<PAGE>
PROSPECTUS
Pursuant to Rule 424(b)(4)
Registration No. 333-63899
7,800,000 Shares
[LOGO OF COVAD COMMUNICATIONS GROUP, INC. APPEARS HERE]
Covad Communications Group, Inc.
Common Stock
All of the shares of Common Stock offered hereby are being sold by Covad
Communications Group, Inc. ("Covad" or the "Company"). Prior to the offering,
there has been no public market for the Common Stock of the Company. See
"Underwriting" for a discussion of the factors considered in determining the
initial public offering price. The Common Stock has been approved for
quotation on the Nasdaq National Market under the symbol "COVD."
----------------
The Common Stock offered hereby involves a high degree of risk. See "Risk
Factors" commencing on page 9 hereof.
----------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Underwriting
Price to Discounts and Proceeds to
Public Commissions(1) Company(2)
- ----------------------------------------------------------------------------------
<S> <C> <C> <C>
Per Share.............................. $18.00 $1.12 $16.88
- ----------------------------------------------------------------------------------
Total(3)............................... $140,400,000 $8,736,000 $131,664,000
- ----------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------
</TABLE>
(1) The Company has agreed to indemnify the Underwriters (as defined) against
certain liabilities, including liabilities under the Securities Act of
1933, as amended (the "Securities Act"). See "Underwriting."
(2) Before deducting expenses of the offering payable by the Company,
estimated at $1.2 million.
(3) The Company has granted the Underwriters a 30-day option to purchase up to
an aggregate of 1,170,000 additional shares of Common Stock on the same
terms as the Common Stock offered hereby solely to cover over-allotments,
if any (the "Over-Allotment Option"). If the Over-Allotment Option is
exercised in full, the total Price to Public, Underwriting Discounts and
Commissions and Proceeds to Company will be $161,460,000, $10,046,400 and
$151,413,600, respectively. See "Underwriting."
----------------
The shares of Common Stock are being offered by the Underwriters, subject to
prior sale, when, as and if accepted by them, subject to certain conditions.
The Underwriters reserve the right to withdraw, cancel or modify such offer
and to reject orders in whole or in part. It is expected that delivery of the
shares will be made on or about January 27, 1999 at the offices of Bear,
Stearns & Co. Inc., 245 Park Avenue, New York, New York, 10167.
Bear, Stearns & Co. Inc.
BT Alex. Brown
Donaldson, Lufkin & Jenrette
Goldman, Sachs & Co.
The date of this Prospectus is January 21, 1999.
<PAGE>
[NATIONAL COVERAGE GRAPHIC]
Header: National DSL Coverage.
Description: Graphic illustration of the United States territory marked with
symbols identifying the 6 cities in which the Company's services are available
and the 16 cities in which the Company's services are planned to be made
available. The name of the city is identified beside each symbol.
Caption: Covad estimates that, when complete, its DSL Networks in these 22
regions will enable the Company to provide service to over 28 million homes
and businesses.
CERTAIN PERSONS PARTICIPATING IN THE OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE MARKET PRICE OF THE COMMON
STOCK, INCLUDING OVER-ALLOTMENT, STABILIZING AND SHORT-COVERING TRANSACTIONS
AND THE IMPOSITION OF PENALTY BIDS. THESE TRANSACTIONS, IF COMMENCED, MAY BE
DISCONTINUED AT ANY TIME. SEE "UNDERWRITING."
<PAGE>
PROSPECTUS SUMMARY
The following summary does not purport to be complete and is qualified in its
entirety by the more detailed information and Consolidated Financial
Statements, including the related Notes thereto, appearing elsewhere in this
Prospectus. This discussion contains forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in the forward-looking statements. The Company disclaims
any obligation to update information contained in any forward-looking
statement. Unless the context otherwise requires, "Covad" and the "Company"
refer to Covad Communications Group, Inc. and its subsidiaries that operate as
competitive local exchange carriers (the "Subsidiaries"). The definitions of
certain terms used herein are set forth in the Appendix to this Prospectus.
Except as otherwise noted, the information in this Prospectus (i) assumes no
exercise of the Over-Allotment Option, (ii) reflects the conversion of all
outstanding shares of the Company's Preferred Stock into shares of Common Stock
or Class B Common Stock immediately prior to the closing of this offering (not
giving effect to the payment in shares of Common Stock of cumulated but unpaid
dividends on the Preferred Stock as of the closing of this offering), and
(iii) reflects the exercise for cash of warrants to purchase 1,800,000 shares
of Common Stock prior to the closing of this offering.
The Company
Covad is a leading packet-based Competitive Local Exchange Carrier ("CLEC")
that provides dedicated high-speed digital communications services using
Digital Subscriber Line ("DSL") technology 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
high-speed remote access to their Local Area Networks ("LANs") to improve
employee productivity and reduce operating costs. The Company believes its
services offer a superior value proposition as compared to currently available
high-speed Internet and remote LAN ("RLAN") access alternatives. The Company's
services are provided over standard copper telephone lines at speeds of up to
1.5 Megabits per second ("Mbps"), approximately 25 times the speed available
through a 56.6 Kilobits per second ("Kbps") modem. The Company currently has
installed over 4,000 DSL lines and received orders for its services from
approximately 100 ISP and enterprise customers, including Cisco Systems,
Concentric Network, Epoch Networks, Oracle, PeopleSoft, Stanford University,
Verio and Whole Earth Networks.
Covad introduced its services in the San Francisco Bay Area in December 1997.
The Company launched its services in the Los Angeles, New York and Boston
metropolitan areas in August 1998 and in the Washington, D.C. and Seattle
metropolitan areas in December 1998. In March 1998, the Company raised
approximately $135 million through the issuance of its Senior Discount Notes
(as defined) to fund the deployment of its networks in these initial six
metropolitan areas (the "Initial Regions"). As a result of the strong market
demand for high-speed digital communications services, the Company has decided
to increase to 22 the number of regions in which it plans to build its networks
and offer its services. The Company estimates that, when complete, its networks
in these 22 regions will enable the Company to provide service to over
28 million homes and businesses in 28 of the top 50 metropolitan statistical
areas ("MSAs") in the United States.
The Company recently 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 (collectively "AT&T Ventures"), $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).
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.
3
<PAGE>
Market Opportunity
Covad was formed to capitalize on the substantial business opportunity
created by the growing demand for high-speed digital communications, the
commercial availability of low cost DSL technology and the passage of the
Telecommunications Act of 1996 (the "1996 Act"). The Company's principal equity
investors include Warburg, Pincus Ventures, L.P. ("Warburg"), Crosspoint
Venture Partners 1996 ("Crosspoint"), Intel Corporation ("Intel"), AT&T
Ventures, NEXTLINK and Qwest.
Growing Market Demand for High-Speed Digital Communications Bandwidth. As
businesses increase their use of the Internet, intranets and extranets, the
Company expects the market size for both small- and medium-sized business
Internet access and RLAN access to continue to grow rapidly. According to
International Data Corporation ("IDC"), the number of Internet users worldwide
reached approximately 69 million in 1997 and will grow to approximately 320
million by 2002. IDC 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%.
Emergence of DSL 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 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, as such networks require a comparatively lower initial fixed investment,
and the subsequent variable investments in DSL electronics are directly related
to the number of paying subscribers.
