<PAGE>
Filed Pursuant to Rule 424(b)(3)
Registration No. 333-75955
PROSPECTUS
Covad Communications Group, Inc.
Offer to Exchange All Outstanding 12 1/2% Senior Notes
due February 15, 2009 for 12 1/2% Senior Notes due February 15, 2009,
Which Have Been Registered Under the Securities Act of 1933
The exchange offer will expire at 5:00 P.M., New York City time, on May 26,
1999, unless we extend the deadline.
. The terms of the new notes are substantially identical to those of the old
notes, except for certain transfer restrictions and registration rights
relating to the old notes.
. No public market currently exists for the new notes. We do not expect that
an active public market in the new notes will develop. We do not intend to
list the new notes on any securities exchange or on the Nasdaq National
Market.
. We will exchange all old notes that are validly tendered and not withdrawn
prior to the expiration of the exchange offer.
. We believe that the exchange of old notes will not be a taxable event for
federal income tax purposes, but you should see "Federal Income Tax
Considerations" on page 116 for more information.
We are mailing this prospectus and the letter of transmittal on April 26,
1999.
See the "Risk Factors" section on page 10 for information that you should
consider before you decide to participate in this exchange offer.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of the new notes or determined that
this prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
The date of this prospectus is April 22, 1999
<PAGE>
PROSPECTUS SUMMARY
This summary highlights information contained elsewhere in this prospectus.
You should read the entire prospectus, including "Risk Factors" beginning on
page 10, carefully before tendering old notes in the exchange offer.
Overview of Our Business
We are a leading high-speed Internet and network access provider offering
digital subscriber line (DSL) services to Internet service provider and
enterprise customers. Internet service providers purchase our services in order
to provide high-speed Internet access to their business and consumer end-users.
Enterprise customers purchase our services to provide employees with remote
access to the enterprise's local area networks to improve employee productivity
and reduce operating costs. We refer to such services as remote local area
network (RLAN) services.
We believe our services offer a superior value proposition as compared to
currently available high-speed Internet and network access alternatives. Our
services are provided over standard copper telephone lines at speeds of up to
1.5 megabits per second (Mbps), which is over 25 times faster than a 56.6
kilobits per second (Kbps) modem. As of January 31, 1999 we had installed over
4,000 DSL lines and received orders for our services from over 100 Internet
service provider and enterprise customers, including Cisco Systems, Concentric
Network, Epoch Networks, Oracle, PeopleSoft, Stanford University, Verio and
Whole Earth Networks.
We have introduced our services in the following metropolitan areas:
<TABLE>
<CAPTION>
April
December 1997 August 1998 December 1998 March 1999 1999
------------- ----------- ------------- ---------- -----
<S> <C> <C> <C> <C>
San Francisco Bay Area Los Angeles Washington, D.C. Philadelphia Baltimore
New York Seattle Sacramento
Boston
</TABLE>
We plan to build our networks and offer our services in 22 regions
nationwide. We estimate that when complete, our networks in these 22 regions
will enable us to provide service to over 28 million homes and businesses in 28
of the top 50 metropolitan statistical areas in the United States.
In January 1999, we entered into strategic relationships with AT&T Corp.,
NEXTLINK Communications, Inc. and Qwest Communications Corporation. As part of
these strategic relationships, we received equity investments of $25 million
from AT&T's venture capital arm and two affiliated funds, $20 million from
NEXTLINK and $15 million from Qwest. Furthermore, these strategic investors
each entered into commercial agreements with us providing for the purchase,
marketing and resale of our services, the purchase by us of fiber optic
transport bandwidth, and collocation of network equipment.
On February 18, 1999, we completed the offering of 12 1/2% senior notes due
2009, our old notes, with an aggregate principal amount of $215 million. We
received net proceeds of $205.1 million from this offering, $74.0 million of
which was used to purchase pledged securities to secure the payment of the
first six scheduled interest payments on these notes.
Market Opportunity
We were formed to capitalize on the substantial business opportunity created
by:
. the growing demand for Internet and network access;
. the commercial availability of low cost DSL technology; and
. the passage of the 1996 Telecommunications Act.
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There is a growing market demand for high-speed digital communications
services. As businesses increase their use of the Internet, intranets and
extranets, we expect the market size for both small- and medium-sized business
Internet and RLAN access to continue to grow rapidly. According to
International Data Corporation, the number of Internet users worldwide reached
approximately 69 million in 1997 and will grow to approximately 320 million by
2002. International Data Corporation also estimates that the value of goods and
services sold worldwide through the Internet will increase from $12 billion in
1997 to over $400 billion in 2002. High-speed digital connections are becoming
increasingly important to businesses and consumers as more high bandwidth
information and applications become available on the Internet. Industry
analysts also estimate that the number of remote access lines in the U.S. will
grow from approximately ten million in 1996 to approximately 30 million in
2000, a compound annual growth rate in excess of 30%.
DSL is emerging as an inexpensive alternative high-speed digital
communications technology. The full potential of Internet and RLAN applications
cannot be realized without removing the performance bottlenecks of the existing
public switched telephone network. DSL technology removes these performance
bottlenecks by increasing the data carrying capacity of the copper telephone
lines from analog modem speeds of 56.6 Kbps and integrated services digital
network (ISDN) speeds of 128 Kbps to DSL speeds of up to 6 Mbps. Because DSL
technology reuses the existing copper plant, DSL technology is significantly
less expensive to deploy on a broad scale than existing alternative high-speed
digital communications technologies, such as cable modems, wireless data and
satellite data. As a result, a significant portion of the investment in a DSL
network is success-based, which means that such networks require a
comparatively lower initial fixed investment and that the subsequent variable
investments in DSL electronics are directly related to the number of paying
end-users.
The passage of the 1996 Telecommunications Act facilitates competition by
competitive local exchange carriers. The passage of the 1996 Telecommunications
Act created a legal framework for competitive local exchange carriers, which we
refer to as competitive telecommunications companies, to provide local analog
and digital communications services in competition with the incumbent local
exchange carriers, which are the traditional telephone companies. The 1996
Telecommunications Act eliminated a substantial barrier to entry for
competitive telecommunications companies by enabling them to leverage the
existing infrastructure built by the traditional telephone companies, which
required a $200 billion investment by these telephone companies and their
ratepayers, rather than constructing a competing infrastructure at significant
cost. The 1996 Telecommunications Act in particular emphasized the need for
competition-driven innovations in the deployment of advanced telecommunications
services, such as our DSL services.
Our Competitive Strengths
We offer higher bandwidth digital connections than alternative services at
similar or lower prices that do not vary with usage. For business Internet
users, our high-end services offer comparable bandwidth to T1 and frame relay
circuits at approximately 25% of the cost. For the RLAN market, our mid-range
services are three to six times the speed of ISDN and up to ten times the speed
of analog modems at monthly rates similar to or lower than those for heavily
used ISDN lines. We believe that many of our enterprise customers can justify
deploying lines to their employees if productivity improves by only a few hours
per month based on increases in the number of hours worked and decreases in
commute time and time spent waiting for information. For consumer Internet
users, we expect that we offer consumer-grade services at prices comparable to
prices offered by cable modem services.
We provide our customers with a widely available, continuously connected and
secure network. Our strategy of providing blanket coverage in each region we
serve is designed to ensure that our services are available to the vast
majority of our customers' end-users. Our networks provide 24-hour continuous
connectivity, unlike ISDN lines and analog modems which require customers to
dial-up each time for Internet or RLAN access. Also, because we use dedicated
connections from each end-user to the Internet service provider or enterprise
network, our customers can reduce the risk of unauthorized access.
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Our management team has extensive industry experience. Our management team
includes individuals with extensive experience in the data communications,
telecommunications and personal computer industries. In July 1998, we hired as
our Chief Executive Officer Robert Knowling, Jr., who formerly served as the
Executive Vice President of Operations and Technologies at U S WEST
Communications and as Vice President of Network Operations at Ameritech. We
also have in place Regional Presidents to cover all 22 of our regions.
Our Business Strategy
The key elements of our strategy are:
. to secure competitive local exchange carrier status and sign
interconnection agreements for the top U.S. markets;
. to enter and roll out our service rapidly in our target regions to
maintain our first-mover advantage;
. to provide blanket coverage in each of our 22 targeted regions;
. to focus on packet-based services;
. to concentrate our sales efforts on Internet service provider and
enterprise customers that can provide a large number of end-users;
. to leverage the success-based economics of DSL technology;
. to establish relationships with leading Internet service providers,
systems integrators, other competitive telecommunications companies and
long-distance carriers in order to expand our distribution channels and
accelerate the sale of our services; and
. to provide a superior and comprehensive product and service solution that
includes line installation, equipment sale and configuration.
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The Exchange Offer
Old Notes............... On February 18, 1999, we completed the offering of
$215 million aggregate principal amount of our 12
1/2% senior notes due 2009 to Bear, Stearns & Co.
Inc., BT Alex. Brown Incorporated, Donaldson, Lufkin
& Jenrette Securities Corporation and Goldman, Sachs
& Co., as initial purchasers. The initial purchasers
sold the old notes to "qualified institutional buy-
ers" as defined in Rule 144A under the Securities Act
of 1933. We have filed the registration statement of
which this prospectus is a part to comply with a reg-
istration rights agreement between us and the initial
purchasers.
Exchange Offer.......... We are offering to exchange the old notes for new
notes in the aggregate principal amount of up to $215
million provided that the old notes are properly
tendered and accepted for exchange. We will issue the
new notes promptly after the expiration of the
exchange offer. If you were not prohibited from
participating in the exchange offer and you did not
tender your old notes prior to the completion of the
exchange offer, you will have no further exchange
rights under the registration rights agreement.
Accordingly, such non-tendered old notes will
continue to be subject to restrictions on transfer.
Expiration Date......... The exchange offer will expire at 5:00 p.m., New York
City time, on May 26, 1999, or on a later extended
date and time as we may decide.
Conditions to the
Exchange Offer.......... The exchange offer is subject to certain customary
conditions. The conditions are limited and relate in
general to proceedings or laws that might impair our
ability to proceed with the exchange offer. As of the
date of this prospectus, none of these events had oc-
curred, and we believe their occurrence to be unlike-
ly. If any such conditions do exist prior to the ex-
piration date, we may take the following actions:
. refuse to accept any old notes and return all
previously tendered old notes;
. extend the duration of the exchange offer; or
. waive such conditions.
Procedures for
Tendering Old Notes.....
If you wish to participate in the exchange offer, you
must complete, sign and date the letter of transmit-
tal and send it, together with your old notes to be
exchanged and any other required documentation to The
Bank of New York, as exchange agent, at the address
set forth in the letter of transmittal. Brokers,
dealers, commercial banks, trust companies and other
nominees may tender old notes which they hold as nom-
inee by book-entry transfer. Questions regarding the
tender of the old notes or the exchange offer, gener-
ally, must be directed to the exchange agent.
Special Procedures for
Beneficial Owners.......
If you are the beneficial owner of old notes which
are registered in the name of a broker, dealer,
commercial bank, trust company or other
4
<PAGE>
nominee and you wish to tender the old notes in the
exchange offer, you should contact such registered
holder promptly and instruct such registered holder
to tender the old notes on your behalf. If you wish
to tender on your own behalf, you must, prior to com-
pleting and executing the letter of transmittal and
delivering the old notes, either make appropriate ar-
rangements to register ownership of the old notes in
your own name or obtain a properly completed bond
power from the registered holder. The transfer of
registered ownership may take considerable time and
it may not be possible to complete prior to the expi-
ration date.
Guaranteed Delivery
Procedures..............
If you wish to tender your old notes and your old
notes are not immediately available or you cannot de-
liver your old notes, the letter of transmittal or
any other documents required by the letter of trans-
mittal to the exchange agent, or you cannot complete
the procedure for book-entry transfer, then prior to
the expiration date you must tender your old notes
according to the guaranteed delivery procedures set
forth in "The Exchange Offer--Guaranteed Delivery
Procedures."
Withdrawal Rights....... Tenders of old notes may be withdrawn at any time be-
fore 5:00 p.m., New York City time, on the expiration
date by delivering a written notice of such with-
drawal to the exchange agent in conformity with the
procedures set forth under "The Exchange Offer--With-
drawal of Tenders."
Acceptance of Old Notes
and Delivery of New
Notes................... We will accept for exchange any and all old notes
which are properly tendered in the exchange offer be-
fore 5:00 p.m., New York City time, on the expiration
date. We will deliver the new notes promptly follow-
ing the expiration date. If we do not accept any of
your old notes for exchange we will return them to
you as promptly as practicable after the expiration
or termination of the exchange offer without any ex-
pense to you.
Certain Tax The exchange pursuant to the exchange offer should
Considerations.......... not result in the recognition of income, gain or loss
to you or to us for federal income tax purposes.
Exchange Agent.......... The Bank of New York, the trustee under the inden-
ture, is serving as exchange agent in connection with
the exchange offer.
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<PAGE>
Consequences of Not Exchanging Old Notes
You may not offer, sell or otherwise transfer the old notes except:
. in compliance with the registration requirements of the Securities Act
and any other applicable securities laws; or
. pursuant to an exemption therefrom; or
. in a transaction not subject to such securities laws. Old notes that
you do not exchange for new notes in the exchange offer will continue
to bear a legend reflecting such restrictions on transfer. In
addition, upon consummation of the exchange offer, you will not be
entitled to any rights to have old notes registered under the
Securities Act. We do not intend to register under the Securities Act
any old notes which remain outstanding after completion of the
exchange offer (subject to such limited exceptions, if applicable).
To the extent that old notes are tendered and accepted in the exchange
offer, any trading market for old notes which remain outstanding after the
exchange offer could be adversely affected.
The new notes and any old notes which remain outstanding after consummation
of the exchange offer will vote together as a single class for purposes of
determining whether holders of the requisite percentage in outstanding
principal amount thereof have taken certain actions or exercised certain rights
under the indenture.
Terms of New Notes
The exchange offer applies to up to $215,000,000 aggregate principal amount
of our old notes. The new notes will evidence the same debt as the old notes
and will be entitled to the benefits of the same indenture. The terms of the
new notes are the same as the terms of the old notes in all material respects
except that the new notes:
. have been registered under the Securities Act,
. do not include certain rights to registration under the Secu-
rities Act, and
. do not contain transfer restrictions or terms with respect to
additional interest payments applicable to the old notes. See
"Description of the Old Notes."
New Notes Offered....... $215.0 million in aggregate principal amount of 12
1/2% senior notes due 2009.
Maturity................ February 15, 2009.
Interest................ The new notes will bear interest at a fixed annual
rate of 12 1/2%, to be paid in cash every six months
on February 15 and August 15 of each year, beginning
on August 15, 1999.
Ranking................. The new notes are our senior obligations. The new
notes will rank equal in right of payment with all of
our existing and future senior debt and will rank se-
nior in right of payment to any of our future subor-
dinated debt. The new notes will be effectively sub-
ordinated to any of our secured debt and to our sub-
sidiaries' existing and future debt and other liabil-
ities (including our subsidiaries' trade payables).
We and our subsidiaries may incur substantial addi-
tional debt under the indenture, subject to certain
restrictions.
Assuming we had completed the offering of the old
notes on December 31, 1998, the new notes:
. would have ranked equally with $142.3 million of
senior debt; and
. would have ranked junior to $17.4 million of debt
and other liabilities (including trade payables) of
our subsidiaries.
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Sinking Fund............ None.
Optional Redemption..... On or after February 15, 2004, we may redeem some or
all of the new notes at any time at the redemption
prices listed in the section "Description of Notes"
under the heading "Optional Redemption." Before
February 15, 2002, we may redeem up to 35% of the new
notes with the proceeds of certain public offerings
of equity in our company at the price listed in the
section "Description of Notes" under the heading
"Optional Redemption."
Mandatory Offer to
Repurchase.............. If we sell certain assets or experience specific
kinds of changes of control, we must offer to repur-
chase the new notes at the prices listed in the sec-
tion "Description of Notes."
Basic Covenants of the
Indenture............... We will issue the new notes under an indenture with
The Bank of New York. The indenture will, among other
things, restrict our ability and the ability of our
subsidiaries to:
. borrow money;
. pay dividends on stock or purchase stock;
. make investments;
. use assets as security in other transactions; and
. sell certain assets or merge with or into other
companies.
For more details, see the section "Description of the
Notes" under the heading "Certain Covenants."
Registration Rights..... Holders of new notes (other than as set forth below)
are not entitled to any registration rights with
respect to the new notes. Pursuant to the
registration rights agreement among the initial
purchasers of the old notes and us, we agreed to file
an exchange offer registration statement with respect
to an offer to exchange the old notes for the new
notes. The registration statement of which this
prospectus is a part constitutes such exchange offer
registration statement. Under certain circumstances,
certain holders of old notes (including holders of
old notes who may not participate in the exchange
offer) may in certain circumstances require us to
file, and cause to become effective, a shelf
registration statement under the Securities Act which
would cover resales of old notes by such holders.
Use of Proceeds......... We will not receive any proceeds from the exchange
offer.
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SUMMARY CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------
1997 1998
----------- -----------
(dollars in thousands,
except per
share amounts)
<S> <C> <C>
Consolidated Statement of Operations Data:
Revenues............................................ $ 26 $ 5,326
Operating expenses:
Network and product costs......................... 54 4,562
Sales, marketing, general and administrative...... 2,374 31,043
Amortization of deferred compensation............. 295 3,997
Depreciation and amortization..................... 70 3,406
----------- -----------
Total operating expenses........................ 2,793 43,008
----------- -----------
Income (loss) from operations....................... (2,767) (37,682)
Net interest income (expense)..................... 155 (10,439)
----------- -----------
Net income (loss)................................... $ (2,612) $ (48,121)
=========== ===========
Net income (loss) per common share.................. $ (0.80) $ (8.43)
Weighted average shares used in computing net income
(loss) per share................................... 3,271,546 5,708,535
Other Financial Data:
EBITDA(1)........................................... $ (2,402) $ (30,154)
Capital expenditures................................ 2,253 59,503
Deficiency of earnings available to cover fixed
charges (2)........................................ (2,612) (48,121)
Consolidated Cash Flow Data:
Provided by (used in) operating activities.......... $ (1,895) $ (9,054)
Provided by (used in) investing activities.......... (2,494) (61,252)
Provided by (used in) financing activities.......... 8,767 130,378
<CAPTION>
As of December 31,
------------------------
1997 1998
----------- -----------
(dollars in thousands)
<S> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents........................... $ 4,378 $ 64,450
Net property and equipment.......................... 3,014 59,145
Total assets........................................ 8,074 139,419
Long-term obligations, including current portion.... 783 142,879
Total stockholders' equity (net capital
deficiency)........................................ 6,498 (24,706)
<CAPTION>
As of December 31,
------------------------
1997 1998
----------- -----------
<S> <C> <C>
Other Operating Data:
Homes and businesses passed......................... 278,000 6,023,217
Lines installed..................................... 26 3,922
</TABLE>
- --------
(1) EBITDA consists of net loss excluding net interest, taxes, depreciation and
amortization, non-cash stock based compensation and other non-operating
income or expenses. We have provided EBITDA because it is a measure of
financial performance commonly used in the telecommunications industry as
well as to enhance an understanding of our operating results. EBITDA should
not be construed as either:
. an alternative to operating income (as determined in accordance with
generally accepted accounting principals) as an indicator of our
operating performance, or
. an alternative to cash flows from operating activities (as determined in
accordance with generally accepted accounting principals) as a measure of
liquidity.
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EBITDA as calculated by us may be calculated differently than EBITDA for
other companies. See our consolidated financial statements and the related
notes thereto contained elsewhere in this prospectus.
(2) For purposes of determining the deficiency of earnings available to cover
fixed charges, "earnings" included pre-tax loss from operations adjusted
for fixed charges. "Fixed charges" included interest expense, capitalized
interest, amortization of debt discount and financing costs, and that
portion of rent expense which we believe to be representative of interest.
In view of our limited operating history and due to additional interest
charges (including amortization of debt discount and debt issuance costs)
which will result from the issuance of the old notes, the deficiency of
earnings available to cover fixed charges should not be considered
indicative of the deficiency of earnings available to cover fixed charges
in the future.
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RISK FACTORS
The new notes, like the old notes, involve a high degree of risk. In
addition to the other information contained in this prospectus, you should
carefully consider the following factors before tendering old notes in the
exchange offer.
Our leverage is substantial and will increase, making it more difficult to
respond to changing business conditions
As of February 28, 1999, we had approximately $356.7 million of long-term
obligations, which consists primarily of the 1998 discount notes and the old
notes. Because our 1998 discount notes accrete to $260 million through March
2003, we will become increasingly leveraged until then, whether or not we
incur new indebtedness in the future. We may also incur additional
indebtedness in the future, subject to certain restrictions contained in the
indentures governing the 1998 discount notes and the old notes, to finance the
continued development, commercial deployment and expansion of our networks and
for funding operating losses or to take advantage of unanticipated
opportunities.The degree to which we are leveraged could have important
consequences to you. For example, it could:
. materially limit or impair our ability to obtain additional financing or
refinancing in the future for working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
. require us to dedicate a substantial portion of our cash flow to the
payment of principal and interest on our indebtedness, which reduces the
availability of cash flow to fund working capital, capital expenditures,
acquisitions, general corporate purposes or other purposes;
. limit our ability to redeem the 1998 discount notes and the new notes in
the event of a change of control; and
. increase our vulnerability to economic downturns, limit our ability to
withstand competitive pressures and reduce our flexibility in responding
to changing business and economic conditions.
We will require a significant amount of cash to service our indebtedness; our
ability to generate cash depends on many factors beyond our control
We expect to continue to generate substantial net losses and negative cash
flow for at least the next several years. We may be unable to maintain a level
of cash flow from operations sufficient to permit us to pay the principal,
premium, if any, and interest on our indebtedness, including the 1998 discount
notes and the new notes, and any additional indebtedness we may incur. Because
the 1998 discount notes accrete to $260.0 million through March 2003, we must
begin paying cash interest on those notes in September 2003. In addition, we
must begin paying cash interest on the new notes in August 1999. However, we
have set aside approximately $74.0 million in government securities in a
pledge account to fund the first three years of interest payments on the new
notes.
Our ability to make scheduled payments with respect to indebtedness
(including the 1998 discount notes and the new notes) will depend upon, among
other things:
. our ability to achieve significant and sustained growth in cash flow;
. the rate of and successful commercial deployment of our network;
. successful operation of our network;
. the market acceptance, customer demand, rate of utilization and pricing
for our services;
. our ability to successfully complete development, upgrades and
enhancements of our network; and
. our ability to complete additional financings, as necessary.
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Each of these factors is affected by economic, financial, competitive and
other factors, many of which are beyond our control. If we are unable to
generate sufficient cash flow to service our indebtedness, we may have to
reduce or delay network deployments, restructure or refinance our indebtedness
or seek additional equity capital, strategies that may not enable us to the
service and repay our indebtedness. Any failure to satisfy our obligations
with respect to the 1998 discount notes or the new notes at or before maturity
would be a default under the related indenture and could cause a default under
agreements governing our other indebtedness. If such defaults occur, the
holders of the indebtedness would have enforcement rights, including the right
to accelerate payment of the entire amount of the debt and the right to
commence an involuntary bankruptcy proceeding against us. In either case, our
business, prospects, operating results, financial condition and our ability to
service and repay our indebtedness, including the new notes, would likely be
materially and adversely affected.
Our business is difficult to evaluate because we have a limited operating
history
We were incorporated in October 1996 and introduced our services
commercially in the San Francisco Bay Area in December 1997. Because of our
limited operating history, you have limited operating and financial data upon
which to base an evaluation of our business. You should consider that we have
the risks of an early stage company in a new and rapidly evolving market. To
overcome these risks, we must:
. rapidly expand the geographic coverage of our services;
. attract and retain customers within our existing and in new regions;
. increase awareness of our services;
. respond to competitive developments;
. continue to attract, retain and motivate qualified persons;
. continue to upgrade our technologies in response to competition and
market factors;
. effectively manage the growth of our operations.
We have a history of losses and expect increasing losses in the future
We have incurred substantial losses and experienced negative cash flow each
fiscal quarter since our inception. As of December 31, 1998, we had an
accumulated deficit of approximately $50.7 million. We intend to increase our
capital expenditures and operating expenses in order to expand our business.
In addition, we expect our net losses to increase in the future due to the
interest and amortization charges related to our 1998 discount notes and the
new notes and the amortization charges related to our issuance of preferred
stock to AT&T's venture capital arm and two affiliated funds ("AT&T
Ventures"), NEXTLINK and Qwest in January 1999. The approximate amount of such
charges and the fiscal year in which such charges will occur are as follows:
. Interest and amortization charges relating to the 1998 discount notes
were approximately $16.0 million during the year ending December 31,
1998. These changes will increase each year until the year ending
December 31, 2004, during which period the interest and amortization
charges will be approximately $36.9 million. Interest and related
amortization will remain at that level through maturity in March 2008.
. Interest and amortization charges relating to the new notes will be
approximately $24.0 million during the year ending December 31, 1999 and
will increase each year until the year ending December 31, 2008 during
which period the interest and related amortization will be approximately
$28.3 million.
. We recorded intangible assets of $28.7 million associated with the
issuance of our preferred stock to AT&T Ventures, NEXTLINK and Qwest.
These amounts will result in an annual amortization charge of
approximately $8.4 million in each of the years in the three year period
ending December 31, 2001, decreasing to approximately $1.2 million per
year for each subsequent year through the year ending December 31, 2004.
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<PAGE>
As a result, we expect to incur substantial additional net losses and
substantial negative cash flow for at least the next several years.
Our operating results are likely to fluctuate in future periods
Our annual and quarterly operating results are likely to fluctuate
significantly in the future as a result of numerous factors, many of which are
outside of our control. These factors include:
. the timing and ability of traditional telephone companies to provide and
construct the required central office space;
. the rate at which customers subscribe to our services;
. decreases in the prices for our services due to competition, volume-based
pricing and other factors;
. Internet service provider and enterprise customer retention and end-user
churn rates;
. the success of our relationships with AT&T, NEXTLINK and Qwest and other
potential third parties in generating significant subscriber demand;
. the ability to deploy on a timely basis our services to adequately
satisfy end-user demand;
. delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead times
that are controlled by traditional telephone companies and other third
parties;
. the mix of line orders between consumer end-users and business end-users
(which typically have higher margins);
. the amount and timing of capital expenditures and other costs relating to
the expansion of our network;
. ability to develop and commercialize new services by us or our
competitors;
. regulatory developments, including interpretations of the 1996
Telecommunications Act;
. successful operation of our network; and
. general economic conditions and economic conditions specific to the
telecommunications industry.
As a result, it is likely that in some future quarters our operating
results will be below the expectations of securities analysts and investors.
If this happens, the trading price of our common stock would likely decline.
We cannot predict whether we will be successful because our business strategy
is unproven
We believe that we were the first competitive telecommunications company to
provide high-speed Internet and network access using DSL technology. As a
result, our business strategy is unproven. To be successful, we must develop
and market services that achieve broad commercial acceptance by Internet
service providers and enterprise customers in our targeted regions. Because
our business and the market for high speed digital communications services are
in the early stages of development, we are uncertain of whether our services
will achieve broad commercial acceptance.
We may experience decreasing prices for our services, which may impair our
ability to achieve profitability or positive cash flow
We may experience decreasing prices for our services due to competition,
volume-based pricing and other factors. Currently, we charge higher prices for
some of our services than some of our competitors do for their similar
services. As a result, we cannot assure you that our customers and their end-
user customers will select our services over those of our competitors. In
addition, prices for digital communications services in general have fallen
historically, and we expect this trend to continue. We have provided and
expect in the future to
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provide price discounts to customers that commit to sell our services to a
large number of their end-user customers. Our consumer grade services have
lower prices than our business grade services. As a result, an increase in
sales from our consumer services in future periods would reduce our overall
profit margins. We also expect to reduce prices periodically in the future to
respond to competition and to generate increased sales volume. As a result, we
cannot predict whether demand for our services will materialize at the prices
we expect to charge or whether future pricing levels will be sustainable. If
we fail to achieve or sustain broad commercial acceptance of our services at
adequate pricing levels we may not be able to achieve profitability or
positive cash flow, which would materially and adversely affect our business,
prospects, operating results, financial condition and our ability to service
and repay our indebtedness, including the new notes.
We depend on Internet service providers and other third parties for the
marketing and sale of our services
We market our Internet access services through Internet service providers
for resale to their business and consumer end-users. To date, a limited number
of Internet service providers have accounted for the significant majority of
our revenues. As a result, a significant reduction in the number of end-users
provided by one or more of our key Internet service providers could result in
a material decrease in our revenues for a given period. We expect that our
Internet service provider customers will account for the majority of our
future market penetration and revenue growth. Our agreements with our Internet
service provider customers are non-exclusive. Many of our Internet service
provider customers also resell services offered by our competitors. In
addition, a number of our Internet service provider customers have committed
to provide large numbers of end-users in exchange for price discounts. If our
Internet service provider customers do not meet their volume commitments or
otherwise do not sell our services to as many end users as we expect, our
business, prospects, operating results, financial condition and our ability to
service and repay our indebtedness, including the new notes, would be
materially adversely affected.
In addition, we recently entered into commercial agreements with each of
AT&T, NEXTLINK and Qwest. Our agreements with AT&T, NEXTLINK and Qwest provide
for the purchase, marketing and resale of our services, primarily to their
small business and enterprise customers. We cannot predict:
. the number of line orders that AT&T, NEXTLINK or Qwest will generate, if
any; or
. whether line orders will be below our expectations.
In addition, relationships that we may establish with other third parties
may not improve our business, prospects, operating results, financial
condition or our ability to service and repay our indebtedness, including the
new notes.
We may be unable to manage our growth effectively
Our strategy is to significantly expand our network within our existing
regions and to deploy networks in a total of 22 regions by the end of the
first quarter of the year 2000. The execution of this strategy involves:
. obtaining the required government authorizations (which allow us to
obtain cost-based pricing from the traditional telephone companies in
each of our target regions);
. identifying, accessing and initiating service in key central offices
within existing and target regions;
. designing and maintaining an adequate operational support system;
. designing and constructing regional data centers;
. obtaining central office space; and
. entering into and renewing interconnection agreements with the
appropriate traditional telephone companies on satisfactory terms and
conditions.
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To accomplish this strategy, we must, among other things:
. market to and acquire a substantial number of customers and end-users;
. continue to implement and improve our operational, financial and
management information systems, including our client ordering,
provisioning, dispatch, trouble ticketing and other operational systems
as well as our billing, accounts receivable and payable tracking, fixed
assets and other financial management systems;
. hire and train additional qualified management and technical personnel;
. establish and maintain relationships with third parties to market and
sell our services, install network equipment and provide field service;
and
. continue to expand and upgrade our network infrastructure.
We may be unable to do these things successfully. Further, we may be unable
to deploy our networks as scheduled or achieve the operational growth
necessary to achieve our business strategy.
Our growth has placed, and is expected to continue to place, significant
demands on our management and operational resources. We expect to continue to
increase significantly our employee base to support the deployment of our
networks. For example, we expect the demands on our network infrastructure and
technical support resources to grow rapidly along with our customer base. If
we are successful in implementing our marketing strategy, we may have
difficulty responding to demand for our services and technical support in a
timely manner and in accordance with our customers' expectations. We expect
these demands to require the addition of new management personnel and the
increased outsourcing of company functions to third parties. We may be unable
to do this successfully. In addition, our networks, procedures and controls
may be inadequate to support our operations.
If we are unable to manage our growth effectively, our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes, will be materially adversely
affected.
We depend on traditional telephone companies to provide central office space
and unbundled network elements, both of which are critical to our success
Our success depends significantly on our ability to provide broad service
availability in our target regions. To do this, we must secure physical space
from the traditional telephone companies for our equipment in the traditional
telephone companies' central offices in these regions. We have experienced
initial rejections of our applications to obtain central office space from
Pacific Bell in a significant number of central offices in Pacific Bell's
service areas in California. We have also experienced similar rejections in
certain central offices in the Los Angeles region from GTE Corporation and in
Massachusetts, Virginia and in other states from Bell Atlantic and other
traditional telephone companies. We expect that as we proceed with our
deployment, we will face additional rejections for central offices in our
other target regions. The rejection of our applications for central office
space has in the past resulted, and could in the future result, in delays and
increased expenses in the rollout of our services in our target regions,
including delays and expenses associated with engaging in legal proceedings
with the traditional telephone companies . These delays and increased expenses
could result in a material adverse effect on our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes.
We also face limitations on the availability of central office space in
high demand target markets in which other competitive telecommunications
companies are seeking or have obtained central office space to offer services.
We have also experienced delays and expect to continue to experience delays
where traditional telephone companies do not maintain our position in the
queue for central office space. We are engaged in a variety of negotiations
and legal actions to resolve situations where traditional telephone companies
assert that
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certain central offices lack sufficient space for our physical collocation. We
may be unable to resolve these legal and regulatory disputes successfully. As
a result of these challenges, we expect that we will continue to experience
delays in obtaining central office spaces and that these delays will adversely
affect our business, prospects, operating results, financial condition and our
ability to service and repay our indebtedness, including the new notes.
The Federal Communications Commission (FCC) has been reviewing the policies
and practices of the traditional telephone companies with the goal of
facilitating the efforts of competitive telecommunications companies to obtain
central office space more easily and on more favorable terms. On March 18,
1999, the FCC announced that it was adopting rules to make it easier and less
expensive for competitive telecommunications companies to obtain central
office space and to require traditional telephone companies to make new
alternative arrangements for obtaining central office space. The FCC's new
rules may not be implemented in a timely manner and may not enhance our
ability to obtain central office space.
We also depend on traditional telephone companies to provide unbundled DSL-
capable lines that connect each end-user to our equipment located in the
central offices. The 1996 Telecommunications Act generally requires that
charges for these unbundled network elements be cost-based and
nondiscriminatory. The nonrecurring and recurring monthly charges for DSL-
capable lines that we require vary greatly. These rates are subject to the
approval of the state regulatory commissions. The rate approval processes for
DSL-capable lines and other unbundled network elements typically involve a
lengthy review of the rates proposed by the traditional telephone companies in
each state. The ultimate rates approved typically depend greatly on the
traditional telephone company's initial rate proposals and such factors as the
policies of the state public utility commission. These rate approval
proceedings are time-consuming and absorb scarce resources including legal
personnel and cost experts as well as participation by our management.
Consequently, we are subject to the risk that the non-recurring and recurring
charges for DSL-capable lines and other unbundled network elements will
increase based on rates proposed by the traditional telephone companies and
approved by state regulatory commissions from time to time. Increases in these
rates in any of our regions could result in a material adverse effect on our
business, prospects, operating results, financial condition and our ability to
service and repay our indebtedness, including the new notes.
We depend on traditional telephone companies to provide transmission
facilities and to provision copper lines
We interconnect with and use traditional telephone companies' networks to
service our customers. Accordingly, we depend upon the technology and
capabilities of traditional telephone companies to meet certain
telecommunications needs of our customers and to maintain our service
standards. We also depend to some extent on cooperation from the traditional
telephone companies for the provision and repair of transmission facilities.
The traditional telephone companies in turn rely significantly on unionized
labor. Labor-related issues and actions on the part of the traditional
telephone companies have in the past, and in the future may, adversely affect
the traditional telephone company's provision of services and network
components that we order. Our dependence on the traditional telephone
companies has caused and could continue to cause us to encounter delays in
establishing our network and providing higher speed DSL services. These delays
could adversely affect our relationships with our customers and result in harm
to our reputation, which would adversely affect our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes.
We rely on the traditional telephone companies to provision copper lines to
our customers and end-users. We must establish efficient procedures for
ordering, provisioning, maintaining and repairing large volumes of DSL-capable
lines from the traditional telephone companies. We must also establish
satisfactory billing arrangements with the traditional telephone companies .
We may not be able to do these things in a manner that will alow us to retain
and grow our customer and end-user base. Failure to do so could have a
material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
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Our business will suffer if our interconnection agreements are not renewed or
if they are renewed or modified on unfavorable terms
We are required to enter into and implement interconnection agreements in
each of our target regions with the appropriate traditional telephone
companies in order to provide service in those regions. Our interconnection
agreements have a maximum term of three years. Therefore, we will have to
renegotiate these agreements with the traditional telephone companies when
they expire. We may not succeed in extending or renegotiating them on
favorable terms. Additionally, disputes have arisen and will likely arise in
the future as a result of differences in interpretations of the
interconnection agreements. For example, we are in arbitration proceedings
with two traditional telephone companies under the dispute resolution clauses
of our interconnection agreements. These disputes have delayed our deployment
of our network. They have also adversely affected our service to our customers
and our ability to enter into additional interconnection agreements with the
traditional telephone companies in other states. Finally, the interconnection
agreements are subject to state commission, FCC and judicial oversight. These
government authorities may modify the terms of the interconnection agreements
in a way that adversely affects our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
We depend on the traditional telephone companies for the quality and
availability of the copper lines that we use
We depend significantly on the quality and availability of the traditional
telephone companies' copper lines and the traditional telephone companies'
maintenance of such lines. We may not be able to obtain the copper lines and
the services we require from the traditional telephone companies at
satisfactory quality levels, rates, terms and conditions. Our inability to do
so could delay the expansion of our networks and degrade the quality of our
services to our customers. If these things happen, our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes, would be materially adversely
affected.
The market in which we operate is highly competitive, and we may not be able
to compete effectively, especially against established industry competitors
with significantly greater financial resources
The markets for business and consumer Internet access and RLAN access
services are intensely competitive. We expect that these markets will become
increasingly competitive in the future. We face competition from the
traditional telephone companies, cable modem service providers, traditional
and new national long distance carriers, Internet service providers, on-line
service providers, wireless and satellite service providers and other
competitive telecommunications companies. The principal bases of competition
in our markets include:
. price/performance;
. breadth of service availability;
. reliability of service;
. network security;
. ease of access and use;
. content bundling;
. customer support;
. brand recognition;
. operating experience;
. relationships with Internet service providers and other third parties;
and
. capital resources.
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All of the largest traditional telephone companies in our target markets
have begun offering DSL services or have announced their intent to provide DSL
services in the near term. As a result, the traditional telephone companies
represent strong competition in all of our target service areas, and we expect
this competition to intensify. For example, the traditional telephone
companies have an established brand name and reputation for high quality in
their service areas, possess sufficient capital to deploy DSL equipment
rapidly, have their own copper lines and can bundle digital data services with
their existing analog voice services to achieve economies of scale in serving
customers. Certain of the traditional telephone companies have aggressively
priced their consumer DSL services as low as $30-$40 per month, placing
pricing pressure on our TeleSpeed services. The traditional telephone
companies are also in a position to offer service to end-users from certain
central offices where we are unable to secure central office space and offer
service. Accordingly, we may be unable to compete successfully against the
traditional telephone companies, and any failure to do so would materially and
adversely affect our business, prospects, operating results, financial
condition and our ability to service and repay our indebtedness, including the
new notes.
Cable modem service providers such as @Home Network and MediaOne (and their
respective cable partners) are deploying high-speed Internet access services
over hybrid fiber coaxial cable networks. Where deployed, these networks
provide similar and in some cases higher-speed Internet access and RLAN access
than we provide. They also offer these services at lower price points than our
TeleSpeed services and target residential consumers, as well as business
customers. As a result, competition with the cable modem service providers may
have a significant negative effect on our ability to secure customers and may
create downward pressure on the prices we can charge for our services.
In addition to the traditional telephone companies and cable modem service
providers, many of our competitors have longer operating histories, greater
name recognition, better strategic relationships and significantly greater
financial, technical and marketing resources than we do. As a result, they may
be able to develop and adopt new or emerging technologies and respond to
changes in customer requirements or devote greater resources to the
development, promotion and sale of their products and services more
effectively than we can. These competitors may form new alliances and rapidly
acquire significant market share. These competitors may be able to undertake
more extensive marketing campaigns, adopt more aggressive pricing policies and
devote substantially more resources to developing high-speed digital services.
This intense competition could materially and adversely affect our business,
prospects, operating results, financial condition and our ability to service
and repay our indebtedness, including the new notes.
The digital communications industry is undergoing rapid technological changes,
and new technologies may be superior to the technology we use
The digital communications industry is subject to rapid and significant
technological change, including continuing developments in DSL technology,
which does not presently have widely accepted standards, and alternative
technologies for providing high speed data communications such as cable modem
technology. As a consequence:
. we will rely on third parties, including some of our competitors and
potential competitors, to develop and provide us with access to
communications and networking technology;
. our success will depend on our ability to anticipate or adapt to new
technology on a timely basis; and
. we expect that new products and technologies will emerge that may be
superior to, or may not be compatible with, our products and
technologies.
If we fail to adapt successfully to technological changes, or obsolescence
or fail to obtain access to important technologies, our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes, could be materially adversely
affected.
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Our operating results will suffer if our enterprise customers do not roll out
our services following their initial phase of deploying our services
Our practice with respect to our enterprise customers has been to enter
into an arrangement to install our service initially for a small number of
end-users. An enterprise customer decides whether to implement a broad rollout
of our services after evaluating the results of this initial phase of
deployment. Based on our experience to date, we believe that an enterprise
customer's initial phase of deployment and its decision to roll out our
service to additional end-users has taken at least six months, and has
generally taken longer than we originally expected. As of December 31, 1998, a
substantial majority of our enterprise customers had not yet rolled out our
services broadly to their employees, and it is not certain when such rollouts
will occur, if at all. We will not receive significant revenue from enterprise
customers until and unless these rollouts occur. During this lengthy sales
cycle we incur significant expenses in advance of the receipt of revenues.
Therefore, any continued or ongoing failure for any reason of enterprise
customers to roll out our services could have a material adverse effect on our
business, prospects, operating results, financial condition and our ability to
service and repay our indebtedness, including the new notes.
Our strategy depends on growth in demand for DSL-based services
The markets for high bandwidth Internet and RLAN access are in the early
stages of development. As a result, we cannot predict the rate at which these
markets will grow, if at all, or whether new or increased competition will
result in market saturation. Various providers of high-speed digital
communications services are testing products from various suppliers for
various applications. We do not know whether DSL will offer the same or more
attractive price-performance characteristics. Critical issues concerning
commercial use of DSL for Internet and RLAN access, including security,
reliability, ease and cost of access and quality of service, remain unresolved
and may impact the growth of such services. If the markets for our services
grow more slowly than we anticipate or become saturated with competitors, our
ability to achieve revenue growth and positive cash flow would be impaired.
This could have a material adverse effect on our business, prospects,
operating results, financial condition and our ability to service and repay
our indebtedness, including the new notes.
The scalability and speed of our network remains largely unproven
To date, we have deployed our network in a total of nine of our 22 regions,
most of which have been deployed only in the last several months. As a result,
the ability of our DSL networks and operational support systems to connect and
manage a substantial number of online end-users at high transmission speeds is
still unknown. Consequently, there remains a risk that we may not be able to
scale our network and operational support systems up to our expected end-user
numbers while achieving superior performance. While peak digital data
transmission speeds across our DSL networks are 1.5 Mbps downstream, the
actual data transmission speeds over our networks could be significantly
slower and will depend on a variety of factors, including
. the type of DSL technology deployed;
. the distance an end-user is located from a central office;
. the configuration of the telecommunications line being used;
. quality of the copper lines provisioned by traditional telephone
companies; and
. our operational support systems which manage our network.
As a result, our networks may be unable to achieve and maintain the highest
possible digital transmission speed.
Our failure to achieve or maintain high-speed digital transmissions would
significantly reduce customer and end-user demand for our services, which
would have a material adverse effect on our business, prospects, operating
results, financial condition and our ability to service and repay our
indebtedness, including the new notes.
Interference in the traditional telephone company's copper plant could degrade
the performance of our services
Certain technical laboratory tests and field experience indicate that some
types of DSL technology may cause interference with and be interfered with by
other signals present in an traditional telephone company's
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copper plant, usually with lines in close proximity. If present, this
interference could cause degradation of performance of our services or render
us unable to offer our services on selected lines. The amount and extent of
such interference will depend on the condition of the traditional telephone
company's copper plant and the number and distribution of DSL and other
signals in such plant and cannot now be ascertained. When interference occurs,
it is difficult to detect and the procedures to resolve interference issues
between competitive telecommunications companies and a traditional telephone
company are still being developed and may not be effective. Although in the
past we have agreed to interference resolution procedures with certain
traditional telephone companies, we may be unable to successfully negotiate
similar procedures with other traditional telephone companies in future
interconnection agreements or in renewals of existing interconnection
agreements. In addition, the traditional telephone companies may not
unilaterally take action to resolve interference issues to the detriment of
our services. If our TeleSpeed services cause widespread network degradation
or are perceived to cause that type of interference, responsive actions by the
traditional telephone companies or state or federal regulators could have a
material adverse effect on our reputation, brand image, service quality, and
customer satisfaction and retention.
A system failure could delay or interrupt service to our customers
Our operations depend upon our ability to support our highly complex
network infrastructure and avoid damage from fires, earthquakes, floods, power
losses, excessive sustained or peak user demand, telecommunications failures,
network software flaws, transmission cable cuts and similar events. The
occurrence of a natural disaster or other unanticipated problem at our network
operations center or any of our regional data centers could cause
interruptions in our services. Additionally, failure of a traditional
telephone company or other service provider, such as competitive
telecommunications companies, to provide communications capacity that we
require, as a result of a natural disaster, operational disruption or any
other reason, could cause interruptions in our services. Any damage or failure
that causes interruptions in our operations could have a material adverse
effect on our business, prospects, operating results, financial condition and
our ability to service and repay our indebtedness, including the new notes.
A breach of network security could delay or interrupt service to our customers
Our networks may be vulnerable to unauthorized access, computer viruses and
other disruptive problems. Internet service providers and corporate networks
have in the past experienced, and may in the future experience, interruptions
in service as a result of accidental or intentional actions of Internet users,
current and former employees and others. Unauthorized access could also
potentially jeopardize the security of confidential information stored in the
computer systems of our customers and the customers' end-users, which might
result in liability to our customers and also might deter potential customers.
Although we intend to implement security measures that are standard within the
telecommunications industry, as well as new developed security measures, we
have not yet done so and we cannot assure you that we will implement such
measures in a timely manner or, that if and when implemented, such measures
will not be circumvented. Eliminating computer viruses and alleviating other
security problems may require interruptions, delays or cessation of service to
our customers and such customers' end-users, which could have a material
adverse effect on our business, prospects, operating results, financial
condition and our ability to service and repay our indebtedness, including the
new notes.
