SEE ATTACHED EXHIBIT A
IF THE TRUSTOR SHALL SELL, CONVEY OR ALIENATE SAID PROPERTY, OR ANY PART
THEREOF, OR ANY INTEREST THEREIN, OR SHALL BE DIVESTED OF HIS TITLED OR ANY
INTEREST THEREIN IN ANY MANNER OR WAY, WHETHER VOLUNTARILY OR INVOLUNTARILY,
WITHOUT THE WRITTEN CONSENT OF THE BENEFICIARY BEING FIRST HAD AND OBTAINED,
BENEFICIARY, SHALL HAVE THE RIGHT, AT ITS OPTION, EXCEPT AS PROHIBITED BY LAW,
TO DECLARE AN INDEBTEDNESS OR OBLIGATIONS SECURED HEREBY, IRRESPECTIVE OF THE
MATURITY DATE SPECIFIED IN ANY NOTE EVIDENCING THE SAME, IMMEDIATELY DUE AND
PAYABLE. CONSENT TO ONE SUCH TRANSACTIONS SHALL NOT BE DEEMED TO BE A WAIVER OF
THE RIGHT TO REQUIRE SUCH CONSENT TO FUTURE SUCCESSIVE TRANSACTIONS. TOGETHER
WITH the rents, issues and profits thereof, SUBJECT, HOWEVER, to the right,
power and authority given to and conferred upon Beneficiary by paragraph (10) of
the provisions incorporated herein by reference to collect and apply such rents,
issues and profits.
FOR THE PURPOSE OF SECURING: 1. Performance of each agreement of Trustor
incorporated by reference or contained herein. 2. Payment of the indebtedness
evidenced by one promissory note of even date herewith, and any extension or
renewal thereof in the principal sum of $500,000 executed by Trustor in favor of
--------
Beneficiary or order. 3. Payment of such further sums as the then record owner
of said property hereafter may borrow from Beneficiary, when evidenced by
another note (or notes) reciting it is so secured.
- --------------------------------------------------------------------------------
<PAGE>
<TABLE>
<CAPTION>
TO PROTECT THE SECURITY OF THIS DEED OF TRUST, TRUSTOR AGREES: By the execution and delivery of this Deed of Trust and the note
secured hereby, that provisions (1) to (14), inclusive, of the fictitious deed of trust recorded in Santa Barbara County and Sonoma
County October 18, 1961, and in all other counties October 23, 1961, in the book and at the page of Official Records in the office
of the county recorder of the county where said property is located, noted below opposite the name of the county, VIZ.:
<S><C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
COUNTY BOOK PAGE COUNTY BOOK PAGE COUNTY BOOK PAGE COUNTY BOOK PAGE
ALAMEDA 435 684 KINGS 792 833 PLACER 895 301 SIERRA 29 335
ALPINE 1 250 LAKE 362 39 PLUMAS 151 5 SISKIYOU 468 181
AMADOR 104 348 LASSEN 171 471 RIVERSIDE 3005 523 SOLANO 1105 182
BUTTE 1145 1 LOS ANGELES T2055 899 SACRAMENTO 4331 62 SONOMA 1851 689
CALAVERAS 145 152 MADERA 810 170 SAN BENITO 271 383 STANISLAUS 1751 456
COLUSA 296 617 MARIN 1508 339 SAN BERNARDINO 5587 61 SUTTER 572 297
CONTRA COSTA 3978 47 MARIPOSA 77 292 SAN FRANCISCO A332 905 TEHAMA 401 289
DEL NORTE 78 414 MENDOCINO 579 530 SAN JOAQUIN 2470 311 TRINITY 93 366
EL DORADO 568 456 MERCED 1547 538 SAN LUIS OBISPO 1151 12 TULARE 2294 275
FRESNO 4626 572 MODOC 184 851 SAN MATEO 4078 420 TUOLUMNE 135 47
GLENN 422 184 MONO 52 429 SANTA BARBARA 1878 860 VENTURA 2062 386
HUMBOLDT 657 527 MONTEREY 2194 538 SANTA CLARA 5336 341 YOLO 653 245
IMPERIAL 1091 501 NAPA 639 86 SANTA CRUZ 1431 494 YUBA 334 486
INYO 147 598 NEVADA 305 320 SHASTA 584 528
KERN 3427 60 ORANGE 5889 611 SAN DIEGO SERIES 2 BOOK 1961, PAGE 183887
(which provisions, identical in all counties, are printed on attached herewith) hereby are adopted and incorporated herein and made
a part hereof as fully as though set forth herein at length; that he will observe and perform said provisions; and that the
references to property, obligations and parties in said provisions shall be construed to refer to the property, obligations, and
parties set forth in this Deed of Trust.