Telecommunications Act of 1996. The passage of the 1996 Act created a legal
framework for CLECs, such as the Company, to provide local analog and digital
communications services in competition with the Incumbent Local Exchange
Carriers ("ILECs"). The 1996 Act eliminated a substantial barrier to entry for
CLECs by enabling them to leverage the existing infrastructure built by the
ILECs, which required a $200 billion investment by ILECs and ILEC ratepayers,
rather than constructing a competing infrastructure at significant cost. The
1996 Act in particular emphasized the need for competition-driven innovations
in the deployment of advanced telecommunications services, such as the
Company's DSL services.
The Covad Solution
Covad's objective is to become the leading provider of DSL-based high-speed
digital communications services in each region that it enters. Key aspects of
the Company's solution to provide high-speed digital communications services
include:
Attractive Value Proposition. The Company offers higher bandwidth digital
connections than alternative services at similar or lower prices that do not
vary with usage. For business Internet users, the Company's high-end services
offer comparable bandwidth to T1 and Frame Relay circuits at approximately 25%
of the cost. For the RLAN market, the Company's 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. The
Company believes that many of its 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, the
Company
4
<PAGE>
expects that it will offer G.Lite compatible services at prices comparable to
prices offered by cable modem services today.
Widely Available, Always-Connected, Secure Network. The Company's strategy of
providing blanket coverage in each region it serves is designed to ensure that
the Company's services are available to the vast majority of its customers'
end-users. The Company's networks provide 24-hour, always-on connectivity,
unlike ISDN lines and analog modems which require customers to connect to the
Internet or their LAN for each use. Also, because the Company uses dedicated
connections from each end-user to the ISP or enterprise network, its customers
can reduce the risk of unauthorized access.
Experienced Management Team. The Company's management team includes
individuals with extensive experience in the data communications,
telecommunications and personal computer industries. In July 1998, the Company
hired as its 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. The
Company has also hired Regional General Managers in order to cover all 22 of
its regions who collectively have over 210 years of telecommunications service
experience.
Business Strategy
The key elements of the Company's strategy are (i) to secure CLEC status and
sign interconnection agreements for the top U.S. markets, (ii) to enter and
roll out its service rapidly in its target regions to maintain its first-mover
advantage, (iii) to provide blanket coverage in each of its 22 targeted
regions, (iv) to focus on packet data services, (v) to concentrate its sales
efforts on ISP and enterprise customers that can provide a large number of end-
users, (vi) to leverage the success-based economics of DSL technology, (vii) to
establish relationships with leading ISPs, systems integrators, other CLECs and
Interexchange Carriers ("IXCs") in order to expand its distribution channels
and accelerate the sale of its services, and (viii) to provide a superior and
comprehensive product and service solution that includes line installation,
equipment sale and configuration and RLAN design.
5
<PAGE>
Risk Factors
The Common Stock offered hereby involves a high degree of risk. See "Risk
Factors" beginning on page 9 hereof.
The Offering
<TABLE>
<C> <S>
Common Stock offered by the Company......... 7,800,000
Common Stock to be outstanding after this
offering................................... 45,999,336(1)
Use of proceeds............................. For capital expenditures to expand the
Company's networks and for working capital
purposes. See "Use of Proceeds."
Nasdaq National Market Symbol............... COVD
</TABLE>
- --------
(1) Based on the number of shares of Common Stock outstanding as of December
31, 1998. Includes (i) 1,800,000 shares of Common Stock to be issued
pursuant to exercise prior to the closing of this offering for cash of
warrants issued to three investors, (ii) 6,379,177 shares of Class B Common
Stock to be issued immediately prior to the closing of this offering on
conversion of Preferred Stock purchased by AT&T Ventures, NEXTLINK and
Qwest (collectively, the "Strategic Investors") in January 1999, which
shares may be converted into Common Stock on a one-for-one basis beginning
in January 2000 and (iii) 18,246,162 shares of Common Stock to be issued on
conversion of Preferred Stock immediately prior to the closing of this
offering. Excludes (i) an aggregate of 11,794,410 shares of Common Stock
subject to outstanding options under the Company's 1997 Stock Plan at
January 20, 1999, (ii) 5,053,764 shares of Common Stock issuable upon
exercise of outstanding warrants issued as part of the issuance of the
Senior Discount Notes (as defined) (the "High Yield Warrants"), (iii)
135,000 shares of Common Stock issuable upon exercise of a warrant issued
to a consultant, (iv) 59,372 shares of Common Stock to be issued as
cumulated but unpaid dividends on Preferred Stock as of the closing of this
offering and (v) 1,186,350 shares issued upon exercise of outstanding
options since December 31, 1998.
----------------
The address of the Company's principal executive office is 2330 Central
Expressway, Santa Clara, California 95050, and the Company's telephone number
is (408) 844-7500.
"Covad(TM)," "TeleSpeed(R)," "The Speed to Work(TM)" and the Covad crescent
logo names and marks are among the trademarks of the Company. This Prospectus
contains other product names, trade names and trademarks of the Company and of
other organizations.
6
<PAGE>
Summary Consolidated Financial Data
<TABLE>
<CAPTION>
Three Months Nine Months
Year Ended Ended Ended
December 31, September 30, September 30,
1997 1998 1998
------------ ------------- -------------
(unaudited)
(in thousands, except share
and per share amounts)
<S> <C> <C> <C>
Consolidated Statement of Operations
Data:
Revenues.............................. $ 26 $ 1,565 $ 2,560
Operating expenses:
Network and product costs........... 54 1,355 2,316
Sales, marketing, general and
administrative..................... 2,374 10,681 17,231
Amortization of deferred
compensation....................... 295 1,837 2,695
Depreciation and amortization....... 70 738 1,348
----------- ----------- -----------
Total operating expenses.......... 2,793 14,611 23,590
----------- ----------- -----------
Income (loss) from operations......... (2,767) (13,046) (21,030)
Net interest income (expense)........ 155 (3,511) (7,231)
----------- ----------- -----------
Net income (loss)..................... $ (2,612) $ (16,557) $ (28,261)
=========== =========== ===========
Net income (loss) per common share.... $ (0.80) $ (2.75) $ (5.26)
Shares used in computing net income
(loss) per share..................... 3,271,546 6,011,610 5,374,924
Pro forma net income (loss) per common
share(1)............................. $ (0.23) $ (0.64) $ (1.14)
Shares used in computing pro forma net
income (loss) per share(1)........... 11,522,916 26,057,772 24,844,824
Other Data:
EBITDA(2)............................. $ (2,402) $ (10,471) $ (16,987)
Consolidated Cash Flow Data:
Provided by (used in) operating
activities........................... $ (1,895) $ (3,319) $ (4,196)
Provided by (used in) investing
activities........................... (2,494) (21,084) (33,464)
Provided by (used in) financing
activities........................... 8,767 (406) 130,358
</TABLE>
<TABLE>
<CAPTION>
As of As of September 30, 1998
December 31, -------------------------------------
1997 Actual Pro Forma(3) As Adjusted(4)
------------ -------- ------------ --------------
(in thousands)
<S> <C> <C> <C> <C>
Consolidated Balance Sheet
Data:
Cash and cash equivalents... $ 4,378 $ 97,076 $157,082 $287,546
Net property and equipment.. 3,014 34,003 34,003 34,003
Total assets................ 8,074 144,622 233,328 363,792
Long-term obligations,
including current portion.. 783 137,926 137,926 137,926
Total stockholders' equity
(net capital deficiency)... 6,498 (6,417) 82,289 212,753
<CAPTION>
As of
December 31,
1997 As of September 30, 1998
------------ -------------------------------------
<S> <C> <C> <C> <C>
Other Operating Data:
Homes and businesses passed. 278,000 3,302,000
Lines installed............. 26 1,948
</TABLE>
- --------
(1) The pro forma net loss per share reflects the conversion of the Preferred
Stock outstanding as of September 30, 1998 into Common Stock on a one-for-
one basis and the exercise for cash of warrants to purchase 1,800,000
shares of Common Stock prior to the closing of this offering.