We depend on a limited number of third parties for equipment supply and
installation
We rely on outside parties to manufacture our network equipment, such as
digital subscriber line access multiplexers, customer premise equipment
modems, network routing and switching hardware, network management software,
systems management software and database management software. As we sign
additional service contracts, we will need to significantly increase the
amount of manufacturing and other services supplied by third parties in order
to meet our contractual commitments. For example, we have a service
arrangement with Lucent Technologies Inc. to increase our ability to order,
install and manage our central office facilities and associated equipment. We
have in the past experienced supply problems with certain of our vendors and
these vendors may not be able to meet our needs in a satisfactory and timely
manner in the future. In addition, we
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may not be able to obtain additional vendors when and if needed. Although we
have identified alternative suppliers for technologies that we consider deems
critical, it could take us a significant period of time to establish
relationships with alternative suppliers for critical technologies and
substitute their technologies into our networks.
Our reliance on third-party vendors involves a number of additional risks,
including:
. the absence of guaranteed capacity; and
. reduced control over delivery schedules, quality assurance, production
yields and costs.
The loss of any of our relationships with these suppliers could have a
material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
Our success depends on our retention of certain key personnel and our ability
to hire additional key personnel
We depend on the performance of our executive officers and key employees.
In particular, our senior management has significant experience in the data
communications, telecommunications and personal computer industries, and the
loss of any one of them could have a material adverse effect on our ability to
execute our business strategy. In addition, we depend upon the Regional
Presidents for each of our target regions. Regional Presidents have direct
responsibility for sales, service and market development efforts in their
respective regions, and the loss of one could disrupt significantly the
operations in the region. Additionally, we do not have "key person" life
insurance policies on any of our employees.
Our future success also depends on our continuing ability to identify,
hire, train and retain other highly qualified technical, sales, marketing and
managerial personnel in connection with our expansion within our existing
regions and the deployment and marketing of our network into targeted regions.
Competition for such qualified personnel is intense, particularly in software
development, network engineering and product management. We may be unable to
attract, assimilate or retain other highly qualified technical, sales,
marketing and managerial personnel in the future. The inability to attract the
necessary technical, sales, marketing and managerial personnel could have a
material adverse effect upon our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
We must comply with Federal and state tax and other surcharges on our
services, the levels of which are uncertain
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate services and intrastate services. Interstate
surcharges include Federal Universal Service Fees, Common Carrier Regulatory
Fees and TRS Fund fees. In addition, state regulators impose similar
surcharges and fees on intrastate services. The division of our services
between interstate services and intrastate services is a matter of
interpretation and may in the future be contested by the FCC or relevant state
commission authorities. A change in the characterization of the jurisdiction
of its services could cause our payment obligations pursuant to the relevant
surcharges to increase. In addition, pursuant to periodic revisions by state
and federal regulators of the applicable surcharges, we may be subject to
increases in the surcharges and fees currently paid.
Our services are subject to government regulation, and changes in current or
future laws or regulations could adversely affect our business
Our services are subject to federal, state and local government regulation.
The 1996 Telecommunications Act, which became effective in February 1996,
introduced widespread changes in the regulation of the telecommunications
industry, including the digital access services segment in which we operate.
The 1996 Telecommunications Act eliminates many of the pre-existing legal
barriers to competition in the
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telecommunications services business and sets basic criteria for relationships
between telecommunications providers.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local exchange telephone market by preempting state and local
laws that restrict competition by providing competitors interconnection,
access to unbundled network elements and retail services at wholesale rates.
The FCC's primary rules interpreting the 1996 Telecommunications Act, which
were issued on August 8, 1996, have been reviewed by the U.S. Court of Appeals
for the Eighth Circuit, which has overruled certain of the FCC's rules. We
have entered into competitive interconnection agreements using the federal
guidelines established in the FCC's interconnection order, which agreements
remain in effect notwithstanding the Eighth Circuit's decision. While the U.S.
Supreme Court overruled the Eighth Circuit in January of 1999 and upheld the
FCC rules, the FCC must now reconsider the definition of unbundled network
elements. Both the FCC and state telecommunications regulatory commissions
will likely review unbundled network element pricing issues consistent with
the U.S. Supreme Court's decision. Any unfavorable decisions by the FCC or
state telecommunications regulatory commissions could have a material adverse
effect on our business, prospects, operating results, financial condition and
our ability to service and repay our indebtedness, including the new notes.
In August 1998, the FCC proposed new rules that would allow traditional
telephone companies to provide their own DSL services free from traditional
telephone company regulation through a separate affiliate. The provision of
DSL services by an affiliate of a traditional telephone company not subject to
such regulation could have a material adverse effect on our business,
prospects, operating results, financial condition and our ability to service
and repay our indebtedness, including the new notes.
Changes to current regulations or the adoption of new regulations by the
FCC or state regulatory authorities or legislative initiatives, such as
changes to the 1996 Telecommunications Act, or court decisions could have a
material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
Our intellectual property protection may be inadequate to protect our
proprietary rights, and we may be subject to infringement claims
We regard our products, services and technology as proprietary and attempt
to protect them with patents, copyrights, trademarks, trade secret laws,
restrictions on disclosure and other methods. We cannot assure you that these
methods may not be sufficient to protect our technology. We also generally
enter into confidentiality or license agreements with our employees and
consultants, and generally control access to and distribution of our
documentation and other proprietary information. Despite these precautions, it
may be possible for a third party to copy or otherwise obtain and use our
products, services or technology without authorization, or to develop similar
technology independently.
Currently we have a number of patent applications and intend to prepare
additional applications and to seek patent protection for our systems and
services to the extent possible. We may not obtain any issued patents. If
issued, such patents may not protect our intellectual property from
competition which could seek to design around or invalidate such patents.
In addition, effective patent, copyright, trademark and trade secret
protection may be unavailable or limited in certain foreign countries. The
global nature of the Internet makes it virtually impossible to control the
ultimate destination of our proprietary information. The steps that we have
taken may not prevent misappropriation or infringement of our technology.
In addition, litigation may be necessary in the future to enforce our
intellectual property rights to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Such litigation could
result in substantial costs and diversion of resources and could have a
material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
21
<PAGE>
An economic downturn could adversely impact demand for our services
In the last few years the general health of the economy, particularly the
California economy, has been relatively strong and growing, a consequence of
which has been increasing capital spending by individuals and growing
companies to keep pace with rapid technological advances. To the extent the
general economic health of the United States or of California declines from
recent historically high levels, or to the extent individuals or companies
fear such a decline is imminent, such individuals and companies may reduce, in
the near term, expenditures such as those for our services. Any such decline
or concern about an imminent decline could delay decisions among certain of
our customers to roll out our services or could delay decisions by prospective
customers to make initial evaluations of our services. Such delays would have
a material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
We rely upon distributions from our subsidiaries to service our indebtedness,
and our indebtedness is subordinated to the indebtedness of our subsidiaries
We are a holding company and conduct a substantial portion of our
operations through our direct subsidiaries. As a result, our cash flow and
ability to service our indebtedness, including the new notes, will depend upon
the cash flow of our subsidiaries and payments of funds by those subsidiaries
to us. These subsidiaries are separate and distinct legal entities with no
legal obligation to pay any amounts due on the new notes or to make any funds
available therefor. In addition, our indentures permit these subsidiaries to
incur indebtedness or become parties to financing arrangements. In certain
circumstances, our indebtedness or financing arrangements may contain
limitations on the ability of our subsidiaries to pay dividends or to make
loans or advances to us.
Substantially all of our operating assets are held directly by our
subsidiaries. As a result, the new notes and our other indebtedness are
structurally subordinated to the indebtedness of our subsidiaries.
Accordingly, holders of indebtedness of subsidiaries, including trade
creditors, would be entitled to repayment of such indebtedness from the assets
of the affected subsidiaries before such assets could be made available for
repayment of our indebtedness, including the new notes.
If our subsidiaries are unable to generate sufficient cash flow or if we
are otherwise unable to obtain funds necessary to meet required payments of
principal, premium, if any, and interest on our indebtedness, including the
new notes, we would be in default under the terms of the agreements governing
such indebtedness. In that case, the holders of such indebtedness could elect
to declare all of the funds borrowed to be due and payable. If an acceleration
occurs and we do not have sufficient funds to pay the accelerated
indebtedness, the holders could initiate enforcement action against us. In any
such proceeding, the holders of our senior indebtedness would be entitled to
receive payment of their claims equal in priority with any distributions to
holders of the new notes. In addition, any holders of secured indebtedness of
us and our subsidiaries would have certain rights to repossess, foreclose upon
and sell the assets securing such indebtedness. Any of the foregoing
circumstances would materially adversely affect the market value of the new
notes and our ability to pay principal, premium, if any, and interest on the
new notes.
Fraudulent Conveyance Risks
Under applicable provisions of the federal bankruptcy law or comparable
provisions of state fraudulent transfer law, if, at the time we issued the old
notes or made any payment in respect of the new notes, either:
(1) we received less than reasonably equivalent value or fair consideration
for such issuance; and
. we were insolvent or were rendered insolvent by such issuance; or
. were engaged or about to engage in a business or transaction for
which our assets constituted unreasonably small capital; or
22
<PAGE>
. intended to incur, or believed that we would incur, debts beyond our
ability to pay our debts as they matured; or
(2) we issued the new notes or made any payment thereunder with intent to
hinder, defraud or delay any of our creditors,
then our obligations under some or all of the new notes could be voided or
held to be unenforceable by a court or could be subordinated to claims of
other creditors, or the new note holders could be required to return payments
already received.
In particular, if we caused a subsidiary to pay a dividend in order to
enable us to make payments in respect of the new notes, and such transfer were
deemed a fraudulent transfer, the holders of the new notes could be required
to return the payment.
The measure of insolvency for purposes of these fraudulent transfer laws
will vary depending upon the law applied in any proceeding to determine
whether a fraudulent transfer has occurred. Generally, however, we would be
considered insolvent if:
. the sum of our debts, including contingent liabilities, was greater than
all of our assets at a fair valuation; or
. we had unreasonably small capital to conduct our business; or
. the present fair salable value of our assets were less than the amount
that would be required to pay the probable liability on our existing
debts, including contingent liabilities, as they become absolute and
mature.
We believe that we will not be insolvent at the time of or as a result of
the issuance of the new notes, that we will not engage in a business or
transaction for which its remaining assets constitute unreasonably small
capital and that we did not and do not intend to incur or believe that we will
incur debts beyond our ability to pay such debts as they mature. We cannot
assure you that a court passing on such questions would agree with our
analysis.
Under certain circumstances, our subsidiaries will be required to guarantee
our obligations under the indenture and the new notes. If any subsidiary
enters into such a guarantee and bankruptcy or insolvency proceedings are
initiated by or against that subsidiary within 90 days (or, possibly, one
year) after that subsidiary issued a guarantee or that subsidiary incurred
obligations under its guarantee in anticipation of insolvency, then all or a
portion of the guarantee could be avoided as a preferential transfer under
federal bankruptcy or applicable state law. In addition, a court could require
holders of the new notes to return all payments made within any such 90 day
(or, possibly, one year) period as preferential transfers.
Applicable bankruptcy law is likely to impair the trustee's right to foreclose
upon the pledged securities
The right of the trustee under the indenture and the pledge agreement
relating to the new notes to foreclose upon and sell the pledged securities
upon the occurrence of an event of default on the new notes is likely to be
significantly impaired by applicable bankruptcy law if a bankruptcy or
reorganization case were to be commenced by or against us or one of our
subsidiaries. Under applicable bankruptcy law, secured creditors such as the
holders of the new notes are prohibited from foreclosing upon or disposing of
a debtor's property without prior bankruptcy court approval.
Consequences of not tendering old notes in the exchange offer
Upon consummation of the exchange offer, we will have no further obligation
to register your old notes. Thereafter, if you do not tender your old notes in
the exchange offer, you will continue to hold restricted securities which may
not be offered, sold or otherwise transferred, pledged or hypothecated except
pursuant to
23
<PAGE>
Rule 144 and Rule 144A under the Securities Act or pursuant to any other
exemption from registration under the Securities Act relating to the
disposition of securities, provided that an opinion of counsel is furnished to
us that such an exemption is available. These restrictions would limit the
trading market and price for the old notes.
There is no public market for the new notes, so you may be unable to sell the
new notes
The new notes are being offered to the holders of the old notes. Prior to
this exchange offer, there has been no existing trading market for any of the
old notes and we expect that a trading market will not develop for the new
notes. We do not intend to apply for listing of the new notes on any
securities exchange or on the Nasdaq National Market. The new notes may trade
at a discount from their initial offering price, depending upon prevailing
interest rates, the market for similar securities, our performance and other
factors. Therefore, we cannot assure you that an active market for the new
notes will develop. Consequently, the new notes may be relatively illiquid,
and you may be unable to sell your new notes.
Volatility in our stock price could adversely affect the trading price of the
new notes
The trading price of our common stock has been and is likely to continue to
be highly volatile. Our stock price could fluctuate widely in response to
factors such as the following:
. actual or anticipated variations in quarterly operating results;
. announcements of new products or services by us or our competitors or new
competing technologies;
. the addition or loss of Internet service providers or enterprise
customers or end-users;
. changes in financial estimates or recommendations by securities analysts;
. conditions or trends in the telecommunications industry, including
regulatory developments;
. growth of the Internet and online commerce industries;
. announcements by us of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
. additions or departures of key personnel;
. future equity or debt offerings or our announcements of such offerings;
. general market and general economic conditions; and
. other events or factors, many of which are beyond our control.
In addition, in recent years the stock market in general, and the Nasdaq
National Market and the market for Internet and technology companies in
particular, have experienced extreme price and volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating
performance of these companies. These market and industry factors may
materially and adversely affect our stock price, regardless of our operating
performance. If that happens, the trading price of the new notes could be
adversely affected.
Future sales of our common stock may depress our stock price and the trading
price of the new notes
Sales of a substantial number of shares of our common stock in the public
market, or the appearance that such shares are available for sale, could
adversely affect the market price for our common stock. In turn, a decline in
our stock price could depress the trading price of the new notes. As of March
15, 1999, we had 48,650,643 shares of common stock outstanding (including our
class B common stock). Of such shares, the 8,970,000 shares of common stock
that we sold in our initial public offering are freely tradeable in the public
market without restriction unless held by our affiliates, in which case the
shares are tradeable subject to certain volume limitations. Based on the
number of shares of common stock outstanding as of March 15, 1999, the
remaining shares of common stock available for sale in the public market are
limited by restrictions under the
24
<PAGE>
securities laws and lock-up agreements applicable to such shares and will be
available for sale in the public market as follows:
<TABLE>
<CAPTION>
Date of Availability For Sale Number of Shares
----------------------------- ----------------
<S> <C>
July 21, 1999 (181st day after the date of
the prospectus for our initial public
offering).................................. 33,301,466 shares of common stock
January 7, 2000............................ 6,379,177 shares of common stock
issuable upon conversion of our class
B common stock
</TABLE>
In addition, we have 15,520,342 shares of our common stock reserved for
issuance pursuant to options under our 1997 Stock Plan, of which 11,383,597
shares were subject to outstanding options at March 15, 1999. We intend to
register, prior to July 21, 1999, the shares of common stock reserved for
issuance under our 1997 Stock Plan and the 1,000,000 shares of common stock
reserved for issuance under our 1998 Employee Stock Purchase Plan.
Accordingly, shares underlying vested options will be eligible for resale in
the public market beginning on July 21, 1999.
In addition, we have 5,188,764 shares underlying outstanding warrants,
including 5,053,764 shares issuable upon exercise of the warrants issued in
connection with the 1998 discount notes. Beginning on July 21, 1999, these
warrants will be eligible for resale in the public market upon expiration of
their respective one-year holding periods under Rule 144. However, to the
extent that warrant holders effect a "cashless" exercise of their warrants,
the underlying shares will be eligible for sale in the public markets
beginning on July 21, 1999. In addition, these warrant holders and the holders
of 20,075,285 shares of our common stock have certain registration rights with
respect to their shares. These registration rights include the right to
request a registration on or after July 21, 1999. Holders of 6,379,177 shares
of class B common stock also have certain registration rights with respect to
the shares of common stock issuable upon conversion of the class B common
stock. The class B common stock is convertible into common stock beginning
January 2000. If these holders exercise their registration rights and cause a
large number of shares to be registered and sold in the public market, such
sales could have a material adverse effect on the market price for our common
stock.
Bear, Stearns & Co. Inc. may, in its sole discretion and at any time
without notice, release all or any portion of the securities subject to lock-
up agreements.
Our principal stockholders and management own a signficant percentage of our
stock and will be able to exercise significant influence over our affairs
Our executive officers and directors and principal stockholders together
beneficially own over 67.0% of our outstanding common stock. Accordingly,
these stockholders will be able to determine the composition of the our board
of directors, will retain the voting power to approve all matters requiring
stockholder approval and will continue to have significant influence over our
affairs. This concentration of ownership could have the effect of delaying or
preventing a change in control of us or otherwise discouraging a potential
acquirer from attempting to obtain control of us, which in turn could have a
material and adverse effect on the market price of the common stock or prevent
our stockholders from realizing a premium over the market prices for their
shares of common stock.
Our failure and the failure of third parties to be Year 2000 compliant could
negatively impact our business
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. We have reviewed
our internally developed information technology systems and programs and
believe that our systems are Year 2000 compliant and that we have no
significant Year 2000 issues within our systems or services. We have not
reviewed our non-information technology systems for Year 2000 issues relating
25
<PAGE>
to embedded microprocessors. To the extent that such issues exist, these
systems may need to be replaced or upgraded to become Year 2000 compliant. We
believe that our non-information technology systems will not present any
significant Year 2000 issues, although there can be no assurance in this
regard. In addition, we utilize third-party equipment and software and
interact with traditional telephone companies that have equipment and software
that may not be Year 2000 compliant. Failure of such third-party or
traditional telephone company equipment or software to operate properly with
regard to the year 2000 and thereafter could require us to incur unanticipated
expenses to remedy any problems, which could have a material adverse effect on
our business, prospects, operating results, financial condition and our
ability to service and repay our indebtedness, including the new notes.
Furthermore, the purchasing patterns of our Internet service provider and
enterprise 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 our
services, which could have a material adverse effect on our business,
prospects, operating results, financial condition and our ability to service
and repay our indebtedness, including the new notes.
We have not made any assessment of the Year 2000 risks associated with our
third-party or ILEC equipment or software or with our Internet service
provider and enterprise customers, have not determined the risks associated
with the reasonably likely worst-case scenario and have not made any
contingency plans to address such risks. However, we intend to devise a Year
2000 contingency plan prior to December 1999.
Certain provisions of our charter and bylaws and Delaware law could delay or
prevent a change of control of Covad
Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, preferences, privileges
and restrictions, including voting rights, of those shares without any further
vote or action by the stockholders. The issuance of preferred stock, while
providing desirable flexibility in connection with possible acquisitions and
other corporate purposes, could have the effect of making it more difficult
for a third party to acquire a majority of our outstanding voting stock. Our
charter and bylaws provide for:
. a classified board of directors,
. limitations on the ability of stockholders to call special meetings and
act by written consent,
. the lack of cumulative voting for directors, and
. procedures for advance notification of stockholder nominations and
proposals.
These provisions, as well as Section 203 under the Delaware General
Corporation Law, could discourage potential acquisition proposals and could
delay or prevent a change of control. The indentures relating to the 1998
discount notes and the new notes provide that, in the event of certain changes
in control, each holder of the notes will have the right to require us to
repurchase such holder's notes at a premium over the aggregate principal
amount or the accreted value, as the case may be, of such debt. The provisions
in the charter, bylaws and indentures could have the effect of discouraging
others from making tender offers for our shares and, as a consequence, they
also may inhibit increases in the market price of our shares that could result
from actual or rumored takeover attempts. Such provisions also may have the
effect of preventing changes in our management.
26
<PAGE>
USE OF PROCEEDS
We will not receive any cash proceeds from the issuance of the new notes
offered in the exchange offer. In consideration for issuing the new notes, we
will receive an equivalent principal amount of old notes. The old notes
surrendered in exchange for new notes will be retired and canceled and cannot
be reissued. Accordingly, issuance of the new notes will not result in any
increase in our indebtedness.
Our net proceeds from the issuance of the old notes were approximately
$205.1 million after deducting discounts, commissions and expenses of the
issuance. We used approximately $74.0 million of such proceeds to fund the
purchase of the pledged securities, which are government securities pledged as
collateral for the first six interest payments under the new notes. We
anticipate that the remaining net proceeds of the issuance of the old notes,
together with the aggregate proceeds from our initial public offering and the
investments by AT&T Ventures, NEXTLINK and Qwest, will be used
. to fund capital expenditures to be incurred in the deployment of our
networks in existing and new regions,
. for expenses associated with continued development and sales and
marketing activities,
. to fund operating losses, and
. for working capital and other general corporate purposes.
The amounts that we actually expend will vary depending upon a number of
factors, including future revenue growth, capital expenditures and the amount
of cash generated by our operations. Additionally, if we determine it would be
in our best interest, we may increase or decrease the number, selection and
timing of entry of our targeted regions. Accordingly, our management will
retain broad discretion in the allocation of such net proceeds. Although we
may use a portion of the net proceeds of the issuance of the old notes to
pursue possible acquisitions of or investments in businesses, technologies or
products complementary to ours in the future, we presently have no commitments
or agreements with respect to any acquisitions. Pending use of such net
proceeds for the above purposes, we intend to invest such funds in short-term,
interest-bearing, investment-grade securities.
DIVIDEND POLICY
We have not paid any dividends since our inception (other than dividends on
our preferred stock that converted into our common stock upon the closing of
our initial public offering) and do not intend to pay any dividends on our
capital stock in the foreseeable future. In addition, the terms of the
indentures relating to the 1998 discount notes and the new notes restrict our
ability to pay dividends on our capital stock.
27
<PAGE>
CAPITALIZATION
The following table sets forth:
(A) our capitalization as of December 31, 1998, and
(B) our pro forma capitalization as of December 31, 1998 after giving
effect to:
. the automatic conversion of all shares of preferred stock outstanding
as of December 31, 1998 into common stock upon the closing of our
initial public offering,
. the exercise of warrants to purchase 1,799,751 shares of common stock
prior to the closing of our initial public offering,
. the issuance of preferred stock to AT&T Ventures, NEXTLINK and Qwest,
and the automatic conversion of such shares into class B common stock
upon the closing of our initial public offering,
. the receipt of the net proceeds from the sale of 8,970,000 shares of
common stock in our initial public offering, and
. the receipt of the net proceeds from the issuance of the old notes
after deducting discounts, commissions and expenses payable by us.
<TABLE>
<CAPTION>
As of December 31,
1998
-------------------
(A) (B)
Actual Pro Forma
-------- ---------
(dollars in
thousands)
<S> <C> <C>
Cash and cash equivalents................................. $ 64,450 $405,721
Pledged Securities(1)..................................... -- 74,018
-------- --------
Total cash, cash equivalents and Pledged Securities..... $ 64,450 $479,739
======== ========
Long-term obligations:
Capital lease obligations (including current portion)..... $ 579 $ 579
13 1/2% Senior Discount Notes due 2008, net(2)............ 142,300 142,300
12 1/2% Senior Notes Due 2009, net(3)..................... -- 210,530
-------- --------
Total long-term obligations (including current
portion)............................................... 142,879 353,409
Stockholders' equity (net capital deficiency):
Preferred Stock, $0.001 par value; no shares authorized,
issued and outstanding (A) actual; 5,000,000 shares
authorized, no shares issued and outstanding (B) pro
forma.................................................... -- --
Convertible Preferred Stock, $0.001 par value; 30,000,000
shares authorized, 18,246,162 shares issued and
outstanding (A) actual; no shares authorized, issued and
outstanding (B) pro forma................................ 18 --
Common Stock, $0.001 par value; 65,000,000 shares
authorized, 11,773,997 shares issued and outstanding (A)
actual; 190,000,000 shares authorized, 40,789,910 shares
issued and outstanding (B) pro forma (4)................. 12 41
Class B-Common Stock, $0.001 par value; no shares
authorized, issued and outstanding (A) actual; 10,000,000
shares authorized, 6,379,177 shares issued and
outstanding (B) pro forma................................ -- 6
Additional paid-in capital(5)............................. 30,685 269,583
Deferred compensation..................................... (4,688) (4,688)
Accumulated deficit....................................... (50,733) (50,733)
-------- --------
Total stockholders' equity (net capital deficiency)..... (24,706) 214,209
-------- --------
Total capitalization................................... $118,173 $567,618
======== ========
</TABLE>
28
<PAGE>
- --------
(1) Represents the portion of the net proceeds from the issuance of the old
notes used to purchase government securities to be held in the pledge
account. See "Description of Notes--Pledged Securities; Interest Reserve."
(2) The 13 1/2% senior discount notes due 2008 are presented net of additional
debt discount of approximately $8.2 million, which represents the value
ascribed to the warrants issued in connection with the 1998 discount
notes. The debt discount will accrete in value through March 15, 2003 at a
rate of 13 1/2% per annum, compounded semi-annually. No cash interest will
be payable on the 1998 discount notes prior to that date.
(3) The old notes are presented net of additional debt discount of
approximately $4.5 million, which represents the additional original issue
discount.
(4) Excludes:
. an aggregate of 15,520,342 shares of common stock reserved for issuance
under the our 1997 Stock Plan, of which 11,383,597 shares were subject to
outstanding options at March 15, 1999 at a weighted average exercise
price of $3.41 per share,
. an aggregate of 1,000,000 shares of common stock reserved for issuance
under the our 1998 Employee Stock Purchase Plan,
. 5,053,764 shares of common stock issuable upon exercise of a warrant
issued in connection with the 1998 discount notes on December 31, 1998 at
an exercise price of $.0033 per share,
. 135,000 shares of common stock issuable upon exercise of a warrant issued
to a consultant at December 31, 1998 at an exercise price of $1.00 per
share and
. 59,372 shares of common stock issued as cumulated but unpaid dividends on
preferred stock upon the closing of our initial public offering.
(5) The amounts under (B) pro forma include the effect of recording intangible
assets of $28.7 million associated with the issuance of preferred stock to
AT&T Ventures, NEXTLINK and Qwest. Such amounts will be amortized over a
period of three to six years.
29
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data for the years ended
December 31, 1997 and December 31, 1998 has been derived from our audited
consolidated financial statements and the related notes, which are included
elsewhere in this prospectus. You should read the following selected
consolidated financial data together with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and our
consolidated financial statements and the related notes included elsewhere in
this prospectus.
<TABLE>
<CAPTION>
Year Ended
December 31,
--------------------
1997 1998
--------- ---------
(dollars in
thousands, except
per share amounts)
<S> <C> <C>
Consolidated Statement of Operations Data:
Revenues................................................ $ 26 $ 5,326
Operating expenses:
Network and product costs............................. 54 4,562
Sales, marketing, general and administrative.......... 2,374 31,043
Amortization of deferred compensation................. 295 3,997
Depreciation and amortization......................... 70 3,406
--------- ---------
Total operating expenses............................ 2,793 43,008
--------- ---------
Income (loss) from operations........................... (2,767) (37,682)
Net interest income (expense)......................... 155 (10,439)
--------- ---------
Net income (loss)....................................... $ (2,612) $ (48,121)
========= =========
Net income (loss) per common share...................... $ (0.80) $ (8.43)
Weighted average shares used in computing net income
(loss) per share....................................... 3,271,546 5,708,535
Other Financial Data:
EBITDA(1)............................................... $ (2,402) $ (30,154)
Capital expenditures.................................... 2,253 59,503
Deficiency of earnings available to cover fixed charges
(2).................................................... (2,612) (48,121)
Consolidated Cash Flow Data:
Provided by (used in) operating activities.............. $ (1,895) $ (9,054)
Provided by (used in) investing activities.............. (2,494) (61,252)
Provided by (used in) financing activities.............. 8,767 130,378
<CAPTION>
As of December 31,
--------------------
1997 1998
--------- ---------
(dollars in
thousands)
<S> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents............................... $ 4,378 $ 64,450
Net property and equipment.............................. 3,014 59,145
Total assets............................................ 8,074 139,419
Long-term obligations, including current portion........ 783 142,879
Total stockholders' equity (net capital deficiency)..... 6,498 (24,706)
<CAPTION>
As of December 31,
--------------------
1997 1998
--------- ---------
<S> <C> <C>
Other Operating Data:
Homes and businesses passed............................. 278,000 6,023,217
Lines installed......................................... 26 3,922
</TABLE>
30
<PAGE>
- --------
(1) EBITDA consists of net loss excluding net interest, taxes, depreciation
and amortization, non-cash stock based compensation and other non-
operating income or expenses. We have provided EBITDA because it is a
measure of financial performance commonly used in the telecommunications
industry as well as to enhance an understanding of our operating results.
EBITDA should not be construed as either:
. an alternative to operating income (as determined in accordance with
generally accepted accounting principals) as an indicator of our
operating performance, or
. an alternative to cash flows from operating activities (as determined in
accordance with generally accepted accounting principles) as a measure of
liquidity.
EBITDA as calculated by us may be calculated differently than EBITDA for
other companies. See our consolidated financial statements and the related
notes thereto contained elsewhere in this prospectus.
(2) For purposes of determining the deficiency of earnings available to cover
fixed charges, "earnings" included pre-tax loss from operations adjusted
for fixed charges. "Fixed charges" included interest expense, capitalized
interest, amortization of debt discount and financing costs, and that
portion of rent expense which we believe to be representative of interest.
In view of our limited operating history and due to additional interest
charges (including amortization of debt discount and debt issuance costs)
which will result from the issuance of the old notes, the deficiency of
earnings available to cover fixed charges should not be considered
indicative of the deficiency of earnings available to cover fixed charges
in the future.
31
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this
prospectus. This discussion contains forward-looking statements the accuracy
of which involves risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements for many
reasons including, but not limited to, those discussed in "Risk Factors" and
elsewhere in this prospectus. We disclaim any obligation to update information
contained in any forward-looking statement. See "--Forward Looking
Statements."
Overview
We are a leading high-speed Internet and network access provider offering
DSL services to Internet service provider and enterprise customers. We
introduced our services in the San Francisco Bay Area in December 1997. We
launched our services in the Los Angeles, New York and Boston metropolitan
areas in August 1998, in the Washington, D.C. and Seattle metropolitan areas
in December 1998, in the Philadelphia and Sacramento metropolitan areas in
March 1999 and in the Baltimore metropolitan area in April 1999. In March
1998, we raised approximately $135 million through the issuance of the 1998
discount notes to fund the deployment of our networks in our first six
regions. As a result of the strong market demand for high-speed digital
communications services, we plan to build a network and offer our services to
22 regions nationwide.
During 1998, we expanded our network in the San Francisco Bay Area and
increased our sales and marketing efforts in that region, which resulted in
higher revenue in each successive month in 1998. As of January 31, 1999, our
networks passed over 6.0 million homes and businesses, including over 1.8
million in the San Francisco Bay Area, and we had installed over 4,000 lines.
In connection with our expansion within existing regions and into new
regions, we expect to significantly increase our capital expenditures, as well
as our sales and marketing expenditures, to deploy our networks and support
additional end-users in those regions. Accordingly, we expect to incur
substantial and increasing net losses for at least the next several years.
For each region, we have targeted three market segments: business Internet,
business RLAN and consumer Internet. A key determinant of our revenues will be
our service penetration into the addressable portion of these market segments.
Using the approach described below, we have estimated the size of the
addressable portion of these market segments in our existing and targeted
regions.
To determine the overall potential market, we specifically identified each
service area in which we plan to offer service and each central office within
these service areas. This determination was based primarily upon both business
and population demographics as well as our desire to be in most central
offices in order to provide blanket coverage in a region. To estimate the
addressable market for each market segment from the overall potential market,
we analyzed the demographics in the following manner:
. Business Internet Addressable Market: Based on an estimate of the number
of small businesses served by the local central office and a third party
estimate of the number of small businesses expected to be online and the
percentage of such small businesses that will purchase high-speed
connectivity.
. RLAN Addressable Market: Based on an estimate of the number of households
served by the local central office with employees working for large
enterprises and a third party estimate for the entire U.S. of the
percentage of households that will purchase high-speed connectivity.
. Consumer Internet Addressable Market: Based on an estimate of the number
of online households (excluding RLAN households) served by the local
central office that will be heavy online users and an estimate of the
percentage of such households that will purchase high-speed connectivity.
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We derive revenue from:
. monthly recurring service charges for connections from the end-user to
our facilities and for backhaul services from our facilities to the
Internet service provider or enterprise customer,
. service order setup and other non-recurring charges, and
. the sale of customer premise equipment that we provide to our customers
due to the general unavailability of customer premise equipment through
retail channels.
We expect prices for the major components of both recurring and non-
recurring revenues to decrease each year in part due to the effects of
competitive pricing and future volume discounts. We intend to sell customer
premise equipment at prices that will provide us with positive margins on such
sales. We believe our revenues from the sale of customer premise equipment
will decline over time as customer premise equipment becomes more generally
available. We expect that the prices we charge to customers for customer
premise equipment will decrease each year. See "Risk Factors--We may
experience decreasing prices for our services, which may impair our ability to
achieve profitability or positive cashflow."
The following factors comprise our network and service costs:
. Monthly non-recurring and recurring circuit fees. We pay traditional
telephone companies and other competitive telecommunications companies
non-recurring and recurring fees for services including installation,
activation, monthly line costs, maintenance and repair of circuits
between and among our digital subscriber line access multiplexers and our
regional data centers, customer backhaul, and end-user lines. As our end-
user base grows, we expect that the largest element of network and
product cost will be the traditional telephone companies' charges for our
leased copper lines.
. Other costs. Other costs that we incur include those for materials in
installation and the servicing of customers and end-users, and the cost
of customer premise equipment.
The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any region involve the procurement, design and construction of our
central office cages, end-user DSL line cards, and expenditures for other
elements of our network design, which includes a regional data center in each
region. We expect that the average capital cost to deploy our facilities in a
central office, excluding end-user line cards, will be approximately $85,000
per central office facility. Following the buildout of our central office
space, the major portion of our capital expenditures is the purchase of DSL
line cards to support incremental subscribers. We expect that the average cost
of such line cards will decline over the next several years. 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 our network, we will use our capital
for marketing our services, acquiring Internet service provider and enterprise
customers, and funding our customer care and field service operations.
Recent Developments
We recently entered into strategic relationships with AT&T, NEXTLINK and
Qwest. As part of these strategic relationships, we received equity
investments of $25 million from AT&T Ventures, $20 million from NEXTLINK and
$15 million from Qwest. Furthermore, AT&T, NEXTLINK and Qwest each entered
into commercial agreements with us providing for the purchase, marketing and
resale of our services, our purchase of fiber optic transport bandwidth, and
collocation of network equipment. As a result, we expect that in the future
AT&T, NEXTLINK, Qwest and other potential third parties, if any, will
increasingly account for a significant portion of new line orders. See "Risk
Factors--We depend on Internet service providers and other third parties for
the marketing and sale of our services."
On January 27, 1999, we completed our initial public offering of 8,970,000
shares of our common stock at an initial public offering price of $18.00 per
share. Net proceeds to us from this initial public offering were
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approximately $150.2 million after deducting underwriting discounts and
commissions and estimated offering expenses. On February 18, 1999, we
completed the issuance of the old notes with an aggregate principal amount of
$215.0 million. Net proceeds from the issuance of the old notes were
approximately $205.1 million. At closing of the old note issuance, we used a
portion of the net proceeds to purchase government securities, which were
pledged as collateral for the payment of the first six scheduled interest
payments on the new notes.
On April 20, 1999, we launched our TeleSurfer and TeleSurfer Pro services
for the consumer internet market. The monthly recurring charges for such
services are significantly lower than those for our business grade services.
As a result, our profit margins on such services are lower than for our
business grade services. However, the market for consumer services is very
large and its increased volumes could potentially offset the impact of lower
prices. Moreover, revenues derived from consumer grade services will leverage
off our existing network infrastructure. Our overall margins will depend on
the mix and volume of business and consumer customers, of which consumer grade
services could comprise a significant percentage. See "Risk Factors--We may
experience decreasing prices for our services, which may impair our ability to
achieve profitability or positive cash flow."
Results of Operations
Our operations from inception in October 1996 to December 1997 were limited
primarily to the development of the technology and activities related to
commencing our business operations. Therefore, our revenues and expenditures
during this period is not indicative of revenues which may be attained or
expenditures which may be incurred by us in future periods. In particular, our
expenditure levels during the year ended December 31, 1997 do not reflect the
issuance of the 1998 discount notes in March 1998 and the related interest and
amortization charges, which were $16.0 million during the year ending December
31, 1998.
Revenues
We recorded revenues of approximately $26,000 for the year ended December
31, 1997 and approximately $5.3 million for the year ended December 31, 1998.
This increase is attributable to growth in the number of customers and end-
users resulting from our increased sales and marketing efforts and the
expansion of our network in the San Francisco Bay Area and to a lesser extent
in the Los Angeles, New York and Boston metropolitan areas. As of December 31,
1998, we had an installed base of over 3,900 end-user lines with a network
that passed approximately 6.0 million homes and businesses. We expect revenues
to increase in future periods as we expand our network within our existing
regions, deploy networks in new regions and increase our sales and marketing
efforts in all of our target regions.
Network and Product Costs
We recorded network and product costs of approximately $54,000 for the year
ended December 31, 1997 and approximately $4.6 million for the year ended
December 31, 1998. This increase is attributable to the expansion of our
network and increased orders resulting from our sales and marketing efforts.
We expect network and product 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 our business, the development of
corporate identification, promotional and advertising materials, expenses for
the establishment of our management team, and sales commissions. These
expenses increased from $2.4 million for the year ended December 31, 1997 to
$31.0 million for the year ended December 31, 1998. This increase is
attributable to growth in headcount in all areas of our company as we expanded
our sales and marketing efforts, expanded the deployment of our networks and
built our operating infrastructure. Sales, marketing, general and
administrative expenses are expected to increase significantly as we continue
to expand our business.
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Deferred Compensation and Intangible Asset Amortization
Through December 31, 1998, we recorded a total of approximately $9.0
million of deferred compensation, with an unamortized balance of approximately
$4.7 million on our December 31, 1998 balance sheet. This deferred
compensation is a result of us granting stock options to our employees with
exercise prices per share subsequently determined to be below the fair values
per share for accounting purposes of our common stock at the dates of grant.
We are amortizing the deferred compensation over the vesting period of the
applicable option. Amortization of deferred compensation was $295,000 during
the year ended December 31, 1997 and $4.0 million during the year ended
December 31, 1998.
In January, 1999, we recorded intangible assets of $28.7 million from the
issuance of preferred stock to AT&T Ventures, NEXTLINK and Qwest. Annual
amortization of this asset will be approximately $8.4 million in each of the
three years ending December 31, 2001, decreasing to approximately $1.2 million
per year through the year ending December 31, 2004.
Depreciation and Amortization
Depreciation and amortization includes: (i) depreciation of network costs
and related equipment, (ii) depreciation of information systems, furniture and
fixtures, (iii) amortization of improvements to central offices, regional data
centers and network operations center facilities and corporate facilities and
(iv) amortization of capitalized software costs. Depreciation and amortization
was approximately $70,000 for the year ended December 31, 1997 and
approximately $3.4 million for the year ended December 31, 1998. The increase
was due to the increase in equipment and facilities placed in service
throughout the period. We expect depreciation and amortization to increase
significantly as we increase our capital expenditures to expand our network.
Net Interest Income and Expense
Net interest income and expense consists primarily of interest income on
our cash balance and interest expense associated with our debt. For the year
ended December 31, 1997, net interest income was approximately $155,000, and
was primarily attributable to the interest income earned from the proceeds
raised in the our preferred stock financing in July 1997. Interest income was
approximately $4.8 million for the year ending December 31, 1998. This
interest income was earned primarily from the investment of the proceeds
raised in the issuance of our 1998 discount notes in March 1998. Interest
expense for the year ended December 31, 1998 was approximately $15.2 million
and consisted primarily of interest on the 1998 discount notes and capital
lease obligations. We expect interest expense to increase significantly
because the 1998 discount notes accrete to $260 million by March 15, 2003 and
we issued the old notes in February 1999.
Income Taxes
Income taxes consist of federal, state and local taxes, when applicable. We
expect significant consolidated net losses for the foreseeable future which
should generate net operating loss carryforwards. However, our ability to use
net operating losses may be subject to annual limitations. In addition, income
taxes may be payable during this time due to operating income in certain tax
jurisdictions. In the future, if we achieve operating profits and the net
operating losses have been exhausted or have expired, we may experience
significant tax expense. We recognized no provision for taxes because we
operated at a loss throughout 1997 and 1998.
Liquidity and Capital Resources
Our operations have required significant capital investment for the
procurement, design and construction of our central office cages, the purchase
of telecommunications equipment and the design and development of our
networks. Capital expenditures were approximately $59.5 million for the year
ending December 31, 1998. We expect that our capital expenditures will be
substantially higher in future periods in connection with the purchase of
infrastructure equipment necessary for the development and expansion of our
network and the development of new regions.
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From our inception through December 31, 1998, we financed our 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 1998 discount notes. As of December 31, 1998, we had an
accumulated deficit of $50.7 million, and cash and cash equivalents of $64.5
million.
Net cash used in our operating activities was approximately $1.9 million
and $9.1 million for the year ended December 31, 1997 and 1998, respectively.
The net cash used for operating activities during these periods was primarily
due to net losses and increases in current assets, offset by non-cash
expenses, increases in accounts payable and other accrued liabilities. Net
cash used in our investing activities was $2.5 million and $61.3 million for
the year ended December 31, 1997 and 1998, respectively. Net cash provided by
financing activities for the year ended December 31, 1997 was $8.8 million and
related to the issuance of common and preferred stock. Net cash provided by
financing activities for the year ended December 31, 1998 was $130.4 million
which primarily related to the issuance of the 1998 discount notes and series
C preferred stock.
In January 1999, we received equity investments of $25 million from AT&T
Ventures, $20 million from NEXTLINK and $15 million from Qwest, representing
an aggregate equity investment of $60 million.
On January 27, 1999, we completed an initial public offering of 8,970,000
shares of our common stock at an initial public offering price of $18.00 per
share. Our net proceeds from the initial public offering were $150.2 million
after deducting underwriting discounts and commissions and estimated offering
expenses.
On February 18, 1999, we completed the issuance of the old notes with an
aggregate principal amount of $215.0 million. Net proceeds from the old notes
were approximately $205.1 million. At the closing of the issuance of the old
notes, we used a portion of the net proceeds to purchase government securities
which were pledged as collateral for the payment of the first six scheduled
interest payments on the new notes.
We expect to experience substantial negative cash flow from operating
activities and negative cash flow before financing activities for at least the
next several years due to continued development, commercial deployment and
expansion of our networks. Our future cash requirements for developing,
deploying and enhancing our networks and operating our business, as well as
our revenues, will depend on a number of factors including:
. the number of regions entered and the timing of entry and services
offered;
. network deployment schedules and associated costs due to issues,
including the physical requirements of the central offices;
. the rate at which customers and end-users purchase our services and the
pricing of such services;
. the level of marketing required to acquire and retain customers and to
attain a competitive position in the marketplace;
. the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology; and
. unanticipated opportunities.
Accordingly, we cannot predict when or to what extent it may be required to
raise additional capital for developing, deploying and enhancing our networks
and operating our business. We may incur additional indebtedness if such
indebtedness becomes available on favorable terms to finance the continued
development, commercial deployment and expansion of our network and for
funding operating losses or to take advantage of unanticipated opportunities.
If we are unable to obtain required additional capital or are required to
obtain it on terms less satisfactory than we desire, we may be required to
delay the expansion of our business or take or forego actions, any or all of
which could materially adversely affect our business, prospects, operating
results, financial condition and our ability to service and repay our
indebtedness, including the new notes.
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In addition, we may wish to selectively pursue possible acquisitions of
businesses, technologies or products complementary to ours in the future in
order to expand our geographic presence and achieve operating efficiencies.
There can be no assurance that we will have sufficient liquidity, or be able
to obtain additional debt or equity financing on favorable terms or at all, in
order to finance such an acquisition. However, no acquisitions are currently
contemplated.
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. We have reviewed
our internally developed information technology systems and programs and
believe that our systems are Year 2000 compliant and that there are no
significant Year 2000 issues within our systems or services. We have not
reviewed our 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. We
believe that our non-information technology systems will not present any
significant Year 2000 issues, although there can be no assurance in this
regard. In addition, we utilize third-party equipment and software and
interact with traditional telephone companies that have equipment and software
that may not be Year 2000 compliant. Failure of such third-party or
traditional telephone company equipment or software to operate properly with
regard to the year 2000 and thereafter could require us to incur unanticipated
expenses to remedy any problems, which could have a material adverse effect on
our business, prospects, operating results and financial condition.
Furthermore, the purchasing patterns of our Internet service provider and
enterprise 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 our
services, which could have a material adverse effect on the our business,
prospects, operating results, and financial condition.
We have not made any assessment of the Year 2000 risks associated with our
third-party or traditional telephone company equipment or software or with our
Internet service provider and enterprise customers. We have not determined the
risks associated with the reasonably likely worst-case scenario and have not
made any contingency plans to address such risks. However, we intend to devise
a Year 2000 contingency plan prior to December 31, 1999. See "Risk Factors--
Our failure and the failure of third parties to be Year 2000 compliant could
negatively impact our business."
Forward Looking Statements
The statements contained in this prospectus that are not historical facts
are "forward-looking statements" (as such term is defined in Section 27A of
the Securities Act and Section 21E of the Exchange Act), 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. Examples of such
forward-looking statements include:
. our plans to expand our existing network or to commence service in new
regions;
. the market opportunity presented by our target regions;
. estimates regarding the timing of launching our service in new regions;
. expectations regarding the extent to which enterprise customers roll out
our service;
. expectations regarding our relationships with AT&T, NEXTLINK, Qwest and
other potential third parties;
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. expectations as to pricing for our services in the future;
. statements regarding development of our business;
. the estimate of market sizes and addressable markets for our services and
products;
. the estimates of future operating results;
. our anticipated capital expenditures;
. the effect of regulatory reform and regulatory litigation; and
. other statements contained in this prospectus regarding matters that are
not historical facts.
These statements are only estimates or predictions and cannot be relied
upon. We can give you no assurance that future results will be achieved.