The undersigned Trustor requests that a copy of any Notice of Default and of any Notices of Sale hereunder be mailed to him
at his address hereinbefore set forth.
STATE OF CALIFORNIA /s/ Robert E. Knowling, Jr.
COUNTY OF SANTA CLARA} ss. Signature of Trustor
On September 4, 1998 before me,
Sandra M. Leonard, Notary Public, personally appeared
Robert E. Knowling, Jr. proved to me on the basis of
satisfactory evidence to be the person whose name is
subscribed to the within instrument and acknowledged [NOTARY SEAL]
to me that he executed the same in his authorized
capacity; and that by his signature on the instrument
the person or the entity upon behalf of which the
person acted, executed the instrument.
WITNESS my hand and official seal.
Signature /s/ Sandra M. Leonard (This area for official notarial seal)
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
FOR RECONVEYANCE SEND TO THE NEAREST OFFICE OF NORTH AMERICAN TITLE COMPANY
REQUEST FOR FULL RECONVEYANCE
TO BE USED ONLY WHEN NOTE HAS BEEN PAID.
Dated__________________________
TO NORTH AMERICAN TITLE COMPANY, Trustee:
The undersigned is the legal owner and holder of all indebtedness
secured by the within Deed of Trust. All sums secured by said Deed of Trust
have been fully paid and satisfied; and you are hereby requested and directed on
payment to you of any sums owing to you under the terms of said Deed of Trust to
cancel all evidences of indebtedness, secured by said Deed of Trust, delivered
to you herewith together with said Deed of Trust, and to reconvey, without
warranty, to the parties designated by the terms of said Deed of Trust, the
estate now held by you under the same.
- --------------------------------------
MAIL RECONVEYANCE TO:
- -------------------------------------- -----------------------------------
- -------------------------------------- -----------------------------------
- -------------------------------------- (BY)-------------------------------
- -------------------------------------- (BY)-------------------------------
DO NOT LOSE OR DESTROY THIS DEED OF TRUST OR THE NOTE WHICH IT SECURES.
BOTH MUST BE DELIVERED TO THE TRUSTEE FOR CANCELLATION BEFORE RECONVEYANCE WILL
BE MADE.
PAGE 2 OF 2
<PAGE>
EXHIBIT 10.3
COVAD COMMUNICATIONS GROUP, INC.
1997 STOCK PLAN
(AMENDED AUGUST 26, 1998)
1. Purposes of the Plan. The purposes of this Stock Plan are to attract
--------------------
and retain the best available personnel for positions of substantial
responsibility, to provide additional incentive to Employees, Directors and
Consultants and to promote the success of the Company's business. Options
granted under the Plan may be Incentive Stock Options or Nonstatutory Stock
Options, as determined by the Administrator at the time of grant. Stock
Purchase Rights may also be granted under the Plan.
2. Definitions. As used herein, the following definitions shall apply:
-----------
(a) "Administrator" means the Board or any of its Committees as shall
-------------
be administering the Plan in accordance with Section 4 hereof.
(b) "Applicable Laws" means the requirements relating to the
---------------
administration of stock option plans under U.S. state corporate laws, U.S.
federal and state securities laws, the Code, any stock exchange or quotation
system on which the Common Stock is listed or quoted and the applicable laws of
any other country or jurisdiction where Options or Stock Purchase Rights are
granted under the Plan.
(c) "Board" means the Board of Directors of the Company.
-----
(d) "Code" means the Internal Revenue Code of 1986, as amended.
----
(e) "Committee" means a committee of Directors appointed by the Board
---------
in accordance with Section 4 hereof.
(f) "Common Stock" means the Common Stock of the Company.
------------
(g) "Company" means Covad Communications Group, Inc., a Delaware
-------
corporation.
(h) "Consultant" means any person who is engaged by the Company or
----------
any Parent or Subsidiary to render consulting or advisory services to such
entity.
(i) "Director" means a member of the Board of Directors of the
--------
Company.