7
<PAGE>
(2) EBITDA consists of net loss excluding net interest, taxes, depreciation and
amortization (including amortization of deferred compensation). EBITDA is
provided because it is a measure of financial performance commonly used in
the telecommunications industry. EBITDA is presented to enhance an
understanding of the Company's operating results and should not be
construed (i) as an alternative to operating income (as determined in
accordance with generally accepted accounting principles ("GAAP")) as an
indicator of the Company's operating performance or (ii) as an alternative
to cash flows from operating activities (as determined in accordance with
GAAP) as a measure of liquidity. EBITDA as calculated by the Company may be
calculated differently than EBITDA for other companies. See the Company's
Consolidated Financial Statements and the related Notes thereto contained
elsewhere in this Prospectus.
(3) In addition to the adjustments in Note (1) hereof, the pro forma balance
sheet information reflects the issuance of Preferred Stock to the Strategic
Investors, which shares will automatically convert into Class B Common
Stock immediately prior to the closing of this offering, and includes the
effect of recording intangible assets of $28.7 million associated with the
issuance of such shares. Such amounts will be amortized for periods of
three to six years.
(4) In addition to the adjustments in Notes (1) and (3) hereof, the as adjusted
balance sheet information reflects the receipt of net proceeds of $130.5
million from this offering (after deducting underwriting discounts and
commissions and estimated offering expenses payable by the Company).
8
<PAGE>
RISK FACTORS
An investment in the Common Stock involves a high degree of risk. In
addition to the other information contained in this Prospectus, prospective
investors should carefully consider the following factors in evaluating an
investment in the Common Stock offered hereby. This Prospectus also includes
"forward-looking" statements within the meaning of Section 27A of the
Securities Act and Section 21E of the Securities Exchange Act of 1934, as
amended (the "Exchange Act"); provided, however, that the safe harbor
provisions of Section 27A and Section 21E are not applicable to any "forward
looking" statements made in connection with the initial issuance of shares of
Common Stock offered hereby pursuant to this Prospectus, although such
provisions are applicable to such statements made in connection with resales
of such shares. The forward-looking statements involve risks and
uncertainties. The Company's actual results could differ materially from those
anticipated in the forward-looking statements as a result of certain factors
including, but not limited to, those discussed below, in "Business" and
elsewhere in this Prospectus. All forward-looking statements attributable to
the Company or persons acting on its behalf are expressly qualified in their
entirety by the cautionary statements set forth herein. The Company disclaims
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."
Limited Operating History
The Company was incorporated in October 1996 and introduced its service
commercially in the San Francisco Bay Area in December 1997, in the Los
Angeles, New York City and Boston metropolitan areas in August 1998 and in the
Washington, D.C. and Seattle metropolitan areas in December 1998. As a result
of the Company's limited operating history, and because the issuance of its 13
1/2% Senior Discount Notes due March 2008 and High Yield Warrants
(collectively, the "Senior Discount Notes") and the Company's use of proceeds
therefrom make recent and future operating results not comparable to
historical operating results, the Company has limited historical financial
data upon which an evaluation of the Company or its prospects can be based.
The Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in an early stage of
deployment, particularly those in new and rapidly evolving markets. To address
these risks, the Company must, among other things, rapidly expand the
geographic coverage of its services; attract and retain customers within its
existing and in new regions; increase awareness of the Company's services;
respond to competitive developments; continue to attract, retain and motivate
qualified persons; continue to upgrade its technologies; commercialize its
network services incorporating such technologies; and effectively manage its
expanding operations. There can be no assurance that the Company will be
successful in addressing such risks, and failure to do so could have a
material adverse effect on the Company's business, prospects, operating
results and financial condition.
History and Continuation of Operating Losses
The Company has incurred substantial and increasing net operating losses and
experienced negative cash flow each month since its inception. As of September
30, 1998, the Company had an accumulated deficit of approximately $30.9
million. The Company currently intends to increase significantly its capital
expenditures and operating expenses in order to expand its networks to support
additional expected end-users in existing and future markets and to market and
provide the Company's services to a growing number of potential end-users. As
a result, the Company expects to incur substantial additional net operating
losses and substantial negative cash flow for at least the next several years.
In addition, the Company raised approximately $135 million through the
issuance of the Senior Discount Notes in March 1998, which accrete to $260
million by March 2003. The Company expects that annual interest and
amortization charges relating to the Senior Discount Notes will be
approximately $16.0 million during the year ending December 31, 1998, will
increase to approximately $36.9 million for the year ending December 31, 2004
and will remain at that level through maturity of the Senior Discount Notes in
March 2008. The Company intends to record intangible assets of $28.7 million
associated with the issuance of Preferred Stock to the Strategic Investors.
Such amounts will result in an annual amortization charge of approximately
$8.4 million in each of the three years ending December 31, 2001,
9
<PAGE>
decreasing to approximately $1.2 million per year through the year ending
December 31, 2004. Accordingly, the Company's operating losses will increase
significantly as a result of the interest and amortization charges related to
the Senior Discount Notes and the amortization charge associated with the
investments by the Strategic Investors. In addition, the Company expects to
incur substantial additional debt in the future. Any additional debt would
increase the Company's interest and amortization charges. See "--Unproven
Business Model and Pricing Sensitivity" and "--Substantial Future Capital
Requirements."
Potential Fluctuations in Operating Results
The Company's annual and quarterly operating results may fluctuate
significantly in the future as a result of numerous factors. Factors that may
affect the Company's operating results include the timing and ability of ILECs
to provide and construct the required central office ("CO") collocation
facilities, the rate at which customers subscribe to the Company's services,
the prices the customers pay for such services and end-user churn rates. The
Company's operating results are sensitive to the pricing of its services and
volume commitments from individual customers. The Company believes its
financial performance depends to a great extent on retaining ISP and
enterprise customers and on levels of subscriber churn, which can vary due to
a variety of factors, including relocation of end-users of ISP customers and
employee turnover within enterprise customers. Additionally, the Company does
not currently have long-term contracts with any of its customers, and there
can be no assurance that the Company's ISP and enterprise customers will not
experience substantial customer or subscriber churn as a result of customers
or subscribers discontinuing the use of its services or switching to an
alternative service provider. Furthermore, the Company's operating results may
fluctuate depending on, among other things, (i) the success of the Company's
relationships with AT&T, NEXTLINK and Qwest and other potential third parties
in generating significant subscriber demand, (ii) the ability of the Company
to deploy on a timely basis its services to adequately satisfy such subscriber
demand, (iii) the ability of the Company to maintain targeted subscriber
levels and (iv) the mix of line orders between consumer end-users and business
end-users (which typically have higher margins). Other factors that may add to
volatility in the Company's annual or quarterly operating results include the
amount and timing of capital expenditures and other costs relating to the
expansion of the Company's network, the introduction of new services by the
Company or its competitors, technical difficulties or network downtime,
general economic conditions and economic conditions specific to the Company's
industry, among other factors. There can be delays in the commencement and
recognition of revenue because the installation of telecommunication lines to
implement certain services has lead times that are controlled by third
parties. Many of these factors are outside the Company's control. In addition,
the Company plans to increase operating expenses to fund operations, sales,
marketing, general and administrative activities and infrastructure, including
increased expenses associated with its relationships with AT&T, NEXTLINK and
Qwest. To the extent that these expenses are not accompanied by an increase in
revenues, the Company could experience a material adverse effect on its
business, prospects, operating results and financial condition. As a result of
all of the foregoing factors, it is likely that in some future quarter the
Company's operating results will be below the expectations of securities
analysts and investors. In such event, the price of the Company's Common Stock
would likely be materially adversely affected. Fluctuations in operating
results may also result in volatility in the price of the Company's Common
Stock.