Actual events or results may differ materially as a result of risks facing us
or actual results differing from the assumptions underlying such statements.
Such risks and assumptions that could cause actual results to vary materially
from the future results indicated, expressed or implied in such forward-
looking statements include our ability to:
. successfully market our services to current and new customers;
. generate customer demand for our services in the particular regions where
we plan to market services;
. achieve favorable pricing for our services;
. respond to increasing competition;
. manage growth of our operations;
. access regions and negotiate suitable interconnection agreements with the
traditional telephone companies, all in a timely manner, at reasonable
costs and on satisfactory terms and conditions consistent with
regulatory, legislative and judicial developments.
All written and oral forward-looking statements made in connection with
this prospectus which are attributable to us or persons acting on our behalf
are expressly qualified in their entirety by the "Risk Factors" and other
cautionary statements included in this prospectus. We disclaim any obligation
to update information contained in any forward-looking statement.
Quantitative and Qualitative Disclosures about Market Risk
Our exposure to financial market risk, including changes in interest rates
and marketable equity security prices, relates primarily to our investment
portfolio and outstanding debt obligations. We typically do not attempt to
reduce or eliminate our market exposure on our investment securities because a
substantial majority of our investments are in fixed-rate, short-term
securities. We do not have any derivative instruments. The fair value of our
investment portfolio or related income would not be significantly impacted by
either a 100 basis point increase or decrease in interest rates due mainly to
the fixed-rate, short-term nature of the substantial majority of our
investment portfolio. In addition, substantially all of our outstanding
indebtedness at December 31, 1998, including our 1998 discount notes, is
fixed-rate debt.
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BUSINESS
The following discussion contains forward-looking statements that involve
risks and uncertainties. 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 in "Risk Factors" and elsewhere
in this prospectus. We disclaim any obligation to update information contained
in any forward-looking statement. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Forward Looking Statements."
Overview
We are a leading high-speed Internet and network access provider offering
DSL services to Internet subscriber provider and enterprise customers.
Internet service providers purchase our services in order to provide high-
speed Internet access to their business and consumer end-users. Enterprise
customers purchase our services to provide employees with remote access to the
enterprise's local area networks to improve employee productivity and reduce
operating costs. We refer to such services as remote local area network (RLAN)
services.
We believe our services offer a superior value proposition as compared to
currently available high-speed Internet and network access alternatives. Our
services are provided over standard copper telephone lines at speeds of up to
1.5 Mbps, over 25 times the speed available through a 56.6 Kbps modem. As of
January 31, 1999 we had installed over 4,000 DSL lines and received orders for
our services from over 100 Internet service provider and enterprise customers,
including Cisco Systems, Concentric Network, Epoch Networks, Oracle,
PeopleSoft, Stanford University, Verio and Whole Earth Networks.
We have introduced our services in the following metropolitan areas:
<TABLE>
<CAPTION>
December 1997 August 1998 December 1998 March 1999 April 1999
------------- ----------- ---------------- ------------ ----------
<S> <C> <C> <C> <C>
San Francisco Bay Area Los Angeles Washington, D.C. Philadelphia Baltimore
New York Seattle Sacramento
Boston
</TABLE>
In March 1998, we raised approximately $135 million through the issuance of
the 1998 discount notes to fund the initial deployment of our networks. As a
result of the strong market demand for high-speed Internet and network access,
we plan to build our networks and offer our services in 22 regions nationwide.
We estimate that when complete, our networks in these 22 regions will enable
us to provide service to over 28 million homes and businesses in 28 of the top
50 metropolitan statistical areas in the United States.
In January 1999, we entered into strategic relationships with AT&T Corp.,
NEXTLINK Communications, Inc. and Qwest Communications Corporation. As part of
these strategic relationships, we received equity investments of $25 million
from AT&T Ventures, $20 million from NEXTLINK and $15 million from Qwest.
Furthermore, these strategic investors each entered into commercial agreements
with us providing for the purchase, marketing and resale of our services, the
purchase by us of fiber optic transport bandwidth, and collocation of network
equipment.
On January 27, 1999, we completed the initial public offering of 8,970,000
shares of common stock at an initial public offering price of $18.00 per
share. We received net proceeds from the initial public offering of $150.2
million after deducting underwriting discounts and commissions and estimated
offering expenses.
On February 18, 1999, we completed the offering of the old notes with an
aggregate principal amount of $215 million. We received net proceeds of $205.1
million from this offering, $74.0 million of which was used to purchase
pledged securities to secure the payment of the first six scheduled interest
payments on the new notes.
We believe that our business model offers attractive economics. Through our
use of DSL technology, we can effectively leverage the existing telephone
network copper infrastructure to deploy service more quickly and at lower
costs than technologies such as cable modems and wireless data networks that
require large initial infrastructure investments before service can be
provided.
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Industry Background
Growing Market Demand for High-Speed Digital Communications Bandwidth
High-speed connectivity has become important to small- and medium-sized
businesses and consumers due to the dramatic increase in Internet usage.
According to International Data Corporation, the number of Internet users
worldwide reached approximately 69 million in 1997 and is forecasted to grow
to approximately 320 million by 2002. The popularity of the Internet with
consumers has driven the rapid proliferation of the Internet as a commercial
medium. Businesses are increasingly establishing Web sites and corporate
intranets and extranets to expand their customer reach and improve their
communications efficiency. Consumers are increasingly using the Internet to
carry out consumer-based transactions. International Data Corporation also
estimates that the value of goods and services sold worldwide through the
Internet will increase from $12 billion in 1997 to over $400 billion in 2002.
Accordingly, to remain competitive, small- and medium-sized businesses
increasingly need high-speed Internet connections to maintain complex Web
sites, access critical business information and communicate more effectively
with employees, customers and business partners. High-speed digital
connections are also becoming increasingly important to businesses and
consumers as more high bandwidth information and applications become available
on the Internet.
The demand for high-speed digital communications services for RLAN access
is also growing rapidly. Over the past ten years, high-speed local area
networks have become increasingly important to enterprises to enable employees
to share information, send e-mail, search databases and conduct business. We
believe that a large majority of personal computers used in enterprises are
connected to local area networks. Enterprises are now seeking to extend this
same high-speed connectivity to employees accessing the local area networks
from home to improve employee productivity and reduce operating costs.
Industry analysts estimate that the number of remote access lines in the U.S.
will grow from approximately ten million in 1996 to approximately 30 million
in 2000, a compound annual growth rate in excess of 30%.
As use of the Internet, intranets and extranets increases, we expect the
market size for both small- and medium-sized business and consumer Internet
and RLAN access to continue to grow rapidly causing the demand for high-speed
digital communications services to also grow rapidly. However, the full
potential of Internet and local area network applications cannot be realized
without removing the performance bottlenecks of the existing public switched
telephone network. Increases in telecommunications bandwidth have
significantly lagged improvements in microprocessor performance over the last
ten years. Since 1988, microprocessor performance has improved nearly 80-fold,
while the fastest consumer modem connection has improved from 9.6 Kbps to 56.6
Kbps, a factor of six. According to industry analysts, there are nearly 40
million personal computers in U.S. homes today, and most of them can only
connect to the Internet or their corporate local area network by low-speed
analog lines. Higher speed connections are available, including:
. Integrated Services Digital Networks (ISDNs)--An ISDN provides standard
interfaces for digital communication networks and is capable of carrying
data, voice, and video over digital circuits. ISDN protocols are used
worldwide for connections to public ISDN networks or to attach ISDN
devices to ISDN-capable PBX systems.
. T1 Line--This is a Bell system term for a digital transmission link with
a capacity of 1.544 Mbps.
. Frame Relay--A high-speed packet-switched data communications protocol.
While these services have recently experienced dramatic growth in the U.S.,
they are expensive and complex to order, install and maintain.
Emergence of DSL Technology
DSL technology emerged in 1990 and is commercially available today to
address the performance bottlenecks of the public switched telephone network.
DSL equipment, when deployed at each end of standard copper telephone lines,
increases the data carrying capacity of these lines from analog modem speeds
of 56.6 Kbps and ISDN speeds of 128 Kbps to DSL speeds of up to 6 Mbps
depending on the length and condition of the copper line. Also, recent
advances in semiconductor technology and digital signal processing algorithms
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and falling equipment prices have made the deployment of DSL technology on a
widespread basis more economical. We anticipate that equipment prices will
continue to fall as a result of continued advances in semiconductor
technologies and increases in equipment production volumes.
Because DSL technology reuses the existing copper plant, it is
significantly less expensive to deploy on a broad scale than alternative
technologies, such as cable modems, wireless data and satellite data. As a
result, a significant portion of the investment in a DSL network is success-
based, requiring a comparatively lower initial fixed investment. Subsequent
variable investments in DSL technology are directly related to the number of
paying customers.
Impact of the Telecommunications Act of 1996
The passage of the 1996 Telecommunications Act created a legal framework
for competitive telecommunications companies to provide local analog and
digital communications services in competition with the traditional telephone
companies. The 1996 Telecommunications Act eliminated a substantial barrier to
entry for competitive telecommunications companies by enabling them to
leverage the existing infrastructure built by the traditional telephone
companies, which required a $200 billion investment by these telephone
companies and their ratepayers, rather than constructing a competing
infrastructure at significant cost. The 1996 Telecommunications Act requires
traditional telephone companies, among other things,
. to allow competitive telecommunications companies to lease copper lines
on a line by line basis;
. to obtain central office space from the traditional telephone companies
for the DSL and other equipment used to connect to the leased copper
lines;
. to lease access on the traditional telephone companies' inter-central
office fiber backbone to link the competitive telecommunications
companies' equipment; and
. to allow competitive telecommunications companies to use their
operational support systems to place orders and access their databases.
The 1996 Telecommunications Act in particular emphasized the need for
competition-driven innovations in the deployment of advanced
telecommunications services, such as our DSL services.
Our Competitive Strengths
We were formed to capitalize on the substantial business opportunity
created by the growing demand for Internet and network access, the commercial
availability of low cost DSL technology and the passage of the 1996
Telecommunications Act. Key aspects of our solution to provide high-speed
digital communications services include:
. an attractive value proposition that provides high-speed connections at
similar or lower prices than alternative high-speed technologies
currently available to customers;
. a widely available, continuously connected, secure network that
facilitates deployment of Internet and intranet applications; and
. a management team experienced in the data communications,
telecommunications and personal computer industries.
Attractive Value Proposition. We offer higher bandwidth digital connections
than alternative services at similar or lower prices that do not vary with
usage. For business Internet users, our high-end services offer comparable
bandwidth to T1 and frame relay circuits at approximately 25% of the cost. For
the RLAN market, our mid-range services are three to six times the speed of
ISDN and up to ten times the speed of analog modems at monthly rates similar
to or lower than those for heavily used ISDN lines. We believe that many of
our enterprise customers can justify deploying lines to their employees if
productivity improves by only a few hours per month based on increases in the
number of hours worked and decreases in commute time and time spent
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waiting for information. For consumer Internet users, our consumer services
are comparably priced to current cable modem services.
Widely Available, Always-Connected, Secure Network. Our strategy of
providing blanket coverage in each region we serve is designed to ensure that
our services are available to the vast majority of our customers' end-users.
Our network provides 24-hour, always-on connectivity, unlike ISDN lines and
analog modems which require customers to dial-up each time for Internet or
RLAN access. Also, because we use dedicated connections from each end-user to
the Internet service provider or enterprise network, our customers can reduce
the risk of unauthorized access.
Experienced Management Team. Our management team includes individuals with
extensive experience in the data communications, telecommunications and
personal computer industries, including Robert Knowling, Jr., President and
Chief Executive Officer (former Executive Vice President of Operations and
Technology at U S WEST Communications), founders Charles McMinn, Chairman of
the Board, Charles Haas, Executive Vice President of Sales, and Dhruv Khanna,
Executive Vice President, General Counsel and Secretary (all of whom worked at
Intel), Timothy Laehy, Chief Financial Officer and Vice President, Finance
(former Vice President of Corporate Finance and Treasurer of Leasing
Solutions, Inc.), Rex Cardinale, Chief Technology Officer and Vice President
of Engineering (former General Manager of the cc:Mail division of Lotus
Development Corporation), Catherine Hemmer, President of Operations (former
Vice President, Network Reliability and Operations at U S WEST Communications,
Inc., former General Manager, Network Provisioning at Ameritech Corporation
and former Vice President, Network Services at MFS), Robert Roblin, Executive
Vice President of Marketing (former Executive Vice President of Marketing at
Adobe Systems, Inc. and former Vice President and General Manager of
Marketing, Consumer Division at IBM Corporation), and Robert Davenport, III,
Executive Vice President, Business Development (former Senior Vice President
and Chief Operating Officer of Tele-Communication, Inc.'s Internet Services
subsidiary TCI.NET). We also have in place Regional Presidents to cover all 22
of our regions.
Business Strategy
Our objective is to become the leading high-speed Internet and network
access provider offering DSL services in each region we enter. We introduced
our services in the San Francisco Bay Area in December 1997, in the Los
Angeles, New York and Boston metropolitan areas in August 1998, in the
Washington, D.C. and Seattle metropolitan areas in December 1998, in the
Philadelphia and Sacramento metropolitan areas in March 1999 and the Baltimore
metropolitan area in April 1999. We plan to increase our network to 22
regions. The key elements of our strategy are as follows:
Secure Competitive Local Exchange Carrier Status and Sign Interconnection
Agreements in the Top U.S. Markets. We obtain competitive local exchange
carrier status in each state that we enter and sign interconnection agreements
with the relevant traditional telephone companies. As of January 31, 1999, we
were authorized under state law to operate as a competitive local exchange
carrier in 19 states, had pending applications in seven additional states and
had entered into interconnection agreements with six different major
traditional telephone companies in the majority of the states covering our 22
target markets. We intend to obtain authorization in the other states
necessary to cover our 22 target regions and we are negotiating
interconnection agreements with traditional telephone companies in the
remaining states. In the aggregate, our 22 existing and target regions
represent over 40% of the U.S. population. We believe we have gained a
competitive advantage by rapidly securing competitive local exchange carrier
status and signing interconnection agreements in multiple regions.
Enter and Roll Out Service Rapidly in These Markets. We seek to be the
first competitive telecommunications company to enter and roll out service
broadly in our target regions in order to:
. secure central office space prior to our competitors;
. secure and retain customers before significant DSL competition arises;
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. maintain advantages over competitors through superior coverage and high
customer satisfaction; and
. build the largest volume and market share in order to allow us to reduce
the costs and prices of our services and, where we are first to market,
maintain our leadership position.
Provide Pervasive Coverage. We are pursuing a blanket coverage strategy of
providing service in a substantial majority of the central offices in each
region that we enter since our Internet service provider customers desire to
market their Internet access services on a region-wide basis. Blanket coverage
is also important to our enterprise customers since the typical enterprise
customer desires to offer RLAN access to all employees regardless of where
they reside in the region. In addition, we believe our presence in 22 markets
will allow us to better serve our Internet service provider and enterprise
customers which are increasingly seeking a single supplier in multiple
metropolitan areas.
Focus on Packet Data Services. Although we are authorized to provide both
data and voice services, we are presently focusing on packet data services. We
believe that we can provide a superior digital service while avoiding the
significant investment that would be required to compete in the analog voice
market.
Sell Directly to Internet Service Providers and Enterprises that Can
Provide a Large Number of End-Users. We target Internet service providers that
can offer their end-users cost and performance advantages for Internet access
using our services. Over 100 Internet service providers currently resell our
services. Our direct sales force also specifically targets enterprises that we
estimate to have over 500 existing ISDN or analog modem-based RLAN users. We
believe that we offer these customers higher performance and dedicated
services at similar or lower prices than those of alternative technologies.
Leverage the Success-Based Economics of DSL. Because we use DSL technology,
a significant portion of our capital expenditures are success-based. We
estimate that approximately 50% of our cumulative capital expenditures over
the next five years will be for DSL equipment that is directly related to our
end-user subscription rate.
Establish Relationships with Internet Service Providers and Other Industry
Participants. We do not provide Internet access directly to any of our
customers. Instead, we provide connections to Internet service providers,
which in turn offer high-speed Internet access using our network. In this way,
we:
. carry the traffic of multiple Internet service providers in any region,
increasing our volume and reducing our costs;
. leverage our selling efforts through the sales and support staff of these
Internet service providers;
. offer Internet service providers a non-competitive transport alternative,
since the traditional telephone company typically provides its own
Internet access services in competition with Internet service providers;
and
. provide Internet service providers a high-speed service offering to
compete with cable-based Internet access.
We are developing a service offering that we believe will also be
increasingly attractive to the interexchange carriers (IXCs) and other
competitive telecommunications companies. As we roll out our network in 22
markets nationwide, we can increasingly serve as a single packet-based service
provider to other telecommunications service companies who seek to offer
packet based services to their customers. Also, we can carry the traffic of
multiple IXCs and competitive telecommunications companies and potentially
provide these services at price points that are more attractive than any one
other company can provide for itself. These companies are also seeking an
alternative to dealing with each traditional telephone company in every region
in which they would like to offer service. Finally, since our networks serve
predominately small business and residential end-users, these networks are
complementary to the large business focused networks of these IXCs and other
competitive telecommunications companies. We believe that these are some of
the reasons AT&T, NEXTLINK and Qwest
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have entered into relationships with us. We are currently discussing
relationships with other IXCs and other competitive telecommunications
companies and intend to continue these discussions as our networks are
deployed in our 22 target markets.
Provide a Superior Product and Service Solution. We believe that we can
build a significant competitive position by providing a comprehensive product
and service solution to our customers. We undertake to provide all of the
necessary product and service elements required to establish and maintain
digital services in our target markets including:
. managing the traditional telephone company's delivery and testing of
copper lines used for our service;
. performing any in-building wiring required to initiate service;
. selling and configuring the DSL modem required at each end-user site;
. providing 24 hours, seven days a week (24x7) monitoring of each end-user
line; and
. designing and provisioning an enterprise's overall RLAN network including
equipment selection, programming and troubleshooting.
Our Product and Service Offerings
We offer six business grade services under the TeleSpeed brand to connect
our customers' end-users to our regional data centers. On April 20, 1999, we
introduced two consumer grade service offerings called TeleSurfer and
TeleSurfer Pro. In addition, Internet service provider and enterprise
customers may purchase backhaul services from us to connect their facilities
to our regional data centers.
TeleSpeed Services
Our TeleSpeed services connect individual end-users on conventional copper
lines to our DSL equipment in their serving central office and from there to
our packet-based digital network serving that metropolitan area. A traditional
telephone company's infrastructure consists of numerous central offices which
are connected by a fiber optic backbone to a regional office that routes local
and long distance traffic. Each central office collects the individual copper
lines from end-users' premises in the neighborhood.
The TeleSpeed services are TeleSpeed 144, TeleSpeed 192, TeleSpeed 384,
TeleSpeed 768, TeleSpeed 1.1, TeleSpeed 1.5 and TeleSpeed Remote. The chart
below compares the performance and markets for each of our end-user services
as of December 31, 1998. The particular TeleSpeed service available to an end-
user depends on the user's distance to the central office. We believe that
substantially all of our potential end-users in our target markets can be
served with one of our services. We estimate that approximately 70% of end-
users are within 18,000 feet of a central office and can be served by at least
our TeleSpeed 384 service. We also believe at least a majority of potential
end-users will be able to obtain our highest speed service offering. However,
the specific number of potential end-users for the higher speeds will vary by
central office and by region and will be affected by line quality.
<TABLE>
<CAPTION>
Speed To Speed From Range*
Service End-User End-User (feet) Market/Usage
------- -------- ---------- ------ ------------------------------------
<S> <C> <C> <C> <C>
TeleSpeed 144........... 144 Kbps 144 Kbps 35,000 ISDN replacement, non-standard lines
TeleSpeed 192........... 192 Kbps 192 Kbps 18,000 RLAN, business Internet
TeleSpeed 384........... 384 Kbps 384 Kbps 18,000 RLAN, business Internet
TeleSpeed 768........... 768 Kbps 768 Kbps 13,500 Business Internet
TeleSpeed 1.1........... 1.1 Mbps 1.1 Mbps 12,000 Business Internet
TeleSpeed 1.5........... 1.5 Mbps 384 Kbps 15,000 High-speed Web access
</TABLE>
- --------
* Estimated maximum distance from the end-user to the central office.
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Prices for our end-user services may vary depending upon the performance
level of the service. For example, our TeleSpeed 144 and 192 services are our
lowest priced end-user services and our TeleSpeed 1.1 and 1.5 services are our
highest priced end-user services. Our prices also vary across regions and for
high volume customers that are eligible for volume discounts. See "Risk
Factors--We may experience decreasing prices for our services" for a
discussion of the risks associated with our ability to sustain current price
levels in the future.
TeleSpeed 144. Our TeleSpeed 144 service operates at up to 144 Kbps in each
direction, which is similar to the performance of an ISDN line. This service,
which can use existing ISDN equipment at the end-user site, is targeted at the
ISDN replacement market where its per month flat rate can compare favorably to
ISDN services from the traditional telephone company when per-minute usage
charges apply. It is also the service that we offer on copper lines that are
either too long to carry our higher speed services or are served by digital
loop carrier systems or similar equipment where a continuous copper connection
is not available from the end-user site to the central office.
TeleSpeed 192. This service provides one and a half to three times the
performance of ISDN at similar or lower price points to heavily-used ISDN
lines.
TeleSpeed 384. This service provides three to six times the performance of
ISDN at similar price points to heavily-used ISDN lines.
TeleSpeed 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 768
service is small businesses needing moderate speed access to the Internet but
who have previously been unable to afford the price of such service. The
service also competes favorably from a price/performance standpoint with
traditional fractional T1 and frame relay services for these same customers.
TeleSpeed 1.1. This service provides over two-thirds the bandwidth of a T1
data circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 1.1
service is small businesses needing T1-level access to the Internet which have
previously been unable to afford the price of such service. The service also
competes favorably from a price/performance standpoint with traditional
fractional T1 and frame relay services for these same customers.
TeleSpeed 1.5. TeleSpeed 1.5 is an asymmetric service, i.e., with different
speeds to and from the end-user. This service is intended for end-users who
consume more bandwidth than they generate, and is especially useful for
accessing Web sites. The service also provides the highest performance of any
TeleSpeed service to stream video or other multimedia content to end-user
locations.
TeleSpeed Remote. This nationwide high-speed access service provides secure
interconnection between corporations, remote branch offices and teleworkers in
geographically distant locations. This service is targeted at small and mid-
sized businesses who want high-speed remote office connections at a cost lower
than ISDN or frame relay services.
TeleSurfer Services
<TABLE>
<CAPTION>
Service Speed To End-User Speed From End-User Range* (feet) Market/Usage
------- ----------------- ------------------- ------------- ------------
<S> <C> <C> <C> <C>
TeleSurfer 384 Kbps 128 Kbps 12,000 Consumer
TeleSurfer
Pro 768 Kbps 384 Kbps 12,000 Consumer
</TABLE>
- --------
* Estimated maximum distance from the end user to the central office.
TeleSurfer. This consumer grade service is an asymmetric service, offering
384 Kbps downstream and 128 Kbps upstream. This service is the base consumer
service. The target market for this service is consumers using either dial-up
analog or ISDN connections for web browsers.
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TeleSurfer Pro. This is a premium consumer grade asymmetric service,
offering 768 Kbps downstream and 386 Kbps upstream. The target market for this
service is consumers using either dial-up analog or ISDN connections for web
browsers.
Backhaul Services
We provide two backhaul services from our regional network to an Internet
service provider or enterprise customer site. These services include the
aggregation of all individual end-users in a metropolitan area and
transmission of the packet information to the customer on a single high-speed
line. The services, prices and suggested maximum aggregation of end-user
traffic are as follows:
Covad DS1. Our DS1 backhaul service is intended for the small business with
up to 50 RLAN end-users. The service operates at 1.5 Mbps and implements a
frame relay protocol compatible with most low-end and mid-range routers. As of
December 31, 1998, the price for such service was $975 per month.
Covad DS3. Our DS3 backhaul service is targeted to large Internet service
providers and enterprises with up to 1,000 end-users. The service utilizes an
asynchronous transfer mode protocol that efficiently handles the high data
rates involved and operates at up to 45 Mbps. As of December 31, 1998, the
price for such service was $4,000 per month.
Non-Recurring Charges
In addition to monthly service charges, as of December 31, 1998, we impose
non-recurring order setup charges of $325 for Internet service provider and
RLAN end-users, $2,500 for a DS1 backhaul and $7,500 for a DS3 backhaul.
Customers must also have purchased a DSL modem (priced from $399 to $600),
from us or a third party for each end-user of our services.
Our Regional Rollout
As part of our strategy to become a leading provider of DSL high-speed
digital communications services in the U.S., we intend to build networks and
offer services in 22 regions. We introduced our services in the San Francisco
Bay Area in December 1997, in the Los Angeles, New York and Boston
metropolitan areas in August 1998, in the Washington, D.C. and Seattle
metropolitan areas in December 1998, in the Philadelphia and Sacramento
metropolitan areas in March 1999 and in the Baltimore metropolitan area in
April 1999. As a result of the strong market demand for high-speed digital
communications services, we have increased our target markets to the following
22 regions:
<TABLE>
<CAPTION>
West Central South East
------------- ----------- ------- ----------------
<S> <C> <C> <C>
Los Angeles Chicago Atlanta Baltimore
Portland Denver Austin Boston
Sacramento Detroit Dallas New York
San Diego Minneapolis Houston Philadelphia
San Francisco Phoenix Miami Washington, D.C.
Seattle Raleigh
</TABLE>
Customers
We offer our services to Internet service providers and enterprises.
According to Claritas, Inc., a leading provider of diagnostic databases, there
are over 169,000 businesses in the U.S. with over 100 employees, of which we
estimate that 34,000 are in the six metropolitan areas that we initially
targeted and approximately 71,000 are in all of our 22 targeted regions. As of
January 31, 1999, we had entered into service agreements, had over 4,000 end-
user lines in operation and were in the initial stages of provisioning
backhaul service and end-user
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lines to over 100 additional Internet service provider and enterprise
customers. The following is a list of selected Internet service provider and
enterprise customers:
<TABLE>
<CAPTION>
Selected Internet Service Provider
Customers Selected Enterprise Customers
---------------------------------- -----------------------------
<C> <S>
Bay Junction Technology Apple Computer
Brainstorm Networks Cisco Systems
Concentric Network Corporation E*Trade Group
Direct Network Access, Ltd.
(DNAI) Fireman's Fund Insurance
DSL Networks Inc. Inktomi
Epoch Networks Intel
Flashcom, Inc. Oracle Corporation
Globix Corporation PeopleSoft
Lan Minds, Inc. Spelling Entertainment
Prodigy Stanford University
Slip.Net, Inc. Sun Microsystems
Verio Inc. Tandem Computers
Whole Earth Networks WebTV
</TABLE>
Our agreements with Internet service providers generally have terms of one
year and are nonexclusive. We do not require the Internet service providers to
generate a minimum number of end-users and generally grant volume discounts
based on order volume. See "Risk Factors--We depend on Internet service
providers and other third parties for the marketing and sale of our services."
Our practice with respect to our enterprise customers has been to enter
into an arrangement for a negotiated price to install the service initially to
a small number of end-users. An enterprise customer decides whether to
implement a broad rollout of our services after evaluating the results of this
initial phase of deployment. To date, an enterprise customer's initial phase
of deployment and its decision to roll out our service to additional end users
has taken at least six months, and has generally taken longer than we
originally expected. As of December 31, 1998, a substantial majority of our
enterprise customers had not yet rolled out our services broadly to their
employees. We will not receive significant revenue from an enterprise customer
until and unless these rollouts occur. During the lengthy sales cycle for an
enterprise customer, we incur significant expenses in advance of the receipt
of revenues.
Sales and Marketing
Business and Consumer Internet. For the business and consumer Internet
access markets, we sell our service to Internet service providers that combine
our lines with their Internet access services and resell the combination to
their existing and new end-users. We address these markets through sales and
marketing personnel dedicated to the Internet service providers sales channel.
We supplement our sales efforts to Internet service providers through training
programs and marketing programs that include promotions and sales incentives
designed to encourage the Internet service providers to sell our services
instead of those of its competitors. As of December 31, 1998, we had more than
100 Internet service providers customers with their own sales personnel
marketing Internet services. See "Risk Factors--We depend on Internet service
providers and other third parties for the marketing and sale of our services."
Remote Local Area Network. We market our RLAN services to businesses
through a direct sales force, augmented by marketing programs with value added
resellers and IXCs. The direct sales force is organized by region, each
managed by a regional sales director who is responsible for lead generation
and sales and marketing efforts to RLAN customers. The sales force is directed
to deal directly with the chief information officer and the telecommunications
manager responsible for remote access within an enterprise. We augment our
sales efforts to RLAN customers through partnerships with value added
resellers, including systems integrators that can offer our TeleSpeed service
as part of a complete work-at-home solution to businesses.
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Third Party Relationships. A key element of our strategy is to enter into
relationships with leading telecommunications companies, including competitive
telecommunications companies and IXCs, in which those companies resell our
TeleSpeed and TeleSurfer services to their customers. For example, we recently
entered into commercial agreements with each of AT&T, NEXTLINK and Qwest
providing for the purchase, marketing and resale of our services, primarily to
their small business and enterprise customers. We believe that these indirect
sales channels will enable us to penetrate our target markets more rapidly and
eventually will generate the majority of sales of our services. See "Risk
Factors--We depend on Internet service providers and other third parties for
the marketing and sale of our services."
We are also pursuing several types of joint marketing arrangements with our
Internet service providers and enterprise customers. In addition, certain of
our equipment suppliers have promoted our services through seminars to
corporate communications managers in the San Francisco Bay Area. We also
support our sales efforts with marketing efforts that include advertising
programs through radio and other popular media, attendance at trade shows and
presentations at industry conferences.
Service Deployment and Operations
Internet service providers and corporate communications managers typically
have had to assemble their digital communications connections using multiple
service and equipment suppliers. This leads to additional work, cost and
coordination problems. With our TeleSpeed service, we emphasize a one-stop
service solution for our customers. This service solution includes:
. extending our network to customers and end-users;
. end-user premise wiring and modem configuration;
. ongoing network monitoring, customer reporting; and
. customer service and technical support.
Extending our Network to Customers and End-Users. We work with our
Internet service provider and enterprise customers to extend our network to
each customer premise and each end-user premise by ordering circuits from the
traditional telephone company or a competitive telecommunications company,
interconnecting the customers and end-users to our network, testing the
circuits, configuring customer routers or switches and end-user routers and
monitoring the circuits from the network operations center.
End-User Premises Wiring. We use our own and subcontracted field service
crews and trucks to perform any required inside wiring at each end-user site.
Network Monitoring. We monitor our network from the network operations
center on a continuous basis, which often enables the correction of potential
network problems before a customer or end-user is affected. We have also
developed network capability to provide Internet service provider and
enterprise customers direct monitoring access of their end-users for more
efficient monitoring of their own network performance.
Customer Reporting. We communicate regularly with our customers about the
status of their end-users. We also operate a toll-free customer care help
line. Additionally, we provide Web-based tools to allow individual Internet
service providers and enterprise communications managers to monitor their end-
users directly, to place orders for new end-users, to enter trouble tickets on
end-user lines and to communicate with us on an ongoing basis.
Customer Service and Technical Support. We provide 24x7 on-line support to
our Internet service provider customers and enterprise communications
managers. The Internet service provider and communications manager serve as
the initial contact for service and technical support, and we provide the
second level of support. By avoiding the higher cost of providing direct end-
user support, we believe we can grow our customer base more rapidly with lower
customer support costs.
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Network Architecture and Technology
The key design principles of our network are to provide: (i) robust network
security required for enterprise intranet applications, (ii) consistent and
scalable performance and (iii) intelligent end-to-end network management.
Robust Network Security. Modem access to enterprise networks presents
significant security risks, since any telephone can be used to attempt to
access such a network simply by dialing the telephone number. As a result,
enterprises expend significant effort and resources to prevent unauthorized
access. Enterprises also typically limit remote access users to reading e-mail
or other non-sensitive applications. Our network is designed to provide
enhanced security to ensure secure availability of all internal applications
and information for remote locations. Our permanent virtual circuit network
architecture connects individual end-users at fixed locations to a single
enterprise, which reduces the possibility of unauthorized access and allows
our customers to safely transmit sensitive information and applications over
our TeleSpeed lines.
Consistent and Scalable Performance. We believe that eventually public
packet networks will evolve to replace over 40 million modems currently
connected to circuit switched networks that have been deployed in the U.S. As
such, we designed our network for scalability and consistent performance to
all users as the network grows. We have designed a "star topology" network
similar to the most popular local area network networking architecture
currently used in high performance enterprise networks. In this model, new
capacity is added automatically as each new user receives a new line. We also
use asynchronous transfer mode equipment in our networks that implement packet
switching directly in silicon circuits rather than slower router-based designs
that implement switching in router software.
Intelligent End-to-End Network Management. Because the customers' and end-
users' lines are continuously connected they can also always be monitored. We
have visibility from the Internet service provider or enterprise site across
the network and into the end-user's home or business. Because our network is
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.
The primary components of our network are the network operations center,
regional data centers, our high-speed private metropolitan networks, central
office spaces, including digital subscriber line access multiplexers (DSLAMs),
copper telephone lines and DSL modems.
Network Operations Center. Our entire network is managed from the network
operations center. We provide end-to-end network management using advanced
network management tools on a 24x7 basis, which enhances our ability to
address performance or connectivity issues before they affect the end-user
experience. From the network operations center, we can monitor the equipment
and circuits in each metropolitan network (including the asynchronous transfer
mode equipment), each central office (including DSLAMs) and individual end-
user lines (including the DSL modems). Currently, the network operations
center is located within our San Francisco Bay Area regional data center. See
"Risk Factors--A system failure could delay or interrupt service to our
customers."
Regional Data Centers. The regional data centers act as service hubs for
each metropolitan area that we enter. Data and network management traffic from
each central office is collected at the regional data center and switched to
our network operations center. We design the regional data centers for high
availability including battery backup power, redundant equipment and active
network monitoring.
Private Metropolitan Network. We operate our own private metropolitan
network in each region that we enter. The network consists of high-speed
asynchronous transfer mode communications circuits that we lease to connect
our regional data centers, our equipment in individual central offices and our
enterprise and Internet service provider customers. This network operates at a
speed of 45 to 155 Mbps.
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Central Office Spaces. Through our interconnection agreements with the
traditional telephone companies, we seek to secure space in every central
office where we desire to offer service. These central office spaces are
designed to offer the same high reliability and availability standards as the
traditional telephone company's other central office space. We require access
to these spaces for our equipment and for persons employed by, or under
contract with, us. We place DSLAMs in our central office spaces to provide the
high-speed DSL signals on each copper line to our end-users. We expect to
deploy 40 to 250 central office spaces in any metropolitan area that we enter.
As of January 31, 1999, we had over 165 central office spaces operational. In
addition, we have a significant number of additional spaces under construction
as well as other spaces on order from various traditional telephone companies.
In December 1998, we entered into a professional service arrangement with
Lucent Technologies to augment and accelerate our ability to deploy our
central office facilities.
Copper Telephone Lines. We lease the copper telephone lines running to end-
users from the traditional telephone companies under terms specified in our
interconnection agreements. We lease lines that, in numerous cases, must be
specially conditioned by the traditional telephone companies to carry digital
signals, usually at an additional charge relative to that for voice grade
copper lines. The price we are obligated to pay for these lines currently
varies from $4 to $43 per month per line with additional one-time charges in
some cases for installation, modification or removal of lines.
DSL Modems and On-Site Connectivity. We buy our DSL modems from our
suppliers for resale to our Internet service provider or enterprise customers
for use by their end-users. We configure and install these modems along with
any required on-site wiring needed to connect the modem to the copper line
leased from the traditional telephone company. For the most part, the DSL
modem and DSLAM equipment used must come from the same vendor for all
services, since there are not yet interoperability standards for the equipment
used in our higher-speed services.
We are also pursuing a program of ongoing network development. Our service
development and engineering efforts focus on the design and development of new
technologies and services to increase the speed, efficiency, reliability and
security of our network and to facilitate the development of network
applications by third parties that will increase the use of our network. See
"Risk Factors--The scalability and speed of our network remains largely
unproven."
Competition
The markets for business and consumer Internet access and RLAN access
services are intensely competitive. We expect that these markets will become
increasingly competitive in the future. We face competition from traditional
telephone companies, cable modem service providers, traditional and new
national long distance carriers, Internet service providers, on-line service
providers, wireless and satellite service providers and other competitive
telecommunications companies. The principal bases of competition in our
markets include:
. price/performance;
. breadth of service availability;
. reliability of service;
. network security;
. ease of access and use;
. content bundling;
. customer support;
. brand recognition;
. operating experience;
. relationships with Internet service providers and other third parties;
and
. capital resources.
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Many of our competitors including the traditional telephone companies have,
among other things, greater brand recognition, operating experience, strategic
relationships, and capital resources. Therefore, we cannot assure you that we
will be able to compete effectively in our target markets.
Traditional Telephone Companies. All of the largest traditional telephone
companies present in our target markets have begun offering DSL services or
have announced their intent to provide DSL services in the near term. As a
result, the traditional telephone companies represent strong competition in
all of our target service areas, and we expect this competition to intensify.
For example, the traditional telephone companies have an established brand
name and reputation for high quality in their service areas, possess
sufficient capital to deploy DSL equipment rapidly, have their own copper
lines and can bundle digital data services with their existing analog voice
services to achieve economies of scale in serving customers. Certain of the
traditional telephone companies have aggressively priced their consumer DSL
services as low as $30-$40 per month, placing pricing pressure on our
TeleSpeed services. The traditional telephone companies are also in a position
to offer service from central offices where we are unable to secure space and
offer service because of asserted or actual space restrictions. Accordingly,
we may be unable to compete successfully against the traditional telephone
companies.
Cable Modem Service Providers. Cable modem service providers such as @Home
Network and MediaOne (and their respective cable partners) are deploying high-
speed Internet access services over hybrid fiber coaxial cable networks.
Hybrid fiber coaxial cable is a combination of fiber optic coaxial cable,
which has become the primary architecture utilized by cable operators in
recent and ongoing upgrades of their systems. Where deployed, these networks
provide similar and in some cases higher-speed Internet access and RLAN access
than we provide. They also offer these services at lower price points than our
TeleSpeed services and target residential consumers, as well as business
customers. We believe the cable modem service providers face a number of
challenges that providers of DSL services do not face. For example, different
regions within a metropolitan area may be served by different cable modem
service providers, making it more difficult to offer the blanket coverage
required by potential business and RLAN access customers. Also, much of the
current cable infrastructure in the U.S. must be upgraded to support cable
modems, a process which we believe is significantly more expensive and time-
consuming than the deployment of DSL-based networks. Notwithstanding these
challenges, actual or prospective competition with cable modem service
providers may have a significant negative effect on our ability to secure
customers and may create downward pressure on the prices we can charge for our
services.
National Long Distance Carriers. IXCs, such as AT&T, Sprint, MCI WorldCom
(acquired by MCI WorldCom) and Qwest, have deployed large-scale Internet
access networks and ATM networks, sell connectivity to businesses and
residential customers, and have high brand recognition. They also have
interconnection agreements with many of the traditional telephone companies
and a number of spaces in central offices from which they are currently
offering or could begin to offer competitive DSL services.
Fiber-Based Competitive Telecommunications Companies. Companies such as
Teleport Communications Group, Inc. (acquired by AT&T), Brooks Fiber
Properties, Inc. (acquired by MCI WorldCom) and MFS (acquired by MCI WorldCom)
have extensive fiber networks in many metropolitan areas primarily providing
high-speed digital and voice circuits to large corporations. They also have
interconnection agreements with the traditional telephone companies pursuant
to which they have acquired central office space in many markets targeted by
us. These companies are modifying or could modify their current business focus
to include residential and small business customers using DSL in combination
with their current fiber networks.
Internet Service Providers. Internet service providers such as BBN
(acquired by GTE), UUNET Technologies (acquired by MCI WorldCom), Earthlink
Networks, Concentric Network, Mindspring Enterprises, Netcom On-Line
Communication Services and PSINet provide Internet access to residential and
business customers, generally using the existing public switched telephone
network at ISDN speeds or below. Some Internet service providers such as UUNET
Technologies in California and New York, HarvardNet Inc. and InterAccess have
begun offering DSL-based services. To the extent we are not able to recruit
Internet service
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providers as customers for our service, Internet service providers could
become competitive DSL service providers.
On-line Service Providers. On-line service providers include companies such
as AOL, Excite, Inc. (recently acquired by @Home), Compuserve (acquired by
AOL), MSN (a subsidiary of Microsoft Corp.) and WebTV (acquired by Microsoft
Corp.) that provide, over the Internet and on proprietary online services,
content and applications ranging from news and sports to consumer video
conferencing. These services are designed for broad consumer access over
telecommunications-based transmission media, which enable the provision of
digital services to the significant number of consumers who have personal
computers with modems. In addition, they provide Internet connectivity, ease-
of-use and consistency of environment. Many of these on-line service providers
have developed their own access networks for modem connections. If these on-
line service providers were to extend their access networks to DSL or other
high-speed service technologies (such as through the recent merger of Excite
and @Home), they would become competitors of ours.
Wireless and Satellite Date. Wireless and satellite data service providers
are developing wireless and satellite-based Internet connectivity. We may face
competition from terrestrial wireless services, including two Gigahertz (Ghz)
and 28 Ghz wireless cable systems (Multi-channel Microwave Distribution System
(MMDS) and Local Multi-channel Distribution System (LMDS)), and 18 Ghz and 39
Ghz point-to-point microwave systems. For example, the FCC is currently
considering new rules to permit MMDS licensees to use their systems to offer
two-way services, including high-speed data, rather than solely to provide
one-way video services. The FCC also recently auctioned spectrum for LMDS
services in all markets. This spectrum is expected to be used for wireless
cable and telephony services, including high-speed digital services. In
addition, companies such as Teligent Inc., Advanced Radio Telecom Corp. and
WinStar Communications, Inc., hold point-to-point microwave licenses to
provide fixed wireless services such as voice, data and videoconferencing.
We also may face competition from satellite-based systems. Motorola
Satellite Systems, Inc., Hughes Communications (a subsidiary of General Motors
Corporation), Teledesic and others have filed applications with the FCC for
global satellite networks which can be used to provide broadband voice and
data services, and the FCC has authorized several of these applicants to
operate their proposed networks.
Other Competitive Telecommunications Companies. Other companies such as
Rhythms NetConnections and NorthPoint Communications offer high-speed digital
services using a business strategy similar to ours. The 1996
Telecommunications Act specifically grants any and all competitive
telecommunications companies the right to negotiate interconnection agreements
with the traditional telephone companies. Further, the 1996 Telecommunications
Act allows competitive telecommunications companies to enter into
interconnection agreements which are identical in all respects to ours. We
have already had an interconnection agreement copied in this manner.
As a first mover in selected markets that we enter, we seek the following
strategic benefits: (i) securing and retaining customers before the same high-
speed services are available from others, (ii) engendering end-user loyalty
through superior coverage and high customer satisfaction and (iii) capturing
the largest customer base and thereby achieving economies of scale sufficient
to drive down prices and develop a leadership position. We may not be able to
achieve these benefits if substantial competition from any of the foregoing
competitors exists or develops in our markets.
Interconnection Agreements with Traditional Telephone Companies
A critical aspect of our business is our interconnection agreements with
the traditional telephone companies. These agreements cover a number of
aspects including:
. the price we pay to lease access to the traditional telephone company's
copper lines;
. the special conditioning the traditional telephone company provides on
certain of these lines to enable the transmission of DSL signals;
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. the price and terms of central office space for our equipment in the
traditional telephone company's central offices;
. the price we pay and access we have to the traditional telephone
company's transport facilities;
. our ability to access conduits and other rights of way the traditional
telephone company has to construct our own network facilities;
. the operational support systems and interfaces that we can use to place
orders and trouble reports and monitor the traditional telephone
company's response to our requests;
. the dispute resolution process that we use to resolve disagreements on
the terms of the interconnection contract; and
. the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of the
traditional telephone company relationship.
As of January 31, 1999, we have entered into interconnection agreements
with six different major traditional telephone companies in the majority of
the states covering our target markets. Traditional telephone companies do not
in many cases agree to our requested provisions in interconnection agreements
and we have not consistently prevailed in obtaining all of our desired
provisions in such agreements either voluntarily or through the
interconnection arbitration process. We cannot be sure that we will be able to
continue to sign interconnection agreements with existing or other traditional
telephone companies. We are currently negotiating agreements with several
traditional telephone companies in our 22 announced regions which are
necessary before we can expand our services into these metropolitan areas
served by such traditional telephone companies. The traditional telephone
companies are also permitting competitive telecommunications companies to
adopt previously signed interconnection agreements. In certain instances, we
have adopted the interconnection agreement of another competitive
telecommunications company. Other competitive telecommunications companies
have also adopted the same or modified versions of our interconnection
agreements, and may continue to do so in the future.
Our interconnection agreements have a maximum term of three years.
Therefore, we will have to renegotiate our existing agreements when they
expire. Although we expect to renew our interconnection agreements and believe
the 1996 Telecommunications Act limits the ability of traditional telephone
companies not to renew such agreements, we may not succeed in extending or
renegotiating our interconnection agreements on favorable terms. Additionally,
disputes have arisen and will likely arise in the future as a result of
differences in interpretations of the interconnection agreements. For example,
we are in arbitration proceedings with two traditional telephone companies
under the dispute resolution clauses of our interconnection agreements. These
disputes have delayed our deployment of our network. They have also adversely
affected our service to our customers and our ability to enter into additional
interconnection agreements with the traditional telephone companies in other
states. Finally, the interconnection agreements are subject to state
commission, FCC and judicial oversight. These government authorities may
modify the terms of the interconnection agreements in a way that adversely
affects our business, prospects, operating results, financial condition and
our ability to service and repay our indebtedness, including the new notes.
Government Regulation
Overview. Our services are subject to a variety of federal regulations.
With respect to certain activities and for certain purposes, we have submitted
our operations to the jurisdiction of state and local authorities who may also
assert more extensive jurisdiction over our facilities and services. The FCC
has jurisdiction over all of our services and facilities to the extent that we
provide interstate and international services. To the extent we provide
identifiable intrastate services, our services and facilities are subject to
state regulations. In addition, local municipal government authorities also
assert jurisdiction over our facilities and operations. The jurisdictional
reach of the various federal, state and local authorities is subject to
ongoing controversy and judicial review, and we cannot predict the outcome of
such review.