(j) "Disability" means total and permanent disability as defined in
----------
Section 22(e)(3) of the Code.
<PAGE>
(k) "Employee" means any person, including Officers and Directors,
--------
employed by the Company or any Parent or Subsidiary of the Company. A Service
Provider shall not cease to be an Employee in the case of (i) any leave of
absence approved by the Company or (ii) transfers between locations of the
Company or between the Company, its Parent, any Subsidiary, or any successor.
For purposes of Incentive Stock Options, no such leave may exceed ninety days,
unless reemployment upon expiration of such leave is guaranteed by statute or
contract. If reemployment upon expiration of a leave of absence approved by the
Company is not so guaranteed, on the 181st day of such leave any Incentive Stock
Option held by the Optionee shall cease to be treated as an Incentive Stock
Option and shall be treated for tax purposes as a Nonstatutory Stock Option.
Neither service as a Director nor payment of a director's fee by the Company
shall be sufficient to constitute "employment" by the Company.
(l) "Exchange Act" means the Securities Exchange Act of 1934, as
------------
amended.
(m) "Fair Market Value" means, as of any date, the value of Common
-----------------
Stock determined as follows:
(i) If the Common Stock is listed on any established stock
exchange or a national market system, including without limitation the Nasdaq
National Market or The Nasdaq SmallCap Market of The Nasdaq Stock Market, its
Fair Market Value shall be the closing sales price for such stock (or the
closing bid, if no sales were reported) as quoted on such exchange or system for
the last market trading day prior to the time of determination, as reported in
The Wall Street Journal or such other source as the Administrator deems
reliable;
(ii) If the Common Stock is regularly quoted by a recognized
securities dealer but selling prices are not reported, its Fair Market Value
shall be the mean between the high bid and low asked prices for the Common Stock
on the last market trading day prior to the day of determination; or
(iii) In the absence of an established market for the Common
Stock, the Fair Market Value thereof shall be determined in good faith by the
Administrator.
(n) "Incentive Stock Option" means an Option intended to qualify as an
----------------------
incentive stock option within the meaning of Section 422 of the Code.
(o) "Nonstatutory Stock Option" means an Option not intended to
-------------------------
qualify as an Incentive Stock Option.
(p) "Officer" means a person who is an officer of the Company within
-------
the meaning of Section 16 of the Exchange Act and the rules and regulations
promulgated thereunder.
(q) "Option" means a stock option granted pursuant to the Plan.
------
<PAGE>
(r) "Option Agreement" means a written or electronic agreement between
----------------
the Company and an Optionee evidencing the terms and conditions of an individual
Option grant. The Option Agreement is subject to the terms and conditions of
the Plan.
(s) "Option Exchange Program" means a program whereby outstanding
-----------------------
Options are exchanged for Options with a lower exercise price.
(t) "Optioned Stock" means the Common Stock subject to an Option or a
--------------
Stock Purchase Right.
(u) "Optionee" means the holder of an outstanding Option or Stock
--------
Purchase Right granted under the Plan.
(v) "Parent" means a "parent corporation," whether now or hereafter
------
existing, as defined in Section 424(e) of the Code.
(w) "Plan" means this 1997 Stock Plan.
----
(x) "Restricted Stock" means shares of Common Stock acquired pursuant
----------------
to a grant of a Stock Purchase Right under Section 11 below.
(y) "Section 16(b)" means Section 16(b) of the Securities Exchange Act
-------------
of 1934, as amended.
(z) "Service Provider" means an Employee, Director or Consultant.
----------------
(aa) "Share" means a share of the Common Stock, as adjusted in
-----
accordance with Section 12 below.
(bb) "Stock Purchase Right" means a right to purchase Common Stock
--------------------
pursuant to Section 11 below.
(cc) "Subsidiary" means a "subsidiary corporation," whether now or
----------
hereafter existing, as defined in Section 424(f) of the Code.
3. Stock Subject to the Plan. Subject to the provisions of Section 12 of
-------------------------
the Plan, the maximum aggregate number of Shares which may be subject to option
and sold under the Plan is 13,970,250 post-split Shares. The Shares may be
authorized but unissued, or reacquired Common Stock.