Unproven Business Model and Pricing Sensitivity
The Company believes that it was the first packet-based CLEC to provide
high-speed digital communications services using DSL technology. As such, the
Company's business strategy is unproven. To be successful, the Company must,
among other things, develop and market services that are widely accepted by
ISPs, enterprises and consumers. The Company's TeleSpeed services are
currently its principal services and have only been launched in the San
Francisco Bay Area and the Los Angeles, New York City, Boston, Washington,
D.C. and Seattle metropolitan areas. There can be no assurance that the
Company's services will achieve broad commercial acceptance. The prices the
Company charges for certain services are in some cases higher than those
charged by its competitors for the same services. There can be no assurance
that a sufficient number of end-users will be willing to pay the prices
charged by the Company for its TeleSpeed services. Additionally, prices for
digital communications
10
<PAGE>
services have fallen historically, and prices in the industry in general, and
for the services the Company offers and plans to offer in particular, are
expected to continue to fall. The Company has provided and expects in the
future to provide price discounts to customers that commit to a large number
of end-users. In addition, the Company may be required to reduce prices
periodically to respond to competition and to generate increased sales volume.
Accordingly, it is difficult to predict whether the Company's pricing model
will prove to be viable, whether demand for the Company's services will
materialize at the prices it expects to charge or whether current or future
pricing levels will be sustainable. The failure to achieve or sustain adequate
pricing levels or to achieve or sustain a profitable business model would
result in a material adverse effect on the Company's business, prospects,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Business--
Business Strategy."
Dependence Upon Indirect Sales Channels
The Company markets its Internet access services through ISPs for resale to
their business and consumer end-users. To date, ISPs have accounted for the
majority of the Company's revenues, and the Company expects that its ISP
customers will account for the majority of its future market penetration and
revenue growth. The Company plans to build relationships with numerous ISP
customers in order to gain access and provide its services to as many ISP
business and consumer end-users as possible. The Company's agreements with its
ISP customers are non-exclusive, and many of the Company's ISP customers also
resell services offered by the Company's competitors. In addition, a number of
the Company's ISP customers have committed to provide large numbers of end-
users in exchange for price discounts. If the number of business and consumer
end-users of the Company's services provided through the ISP channel is
significantly lower than the Company's forecast for any reason, or if the ISPs
with which the Company has entered into such arrangements are unsuccessful in
competing in their own intensely competitive markets, the Company's business,
prospects, operating results and financial condition would be materially
adversely affected. The Company also intends to market its products through
value added resellers and systems integrators and to enter into marketing
relationships with leading CLECs and IXCs, which the Company believes will
enable it to penetrate its markets and gain market acceptance more rapidly.
For example, the Company recently entered into commercial agreements with each
of AT&T, NEXTLINK and Qwest providing for the purchase, marketing and resale
of the Company's services, primarily to their small business and enterprise
customers. The Company cannot predict the number of line orders that AT&T,
NEXTLINK or Qwest will generate, if any, whether line orders will be below the
Company's, AT&T's, NEXTLINK's or Qwest's expectations or whether AT&T,
NEXTLINK or Qwest will discontinue purchasing or selling the Company's
services entirely. No assurance can be given that the Company will establish
similar relationships with other third parties or, if it does, that such
relationships or the AT&T, NEXTLINK or Qwest relationships will improve the
Company's business, prospects, operating results or financial condition. In
addition, the Company expects that AT&T, NEXTLINK, Qwest and other potential
third parties will purchase, market and resell the Company's RLAN services
primarily to their small business and enterprise customers. Therefore, future
growth in the Company's RLAN business may depend in part on the efforts of
these parties, which are outside the Company's control. See "Business--
Customers" and "--Sales and Marketing" and "Certain Relationships and Related
Transactions--The Strategic Investments and Relationships."
Lengthy Sales Cycle for Enterprise Customers
The Company's practice with respect to its enterprise customers has been to
enter into an arrangement for a negotiated price to install the service
initially for a small number of end-users. An enterprise customer decides
whether to implement a broad rollout of the Company's services after
evaluating the results of this initial phase of deployment. Based on its
experience to date, the Company believes that an enterprise customer's initial
phase of deployment and its decision to roll out the Company's service to
additional end-users has taken at least six months, and has generally taken
longer than the Company originally expected. As of December 31, 1998, a
substantial majority of the Company's enterprise customers had not yet rolled
out the Company's services broadly to their employees, and it is not certain
when such rollouts will occur, if at all. The Company will not receive
significant revenue from enterprise customers until and unless these rollouts
occur. During this lengthy
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sales cycle the Company incurs significant expenses in advance of the receipt
of revenues. Therefore, any continued or ongoing failure for any reason of
enterprise customers to roll out the Company's services will have a material
adverse effect on the Company's business, prospects, operating results and
financial condition. See "Business--Customers."
Uncertain Availability of Collocation Space and Dependence on ILECs to Provide
Collocation Space and Collocation Facilities and Unbundled Network Elements
("UNEs")
The primary dependency of the Company in its initial years is the ability to
secure space from the various ILECs for physical collocation of the Company's
equipment in the ILECs' COs. Such physical collocation allows the Company to
own, install, operate, maintain and upgrade its own equipment at the ILECs'
COs. The Company has experienced initial rejections of its applications to
obtain collocation space from Pacific Bell in a significant number of COs in
Pacific Bell's service areas in California. The Company has also experienced
similar rejections in certain COs in the Los Angeles region from GTE
Corporation ("GTE") and in Massachusetts, Virginia and in other states from
Bell Atlantic and other ILECs. The Company expects that as it proceeds with
its deployment, it will submit applications for collocation space and it will
face additional rejections, which may be material in number, for COs in its
other target markets. Although a majority of CO applications that were
initially rejected by Pacific Bell have been subsequently accepted, there can
be no assurance that the Company will continue to be successful in reversing
CO rejections in other regions. The Company cannot predict the extent of these
rejections or their impact on its ability to provide broad service
availability in its target markets. The rejection of the Company's
applications for collocation space has in the past resulted, and could in the
future result, in delays in, and increased expenses associated with, the
rollout of its services in its target markets, which could result in a
material adverse effect on its business, prospects, operating results and
financial condition.
Broad service availability is important for the Company's ISP and enterprise
customers that desire to provide Internet access and RLAN access on a regional
basis. The Company's inability to obtain physical collocation space could have
a material adverse impact on the Company's ability to offer broad service
availability and therefore to secure and retain customers. In this regard, the
Company is in a variety of proceedings with multiple ILECs regarding certain
collocation spaces in which it has faced rejections which have adversely
affected and, in the future, may continue to adversely affect the Company's
ability to deploy its network, provide service to customers, and enter into
additional interconnection agreements with the ILECs in other states. The
availability of collocation space in high demand target markets will also be
affected to the extent that other CLECs are seeking or have obtained
collocation space to offer services. In such COs, the Company has the option
of virtual collocation (where the ILEC manages and operates the Company's
equipment), which the Company believes is an unattractive solution due to
restrictions on the Company's ability to maintain the quality of its network.