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Federal Regulation. We must comply with the requirements of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, as
well as the FCC's regulations under the statute. The 1996 Telecommunications
Act eliminates many of the pre-existing legal barriers to competition in the
telecommunications and video programming communications businesses, preempts
many of the state barriers to local telecommunications service competition
that previously existed in state and local laws and regulations, and sets
basic standards for relationships between telecommunications providers. The
law delegates to the FCC and the states broad regulatory and administrative
authority to implement the 1996 Telecommunications Act.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications market. It does this by preempting state
and local laws that are barriers to competition and by requiring traditional
telephone companies to provide nondiscriminatory access and interconnection to
potential competitors, such as cable operators, wireless telecommunications
providers, IXCs and competitive telecommunications companies such as us.
Regulations promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements of the 1996 Telecommunications Act
imposed on the traditional telephone companies to open their networks to
competition by providing competitors interconnection, central office space,
access to unbundled network elements, retail services at wholesale rates and
nondiscriminatory access to telephone poles, ducts, conduits, and rights-of-
way. The requirements enable companies such as us to interconnect with the
traditional telephone companies in order to provide local telephone exchange
services and to use portions of the traditional telephone companies' existing
network to offer new and innovative services such as our TeleSpeed and
TeleSurfer services. The U.S. Supreme Court has recently ruled on challenges
to the FCC regulations. Although the U.S. Supreme Court upheld most of the
FCC's authority and its regulations, the FCC must now reexamine and redefine
which unbundled networks elements the traditional telephone companies must
offer. There can be no guarantee that the FCC will not issue new regulations
that have a material adverse impact on our ability to compete.
The 1996 Telecommunications Act also allows the regional bell operating
companies (RBOCs), which are the traditional telephone companies created by
AT&T's divestiture of its local exchange business, to enter the long distance
market within their own local service regions upon meeting certain
requirements. The remaining RBOCs include BellSouth, Bell Atlantic
Corporation, Ameritech Corporation, U S WEST Communications, Inc. and SBC
Communications, Inc. The timing of the various RBOCs' entry into their
respective in-region long distance service businesses is also extremely
uncertain. The timing of the various RBOCs' in-region long distance entry will
likely affect the level of cooperation we receive from each of the RBOCs.
In addition, the 1996 Telecommunications Act provides relief from the
earnings restrictions and price controls that have governed the local
telephone business for many years. Traditional telephone company tariff
filings at the FCC have been subjected to increasingly less regulatory review.
However, precisely when and to what extent the traditional telephone companies
will secure pricing flexibility or other regulatory freedom for their services
is uncertain. For example, under the 1996 Telecommunications Act, the FCC is
considering eliminating certain regulations that apply to the traditional
telephone company's provision of services that are competitive with ours. The
timing and the extent of regulatory freedom and pricing flexibility and
regulatory freedom granted to the traditional telephone companies will affect
the competition we face from the traditional telephone companies' competitive
services.
Further, the 1996 Telecommunications Act provides the FCC with the
authority to forbear from regulating entities such as us who are classified as
"non-dominant" carriers. The FCC has exercised its forbearance authority. As a
result, we are not obligated to obtain prior certificate approval from the FCC
for our interstate services or file tariffs for such services. We have
determined not to file tariffs for our interstate services. We provide our
interstate services to our customers on the basis of contracts rather than
tariffs. We believe that it is unlikely that the FCC will require us to file
tariffs for our interstate services in the future.
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On March 18, 1999, the FCC announced that it was adopting rules to make it
easier and less expensive for competitive telecommunications companies to
obtain central office space and to require traditional telephone companies to
make new alternative arrangements for obtaining central office space. New
entrants will be able to locate all equipment necessary for interconnection,
whether or not such equipment has a switching function. The FCC's rules may
not be successfully implemented. In the same announcement, the FCC provided
notice of proposed rule-making technical feasibility of two different carriers
to share a single line to provide voice service and advanced services. The
notice will seek comments on the operational, pricing, legal and policy
ramifications of mandating such line sharing at the federal level. If adopted,
these rules could materially lower the price we pay to lease access to the
traditional telephone company's copper lines. While we believe that these
rules would be advantageous to us, the FCC may decide not to implement such
rules.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with traditional telephone
companies, the prospective entry of the RBOCs into the in-region long distance
business and grant of regulatory freedom and pricing flexibility to the
traditional telephone companies, could have a material adverse impact on our
business prospects, operating results, financial condition and our ability to
service and repay our indebtedness, including the new notes.
State Regulation. To the extent we provide identifiable intrastate services
or have otherwise submitted ourselves to the jurisdiction of the relevant
state telecommunications regulatory commissions, we are subject to such
jurisdiction. In addition, certain states have required prior state
certification as a prerequisite for processing and deciding an arbitration
petition for interconnection under the 1996 Telecommunications Act. As of
December 31, 1998, we were authorized under state law to operate as a
competitive local exchange carrier in 19 states, have pending applications in
seven additional states, and intend to obtain authorization in the other
states necessary to cover our 22 target regions. We have pending arbitration
proceedings in different states for interconnection arrangements with the
relevant traditional telephone companies. We have concluded arbitration
proceedings in a number of states by entering into interconnection agreements
with the relevant traditional telephone companies. We have filed tariffs in
certain states for intrastate services as required by state law or regulation.
We are also subject to periodic financial and other reporting requirements of
these states with respect to our intrastate services.
The different state commissions have various proceedings to determine the
rates, charges and terms and conditions for unbundled network elements
(unbundled network elements are the various portions of a traditional
telephone company's network that a competitive telecommunications company can
lease for purposes of building a facilities-based competitive network,
including copper lines, central office space, inter-office transport,
operational support systems, local switching and rights of way), as well as
the discount for wholesale services that we purchase from the relevant
traditional telephone company. The rates set forth in our interconnection
agreements are interim rates and will be prospectively, and, in some cases,
retroactively, affected by the permanent rates set by the various state
commissions for such unbundled network elements as unbundled loops and
interoffice transport. We have participated in unbundled network element rate
proceedings in the states of California and Washington in an effort to reduce
these rates. Any state commission rate determinations to increase unbundled
network element rates could have a material adverse effect on our business,
prospects, operating results, financial condition and our ability to service
and repay our indebtedness, including the new notes.
The applicability of the various state regulations on our business and
compliance requirements will be further affected to the extent to which our
services are determined to be intrastate services. Jurisdictional
determinations of our services as intrastate services could have a material
adverse effect on our business, prospects, operating results, financial
condition and our ability to service and repay our indebtedness, including the
new notes.
Local Government Regulation. We may be required to obtain various permits
and authorizations from municipalities in which we operate our own facilities.
The issue of whether actions of local governments over the activities of
telecommunications carriers, including requiring payment of franchise fees or
other surcharges,
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pose barriers to entry for competitive telecommunications companies which may
be preempted by the FCC is the subject of litigation. Although we rely
primarily on the unbundled network elements of the traditional telephone
companies, in certain instances we deploy our own facilities, including fiber
optic cables, and therefore may need to obtain certain municipal permits or
other authorizations. The actions of municipal governments in imposing
conditions on the grant of permits or other authorizations or their failure to
act in granting such permits or other authorizations could have a material
adverse effect on our business, prospects, operating results, financial
condition and our ability to service and repay our indebtedness, including the
new notes.
The foregoing does not purport to describe all present and proposed
federal, state and local regulations and legislation affecting the
telecommunications industry. Other existing federal regulations are currently
the subject of judicial proceedings, legislative hearings and administrative
proposals, which could change, in varying degrees, the manner in which
communications companies operate in the U.S. The ultimate outcome of these
proceedings, and the ultimate impact of the 1996 Telecommunications Act or any
final regulations adopted pursuant to the 1996 Telecommunications Act or our
business cannot be determined at this time but may well be adverse to our
interests. We cannot predict the impact, if any, that future regulation or
regulatory changes may have on our business and we can give you no assurance
that such future regulation or regulatory changes will not have a material
adverse effect on our business, prospects, operating results, financial
condition and our ability to service and repay our indebtedness, including the
new notes. See "Risk Factors--We depend on traditional telephone companies to
provide central office space and unbundled network elements, both of which are
critical to our success" and "--Our services are subject to government
regulation, and changes in current or future laws or regulations could
adversely affect our business."
Intellectual Property
We regard our products, services and technology as proprietary and attempt
to protect them with patents, copyrights, trademarks, trade secret laws,
restrictions on disclosure and other methods. These methods may not be
sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently. Currently we have a number of patent applications and intend to
prepare additional applications and to seek patent protection for our systems
and services to the extent possible. We may not obtain any issued patents or
that, if issued, any such patents would protect our intellectual property from
competition which could seek to design around or invalidate such patents. In
addition, effective patent, copyright, trademark and trade secret protection
may be unavailable or limited in certain foreign countries. The global nature
of the Internet makes it virtually impossible to control the ultimate
destination of our proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our technology. In addition, litigation
may be necessary in the future to enforce our intellectual property rights to
protect our trade secrets or to determine the validity and scope of the
proprietary rights of others. Such litigation could result in substantial
costs and diversion of resources and could have a material adverse effect on
our business, prospects, operating results, financial condition and our
ability to service and repay our indebtedness, including the new notes. In
early 1999, one of our patents entitled "A system, method, and network for
providing high speed remote access from any location connected by a local loop
to a central office," was allowed by the U.S. Patent and Trademark Office. We
expect the patent to be issued shortly.
Employees
As of December 31, 1998, we had 335 employees (excluding temporary
personnel and consultants), employed in engineering, sales, marketing,
customer support, and general and administrative functions. None of our
employees are represented by a labor union, and we considers our relations
with our employees to be good. Our ability to achieve our financial and
operational objectives depends in large part upon the continued service of our
senior management and key technical, sales, marketing and managerial
personnel, and our continuing
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ability to attract and retain highly qualified technical, sales, marketing and
managerial personnel. Competition for such qualified personnel is intense,
particularly in software development, network engineering and product
management.
Board of Advisors
We maintain a board of advisors and conduct meetings of this advisory group
for two days each quarter. The board of advisors gives us guidance on issues
such as developments in communications equipment technology, network design
strategy, regulatory matters, the competitive landscape, marketing of our
services, identification of potential employees, financial strategy, and
introductions to potential strategic partners and alliances. The board of
advisors serves in an advisory capacity and does not have any managerial
control over us. Below is a list of our board of advisors as of December 31,
1998 and their backgrounds.
Robert Berger is a founder of InterNex Information Services, an ISDN and
high bandwidth services-focused Internet service provider in California.
Duncan Davidson is one of our founders and is currently Senior Vice
President of InterTrust Technologies Corporation, a leading provider of trust
management systems for electronic commerce and digital rights management. He
previously served as Managing Partner of Regis McKenna's consulting company.
Dave Farber is a chaired telecommunications professor at the University of
Pennsylvania and currently serves as a member of the Presidential Advisory
Committee on Information Technology.
Robert Hawk is a member of our board of directors. For a description of his
professional background, see "Management--Directors and Executive Officers."
William Lane is the former Chief Financial Officer at Intuit Inc. and is a
board member of MetaCreations Corporation, Quarterdeck Corporation, Expert
Software Inc., Storm Technology Inc. and several private companies.
Daniel Lynch is a member of our board of directors. For a description of
his professional background, see "Management--Directors and Executive
Officers."
Frank Marshall is a member of our board of directors. For a description of
his professional background, see "Management--Directors and Executive
Officers."
Kim Maxwell is the former Chairperson of the ADSL Forum and founder of
Racal Vadic and Amati.
Sharon Nelson is the former Chairperson of the Washington State Public
Utilities Commission.
David Piscitello is the President of Core Competence, Inc., program
chairman for U.S. (domestic) Networld and Interop Conferences, and co-producer
of the Internet Security Conference.
David Strom is the president of David Strom, Inc. and was the founding
editor-in-chief of Network Computing Magazine.
Properties
We are headquartered in Santa Clara, California in facilities consisting of
approximately 62,000 square feet pursuant to a lease that will expire on or
before July 14, 2002. We also lease office space in each of the regions in
which we have begun operations. We are in the process of acquiring office
space for regional headquarters for each of our additional target regions. In
addition, our San Francisco Bay Area regional data center consists of
approximately 2,000 square feet and is located in San Jose, California, which
we occupy under a ten-year lease with two five-year renewal options.
Currently, and until a permanent location is secured, we utilize a portion of
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the San Francisco Bay Area regional data center space to operate our network
operations center. We also lease central office space from the traditional
telephone company in each region that we operate or plan to operate under the
terms of our interconnection agreements and obligations imposed by state
public utilities commissions and the FCC. While the terms of these leases are
perpetual, the productive use of our central office space is subject to the
terms of our interconnection agreements which expire on or before March 2001.
We will increase our central office space as we expand our network in the San
Francisco Bay Area and other regions.
Legal Proceedings
We are engaged in a variety of negotiations, arbitrations and regulatory
and court proceedings with multiple traditional telephone companies. These
negotiations, arbitrations and proceedings concern the traditional telephone
companies' denial of physical central office space to us in certain central
offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. For example, we are currently involved in commercial
arbitration proceedings with Pacific Bell over these issues. We have also
filed a lawsuit against Pacific Bell in the Federal District Court in the
Northern District of California. We are pursuing a variety of contract, tort,
antitrust and other claims, such as violations of the Telecommunications Act
in these proceedings. In November 1998, we prevailed in our commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with us and failed to act
in good faith on multiple counts. The arbitration panel ruled in favor of
awarding us direct damages, as well as attorneys fees and costs of the
arbitration. Pacific Bell is currently attempting to have the decision
vacated. Failure to resolve the various legal disputes and controversies
between us and the various traditional telephone companies without excessive
delay and cost and in a manner that is favorable to us could have a material
adverse effect on our business, prospects, operating results and financial
condition.
We are not currently engaged in any other legal proceedings that we believe
could have a material adverse effect on our business, prospects, operating
results and financial condition. We are, however, subject to state commission,
FCC and court decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the interpretation of
competitive telecommunications companies interconnection agreements in general
and our interconnection agreements in particular. In some cases, we 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 our agreements. The results of any of these proceedings could have
a material adverse effect on our business, prospects, operating results,
financial condition and our ability to service and repay our indebtedness,
including the new notes.
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MANAGEMENT
Directors and Executive Officers
Our directors and executive officers, and their respective ages as of March
15, 1999, are as follows:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Robert Knowling, Jr..... 43 President, Chief Executive Officer and Director
Charles McMinn.......... 47 Chairman, Board of Directors
Timothy Laehy........... 42 Chief Financial Officer and Vice President, Finance
Rex Cardinale........... 46 Chief Technology Officer and Vice President, Engineering
Robert Davenport, III... 39 Executive Vice President, Business Development
Charles Haas............ 39 Executive Vice President, Sales
Catherine Hemmer........ 40 President, Operations
Dhruv Khanna............ 39 Executive Vice President, General Counsel and Secretary
Robert Roblin........... 46 Executive Vice President, Marketing
Robert Hawk............. 59 Director
Henry Kressel........... 65 Director
Joseph Landy............ 37 Director
Daniel Lynch............ 57 Director
Frank Marshall.......... 52 Director
Rich Shapero............ 51 Director
</TABLE>
Robert Knowling, Jr. has been our President, Chief Executive Officer and a
member of our board of directors since July 1998. From October 1997 through
July 1998, Mr. Knowling served as the Executive Vice President of Operations
and Technologies at U S WEST Communications, Inc. In this capacity, Mr.
Knowling was responsible for planning, delivering and maintaining high-quality
telecommunications services for more than 25 million customers in 14 western
and midwestern states. From March 1996 through September 1997, he served as
Vice President of Network Operations at U S WEST Communications, Inc. From
November 1994 through March 1996, he served as Vice President of Network
Operations for Ameritech Corporation. Mr. Knowling began his career in 1977 at
Indiana Bell where he progressed through a variety of assignments in
operations, engineering and marketing. When Indiana Bell became a part of
Ameritech Corporation, Mr. Knowling assumed positions of increasing
responsibility in marketing, product development, large business marketing and
network operations, including service on Ameritech Corporation's re-
engineering breakthrough development team. As lead architect of the Ameritech
Corporation transformation, Mr. Knowling reported directly to the Chairman.
Mr. Knowling currently serves on the board of directors of Shell Oil Company.
Charles McMinn is one of our founders and has been the Chairman of our
board of directors since July 1998. He served as our President and Chief
Executive Officer and as a member of our board of directors from October 1996
to July 1998. Mr. McMinn has over 20 years of experience in creating,
financing, operating and advising high technology companies. From July 1995 to
October 1996, and from August 1993 to June 1994, Mr. McMinn managed his own
consulting firm, Cefac Consulting, which focused on strategic development for
information technology and communications businesses. From June 1994 to
November 1995, he served as Principal, Strategy Discipline, at Gemini
Consulting. From August 1992 to June 1993, he served as President and Chief
Executive Officer of Visioneer Communications, Inc. and from October 1985 to
June 1992 was a general partner at InterWest Partners, a venture capital firm.
Mr. McMinn began his Silicon Valley career as the product manager for the 8086
microprocessor at Intel.
Timothy Laehy joined us in August 1997. He served as our Chief Financial
Officer, Treasurer and Vice President, Finance until February 1999 and has
served as our Chief Financial Officer and Vice President, Finance since that
date. Prior to joining us, Mr. Laehy served as Vice President, Corporate
Finance and Treasurer of Leasing Solutions, Inc., a computer equipment leasing
company, from February 1991 to August 1997. From 1990 to 1991, Mr. Laehy
served as a senior associate with Recovery Equity Partners, a private venture
capital
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investment fund. From 1985 to 1990, he served in various capacities at
Guarantee Acceptance Capital Corporation, an investment bank, Liberty Mutual
Insurance Company and Union Carbide Corporation.
Rex Cardinale joined us in June 1997. He served as our Vice President,
Engineering until February 1999 and has served as our Chief Technology Officer
and Vice President, Engineering since that date. From February 1996 to March
1997, Mr. Cardinale served as Chief Executive Officer and Vice President,
Engineering at GlobalCenter Inc., an Internet service provider for small
businesses. From January 1994 to February 1996, Mr. Cardinale served as Vice
President and General Manager, Internet Services Division, at Global Village
Communication. From June 1992 to September 1993, Mr. Cardinale was Vice
President and General Manager of the cc:Mail division of Lotus Development
Corporation. Prior to that time, he served for five years as Vice President,
Engineering for Ultra Network Technologies, a provider of high-speed
networking systems for supercomputers and for ten years in various engineering
management capacities at Rolm Corporation.
Robert R. Davenport, III joined us in January 1999. He served as our Vice
President, Business Development until February 1999 and has served as our
Executive Vice President, Business Development since that date. Prior to
joining us, Mr. Davenport was Senior Vice President and Chief Operating
Officer at Tele-Communications, Inc.'s Internet Services subsidiary, TCI.NET
from 1997 to 1999. Between 1995 and 1997, Mr. Davenport was with Tele-
Communications, Inc., as Vice President, Finance and Development for the
Telephony Services subsidiary. From 1992 to 1995, he was Managing Partner of
RD Partners, LLC, a private investment firm focused on leveraged equity
investments.
Charles Haas is one of our founders. He served as our Vice President, Sales
and Marketing from May 1997 until November 1998 and as our Vice President,
Sales from November 1998 until February 1999. Since February 1999, Mr. Haas
has served as our Executive Vice President Sales. Mr. Haas has over fourteen
years of sales and business development experience with Intel where he held
various positions from July 1982 to April 1997. At Intel, Mr. Haas served as
manager of corporate business development, focusing on opportunities in the
broadband computer communications area, and played a principal role in the
development of our Residential Broadband strategy for telephone and satellite
companies (DSL, Fiber-to-the-Curb and satellite modems).
Catherine Hemmer joined us in August 1998. She served as our Vice
President, Operations until February 1999 and has served as our President,
Operations since that date. From 1996 to August 1998, she was Vice President,
Network Reliability and Operations at U S WEST Communications, Inc. From 1995
to 1996, she served as General Manager, Network provisioning at Ameritech
Services, Inc., a telecommunications company. From 1987 to 1995, she served in
various capacities, including Vice President, Network Services, at MFS
Telecom, Inc. From 1987 to 1988, she served as Senior Manager, Management
Information Systems at Chicago Fiber Optic Corporation d/b/a Metropolitan
Fiber Systems of Chicago, Inc., a start-up venture developing a market niche
for fiber optic local access networks.
Dhruv Khanna is one of our founders. He served as our Vice President,
General Counsel and Secretary from October 1996 until February 1999 and has
served as our Executive Vice President, General Counsel and Secretary since
that date. He was an in-house counsel for Intel's communications products
division and its Senior Telecommunications Attorney between 1993 and 1996.
Between 1987 and 1993, Mr. Khanna was an associate at Morrison & Foerster
where his clients included Teleport Communications Group (now AT&T), McCaw
Cellular Communications, Inc. (now AT&T Wireless), and Southern Pacific
Telecom (now Qwest). Mr. Khanna has extensive experience with regulatory
matters, litigation and business transactions involving the RBOCs and other
telecommunications companies. While at Intel, he helped shape the computer
industry's positions on the Telecommunications Act of 1996 and the FCC's rules
implementing the 1996 Act.
Robert Roblin joined us in November 1998. He served as our Vice President,
Marketing until February 1999 and has served as our Executive Vice President,
Marketing since that date. Prior to joining us, he was Executive Vice
President of Marketing at Adobe Systems, Inc. from 1996 to November 1998. From
1994 to 1996, Mr. Roblin served as Vice President and General Manager of
Marketing of the Consumer Division of IBM
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Corporation. Between 1992 and 1994, Mr. Roblin was the Vice President of
Marketing of Pensoft, a start-up pen-based software company that produced a
database-driven personal information manager.
Robert Hawk has served as a member of our board of directors since April
1998. Mr. Hawk is President of Hawk Communications and recently retired as
President and Chief Executive Officer of U S WEST Multimedia Communications,
Inc., where he headed the cable, data and telephony communications business
from May 1996 to April 1997. He was president of the Carrier Division of U S
West Communications, a regional telecommunications service provider, from
September 1990 to May 1996. Prior to that time, Mr. Hawk was Vice President of
Marketing and Strategic Planning for CXC Corporation. Prior to joining CXC
Corporation, Mr. Hawk was director of Advanced Systems Development for
AT&T/American Bell. He currently serves on the boards of Xylan Corporation,
PairGain Technologies, Inc., Premisys Communications, Concord Communications
and Radcom.
Henry Kressel has served as a member of our board of directors since July
1997. Dr. Kressel has been with E.M. Warburg, Pincus & Co., LLC since 1983 and
is currently a managing director of the firm. He is also a partner of Warburg,
Pincus & Co., the general partner of Warburg, Pincus Investors, L.P. Prior to
that time, he served as Staff Vice President of the RCA Corporation
responsible for research and development of optoelectronics, semiconductors
and related software and technologies. Dr. Kressel serves as a director of
Earthweb, Inc., Level One Communications, Inc., IA Corporation, NOVA
Corporation, Inc. and several privately held companies.
Joseph Landy has served as a member of our board of directors since July
1997. Mr. Landy has been with E.M. Warburg, Pincus & Co., LLC since 1985 and
is currently a managing director of the firm. Throughout his career at E.M.
Warburg, Pincus & Co., LLC, Mr. Landy has focused primarily on investments in
information technology and specialty semiconductors. Mr. Landy is a director
of two publicly traded companies, Indus International, Inc. and Level One
Communications, Inc., and of several privately held companies.
Daniel Lynch has served as a member of our board of directors since April
1997. Mr. Lynch is also a founder of CyberCash, Inc. and has served as
chairman of its board of directors since August 1994. From December 1990 to
December 1995, he served as Chairman of the board of directors of Softbank
Forums, a provider of education and conference services for the information
technology industry. Mr. Lynch founded Interop Company in 1986, which is now a
division of ZD Comdex and Forums. Mr. Lynch is a member of the Association for
Computing Machinery and the Internet Society. He is also a member of the Board
of Trustees of the Santa Fe Institute, the Bionomics Institute and
CommerceNet. He previously served as Director of the Information Processing
Division for the Information Sciences Institute in Marina del Rey, where he
led the Arpanet team that made the transition from the original NCP protocols
to the current TCP/IP based protocols. He has served as a director of Exodus
Communications since January 1998. Mr. Lynch previously served as a member of
the board of directors at UUNET Technologies from April 1994 until August
1996.
Frank Marshall has served as a member of our board of directors since
October 1997. Mr. Marshall currently serves on the board of directors of PMC-
Sierra Inc. and several private companies. Mr. Marshall also serves on the
technical advisory board of several high technology private companies. He is a
member of the InterWest Partners Advisory Committee and a Venture Partner at
Sequoia Capital. From 1992 to 1997, Mr. Marshall served as Vice President of
Engineering and Vice President and General Manager, Core Business Unit of
Cisco Systems Inc. From 1982 to 1992, he served as Senior Vice President,
Engineering at Convex Computer Corporation.
Rich Shapero has served as a member of our board of directors since July
1997. Mr. Shapero has been a general partner of Crosspoint Venture Partners,
L.P., a venture capital investment firm, since April 1993. From January 1991
to June 1992, he served as Chief Operating Officer of Shiva Corporation, a
computer network company. Previously, he was a Vice President of Sun
Microsystems, Senior Director of Marketing at AST, and held marketing and
sales positions at Informatics General Corporation and UNIVAC's Communications
Division. Mr. Shapero serves as a member of the board of directors of
Powerwave Corporation.
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Classified Board
The board of directors is divided into three classes. The term of office
and directors consisting of each class is as follows:
<TABLE>
<CAPTION>
Class Directors Term of Office
----- --------- --------------
<C> <C> <S>
Class I . expires at the annual meeting of
Daniel Lynch stockholders in 2000 and at each third
Rich Shapero succeeding annual meeting thereafter
Class II Henry Kressel . expires at the annual meeting of
Frank Marshall stockholders in 2001 and at each third
Charles McMinn succeeding annual meeting thereafter
Class III Robert Hawk . expires at the annual meeting of
Robert Knowling, Jr. stockholders in 2002 and at each third
Joseph Landy succeeding annual meeting thereafter
</TABLE>
The classification of directors has the effect of making it more difficult
to change the composition of the board of directors.
Board Committees
In April 1998, our board of directors established an audit committee and a
compensation committee. The audit committee consists of two of our outside
directors, Messrs. Landy and Lynch. The audit committee's primary
responsibilities include:
. conducting a post-audit review of the financial statements and audit
findings;
. reviewing our independent auditors proposed audit scope and approach; and
. reviewing on a continuous basis the adequacy of our system of internal
accounting controls.
The compensation committee also consists of two of our outside directors,
Dr. Kressel and Mr. Shapero. The primary responsibilities of the compensation
committee include:
. reviewing and determining the compensation policy for our executive
officers and directors, and other employees as directed by the board of
directors;
. reviewing and determining all forms of compensation to be provided to our
executive officers; and
. reviewing and making recommendations to our board of directors regarding
general compensation goals and guidelines for our employees and the
criteria by which bonuses to our employees are determined.
Compensation Committee Interlocks and Insider Participation
No member of our board of directors or of its compensation committee serves
as an executive officer of any entity that has one or more of our executive
officers serving as members of its board of directors or board of directors
compensation committee. No such interlocking relationship has existed in the
past. See "Certain Relationships and Related Transactions" for a description
of transactions between us and entities affiliated with members of our
compensation committee.
Director Compensation
Except for grants of stock options subject to vesting and restricted stock
subject to repurchase, our directors generally do not receive compensation for
services provided as a director. We do not pay additional amounts for
committee participation or special assignments of our board of directors,
except for reimbursement of expenses in attending board of directors and
committee meetings.
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Executive Compensation
The following table sets forth certain information with respect to
compensation awarded to, earned by or paid to each person who served as our
Chief Executive Officer or was one of our four other most highly compensated
executive officers (collectively, the "Named Executive Officers") during the
fiscal years ended December 31, 1997 and December 31, 1998.
Summary Compensation Table
<TABLE>
<CAPTION>
Long-Term
Compensation
------------
Annual
Compensation
-------------------- Securities
Name and Principal Underlying All Other
Position Year Salary Bonus Options/SARs Compensation(1)
- ------------------ ---- -------- -------- ------------ --------------
<S> <C> <C> <C> <C> <C>
Robert Knowling, Jr. ... 1998 $180,768(4) $750,000 2,100,000 $196
President and Chief 1997 -- -- -- --
Executive Officer(2)
Charles McMinn ......... 1998 $167,019 $ 15,764 -- $286
Chairman, Board of 1997 87,500(4) -- -- 126
Directors(3)
Rex Cardinale .......... 1998 $144,451 $ 15,764 -- $281
Vice President, 1997 73,233(4) -- -- 126
Engineering
Charles Haas............ 1998 $133,615 $ 15,962 -- $269
Vice President, Sales 1997 70,000(4) -- -- 126
Dhruv Khanna............ 1998 $133,615 $ 15,943 -- $269
Vice President, General 1997 70,000(4) -- -- 126
Counsel and Secretary
Timothy Laehy........... 1998 $129,327 $ 16,189 -- $269
Chief Financial 1997 45,000(4) -- -- 126
Officer, Treasurer and
Vice President, Finance
</TABLE>
- --------
(1) The dollar amount in this column represents premium payments we made for
life insurance policies.
(2) Mr. Knowling assumed the offices of President and Chief Executive Officer
in July 1998.
(3) Mr. McMinn stepped down as our President and Chief Executive Officer and
assumed the position of Chairman of our board of directors in July 1998.
(4) Based on annual salaries of $150,000 and $140,000 for Messrs. McMinn and
Cardinale, respectively, and $120,000 for Messrs. Haas, Khanna and Laehy.
Option Grants in Last Fiscal Year
The following table sets forth information regarding stock options granted
during the fiscal year ended December 31, 1998 to Robert Knowling, Jr., our
President and Chief Executive Officer. Stock options were not granted to any
other Named Executive Officer during 1998.
Option Grants in 1998
<TABLE>
<CAPTION>
Individual Grants
---------------------------------------------------------
Potential Realizable
Value at Assumed
Annual Rates of Stock
Number of Percent of Total Price Appreciation
Securities Options Granted Exercise for Option Term($)(3)
Underlying Options to Employees in Price Per Expiration ---------------------
Name Granted(#)(1) Fiscal 1998(%)(2) Share($) Date 5% 10%
- ---- ------------------ ----------------- --------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Robert Knowling, Jr..... 2,100,000 22.45% $1.00 7/7/2006 $1,002,656 $2,401,537
</TABLE>
- --------
(1) These options become exercisable over a four-year period, with 12.5% of
the option shares vesting on the six month anniversary of the grant date
and the remainder vesting in 42 equal monthly installments. All the
options have a term of eight years, subject to earlier termination in
certain situations related to termination of employment. See "1997 Stock
Plan."
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(2) Based on an aggregate of 9,352,978 options we granted during 1998 pursuant
to our 1997 Stock Plan.
(3) These amounts represent hypothetical gains that could be achieved for the
options if exercised at the end of the option term. The potential
realizable values are calculated by assuming that our common stock
appreciates at the annual rate shown, compounded annually, from the date
of grant until expiration of the granted options. The assumed 5% and 10%
rates of stock price appreciation are mandated by the rules of the
Securities and Exchange Commission and do not represent our estimate or
projection of future stock price growth.
Aggregated Option Exercises in Last Fiscal Year and Year-End Option Values
The following table sets forth the number and value of shares of our common
stock underlying the unexercised options held by Robert Knowling, Jr., our
President and Chief Executive Officer. As of December 31, 1998, no stock
options have been granted to any other Named Executive Officer.
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised
Underlying Unexercised In-the-Money Options at
Options at December 31, 1998 December 31, 1998(1)
--------------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
---- ------------- ----------------- ----------- -------------
<S> <C> <C> <C> <C>
Robert Knowling, Jr..... -- 2,100,000 -- $35,700,000
</TABLE>
- --------
(1) The value is calculated on the basis of $18.00 per share, our initial
public offering price, less the aggregate exercise price.
Employment Agreements and Change in Control Arrangements
We have entered into a written employment agreement with Robert Knowling,
Jr., our President and Chief Executive Officer. The agreement provides that
Mr. Knowling will receive compensation in the form of a $400,000 annual base
salary and a $250,000 minimum annual bonus. Mr. Knowling received (i) a
signing bonus of $1,500,000, one half of which was paid when he began working
for us, and the remaining half of which will be paid once he has worked for us
for one full year (July 1999) or, before then, upon a change of control (as
that term is defined in the agreement), and (ii) stock options to purchase
2,100,000 shares of our common stock at an exercise price of $1.00 per share.
If we terminate Mr. Knowling's employment relationship without cause (as that
term is defined in the agreement), or if Mr. Knowling resigns for good reason
(as that term is defined in the agreement), we must continue to pay Mr.
Knowling's annual salary and targeted bonus for a period of two years after
the date of termination so long as Mr. Knowling does not become employed by
one of our direct competitors. Mr. Knowling has agreed to be bound by
customary confidentiality provisions during the term of his employment. As
provided in the agreement, in August 1998 we loaned Mr. Knowling $500,000
pursuant to a secured promissory note that bears no interest during his
employment. The loan has provisions for forgiveness based on continued
employment and matures in four years, subject to acceleration in certain
events. See "Certain Relationships and Related Transactions--Employee Loans."
We have entered into written employment agreements with Dhruv Khanna and
Rex Cardinale whereby we have agreed to hire each employee for a two-year
term. Pursuant to the employment agreements, Messrs. Khanna and Cardinale
currently receive compensation in the form of annual base salaries of $160,000
and bonuses to be determined by our board of directors or our compensation
committee. The employment commencement date for both Messrs. Khanna and
Cardinale was July 15, 1997. During the two-year term, these employees can
only be terminated for cause (as that term is defined in their agreements), at
which time they will only be eligible for benefits in accordance with our
established policies. After the two-year term, the employment relationship may
be terminated by us or the employee with or without cause. If we terminate Mr.
Khanna's or Mr. Cardinale's employment relationship without cause, we must
continue to pay such employee's salary and benefits as he received immediately
before termination for a period of six months after the date of termination.
Under the employment agreements, Messrs. Khanna and Cardinale have agreed,
during the terms of their employment with us, not to (i) open or operate a
business which is then in competition with ours, (ii) act as an employee,
agent, advisor or consultant of any of our then existing competitors, or (iii)
take any action to divert our business or
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<PAGE>
influence any of our existing customers to cease doing business with us or to
alter its then existing business relationship with us.
With respect to all options granted under our 1997 Stock Plan, in the event
that we merge with or into another corporation resulting in a change of
control involving a shift in 50% or more of the voting power of our capital
stock, or the sale of all or substantially all of our assets, the options will
fully vest and become exercisable one year after the change of control or
earlier in the event the individual is constructively terminated or terminated
without cause or in the event the successor corporation refuses to assume the
options. See "--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with certain
of our officers and directors. The shares of our common stock issued pursuant
to these restricted stock purchase agreements are subject to our right of
repurchase which lapses in accordance with the vesting schedule of the
agreements. The agreements also include similar provisions to the stock
options, providing for accelerated vesting in the event of a change of
control. See "Certain Relationships and Related Transactions--Issuance of
Common Stock."
1997 Stock Plan
Our 1997 Stock Plan was adopted by our board of directors and the
stockholders in July 1997. The number of shares of our common stock which are
reserved for issuance under the 1997 Stock Plan is 15,520,342 shares, plus an
annual increase beginning in January 2000, equal to the lesser of (i) 3% of
the outstanding shares on such date or (ii) an amount determined by our board
of directors. The annual increase is subject to adjustment upon changes in our
capitalization. The 1997 Stock Plan provides for the granting to employees
(including officers and directors) of qualified "incentive stock options"
within the meaning of Section 422 of the Internal Revenue Code of 1986, as
amended (the "Code"), and for the granting to employees (including officers
and directors) and consultants of nonstatutory stock options. The 1997 Stock
Plan also provides for the granting of stock purchase rights ("SPRs"). As of
March 15, 1999, options to purchase an aggregate of 11,383,597 shares were
outstanding and 2,502,837 shares remained available for future grants.
The 1997 Stock Plan is administered by our board of directors or a
committee appointed by the board of directors. The administrator of the 1997
Stock Plan has the power to determine the terms of the options or SPRs
granted, including the exercise price of the option or SPR, the number of
shares subject to each option or SPR, the exercisability thereof, and the form
of consideration payable upon such exercise. In addition, the administrator
has the authority to amend, suspend or terminate the 1997 Stock Plan, provided
that no such action may affect any shares of our common stock previously
issued and sold or any option previously granted under the 1997 Stock Plan. We
may grant each optionee a maximum of 2,000,000 shares covered by option during
a fiscal year and an additional 2,000,000 shares covered by option in
connection with an optionee's initial employment. Options generally vest at a
rate of 12.5% of the shares subject to the option on the date six months
following the grant date and 1/48th of the shares subject to the option at the
end of each one-month period thereafter and generally expire eight years from
the date of grant.
Options and SPRs granted under the 1997 Stock Plan generally are not
transferable by the optionee, and each option and SPR is exercisable during
the lifetime of the optionee only by such optionee. Options granted under the
1997 Stock Plan generally must be exercised within thirty days after the end
of optionee's status as our employee, director or consultant, or within twelve
months after such optionee's termination by death or disability, but in no
event later than the expiration of the option's term.
In the case of SPRs, unless the administrator determines otherwise,
restricted stock purchase agreements must grant us a repurchase option
exercisable upon the voluntary or involuntary termination of the purchaser's
service for any reason, including death or disability. The purchase price for
shares repurchased pursuant to the restricted stock purchase agreements will
be the original price paid by the purchaser and may be paid by cancellation of
any indebtedness owed to us by the purchaser. Repurchase options lapse at a
rate determined by the administrator.
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<PAGE>
The exercise price of all incentive stock options granted under the 1997
Stock Plan must be at least equal to the fair market value of our common stock
on the date of grant. The exercise price of nonstatutory stock options and
SPRs granted under the 1997 Stock Plan is determined by the administrator, but
with respect to nonstatutory stock options intended to qualify as
"performance-based compensation" within the meaning of Section 162(m) of the
Code, the exercise price must be at least equal to the fair market value of
our common stock on the date of grant. With respect to any participant who
owns stock possessing more than 10% of the voting power of all classes of our
outstanding capital stock, the exercise price of any incentive stock option
granted must be at least equal to 110% of the fair market value on the grant
date and the term of such incentive stock option must not exceed five years.
The term of all other options granted under the 1997 Stock Plan may not exceed
ten years.
All stock options and restricted stock grants to officers, employees,
directors and consultants provide that in the event we merge with or into
another corporation resulting in a change of control involving a shift in 50%
or more of the voting power of our capital stock, or the sale of all or
substantially all of our assets, the options will fully vest and become
exercisable one year after the change of control. In the event the individual
is constructively terminated or terminated without cause or in the event that
the successor corporation refuses to assume or substitute the options, the
options will fully vest and become exercisable at that time.
1998 Employee Stock Purchase Plan
Our 1998 Employee Stock Purchase Plan was adopted by our board of directors
in December 1998, and approved by the stockholders in January 1999. A total of
1,000,000 shares of our common stock have been reserved for issuance under
this plan, plus annual increases equal to the lesser of (i) 2% of the
outstanding shares on such date or (ii) an amount determined by the board of
directors. To date, no shares have been issued under the 1998 Employee Stock
Purchase Plan, however, a significant number of employees have enrolled as
participants in this plan.
The 1998 Employee Stock Purchase Plan, which is intended to qualify under
Section 423 of the Code, contains consecutive, overlapping, twenty-four month
offering periods. Each offering period includes four six-month purchase
periods. The offering periods generally start on the first trading day on or
after May 1 and November 1 of each year, except for the first offering period
which commenced on the first trading day after our initial public offering
(January 22, 1999) and ends on the last trading day on or before October 31,
2000.
Employees are eligible to participate if they are customarily employed by
us or any of our participating subsidiaries for at least 20 hours per week and
more than five months in any calendar year. However, no employee may be
granted a right to purchase stock under the 1998 Employee Stock Purchase Plan
(i) to the extent that, immediately after the grant of the right to purchase
stock, the employee would own stock possessing 5% or more of the total
combined voting power or value of all classes of our capital stock, or (ii) to
the extent that his or her rights to purchase stock under all our employee
stock purchase plans accrues at a rate which exceeds $25,000 worth of stock
for each calendar year. The 1998 Employee Stock Purchase Plan permits
participants to purchase our common stock through payroll deductions of up to
12% of the participant's "compensation." Compensation is defined as the
participant's base straight time gross earnings and commissions but excludes
payments for overtime, shift premium, incentive compensation, incentive
payments, bonuses and other compensation. The maximum number of shares a
participant may purchase during a single purchase period is 5,000 shares.
Amounts deducted and accumulated by the participant are used to purchase
shares of our common stock at the end of each purchase period. The price of
stock purchased under the 1998 Employee Stock Purchase Plan is generally 85%
of the lower of the fair market value of our common stock (i) at the beginning
of the offering period or (ii) at the end of the purchase period. In the event
the fair market value at the end of a purchase period is less than the fair
market value at the beginning of the offering period, the participants will be
withdrawn from the current offering period following exercise and
automatically re-enrolled in a new offering period. The new offering period
will use the lower fair market value as of the first date of the new offering
period to determine the purchase price for future purchase periods.
Participants may end their participation at any time during an
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<PAGE>
offering period, and they will be paid their payroll deductions to date.
Participation ends automatically upon termination of employment.
Rights to purchase stock granted under the 1998 Employee Stock Purchase
Plan are not transferable by a participant other than by will, the laws of
descent and distribution, or as otherwise provided under the plan. The 1998
Employee Stock Purchase Plan provides that, in the event we merge with or into
another corporation or sell substantially all of our assets, each outstanding
right to purchase stock may be assumed or substituted for by the successor
corporation. If the successor corporation refuses to assume or substitute for
the outstanding rights to purchase stock, the offering period then in progress
will be shortened and a new exercise date will be set.
Our board of directors has the authority to amend or terminate the 1998
Employee Stock Purchase Plan, except that no such action may adversely affect
any outstanding rights to purchase stock under the plan. Our board of
directors may terminate an offering period on any exercise date if it
determines that the termination of the plan is in our best interests and the
best interest of our stockholders. The board of directors may in its sole
discretion amend the plan to the extent necessary and desirable to avoid
unfavorable financial accounting consequences by altering the purchase price
for any offering period, shortening any offering period or allocating
remaining shares among the participants. Unless sooner terminated by our board
of directors, the plan will automatically terminate ten years from the
effective date of our initial public offering.
Management Bonus Plan
On July 22, 1998, our board of directors approved its Executive Bonus
Performance Plan. Under this plan, each of our officers receives a cash bonus
up to a designated percentage of their annual base salary depending upon the
extent to which specific performance metrics are achieved.
Limitation on Liability and Indemnification Matters
Our Amended and Restated Certificate of Incorporation limits the liability
of our directors to the maximum extent permitted by Delaware law, and our
Bylaws provide that we will indemnify our directors and officers and may
indemnify our other employees and agents to the fullest extent permitted by
law. We have also entered into agreements to indemnify our directors and
executive officers, in addition to the indemnification provided for in our
Bylaws. We believe that these provisions and agreements are necessary to
attract and retain qualified directors and executive officers. At present,
there is no pending litigation or proceeding involving any of our directors,
officers, employees or agents in which indemnification will be required or
permitted. We are not aware of any threatened litigation or proceeding that
might result in a claim for such indemnification. We have been informed that,
in the opinion of the Securities and Exchange Commission, the indemnification
of directors, officers or persons that control us for liabilities arising
under the Securities Act pursuant to the above mentioned provisions is against
public policy as expressed in the Securities Act and is therefore
unenforceable.
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CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Series C Preferred Stock and Warrant Subscription Agreement
On February 20, 1998, we entered into a Series C Preferred Stock and
Warrant Subscription Agreement (the "Subscription Agreement") with Warburg and
Crosspoint. Under this agreement, Warburg and Crosspoint unconditionally
agreed to purchase an aggregate of 5,764,143 shares of our series C preferred
stock and warrants to purchase an aggregate of 4,729,500 shares of our series
C preferred stock for an aggregate purchase price of $16.0 million at a date
that we were to determine but, in any event, not later than March 11, 1999. We
agreed to either call this commitment or complete an alternate equity
financing of at least $16.0 million by March 11, 1999. A proposed alternate
equity financing providing for a price per share greater than or equal to
$2.7767 and including securities that are equal in right with, or more
favorable to us than, our series C preferred stock as set forth in our Amended
and Restated Certificate of Incorporation required approval by a majority of
our disinterested directors. A proposed alternate equity financing providing
for a price per share of less than $2.7767 or involving securities whose terms
are less favorable to us than our series C preferred stock required unanimous
approval by our entire board of directors. In consideration of this
commitment, we issued to Warburg and Crosspoint warrants to purchase an
aggregate of 1,694,148 shares of our common stock at a purchase price of
$0.0033 per share. The parties have agreed that the stock purchases by AT&T
Ventures and NEXTLINK constitute an alternate equity financing. As a result,
we did not issue and sell our series C preferred stock and warrants to
purchase series C preferred stock to Warburg and Crosspoint. Dr. Henry Kressel
and Mr. Joseph Landy, two of our directors, are affiliated with Warburg, and
Mr. Shapero, also one of our directors is affiliated with Crosspoint.
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement to which we were a party along with
Warburg, Crosspoint and Mr. Hawk. By the terms of this agreement, Warburg and
Crosspoint assigned to Mr. Hawk their obligation to purchase 36,015 shares of
our series C preferred stock and 29,559 warrants to purchase series C
preferred stock for an aggregate purchase price of $100,001.65. On the same
date, Mr. Hawk purchased 36,015 shares of our series C preferred stock at a
price per share of $2.7767. As a result of this amendment, the aggregate
obligation of Warburg and Crosspoint to purchase our series C preferred stock
and warrants to purchase series C preferred stock 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). On the same date, the Amended and Restated Stockholder Rights
Agreement dated March 11, 1998 was amended to add Mr. Hawk as a party.
The warrants to purchase our common stock issued upon the signing of the
Subscription Agreement had five-year terms (but had to be exercised prior to
the closing of our initial public offering), had purchase prices of $0.0033
per share were immediately exercisable and contained net exercise provisions.