If an Option or Stock Purchase Right expires or becomes unexercisable
without having been exercised in full, or is surrendered pursuant to an Option
Exchange Program, the unpurchased Shares which were subject thereto shall become
available for future grant or sale
<PAGE>
under the Plan (unless the Plan has terminated). However, Shares that have
actually been issued under the Plan, upon exercise of either an Option or Stock
Purchase Right, shall not be returned to the Plan and shall not become available
for future distribution under the Plan, except that if Shares of Restricted
Stock are repurchased by the Company at their original purchase price, such
Shares shall become available for future grant under the Plan.
4. Administration of the Plan.
--------------------------
(a) Administrator. The Plan shall be administered by the Board or a
-------------
Committee appointed by the Board, which Committee shall be constituted to comply
with Applicable Laws.
(b) Powers of the Administrator. Subject to the provisions of the Plan
---------------------------
and, in the case of a Committee, the specific duties delegated by the Board to
such Committee, and subject to the approval of any relevant authorities, the
Administrator shall have the authority in its discretion:
(i) to determine the Fair Market Value;
(ii) to select the Service Providers to whom Options and Stock
Purchase Rights may from time to time be granted hereunder;
(iii) to determine the number of Shares to be covered by each
such award granted hereunder;
(iv) to approve forms of agreement for use under the Plan;
(v) to determine the terms and conditions, of any Option or
Stock Purchase Right granted hereunder. Such terms and conditions include, but
are not limited to, the exercise price, the time or times when Options or Stock
Purchase Rights may be exercised (which may be based on performance criteria),
any vesting acceleration or waiver of forfeiture restrictions, and any
restriction or limitation regarding any Option or Stock Purchase Right or the
Common Stock relating thereto, based in each case on such factors as the
Administrator, in its sole discretion, shall determine;
(vi) to determine whether and under what circumstances an Option
may be settled in cash under subsection 9(e) instead of Common Stock;
(vii) to reduce the exercise price of any Option to the then
current Fair Market Value if the Fair Market Value of the Common Stock covered
by such Option has declined since the date the Option was granted;
(viii) to initiate an Option Exchange Program;
<PAGE>
(ix) to prescribe, amend and rescind rules and regulations
relating to the Plan, including rules and regulations relating to sub-plans
established for the purpose of qualifying for preferred tax treatment under
foreign tax laws;
(x) to allow Optionees to satisfy withholding tax obligations
by electing to have the Company withhold from the Shares to be issued upon
exercise of an Option or Stock Purchase Right that number of Shares having a
Fair Market Value equal to the amount required to be withheld. The Fair Market
Value of the Shares to be withheld shall be determined on the date that the
amount of tax to be withheld is to be determined. All elections by Optionees to
have Shares withheld for this purpose shall be made in such form and under such
conditions as the Administrator may deem necessary or advisable; and
(xi) to construe and interpret the terms of the Plan and awards
granted pursuant to the Plan.
(c) Effect of Administrator's Decision. All decisions, determinations
----------------------------------
and interpretations of the Administrator shall be final and binding on all
Optionees.
5. Eligibility.
-----------
(a) Nonstatutory Stock Options and Stock Purchase Rights may be
granted to Service Providers. Incentive Stock Options may be granted only to
Employees.
(b) Each Option shall be designated in the Option Agreement as either
an Incentive Stock Option or a Nonstatutory Stock Option. However,
notwithstanding such designation, to the extent that the aggregate Fair Market
Value of the Shares with respect to which Incentive Stock Options are
exercisable for the first time by the Optionee during any calendar year (under
all plans of the Company and any Parent or Subsidiary) exceeds $100,000, such
Options shall be treated as Nonstatutory Stock Options. For purposes of this
Section 5(b), Incentive Stock Options shall be taken into account in the order
in which they were granted. The Fair Market Value of the Shares shall be
determined as of the time the Option with respect to such Shares is granted.
(c) Neither the Plan nor any Option or Stock Purchase Right shall
confer upon any Optionee any right with respect to continuing the Optionee's
relationship as a Service Provider with the Company, nor shall it interfere in
any way with his or her right or the Company's right to terminate such
relationship at any time, with or without cause.
6. Term of Plan. The Plan shall become effective upon its adoption by the
------------
Board. It shall continue in effect for a term of ten (10) years unless sooner
terminated under Section 14 of the Plan.