In addition, in some COs where the Company plans to collocate, the Company
believes space will become available at a later date. Currently, however,
ILECs are not in all cases agreeing to maintain the Company's position in the
queue for CO collocation space where the Company is seeking collocation;
hence, the Company is unable to determine if or when it will be able to obtain
collocation space in these COs. The Company is engaged in a variety of
negotiations and legal actions to resolve situations where ILECs assert that
certain COs lack sufficient space for physical collocation by the Company. The
Federal Communications Commission (the "FCC") is reviewing the collocation
policies and practices of the ILECs with the goal of facilitating the efforts
of CLECs such as the Company to obtain collocation space more easily and on
more favorable terms. There is no guarantee that the FCC's review will result
in fewer ILEC rejections of the Company's physical collocation applications or
collocation availability on more favorable terms for the Company. There can be
no assurance that the Company's legal and regulatory disputes will be resolved
successfully or that it will achieve collocation arrangements in a sufficient
number of COs in one or more of its target markets within the Company's
desired time frame, if at all.
Under the 1996 Act and a December 31, 1997 ruling of the Federal District
Court for the Northern District of Texas (the "December 31, 1997 Ruling"), the
Regional Bell Operating Companies ("RBOCs"), formerly subject to antitrust
decree restrictions on interLATA (interexchange) long distance services, would
no longer be barred from entry into this market. The December 31, 1997 Ruling
declared that the portions of the 1996 Act
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subjecting RBOCs to a prior FCC approval process in order to provide interLATA
services within their respective incumbent service regions are
unconstitutional. Under the December 31, 1997 Ruling, RBOCs would no longer be
compelled to prove to the FCC that, in the states where they desire to provide
interLATA services, they have entered into one or more state utility
commission-approved agreements with one or more facilities-based competitors
which provide business and residential local exchange service and such
agreement satisfies 14 specified interconnection requirements. On September 4,
1998, the United States Appeals Court for the Fifth Circuit reversed the
December 31, 1997 Ruling. This decision was appealed to the United States
Supreme Court, and in January 1999 the United States Supreme Court declined to
hear the appeal.
The 1996 Act nevertheless continues to impose interconnection obligations on
ILECs and the obligation that ILECs provide CLECs, such as the Company, access
to their UNEs. The 1996 Act generally requires that interconnection charges as
well as charges for UNEs be cost-based and nondiscriminatory. In particular,
the Company depends on ILECs to provide unbundled DSL-capable lines that
connect each end-user to the Company's equipment collocated in the COs. The
FCC has commenced a review of the manner in which ILECs provision DSL-capable
lines to CLECs, including the Company, with the goal of increasing CLECs'
access to such lines. For instance, the FCC is examining the imposition of
additional obligations on the ILECs to allow CLECs such as the Company to
provide higher speed DSL services through local loops that involve digital
loop carrier ("DLC") systems. The nonrecurring and recurring monthly charges
for DSL-capable lines required by the Company vary greatly. These rates are
subject to the approval of the appropriate state regulatory commission. The
rate approval processes for DSL-capable lines and other UNEs typically involve
a lengthy review of the ILEC-proposed rates in each state. The ultimate rates
approved typically depend greatly on the ILEC's initial rate proposals and
such factors as the geographic deaveraging/averaging policy 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 Company management. Consequently, the Company is subject
to the risk that the non-recurring and recurring charges for DSL-capable lines
and other UNEs will increase based on new rates proposed by the ILECs and
approved by state regulatory commissions from time to time. Any of the
foregoing matters could result in a material adverse effect on the Company's
business, prospects, operating results and financial condition. See
"Business--Network Architecture and Technology," "--Government Regulation" and
"--Legal Proceedings."
Dependence on ILECs to Provide Transmission Facilities and to Provision Copper
Lines
The Company interconnects with and uses ILECs' networks to service its
customers, and accordingly, the Company is highly dependent upon the
technology and capabilities of the ILEC to meet certain telecommunications
needs of the Company's customers and to maintain its service standards. The
availability and reliability of transmission and other telecommunication
services from other CLECs is limited. The Company is also dependent to some
extent on cooperation from the ILECs, including the provision and repair of
transmission facilities. For example, the Company depends on the ILECs to
provide the Company's DSL service through DLC systems. The ILECs in turn rely
significantly on unionized labor. Labor-related issues and actions on the part
of the ILECs have in the past, and in the future may, adversely affect the
ILEC's provision of services and network components ordered by the Company.
The Company's dependence on the ILECs has caused and could continue to cause
the Company to encounter delays in establishing its network and providing
higher speed DSL services. Any such delays could adversely affect the
Company's relationships with its customers, result in harm to the Company's
reputation or could otherwise have a material adverse effect on the Company's
business, prospects, operating results and financial condition.
In particular, the Company has not yet established a history of ordering and
obtaining the provisioning and repair of very large volumes of DSL-capable
lines from any ILEC. For example, the Company is not certain whether it can
successfully deploy higher speed DSL services through the growing number of
copper lines provided through DLC systems. It is uncertain whether the Company
will be successful in doing so or whether the ordering and provisioning
processes achieved by the Company will be satisfactory for the retention and
growth of its end-user base and customer base, and any failure to do so could
have a material adverse effect on
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the Company's business, prospects, operating results and financial condition.
Further, the Company does not have an established history of addressing the
billing practices of the different ILECs. As the Company's geographic and
customer base grows, the Company may encounter billing disputes with the ILECs
that could have a material adverse effect on the Company's business,
prospects, operating results and financial condition.
Dependence on Interconnection Agreements with ILECs
The success of the Company's strategy is dependent upon the Company's
ability to enter into and implement interconnection agreements in each of its
target markets with the appropriate ILECs on a timely basis. The Company's
interconnection agreements have a maximum term of three years, requiring the
Company to renegotiate agreements with the ILECs. There is no guarantee that
existing or new agreements will be extended or renegotiated on terms favorable
to the Company. Additionally, the Company's interconnection agreements are
subject to interpretation by both parties, and differences in interpretation
may arise that cannot be resolved on favorable terms to the Company. For
example, the Company is in arbitration proceedings with two ILECs under the
dispute resolution clauses of the Company's interconnection agreements. These
disputes have adversely affected and, in the future, may continue to adversely
affect the Company's ability to deploy its network, provide service to
customers, and enter into additional interconnection agreements with the ILECs
in other states. Finally, the interconnection agreements are subject to state
commission, FCC and judicial oversight. There can be no assurance that
modification to the terms, conditions or prices of the Company's
interconnection agreements by these governmental bodies, or that disputes with
ILECs over the terms of the interconnection agreements generally, will not
have a material adverse affect on the Company's business, prospects, operating
results and financial condition. See "Business--Interconnection Agreements
with ILECs."
Uncertain Quality and Availability of the ILEC Copper Lines Used by the
Company
The 1996 Act imposes obligations on ILECs and generally requires that
interconnection charges and charges for UNEs and provisioning of
interconnection facilities and UNEs be cost-based and nondiscriminatory. The
Company's strategy requires the Company to interconnect with and use an ILEC's
copper telecommunications lines to service the Company's customers. As such,
the Company is dependent upon the technology and capabilities of the ILECs to
meet certain telecommunications needs of the Company's customers and maintain
its service standards. The Company is highly dependent on the quality and
availability of the ILECs' copper lines and the ILECs' maintenance of such
lines. There can be no assurance that the Company will be able to obtain the
copper lines and the services it requires from the ILECs and at quality
levels, rates, terms and conditions satisfactory to the Company, and the
failure to obtain such services and satisfactory quality levels, rates, terms
and conditions would have a material adverse effect on the Company's business,
prospects, operating results and financial condition.