Prior to our initial public offering, Warburg and Crosspoint exercised their
warrants to purchase series C preferred stock for 1,355,070 and 338,829 shares
of our common stock.
On March 11, 1998, we amended the Stockholder Rights Agreement, to extend
the rights held by Warburg, Crosspoint and Intel to our warrants to purchase
common stock, series C preferred stock and warrants to purchase series C
preferred stock issued or issuable to Warburg, Crosspoint and Intel pursuant
to the Subscription Agreement.
The Intel Stock Purchase
As provided in the Subscription Agreement, Intel purchased 360,144 shares
of our series C preferred stock and warrants to purchase 295,500 shares of our
series C preferred stock for an aggregate purchase price of $1.0 million
concurrently with the closing of the issuance of the 1998 discount notes in
March 1998. We did not have any obligation to issue the warrants to purchase
series C preferred stock to Intel until such time as Warburg and Crosspoint
funded their respective commitments under the Subscription Agreement. The
parties agreed that our initial public offering constituted an alternate
equity financing and, therefore, we will not issue the warrants
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to purchase series C preferred stock to Intel. In connection with its
agreement to purchase such series C preferred stock and warrants to purchase
series C preferred stock, we issued to Intel warrants to purchase an aggregate
of 105,852 shares of our common stock at a purchase price of $0.0033 per
share. Prior to our initial public offering, Intel exercised their warrants
for 105,852 shares of our common stock.
Transactions in Connection with the Formation of the Delaware Holding Company
We were originally incorporated in California as Covad Communication
Company ("Covad California") in October 1996. In July 1997, we were
incorporated in Delaware as part of our strategy to operate through a holding
company structure and to conduct substantially all of our operations through
subsidiaries. To effect the holding company structure, in July 1997 we entered
into an Exchange Agreement with the existing holders of the common stock and
series A preferred stock of Covad California to acquire all of such stock in
exchange for a like number of shares of our common and preferred stock, so
that after giving effect to the exchange Covad California became our wholly-
owned subsidiary. In addition, we entered into an Assumption Agreement
pursuant to which we assumed certain outstanding obligations of Covad
California, including a $500,000 demand note issued to Warburg and certain
commitments to issue stock options to two of our consultants.
In connection with the Exchange Agreement, three of our officers, Messrs.
McMinn, Khanna and Haas, each exchanged 3,000,000 shares of common stock of
Covad California, originally purchased for $0.0042 per share, for a like
number of our shares of common stock pursuant to restricted stock purchase
agreements. In addition, Mr. Lynch, one of our directors, exchanged 144,000
shares of common stock of Covad California, originally purchased for $0.0333
per share, for a like number of our shares of common stock pursuant to a
restricted stock purchase agreement. The common stock issued to Messrs.
McMinn, Khanna, Haas and Lynch are generally subject to vesting over a period
of four years. This vesting is subject to acceleration upon a change of
control involving a merger, sale of all or substantially all our assets or a
shift in 50% or more of the voting power of our capital stock. Our repurchase
rights lapse one year after the change of control or earlier in the event the
individual is constructively terminated or terminated without cause, or in the
event the successor corporation refuses to assume the agreements.
Issuance of Common Stock
On July 15, 1997, we issued 1,125,000 shares of our common stock to Mr.
Cardinale, one of our officers, for a purchase price of $0.0333 per share. On
August 30, 1997, we issued 345,000 shares of our common stock to Mr. Laehy,
one of our officers, for $0.05 per share. On October 14, 1997, we issued
144,000 shares of our common stock to Mr. Marshall, one of our directors, for
a purchase price of $0.05 per share. On April 24, 1998, we issued 96,000
shares of our common stock to Mr. Hawk, one of our directors, for a purchase
price of $0.6667 per share. On August 28, 1998, we issued 40,000 shares of our
common stock to Mr. Hawk for a purchase price of $5.75 per share. The shares
of our common stock issued to Messrs. Cardinale, Laehy, Marshall and Hawk were
issued pursuant to restricted stock purchase agreements which contain vesting
and change of control provisions similar to those contained in the above-
described restricted stock purchase agreements of Messrs. McMinn, Khanna, Haas
and Lynch.
Issuance of Series A Preferred Stock
On June 30, 1997 Covad California issued 150,000 shares of series A
preferred stock to each of Messrs. McMinn, Khanna and Haas and 300,000 shares
of series A preferred stock to Mr. Lynch for a purchase price of $0.3333 per
share. In July 1997, these shares were exchanged for a like number of our
shares of series A preferred stock pursuant to the Exchange Agreement.
Issuance of Series B Preferred Stock
In July 1997, we sold an aggregate of 17,000,001 shares of our series B
preferred stock, of which 12,000,000 shares were sold to Warburg, 3,000,000
shares were sold to Crosspoint and 2,000,001 shares were
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sold to Intel. The purchase price of our series B preferred stock was $0.50
per share. A portion of the purchase price of the series B preferred stock was
paid by cancellation of a $500,000 demand note issued to Warburg in June 1997.
Messrs. Kressel and Landy, each of whom currently serve as members of our
board of directors, are affiliated with Warburg. Mr. Shapero, who currently
serves on our board of directors, is affiliated with Crosspoint.
On February 12, 1998, we sold an additional 100,002 shares of series B
preferred stock at a purchase price of $1.00 per share to Mr. Marshall, one of
our directors.
The Strategic Investments and Relationships
In January 1999, we received equity investments from AT&T Ventures,
NEXTLINK and Qwest. AT&T Ventures purchased an aggregate of 1,500,583 shares
of our series C-1 preferred stock at $2.7767 per share and an aggregate of
1,157,408 shares of our series D-1 preferred stock at $18.00 per share. These
purchases represent an aggregate investment of $25 million, of which $11
million was invested by AT&T Venture Fund II, LP and $14 million was invested
by the two affiliated funds. NEXTLINK purchased 1,200,466 shares of our series
C-1 preferred stock at $2.7767 per share and 925,926 shares of our series D-1
preferred stock at $18.00 per share, representing an investment of $20
million. Qwest purchased 900,349 shares of our series C-1 preferred stock at
$2.7767 per share and 694,445 shares of our series D-1 preferred stock at
$18.00 per share, representing an aggregate investment of $15 million. At the
completion of our initial public offering, our series C-1 preferred stock
converted into our class B common stock on a one-for-one basis. The series D-1
preferred stock also converted into our class B common stock at that time on a
one-for-one basis. These strategic investors have each agreed not to transfer
any of our series C-1 preferred stock, series D-1 preferred stock or class B
common stock to any non-affiliated third party until January 2000. They have
also each agreed not to acquire more than 10% of our voting stock without our
consent until January 2002. In addition, until January 2002, they have agreed
to vote any voting securities it holds as recommended by our board of
directors.
Concurrently with these strategic equity investments, we entered into
commercial agreements with AT&T, NEXTLINK and Qwest. These agreements provide
for the purchase, marketing and resale of our services at volume discounts,
our purchase of fiber optic transport bandwidth at volume discounts,
collocation of network equipment and development of new DSL services. These
agreements have terms ranging from six months to several years subject to
earlier termination in certain circumstances. We cannot predict the number of
line orders that AT&T, NEXTLINK or Qwest will generate, if any, whether line
orders will be below our expectations or the expectations of, AT&T, NEXTLINK
or Qwest or whether AT&T, NEXTLINK or Qwest will discontinue selling our
services entirely.
Equipment Lease Financing
Through December 31, 1998, we have incurred a total of $860,000 of
equipment lease financing obligations (including principal and interest)
through a sale lease-back transaction with Charter Financial, Inc.. Through
December 31, 1998, we have made total payments of approximately $331,000 to
Charter Financial on these obligations. Warburg, one of our principal
stockholders, owns a majority of the capital stock of Charter Financial. We
believe that the terms of the lease financing with Charter Financial were
completed at rates similar to those available from alternative providers. Our
belief that the terms of the sale lease-back arrangement are similar to those
available from alternative providers is based on the advice of our officers
who reviewed at least two alternative proposals and who reviewed and
negotiated the terms of the arrangement with Charter Financial.
Vendor Relationship
Crosspoint, one of our principal stockholders, owns approximately 12% of
the capital stock of Diamond Lane, one of our vendors. Our payments to Diamond
Lane through December 31, 1998 totaled approximately
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$5,844,000. We believe that the terms of its transactions with Diamond Lane
were completed at rates similar to those available from alternative vendors.
This belief is based on our management team's experience in obtaining vendors
and the fact that we sought competitive bidders before entering into the
relationship with Diamond Lane.
Registration Rights
Certain holders of our common stock are entitled to registration rights.
Pursuant to the Stockholder Rights Agreement holders of 20,075,285 shares of
common stock and holders of 6,379,177 shares of class B common stock
(collectively, the "Rights Holders") are entitled to certain rights with
respect to the registration under the Securities Act of the shares of common
stock held by them or issuable upon conversion of the class B common stock.
The class B common stock may be converted into common stock at the election of
the holder commencing January 2000. The Rights Holders are entitled to demand,
"piggy-back" and S-3 registration rights, subject to certain limitations and
conditions. The number of securities requested to be included in a
registration involving the exercise of demand and "piggy-back" rights are
subject to a pro rata reduction based on the number of shares of common stock
held by each Rights Holder and any other security holders exercising their
respective registration rights to the extent that the managing underwriter
advises that the total number of securities requested to be included in the
underwriting is such as to materially and adversely affect the success of the
offering. The registration rights terminate as to any Rights Holder at the
later of (i) three years after our initial the offering made hereby or (ii)
such time as such Rights Holder may sell under Rule 144 in a three month
period all registrable securities then held by such Rights Holder.
Pursuant to the Warrant Registration Rights Agreement dated March 11, 1998,
between us and Bear, Stearns & Co. Inc. and BT Alex. Brown Incorporated,
holders of the warrants that were issued in connection with our senior
discount note offering in March 1998 are entitled to certain registration
rights with respect to the shares of common stock issuable upon exercise of
such warrants. The warrant holders are entitled to demand and "piggy-back"
registration rights, subject to certain limitations and conditions. Like the
Rights Holders, the number of securities that a warrant holder may request to
be included in a registration involving an exercise of its demand or "piggy-
back" rights is subject to a pro rata reduction. Such a reduction will be
based upon the number of shares held by each warrant holder and any other
security holders exercising their respective registration rights to the extent
that the managing underwriter advises us that the total number of securities
requested to be included in the underwriting is such as to materially and
adversely affect the success of the offering.
Employment Agreements
We have entered into employment agreements with certain of our officers.
See "Executive Compensation--Employment Agreements and Change in Control
Arrangements."
Employee Loans
In August 1998, we loaned Robert Knowling, Jr., our President and Chief
Executive Officer, the principal amount of $500,000 pursuant to a Note Secured
by Deed of Trust, which was secured by certain real property of Mr. Knowling.
The entire principal balance of this note becomes due and payable in one lump
sum on August 14, 2002. No interest is charged on the note. This note has
provisions for forgiveness based on continued employment and is subject to
acceleration in certain events.
In October 1998, we loaned Catherine Hemmer, our Vice President,
Operations, and her husband, one of our employees, the principal amount of
$600,000 pursuant to a Note Secured By Deed of Trust, which was secured by
certain real property of the Hemmers. The outstanding principal balance of
this note becomes due in four equal annual installments commencing August 10,
1999, with the last installment due on August 10, 2002. No interest is charged
on the note. This note has provisions for forgiveness based upon continued
employment of each of the Hemmers and is subject to acceleration in certain
events.
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PRINCIPAL STOCKHOLDERS
The following table sets forth certain information regarding ownership of
our common stock as of March 15, 1999 by:
(i)each Named Executive Officer,
(ii)each of our directors,
(iii)all of our executive officers and directors as a group, and
(iv)all persons who directly own 5% or more of our common stock.
Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of March
15, 1999 as described in the footnotes below. Percentage ownership is
calculated pursuant to SEC Rule 13d-3(d)(1). Except as otherwise indicated,
the address of each of the persons in this table is as follows: c/o Covad
Communications Group, Inc., 2330 Central Expressway, Santa Clara, CA 95050.
<TABLE>
<CAPTION>
Number of
Shares Percentage
Beneficially Beneficially
Beneficial Owner Owned(1) Owned(1)
- ---------------- ------------ ------------
<S> <C> <C>
Robert Knowling Jr.(2).. 432,500 1.0%
Charles McMinn(3)....... 3,027,052 7.2
Robert Hawk(4).......... 178,015 *
Henry Kressel(5)........ 13,366,056 31.6
Joseph Landy(5)......... 13,366,056 31.6
Daniel Lynch(6)......... 462,439 1.1
Frank Marshall(6)....... 262,215 *
Rich Shapero(7)......... 3,349,075 7.9
Rex Cardinale........... 1,125,000 2.7
Charles Haas(8)......... 3,027,052 7.2
Dhruv Khanna(9)......... 3,027,053 7.2
Timothy Laehy(10)....... 345,000 *
All executive officers
and directors as a
group(11).............. 28,650,796 67.0
Warburg, Pincus
Ventures, L.P. (12).... 13,366,056 31.6
Crosspoint Venture
Partners 1996 (13)..... 3,349,075 7.9
Intel Corporation (14).. 2,472,828 5.9
</TABLE>
- --------
* Represents beneficial ownership of less than 1% of our outstanding voting
stock.
(1) The percentages are based on 42,271,466 outstanding shares of common stock
as of March 15, 1999. Not included in this table are 6,379,177 outstanding
shares of our class B common stock which are non-voting. These shares are
held by certain strategic investors. See "Certain Relationships and
Related Transactions--The Strategic Investments and Relationships."
(2) Consists of 432,500 shares of common stock subject to options exercisable
within 60 days of March 15, 1999.
(3) Includes 475,000 shares of common stock held by a trust for the benefit of
two members of Mr. McMinn's immediate family, who also serve as co-
trustees. Mr. McMinn disclaims beneficial ownership of the shares of
common stock held by such trust.
(4) Includes 6,000 shares of common stock subject to options exercisable
within 60 days of March 15, 1999.
(5) All of the shares indicated are owned of record by Warburg and are
included because of Dr. Kressel's and Mr. Landy's affiliation with
Warburg. Dr. Kressel and Mr. Landy disclaim beneficial ownership of these
shares within the meaning of Rule 13d-3 under the Exchange Act. The
address of Dr. Kressel and Mr. Landy is c/o E.M. Warburg, Pincus & Co.,
LLC, 466 Lexington Avenue, New York, NY 10017-3147.
(6) Includes 18,000 shares of common stock subject to options exercisable
within 60 days of March 15, 1999.
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(7) All of the shares indicated are owned of record by Crosspoint and are
included because of Mr. Shapero's affiliation with Crosspoint. Mr.
Shapero disclaims beneficial ownership of these shares within the meaning
of Rule 13d-3 under the Exchange Act. The address of Mr. Shapero is c/o
Crosspoint Venture Partners, The Pioneer Hotel Building, 2925 Woodside
Road, Woodside, CA 94062.
(8) Includes 120,000 shares of common stock held by a limited partnership of
which Mr. Haas is a general partner and a limited partner. Mr. Haas
disclaims beneficial ownership of the shares of common stock held by such
limited partnership except to the extent of his pecuniary interest
therein.
(9) Includes 375,000 shares of common stock held by a limited partnership of
which Mr. Khanna is a general partner and a limited partner. Mr. Khanna
disclaims beneficial ownership of the shares of common stock held by such
limited partnership except to the extent of his pecuniary interest
therein.
(10) Includes a total of 30,000 shares of common stock held by three trusts
for the benefit of three members of Mr. Laehy's immediate family. Mr.
Laehy disclaims beneficial ownership of the shares of common stock held
by such trusts.
(11) Includes 523,839 shares of common stock subject to options exercisable
within 60 days of March 15, 1999.
(12) The sole general partner of Warburg, Pincus Ventures, L.P. is Warburg,
Pincus & Co., a New York general partnership ("WP"). E.M. Warburg, Pincus
& Co., LLC, a New York limited liability company ("EMW LLC"), manages
Warburg. The members of EMW LLC are substantially the same as the
partners of WP. Lionel I. Pincus is the managing partner of WP and the
managing member of EMW LLC and may be deemed to control both WP and EMW
LLC. WP has a 15% interest in the profits of Warburg as a general partner
and also owns approximately 1.3% of the limited partnership interests in
Warburg. Dr. Kressel and Mr. Landy, two of our directors, are Managing
Directors and members of EMW LLC and partners of WP and as such may be
deemed to have an indirect pecuniary interest (within the meaning of Rule
16a-1 under the Exchange Act) in an indeterminate portion of the shares
beneficially owned by Warburg. See Note 5 above. The address of Warburg
is c/o E.M. Warburg, Pincus & Co., LLC, 466 Lexington Avenue, New York,
NY 10017-3147.
(13) Mr. Shapero, one of our directors, is affiliated with Crosspoint and as
such may be deemed to have an indirect pecuniary interest (within the
meaning of Rule 16a-1 under the Exchange Act) in an indeterminate portion
of the shares beneficially owned by Crosspoint. See Note 7 above. The
address of Crosspoint is The Pioneer Hotel Building, 2925 Woodside Road,
Woodside, CA 94062.
(14) The address of Intel is 2200 Mission College Boulevard, Mail Stop SC4-
210, Santa Clara, CA 95052-8199.
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THE EXCHANGE OFFER
Purposes of the Exchange Offer
We sold the old notes to the initial purchasers. The initial purchasers
resold the old notes to "qualified institutional buyers" (as defined in Rule
144A under the Securities Act). In issuing the old notes, we agreed to use our
reasonable best efforts to cause to become effective within the time period
specified in the registration rights agreement dated February 18, 1999, a
registration statement with respect to the exchange offer (the "Exchange Offer
Registration Statement"). We will file with the SEC a shelf registration
statement (the "Shelf Registration Statement") if:
(1) we are not required to file the Exchange Offer Registration Statement or
permitted to consummate the exchange offer because the exchange offer is
not permitted by applicable law or SEC policy; or
(2) any holder of old notes notifies us prior to the 20th day following the
consummation of the exchange offer that:
(a) it is prohibited by law or SEC policy from participating in the
exchange offer; or
(b) it may not resell the new notes it acquired in the exchange offer to
the public without delivering a prospectus and the prospectus contained
in the Exchange Offer Registration Statement is not appropriate or
available for such resales; or
(c) it is a broker-dealer and owns old notes acquired directly from us or
one of our affiliates.
The Shelf Registration Statement will cover resales of old notes by holders
who have provided certain information required by us in connection with the
Shelf Registration Statement.
We are making the exchange offer to satisfy our obligations under the
registration rights agreement. Once the exchange offer is complete, we will
have no further obligation to register any of the old notes not tendered by
the holders for exchange. See "Risk Factors--Consequences of not tendering old
notes in the exchange offer." We filed a copy of the Registration Rights
Agreement as an exhibit to the registration statement of which this prospectus
is a part.
We believe that new notes issued in the exchange offer in exchange for old
notes may be offered for resale, resold and otherwise transferred by their
holders without compliance with the registration and prospectus delivery
provisions of the Securities Act. Our belief is based on an interpretation by
the staff of the SEC set forth in the staff's Exxon Capital Holdings Corp. SEC
No-Action Letter (available April 13, 1989), Morgan Stanley & Co., Inc. SEC
No-Action Letter (available June 5, 1991), Shearman & Sterling SEC No-Action
Letter (available July 7, 1993), and other no-action letters issued to third
parties. Any holder who is an "affiliate" of ours or who intends to
participate in the exchange offer for the purpose of distributing the new
notes:
(1) cannot rely on the interpretation by the staff of the SEC set forth in the
above referenced no-action letters,
(2) cannot tender its old notes in the exchange offer, and
(3) must comply with the registration and prospectus delivery requirements of
the Securities Act in connection with any sale or transfer of the old
notes, unless such sale or transfer is made pursuant to an exemption from
such requirements.
In addition, each broker-dealer that holds old notes acquired for its own
account as a result of market-making or other trading activities (a
"Participating Broker-Dealer") that receives new notes for its own account in
exchange for old notes not acquired directly from us must acknowledge that it
will deliver a prospectus in connection with any resale of such new notes. See
"Plan of Distribution."
Except as described above, this prospectus may not be used for an offer to
resell, resale or other transfer of new notes.
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Terms of the Exchange Offer
General. Upon the terms and subject to the conditions of the exchange offer
described in this prospectus and the letter of transmittal, we will accept any
and all old notes validly tendered and not withdrawn before 5:00 p.m., New
York City time, on the expiration date. We will issue $1,000 principal amount
of new notes in exchange for each $1,000 principal amount of outstanding old
notes accepted in the exchange offer. You may tender some or all of your old
notes pursuant to the exchange offer. Old notes may be tendered only in
integral multiples of $1,000 principal amount.
As of April 22, 1999, there was $215,000,000 of aggregate principal amount
of the old notes outstanding. We are sending this prospectus, together with
the letter of transmittal to all registered holders of old notes as of April
26, 1999.
We arranged for the old notes to be issued and transferable in book-entry
form through the facilities of The Depository Trust Company acting as
depositary. The new notes will also be issued and transferable in book-entry
form through DTC. See "--Book-Entry Transfer; Delivery and Form."
We will accept validly tendered old notes by giving oral (confirmed in
writing) or written notice of acceptance to the exchange agent. The exchange
agent will act as agent for the tendering holders of old notes for the purpose
of receiving the new notes from us.
If any tendered old notes are not accepted for exchange because of an
invalid tender, the occurrence of certain other events described in this
prospectus or otherwise, the certificates for any such unaccepted old notes
will be returned, without expense, to the holder tendering them or the
appropriate book-entry transfer will be made, in each case, as promptly as
practicable after the expiration date.
You will not be required to pay brokerage commissions or fees or, subject
to the instructions in the letter of transmittal, transfer taxes with respect
to the exchange of old notes tendered in the exchange offer. We will pay the
expenses, other than certain applicable taxes, of the exchange offer. See "--
Fees and Expenses."
We are not making, nor is our board of directors making, any recommendation
to you as to whether to tender or refrain from tendering all or any portion of
your old notes in the exchange offer. No one has been authorized to make any
such recommendation. You must make your own decision whether to tender in the
exchange offer and, if so, the aggregate amount of old notes to tender after
reading this prospectus and the letter of transmittal and consulting with your
advisers, if any, based on your own financial position and requirements.
Expiration Date; Extensions; Amendments. The "expiration date" is May 26,
1999. In our sole discretion, we may extend the exchange offer, in which case
the term "expiration date" means the latest date to which the exchange offer
is extended.
To extend the expiration date, we will notify the exchange agent and the
record holders of old notes of any extension by oral (followed by written)
notice, before 9:00 a.m., New York City time, on the business day following
the previously scheduled expiration date. We may extend the exchange offer for
a specified period of time or on a daily basis until 5:00 p.m., New York City
time, on the date on which a specified percentage of old notes are tendered.
We reserve the right to delay accepting any old notes, to extend the
exchange offer, to amend the exchange offer or to terminate the exchange offer
and not accept old notes not previously accepted if any of the conditions
described in "--Conditions" occurs and is not waived. Waiver must be given by
oral (confirmed in writing) or written notice to the exchange agent as
promptly as practicable. If the exchange offer is amended in a manner we
determine to be material, we will promptly disclose such amendment in a manner
reasonably calculated to inform the holders of such amendment. We will also
extend the exchange offer in such circumstances for a period of five to ten
business days, depending upon the significance of the amendment and the manner
of disclosure to holders of the old notes, if the exchange offer would
otherwise expire during such five to ten business day period.
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<PAGE>
We have no obligation to publish, advertise, or otherwise communicate any
public announcement of any delay, extension, amendment or termination of the
exchange offer, other than by making a timely release to the Dow Jones News
Service. We may make such announcement in any additional ways at our
discretion.
Interest on the New Notes and the Old Notes
The old notes will continue to accrue interest at the rate of 12 1/2% per
annum through (but not including) the date of issuance of the new notes. Any
old notes not tendered or accepted for exchange will continue to accrue
interest at the rate of 12 1/2% per annum in accordance with their terms. From
and after the date of issuance of the new notes, the new notes will accrue
interest at the rate of 12 1/2% per annum. Interest on the new notes and any
old notes not tendered or accepted for exchange will be payable semi-annually
in arrears on February 15 and August 15 of each year, commencing on August 15,
1999.
Procedures for Tendering
To tender in the exchange offer, you must follow these steps:
(a) complete, sign and date the letter of transmittal, or a facsimile of
it;
(b) have the signatures on the letter guaranteed if required by Instruction
3 of the letter of transmittal; and
(c) mail or otherwise deliver such letter of transmittal or such facsimile,
together with the old notes and any other required documents, to the
exchange agent before 5:00 p.m., New York City time, on the expiration
date.
If delivery of the old notes is made through book-entry transfer into the
exchange agent's account at DTC, you must tender the old notes in accordance
with DTC's Automated Tender Offer Program (ATOP) procedures. See "--Book-Entry
Transfer; Delivery and Form."
Your tender of old notes will constitute an agreement between us in
accordance with the terms and subject to the conditions set forth in this
prospectus and in the letter of transmittal.
You must deliver all documents for tender to the exchange agent at its
address set forth below. You may also request your brokers, dealers,
commercial banks, trust companies or nominees to effect the above transactions
for you.
The method of delivery of certificates, the letter of transmittal and all
other required documents, is at your option and your sole risk. Documents are
delivered only when actually received by the exchange agent. If delivery is by
mail, we recommend registered mail, return receipt requested, properly
insured, or an overnight delivery service. In all cases, you should allow
sufficient time to insure timely delivery.
Only a holder of old notes may tender such old notes in the exchange offer.
The term "holder" with respect to the exchange offer means any person in whose
name old notes are registered on our books or any other person who has
obtained a properly completed bond power from the registered holder.
If your old notes are registered in the name of your broker, dealer,
commercial bank, trust company or other nominee and you wish to tender, you
should contact such registered holder promptly and instruct such registered
holder to tender on your behalf. If your old notes are so registered and you
wish to tender on your own behalf, you must, prior to completing and executing
the letter of transmittal and delivering your old notes, either make
appropriate arrangements to register ownership of the old notes in your name
or obtain a properly completed bond power from the registered holder. The
transfer of record ownership may take considerable time.
Signatures on a letter of transmittal or notice of withdrawal must be
guaranteed by a member firm of a registered national securities exchange or of
the National Association of Securities Dealers, Inc., or a commercial
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bank or trust company having an office or correspondent in the U.S. (an
"Eligible Institution"). Signatures do not need to be guaranteed if the old
notes are tendered (i) by a registered Holder who has not completed the box
entitled "Special Payment Instructions" or "Special Delivery Instructions" on
the letter of transmittal or (ii) for the account of an Eligible Institution.
If the letter of transmittal is signed by a person other than the
registered holder of any old notes listed on the letter, such old notes must
be endorsed or accompanied by appropriate bond powers signed as the name of
the registered holder or holders appears on the old notes.
If the letter of transmittal or any old notes or bond powers are signed by
trustees, executors, administrators, guardians, attorneys-in-fact, officers of
corporations or others acting in a fiduciary or representative capacity, such
persons must indicate their capacity when signing. Unless waived by us, you
must then submit evidence satisfactory to us of their authority to so act with
the letter of transmittal.
We will determine in our sole discretion all questions as to the validity,
form, eligibility (including time of receipt) and acceptance of tendered old
notes and withdrawal of tendered old notes. Our determination will be final
and binding. We reserve the absolute right to reject any and all old notes not
properly tendered or any old notes acceptance of which would, in the opinion
of our counsel, be unlawful for us to accept. We also reserve the right to
waive any defects, irregularities or conditions of tender as to particular old
notes. Our interpretation of the terms and conditions of the exchange offer
(including the instructions in the letter of transmittal) will be final and
binding on all parties. Unless waived, any defects or irregularities in
connection with tenders of old notes must be cured within such time as we
determine. No one is under any duty to give notification of defects or
irregularities with respect to tenders of old notes, nor will any person incur
any liability for failure to give such notification. Old notes are not
properly tendered until such irregularities have been cured or waived. Any old
notes received by the exchange agent that are not properly tendered and as to
which the defects or irregularities have not been cured or waived will be
returned by the exchange agent to the tendering holders of such old notes,
unless otherwise provided in the letter of transmittal, as soon as practicable
after the expiration date.
In addition, we reserve the right in our sole discretion:
. to purchase or make offers for any old notes that remain outstanding
after the expiration date;
. to terminate the exchange offer as described in "--Conditions"; and
. to the extent permitted by applicable law, purchase old notes in the open
market, in privately negotiated transactions or otherwise. The terms of
any such purchases or offers could differ from the terms of the exchange
offer.
By tendering, you will represent to us, among other things, that:
. the new notes you acquire in the exchange offer are being obtained in the
ordinary course of your business;
. you have no arrangement with any person to participate in the
distribution of such new notes; and
. you are not an "affiliate," as defined under Rule 405 of the Securities
Act, of ours.
If you are a Participating Broker-Dealer that will receive new notes for
your own account in exchange for old notes that were not acquired directly
from us, by tendering you will acknowledge that you will deliver a prospectus
in connection with any resale of such new notes. See "Plan of Distribution."
Book-Entry Transfer; Delivery and Form
The old notes were initially represented:
. if initially purchased by "qualified institutional buyers" (as such term
is defined in Rule 144A under the Securities Act), by two global old
notes in fully registered form, all registered in the name of a nominee
of DTC; and
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. if held by persons, other than U.S. persons, relying upon Regulation S
under the Securities Act, by one global Regulation S old note in fully
registered form, all registered in the name of a nominee of DTC for the
accounts of Euroclear System and Cedel Bank, societe anonyme.
The new notes exchanged for the old notes represented by the global old
notes and global Regulation S old note will be represented by global new notes
in fully registered form, registered in the name of the nominee of DTC.
The global new notes will be exchangeable for definitive new notes in
registered form, in denominations of $1,000 principal amount and integral
multiples of $1,000. The new notes in global form will trade in DTC's same-day
funds settlement system, and secondary market trading activity in such new
notes will therefore settle in immediately available funds.
We understand that the exchange agent will make a request promptly after
the date of this prospectus to establish an account with respect to the old
notes at DTC for the purpose of facilitating the exchange offer. Subject to
the establishment of this account, any financial institution that is a
participant in DTC's system may make book-entry delivery of old notes by
causing DTC to transfer such old notes into the exchange agent's account with
respect to the old notes in accordance with DTC's ATOP procedures for such
book-entry transfers. Although delivery of the old notes may be effected
through book-entry transfer into the exchange agent's account at DTC, the
exchange for old notes so tendered will be made only after two conditions are
met.
First, DTC must timely confirm (a "Book-Entry Confirmation") such book-
entry transfer of the old notes into the exchange agent's account.
Second, the exchange agent must timely receive a Book-Entry Confirmation
with a message, transmitted by DTC and received by the exchange agent and
forming part of the Book-Entry Confirmation, which states that DTC has
received express acknowledgment from a participant tendering old notes that
such participant has received and agrees to be bound by the terms of the
letter of transmittal, and that such agreement may be enforced against such
participant.
Guaranteed Delivery Procedures
If your old notes are not immediately available or if you cannot deliver
your old notes, the letter of transmittal or any other required documents to
the exchange agent prior to the expiration date, you may effect a tender if:
(1) the tender is made through an Eligible Institution;
(2) before the expiration date, the exchange agent receives from such Eligible
Institution a properly completed and duly executed notice of guaranteed
delivery (by facsimile transmission, mail or hand delivery) setting forth
the name and address of the holder of the old notes, the certificate
number or numbers of such old notes and the principal amount of old notes
tendered, stating that the tender is being made thereby and guaranteeing
that, within three New York Stock Exchange trading days after the
expiration date, the letter of transmittal (or facsimile of such letter)
together with the certificate(s) representing the old notes to be tendered
in proper form for transfer and any other documents required by the letter
of transmittal, or a Book-Entry Confirmation, as the case may be, will be
delivered by the Eligible Institution to the exchange agent; and
(3) such properly completed and executed letter of transmittal (or facsimile
of such letter), as well as the certificate(s) representing all tendered
old notes in proper form for transfer and all other documents required by
the letter of transmittal, or a Book-Entry Confirmation, as the case may
be, are received by the exchange agent within three New York Stock
Exchange trading days after the expiration date.
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Upon request of the exchange agent, a notice of guaranteed delivery will be
sent to holders who wish to tender their old notes according to the guaranteed
delivery procedures set forth above.
Withdrawal of Tenders
Except as otherwise described in this prospectus, tenders of old notes may
be withdrawn at any time before 5:00 p.m., New York City time, on the
expiration date. To withdraw a tender of old notes in the exchange offer, the
exchange agent must receive a written or facsimile transmission notice of
withdrawal at its address set forth in this prospectus before 5:00 p.m., New
York City time, on the expiration date. Any such notice of withdrawal must:
(1) specify the name of the person having deposited the old notes to be
withdrawn (the "Depositor");
(2) identify the old notes to be withdrawn (including the certificate number
or numbers and principal amount at of such old notes);
(3) be signed by the holder in the same manner as the original signature on
the letter of transmittal by which such old notes were tendered (including
any required signature guarantees) or be accompanied by documents of
transfer sufficient to have the trustee with respect to the old notes
register the transfer of such old notes into the name of the person
withdrawing the tender; and
(4) specify the name in which any such old notes are to be registered, if
different from that of the Depositor.
All questions as to the validity, form and eligibility (including time of
receipt) of such notices will be determined by us. Our determination will be
final and binding on all parties. Any old notes so withdrawn will be deemed
not to have been validly tendered for purposes of the exchange offer and no
new notes will be issued with respect thereto unless the old notes so
withdrawn are validly retendered. Any old notes which have been tendered but
which are not accepted for exchange will be returned to their holder without
cost to such holder as soon as practicable after withdrawal, rejection of
tender or termination of the exchange offer. Properly withdrawn old notes may
be retendered by following one of the procedures, described above under "--
Procedures for Tendering" at any time before the expiration date.
Conditions
Notwithstanding any other term of the exchange offer, we will not be
required to accept for exchange, or exchange new notes for, any old notes not
accepted for exchange, and may terminate or amend the exchange offer as
provided in this prospectus before the acceptance of such old notes, if any of
the following conditions exist:
(1) the exchange offer, or the making of any exchange by a holder, violates
applicable law or any applicable interpretation of the SEC;
(2) any action or proceeding is instituted or threatened in any court or by or
before any governmental agency with respect to the exchange offer which,
in our sole judgment, might impair our ability to proceed with the
exchange offer;
(3) any law, statute, rule or regulation is adopted or enacted which, in our
sole judgment, might materially impair our ability to proceed with the
exchange offer;
(4) a banking moratorium is declared by U.S. federal or California or New York
state authorities which, in our judgment, would reasonably be expected to
impair our ability to proceed with the exchange offer;
(5) trading on the New York Stock Exchange or generally in the U.S. over-the-
counter market is suspended by order of the SEC or any other governmental
authority which, in our judgment, would reasonably be expected to impair
our ability to proceed with the exchange offer; or
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(6) a stop order is issued by the SEC or any state securities authority
suspending the effectiveness of the registration statement or proceedings
are initiated or, to our knowledge, threatened for that purpose.
If any such conditions exist, we may
. refuse to accept any old notes and return all tendered old notes to
exchanging holders;
. extend the exchange offer and retain all old notes tendered prior to the
expiration of the exchange offer, subject, however, to the rights of
holders to withdraw such old notes (see "--Withdrawal of Tenders"); or
. waive certain of such conditions with respect to the exchange offer and
accept all properly tendered old notes which have not been withdrawn or
revoked.
If such waiver constitutes a material change to the exchange offer, we will
promptly disclose such waiver in a manner reasonably calculated to inform
holders of old notes of such waiver.
The conditions described above are for our sole benefit. We may assert any
condition regardless of the circumstances giving rise to any such condition.
We may waive any condition in whole or in part at any time and from time to
time in our sole discretion. We are not waiving these rights by failing to
exercise them. These rights are ongoing and may be asserted at any time and
from time to time.
Exchange Agent
We appointed The Bank of New York as exchange agent for the exchange offer.
Send letters of transmittal and notices of guaranteed delivery to the exchange
agent addressed as follows:
<TABLE>
<S> <C>
By Registered or Certified
Mail: By Overnight Courier:
Attention: Theresa Gass Attention: Theresa Gass
Reorganization Section Reorganization Section
The Bank of New York The Bank of New York
101 Barclay Street, Floor 7E 101 Barclay Street
New York, New York 10286 Corporate Trust Services Window
Ground Floor
New York, New York 10286
By Hand: By Facsimile:
Attention: Theresa Gass (212) 815-6339
Reorganization Section Attention: Theresa Gass
The Bank of New York Reorganization Section
101 Barclay Street
Corporate Trust Services
Window Confirm by telephone:
Ground Floor (212) 815-5942
New York, New York 10286
</TABLE>
Fees and Expenses
We will pay the expenses of soliciting tenders. The principal solicitation
is being made by mail. Additional solicitation may be made by telegraph,
telephone or in person by officers and regular employees of ours and our
affiliates and by persons so engaged by the exchange agent.
We will not make any payments to brokers, dealers or others soliciting
acceptances of the exchange offer. We will pay the exchange agent reasonable
and customary fees for its services and will reimburse it for its reasonable
out-of-pocket expenses in connection therewith. We may also pay brokerage
houses and other custodians, nominees and fiduciaries the reasonable out-of-
pocket expenses incurred by them in forwarding
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copies of this prospectus and related documents to the beneficial owners of
the old notes, and in handling or forwarding tenders for exchange.
We will pay the cash expenses to be incurred in connection with the
exchange offer. We estimate these cash expenses will aggregate approximately
$250,000, including fees and expenses of the exchange agent and the trustee
under the indenture and accounting and legal fees.
We will pay all transfer taxes, if any, applicable to the exchange of old
notes in the exchange offer. The amount of any such transfer taxes (whether
imposed on the registered holder or any other persons) will be payable by the
tendering holder if:
(1) certificates representing new notes or old notes for principal amounts at
maturity not tendered or accepted for exchange are to be delivered to, or
are to be registered in the name of, any person other than the registered
holder of the old notes tendered;
(2) tendered old notes are registered in the name of any person other than the
person signing the letter of transmittal; or
(3) a transfer tax is imposed for any reason other than the exchange of old
notes in the exchange offer.
In such circumstances, you must submit satisfactory evidence of payment of
such taxes or exception from such taxes with the letter of transmittal or the
amount of such transfer taxes will be billed directly to you.
Accounting Treatment
The new notes will be recorded at the same carrying value as the old notes,
which is face value less unamortized original issue discount as reflected in
our accounting records on the date of the exchange offer. Accordingly, no gain
or loss for accounting purposes will be recognized upon completion of the
exchange offer. The issuance costs incurred in connection with the exchange
offer will be capitalized and amortized over the term of the new notes.
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DESCRIPTION OF THE OLD NOTES
General
The old notes were issued pursuant to the Indenture between the Company and
The Bank of New York, as trustee, in a private transaction that was not
subject to the registration requirements of the Securities Act. The terms of
the old notes include those stated in the Indenture and those made part of the
Indenture by reference to the Trust Indenture Act of 1939, as amended (the
"Trust Indenture Act"). The old notes are subject to all such terms, and
holders of old notes are referred to the Indenture and the Trust Indenture Act
for a statement thereof. The following summary of the material provisions of
the Indenture and the Registration Rights Agreement does not purport to be
complete and is qualified in its entirety by reference to such agreements,
including the definitions therein of certain terms used below. Copies of such
agreements have been filed as exhibits to the registration statement of which
this prospectus is a part and are available from the SEC or as set forth below
under "--Where You Can Find More Information." The definitions of certain
terms used in the following summary are set forth below under "--Certain
Definitions." For purposes of this summary, the term "Company" refers only to
Covad Communications Group, Inc. and not to any of its Subsidiaries and the
term "Notes" refers only to the old notes.
Brief Description of the Old Notes
The Notes:
. are senior obligations of the Company;
. rank equal in right of payment with all existing and future senior Debt
of the Company;
. rank senior in right of payment to any future subordinated Debt of the
Company; and
. are effectively subordinated to any secured Debt of the Company and
existing and future Debt and other liabilities (including subordinated
Debt and trade payables) of its Subsidiaries.
The Indenture will permit the Company and its Subsidiaries to incur
substantial additional Debt, subject to certain restrictions. See "Risk
Factors--We rely upon distributions from our subsidiaries to service our
indebtedness, and our indebtedness is subordinated to the indebtedness of our
subsidiaries." As of December 31, 1998, on a pro forma basis after giving
effect to the issuance of the old notes, the total amount of long-term
obligations (including current portion but net of debt discount, which
represents the value ascribed to the warrants issued in connection with the
1998 discount notes) was approximately $353.4 million.
The Company's operations are conducted through its Subsidiaries and,
therefore, the Company is dependent upon the cash flow of its Subsidiaries to
meet its obligations, including its obligations under the Notes. See "Risk
Factors--We rely upon distributions from our subsidiaries to service our
indebtedness, and our indebtedness is subordinated to the indebtedness of our
subsidiaries."
The Company currently has two Subsidiaries, both of which are designated as
Restricted Subsidiaries under the Indenture. Under certain circumstances, the
Company will be permitted to designate certain of its Subsidiaries, including
Subsidiaries that it creates or acquires in the future, to be Unrestricted
Subsidiaries. Unrestricted Subsidiaries are not subject to many of the
restrictive covenants in the Indenture. See "--Certain Covenants--Restricted
Payments."
Principal, Maturity and Interest
The Company has limited the aggregate principal amount of the Notes to
$265.0 million, of which approximately $215.0 million aggregate principal
amount of Notes has been issued and $50.0 million aggregate principal amount
of Notes are available for issuance in the future, subject to the covenant
described under "--Certain Covenants--Incurrence of Debt and Issuance of
Disqualified Stock." We issued the Notes in denominations of $1,000 and
integral multiples of $1,000. The Notes will mature on February 15, 2009.
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Interest on the Notes accrues at the rate of 12 1/2% per annum and is
payable in cash semi-annually in arrears on February 15 and August 15,
commencing on August 15, 1999, to the Holders of record of the Notes on the
immediately preceding February 1 and August 1.
Interest on the Notes has accrued from the closing date of the issuance of
the old notes. Interest will be computed on the basis of a 360-day year
comprised of twelve 30-day months.
Pledged Securities; Interest Reserve
We used approximately $74.0 million of the net proceeds of the issuance of
the old notes to purchase the Pledged Securities in an amount sufficient, upon
receipt of scheduled interest and principal payments on the Pledged
Securities, to pay in full the first six scheduled interest payments due on
the Notes. We pledged the Pledged Securities to The Bank of New York as escrow
agent for the benefit of the Holders of the Notes pursuant to the Pledge
Agreement, and the escrow agent holds the Pledged Securities in the Pledge
Account.
Pursuant to the Pledge Agreement, immediately prior to an interest payment
date on the Notes, we may either deposit with the Trustee from funds otherwise
available to us cash sufficient to pay the interest scheduled to be paid on
the Notes on such date or we may direct the escrow agent to release from the
Pledge Account proceeds sufficient to pay the interest then due. If we choose
to deposit cash with the Trustee, we may then direct the escrow agent to
release to us from the Pledge Account proceeds or Pledged Securities in the
amount of our cash deposit. If we fail to pay interest on the Notes in a
timely manner through February 2002, our failure will constitute an immediate
Event of Default under the Indenture, with no grace or cure period.
We will add interest we earn on the Pledged Securities to the Pledge
Account. If the funds or Pledged Securities in the Pledge Account exceed the
amount sufficient, in the opinion of a nationally recognized firm of
independent certified public accountants selected by us, to pay in full the
first six scheduled interest payments due on the Notes (or, if an interest
payment or payments have been made, an amount sufficient to pay in full any
interest payments remaining, up to and including the sixth scheduled interest
payment), the escrow agent will be permitted to release to us at our request
any such excess amount. The Notes are secured by a first priority security
interest in the Pledged Securities and the Pledge Account also secures
repayment of the principal amount of the Notes to the extent of such security.
Under the Pledge Agreement, assuming that we make the first six scheduled
interest payments on the Notes in a timely manner, all of the Pledged
Securities will be released from the Pledge Account.
Methods of Receiving Payments on the Notes
If a Holder has given wire transfer instructions to the Company, we will
make all principal, premium and interest payments on those Notes in accordance
with those instructions. All other payments on the Notes will be made at the
office or agency of the Paying Agent and Registrar within the City and State
of New York unless we elect to make interest payments by check mailed to the
Holders at their address set forth in the register of Holders.
Paying Agent and Registrar for the Notes
The Trustee will initially act as Paying Agent and Registrar. We may change
the Paying Agent or Registrar without prior notice to the Holders of the
Notes, and we or any of our Subsidiaries may act as Paying Agent or Registrar.
Transfer and Exchange
A Holder may transfer or exchange Notes in accordance with the Indenture.
The Registrar and the Trustee may require a Holder, among other things, to
furnish appropriate endorsements and transfer documents and we
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may require a Holder to pay any taxes and fees required by law or permitted by
the Indenture. We are not required to transfer or exchange any Note selected
for redemption. Also, we are not required to exchange or register the transfer
of any Note for a period of 15 days before a selection of Notes to be
redeemed.
The registered Holder of a Note will be treated as its owner for all
purposes.
Optional Redemption
At any time on or prior to February 15, 2002, the Company may on any one or
more occasions redeem up to 35% of the Notes originally issued under the
Indenture at a redemption price of 112.50% of the aggregate principal amount
of the Notes, plus accrued and unpaid interest to the redemption date, with
the net cash proceeds (but only to the extent such proceeds consist of cash or
Cash Equivalents) of one or more Public Equity Offerings; provided that
(1) at least $140.0 million of the aggregate principal amount of the Notes
remains outstanding immediately after the occurrence of such redemption
(excluding Notes held by us and our Subsidiaries); and
(2) we must mail a notice of redemption no later than 30 days after the
related Public Equity Offering and must consummate the redemption within
60 days of the closing of such Public Equity Offering.
Except pursuant to the preceding paragraph, the Notes will not be
redeemable at the Company's option prior to February 15, 2004.