7. Term of Option. The term of each Option shall be stated in the Option
--------------
Agreement; provided, however, that the term shall be no more than ten (10) years
from the date of grant thereof. In the case of an Incentive Stock Option
granted to an Optionee who, at the time the Option is
<PAGE>
granted, owns stock representing more than ten percent (10%) of the voting power
of all classes of stock of the Company or any Parent or Subsidiary, the term of
the Option shall be five (5) years from the date of grant or such shorter term
as may be provided in the Option Agreement.
8. Option Exercise Price and Consideration.
---------------------------------------
(a) The per share exercise price for the Shares to be issued upon
exercise of an Option shall be such price as is determined by the Administrator,
but shall be subject to the following:
(i) In the case of an Incentive Stock Option
(A) granted to an Employee who, at the time of grant of
such Option, owns stock representing more than ten percent (10%) of the voting
power of all classes of stock of the Company or any Parent or Subsidiary, the
exercise price shall be no less than 110% of the Fair Market Value per Share on
the date of grant.
(B) granted to any other Employee, the per Share exercise
price shall be no less than 100% of the Fair Market Value per Share on the date
of grant.
(ii) In the case of a Nonstatutory Stock Option
(A) granted to a Service Provider who, at the time of grant
of such Option, owns stock representing more than ten percent (10%) of the
voting power of all classes of stock of the Company or any Parent or Subsidiary,
the exercise price shall be no less than 110% of the Fair Market Value per Share
on the date of grant.
(B) granted to any other Service Provider, the per Share
exercise price shall be no less than 85% of the Fair Market Value per Share on
the date of grant.
(iii) Notwithstanding the foregoing, Options may be granted with
a per Share exercise price other than as required above pursuant to a merger or
other corporate transaction.
(b) The consideration to be paid for the Shares to be issued upon
exercise of an Option, including the method of payment, shall be determined by
the Administrator (and, in the case of an Incentive Stock Option, shall be
determined at the time of grant). Such consideration may consist of (1) cash,
(2) check, (3) promissory note, (4) other Shares which (x) in the case of Shares
acquired upon exercise of an Option, have been owned by the Optionee for more
than six months on the date of surrender, and (y) have a Fair Market Value on
the date of surrender equal to the aggregate exercise price of the Shares as to
which such Option shall be exercised, (5) consideration received by the Company
under a cashless exercise program implemented by the Company in connection with
the Plan, or (6) any combination of the foregoing methods of payment. In making
its determination as to the type of consideration to accept, the Administrator
shall consider if acceptance of such consideration may be reasonably expected to
benefit the Company.
<PAGE>
9. Exercise of Option.
------------------
(a) Procedure for Exercise; Rights as a Stockholder. Any Option
-----------------------------------------------
granted hereunder shall be exercisable according to the terms hereof at such
times and under such conditions as determined by the Administrator and set forth
in the Option Agreement. Except in the case of Options granted to Officers,
Directors and Consultants, Options shall become exercisable at a rate of no less
than 20% per year over five (5) years from the date the Options are granted.
Unless the Administrator provides otherwise, vesting of Options granted
hereunder shall be tolled during any unpaid leave of absence. An Option may not
be exercised for a fraction of a Share.
An Option shall be deemed exercised when the Company receives: (i)
written or electronic notice of exercise (in accordance with the Option
Agreement) from the person entitled to exercise the Option, and (ii) full
payment for the Shares with respect to which the Option is exercised. Full
payment may consist of any consideration and method of payment authorized by the
Administrator and permitted by the Option Agreement and the Plan. Shares issued
upon exercise of an Option shall be issued in the name of the Optionee or, if
requested by the Optionee, in the name of the Optionee and his or her spouse.
Until the Shares are issued (as evidenced by the appropriate entry on the books
of the Company or of a duly authorized transfer agent of the Company), no right
to vote or receive dividends or any other rights as a stockholder shall exist
with respect to the Shares, notwithstanding the exercise of the Option. The
Company shall issue (or cause to be issued) such Shares promptly after the
Option is exercised. No adjustment will be made for a dividend or other right
for which the record date is prior to the date the Shares are issued, except as
provided in Section 12 of the Plan.
Exercise of an Option in any manner shall result in a decrease in
the number of Shares thereafter available, both for purposes of the Plan and for
sale under the Option, by the number of Shares as to which the Option is
exercised.