Intense Competition
The markets for business and consumer Internet access and RLAN access
services are intensely competitive, and the Company expects that such markets
will become increasingly competitive in the future. The Company's most
immediate competitors are the ILECs, Cable Modem Service Providers ("CMSPs"),
IXCs, Fiber-Based CLECs ("FCLECs"), ISPs, Online Service Providers ("OSPs"),
Wireless and Satellite Data Service Providers ("WSDSPs") and other CLECs. Many
of these competitors are offering, or may soon offer, technologies and
services that directly compete with some or all of the Company's high-speed
digital services. Such technologies include ISDN, DSL, wireless data and cable
modems. The principal bases of competition in the Company's markets include
transmission speed, reliability of service, breadth of service availability,
price/performance, network security, ease of access and use, content bundling,
customer support, brand recognition, operating experience, capital
availability and exclusive contracts. The Company believes that it compares
unfavorably with its competitors with respect to such factors as, among other
things, brand recognition, operating experience, exclusive contracts and
capital availability. Many of the Company's competitors and potential
competitors have
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substantially greater resources than the Company and there can be no assurance
that the Company will be able to compete effectively in its target markets.
All of the largest ILECs present in the Company's target markets are
conducting technical and/or market trials or have entered into commercial
deployment of DSL-based services. The Company recognizes that each ILEC has
the potential to quickly overcome many of the issues that the Company believes
have slowed wide deployment of DSL services by ILECs in the past. The ILECs
currently represent and will in the future increasingly represent strong
competition in all of the Company's target service areas. The ILECs 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 ILECs have aggressively priced their consumer asymmetric digital
subscriber line ("ADSL") services as low as $30-$40 per month, placing pricing
pressure on the Company's TeleSpeed services. The ILECs are in a position to
offer service from COs where the Company is unable to secure collocation space
and offer service because of asserted or actual space restrictions, which
provides the ILECs with a potential competitive advantage compared with the
Company. Accordingly, the Company may be unable to compete successfully
against the ILECs, and any failure to do so would materially and adversely
affect the Company's business, prospects, operating results and financial
condition.
CMSPs 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 the Company
provides. They also offer these services at lower price points than the
Company's TeleSpeed services and target residential consumers, as well as
business customers. They achieve these lower price points in part by offering
a consumer grade of service, which shares the bandwidth available on the cable
network among multiple end-users. This architecture is well-suited to compete
with the Company's consumer Internet market but is less well-suited to the
Company's markets for business Internet access and RLAN access where
guaranteed bandwidth, symmetric upstream and downstream bandwidth and network
security issues are more important than in the consumer market. Actual or
prospective CMSP competition may have a significant negative effect on the
ability of the Company to secure customers and may create downward pressure on
the prices the Company can charge for its services.
In addition to the ILECs and CMSPs, many of the Company's potential
competitors have longer operating histories, greater name recognition and
significantly greater financial, technical and marketing resources than the
Company. 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 the Company. It is also possible that such
competitors may form new alliances and rapidly acquire significant market
share. Such 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. Such intense
competition could materially and adversely affect the Company's business,
prospects, operating results and financial condition.
The telecommunications industry is subject to rapid and significant changes
in technology, and the effect of technological changes on the business of the
Company, such as continuing developments in DSL technology and alternative
technologies for providing high-speed digital communications, cannot be
predicted. There can be no assurance that technological developments in the
telecommunications industry will not have a material adverse effect on the
competitive position, business, prospects, operating results and financial
condition of the Company. For a detailed description of the current and
potential competition of the Company, including competition from ILECs, CMSPs,
IXCs, FCLECs, ISPs, OSPs, WSDSPs and other CLECs, see "Business--Competition"
and "--Government Regulation."
Risks Associated with Management of Substantial Growth in Operations
The Company's strategy is to significantly expand its network within its
existing regions and to deploy networks in a total of 22 regions by the end of
the first quarter of 2000. The development and expansion of the
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Company's operations will depend upon, among other things, the Company's
ability to identify, access and initiate service in key COs within existing
and target regions, design an adequate Operating Support System ("OSS"),
design and construct regional data centers ("RDCs"), obtain CO collocation
facilities, obtain the required government authorizations (which allow the
Company to obtain cost-based pricing from the ILECs in each of its target
regions), enter into and renew interconnection agreements with the appropriate
ILECs on satisfactory terms and conditions, and raise additional capital to
fund the completion of the deployment of its networks. To grow at its desired
pace, the Company must, among other things, (i) market to and acquire a
substantial number of customers and end-users; (ii) continue to implement and
improve its operational, financial and management information systems,
including its client ordering, provisioning, installation, dispatch, trouble
ticketing and other operational systems as well as its billing, accounts
receivable and payable tracking, fixed assets and other financial management
systems; (iii) hire and train additional qualified personnel; and
(iv) continue to expand and upgrade its network infrastructure. There can be
no assurance that the Company will deploy its networks as scheduled, will gain
ISP and enterprise customers as expected, or will otherwise achieve the
operational growth necessary to achieve its business strategy, and any
material or ongoing failure to do so may adversely affect the price of the
Company's Common Stock in the public market.
The Company is currently experiencing a period of rapid and substantial
growth, and it expects to continue to experience substantial growth as the
Company executes its strategy of expanding its networks into 22 regions and
providing blanket coverage within each region. This growth has placed, and is
expected to place, a significant strain on the Company's management and
operational resources. The Company has increased its employees from 42 at
December 31, 1997, to 335 at December 31, 1998, and expects to continue to
increase significantly its employee base to support the deployment of its
networks. In addition, the Company expects the demands on its network
infrastructure and technical support resources to grow rapidly along with the
Company's customer base, and if the Company is successful in implementing its
marketing strategy, it may experience difficulties responding to demand for
its services and technical support in a timely manner and in accordance with
its customers' expectations. These demands are expected to require the
addition of new management personnel and the development of additional
expertise by existing management personnel. There can be no assurance that the
Company's networks, procedures or controls will be adequate to support the
Company's operations or that management will be able to keep pace with such
growth. If the Company is unable to manage growth effectively, the Company's
business, prospects, operating results and financial condition will be
materially adversely affected. See "Management."
Substantial Future Capital Requirements
The Company will require substantial additional funds for the continued
development, commercial deployment and expansion of its networks. As of
September 30, 1998, the Company had approximately $97.1 million in cash and
cash equivalents. From inception until September 30, 1998, the Company had
made approximately $35.4 million in capital expenditures (including
capitalized leases) and had incurred operating expenses of approximately
$26.4 million in the development of its business, the development of
technology and operating support systems, the conduct of sales and marketing
activities and the establishment of its management team. In addition, the
Company has made and expects to continue to make significant capital outlays
in order to continue to commercially deploy its networks. The Company believes
its current capital resources, including the proceeds of this offering and the
investments from the Strategic Investors, will be sufficient to fund the
Company's aggregate capital expenditures and working capital requirements,
including operating losses, through the end of 1999. The Company expects to
raise substantial additional financing during 1999 to fund the growth of its
operations, including funding the significant capital expenditures and working
capital requirements necessary for the Company to provide services in its 22
targeted regional networks. There can be no assurance that the Company will be
able to raise the additional capital necessary to implement its rollout
strategy in a timely fashion, if at all.
In addition, the Company's ability to fund the commercial deployment and
expansion of its network should also be considered in light of the Company's
significant interest and amortization charges relating to the Senior Discount
Notes. Although no cash interest is payable on the Senior Discount Notes until
September 2003, the
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Senior Discount Notes accrete to $260 million until March 2003. Thereafter,
the Company expects interest and amortization charges relating to the Senior
Discount Notes to accrue at a rate of $36.9 million for the year ending
December 31, 2004 and to remain at that level through the maturity of the
Senior Discount Notes in March 2008. Such interest and amortization charges
may require the Company to obtain additional financing earlier than expected
or on terms less favorable than the Company would otherwise agree.