After February 15, 2004, the Company may redeem all or a part of these
Notes upon not less than 30 nor more than 60 days' notice, at the redemption
prices (expressed as percentages of principal amount) set forth below, plus
accrued and unpaid interest thereon, if any, to the applicable redemption
date, if redeemed during the twelve-month period beginning on February 15 of
the years indicated below:
<TABLE>
<CAPTION>
Year Percentage
---- ----------
<S> <C>
2004.......................................... 106.250%
2005.......................................... 104.167%
2006.......................................... 102.083%
2007 and thereafter........................... 100.000%
</TABLE>
Selection and Notice
If less than all of the Notes are to be redeemed at any time, the Trustee
will select Notes for redemption as follows:
(1) if the Notes are listed, in compliance with the requirements of the
principal national securities exchange on which the Notes are listed; or
(2) if the Notes are not so listed, on a pro rata basis, by lot or by such
other method as the Trustee shall deem fair and appropriate.
No Notes of $1,000 or less shall be redeemed in part. Notices of redemption
shall be mailed by first class mail at least 30 but not more than 60 days
before the redemption date to each Holder of Notes to be redeemed at its
registered address. Notices of redemption may not be conditional.
If any Note is to be redeemed in part only, the notice of redemption that
relates to that Note shall state the portion of the principal amount thereof
to be redeemed. A new Note in principal amount equal to the unredeemed portion
of the original Note will be issued in the name of the Holder thereof upon
cancellation of the original Note. Notes called for redemption become due on
the date fixed for redemption. On and after the redemption date, interest
ceases to accrue on Notes or portions of them called for redemption.
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Mandatory Redemption
The Company will not be required to make mandatory redemption or sinking
fund payments with respect to the Notes.
Repurchase at the Option of Holders
Change of Control
If a Change of Control occurs, each Holder of Notes will have the right to
require the Company to repurchase all or any part (equal to $1,000 or an
integral multiple thereof) of that Holder's Notes pursuant to the Change of
Control Offer. In the Change of Control Offer, the Company will offer a Change
of Control Payment equal to 101% of the aggregate principal amount of Notes
repurchased, plus accrued and unpaid interest thereon, if any, to the date of
purchase. Within ten days following any Change of Control, the Company will
mail a notice to each Holder describing the transaction or transactions that
constitute the Change of Control and offering to repurchase Notes on the date
specified in such notice, pursuant to the procedures required by the Indenture
and described in such notice. The Company will comply with the requirements of
Rule 14e-1 under the Exchange Act and any other securities laws and
regulations thereunder to the extent such laws and regulations are applicable
in connection with the repurchase of the Notes as a result of a Change of
Control.
On the Change of Control Payment Date, the Company will, to the extent
lawful:
(1) accept for payment all Notes or portions thereof properly tendered
pursuant to the Change of Control Offer;
(2) deposit with the Paying Agent an amount equal to the Change of Control
Payment in respect of all Notes or portions thereof so tendered; and
(3) deliver or cause to be delivered to the Trustee the Notes so accepted
together with an Officers' Certificate stating the aggregate principal
amount of Notes or portions thereof being purchased by the Company.
The Paying Agent will promptly mail to each Holder of Notes so tendered the
Change of Control Payment for such Notes. The Trustee will promptly
authenticate and mail (or cause to be transferred by book entry) to each
Holder a new Note equal in principal amount to any unpurchased portion of the
Notes surrendered, if any; provided that each such new Note will be in a
principal amount of $1,000 or an integral multiple thereof.
The Company will publicly announce the results of the Change of Control
Offer on or as soon as practicable after the Change of Control Payment Date.
The provisions described above that require the Company to make a Change of
Control Offer following a Change of Control will be applicable regardless of
whether or not any other provisions of the Indenture are applicable. Except as
described above with respect to a Change of Control, the Indenture does not
contain provisions that permit the Holders of the Notes to require that the
Company repurchase or redeem the Notes in the event of a takeover,
recapitalization or similar transaction.
The Company will not be required to make a Change of Control Offer upon a
Change of Control if a third party makes the Change of Control Offer in the
manner, at the times and otherwise in compliance with the requirements set
forth in the Indenture applicable to a Change of Control Offer made by the
Company and purchases all Notes validly tendered and not withdrawn under such
Change of Control Offer.
The definition of Change of Control includes a phrase relating to the sale,
lease, transfer, conveyance or other disposition of "all or substantially all"
of the assets of the Company and its Subsidiaries taken as a whole. Although
there is a limited body of case law interpreting the phrase "substantially
all," there is no precise established definition of the phrase under
applicable law. Accordingly, the ability of a Holder of Notes to require the
Company to repurchase such Notes as a result of a sale, lease, transfer,
conveyance or other disposition of less than all of the assets of the Company
and its Subsidiaries taken as a whole to another Person or group may be
uncertain.
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Asset Sales
The Company will not, and will not permit any of its Restricted
Subsidiaries to, consummate an Asset Sale unless:
(1) the Company (or the Restricted Subsidiary, as the case may be) receives
consideration at the time of such Asset Sale at least equal to the fair
market value of the assets or Equity Interests issued or sold or otherwise
disposed of;
(2) such fair market value is determined by the Company's board of directors
and evidenced by a resolution of the board of directors set forth in an
Officers' Certificate delivered to the Trustee; and
(3) at least 75% of the consideration therefor received by the Company or such
Restricted Subsidiary is in the form of any combination of cash or Cash
Equivalents. For purposes of this provision, each of the following are
considered cash:
(a) any liabilities (as shown on the Company's or such Restricted
Subsidiary's most recent balance sheet) of the Company or such
Restricted Subsidiary (other than contingent liabilities and
liabilities that are by their terms subordinated to the Notes or any
guarantee thereof) that are assumed by the transferee of any such
assets pursuant to a customary novation agreement that releases the
Company or such Restricted Subsidiary from further liability; and
(b) any securities, notes or other obligations received by the Company or
such Restricted Subsidiary from such transferee that are
contemporaneously (subject to ordinary settlement periods) converted by
the Company or such Restricted Subsidiary into cash (to the extent of
the cash received in that conversion).
The Company and its Restricted Subsidiaries will be permitted to consummate
an Asset Sale without complying with clause (3) of the immediately proceeding
paragraph if:
(1) the Company (or the Restricted Subsidiary, as the case may be) receives
consideration at the time of such Asset Sale at least equal to the Fair
Market Value of the assets or other property sold, issued or otherwise
disposed of; and
(2) at least 75% of the consideration for such Asset Sale constitutes any
combination of cash, Cash Equivalents and Productive Assets. Each of the
following shall be deemed to be Net Cash Proceeds subject to the
provisions of this paragraph:
(a) any cash consideration;
(b) any non-cash consideration not constituting Productive Assets received
by the Company or any of its Restricted Subsidiaries in connection with
such Asset Sale that is converted into or sold or otherwise disposed of
for cash or Cash Equivalents at any time within 365 days after such
Asset Sale; and
(c) any Productive Assets constituting cash or Cash Equivalents received by
the Company or any of its Restricted Subsidiaries in connection with
such Asset Sale.
Within 365 days after the receipt of any Net Proceeds from an Asset Sale,
the Company (or such Restricted Subsidiary, as the case may be) may apply such
Net Proceeds to:
(1) permanently reduce the amounts permitted to be borrowed by the Company or
such Restricted Subsidiary under the terms of any of its Debt that is not
subordinated Debt; or
(2) the purchase of Telecommunications Related Assets or Voting Stock of any
Person engaged in the Telecommunications Business in the U.S. (provided
that such Person concurrently becomes a Restricted Subsidiary of the
Company).
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Pending the final application of any such Net Proceeds, the Company may
temporarily reduce revolving credit borrowings or otherwise invest such Net
Proceeds in any manner that is not prohibited by the Indenture.
Any Net Proceeds from Asset Sales that are not applied or invested as
provided in the preceding paragraph will constitute Excess Proceeds. When the
aggregate amount of Excess Proceeds exceeds the greater of $10.0 million or
10% of the Consolidated Tangible Net Worth of the Company, the Company will
make an Asset Sale Offer to all Holders of Notes to repurchase the maximum
principal amount of Notes that may be purchased out of the Excess Proceeds.
The offer price in any Asset Sale Offer will be equal to 100% of the principal
amount of the Notes to be purchased, plus accrued and unpaid interest thereon,
if any, to the date of purchase, and will be payable in cash. If any Excess
Proceeds remain after consummation of an Asset Sale Offer, the Company may use
such Excess Proceeds for any purpose not otherwise prohibited by the
Indenture. If the aggregate principal amount of Notes tendered pursuant to
such Asset Sale Offer exceeds the amount of Excess Proceeds, the Trustee shall
select the Notes to be purchased on a pro rata basis. Upon completion of each
Asset Sale Offer, the amount of Excess Proceeds shall be reset at zero.
The Company will comply with the requirements of Rule 14e-1 under the
Exchange Act and any other securities laws and regulations thereunder to the
extent such laws and regulations are applicable to the repurchase of Notes
pursuant to an Asset Sale Offer. To the extent that the provisions of any
securities laws or regulations conflict with the Asset Sale provisions of the
Indenture, the Company shall comply with the applicable securities laws and
regulations and will not be deemed to have breached its obligations under the
Asset Sale provisions of the Indenture by virtue thereof.
Certain Covenants
Restricted Payments
The Company will not, and will not permit any of its Restricted
Subsidiaries to, directly or indirectly:
(1) declare or pay any dividend or make any other payment or distribution on
account of the Company's or any of its Restricted Subsidiaries' Equity
Interests (including, without limitation, any payment in connection with
any merger or consolidation involving the Company or any of its Restricted
Subsidiaries) or to the direct or indirect holders of the Company's or any
of its Restricted Subsidiaries' Equity Interests in their capacity as such
(other than dividends or distributions payable in Equity Interests (other
than Disqualified Stock) of the Company or to the Company or a Restricted
Subsidiary of the Company);
(2) purchase, redeem or otherwise acquire or retire for value (including,
without limitation, in connection with any merger or consolidation
involving the Company) any Equity Interests of the Company or any direct
or indirect parent of the Company (other than any such Equity Interests
owned by the Company or any Restricted Subsidiary of the Company);
(3) make any payment on or with respect to, or purchase, redeem, defease or
otherwise acquire or retire for value, any Debt that is subordinated to
the Notes, except a payment of interest or principal at Stated Maturity;
or
(4) make any Restricted Investment (all such payments and other actions set
forth in clauses (1) through (4) above being collectively referred to as
"Restricted Payments"),
unless, at the time of and after giving effect to such Restricted Payment:
(1) no Default or Event of Default has occurred and is continuing or would
occur as a consequence thereof; and
(2) the Company would, at the time of such Restricted Payment and after giving
pro forma effect thereto as if such Restricted Payment had been made at
the beginning of the applicable two-quarter Measurement Period, have been
permitted to incur at least $1.00 of additional Debt pursuant to the Debt
to Annualized Cash Flow Ratio test set forth in the first paragraph of the
covenant described below under the caption "--Incurrence of Debt and
Issuance of Disqualified Stock;" and
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(3) such Restricted Payment, together with the aggregate amount of all other
Restricted Payments made by the Company and its Restricted Subsidiaries
after the Closing Date (excluding Restricted Payments permitted by
clauses (2), (3) and (4) of the next succeeding paragraph), is less than
the sum, without duplication, of
(a) 50% of the Consolidated Net Income of the Company for the period (taken
as one accounting period) from the beginning of the first fiscal
quarter commencing after the date of the Indenture to the end of the
Company's most recently ended fiscal quarter for which internal
financial statements are available at the time of such Restricted
Payment (or, if such Consolidated Net Income for such period is a
deficit, less 100% of such deficit), plus
(b) 100% of the aggregate net cash proceeds received by the Company since
the Closing Date as a contribution to its common equity capital or from
the issue or sale of Equity Interests of the Company (other than
Disqualified Stock) or from the issue or sale of Disqualified Stock or
debt securities of the Company that have been converted into such
Equity Interests (other than Equity Interests (or Disqualified Stock or
convertible debt securities) sold to a Subsidiary of the Company), plus
(c) to the extent that any Restricted Investment that was made after the
date of the Indenture is sold for cash or otherwise liquidated or
repaid for cash, the lesser of (i) the cash return of capital with
respect to such Restricted Investment (less the cost of disposition, if
any) and (ii) the initial amount of such Restricted Investment.
The preceding provisions will not prohibit:
(1) the payment of any dividend within 60 days after the date of declaration
thereof, if at said date of declaration such payment would have complied
with the provisions of the Indenture;
(2) the redemption, repurchase, retirement, defeasance or other acquisition of
any subordinated Debt or Equity Interests of the Company in exchange for,
or out of the net cash proceeds of the substantially concurrent sale
(other than to a Subsidiary of the Company) of, other Equity Interests of
the Company (other than any Disqualified Stock); provided that the amount
of any such net cash proceeds that are utilized for any such redemption,
repurchase, retirement, defeasance or other acquisition shall be excluded
from clause (3)(b) of the preceding paragraph;
(3) the defeasance, redemption, repurchase or other acquisition of
subordinated Debt with the net cash proceeds from an incurrence of
Permitted Refinancing Debt;
(4) the payment of any dividend by a Restricted Subsidiary of the Company to
the holders of its common Equity Interests on a pro rata basis;
(5) the repurchase, redemption or other acquisition or retirement for value of
any Equity Interests of the Company or any Restricted Subsidiary of the
Company held by any member of the Company's or any of its Restricted
Subsidiaries' management; provided, that (a) the aggregate price paid for
all such repurchased, redeemed, acquired or retired Equity Interests shall
not exceed $250,000 in any twelve-month period and (b) no Default or Event
of Default shall have occurred and be continuing immediately after such
transaction; and
(6) other Restricted Payments not to exceed $10.0 million in the aggregate at
any time outstanding (with Restricted Payments pursuant to this clause not
being counted as Restricted Payments for purposes of clause (3) of the
immediately preceding paragraph).
The amount of all Restricted Payments (other than cash) will be the fair
market value on the date of the Restricted Payment of the asset(s) or
securities proposed to be transferred or issued by the Company or such
Restricted Subsidiary, as the case may be, pursuant to the Restricted Payment.
The fair market value of any non-cash Restricted Payment will be determined by
the board of directors whose resolution with respect thereto shall be
delivered to the Trustee. The board of directors' determination must be based
upon an opinion or appraisal issued by an accounting, appraisal or investment
banking firm of national standing if the fair market value exceeds $5.0
million. Not later than the date of making any Restricted Payment, the Company
shall deliver to
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the Trustee an Officers' Certificate stating that such Restricted Payment is
permitted and setting forth the basis upon which the calculations required by
this "Restricted Payments" covenant were computed, together with a copy of any
fairness opinion or appraisal required by the Indenture.
Designation of Restricted and Unrestricted Subsidiaries
The board of directors may designate any Restricted Subsidiary to be an
Unrestricted Subsidiary if that designation would not cause a Default. If a
Restricted Subsidiary is designated as an Unrestricted Subsidiary, all
outstanding Investments by the Company and its Restricted Subsidiaries (except
to the extent repaid in cash or Cash Equivalents) in the Subsidiary so
designated will be deemed to be Restricted Payments at the time of the
designation and will reduce the amount available for Restricted Payments under
the "Restricted Payments" covenant. All such outstanding Investments will be
valued at their fair market value at the time of such designation. That
designation will be permitted only if such Restricted Payment would be
permitted at that time and if the Restricted Subsidiary otherwise meets the
definition of an Unrestricted Subsidiary. Any designation by the board of
directors shall be evidenced to the Trustee by filing with the Trustee a
certified copy of the Board Resolution giving effect to the designation and an
Officers' Certificate certifying that the designation complied with these
conditions and was permitted by the "Restricted Payments" covenant.
If, at any time, any Unrestricted Subsidiary would fail to meet the
requirements of the definition of an Unrestricted Subsidiary, it shall
thereafter cease to be an Unrestricted Subsidiary for purposes of the
Indenture and any Debt of the Subsidiary will be deemed to be incurred by a
Restricted Subsidiary of the Company as of that date (and, if such Debt is not
permitted to be incurred as of that date under the covenant described under
the caption "Incurrence of Debt and Issuance of Disqualified Stock," the
Company will be in default of such covenant).
The board of directors of the Company may at any time designate any
Unrestricted Subsidiary to be a Restricted Subsidiary; provided that such
designation will be deemed to be an incurrence of Debt by a Restricted
Subsidiary of the Company of any outstanding Debt of such Unrestricted
Subsidiary and such designation will be permitted only if (i) such Debt is
permitted under the covenant described under the caption "Incurrence of Debt
and Issuance of Disqualified Stock," calculated on a pro forma basis as if the
designation had occurred at the beginning of the two-quarter Measurement
Period, and (ii) no Default or Event of Default would be in existence
following the designation.
Incurrence of Debt and Issuance of Disqualified Stock
The Company will not, and will not permit any of its Restricted
Subsidiaries to, directly or indirectly, create, incur, issue, assume,
guarantee or otherwise become directly or indirectly liable, contingently or
otherwise, with respect to (collectively, "incur") any Debt (including
Acquired Debt) and the Company will not issue any Disqualified Stock;
provided, however, that the Company may incur Debt (including Acquired Debt)
or issue shares of Disqualified Stock if the Company's Debt to Annualized Cash
Flow Ratio is no greater than 6.0 to 1.0.
The first paragraph of this covenant will not prohibit the incurrence of
any of the following items of Debt (collectively, "Permitted Debt"):
(1) the incurrence by the Company and/or any of its Restricted Subsidiaries of
Debt under Credit Facilities; provided that the aggregate principal amount
(with letters of credit being deemed to have a principal amount equal to
the maximum reimbursement obligations of the Company and/or any of its
Restricted Subsidiaries thereunder) does not exceed the greater of $100.0
million or the Borrowing Base, at any one time outstanding, less the
aggregate amount of all Net Proceeds of Asset Sales applied to permanently
reduce the commitments with respect to such Debt pursuant to the covenant
described above under the caption "--Asset Sales;"
(2) the incurrence by the Company and/or any of its Restricted Subsidiaries of
Vendor Debt, provided that the aggregate amount of Vendor Debt incurred
does not exceed the total cost of the Telecommunications Related Assets
acquired and financed by such Vendor Debt (including acquisitions of
Capital Stock of a
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Person engaged in a Telecommunications Business that is or becomes a
Restricted Subsidiary of the Company);
(3) the incurrence by the Company and its Restricted Subsidiaries of Existing
Debt;
(4) the incurrence by the Company and/or any of its Restricted Subsidiaries of
Debt in an aggregate principal amount that does not exceed $50.0 million
at any one time outstanding;
(5) the incurrence by the Company of Debt (other than secured Acquired Debt)
in an aggregate principal amount that does not exceed 2.5 times the sum of
the net cash proceeds received by the Company after the date of the
Indenture in connection with any issuance and sale of Equity Interests
(other than Disqualified Stock), plus the fair market value of Equity
Interests (other than Disqualified Stock) issued after consummation of a
Public Equity Offering in connection with an acquisition of a
Telecommunications Business or Telecommunications Related Assets; provided
that such Debt does not mature prior to the Stated Maturity of the Notes
or has an Average Life to Stated Maturity at least equal to the Notes;
(6) the incurrence by the Company of Debt represented by the principal amount
of Notes originally issued under the Indenture;
(7) the incurrence by the Company or any of its Restricted Subsidiaries of
Permitted Refinancing Debt in exchange for, or the net proceeds of which
are used to refund, refinance or replace Debt (other than intercompany
Debt) that was permitted by the Indenture to be incurred under the first
paragraph hereof or clauses (3) or (6) of this paragraph;
(8) the incurrence by the Company or any of its Wholly Owned Restricted
Subsidiaries of intercompany Debt; provided, however, that:
(a) any subsequent issuance or transfer of Equity Interests that results
in any such Debt being held by a Person other than the Company or a
Wholly Owned Restricted Subsidiary of the Company; and
(b) any sale or other transfer of any such Debt to a Person that is not
either the Company or a Wholly Owned Restricted Subsidiary of the
Company shall be deemed, in each case, to constitute an incurrence of
such Debt by the Company or such Restricted Subsidiary, as the case
may be, that was not permitted by this clause (8);
(9) the incurrence by the Company or any of its Restricted Subsidiaries of
Hedging Obligations that are incurred for the purpose of fixing or hedging
interest rate risk with respect to any floating rate Debt that is
permitted by the terms of this Indenture to be outstanding; and
(10) the incurrence by the Company or any of its Restricted Subsidiaries of
Purchase Money Debt, in each case incurred for the purpose of financing
all or any part of the purchase price or cost of development,
construction, maintenance, enhancement or improvement of Productive
Assets; provided, however, that the aggregate principal amount of
Purchase Money Debt shall not exceed $25.0 million at any one time
outstanding, less the aggregate amount of all Net Proceeds of Asset Sales
applied to permanently reduce the commitments with respect to such Debt
pursuant to the covenant described above under the caption "--Asset
Sales."
For purposes of determining compliance with this "Incurrence of Debt and
Issuance of Disqualified Stock" covenant, in the event that an item of Debt
meets the criteria of more than one of the categories of Permitted Debt
described in clauses (1) through (10) above, or is entitled to be incurred
pursuant to the first paragraph of this covenant, the Company will be
permitted to classify such item of Debt on the date of its incurrence in any
manner that complies with this covenant. Accrual of interest and accretion or
amortization of original issue discount will not be deemed to be an incurrence
of Debt for purposes of this covenant.
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Liens
The Company will not, and will not permit any of its Restricted
Subsidiaries to, directly or indirectly, create, incur, assume or suffer to
exist any Lien on any asset now owned or hereafter acquired, or any income or
profits therefrom or assign or convey any right to receive income therefrom,
except Permitted Liens.
Dividend and Other Payment Restrictions Affecting Restricted Subsidiaries
The Company will not, and will not permit any of its Restricted
Subsidiaries to, directly or indirectly, create or otherwise cause or suffer
to exist or become effective any encumbrance or restriction on the ability of
any Restricted Subsidiary to:
(1) pay dividends or make any other distributions to the Company or any of its
Restricted Subsidiaries on its Capital Stock, or with respect to any other
interest or participation in, or measured by, its profits, or pay any
indebtedness owed to the Company or any of its Restricted Subsidiaries;
(2) make loans or advances to the Company or any of its Restricted
Subsidiaries; or
(3) transfer any of its properties or assets to the Company or any of its
Restricted Subsidiaries.
However, the preceding restrictions will not apply to encumbrances or
restrictions existing under or by reason of:
(1) Existing Debt as in effect on the Closing Date;
(2) the Indenture and the Notes;
(3) applicable law;
(4) any instrument governing Debt or Capital Stock of a Person acquired by the
Company or any of its Restricted Subsidiaries as in effect at the time of
such acquisition (except to the extent such Debt was incurred in
connection with or in contemplation of such acquisition), which
encumbrance or restriction is not applicable to any Person, or the
properties or assets of any Person, other than the Person, or the property
or assets of the Person, so acquired, provided that, in the case of Debt,
such Debt was permitted by the terms of the Indenture to be incurred;
(5) customary non-assignment provisions in contracts entered into in the
ordinary course of business;
(6) customary restrictions on encumbrance, transfer or disposition of financed
assets pursuant to agreements governing Purchase Money Debt and Vendor
Debt permitted by the Indenture on the property so acquired;
(7) any agreement for the sale of a Restricted Subsidiary that restricts
distributions by that Restricted Subsidiary pending its sale;
(8) Permitted Refinancing Debt, provided that the restrictions contained in
the agreements governing such Permitted Refinancing Debt are no more
restrictive, taken as a whole, than those contained in the agreements
governing the Debt being refinanced;
(9) secured Debt otherwise permitted to be incurred pursuant to the provisions
of the covenant described above under the caption "--Liens" that limits
the right of the debtor to dispose of the assets securing such Debt;
(10) provisions with respect to the disposition or distribution of assets or
property in joint venture agreements and other similar agreements entered
into in the ordinary course of business;
(11) restrictions on cash or other deposits or net worth imposed by customers
under contracts entered into in the ordinary course of business; and
(12) the terms of any Credit Facility if (A) the encumbrance limits, but does
not prohibit, the payment of dividends, (B) the encumbrance or
restriction is not more disadvantageous to the holders of the Notes than
is customary in comparable Credit Facilities, as determined by the Board
of Directors and (C) the Board
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of Directors of the Company determines that any such encumbrance or
restriction is not reasonably expected to materially affect the Company's
ability to satisfy any payment obligations on the Notes or the 1998
Discount Notes, when the same may become due and payable, whether
including payments made in respect of principal, interest, premium, if
any, repayment or Change of Control.
Merger, Consolidation, or Sale of Assets
The Company and any of its Restricted Subsidiaries may not: (1) consolidate
or merge with or into another Person (whether or not the Company or such
Restricted Subsidiary is the surviving corporation); or (2) sell, assign,
transfer, lease, convey or otherwise dispose of all or substantially all of
its properties or assets, in one or more related transactions, to another
corporation, Person or entity unless:
(1) either: (a) the Company or such Restricted Subsidiary is the surviving
corporation; or (b) the entity or the Person formed by or surviving any
such consolidation or merger (if other than the Company or such Restricted
Subsidiary) or to which such sale, assignment, transfer, lease, conveyance
or other disposition was made is a corporation organized or existing under
the laws of the United States, any state thereof or the District of
Columbia;
(2) the entity or Person formed by or surviving any such consolidation or
merger (if other than the Company or such Restricted Subsidiary) or the
entity or Person to which such sale, assignment, transfer, lease,
conveyance or other disposition was made assumes all the obligations of
the Company under the Notes, the Indenture, the Pledge Agreement and the
Registration Rights Agreement pursuant to a supplemental indenture in a
form reasonably satisfactory to the Trustee;
(3) immediately after such transaction no Default or Event of Default exists;
and
(4) except in the case of a merger of the Company with or into a Wholly Owned
Restricted Subsidiary of the Company, the Company or the entity or Person
formed by or surviving any such consolidation or merger (if other than the
Company), or to which such sale, assignment, transfer, lease, conveyance
or other disposition was made:
(a) will have Consolidated Net Worth immediately after the transaction
equal to or greater than the Consolidated Net Worth of the Company
immediately preceding the transaction; and
(b) will have a Debt to Annualized Cash Flow Ratio of the Company
immediately after the transaction and after giving pro forma effect
thereto as if such transaction had occurred at the beginning of the
applicable two-quarter Measurement Period equal to or less than the
Debt to Annualized Cash Flow Ratio of the Company immediately preceding
the transaction.
Alternatively, clause (4) of the preceding sentence may be satisfied by any
other Person which:
(1) assumes or guarantees the obligations of the Company under the Notes, the
Indenture, the Pledge Agreement and the Registration Rights Agreement
pursuant to a supplemental indenture in a form reasonably satisfactory to
the Trustee;
(2) would, as a result of the applicable transaction, properly classify the
Company or such Restricted Subsidiary as a consolidated subsidiary in
accordance with generally accepted accounting principles; and
(3) would, if the conditions set forth in clauses (a) and (b) of the preceding
sentence were tested substituting such Person for the Company, satisfy
such conditions.
Transactions with Affiliates
The Company will not, and will not permit any of its Restricted
Subsidiaries to, make any payment to, or sell, lease, transfer or otherwise
dispose of any of its properties or assets to, or purchase any property or
assets from, or enter into or make or amend any transaction, contract,
agreement, understanding, loan, advance or guarantee with, or for the benefit
of, any Affiliate (each, an "Affiliate Transaction"), unless:
(1) such Affiliate Transaction is on terms that are no less favorable to the
Company or such Restricted Subsidiary than those that would have been
obtained in a comparable transaction by the Company or such Restricted
Subsidiary with an unrelated Person; and
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(2) the Company delivers to the Trustee:
(a) with respect to any Affiliate Transaction or series of related
Affiliate Transactions involving aggregate consideration in excess of
$1.0 million, a resolution of the Board of Directors set forth in an
Officers' Certificate certifying that such Affiliate Transaction
complies with clause (1) above and that such Affiliate Transaction has
been approved by a majority of the disinterested members of the Board
of Directors; and
(b) with respect to any Affiliate Transaction or series of related
Affiliate Transactions involving aggregate consideration in excess of
$5.0 million, an opinion as to the fairness to the holders of such
Affiliate Transaction from a financial point of view issued by an
accounting, appraisal or investment banking firm of national standing.
The following items will not be deemed to be Affiliate Transactions:
(1) any employment agreement and related arrangement entered into by the
Company or any of its Restricted Subsidiaries in the ordinary course of
business;
(2) transactions between or among the Company and/or its Restricted
Subsidiaries;
(3) payment of reasonable directors fees to Persons who are not otherwise
Affiliates of the Company; and
(4) Restricted Payments that are permitted by the provisions of the Indenture
described above under the caption "--Restricted Payments."
Limitations on Issuances of Guarantees of Debt
The Company will not permit any Subsidiary, directly or indirectly, to
guarantee, assume or in any other manner become liable with respect to any
Pari Passu Debt or Subordinated Debt of the Company unless such Subsidiary
simultaneously executes and delivers a supplemental indenture to the Indenture
providing for a guarantee of the Notes on the same terms as the guarantee of
such Debt except that:
(1) such guarantee need not be secured unless required pursuant to the caption
"--Liens" above; and
(2) if such Debt is by its terms expressly subordinated to the Notes, any such
assumption, guarantee or other liability of such Subsidiary with respect
to such Debt shall be subordinated to such Subsidiary's guarantee of the
Notes at least to the same extent as such Debt is subordinated to the
Notes; provided, that this paragraph does not apply to any guarantee or
assumption of liability of Debt permitted under the Indenture described in
clauses (1), (6), (7), (8) and (9) of the second paragraph under "--
Incurrence of Debt and Issuance of Disqualified Stock."
Notwithstanding the preceding paragraph, any guarantee by a Subsidiary of
the Notes will provide by its terms that it (and all Liens securing the same)
will be automatically and unconditionally released and discharged upon any
sale, exchange or transfer, to any Person not an Affiliate of the Company, of
all of the Company's Capital Stock in, or all or substantially all of the
assets of, such Subsidiary, which transaction is in compliance with the terms
of the Indenture and such Subsidiary is released from its guarantees of other
Debt of the Company or any of its Subsidiaries.
Limitations on Issuances and Sales of Equity Interests in Wholly Owned
Restricted Subsidiaries
The Company will not, and will not permit any of its Wholly Owned
Restricted Subsidiaries to, transfer, convey, sell, lease or otherwise dispose
of any Equity Interests in any Wholly Owned Restricted Subsidiary of the
Company to any Person (other than the Company or another Wholly Owned
Restricted Subsidiary), unless:
(1) such transfer, conveyance, sale, lease or other disposition is of all of
the Equity Interests in such Wholly Owned Restricted Subsidiary; and
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(2) the Net Proceeds from such transfer, conveyance, sale, lease or other
disposition are applied in accordance with the covenant described above
under the caption "--Repurchase at the Option of Holders--Asset Sales."
In addition, the Company will not permit any Wholly Owned Restricted
Subsidiary of the Company to issue any of its Equity Interests (other than, if
necessary, shares of its Capital Stock constituting directors' qualifying
shares) to any Person other than to the Company or another Wholly Owned
Restricted Subsidiary.
Business Activities
The Company and its Restricted Subsidiaries may not, directly or
indirectly, engage in any business other than the Telecommunications Business.
Limitations on Sale and Leaseback Transactions
The Company and its Restricted Subsidiaries will not, directly or
indirectly, enter into, assume, guarantee or otherwise become liable with
respect to any Sale and Leaseback Transactions; provided, that the Company or
any Restricted Subsidiary of the Company may enter into any such transaction
if:
(1) the Company or such Restricted Subsidiary would be permitted under the
covenants described above under "--Incurrence of Debt and Issuance of
Disqualified Stock" and "--Liens" to incur secured Debt in an amount equal
to the Attributable Debt with respect to such transaction;
(2) the consideration received by the Company or such Restricted Subsidiary
from such transaction is at least equal to the Fair Market Value of the
property being transferred; and
(3) the Net Proceeds received by the Company or such Restricted Subsidiary
from such transaction are applied in accordance with the covenant
described above under the caption "--Asset Sales."
Payments for Consent
Neither the Company nor any of its Affiliates will, directly or indirectly,
pay or cause to be paid any consideration, whether by way of interest, fee or
otherwise, to any Holder of any Notes for or as an inducement to any consent,
waiver or amendment of any of the terms or provisions of the Indenture or the
Notes unless such consideration is offered to be paid or agreed to be paid to
all Holders of the Notes that consent, waive or agree to amend in the time
frame set forth in the solicitation documents relating to such consent, waiver
or agreement.
Reports
Whether or not required by the rules and regulations of the Commission, so
long as any Notes are outstanding, the Company will furnish to the Holders of
Notes and file with the Commission, in each case within the time periods
specified in the Commission's rules and regulations:
(1) all quarterly and annual financial information that would be required to
be contained in a filing with the Commission on Forms 10-Q and 10-K if the
Company were required to file such forms, including a "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
that describes the financial condition and results of operations of the
Company and its consolidated Subsidiaries (showing in reasonable detail,
either on the face of the financial statements or in the footnotes thereto
and in "Management's Discussion and Analysis of Financial Condition and
Results of Operations," the financial condition and results of operations
of the Company and its Restricted Subsidiaries separate from the financial
condition and results of operations of the Unrestricted Subsidiaries of
the Company) and, with respect to the annual information only, a report
thereon by the Company's certified independent accountants; and
(2) all current reports that would be required to be filed with the Commission
on Form 8-K if the Company were required to file such reports.
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In addition, for so long as any Notes are outstanding, the Company will
furnish to the Holders of the Notes, securities analysts, prospective
investors and beneficial owners of the Notes, upon their request, the
information required to be delivered pursuant to Rule 144A(d)(4) under the
Securities Act.
Events of Default and Remedies
Each of the following is an Event of Default:
(1) default for 30 days in the payment when due of interest on the Notes
(including any Additional Interest);
(2) default in payment when due of the principal of or premium, if any, on the
Notes;
(3) failure by the Company or any of its Restricted Subsidiaries to comply
with the provisions described under the captions "--Change of Control,"
"--Asset Sales," "--Restricted Payments," "--Incurrence of Debt and
Issuance of Disqualified Stock" or "--Merger, Consolidation, or Sale of
Assets;"
(4) failure by the Company or any of its Restricted Subsidiaries for 30 days
after receiving notice to comply with any of its other agreements in the
Indenture or the Notes;
(5) default under any mortgage, indenture or instrument under which there may
be issued or by which there may be secured or evidenced any Debt for money
borrowed by the Company or any of its Restricted Subsidiaries (or the
payment of which is guaranteed by the Company or any of its Restricted
Subsidiaries), whether such Debt or guarantee now exists or is created
after the Closing Date, if that default
(a) is caused by a failure to pay principal of or premium, if any, or
interest on such Debt prior to the expiration of the grace period
provided in such Debt on the date of such default (a "Payment
Default"); or
(b) results in the acceleration of such Debt prior to its express maturity,
and, in each case, the principal amount of any such Debt, together with
the principal amount of any other such Debt under which there has been
a Payment Default or the maturity of which has been so accelerated,
aggregates $5.0 million or more;
(6) failure by the Company or any of its Restricted Subsidiaries to pay final
judgments aggregating in excess of $5.0 million, which judgments are not
paid, discharged or stayed for a period of 60 days;
(7) default by the Company in the performance of any covenant set forth in the
Pledge Agreement, or repudiation by the Company of any of its obligations
under the Pledge Agreement or the unenforceability of the Pledge Agreement
against the Company for any reason which in any one case or in the
aggregate results in a material impairment of the rights intended to be
afforded thereby; and
(8) certain events of bankruptcy or insolvency with respect to the Company or
any of its Restricted Subsidiaries.
In the case of an Event of Default arising from certain events of
bankruptcy or insolvency with respect to the Company, any Significant
Subsidiary or any group of Restricted Subsidiaries that, taken together, would
constitute a Significant Subsidiary, all outstanding Notes will become due and
payable without further action or notice. If any other Event of Default occurs
and is continuing, the Trustee or the Holders of at least 25% in aggregate
principal amount at maturity of the then outstanding Notes may declare all the
Notes to be due and payable immediately.
Holders of the Notes may not enforce the Indenture or the Notes except as
provided in the Indenture. Subject to certain limitations, Holders of a
majority in principal amount of the then outstanding Notes may direct the
Trustee in its exercise of any trust or power. The Trustee may withhold from
Holders of the Notes notice of any continuing Default or Event of Default
(except a Default or Event of Default relating to the payment of principal or
interest) if it determines that withholding notice is in their interest.
The Holders of a majority in aggregate principal amount of the Notes then
outstanding by notice to the Trustee may on behalf of the Holders of all of
the Notes, waive any existing Default or Event of Default and its
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consequences under the Indenture except a continuing Default or Event of
Default in the payment of interest on, or the principal of, the Notes.
In the case of any Event of Default occurring by reason of any willful
action (or inaction) taken (or not taken) by or on behalf of the Company with
the intention of avoiding payment of the premium that the Company would have
had to pay if the Company then had elected to redeem the Notes pursuant to the
optional redemption provisions of the Indenture, an equivalent premium will
also become and be immediately due and payable to the extent permitted by law
upon the acceleration of the Notes. If an Event of Default occurs prior to
February 15, 2004 by reason of any willful action (or inaction) taken (or not
taken) by or on behalf of the Company with the intention of avoiding the
prohibition on redemption of the Notes prior to February 15, 2004, then the
premium specified in the Indenture shall also become immediately due and
payable to the extent permitted by law upon the acceleration of the Notes.
The Company is required to deliver to the Trustee annually a statement
regarding compliance with the Indenture. Upon becoming aware of any Default or
Event of Default, the Company is required to deliver to the Trustee a
statement specifying such Default or Event of Default.
No Personal Liability of Directors, Officers, Employees and Stockholders
No director, officer, employee, incorporator or stockholder of the Company,
as such, will have any liability for any obligations of the Company under the
Notes or the Indenture or for any claim based on, in respect of, or by reason
of, such obligations or their creation. Each Holder of Notes by accepting a
Note waives and releases all such liability. The waiver and release are part
of the consideration for issuance of the Notes. The waiver may not be
effective to waive liabilities under the federal securities laws and it is the
view of the Commission that such a waiver is against public policy.
Legal Defeasance and Covenant Defeasance
The Company may, at its option and at any time, elect to have all of its
obligations under the Notes discharged ("Legal Defeasance") except for:
(1) the rights of Holders of outstanding Notes to receive payments in respect
of the principal of, premium, if any, and interest on such Notes when such
payments are due from the trust referred to below;
(2) the Company's obligations with respect to the Notes concerning issuing
temporary Notes, registration of Notes, mutilated, destroyed, lost or
stolen Notes and the maintenance of an office or agency for payment and
money for security payments held in trust;
(3) the rights, powers, trusts, duties and immunities of the Trustee, and the
Company's obligations in connection therewith; and
(4) the Legal Defeasance provisions of the Indenture.
In addition, the Company may, at its option and at any time, elect to have
the obligations of the Company released with respect to certain covenants that
are described in the Indenture ("Covenant Defeasance") and thereafter any
omission to comply with such obligations will not constitute a Default or
Event of Default with respect to the Notes. If Covenant Defeasance occurs,
certain events (not including non-payment, bankruptcy, receivership,
rehabilitation and insolvency events) described under "Events of Default" will
no longer constitute an Event of Default with respect to the Notes.
In order to exercise either Legal Defeasance or Covenant Defeasance:
(1) the Company must irrevocably deposit with the Trustee, in trust, for the
benefit of the Holders of the Notes, cash in U.S. dollars, non-callable
Government Securities, or a combination thereof, in such amounts as will
be sufficient, in the opinion of a nationally recognized firm of
independent public accountants, to pay the
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principal of, premium, if any, and interest on the outstanding Notes on the
stated maturity or on the applicable redemption date, as the case may be,
and the Company must specify whether the Notes are being defeased to
maturity or to a particular redemption date;
(2) in the case of Legal Defeasance, the Company must deliver to the Trustee
an opinion of counsel in the United States confirming that (a) the Company
has received from, or there has been published by, the Internal Revenue
Service a ruling or (b) since the date of the Indenture, there has been a
change in the applicable federal income tax law, in either case to the
effect that, and based thereon such opinion of counsel will confirm that,
the holders of the outstanding Notes will not recognize income, gain or
loss for federal income tax purposes as a result of such Legal Defeasance
and will be subject to federal income tax on the same amounts, in the same
manner and at the same times as would have been the case if such Legal
Defeasance had not occurred;
(3) in the case of Covenant Defeasance, the Company must deliver to the
Trustee an opinion of counsel in the United States confirming that the
Holders of the outstanding Notes will not recognize income, gain or loss
for federal income tax purposes as a result of such Covenant Defeasance
and will be subject to federal income tax on the same amounts, in the same
manner and at the same times as would have been the case if such Covenant
Defeasance had not occurred;
(4) no Default or Event of Default will have occurred and be continuing
either: (a) on the date of such deposit (other than a Default or Event of
Default resulting from the borrowing of funds to be applied to such
deposit); or (b) insofar as Events of Default from bankruptcy or
insolvency events are concerned, at any time in the period ending on the
91st day after the date of deposit;
(5) such Legal Defeasance or Covenant Defeasance will not result in a breach
or violation of, or constitute a default under any material agreement or
instrument (other than the Indenture) to which the Company or any of its
Subsidiaries is a party or by which the Company or any of its Subsidiaries
is bound;
(6) the Company must deliver to the Trustee an opinion of counsel to the
effect that (assuming that no Holder of any Notes would be considered an
insider of the Company under applicable bankruptcy or insolvency law)
after the 91st day following the deposit, the trust funds will not be
subject to the effect of any applicable bankruptcy, insolvency,
reorganization or similar laws affecting creditors rights generally;
(7) the Company must deliver to the Trustee an Officers' Certificate stating
that the deposit was not made by the Company with the intent of preferring
the Holders of Notes over any other creditors of the Company with the
intent of defeating, hindering, delaying or defrauding creditors of the
Company or others; and
(8) the Company must deliver to the Trustee an Officers' Certificate and an
opinion of counsel, each stating that all conditions precedent provided
for relating to the Legal Defeasance or the Covenant Defeasance have been
satisfied.
Amendment, Supplement and Waiver
Except as provided in the next two succeeding paragraphs, the Indenture or
the Notes may be amended or supplemented with the consent of the Holders of at
least a majority in principal amount of the Notes then outstanding (including,
without limitation, consents obtained in connection with a purchase of, or
tender offer or exchange offer for, Notes), and any existing default or Event
of Default or compliance with any provision of the Indenture or the Notes may
be waived with the consent of the Holders of a majority in principal amount of
the then outstanding Notes (including, without limitation, consents obtained
in connection with a purchase of, or tender offer or exchange offer for,
Notes).
Without the consent of each Holder affected, an amendment or waiver may not
(with respect to any Notes held by a non-consenting holder):
(1) reduce the principal amount of Notes whose Holders must consent to an
amendment, supplement or waiver;
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(2) reduce the principal of or change the fixed maturity of any Note or alter
the provisions with respect to the redemption of the Notes (other than
provisions relating to the covenants described above under the caption "--
Repurchase at the Option of Holders");
(3) reduce the rate of or change the time for payment of interest on any Note;
(4) waive a Default or Event of Default in the payment of principal of or
premium, if any, or interest on the Notes (except a rescission of
acceleration of the Notes by the Holders of at least a majority in
aggregate principal amount at maturity of the Notes and a waiver of the
payment default that resulted from such acceleration);
(5) make any Note payable in money other than that stated in the Notes;
(6) make any change in the provisions of the Indenture relating to waivers of
past Defaults or the rights of Holders of Notes to receive payments of
principal of or premium, if any, or interest on the Notes;
(7) waive a redemption payment with respect to any Note (other than a payment
required by one of the covenants described above under the caption "--
Repurchase at the Option of Holders");
(8) amend the Pledge Agreement in a manner that adversely affects the Holders
of the Notes; or
(9) make any change in the preceding amendment and waiver provisions.
Notwithstanding the provisions described above, without the consent of any
Holder of Notes, the Company and the Trustee may amend or supplement the
Indenture or the Notes:
(1) to cure any ambiguity, defect or inconsistency;
(2) to provide for uncertificated Notes in addition to or in place of
certificated Notes;
(3) to provide for the assumption of the Company's obligations to Holders of
Notes in the case of a merger or consolidation or sale of all or
substantially all of the Company's assets;
(4) to make any change that would provide any additional rights or benefits to
the Holders of Notes or that does not adversely affect the legal rights
under the Indenture of any such Holder;
(5) to comply with requirements of the Commission in order to effect or
maintain the qualification of the Indenture under the Trust Indenture Act
or otherwise to comply with applicable law; or
(6) to provide for the issuance of Additional Notes in accordance with the
limitations provided in the Indenture.
Concerning the Trustee
If the Trustee becomes a creditor of the Company, the Indenture limits its
right to obtain payment of claims in certain cases, or to realize on certain
property received in respect of any such claim as security or otherwise. The
Trustee will be permitted to engage in other transactions; however, if it
acquires any conflicting interest it must eliminate such conflict within 90
days, apply to the Commission for permission to continue or resign.
The Holders of a majority in principal amount of the then outstanding Notes
will have the right to direct the time, method and place of conducting any
proceeding for exercising any remedy available to the Trustee, subject to
certain exceptions. The Indenture provides that if an Event of Default occurs
(which is not cured or waived), the Trustee will be required, in the exercise
of its power, to use the degree of care of a prudent man in the conduct of his
own affairs. Subject to such provisions, the Trustee will be under no
obligation to exercise any of its rights or powers under the Indenture at the
request of any Holder of Notes, unless such Holder offered to the Trustee
security and indemnity satisfactory to it against any loss, liability or
expense.
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Additional Information
Anyone who receives this prospectus may obtain a copy of the Indenture and
Registration Rights Agreement without charge by writing to Covad
Communications Group, Inc., 2330 Central Expressway, Santa Clara, California
95050, Attention: General Counsel.
Registration Rights; Additional Interest
Pursuant to the Registration Rights Agreement, the Company agreed to file
with the Commission the Exchange Offer Registration Statement on the
appropriate form under the Securities Act for a registered offer to exchange
the old notes for the new notes. The registration statement of which this
prospectus is a part constitutes such Exchange Offer Registration Statement.
The terms of the new notes will be substantially identical in all material
respects to the terms of the old notes (except that the new notes will not
contain terms with respect to transfer restrictions, registration rights or
payment of Additional Interest).