(b) Termination of Relationship as a Service Provider. If an Optionee
-------------------------------------------------
ceases to be a Service Provider, such Optionee may exercise his or her Option
within such period of time as is specified in the Option Agreement (of at least
thirty (30) days) to the extent that the Option is vested on the date of
termination (but in no event later than the expiration of the term of the Option
as set forth in the Option Agreement). In the absence of a specified time in
the Option Agreement, the Option shall remain exercisable for three (3) months
following the Optionee's termination. If, on the date of termination, the
Optionee is not vested as to his or her entire Option, the Shares covered by the
unvested portion of the Option shall revert to the Plan. If, after termination,
the Optionee does not exercise his or her Option within the time specified by
the Administrator, the Option shall terminate, and the Shares covered by such
Option shall revert to the Plan.
(c) Disability of Optionee. If an Optionee ceases to be a Service
----------------------
Provider as a result of the Optionee's Disability, the Optionee may exercise his
or her Option within such period of time as is specified in the Option Agreement
(of at least six (6) months) to the extent the Option is vested on the date of
termination (but in no event later than the expiration of the term of such
Option as set forth in the Option Agreement). In the absence of a specified
time in the Option Agreement,
<PAGE>
the Option shall remain exercisable for twelve (12) months following the
Optionee's termination. If, on the date of termination, the Optionee is not
vested as to his or her entire Option, the Shares covered by the unvested
portion of the Option shall revert to the Plan. If, after termination, the
Optionee does not exercise his or her Option within the time specified herein,
the Option shall terminate, and the Shares covered by such Option shall revert
to the Plan.
(d) Death of Optionee. If an Optionee dies while a Service Provider,
-----------------
the Option may be exercised within such period of time as is specified in the
Option Agreement (of at least six (6) months) to the extent that the Option is
vested on the date of death (but in no event later than the expiration of the
term of such Option as set forth in the Option Agreement) by the Optionee's
estate or by a person who acquires the right to exercise the Option by bequest
or inheritance. In the absence of a specified time in the Option Agreement, the
Option shall remain exercisable for twelve (12) months following the Optionee's
termination. If, at the time of death, the Optionee is not vested as to the
entire Option, the Shares covered by the unvested portion of the Option shall
immediately revert to the Plan. If the Option is not so exercised within the
time specified herein, the Option shall terminate, and the Shares covered by
such Option shall revert to the Plan.
(e) Buyout Provisions. The Administrator may at any time offer to buy
-----------------
out for a payment in cash or Shares, an Option previously granted, based on such
terms and conditions as the Administrator shall establish and communicate to the
Optionee at the time that such offer is made.
10. Non-Transferability of Options and Stock Purchase Rights. The Options
--------------------------------------------------------
and Stock Purchase Rights may not be sold, pledged, assigned, hypothecated,
transferred, or disposed of in any manner other than by will or by the laws of
descent or distribution and may be exercised, during the lifetime of the
Optionee, only by the Optionee.
11. Stock Purchase Rights.
---------------------
(a) Rights to Purchase. Stock Purchase Rights may be issued either
------------------
alone, in addition to, or in tandem with other awards granted under the Plan
and/or cash awards made outside of the Plan. After the Administrator determines
that it will offer Stock Purchase Rights under the Plan, it shall advise the
offeree in writing or electronically of the terms, conditions and restrictions
related to the offer, including the number of Shares that such person shall be
entitled to purchase, the price to be paid, and the time within which such
person must accept such offer. The terms of the offer shall comply in all
respects with Section 260.140.42 of Title 10 of the California Code of
Regulations. The offer shall be accepted by execution of a Restricted Stock
purchase agreement in the form determined by the Administrator.
(b) Repurchase Option. Unless the Administrator determines otherwise,
-----------------
the Restricted Stock purchase agreement shall grant the Company a repurchase
option exercisable upon the voluntary or involuntary termination of the
purchaser's service with the Company for any reason (including death or
disability). The purchase price for Shares repurchased pursuant to the
Restricted Stock purchase agreement shall be the original price paid by the
purchaser and may be paid by cancellation of any indebtedness of the purchaser
to the Company. The repurchase option shall lapse
<PAGE>
at such rate as the Administrator may determine. Except with respect to Shares
purchased by Officers, Directors and Consultants, the repurchase option shall in
no case lapse at a rate of less than 20% per year over five (5) years from the
date of purchase.
(c) Other Provisions. The Restricted Stock purchase agreement shall
----------------
contain such other terms, provisions and conditions not inconsistent with the
Plan as may be determined by the Administrator in its sole discretion.