The Company has no present commitments or arrangements assuring it of any
future equity or debt financing, and there can be no assurance that any such
equity or debt financing will be available to the Company on favorable terms
or at all. The Company expects to seek to raise additional capital during 1999
through additional debt and possibly equity financing, the timing of which
will depend on market conditions and which could occur in the near term. Such
financing may be dilutive to existing stockholders. The indenture governing
the Senior Discount Notes (the "Indenture") contains certain covenants
restricting the Company's ability to incur further indebtedness, and future
borrowing instruments such as credit facilities are likely to contain similar
or more restrictive covenants and could require the Company to pledge assets
as security for borrowings thereunder. If the Company is unable to obtain such
additional capital or is required to obtain it on terms less satisfactory than
desired by the Company, the Company will be required to delay the expansion of
its business or take or forego actions, any or all of which would materially
adversely affect the Company's business, prospects, operating results and
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
Dependence on Growth in Demand for DSL-Based Services
The markets for high bandwidth small- and medium-sized business Internet and
RLAN access are in the early stages of development. Since these markets are
new and because current and future competitors are likely to introduce
competing services, it is difficult to predict the rate at which these markets
will grow, if at all, or whether new or increased competition will result in
market saturation. Because packet-based high-speed digital communications
services using copper telephone lines is a relatively new and evolving market,
it is difficult to predict its future growth rate and size. Various providers
of high-speed digital communications services are testing products from
various suppliers for various applications, and no industry standard has been
broadly adopted. Certain 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 the services offered by the Company,
including Internet access, fail to develop, grow more slowly than anticipated
or become saturated with competitors, the Company's business, prospects,
operating results and financial condition could be materially adversely
affected. See "Business--Industry Background."
Substantial and Increasing Leverage
The Company is highly leveraged. As of September 30, 1998, the Company had
approximately $137.7 million of long-term obligations. The Company's
indebtedness should be considered in light of expected annual interest and
amortization charges relating to the Senior Discount Notes, which the Company
expects will increase from approximately $16.0 million during the year ending
December 31, 1998 to $36.9 million for the year ending December 31, 2004 and
will remain at that level through the maturity of the Senior Discount Notes in
March 2008. The Company plans to incur substantial additional indebtedness to
finance the continued development, commercial deployment and expansion of its
networks and to fund operating losses and investments in working capital,
which could occur in the near term. The degree to which the Company is
leveraged could have important consequences to the holders of the Common
Stock, including, but not limited to, the following: (i) the Company's ability
to obtain additional financing or refinancing in the future for working
capital, capital expenditures, service development and enhancement,
acquisitions, general corporate purposes or other purposes may be materially
limited or impaired; (ii) the Company's cash flow, if any, may be unavailable
for the Company's business as a substantial portion of the Company's cash flow
must be dedicated to the payment of principal and interest on its indebtedness
on the Senior Discount Notes beginning in March 2003 or other
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indebtedness that the Company incurs in the future; and (iii) the Company's
high degree of leverage may make it more vulnerable to economic downturns, may
limit its ability to withstand competitive pressures and may reduce its
flexibility in responding to changing business and economic conditions.
No Assurance of Ability to Service Indebtedness
The Company expects that it will continue to generate substantial operating
losses and negative cash flow for at least the next several years. No
assurance can be given that the Company will be successful in developing and
maintaining a level of cash flow from operations sufficient to permit it to
pay the principal, premium, if any, and interest on its indebtedness,
including the Senior Discount Notes, and the substantial additional
indebtedness the Company plans to incur. The Senior Discount Notes accrete to
$260 million in March 2003. The Company must begin paying cash interest on the
Senior Discount Notes in September 2003, and the Company expects that annual
interest and amortization charges relating to the Senior Discount Notes will
be approximately $36.9 million for the year ending December 31, 2004 and will
remain at that level through the maturity of the Senior Discount Notes in
March 2008. The ability of the Company to make scheduled payments with respect
to indebtedness, including the Senior Discount Notes, will depend upon, among
other things: (i) the Company's ability to achieve significant and sustained
growth in cash flow; (ii) the rate of and successful commercial deployment of
its network; (iii) the market acceptance, customer demand, rate of utilization
and pricing for the Company's services; (iv) the future operating performance
of the Company and the extent to which the Company's TeleSpeed service is
subject to performance problems; (v) the Company's ability to successfully
complete development, upgrades and enhancements of its network; and (vi) the
Company's ability to complete additional financings, as necessary. Each of
these factors is, to a large extent, subject to economic, financial,
competitive and other factors, many of which are beyond the Company's control.
If the Company is unable to generate sufficient cash flow to service its
indebtedness, including the Senior Discount Notes, it may have to reduce or
delay network deployments, restructure or refinance its indebtedness or seek
additional equity capital. There can be no assurance that any of these
strategies could be effected on satisfactory terms, if at all, in light of the
Company's high leverage, or that any such strategy would yield sufficient
proceeds to service and repay the Company's indebtedness, including the Senior
Discount Notes. Any failure by the Company to satisfy its obligations with
respect to the Senior Discount Notes at maturity or prior thereto would
constitute a default under the Indenture and could cause a default under
agreements governing other indebtedness of the Company. In the event of such
default, the holders of such indebtedness would have enforcement rights,
including the right to accelerate such debt and the right to commence an
involuntary bankruptcy proceeding against the Company. The inability of the
Company to service its current and future indebtedness would have a material
adverse effect on the Company's business, prospectus, operating results and
financial condition and the price of the Common Stock.
Unproven Network Scalability and Speed
Due to the limited deployment of the Company's services, the ability of the
Company's DSL networks and OSS to connect and manage a substantial number of
online end-users at high transmission speeds is still unknown, and the Company
faces risks related to its ability to scale its network and OSS up to its
expected end-user numbers while achieving superior performance. While peak
digital data transmission speeds across the Company's DSL networks are 1.5
Mbps downstream, the actual data transmission speeds over the Company's
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 CO, the configuration of the telecommunications line
being used, the existence of analog load coils, the number of bridged taps,
the gauge of the copper wires, the presence and severity of interfering
transmissions on nearby lines and the Company's OSS which manages its network.
As a result, there can be no assurance that the Company's networks will be
able to achieve and maintain the highest possible digital transmission speed.
The Company's failure to achieve or maintain high-speed digital transmissions
would significantly reduce customer and end-user demand for its services and
have a material adverse effect on its business, prospects, operating results
and financial condition. See "Business--Covad's Product and Service Offerings"
and "--Network Architecture and Technology."
18
<PAGE>
Digital Communications Signal Compatibility and Potential Network Interference
Certain technical laboratory tests and field experience indicate that the
DSL technology the Company and others are using may cause interference with
and be interfered with by other signals present in an ILEC's copper plant,
usually with lines in close proximity, while other laboratory tests indicate
that this equipment does not cause interference. Interference, if present,
could cause degradation of performance of the Company's services or render the
Company unable to offer its services on selected lines. The amount and extent
of such interference will depend on the condition of the ILEC'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. Further, the procedures to resolve interference issues between CLECs
and an ILEC are still being developed and there is no assurance that these
procedures will be effective. Although the Company has agreed to interference
resolution procedures with certain ILECs, there can be no assurance that the
Company will successfully negotiate similar procedures with other ILECs in
future interconnection agreements or in renewals of existing interconnection
agreements, or that the ILECs will not unilaterally take action to resolve
interference issues to the detriment of the Company's services. If the
Company's TeleSpeed services cause widespread network degradation or are
perceived to cause such interference, responsive actions by the ILECs or state
or federal regulators could have a material adverse effect on the Company's
reputation, brand image, service quality, and customer satisfaction and
retention. Any such network interference or network interference perceived by
the ILECs or state or federal regulators could have a material adverse effect
on the Company's business, prospects, operating results and financial
condition.