When the Exchange Offer Registration Statement is declared effective by the
Commission, the Company will offer to the Holders of Transfer Restricted
Securities who are able to make certain representations the opportunity to
exchange their Transfer Restricted Securities for new notes pursuant to the
exchange offer. If:
(1) the Company is not required to file the Exchange Offer Registration
Statement or permitted to consummate the exchange offer because the
exchange offer is not permitted by applicable law or Commission policy;
(2) for any reason the exchange offer is not consummated within 210 days after
the Closing Date;
(3) any Holder of Transfer Restricted Securities notifies the Company prior to
the 20th day following consummation of the exchange offer that:
(a) it is prohibited by law or Commission policy from participating in the
exchange offer; or
(b) that it may not resell the new notes acquired by it in the exchange
offer to the public without delivering a prospectus and the prospectus
contained in the Exchange Offer Registration Statement is not
appropriate or available for such resales; or
(c) that it is a broker-dealer and owns Notes acquired directly from the
Company or an affiliate of the Company,
the Company will file with the Commission a Shelf Registration Statement to
cover resales of the Transfer Restricted Securities by the Holders thereof who
satisfy certain conditions relating to the provision of information in
connection with the Shelf Registration Statement. The Company will use its
best efforts to cause the applicable registration statement to be declared
effective as promptly as possible by the Commission on or before the 180th day
after such obligation arises.
For purposes of the preceding paragraph, "Transfer Restricted Securities"
means each Note until:
(1) the date on which such Note has been exchanged by a person other than a
broker-dealer for a new note in the exchange offer;
(2) following the exchange by a broker-dealer in the exchange offer of a Note
for a new note, the date on which such new note is sold to a purchaser who
receives from such broker-dealer on or prior to the date of such sale a
copy of the prospectus contained in the Exchange Offer Registration
Statement;
(3) the date on which such Note has been effectively registered under the
Securities Act and disposed of in accordance with the Shelf Registration
Statement; or
(4) the date on which such Note is distributed to the public pursuant to Rule
144 under the Securities Act.
The Registration Rights Agreement provides that:
(1) the Company will file an Exchange Offer Registration Statement with the
Commission on or prior to 60 days after the Closing Date;
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(2) the Company will use its best efforts to have the Exchange Offer
Registration Statement declared effective by the Commission on or prior to
180 days after the Closing Date;
(3) unless the exchange offer would not be permitted by applicable law or
Commission policy, the Company will commence the exchange offer and use
its best efforts to issue, on or prior to 30 business days after the date
on which the Exchange Offer Registration Statement was declared effective
by the Commission, new notes in exchange for all Notes tendered prior
thereto in the exchange offer; and
(4) if obligated to file the Shelf Registration Statement, the Company will
use its best efforts to file the Shelf Registration Statement with the
Commission on or prior to 30 days after such filing obligation arises and
to cause the Shelf Registration Statement to be declared effective by the
Commission on or prior to 180 days after such obligation arises.
The Company complied with the requirements of clauses (1) and (2) in the
immediately preceding sentence on a timely basis.
Additional Interest will accrue on the Notes and the new notes (in addition
to the stated interest on the Notes and the new notes) if:
(1) the Company fails to file any of the Registration Statements required by
the Registration Rights Agreement on or before the date specified for such
filing;
(2) any of such Registration Statements is not declared effective by the
Commission on or prior to the date specified for such effectiveness (the
"Effectiveness Target Date");
(3) the Company fails to consummate the exchange offer within 30 business days
of the Effectiveness Target Date with respect to the Exchange Offer
Registration Statement; or
(4) the Shelf Registration Statement or the Exchange Offer Registration
Statement is declared effective but thereafter ceases to be effective or
usable in connection with resales of Transfer Restricted Securities during
the periods specified in the Registration Rights Agreement.
Each such event referred to in clauses (1) through (4) in the preceding
sentence is a Registration Default. Additional Interest will begin accruing on
the date on which any such Registration Default shall occur, excluding the
date on which all Registration Defaults have been cured. Additional Interest
will accrue at a rate of 0.50% per annum during the 90-day period immediately
following the occurrence of any Registration Default and shall increase by
0.25% per annum at the end of each subsequent 90-day period, but in no event
shall such Additional Interest exceed 2.00% per annum. Additional Interest
will be payable in cash, semiannually in arrears on each February 15 and
August 15, regardless of whether any such date is otherwise an Interest
Payment Date. All references in this description and in the Indenture to
"interest" on the Notes and the new notes include any Additional Interest that
may become payable thereon according to the provisions of this paragraph.
Holders of Notes will be required to make certain representations to the
Company (as described in the Registration Rights Agreement) in order to
participate in the exchange offer and will be required to deliver certain
information to be used in connection with the Shelf Registration Statement and
to provide comments on the Shelf Registration Statement within the time
periods set forth in the Registration Rights Agreement in order to have their
Notes included in the Shelf Registration Statement and benefit from the
provisions regarding Additional Interest set forth above.
Certain Definitions
Set forth below are certain defined terms used in the Indenture. Reference
is made to the Indenture for a full disclosure of all such terms, as well as
any other capitalized terms used herein for which no definition is provided.
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"Acquired Debt" means, with respect to any specified Person:
(1) Debt of any other Person existing at the time such other Person is merged
with or into or becomes a Restricted Subsidiary of such specified Person,
including, without limitation, Debt incurred in connection with, or in
contemplation of, such other Person merging with or into or becoming a
Restricted Subsidiary of such specified Person; and
(2) Debt secured by a Lien encumbering any asset acquired by such specified
Person.
"Affiliate" of any specified Person means any other Person directly or
indirectly controlling or controlled by or under direct or indirect common
control with such specified Person. For purposes of this definition,
"control," as used with respect to any Person, shall mean the possession,
directly or indirectly, of the power to direct or cause the direction of the
management or policies of such Person, whether through the ownership of voting
securities, by agreement or otherwise; provided that beneficial ownership of
10% or more of the Voting Stock of a Person shall be deemed to be control. For
purposes of this definition, the terms "controlling," "controlled by" and
"under common control with" shall have correlative meanings.
"Asset Sale" means:
(1) the sale, lease, conveyance or other disposition of any assets or rights
(including, without limitation, by way of a sale and leaseback) other than
sales of services in the ordinary course of business; provided that the
sale, lease, conveyance or other disposition of all or substantially all
of the assets of the Company and its Restricted Subsidiaries taken as a
whole will be governed by the provisions of the Indenture described above
under the caption "--Change of Control" and/or the provisions described
above under the caption "--Merger, Consolidation, or Sale of Assets" and
not by the provisions of the Asset Sale covenant; and
(2) the issue or sale by the Company or any of its Subsidiaries of Equity
Interests of any of the Company's Subsidiaries.
Notwithstanding the preceding, the following items shall not be deemed to
be Asset Sales:
(1) any single transaction or series of related transactions that: (a)
involves assets having a fair market value of less than $1.0 million; or
(b) results in net proceeds to the Company and its Subsidiaries of less
than $1.0 million;
(2) a transfer of assets by the Company to a Wholly Owned Restricted
Subsidiary or by a Wholly Owned Restricted Subsidiary to the Company or to
another Wholly Owned Restricted Subsidiary;
(3) an issuance of Equity Interests by a Wholly Owned Restricted Subsidiary to
the Company or to another Wholly Owned Restricted Subsidiary;
(4) a Restricted Payment that is permitted by the covenant described above
under the caption "--Restricted Payments;"
(5) disposals or replacements of obsolete, uneconomical, negligible, worn-out
or surplus property in the ordinary course of business; or
(6) a conveyance constituting or pursuant to a Permitted Lien.
"Attributable Debt" in respect of any Sale and Leaseback Transaction,
means, at the time of determination, the present value (discounted at a rate
consistent with accounting guidelines, as determined in good faith by the
Company) of the payments during the remaining term of the lease included in
such Sale and Leaseback Transaction (including any period for which such lease
has been extended or may, at the option of the lessee, be extended) or until
the earliest date on which the lessee may terminate such lease without penalty
or upon payment of a penalty (in which case the rental payments shall be
calculated to include such penalty), after excluding all amounts required to
be paid on account of maintenance and repairs, insurance, taxes, assessments,
water, utilities and similar charges.
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"Average Life to Stated Maturity" means, as of any date of determination
with respect to any Debt, the quotient obtained by dividing (i) the sum of the
products of (a) the number of years from the date of determination to the date
or dates of each successive scheduled principal payment of such Debt
multiplied by (b) the amount of each such principal payment; by (ii) the sum
of all such principal payments.
"Beneficial Owner" has the meaning assigned to such term in Rules 13d-3 and
13d-5 under the Exchange Act (or any successor rules), including the provision
of such Rules that a Person shall be deemed to have beneficial ownership of
all securities that such Person has a right to acquire within 60 days;
provided that a Person will not be deemed a beneficial owner of, or to own
beneficially, any securities if such beneficial ownership:
(1) arises solely as a result of a revocable proxy delivered in response to a
proxy or consent solicitation made pursuant to, and in accordance with,
the Exchange Act; and
(2) is not also then reportable on Schedule 13D or Schedule 13G (or any
successor schedule) under the Exchange Act.
"Borrowing Base" means an amount equal to the sum of 85% of the value of
accounts receivable (before giving effect to any related reserves) shown on
the Company's most recent consolidated balance sheet in accordance with
generally accepted accounting principles not more than 60 days past due.
"Capital Lease Obligation" means, at the time any determination thereof is
to be made, the amount of the liability in respect of a capital lease that
would at such time be required to be capitalized on the balance sheet of the
lessee in accordance with generally accepted accounting principles.
"Capital Stock" means:
(1) in the case of a corporation, corporate stock;
(2) in the case of an association or business entity, any and all shares,
interests, participations, rights or other equivalents (however
designated) of corporate stock;
(3) in the case of a partnership or limited liability company, partnership or
membership interests (whether general or limited); and
(4) any other interest or participation that confers on a Person the right to
receive a share of the profits and losses of, or distributions of assets
of (other than distributions of assets in respect of Debt), the issuing
Person.
"Cash Equivalents" means:
(1) United States dollars;
(2) securities issued or directly and fully guaranteed or insured by the
United States government or any agency or instrumentality thereof
(provided that the full faith and credit of the United States is pledged
in support thereof) having maturities of not more than six months from the
date of acquisition;
(3) certificates of deposit and eurodollar time deposits with maturities of
six months or less from the date of acquisition, bankers acceptances with
maturities not continued exceeding six months and overnight bank deposits,
in each case with any domestic commercial bank having capital and surplus
in excess of $500 million and a Thompson Bank Watch Rating of "B" or
better;
(4) repurchase obligations with a term of not more than seven days for
underlying securities of the types described in clauses (2) and (3) above
entered into with any financial institution meeting the qualifications
specified in clause (3) above;
(5) commercial paper having the highest rating obtainable from Moody's
Investors Service, Inc. or Standard & Poor's Corporation and in each case
maturing within six months after the date of acquisition; and
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(6) money market and mutual funds at least 95% of the assets of which
constitute Cash Equivalents of the kinds described in clauses (1) through
(5) of this definition.
"Change of Control" means the occurrence of any of the following:
(1) the sale, lease, transfer, conveyance or other disposition, in one or a
series of related transactions, of all or substantially all of the assets
of the Company and its Restricted Subsidiaries, taken as a whole, to any
Person or group (as such term is used in Section 13(d)(3) and 14(d)(2) of
the Exchange Act);
(2) the adoption of a plan relating to the liquidation or dissolution of the
Company;
(3) the consummation of any transaction (including by way of merger,
consolidation or otherwise) the result of which is that any Person or
group (as defined above) other than the Permitted Holders becomes the
Beneficial Owner, directly or indirectly, of more than 50% of the total
Voting Stock or Total Common Equity of the Company; or
(4) the first day on which a majority of the members of the Board of Directors
of the Company are not Continuing Directors.
"Closing Date" means the first date on which Notes are issued by the
Company.
"Closing Price" on any Trading Day with respect to the per share price of
any shares of Capital Stock means the last reported sale price regular way or,
in case no such reported sale takes place on such day, the average of the
reported closing bid and asked prices regular way, in either case on the New
York Stock Exchange or, if such shares of Capital Stock are not listed or
admitted to trading on such exchange, on the principal national securities
exchange on which such shares are listed or admitted to trading or, if not
listed or admitted to trading on any national securities exchange, on the
Nasdaq National Market or, if such shares are not listed or admitted to
trading on any national securities exchange or quoted on Nasdaq National
Market but the issuer is a Foreign Issuer (as defined in Rule 3b-4(b) under
the Exchange Act) and the principal securities exchange on which such shares
are listed or admitted to trading is a Designated Offshore Securities Market
(as defined in Rule 902(b) under the Securities Act), the average of the
reported closing bid and asked prices regular way on such principal exchange,
or, if such shares are not listed or admitted to trading on any national
securities exchange or quoted on Nasdaq National Market and the issuer and
principal securities exchange do not meet such requirements, the average of
the closing bid and asked prices in the over-the-counter market as furnished
by any New York Stock Exchange member firm is selected from time to time by
the Company for that purpose and is reasonably acceptable to the Trustee.
"Commission" means the Securities and Exchange Commission, as from time to
time constituted.
"Common Stock" means the common stock, par value $0.001 per share, of the
Company.
"Consolidated Cash Flow" means, with respect to any Person for any period,
the Consolidated Net Income of such Person for such period plus:
(1) an amount equal to any extraordinary loss plus any net loss realized in
connection with an Asset Sale, to the extent such losses were deducted in
computing such Consolidated Net Income; plus
(2) provision for taxes based on income or profits of such Person and its
Restricted Subsidiaries for such period, to the extent that such provision
for taxes was included in computing such Consolidated Net Income; plus
(3) consolidated interest expense of such Person and its Restricted
Subsidiaries for such period, whether paid or accrued and whether or not
capitalized (including, without limitation, amortization of debt issuance
costs and original issue discount, non-cash interest payments, the
interest component of any deferred payment obligations, the interest
component of all payments associated with Capital Lease Obligations,
commissions, discounts and other fees and charges incurred in respect of
letter of credit or bankers' acceptance financings, and net payments (if
any) pursuant to Hedging Obligations), to the extent that any such expense
was deducted in computing such Consolidated Net Income; plus
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(4) depreciation, amortization (including amortization of goodwill and other
intangibles but excluding amortization of prepaid cash expenses that were
paid in a prior period) and other non-cash expenses (excluding any such
non-cash expense to the extent that it represents an accrual of or reserve
for cash expenses in any future period or amortization of a prepaid cash
expense that was paid in a prior period) of such Person and its Restricted
Subsidiaries for such period to the extent that such depreciation,
amortization and other non-cash expenses were deducted in computing such
Consolidated Net Income; minus
(5) non-cash items increasing such Consolidated Net Income for such period, in
each case, on a consolidated basis and determined in accordance with
generally accepted accounting principles.
Notwithstanding the preceding, the provision for taxes on the income or
profits of, and the depreciation and amortization and other non-cash expenses
of, a Restricted Subsidiary of the referent Person shall be added to
Consolidated Net Income to compute Consolidated Cash Flow only to the extent
that a corresponding amount would be permitted at the date of determination to
be dividended to the Company by such Restricted Subsidiary without prior
governmental approval (that has not been obtained), and without direct or
indirect restriction pursuant to the terms of its charter and all agreements,
instruments, judgments, decrees, orders, statutes, rules and governmental
regulations applicable to that Restricted Subsidiary or its stockholders.
"Consolidated Debt" means, with respect to any Person as of any date of
determination, the sum, without duplication, of:
(1) the total amount of Debt of such Person and its Restricted Subsidiaries;
plus
(2) the total amount of Debt of any other Person, to the extent that such Debt
has been guaranteed by the referent Person or one or more of its
Restricted Subsidiaries; plus
(3) the aggregate liquidation value of all preferred stock of Restricted
Subsidiaries of such Person, in each case, determined on a consolidated
basis in accordance with generally accepted accounting principles.
"Consolidated Net Income" means, with respect to any Person for any period,
the aggregate of the Net Income of such Person and its Restricted Subsidiaries
for such period, on a consolidated basis, determined in accordance with
generally accepted accounting principles; provided that:
(1) the Net Income (but not loss) of any Person that is not a Wholly Owned
Restricted Subsidiary shall be included only to the extent of the
percentage ownership interest in the Net Income of such Person owned on
the last day of such period by the referent Person or a Restricted
Subsidiary thereof; provided that the Net Income of any Person that is an
Unrestricted Subsidiary or that is accounted for by the equity method of
accounting shall be included only to the extent of the amount of dividends
or distributions paid in cash to the referent Person or a Restricted
Subsidiary thereof;
(2) the Net Income of any Restricted Subsidiary shall be excluded to the
extent that the declaration or payment of dividends or similar
distributions by such Restricted Subsidiary of that Net Income is not at
the date of determination permitted without any prior governmental
approval (that has not been obtained) or, directly or indirectly, by
operation of the terms of its charter or any agreement, instrument,
judgment, decree, order, statute, rule or governmental regulation
applicable to such Restricted Subsidiary or its stockholders;
(3) the Net Income of any Person acquired in a pooling of interests
transaction for any period prior to the date of such acquisition shall be
excluded; and
(4) the cumulative effect of a change in accounting principles shall be
excluded.
"Consolidated Net Worth" means, with respect to any Person as of any date,
the sum of:
(1) the consolidated equity of the common stockholders of such Person and its
consolidated Restricted Subsidiaries as of such date; plus
(2) the respective amounts reported on such Person's balance sheet as of such
date with respect to any series of preferred stock (other than
Disqualified Stock) that by its terms is not entitled to the payment of
dividends
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unless such dividends may be declared and paid only out of net earnings in
respect of the year of such declaration and payment, but only to the extent
of any cash received by such Person upon issuance of such preferred stock;
less
(a) all write-ups (other than write-ups resulting from foreign currency
translations and write-ups of tangible assets of a going concern
business made within 12 months after the acquisition of such business)
subsequent to the Closing Date in the book value of any asset owned by
such Person or a consolidated Restricted Subsidiary of such Person;
(b) all investments as of such date in unconsolidated Subsidiaries and in
Persons that are not Restricted Subsidiaries; and
(c) all unamortized debt discount and expense and unamortized deferred
charges as of such date, all of the foregoing determined in accordance
with GAAP.
"Consolidated Tangible Net Worth" means, with respect to any Person as of
any date, Consolidated Net Worth, after deducting therefrom amounts
attributable to goodwill, trade names, patents, unamortized debt discount and
expense and any other intangibles, all as set forth on the most recent
consolidated balance sheet of such Person.
"Continuing Directors" means, as of any date of determination, any member
of the Board of Directors of the Company who:
(1) was a member of such Board of Directors on the date of issuance; or
(2) was nominated for election to such Board of Directors with the affirmative
vote of a majority of the Continuing Directors who were members of such
Board at the time of such nomination or election or who was elected or
appointed in the ordinary course by Continuing Directors or other
directors so elected or appointed.
"Credit Facilities" means, with respect to the Company or any Restricted
Subsidiary, one or more debt facilities or commercial paper facilities with
any combination of banks, other institutional lenders and other Persons
extending financial accommodations or holding corporate debt obligations in
the ordinary course of their business, providing for revolving credit loans,
term loans, receivables financing (including through the sale of receivables
to such lenders or to special purpose entities formed to borrow from such
lenders against such receivables) or letters of credit, in each case, as
amended, restated, modified, renewed, refunded, replaced or refinanced in
whole or in part from time to time by the same or different institutional
lenders.
"Debt" means, with respect to any Person, any indebtedness of such Person,
whether or not contingent, in respect of:
(1) borrowed money;
(2) evidenced by bonds, notes, debentures or similar instruments or letters of
credit (or reimbursement agreements in respect thereof);
(3) banker's acceptances;
(4) representing Capital Lease Obligations;
(5) the balance deferred and unpaid of the purchase price of any property or
representing any Hedging Obligations, except any such balance that
constitutes an accrued expense or trade payable,
if and to the extent any of the preceding items (other than letters of credit
and Hedging Obligations) would appear as a liability upon a balance sheet of
such Person prepared in accordance with GAAP. In addition, the term "Debt"
includes all Debt of others secured by a Lien on any asset of such Person
(whether or not such Debt is assumed by such Person, valued, if not assumed,
at the lesser of the Fair Market Value of the encumbered assets or the amount
of Debt so secured) and, to the extent not otherwise included, the guarantee
by such Person of any indebtedness of any other Person.
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The amount of any Debt outstanding as of any date shall be:
(1) the accreted value thereof, in the case of any Debt issued with original
issue discount; and
(2) the principal amount thereof, together with any interest thereon that is
more than 30 days past due, in the case of any other Debt.
"Debt to Annualized Cash Flow Ratio" means, as of any date of
determination, the ratio of:
(1) the Consolidated Debt of the Company as of such date to
(2) two times the Consolidated Cash Flow of the Company for the two most
recent full fiscal quarters ending immediately prior to such date for
which internal financial statements are available (the "Measurement
Period"),
determined on a pro forma basis after giving effect to all acquisitions or
dispositions of assets made by the Company and its Restricted Subsidiaries
from the beginning of such two-quarter period through and including such date
of determination (including any related financing transactions) as if such
acquisitions and dispositions had occurred at the beginning of such two-
quarter period.
In addition, for purposes of calculating the Debt to Annualized Cash Flow
Ratio:
(1) acquisitions that have been made by the Company or any of its Restricted
Subsidiaries, including through mergers or consolidations and including
any related financing transactions, during the two-quarter Measurement
Period or subsequent to such Measurement Period and on or prior to the
date of calculation shall be deemed to have occurred on the first day of
the two-quarter Measurement Period and Consolidated Cash Flow for such
Measurement Period shall be calculated without giving effect to clause (3)
of the proviso set forth in the definition of Consolidated Net Income; and
(2) the Consolidated Cash Flow attributable to discontinued operations, as
determined in accordance with GAAP, and operations or businesses disposed
of prior to the Calculation Date, shall be excluded.
"Default" means any event that is, or with the passage of time or the
giving of notice or both would be, an Event of Default.
"Disqualified Stock" means any Capital Stock that, by its terms (or by the
terms of any security into which it is convertible, or for which it is
exchangeable, at the option of the holder thereof), or upon the happening of
any event, matures or is mandatorily redeemable, pursuant to a sinking fund
obligation or otherwise, or redeemable at the option of the holder thereof, in
whole or in part, on or prior to the date that is 91 days after the date on
which the Notes mature. Notwithstanding the preceding sentence, any Capital
Stock that would constitute Disqualified Stock solely because the holders
thereof have the right to require the Company to repurchase such Capital Stock
upon the occurrence of a Change of Control or an Asset Sale shall not
constitute Disqualified Stock if the terms of such Capital Stock provide that
the Company may not repurchase or redeem any such Capital Stock pursuant to
such provisions unless such repurchase or redemption complies with the
covenant described above under the caption "Certain Covenants--Restricted
Payments."
"Equity Interests" means Capital Stock and all warrants, options or other
rights to acquire Capital Stock (but excluding any debt security that is
convertible into, or exchangeable for, Capital Stock).
"Exchange Act" means the Securities Exchange Act of 1934, as amended (or
any successor act), and the rules and regulations thereunder.
"Existing Debt" means Debt of the Company and its Restricted Subsidiaries
in existence on the Closing Date (including the accreted value of the 1998
discount notes during the term such indebtedness is outstanding).
"Fair Market Value" means with respect to any asset or property, the sale
value that would be obtained in an arm's length transaction between an
informed and willing seller under no compulsion to sell and an informed and
willing buyer under no compulsion to buy.
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"GAAP" means generally accepted accounting principles set forth in the
opinions and pronouncements of the Accounting Principles Board of the American
Institute of Certified Public Accountants and statements and pronouncements of
the Financial Accounting Standards Board or in such other statements by such
other entity as have been approved by a significant segment of the accounting
profession, which are in effect on the Closing Date.
"Government Securities" means direct obligations of, or obligations
guaranteed by, the United States of America for the payment of which guarantee
or obligations the full faith and credit of the United States is pledged.
"Guarantee" means, with respect to any Person, without duplication, a
guarantee (other than by endorsement of negotiable instruments for collection
in the ordinary course of business), direct or indirect, in any manner
(including, without limitation, by way of a pledge of assets or through
letters of credit or reimbursement agreements in respect thereof), of all or
any part of any Debt of another Person.
"Guarantor" means any Subsidiary which is a guarantor of the Notes,
including any Person that is required after the date of the Indenture to
execute a guarantee of the Notes pursuant to the "Limitations on Issuance of
Guarantees of Debt" covenant until a successor replaces such party pursuant to
the applicable provisions of the Indenture and, thereafter, shall mean such
successor.
"Hedging Obligations" means, with respect to any Person, the obligations of
such Person under:
(1) interest rate swap agreements, interest rate cap agreements and interest
rate collar agreements; and
(2) other agreements or arrangements designed to protect such Person against
fluctuations in interest rates.
"Holder" means a person in whose name a Note is registered.
"Investments" means, with respect to any Person, all investments by such
Person in other Persons (including Affiliates) in the forms of direct or
indirect loans (including guarantees of Debt or other obligations), advances
or capital contributions (excluding commission, travel and similar advances to
officers and employees made in the ordinary course of business), purchases or
other acquisitions for consideration of Debt, Equity Interests or other
securities, together with all items that are or would be classified as
investments on a balance sheet prepared in accordance with GAAP. If the
Company or any Restricted Subsidiary of the Company sells or otherwise
disposes of any Equity Interests of any direct or indirect Restricted
Subsidiary of the Company such that, after giving effect to any such sale or
disposition, such Person is no longer a Subsidiary of the Company, the Company
shall be deemed to have made an Investment on the date of any such sale or
disposition equal to the fair market value of the Equity Interests of such
Subsidiary not sold or disposed of in an amount determined as provided in the
final paragraph of the covenant described above under the caption "--
Restricted Payments."
"Lien" means, with respect to any asset, any mortgage, lien, pledge,
charge, security interest or encumbrance of any kind in respect of such asset,
whether or not filed, recorded or otherwise perfected under applicable law,
including any conditional sale or other title retention agreement, any lease
in the nature thereof, any option or other agreement to sell or give a
security interest in and any filing of or agreement to give any financing
statement under the Uniform Commercial Code (or equivalent statutes) of any
jurisdiction.
"Measurement Period" shall have the definition set forth above under "Debt
to Annualized Cash Flow Ratio."
"Net Income" means, with respect to any Person, the net income (loss) of
such Person, determined in accordance with GAAP and before any reduction in
respect of preferred stock dividends, excluding, however:
(1) any gain (but not loss), together with any related provision for taxes on
such gain (but not loss), realized in connection with: (a) any Asset Sale
(including, without limitation, dispositions pursuant to sale and
leaseback transactions); or (b) the disposition of any securities by such
Person or any of its Restricted Subsidiaries or the extinguishment of any
Debt of such Person or any of its Restricted Subsidiaries; and
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(2) any extraordinary or nonrecurring gain (but not loss), together with any
related provision for taxes on such extraordinary or nonrecurring gain
(but not loss).
"Net Proceeds" means the aggregate cash proceeds received by the Company or
any of its Restricted Subsidiaries in respect of any Asset Sale (including,
without limitation, any cash received upon the sale or other disposition of
any non-cash consideration received in any Asset Sale), net of the direct
costs relating to such Asset Sale, including, without limitation, legal,
accounting and investment banking fees, and sales commissions, and any
relocation expenses incurred as a result thereof, taxes paid or payable as a
result thereof, in each case after taking into account any available tax
credits or deductions and any tax sharing arrangements, amounts required to be
applied to the repayment of Debt secured by a Lien on the asset or assets that
were the subject of such Asset Sale and any reserve for adjustment in respect
of the sale price of such asset or assets established in accordance with GAAP.
"Non-Recourse Debt" means Debt:
(1) as to which neither the Company nor any of its Restricted Subsidiaries (a)
provides credit support of any kind (including any undertaking, agreement
or instrument that would constitute Debt), (b) is directly or indirectly
liable as a guarantor or otherwise, or (c) constitutes the lender;
(2) no default with respect to which (including any rights that the holders
thereof may have to take enforcement action against an Unrestricted
Subsidiary) would permit upon notice, lapse of time or both any holder of
any other Debt of the Company or any of its Restricted Subsidiaries to
declare a default on such other Debt or cause the payment thereof to be
accelerated or payable prior to its stated maturity; and
(3) as to which the lenders have been notified in writing that they will not
have any recourse to the stock or assets of the Company or any of its
Restricted Subsidiaries.
"Obligations" means any principal, interest, penalties, fees,
indemnifications, reimbursements, damages and other liabilities payable under
the documentation governing any Debt.
"Pari Passu Debt" means:
(1) any Debt of the Company that is equal in right of payment to the Notes;
and
(2) with respect to any guarantee, Debt which ranks equal in right of payment
to such guarantee.
"Permitted Holder" means:
(1) any Warburg Entity; or
(2) Charles J. McMinn, his spouse, his lineal descendants, whether acting in
their own name or as a majority of persons having the power to exercise
the voting rights attached to, or having investment power over, shares
held by others, any Affiliate of such persons, any trust principally for
the benefit of one or more members of such persons, (whether or not any
such person is a trustee of such trust) and any charitable foundation
whose majority of members, trustees or directors, as the case may be, are
any of such persons.
"Permitted Investments" means:
(1) any Investment in the Company or in any Wholly Owned Restricted Subsidiary
of the Company;
(2) any Investment in Cash Equivalents;
(3) any Investment by the Company or any Wholly Owned Restricted Subsidiary of
the Company in a Person if, as a result of such Investment:
(a) such Person becomes a Wholly Owned Restricted Subsidiary of the
Company; or
(b) such Person is merged, consolidated or amalgamated with or into, or
transfers or conveys substantially all of its Debt, Equity Interests or
other securities to, or is liquidated into, the Company or a Wholly
Owned Restricted Subsidiary of the Company;
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(4) any Investment made as a result of the receipt of non-cash consideration
from an Asset Sale that was made pursuant to and in compliance with the
covenant described above under the caption "--Repurchase at the Option of
Holders--Asset Sales;"
(5) any acquisition of assets to the extent acquired in exchange for the
issuance of Equity Interests (other than Disqualified Stock) of the
Company;
(6) any Investment by the Company in joint ventures or one or more Wholly
Owned Unrestricted Subsidiaries of the Company; provided, however, that
the aggregate amount of Investments made pursuant to this clause (6) shall
not exceed the greater of $50.0 million and 5% of the Company's Total
Common Equity at any one time outstanding;
(7) accounts receivable created or acquired in the ordinary course of business
of the Company or any Restricted Subsidiary and on ordinary business
terms; and
(8) Investments arising from transactions by the Company or any Restricted
Subsidiaries with trade creditors or customers in the ordinary course of
business (including any such Investment received pursuant to any plan of
reorganization or similar arrangement pursuant to the bankruptcy or
insolvency of such trade creditors or customers or otherwise in settlement
of a claim).
"Permitted Liens" means:
(1) Liens in favor of the Company or holders of the Notes;
(2) Liens on property of a Person existing at the time such Person is merged
into or consolidated with the Company or any Restricted Subsidiary of the
Company; provided that such Liens were in existence prior to the
contemplation of such merger or consolidation and do not extend to any
assets other than those of the Person merged into or consolidated with
the Company;
(3) Liens on property existing at the time of acquisition thereof by the
Company or any Restricted Subsidiary of the Company; provided that such
Liens were in existence prior to the contemplation of such acquisition;
(4) Liens to secure the performance of statutory obligations, surety or
appeal bonds, performance bonds or other obligations of a like nature
incurred in the ordinary course of business;
(5) Liens existing on the Closing Date;
(6) Liens for taxes, assessments or governmental charges or claims that are
not yet delinquent or that are being contested in good faith by
appropriate proceedings promptly instituted and diligently concluded,
provided that any reserve or other appropriate provision as shall be
required in conformity with GAAP shall have been made therefor;
(7) Liens securing Vendor Debt or Purchase Money Debt permitted by the
Indenture, in each case, on the property together with proceeds, product,
accessions, substitutions and replacements thereof;
(8) Liens created by "notice" or "precautionary" filings in connection with
operating leases or other transactions pursuant to which no Debt or
Attributable Debt is Incurred by the Company or any Restricted
Subsidiary;
(9) Liens on securities constituting "margin stock" within the meaning of
Regulation T, U or X promulgated by the Board of Governors of the Federal
Reserve System, to the extent that the Investment by the Company or any
Restricted Subsidiary in such margin stock is not prohibited by the
Indenture;
(10) Liens on Capital Stock of Unrestricted Subsidiaries;
(11) Liens in favor of the Trustee arising under the Indenture; and
(12) Liens incurred in the ordinary course of business of the Company or any
Subsidiary of the Company with respect to obligations that do not exceed
$2.0 million at any one time outstanding and that:
(a) are not incurred in connection with the borrowing of money or the
obtaining of advances or credit (other than trade credit in the
ordinary course of business); and
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(b) do not in the aggregate materially detract from the value of the
property or materially impair the use thereof in the operation of
business by the Company or such Restricted Subsidiary.
"Permitted Refinancing Debt" means any Debt of the Company or any of its
Restricted Subsidiaries issued in exchange for, or the net proceeds of which
are used to extend, refinance, renew, replace, defease or refund other Debt of
the Company or such Restricted Subsidiary (other than intercompany Debt);
provided that:
(1) the principal amount (or accreted value, if applicable) of such Permitted
Refinancing Debt does not exceed the principal amount of (or accreted
value, if applicable), plus accrued interest on, the Debt so extended,
refinanced, renewed, replaced, defeased or refunded (plus the amount of
reasonable expenses incurred in connection therewith);
(2) such Permitted Refinancing Debt has a final maturity date later than the
final maturity date of, and has a Weighted Average Life to Maturity equal
to or greater than the Weighted Average Life to Maturity of, the Debt
being extended, refinanced, renewed, replaced, defeased or refunded;
(3) if the Debt being extended, refinanced, renewed, replaced, defeased or
refunded is subordinated in right of payment to the Notes, such Permitted
Refinancing Debt has a final maturity date later than the final maturity
date of, and is subordinated in right of payment to, the Notes on terms at
least as favorable to the holders of Notes as those contained in the
documentation governing the Debt being extended, refinanced, renewed,
replaced, defeased or refunded; and
(4) such Debt is incurred either by the Company or by the Restricted
Subsidiary who is the obligor on the Debt being extended, refinanced,
renewed, replaced, defeased or refunded.
"Pledge Account" means an account established with the escrow agent
pursuant to the terms of the Pledge Agreement for the deposit of the Pledged
Securities purchased by the Company with a portion of the proceeds from the
sale of the Notes.
"Pledge Agreement" means the Pledge and Escrow Agreement, dated as of the
date of the Indenture, by and between The Bank of New York, as escrow agent,
and the Company, governing the disbursement of funds from the Pledge Account.
"Pledged Securities" means the securities purchased by the Company with a
portion of the proceeds from the sale of the Notes, which shall consist of
Government Securities, to be deposited in the Pledge Account.
"Public Equity Offering" means an underwritten offering of Common Stock
with gross proceeds to the Company of at least $35.0 million pursuant to a
registration statement that has been declared effective by the Commission
pursuant to the Securities Act (other than a registration statement on Form S-
8 or otherwise relating to equity securities issuable under any employee
benefit plan of the Company).
"Productive Assets" means assets, including assets owned directly or
indirectly through Capital Stock of a Restricted Subsidiary, of a kind used or
usable in the Telecommunications Business of the Company.
"Purchase Money Debt" means Debt of the Company (including Acquired Debt
and Debt represented by Capital Lease Obligations, mortgage financings and
purchase money obligations), including any related notes, guarantees,
collateral documents, instruments and agreements executed in connection
therewith, as the same may be amended, supplemented, modified or restated from
time to time incurred for the purpose of financing all or any part of the cost
of development, construction, acquisition or improvement by the Company or any
Restricted Subsidiary of the Company of any Productive Assets of the Company
or any Restricted Subsidiary of the Company.
"Restricted Investment" means an Investment other than a Permitted
Investment.
"Restricted Subsidiary" of a Person means any Subsidiary of the referent
Person that is not an Unrestricted Subsidiary. If no referent Person is
identified, the term "Restricted Subsidiaries" shall be deemed to refer to
Restricted Subsidiaries of the Company.
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"Sale and Leaseback Transaction" means, with respect to any Person, any
direct or indirect arrangement pursuant to which any property (other than
Capital Stock) is sold by such Person or a Subsidiary, or, in the case of the
Company, a Restricted Subsidiary of such Person and is thereafter leased back
from the purchaser or transferee thereof by such Person or one of its
Subsidiaries or, in the case of the Company, one of its Restricted
Subsidiaries.
"Significant Subsidiary" means any Restricted Subsidiary that would be a
"significant subsidiary" as defined in Article 1, Rule 1-02 of Regulation S-X,
promulgated pursuant to the Securities Act, as such Regulation is in effect on
the Closing Date.
"Stated Maturity" means, with respect to any installment of interest or
principal on any series of Debt, the date on which such payment of interest or
principal was scheduled to be paid in the original documentation governing
such Debt, and shall not include any contingent obligations to repay, redeem
or repurchase any such interest or principal prior to the date originally
scheduled for the payment thereof.
"Subordinated Debt" means Debt of the Company or a Guarantor subordinated
in right of payment to the Notes or the guarantee of such Guarantor, as the
case may be.
"Subsidiary" means, with respect to any Person:
(1) any corporation, association or other business entity of which more than
50% of the total voting power of shares of Capital Stock entitled (without
regard to the occurrence of any contingency) to vote in the election of
directors, managers or trustees thereof is at the time owned or
controlled, directly or indirectly, by such Person or one or more of the
other Subsidiaries of that Person (or a combination thereof); and
(2) any partnership, limited liability company or similar pass-through entity,
(a) the sole general partner or the managing general partner or managing
member of which is such Person or a Subsidiary of such Person or (b) the
only general partners, managing members, or Persons, however designated in
corresponding roles, of which are such Person or of one or more
Subsidiaries of such Person (or any combination thereof).
"Telecommunications Business" means, when used in reference to any Person,
that such Person is engaged primarily in the business of transmitting, or
providing services relating to the transmission of, voice or data through
leased transmission facilities (including facilities such as fiber, copper and
switches), and any business related, ancillary or complementary thereto (as
determined in good faith by the Board of Directors).
"Telecommunications Related Assets" means all assets, rights (contractual
or otherwise) and properties, whether tangible or intangible, real or
personal, used or to be used, in connection with a Telecommunications
Business.
"Total Common Equity" of any Person means, as of any date of determination
the product of:
(1) the aggregate number of outstanding primary shares of Common Stock of such
Person on such day (which shall not include any options or warrants on, or
securities convertible or exchangeable into, shares of Common Stock of
such Person); and
(2) the average Closing Price of such Common Stock over the 20 consecutive
Trading Days immediately preceding such day.
If no such Closing Price exists with respect to shares of any such class,
the value of such shares for purposes of clause (2) of the preceding sentence
shall be determined by the Board of Directors of the Company in good faith and
evidenced by a resolution of the Board of Directors filed with the Trustee.
"Trading Day", with respect to a securities exchange or automated quotation
system, means a day on which such exchange or system is open for a full day of
trading.
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"Unrestricted Subsidiary" means any Subsidiary that is designated by the
Board of Directors as an Unrestricted Subsidiary pursuant to a Board
Resolution, but only to the extent that such Subsidiary:
(1) has no Debt other than Non-Recourse Debt;
(2) is not party to any agreement, contract, arrangement or understanding with
the Company or any Restricted Subsidiary of the Company unless the terms
of any such agreement, contract, arrangement or understanding are no less
favorable to the Company or such Restricted Subsidiary than those that
might be obtained at the time from Persons who are not Affiliates of the
Company, unless such agreement, contract, arrangement or understanding
constitutes a Restricted Payment permitted by the Indenture;
(3) is a Person with respect to which neither the Company nor any of its
Restricted Subsidiaries has any direct or indirect obligation (a) to
subscribe for additional Equity Interests or (b) to maintain or preserve
such Person's financial condition or to cause such Person to achieve any
specified levels of operating results;
(4) has not guaranteed or otherwise directly or indirectly provided credit
support for any Debt of the Company or any of its Restricted Subsidiaries;
and
(5) has at least one director on its board of directors that is not a director
or executive officer of the Company or any of its Restricted Subsidiaries
or has at least one executive officer that is not a director or executive
officer of the Company or any of its Restricted Subsidiaries.
"Vendor Debt" means any Debt of the Company or any Restricted Subsidiary
incurred in connection with the acquisition or construction of
Telecommunications Related Assets.
"Voting Stock" of any Person means Capital Stock of such Person which
ordinarily has voting power for the election of directors (or Persons
performing similar functions) of such Person, whether at all times or only so
long as no senior class of securities has such voting power by reason of any
contingency.
"Warburg Entities" means Warburg, Pincus Ventures, L.P. or any wholly owned
Subsidiary thereof.
"Weighted Average Life to Maturity" means, when applied to any Debt at any
date, the number of years obtained by dividing:
(1) the sum of the products obtained by multiplying (a) the amount of each
then remaining installment, sinking fund, serial maturity or other
required payments of principal, including payment at final maturity, in
respect thereof, by (b) the number of years (calculated to the nearest
one-twelfth) that will elapse between such date and the making of such
payment; by
(2) the then outstanding principal amount of such Debt.
"Wholly Owned Restricted Subsidiary" of any Person means a Restricted
Subsidiary of such Person all of the outstanding Capital Stock or other
ownership interests of which (other than directors' qualifying shares) shall
at the time be owned by such Person or by one or more Wholly Owned Restricted
Subsidiaries of such Person and one or more Wholly Owned Restricted
Subsidiaries of such Person.
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DESCRIPTION OF THE NEW NOTES
The terms of the new notes will be identical in all material respects to
those of the old notes, except that the new notes:
. will have been registered under the Securities Act and therefore will not
be subject to certain restrictions on transfer applicable to the old
notes; and
. will not be entitled to certain registration rights under the
Registration Rights Agreement, including the provision for Additional
Interest of up to 2.0% on the old notes. Holders of old notes should
review the information set forth under "Summary--Consequences of Failure
to Exchange Old Notes" and "--Terms of New Notes."
DESCRIPTION OF CERTAIN INDEBTEDNESS
1998 Discount Notes
We have outstanding $260.0 million in aggregate principal amount at
maturity of our 1998 discount notes. The 1998 discount notes mature on March
15, 2008 and are accreting in value through March 15, 2003 at a rate of 13
1/2% per annum, compounded semi-annually. After March 15, 2003, the 1998
discount notes will bear interest at a rate of 13 1/2% per annum, payable in
cash semi-annually in arrears on March 15 and September 15 of each year until
maturity beginning September 15, 2003. We may redeem the 1998 discount notes
at our option, in whole or in part, at any time on or after March 15, 2003, at
a premium declining to par on March 15, 2006, plus accrued and unpaid interest
through the redemption date. If a change of control occurs, the holders of the
1998 discount notes will have the right to require us to purchase the 1998
discount notes at a price equal to 101% of the aggregate principal amount or
accreted value thereof, as applicable, plus accrued and unpaid interest, if
any, to the date of purchase.
The covenants set forth in the indenture relating to the 1998 discount
notes are similar to, but more restrictive in some instances than, those in
the indenture, including with respect to the covenant described above under
the caption "Description of Notes--Certain Covenants--Incurrence of Debt and
Issuance of Disqualified Stock." The indenture relating to the 1998 discount
notes contains certain covenants, that, among other things, limit our ability
and the ability of our subsidiaries to:
. make certain restricted payments;
. incur additional indebtedness and issue preferred stock;
. pay dividends or make other distributions, repurchase equity interests or
subordinated indebtedness;
. engage in sale and leaseback transactions;
. create certain liens;
. enter into certain transactions with affiliates;
. sell our assets or those of our subsidiaries, conduct certain lines of
business, issue or sell equity interests of our subsidiaries or enter
into certain mergers and consolidations. In addition, under certain
circumstances, we are required to offer to purchase the 1998 discount
notes at a price equal to 100% of the principal amount or accreted value
thereof, as applicable, plus accrued and unpaid interest, if any, to the
date of purchase, with the proceeds of certain asset sales.
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<PAGE>
DESCRIPTION OF CAPITAL STOCK
The following summary describes the material terms of our capital stock.
However, it does not purport to be complete and is qualified in its entirety
by the actual terms of our capital stock contained in our Amended and Restated
Certificate of Incorporation and other agreements referenced below.
Our authorized capital stock currently consists of 190,000,000 shares of
common stock, 10,000,000 shares of class B common stock and 5,000,000 shares
of preferred stock. As of March 15, 1999, there were 335 holders of record of
common stock and five holders of class B common stock. The common stock and
preferred stock each have a par value of $0.001 per share. As of March 15,
1999, there were 42,271,466 shares of common stock, 6,379,177 shares of class
B common stock and no shares of preferred stock outstanding. As of March 15,
1999, options to purchase 11,383,597 shares of common stock at a weighted
average exercise price of $3.41 per share were outstanding.
Common Stock
The holders of our common stock are entitled to one vote per share on all
matters submitted to a vote of the stockholders. Subject to preferential
rights of any outstanding series of preferred stock, the holders of common
stock are entitled to receive ratably such dividends, if any, as may be
declared from time to time by the board of directors out of funds legally
available for that purpose. In the event of our liquidation, dissolution or
winding up, the holders of common stock are entitled to share ratably in all
our remaining assets after payment of liabilities and satisfaction of
preferential rights of any outstanding series of preferred stock. The common
stock has no preemptive or conversion rights or other subscription rights.
There are no redemption or sinking fund provisions applicable to the common
stock. All outstanding shares of common stock are fully paid and non-
assessable.
Class B Common Stock
The rights of holders of our class B common stock are identical to the
rights of holders of our common stock except that the holders of our class B
common stock do not have voting rights. Commencing in January 2000, the class
B common stock may be converted into common stock on a one-for-one basis at
the election of the holder, provided that such holder and its affiliates would
not hold more than 10% of our voting stock. In addition, commencing in January
2000 the class B common stock will automatically convert into common stock
upon transfer to a third party.
Preferred Stock
The board of directors has the authority to issue up to 5,000,000 shares of
preferred stock in one or more series without any further action or vote by
the stockholders. In addition, the board of directors is authorized, without
stockholder approval, to fix the rights, preferences, privileges, and
restrictions granted to or imposed upon such preferred stock, including:
. dividend rights,
. conversion rights,
. terms of redemption,
. liquidation preferences,
. voting rights,
. sinking fund terms, and
. the number of shares constituting any series or the designation of such
series.