(d) Rights as a Stockholder. Once the Stock Purchase Right is
-----------------------
exercised, the purchaser shall have rights equivalent to those of a stockholder
and shall be a stockholder when his or her purchase is entered upon the records
of the duly authorized transfer agent of the Company. No adjustment shall be
made for a dividend or other right for which the record date is prior to the
date the Stock Purchase Right is exercised, except as provided in Section 12 of
the Plan.
12. Adjustments Upon Changes in Capitalization, Merger or Asset Sale.
----------------------------------------------------------------
(a) Changes in Capitalization. Subject to any required action by the
-------------------------
stockholders of the Company, the number of shares of Common Stock covered by
each outstanding Option or Stock Purchase Right, and the number of shares of
Common Stock which have been authorized for issuance under the Plan but as to
which no Options or Stock Purchase Rights have yet been granted or which have
been returned to the Plan upon cancellation or expiration of an Option or Stock
Purchase Right, as well as the price per share of Common Stock covered by each
such outstanding Option or Stock Purchase Right, shall be proportionately
adjusted for any increase or decrease in the number of issued shares of Common
Stock resulting from a stock split, reverse stock split, stock dividend,
combination or reclassification of the Common Stock, or any other increase or
decrease in the number of issued shares of Common Stock effected without receipt
of consideration by the Company. The conversion of any convertible securities
of the Company shall not be deemed to have been "effected without receipt of
consideration." Such adjustment shall be made by the Board, whose determination
in that respect shall be final, binding and conclusive. Except as expressly
provided herein, no issuance by the Company of shares of stock of any class, or
securities convertible into shares of stock of any class, shall affect, and no
adjustment by reason thereof shall be made with respect to, the number or price
of shares of Common Stock subject to an Option or Stock Purchase Right.
(b) Dissolution or Liquidation. In the event of the proposed
--------------------------
dissolution or liquidation of the Company, the Administrator shall notify each
Optionee as soon as practicable prior to the effective date of such proposed
transaction. The Administrator in its discretion may provide for an Optionee to
have the right to exercise his or her Option or Stock Purchase Right until
fifteen (15) days prior to such transaction as to all of the Optioned Stock
covered thereby, including Shares as to which the Option or Stock Purchase Right
would not otherwise be exercisable. In addition, the Administrator may provide
that any Company repurchase option applicable to any Shares purchased upon
exercise of an Option or Stock Purchase Right shall lapse as to all such Shares,
provided the proposed dissolution or liquidation takes place at the time and in
the manner contemplated. To the
<PAGE>
extent it has not been previously exercised, an Option or Stock Purchase Right
will terminate immediately prior to the consummation of such proposed action.
(c) Merger or Asset Sale. In the event of a merger of the Company with
--------------------
or into another corporation, or the sale of substantially all of the assets of
the Company, each outstanding Option and Stock Purchase Right shall be assumed
or an equivalent option or right substituted by the successor corporation or a
Parent or Subsidiary of the successor corporation. In the event that the
successor corporation refuses to assume or substitute for the Option or Stock
Purchase Right, the Optionee shall fully vest in and have the right to exercise
the Option or Stock Purchase Right as to all of the Optioned Stock, including
Shares as to which it would not otherwise be vested or exercisable. If an Option
or Stock Purchase Right becomes fully vested and exercisable in lieu of
assumption or substitution in the event of a merger or sale of assets, the
Administrator shall notify the Optionee in writing or electronically that the
Option or Stock Purchase Right shall be fully exercisable for a period of
fifteen (15) days from the date of such notice, and the Option or Stock Purchase
Right shall terminate upon the expiration of such period. For the purposes of
this paragraph, the Option or Stock Purchase Right shall be considered assumed
if, following the merger or sale of assets, the option or right confers the
right to purchase or receive, for each Share of Optioned Stock subject to the
Option or Stock Purchase Right immediately prior to the merger or sale of
assets, the consideration (whether stock, cash, or other securities or property)
received in the merger or sale of assets by holders of Common Stock for each
Share held on the effective date of the transaction (and if holders were offered
a choice of consideration, the type of consideration chosen by the holders of a
majority of the outstanding Shares); provided, however, that if such
consideration received in the merger or sale of assets is not solely common
stock of the successor corporation or its Parent, the Administrator may, with
the consent of the successor corporation, provide for the consideration to be
received upon the exercise of the Option or Stock Purchase Right, for each Share
of Optioned Stock subject to the Option or Stock Purchase Right, to be solely
common stock of the successor corporation or its Parent equal in fair market
value to the per share consideration received by holders of Common Stock in the
merger or sale of assets.