As a result, the board of directors could issue additional preferred stock
with voting and conversion rights which could adversely affect the voting
power of the holders of common stock. Issuing preferred stock could
114
<PAGE>
also have the effect of delaying, deferring or preventing a change in control
or the removal of our management. We have no present plan to issue any shares
of preferred stock.
Warrants
In connection with the issuance of our senior discount notes in March 1998,
we issued warrants to purchase an aggregate of 5,053,764 shares of our common
stock with exercise prices of $0.0033 per share. These warrants became
exercisable on September 15, 1998 and automatically expire on March 15, 2008.
We also issued to a consultant a five-year warrant to purchase 135,000 shares
with an exercise price of $1.00 per share. This warrant is immediately
exercisable.
Registration Rights
Certain holders of our common stock are entitled to registration rights.
Pursuant to the Stockholder Rights Agreement holders of 20,075,285 shares of
common stock and holders of 6,379,177 shares of class B common stock
(collectively, the "Rights Holders") are entitled to certain rights with
respect to the registration under the Securities Act of the shares of common
stock held by them or issuable upon conversion of the class B common stock.
The class B common stock may be converted into common stock at the election of
the holder commencing January 2000. The Rights Holders are entitled to demand,
"piggy-back" and S-3 registration rights, subject to certain limitations and
conditions. The number of securities requested to be included in a
registration involving the exercise of demand and "piggy-back" rights are
subject to a pro rata reduction based on the number of shares of common stock
held by each Rights Holder and any other security holders exercising their
respective registration rights to the extent that the managing underwriter
advises that the total number of securities requested to be included in the
underwriting is such as to materially and adversely affect the success of the
offering. The registration rights terminate as to any Rights Holder at the
later of (i) three years after our initial the offering made hereby or (ii)
such time as such Rights Holder may sell under Rule 144 in a three month
period all registrable securities then held by such Rights Holder.
Pursuant to the Warrant Registration Rights Agreement dated March 11, 1998,
between us and Bear, Stearns & Co. Inc. and BT Alex. Brown Incorporated,
holders of the warrants that were issued in connection with our senior
discount note offering in March 1998 are entitled to certain registration
rights with respect to the shares of common stock issuable upon exercise of
such warrants. The warrant holders are entitled to demand and "piggy-back"
registration rights, subject to certain limitations and conditions. Like the
Rights Holders, the number of securities that a warrant holder may request to
be included in a registration involving an exercise of its demand or "piggy-
back" rights is subject to a pro rata reduction. Such a reduction will be
based on the number of shares held by each warrant holder and any other
security holders exercising their respective registration rights to the extent
that the managing underwriter advises us that the total number of securities
requested to be included in the underwriting is such as to materially and
adversely affect the success of the offering.
Antitakeover Effects of Certain Provisions of Covad's Charter, Bylaws and
Delaware Law
As noted above, our board of directors, without stockholder approval, has
the authority under our charter to issue preferred stock with rights superior
to the rights of the holders of common stock. As a result, preferred stock
could be issued quickly and easily, could adversely affect the rights of the
common stock holders and could be issued with terms calculated to delay or
prevent a change of control of our company or make removal of management more
difficult.
Election and Removal of Directors. Our charter and bylaws provide for the
division of our board of directors into three classes, as nearly equal in
number as possible, with the directors in each class serving for a three-year
term, and one class being elected each year by our stockholders. Our directors
may be removed only for cause. This system of electing and removing directors
may tend to discourage a third party from making a tender offer or otherwise
attempting to obtain control of our company and may maintain the incumbency of
the board of directors, as it generally makes it more difficult for
stockholders to replace a majority of the directors. See "Management--
Classified Board."
115
<PAGE>
Stockholder Meetings and Written Consent. Under our bylaws, the
stockholders may not call a special meeting of the stockholders of our
company. Rather, only our board of directors, the chairman of our board of
directors and the President may call special meetings of our stockholders. Our
charter provides that stockholders may not act by written consent. As a
result, stockholders can only act at a meeting.
Requirements for Advance Notification of Stockholder Nominations and
Proposals. Our bylaws establish advance notice procedures with respect to
stockholder proposals and the nomination of candidates for election as
directors, other than nominations made by or at the direction of the board of
directors or a committee thereof.
Section 203 of the Delaware General Corporation Law. We are subject to
Section 203 of the Delaware General Corporation Law. Section 203 prohibits a
publicly held Delaware corporation from engaging in a "business combination"
with an "interested stockholder" for a period of three years after the date of
the transaction in which the person became an interested stockholder, unless
. prior to such date, the board of directors of the corporation approves
either the business combination or the transaction that resulted in the
stockholder's becoming an interested stockholder,
. upon consummation of the transaction that resulted in the stockholder's
becoming an interested stockholder, the interested stockholder owns at
least 85% of the outstanding voting stock, excluding shares held by
directors, officers and certain employee stock plans, or
. on or after the consummation date the business combination is approved by
the board of directors and by the affirmative vote at an annual or
special meeting of stockholders of at least 66 2/3 % of the outstanding
voting stock that is not owned by the interested stockholder.
For purposes of Section 203, a "business combination" includes, among other
things, a merger, asset sale or other transaction resulting in a financial
benefit to the interested stockholder. An "interested stockholder" is
generally a person who, together with affiliates and associates of such
person,
. owns 15% or more of the corporation's voting stock or
. is an affiliate or associate of the corporation and was the owner of 15%
or more of the outstanding voting stock of the corporation as any time
within the prior three years.
These charter and bylaw provisions and provisions of Delaware law may have
the effect of delaying, deterring or preventing a change of control of our
company.
116
<PAGE>
FEDERAL INCOME TAX CONSIDERATIONS
The following discussion is a general summary of the material U.S. federal
income tax considerations relating to the exchange offer and to the purchase,
ownership and disposition of the new notes. The discussion of the federal
income tax consequences set forth below is based upon the Internal Revenue
Code of 1986, as amended (the "Code"), and judicial decisions and
administrative interpretations thereunder, as of the date hereof, and such
authorities may be repealed, revoked or modified or interpreted differently so
as to result in federal income tax consequences different from those discussed
below. We cannot asure you that the Internal Revenue Service will not
successfully challenge one or more of the tax consequences described herein,
and we have not obtained, nor do we intend to obtain, a ruling from the IRS or
an opinion of counsel with respect to the U.S. federal income tax consequences
of acquiring or holding new notes.
This discussion does not purport to deal with all aspects of U.S. federal
income taxation that may be relevant to a particular holder in light of the
holder's circumstances (for example, persons subject to the alternative
minimum tax provisions of the Code). Also, it is not intended to be wholly
applicable to all categories of investors, such as foreign persons, dealers in
securities, banks, insurance companies, tax-exempt organizations, and persons
holding new notes as part of a hedging or conversion transaction or straddle
or persons deemed to sell new notes under the constructive sale provisions of
the Code, some of which may be subject to special rules. The discussion below
is premised upon the assumption that the new notes and old notes are held (or
would be held if acquired) as capital assets within the meaning of Section
1221 of the Code. The discussion also does not discuss any aspect of state,
local or foreign law.
Each holder or prospective holder of new notes is strongly urged to consult
its own tax advisor with respect to its particular tax situation including the
tax effects of any state, local, foreign, or other tax laws and possible
changes in the tax laws.
Exchange of Notes
The exchange of old notes for new notes pursuant to the exchange offer
should not be a taxable exchange for U.S. federal income tax purposes.
Accordingly, a holder should have the same adjusted issue price, adjusted
basis and holding period in the new notes as it had in the old notes
immediately before the exchange.
117
<PAGE>
PLAN OF DISTRIBUTION
Each Participating Broker-Dealer receiving new notes for its own account in
connection with the exchange offer must acknowledge that it will deliver a
prospectus in connection with any resale of such new notes. Participating
Broker-Dealers may use this prospectus during the period referred to below in
connection with resales of the new notes received in exchange for old notes if
such old notes were acquired by such Participating Broker-Dealers for their
own accounts. We agreed that this prospectus may be used by a Participating
Broker-Dealer in connection with resales of such new notes for a period ending
150 days after the effective date of the registration statement (subject to
extension under certain limited circumstances described herein) or, if
earlier, when all such new notes have been disposed of by such Participating
Broker-Dealer. See "The Exchange Offer--Terms of the Exchange Offer."
We will not receive any cash proceeds from the issuance of the new notes
offered by this prospectus. New notes received by Participating Broker-Dealers
for their own accounts in connection with the exchange offer may be sold from
time to time in one or more transactions in the over-the-counter market, in
negotiated transactions, through the writing of options on the new notes or a
combination of such methods of resale, at market prices prevailing at the time
of resale, at prices related to such prevailing market prices or at negotiated
prices. Any such resale may be made directly to purchasers or to or through
brokers or dealers who may receive compensation in the form of commissions or
concessions from any such broker-dealer and/or the purchasers of any such new
notes. Any Participating Broker-Dealer that resells new notes that were
received by it for its own account in the exchange offer and any broker or
dealer that participates in a distribution of such new notes may be deemed to
be an "underwriter" within the meaning of the Securities Act. Any profit on
any such resale of new notes and any commissions or concessions received by
any such persons may be deemed to be underwriting compensation under the
Securities Act. The letter of transmittal states that by acknowledging that it
will deliver and by delivering a prospectus, a Participating Broker-Dealer
will not be deemed to admit that it is an "underwriter" within the meaning of
the Securities Act.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the Securities and Exchange Commission a registration
statement on Form S-4 covering the new notes to be issued in the exchange
offer. This prospectus does not contain all of the information included in the
registration statement. Statements contained in this prospectus concerning the
provisions of any document are not necessarily complete. You should refer to
the copy of these documents filed as an exhibit to the registration statement
or otherwise filed by us with the SEC for a more complete understanding of the
matter involved. Each statement concerning these documents is qualified in its
entirety by such reference.
We are also subject to the informational requirements of the Securities
Exchange Act of 1934. In accordance with the Exchange Act, we file reports,
proxy statements and other information with the SEC. The registration
statement, including the attached exhibits and schedules, may be inspected and
copied at the public reference facilities maintained by the SEC, Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the
regional offices of the Commission located at Seven World Trade Center, New
York, New York 10048, and 500 West Madison Street, Chicago, Illinois 60661.
Please call the SEC at 1-800-SEC-0330 for further information about the public
reference rooms. The SEC maintains a Web site that contains reports, proxy and
information statements and other information regarding registrants that file
electronically with the SEC. Copies of the registration statement and the
reports, proxy and information statements and other information that we file
with the SEC may be obtained from the SEC's Internet address at
http://www.sec.gov.
The SEC allows us to incorporate by reference into the registration
statement certain information that we have filed with them. We incorporate by
reference certain of our exhibits that are not included in or delivered
118
<PAGE>
with this registration statement or this prospectus. You may request a copy of
these documents, at no cost, by writing or telephoning us at the following
address:
Covad Communications Group, Inc.
Attention: Nick Kormeluk
2330 Central Expressway
Santa Clara, California 95050
(408) 844-7500
The "Covad/TM/", "TeleSpeed/SM/", "The Speed to Work/SM/" and the Covad
crescent logo names and marks are our trademarks. This prospectus contains
other product names, trade names and trademarks of ours and of other
organizations.
LEGAL MATTERS
The validity of the new notes offered hereby will be passed upon for us by
Wilson Sonsini Goodrich & Rosati, P.C., Palo Alto, California. Certain
attorneys at Wilson Sonsini Goodrich & Rosati, P.C. hold an aggregate of 6,100
shares of our common stock.
EXPERTS
Our consolidated financial statements as of December 31, 1997 and 1998 and
for the years then ended included in this prospectus have been audited by
Ernst & Young LLP, independent auditors, as stated in their report appearing
herein, and have been so included in reliance upon the report of such firm
given upon their authority as experts in accounting and auditing.
119
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Report of Ernst & Young
LLP, Independent
Auditors............... F-2
Consolidated Balance
Sheets................. F-3
Consolidated Statements
of Operations.......... F-4
Consolidated Statements
of Stockholders' Equity
(Net Capital
Deficiency)............ F-5
Consolidated Statements
of Cash Flows.......... F-6
Notes to Consolidated
Financial Statements... F-7
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders of
Covad Communications Group, Inc.
We have audited the accompanying consolidated balance sheets of Covad
Communications Group, Inc. as of December 31, 1997 and 1998, and the related
consolidated statements of operations, stockholders' equity (net capital
deficiency), and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Covad
Communications Group, Inc. as of December 31, 1997 and 1998, and the
consolidated results of its operations and its cash flows for the years then
ended in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
San Jose, California
February 15, 1999
F-2
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in 000's, except share and per share amounts)
<TABLE>
<CAPTION>
December 31,
----------------------
1997 1998
ASSETS ------------- --------
Current assets: (Restated)(1)
<S> <C> <C>
Cash and cash equivalents.............................. $4,378 $ 64,450
Accounts receivable, net of allowances for
uncollectibles of $0 and $220......................... 25 1,933
Unbilled revenue....................................... 4 663
Inventories............................................ 43 946
Prepaid expenses....................................... 52 1,183
Other current assets................................... 317 514
------ --------
Total current assets................................ 4,819 69,689
Property and equipment:
Networks and communication equipment................... 2,185 55,189
Computer equipment..................................... 600 4,426
Furniture and fixtures................................. 185 1,119
Leasehold improvements................................. 114 1,887
------ --------
3,084 62,621
Less accumulated depreciation and amortization......... (70) (3,476)
------ --------
Net property and equipment............................ 3,014 59,145
Other assets:
Restricted cash........................................ 210 225
Deposits............................................... 31 337
Deferred debt issuance costs (net)..................... -- 8,112
Other long term assets................................. -- 1,911
------ --------
Total other assets.................................. 241 10,585
------ --------
Total assets........................................ $8,074 $139,419
====== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (NET CAPITAL
DEFICIENCY)
Current liabilities:
Accounts payable....................................... $ 651 $ 14,975
Unearned revenue....................................... 7 551
Accrued network costs.................................. 58 1,866
Other accrued liabilities.............................. 77 3,854
Current portion of capital lease obligations........... 229 263
------ --------
Total current liabilities........................... 1,022 21,509
Long-term debt (net of discount)....................... -- 142,300
Long-term capital lease obligations.................... 554 316
------ --------
Total liabilities................................... 1,576 164,125
Stockholders' equity (net capital deficiency):
Convertible preferred stock ($0.001 par value):
Authorized shares--30,000,000
Issued and outstanding shares--17,750,001 and
18,246,162 at December 31, 1997 and December 31,
1998, respectively................................... 18 18
Common stock ($0.001 par value):
Authorized shares--65,000,000
Issued and outstanding shares--11,361,204 and
11,773,997 at December 31, 1997 and December 31,
1998, respectively................................... 11 12
Additional paid-in capital............................. 9,692 30,685
Deferred compensation.................................. (611) (4,688)
Retained earnings (deficit)............................ (2,612) (50,733)
------ --------
Total stockholders' equity (net capital deficiency)... 6,498 (24,706)
------ --------
Total liabilities and stockholders' equity (net
capital deficiency).................................. $8,074 $139,419
====== ========
</TABLE>
- --------
(1) See Note 6.
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Amounts in 000's, except share and per share amounts)
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------
1997 1998
------------- ---------
(Restated)(1)
<S> <C> <C>
Revenues............................................. $ 26 $ 5,326
Operating expenses:
Network and product costs.......................... 54 4,562
Sales, marketing, general and administrative....... 2,374 31,043
Amortization of deferred compensation.............. 295 3,997
Depreciation and amortization...................... 70 3,406
--------- ---------
Total operating expenses......................... 2,793 43,008
--------- ---------
Income (loss) from operations........................ (2,767) (37,682)
Interest income (expense):
Interest income.................................... 167 4,778
Interest expense................................... (12) (15,217)
--------- ---------
Net interest income (expense)...................... 155 (10,439)
--------- ---------
Net income (loss).................................... $ (2,612) $ (48,121)
========= =========
Net income (loss) per common share................... $ (0.80) $ (8.43)
Weighted average shares used in computing net loss
per share........................................... 3,271,546 5,708,535
</TABLE>
- --------
(1) See Note 6.
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
(Restated)(1)
(Amounts in 000's, except share amounts)
<TABLE>
<CAPTION>
Total
Convertible Stockholders'
Preferred Stock Common Stock Additional Retained Equity (Net
----------------- ------------------ Paid-In Deferred Earnings Capital
Shares Amount Shares Amount Capital Compensation (Deficit) Deficiency)
---------- ------ ---------- ------ ---------- ------------ --------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Initial issuance of
common stock........... -- $-- 12,000,000 $12 $ 38 $ -- $ -- $ 50
Repurchase of common
stock.................. -- -- (2,410,296) (3) (7) -- -- (10)
Issuance of common
stock.................. -- -- 1,771,500 2 66 -- -- 68
Issuance of Series A
Preferred Stock........ 750,000 1 -- -- 249 -- -- 250
Issuance of Series B
Preferred Stock (net of
$43 of financing
costs)................. 17,000,001 17 -- -- 8,440 -- -- 8,457
Deferred compensation... -- -- -- -- 906 (906) -- --
Amortization of deferred
compensation........... -- -- -- -- -- 295 -- 295
Net loss................ -- -- -- -- -- -- (2,612) (2,612)
---------- --- ---------- --- ------- ------- -------- --------
Balance at December 31,
1997................... 17,750,001 18 11,361,204 11 9,692 (611) (2,612) 6,498
Issuance of common
stock.................. -- -- 412,793 1 570 -- -- 571
Issuance of Series B
Preferred Stock........ 100,002 -- -- -- 100 -- -- 100
Issuance of Series C
Preferred Stock........ 396,159 -- -- -- 1,100 -- -- 1,100
Issuance of common stock
warrants as part of
debt offering issuance
costs.................. -- -- -- -- 2,928 -- -- 2,928
Issuance of common stock
warrants pursuant to
debt offering.......... -- -- -- -- 8,221 -- -- 8,221
Deferred compensation... -- -- -- -- 8,074 (8,074) -- --
Amortization of deferred
compensation........... -- -- -- -- -- 3,997 -- 3,997
Net loss................ -- -- -- -- -- -- (48,121) (48,121)
---------- --- ---------- --- ------- ------- -------- --------
Balance at December 31,
1998................... 18,246,162 $18 11,773,997 $12 $30,685 $(4,688) $(50,733) $(24,706)
========== === ========== === ======= ======= ======== ========
</TABLE>
- --------
(1) See Note 6.
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Amounts in 000's)
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------
1997 1998
----------------------------
(Restated)(1)
<S> <C> <C>
Operating activities:
Net loss......................................... $ (2,612) $ (48,121)
Reconciliation of net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization.................. 70 3,406
Amortization of deferred compensation.......... 295 3,997
Accreted interest and amortization of debt
discount and deferred debt issuance costs..... -- 16,009
Net changes in current assets and liabilities:
Accounts receivable.......................... (25) (1,908)
Inventories.................................. (43) (903)
Other current assets......................... (373) (1,987)
Accounts payable............................. 651 14,324
Unearned revenue............................. 7 544
Other current liabilities.................... 135 5,585
----------- ------------
Net cash used in operating activities ........... (1,895) (9,054)
Investing activities:
Purchase of restricted cash...................... (210) (15)
Deposits......................................... (31) (306)
Other long-term assets........................... -- (1,428)
Purchase of property and equipment............... (2,253) (59,503)
----------- ------------
Net cash used in investing activities ........... (2,494) (61,252)
Financing activities:
Net proceeds from issuance of long-term debt and
warrants........................................ -- 129,328
Principal payments under capital lease
obligations..................................... (48) (238)
Proceeds from common stock issuance, net of
repurchase...................................... 108 571
Proceeds from preferred stock issuance........... 8,707 1,200
Offering costs related to common stock offering.. -- (483)
----------- ------------
Net cash provided by financing activities........ 8,767 130,378
----------- ------------
Net increase in cash and cash equivalents........ 4,378 60,072
Cash and cash equivalents at beginning of year... -- 4,378
----------- ------------
Cash and cash equivalents at end of year......... $ 4,378 $ 64,450
=========== ============
Supplemental disclosures of cash flow
information:
Cash paid during the year for interest......... $ 9 $ 99
=========== ============
Supplemental schedule of non-cash investing and
financing activities:
Equipment purchased through capital leases..... $ 831 $ 34
=========== ============
Warrants issued for equity commitment.......... -- $ 2,928
=========== ============
</TABLE>
- --------
(1) See Note 6.
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Nature of Operations and Summary of Significant Accounting Policies
Organization and Nature of Operations
Covad Communications Group, Inc (the "Company") is a high-speed Internet
and network access provider offering Digital Subscriber Line ("DSL") services
to Internet Service Provider ("ISP") and enterprise customers. ISPs purchase
the Company's services in order to provide high-speed Internet access to their
business and consumer end-users. Enterprise customers purchase the Company's
services to provide employees with remote access to their Local Area Networks
to improve employee productivity and reduce operating costs. The Company's
services are provided over standard copper telephone lines at considerably
faster speeds than available through a standard modem.
The Company's operations are subject to significant risks and uncertainties
including competitive, financial, developmental, operational, growth and
expansion, technological, regulatory, and other risks associated with an
emerging business.
Summary of Significant Accounting Policies
A. Basis of Presentation
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements.
Actual results may differ from those estimates.
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 accompanying statements of operations, stockholders' equity, and cash
flows for the year ended December 31, 1997 include $50,000 received during
1996 upon issuance of the initial capital stock of the Company and $2,000
expended in 1996 for general and administrative expenses. Due to the
insignificance of balances at December 31, 1996 and activity for the period
from inception through December 31, 1996, financial statements for 1996 have
not been presented.
B. Revenue Recognition
Revenue related to installation of service and sale of customer premise
equipment is recognized when equipment is delivered and installation is
completed. Revenue from monthly recurring service is recognized in the month
the service is provided. Recognized revenue for which the customer has not
been billed is recorded as unbilled revenue until the period such billings are
provided. Amounts billed in advance of providing services are recorded as
unearned revenue until the period such services are provided. For the year
ended December 31, 1998, one customer accounted for approximately 17% of the
Company's revenue. For the year ended December 31, 1998, no other customer
accounted for more than 10% of the Company's revenue.
C. Cash and Cash Equivalents
All highly liquid investments with a maturity of three months or less from
the date of original issuance are considered to be cash equivalents.
D. Restricted Cash
As of December 31, 1997 and December 31, 1998, the Company had $210,000 and
$225,000, respectively, in commercial deposits held in the Company's name but
restricted as security for certain of the Company's capital lease
arrangements.
F-7
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
E. Inventories
Inventories are stated at the lower of cost or market and consist primarily
of customer premise equipment. Costs are based on the first-in first-out
method.
F. Property and Equipment
Property and equipment are recorded at cost and depreciated using the
straight-line method over the following estimated useful lives:
<TABLE>
<S> <C>
Leasehold improvements....................... 15 years or life of the lease
Electronic communication equipment........... 2 to 5 years
Furniture and fixtures....................... 3 to 7 years
Computer equipment........................... 3 years
Office equipment............................. 2 to 5 years
Computer software............................ 2 to 7 years
</TABLE>
The Company capitalizes costs associated with the design, deployment and
expansion of the Company's network including internally and externally
developed software. Capitalized external software costs include the actual
costs to purchase software from vendors. Capitalized internal software costs
generally include personnel and related costs incurred in the enhancement and
implementation of purchased software packages. Capitalized internal labor
costs for the years ending December 31, 1997 and December 31, 1998 were
$139,000 and $3,063,000, respectively. Capitalized interest cost for the year
ending December 31, 1998 was $900,000.
G. Equipment Under Capital Leases
The Company leases certain of its equipment and other fixed assets under
capital lease agreements. The assets and liabilities under capital leases are
recorded at the lesser of the present value of aggregate future minimum lease
payments, including estimated bargain purchase options, or the fair value of
the assets under lease, whichever is less. Assets under capital lease are
amortized over the lease term or useful life of the assets.
H. Income Taxes
Due to the Company's overall loss position, there is no provision for
income taxes for 1997 or 1998. The reconciliation of income tax computed at
the US federal statutory rate to income tax expense is as follows:
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1998
--------- ------------
<S> <C> <C>
Federal at 34%, statutory........................ $(757,000) $(16,363,000)
Non deductible interest.......................... -- 911,000
Losses with no current benefit................... 757,000 15,436,000
Other............................................ -- 16,000
--------- ------------
Provision........................................ $ -- $ --
========= ============
</TABLE>
As of December 31, 1998, the Company had federal and state net operating
loss carryforwards of approximately $40,000,000. The net operating loss and
credit carryforwards will expire at various dates beginning in 2005 through
2018, if not utilized.
The utilization of the net operating loss is subject to a substantial
annual limitation due to the "change in ownership" provisions of the Internal
Revenue Code of 1986 and similar state provisions. The annual limitation
F-8
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
may result in the expiration of net operating losses and credits before
utilization. Significant components of the Company's deferred tax assets and
liabilities for federal and state income taxes are as follows:
<TABLE>
<CAPTION>
December 31,
---------------------
1997 1998
-------- -----------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards.................. $820,000 $16,000,000
Depreciation...................................... -- 1,000,000
Other............................................. -- 1,500,000
-------- -----------
Net deferred tax assets........................... 820,000 18,500,000
Valuation allowance................................. (820,000) (18,500,000)
-------- -----------
Net deferred tax assets............................. -- --
======== ===========
</TABLE>
The net valuation allowance increased by $17,680,000 during the year ended
December 31, 1998.
I. Fair Value of Financial Instruments
Statement of Financial Accounting Standards ("SFAS") No. 107, "Disclosures
About Fair Value of Financial Instruments," as amended by SFAS No. 119,
"Disclosures About Derivative Financial Instruments and Fair Value of Financial
Instruments," requires disclosure of fair value information about financial
instruments whether or not recognized in the balance sheet, for which it is
practicable to estimate that value. In cases where quoted market prices are not
available for identical or comparable financial instruments, fair values are
based on estimates using the present value of estimated cash flows or other
valuation techniques. The resulting fair values can be significantly affected
by the assumptions used, including the discount rate and estimates as to the
amounts and timing of future cash flows.
The following methods and assumptions were used to estimate the fair value
for financial instruments:
Cash and cash equivalents. The carrying amount approximates fair value.
Borrowings. The fair values of borrowings, including long-term debt, capital
lease obligations and other obligations, were estimated based on quoted market
prices, where available, or by discounting the future cash flows using
estimated borrowing rates at which similar types of borrowing arrangements with
the same remaining maturities could be obtained by the Company. For all
borrowings outstanding at December 31, 1997 and December 31, 1998, fair value
approximates recorded value.
J. Earnings (Loss) Per Share
Basic earnings per share is computed by dividing income or loss applicable
to common shareholders by the weighted average number of shares of the
Company's common stock ("Common Stock"), after giving consideration to shares
subject to repurchase, outstanding during the period.
Diluted earnings per share is determined in the same manner as basic
earnings per share except that the number of shares is increased assuming
exercise of dilutive stock options and warrants using the treasury stock method
and conversion of the Company's convertible preferred stock ("Preferred
Stock"). In addition, income or loss is adjusted for dividends and other
transactions relating to preferred shares for which conversion is assumed. The
diluted earnings per share amount has not been reported because the Company has
a net loss and the impact of the assumed exercise of the stock options and
warrants and the assumed preferred stock conversion is not dilutive.
F-9
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Under the Company's Certificate of Incorporation, all outstanding Preferred
Stock will convert into Common Stock on a one-for-one basis upon the
completion of the Company's initial public offering of Common Stock (see note
9).
The consolidated financial statements applicable to the prior periods have
been restated to reflect a two-for-one stock split effective May 1998 and a
three-for-two stock split effective August 1998.
The following table presents the calculation of basic and diluted net
income (loss) per share (in thousands, except share and per share amounts):
<TABLE>
<CAPTION>
Year Ended December
31,
----------------------
1997 1998
---------- ----------
<S> <C> <C>
Net income (loss)................................... $ (2,612) $ (48,121)
Basic and diluted:
Weighted average shares of common stock
outstanding...................................... 11,021,269 11,505,307
Less: Weighted average shares subject to
repurchase....................................... 7,749,723 5,796,772
---------- ----------
Weighted average shares used in computing basic and
diluted net income (loss) per share................ 3,271,546 5,708,535
========== ==========
Basic and diluted net income (loss) per share....... $ (0.80) $ (8.43)
========== ==========
</TABLE>
K. Concentration of Credit Risk
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents
and accounts receivable. The Company's cash and investment policies limit
investments to short-term, investment grade instruments. Concentrations of
credit risk with respect to accounts receivable are limited due to the large
number of customers comprising the Company's customer base. In addition, the
Company typically offers its customers credit terms. The Company performs
ongoing credit evaluations of its customers' financial condition and generally
does not require collateral.
L. Key Suppliers
The Company is dependant on limited source suppliers for certain equipment
used to provide its services. The Company has generally been able to obtain an
adequate supply of equipment. In addition, the Company believes that there are
alternative suppliers for the equipment used to provide its service. However,
an extended interruption in the supply of equipment currently obtained from
limited source suppliers could adversely affect the Company's business and
results of operations.
M. Accounts Receivable Allowance:
The Company established a reserve for uncollectible accounts receivable in
the amount of $220,000 at December 31, 1998. No significant charges were made
against this reserve as of December 31, 1998.
N. Recently Issued Accounting Pronouncements:
In June 1997, the Financial Accounting Standards Board issued Statement No.
131, "Disclosures About Segments of an Enterprise and Related Information"
("SFAS 131"), which establishes standards for the way that public business
enterprises report information about operating segments in quarterly and
annual financial statements. SFAS 131 changes segment reporting from an
industry segment basis to an operating segment basis defined based on how the
business is managed. The Company operates in only one segment, high-speed
digital communications services, and hence, separate segment reporting is not
applicable.
F-10
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 $129.6 million, after transaction costs of approximately $5.5
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 amortized over the life of the Notes. Debt issuance costs
were incurred through the issuance of additional 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 year ended December 31,
1998, the accretion of the Notes and the amortization of debt discount and
debt issuance costs was $16 million, of which $15.1 million is included in
interest expense and $900,000 is capitalized in property, plant and equipment.
The Unit Warrants have ten year terms, have exercise prices of $0.0033 per
share (subject to adjustment in certain events), contain net exercise
provisions and are currently exercisable.
3. Capital Leases
The Company has entered into capital lease arrangements to finance the
acquisition of certain operating assets, two of which have bargain purchase
options. The principal value of these leases totaled $831,000 and $865,000 as
of December 31, 1997 and December 31, 1998, respectively, and was equivalent
to the fair value of the assets leased.
Future minimum lease payments under capital leases are as follows:
<TABLE>
<CAPTION>
Year Ending December 31,
------------------------
<S> <C>
1999............................................................ 335,000
2000............................................................ 294,000
2001............................................................ 44,000
2002............................................................ 4,000
2003............................................................ --
Thereafter...................................................... --
--------
677,000
Less amount representing interest............................... (98,000)
Less current portion............................................ (263,000)
--------
Total long-term portion......................................... $316,000
========
</TABLE>
F-11
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Accumulated amortization for equipment under capital leases is reflected in
accumulated depreciation and amortization for property and equipment.
4. Operating Leases
The Company leases vehicles, equipment, and office space under various
operating leases. Future minimum lease payments by year under operating leases
are as follows:
<TABLE>
<CAPTION>
Year Ending December 31,
------------------------
<S> <C>
1999........................................................... 2,656,000
2000........................................................... 2,105,000
2001........................................................... 2,159,000
2002........................................................... 1,436,000
2003........................................................... 506,000
Thereafter..................................................... 351,000
----------
Total........................................................ $9,213,000
==========
</TABLE>
Rental expense on operating leases totaled $131,000 and $1,507,000 for the
year ended December 31, 1997 and December 31, 1998, respectively.
5. Stockholders' Equity
Covad Communications Group, Inc.
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 December 31, 1998, were 11,361,204
and 11,773,997 shares, respectively, of which 7,033,107 and 4,773,083 shares,
respectively, remain subject to repurchase provisions which generally lapse
over a four year period from the date of issuance.
Common Stock reserved for future issuance as of December 31, 1998 is as
follows:
<TABLE>
<S> <C>
Convertible preferred stock..................................... 18,246,162
Outstanding and reserved options................................ 15,306,843
Outstanding warrants............................................ 6,988,764
----------
Total........................................................ 40,541,769
==========
</TABLE>
F-12
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Convertible Preferred Stock:
Convertible preferred stock consists of the following:
<TABLE>
<CAPTION>
December 31,
--------------
1997 1998
------ ------
<S> <C> <C>
Authorized shares--30,000,000
Series A preferred stock ($0.001 par value):
Authorized shares--750,000
Issued and outstanding shares--750,000 at December 31, 1997
and December 31, 1998..................................... $ 1 $ 1
Series B preferred stock ($0.001 par value):
Authorized shares--17,100,003
Issued and outstanding shares--17,000,001 at December 31,
1997 and 17,100,003 at December 31, 1998.................. 17 17
Series C preferred stock ($0.001 par value):
Authorized shares--11,149,287
Issued and outstanding shares--None at December 31, 1997
and 396,159 at December 31, 1998.......................... -- --
------ ------
$18 $18
====== ======
</TABLE>
In January 1999, all of the outstanding convertible Preferred Stock
converted into Common Stock (see Note 9).
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 the Equity Commitment or to complete an alternate equity financing of at
least $16.0 million by March 11, 1999. In consideration of this commitment,
the 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"). In January 1999, the
Company completed an alternative equity financing and, as a result, the Equity
Commitment will not be called (see Note 9).
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
F-13
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
purchase price of $1.0 million; provided, that 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 Dividends
The holders of Series A, Series B and Series C were 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 were
cumulative and accrue to the holders to the extent they were not declared or
paid were payable, in cash or Common Stock, 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 and December 31, 1998 for Preferred Stock were
$318,250 and $1,084,740, respectively, none of which has been declared or
paid.
6. 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 December
31, 1998 the Plan has reserved 15,520,342 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 is a summary of the status of stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------ ------------------------
Weighted- Weighted- Weighted-
Exercise Price Number of Average Life Average Number of Average
Range Shares Remaining Exercise Price Shares Exercise Price
-------------- --------- ------------ -------------- --------- --------------
<C> <S> <C> <C> <C> <C>
$0.033--$0.667.. 6,503,028 6.4 years $0.2675 1,775,834 $0.1672
$1.00 --$1.627.. 2,782,499 7.5 years $1.1538 46,870 $1.6270
$5.75........... 1,438,802 7.6 years $5.7500 4,372 $5.7500
$7.38 --$7.93... 1,311,961 7.7 years $7.7741 8,066 $7.6733
$8.16........... 195,500 7.9 years $8.1600 500 $8.1600
</TABLE>
The following table summarizes stock option activity for the year ended
December 31, 1997 and December 31, 1998:
<TABLE>
<CAPTION>
Number of Shares Option Price
of Common Stock Per Share
---------------- ----------------
<S> <C> <C>
Balance as of December 31, 1996......... -- N/A
Granted................................. 3,843,750 $0.033 -- $0.05
Exercised............................... (6,000) $0.033
Forfeited............................... (33,000) $0.033 -- $0.05
---------- ----------------
Balance as of December 31, 1997......... 3,804,750 $0.033 -- $0.05
Granted................................. 9,358,978 $0.10 -- $8.16
Exercised............................... (207,499) $0.033 -- $0.667
Forfeited............................... (724,439) $0.033 -- $7.93
---------- ----------------
Balance as of December 31, 1998......... 12,231,790 $0.033 -- $8.16
========== ================
</TABLE>
F-14
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 a result of the Company's reassessment during 1998 of the fair values per
share of its common stock, the Company has restated its financial statements
for the year ended December 31, 1997 to record 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
year ended December 31, 1998, the Company recorded additional deferred
compensation of approximately $8.1 million. Amortization of deferred
compensation during this same period was approximately $4.0 million.
Stock-Based Compensation
Pro forma information regarding results of operations and loss per share is
required by SFAS 123 as if the Company had accounted for its stock-based
awards under the fair value method of SFAS 123. The fair value of the
Company's stock-based awards to employees has been estimated using the minimum
value option pricing model which does not consider stock price volatility.
Because the Company does not have actively traded equity securities,
volatility is not considered in determining the fair value of stock-based
awards to employees.
For the year ended December 31, 1997 and December 31, 1998, the fair value
of the Company's stock-based awards to employees was estimated using the
following weighted average assumptions:
<TABLE>
<CAPTION>
1997 1998
---- ----
<S> <C> <C>
Expected life of options in years.............................. 4.0 4.0
Risk-free interest rate........................................ 7.0% 7.0%
Expected dividend yield........................................ 0.00% 0.00%
</TABLE>
The weighted average fair value of stock options granted during the year
ended December 31, 1997 and December 31, 1998 was $0.26 and $2.05 per share,
respectively. For pro forma purposes, the estimated fair value of the
Company's stock-based awards to employees is amortized over the options'
vesting period which would result in an increase in net loss of approximately
$12,000 and $1.7 million for the year ended December 31, 1997 and 1998,
respectively. The result of applying SFAS 123 to the Company's option grants
was not material to the results of operations or loss per share for the year
ended December 31, 1997 and would have increased the net loss per share by
$0.30 per share for the year ended December 31, 1998.
7. Related Party Transactions
The Company purchases equipment from a supplier which is partially owned by
an investor in the Company. Purchases from this supplier totaled $85,000 and
$5.8 million for the years ending December 31, 1997 and December 31, 1998,
respectively.
8. Legal Proceedings
The Company is engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with incumbent local exchange carriers
("ILECs"). These negotiations, arbitrations and proceedings concern the ILECs'
denial of physical collocation space to the Company in certain central
offices, the cost and delivery of
F-15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
collocation spaces, the delivery of transmission facilities and telephone
lines, billing issues and other operational issues. None of these actions
involve a potential liability for the Company. However, failure to resolve any
of these matters without undue delay or expense could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. 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 competitive local exchange carrier
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.
9. Subsequent Events
In January 1999, the Company entered into strategic relationships with AT&T
Corp. ("AT&T"), NEXTLINK Communications, Inc. ("NEXTLINK") and Qwest
Communications Corporation ("QCC"). As part of these strategic relationships,
the Company received equity investments of $25 million from AT&T's venture
capital arm and two affiliated funds, $20 million from NEXTLINK and $15
million from QCC's wholly owned subsidiary, U.S. Telesource, Inc. (as used
herein, "Qwest" refers to QCC or its subsidiary, as applicable). The Company
intends to record intangible assets of $28.7 million associated with these
transactions. Furthermore, AT&T, NEXTLINK and Qwest each entered into
commercial agreements with the Company providing for the purchase, marketing
and resale of the Company's services, the purchase by the Company of fiber
optic transport bandwidth, and collocation of network equipment. In addition,
the equity investments by AT&T, NEXTLINK and Qwest satisfied the conditions of
an alternate equity financing and thus the Equity Commitment will not be
called.
On January 27, 1999, the Company completed the Initial Public Offering
("IPO") of 8,970,000 shares of Common Stock at an initial public offering
price of $18.00 per share. Net proceeds to the Company from the IPO were
$150.2 million after deducting underwriting discounts and commissions and
estimated offering expenses payable by the Company. As a result of the IPO,
all shares of Preferred Stock, including shares issued in the above-mentioned
strategic transactions, were converted into Common Stock, all cumulative but
unpaid dividends on Series A and Series B were paid in Common Stock and the
Common Warrants were exercised.
On February 11, 1999 the Company issued 12% Senior Notes due February 15,
2009 through a private placement. Interest is due and payable in cash on
February 15 and August 15 of each year, beginning on August 15, 1999. Net
proceeds to the Company were approximately $205.4 million after discounts and
transaction costs of approximately $9.6 million. Approximately $74.0 million
of the net proceeds will be used to purchase pledged securities representing
sufficient funds to pay the first six scheduled interest payments on the
notes.
F-16
<PAGE>
APPENDIX
COVAD COMMUNICATIONS GROUP, INC.
GLOSSARY OF TERMS
Access Line--A circuit that connects a telephone end-user to the
traditional telephone company central office.
Analog Modem--A telecommunications device that allows the communication of
digital information over analog telephone lines and through the public
switched telephone network by translating such information in a way that
simulates and uses only the bandwidth of normal voice transmissions.
Asynchronous Transfer Mode (ATM)--A standard packet-switching protocol that
segments digital information into 53-byte cells (each cell has a 5-byte
standard packet-switching header and 48 bytes of data) that are switched very
quickly throughout a network over virtual circuits. ATM is able to accommodate
multiple types of media (voice, video, data).
Bandwidth--Refers to the maximum amount of data that can be transferred
through a computer's backplane or communication channel in a given time. It is
usually measured in Hertz for analog communications and bits per second for
digital communication.
Central Office--Facility of the traditional telephone companies where end-
user lines are joined to switching equipment.
Competitive Local Exchange Carrier or Competitive Telecommunications
Company--Category of telephone service provider (carrier) that offers services
similar to those of the traditional telephone company, as allowed by recent
changes in telecommunications law and regulation. A competitive local exchange
carrier may also provide other types of services such as long distance,
Internet access and entertainment.
Competitive Local Exchange Carrier Certification--Granted by a state public
service commission or public utility commission, this certification provides a
telecommunications services provider with the legal standing to offer
telecommunications services in direct competition with the traditional
telephone company and other competitive local exchange carriers. Such
certifications are granted on a state-by-state basis.
Communications Act of 1934--The federal legislation governing broadcast and
non-broadcast communications, including both wireless and wired telephone
service, and which established the FCC.
Digital Service 3 (DS-3)--In the digital hierarchy, this signaling standard
defines a transmission speed of 44.736 Mbps, equivalent to 28 T1 channels;
this term is often used interchangeably with T3.
DSL--Digital Subscriber Line.
FCC (Federal Communications Commission)--The U.S. government agency charged
with the oversight of communications originating in the U.S. and crossing
state lines.
Facilities-Based Provider--A telecommunications provider that delivers its
services to the end-user via owned equipment and leased (or owned) transport
in contrast to a reseller of an traditional telephone company's services.
Frame Relay--A high-speed packet-switched data communications protocol.
G.lite--A specification to define a standard for a mass market version of
asymmetric DSL which is interoperable with full rate asymmetric DSL but is not
as fast. The specification is intended to reduce the installation complexity
and cost of a consumer DSL solution.
A-1
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Hybrid Fiber Coax--A combination of fiber optic and coaxial cable, which
has become the primary architecture utilized by cable operators in recent and
ongoing upgrades of their systems. A hybrid fiber coax architecture generally
utilizes fiber optic wire between the head end and the nodes and coaxial wire
from nodes to individual end-users.
Incumbent Local Exchange Carrier or Traditional Telecommunications
Company--The traditional telephone company that was the monopoly carrier in a
region, prior to the opening of local exchange services to competition.
Interconnection (Co-Carrier) Agreement--A contract between a traditional
telephone company and a competitive local exchange carrier for the
interconnection of the two networks and competitive local exchange carrier
access to traditional telephone company unbundled network elements. These
agreements set out the financial and operational aspects of such
interconnection and access.
Internet Service Provider--A vendor that provides subscribers access to the
Internet.
ISDN (Integrated Services Digital Network)--ISDN provides standard
interfaces for digital communication networks and is capable of carrying data,
voice, and video over digital circuits. ISDN protocols are used worldwide for
connections to public ISDN networks or to attach ISDN devices to ISDN-capable
PBX systems (ISPBXs). Developed by the International Telecommunications Union,
ISDN includes two user-to-network interfaces: basic rate interface (BRI) and
primary rate interface (PRI). An ISDN interface contains one signaling channel
(D-channel) and a number of information channels ("bearer" or B channels). The
D-channel is used for call setup, control, and call clearing on the B-
channels. It also transports feature information while calls are in progress.
The B-channels carry the voice, data, or video information.
IXC (Interexchange Carrier)--Facilities-based long distance/interLATA
carriers (e.g., AT&T, MCI WorldCom and Sprint), who also provide intraLATA
toll service and may operate as competitive local exchange carriers.
Kbps (Kilobits per second)--One thousand bits per second.
LATA (Local Access and Transport Area)--A geographic area inside of which a
local telephone company can offer switched telecommunications services,
including long distance (known as toll). There are 196 LATAs in the U.S.
Mbps (Megabits Per Second)--One million bits per second.
RBOCs (Regional Bell Operating Companies)--Traditional telephone companies
created by AT&T's divestiture of its local exchange business. The remaining
RBOCs include BellSouth, Bell Atlantic Corporation, Ameritech Corporation, U S
WEST Communications, Inc. and SBC Communications, Inc.
T1--This is a Bell system term for a digital transmission link with a
capacity of 1.544 Mbps.
Unbundled Network Elements--The various portions of a traditional telephone
company's network that a competitive local exchange carriers can lease for
purposes of building a facilities-based competitive network, including copper
lines, central office space, inter-office transport, operational support
systems, local switching and rights of way.
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We have not authorized any dealer, salesperson or other person to give any
information or represent anything not contained in this prospectus. You must
not rely on any unauthorized information. This prospectus does not offer to
sell or buy any notes in any jurisdiction where it is unlawful. The
information in this prospectus is current as of April 22, 1999.
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
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<S> <C>
Prospectus Summary....................................................... 1
Risk Factors............................................................. 10
Use of Proceeds.......................................................... 27
Dividend Policy.......................................................... 27
Capitalization........................................................... 28
Selected Consolidated Financial Data..................................... 30
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 32
Business................................................................. 39
Management............................................................... 59
Certain Relationships and Related Transactions........................... 68
Principal Stockholders................................................... 72
The Exchange Offer....................................................... 74
Description of the Old Notes............................................. 82
Description of the New Notes............................................. 113
Description of Certain Indebtedness...................................... 113
Description of Capital Stock............................................. 114
Federal Income Tax Considerations........................................ 117
Plan of Distribution..................................................... 118
Where You Can Find More Information...................................... 118
Legal Matters............................................................ 119
Experts.................................................................. 119
Index to Financial Statements............................................ F-1
Glossary................................................................. A-1
</TABLE>
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$215,000,000
Covad Communications
Group, Inc.
Offer to Exchange All Outstanding 12 1/2% Senior Notes due February 15, 2009
for 12 1/2% Senior Notes due February 15, 2009, Which Have Been Registered
Under the Securities Act of 1933
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PROSPECTUS
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April 22, 1999
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