13. Time of Granting Options and Stock Purchase Rights. The date of grant
--------------------------------------------------
of an Option or Stock Purchase Right shall, for all purposes, be the date on
which the Administrator makes the determination granting such Option or Stock
Purchase Right, or such other date as is determined by the Administrator.
Notice of the determination shall be given to each Service Provider to whom an
Option or Stock Purchase Right is so granted within a reasonable time after the
date of such grant.
14. Amendment and Termination of the Plan.
-------------------------------------
(a) Amendment and Termination. The Board may at any time amend, alter,
-------------------------
suspend or terminate the Plan.
(b) Stockholder Approval. The Board shall obtain stockholder approval
--------------------
of any Plan amendment to the extent necessary and desirable to comply with
Applicable Laws.
<PAGE>
(c) Effect of Amendment or Termination. No amendment, alteration,
----------------------------------
suspension or termination of the Plan shall impair the rights of any Optionee,
unless mutually agreed otherwise between the Optionee and the Administrator,
which agreement must be in writing and signed by the Optionee and the Company.
Termination of the Plan shall not affect the Administrator's ability to exercise
the powers granted to it hereunder with respect to Options granted under the
Plan prior to the date of such termination.
15. Conditions Upon Issuance of Shares.
----------------------------------
(a) Legal Compliance. Shares shall not be issued pursuant to the
----------------
exercise of an Option unless the exercise of such Option and the issuance and
delivery of such Shares shall comply with Applicable Laws and shall be further
subject to the approval of counsel for the Company with respect to such
compliance.
(b) Investment Representations. As a condition to the exercise of an
--------------------------
Option, the Administrator may require the person exercising such Option to
represent and warrant at the time of any such exercise that the Shares are being
purchased only for investment and without any present intention to sell or
distribute such Shares if, in the opinion of counsel for the Company, such a
representation is required.
16. Inability to Obtain Authority. The inability of the Company to obtain
-----------------------------
authority from any regulatory body having jurisdiction, which authority is
deemed by the Company's counsel to be necessary to the lawful issuance and sale
of any Shares hereunder, shall relieve the Company of any liability in respect
of the failure to issue or sell such Shares as to which such requisite authority
shall not have been obtained.
17. Reservation of Shares. The Company, during the term of this Plan,
---------------------
shall at all times reserve and keep available such number of Shares as shall be
sufficient to satisfy the requirements of the Plan.
18. Stockholder Approval. The Plan shall be subject to approval by the
--------------------
stockholders of the Company within twelve (12) months after the date the Plan is
adopted. Such stockholder approval shall be obtained in the degree and manner
required under Applicable Laws.
19. Information to Optionees and Purchasers. The Company shall provide to
---------------------------------------
each Optionee and to each individual who acquires Shares pursuant to the Plan,
not less frequently than annually during the period such Optionee or purchaser
has one or more Options or Stock Purchase Rights outstanding, and, in the case
of an individual who acquires Shares pursuant to the Plan, during the period
such individual owns such Shares, copies of annual financial statements. The
Company shall not be required to provide such statements to key employees whose
duties in connection with the Company assure their access to equivalent
information.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 97,076
<SECURITIES> 0
<RECEIVABLES> 1,137
<ALLOWANCES> 75
<INVENTORY> 868
<CURRENT-ASSETS> 100,624
<PP&E> 35,421
<DEPRECIATION> 1,418
<TOTAL-ASSETS> 144,622
<CURRENT-LIABILITIES> 13,367
<BONDS> 137,292
0
18
<COMMON> 12
<OTHER-SE> (6,447)
<TOTAL-LIABILITY-AND-EQUITY> 144,622
<SALES> 2,560
<TOTAL-REVENUES> 2,560
<CGS> 2,316
<TOTAL-COSTS> 2,316
<OTHER-EXPENSES> 21,274
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 10,904
<INCOME-PRETAX> (28,261)
<INCOME-TAX> 0
<INCOME-CONTINUING> (28,261)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (28,261)
<EPS-PRIMARY> (5.26)
<EPS-DILUTED> (5.26)
</TABLE>