Risk of System Failure
The Company's operations are dependent upon its ability to support its
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 the Company's Network Operations Center ("NOC") or
any of the Company's RDCs could cause interruptions in the services provided
by the Company. Additionally, failure of an ILEC or other service provider,
such as other CLEC service providers, to provide communications capacity
required by the Company, as a result of a natural disaster, operational
disruption or any other reason, could cause interruptions in the services
provided by the Company. Any damage or failure that causes interruptions in
the Company's operations could have a material adverse effect on the Company's
business, prospects, operating results and financial condition. See
"Business--Network Architecture and Technology."
Security Risk in the Network
Despite the implementation of security measures, the Company's networks may
be vulnerable to unauthorized access, computer viruses and other disruptive
problems. ISPs 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 the Company's
customers and such customers' end-users, which might result in liability of
the Company to its customers and also might deter potential customers.
Although the Company intends to implement security measures that are standard
within the telecommunications industry, as well as new Company-developed
security measures, the Company has not yet done so and there can be no
assurance that the Company will implement such measures in a timely manner or
to the degree that may be compatible with its various customers' expectations,
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 the Company's
customers and such customers' end-users, which could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. See "Business--Network Architecture and Technology."
Dependence Upon Suppliers and Limited Sources of Supply
The Company relies and will continue to rely on outside parties to
manufacture its network equipment, such as digital subscriber line access
multiplexers ("DSLAMs"), customer premise equipment ("CPE") modems,
19
<PAGE>
network routing and switching hardware, network management software, systems
management software and database management software. As the Company signs
additional service contracts, the Company believes there may need to be a
significant ramp-up in the amount of manufacturing and other services supplied
by third parties in order for the Company to meet its contractual commitments.
For example, the Company has recently entered into a service arrangement with
Lucent Technologies Inc. ("Lucent Technologies") to increase its ability to
order, install and manage its collocation facilities and associated equipment.
The Company has in the past experienced supply problems with certain of its
vendors and there can be no assurance that these vendors will be able to meet
the Company's needs in a satisfactory and timely manner in the future or that
the Company will be able to obtain additional vendors when and if needed.
Although the Company has identified alternative suppliers for technologies
that it deems critical and it is not constrained to use the same DSLAM or CPE
vendor in multiple regions, it could take a significant period of time to
establish relationships with alternative suppliers for critical technologies
and substitute their technologies into the Company's networks. The Company's
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
the Company's relationships with these suppliers could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. See "Business--Network Architecture and Technology."
Dependence Upon and Need to Hire Additional Key Personnel
The Company's performance is dependent on the performance of its executive
officers and key employees. In particular, the Company's senior management has
significant experience in the data communications, telecommunications and
personal computer industries, and the loss of any one of the Company's
executive officers could have a material adverse effect of the Company's
ability to execute its business strategy effectively. In addition, the Company
is dependent upon the regional general managers for each region the Company
has entered and prepares to enter. Regional general managers 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, given the Company's early stage of
deployment, the Company is dependent on its ability to retain and motivate
high quality personnel, especially its management. The Company does not have
"key person" life insurance policies on any of its employees. There can be no
assurance that key personnel will continue to be employed by the Company or
that the Company will be able to attract and retain qualified personnel in the
future. The Company's future success also depends on its continuing ability to
identify, hire, train and retain other highly qualified technical, sales,
marketing and managerial personnel in connection with its expansion within its
existing regions and the deployment and marketing of its network into targeted
regions. Competition for such qualified personnel is intense, particularly in
software development, network engineering and product management. There can be
no assurance that the Company will be able to attract, assimilate or retain
other highly qualified technical, sales, marketing and managerial personnel in
the future. The inability to attract and retain its officers and key employees
and the necessary technical, sales, marketing and managerial personnel could
have a material adverse effect upon the Company's business, prospects,
operating results and financial condition. See "Business--Employees" and
"Management."
Uncertain Federal and State Tax and Other Surcharges on the Company's Services
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 the Company's
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 the Company's payment obligations pursuant to the
relevant surcharges to increase. In addition, pursuant to periodic revisions
by state and federal regulators of the applicable surcharges, the Company may
be subject to increases in the surcharges and fees currently paid.
20
<PAGE>
Government Regulation and Current Industry Litigation
The services offered by the Company are subject to federal, state and local
government regulation. The 1996 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 the Company
operates. The 1996 Act eliminates many of the pre-existing legal barriers to
competition in the telecommunications services business and sets basic
criteria for relationships between telecommunications providers.
Among other things, the 1996 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 UNEs and
retail services at wholesale rates. The FCC's primary rules interpreting the
1996 Act, which were issued on August 8, 1996 (the "FCC Order"), have been
reviewed by the U.S. Court of Appeals for the Eighth Circuit, which has
overruled certain of the FCC's pricing, UNE combination, nondiscrimination and
other regulations and upheld the FCC's definition of UNEs and OSS rules. The
Company has entered into competitive interconnection agreements using the
federal guidelines established in the FCC's interconnection order, which
agreements remain in effect notwithstanding the overruling of certain of the
FCC's regulations. The Eighth Circuit's overruling of the FCC Order has been
appealed to the U.S. Supreme Court, which has agreed to decide the case. The
U.S. Supreme Court's ruling, expected in 1999, could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition.
In August 1998, the FCC proposed new rules that would allow ILECs to provide
their own DSL services free from ILEC regulation through a separate affiliate.
The FCC has also simultaneously proposed additional rules requiring ILECs to
provide collocation and loops to CLECs such as the Company on more favorable
terms to the CLECs than previously prescribed by the FCC. The FCC's August
1998 rulings, proposals and actions thereunder may be appealed or
reconsidered, and it is uncertain whether the FCC will in fact order more
favorable collocation and loop availability for CLECs. The provision of DSL
services by an affiliate of an ILEC not subject to ILEC regulation could have
a material adverse effect on the Company's business, prospects, operating
results and financial condition.
No assurance can be given that 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 Act, or court decisions
would not have a material adverse effect on the Company's business, prospects,
operating results and financial condition. See "Business--Government
Regulations" and "--Legal Proceedings."
Risks Associated with Potential General Economic Downturn
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 the services offered by the
Company. Any such decline or concern about an imminent decline could delay
decisions among certain of the Company's customers to roll out the Company's
services or could delay decisions by prospective customers to make initial
evaluations of the Company's services. Such delays would have a material
adverse effect on the Company's business, prospects, operating results and
financial condition.
Control by Principal Stockholders and Management
The Company's executive officers and directors and principal stockholders
together will beneficially own over 71.3% of the outstanding Common Stock
after completion of this offering (69.3% if the Over-Allotment
21
<PAGE>
Option is exercised in full). Accordingly, these stockholders will be able to
determine the composition of the Company's Board of Directors, will retain the
voting power to approve all matters requiring stockholder approval and will
continue to have significant influence over the affairs of the Company. This
concentration of ownership could have the effect of delaying or preventing a
change in control of the Company or otherwise discouraging a potential
acquirer from attempting to obtain control of the Company, which in turn could
have a material adverse effect on the market price of the Common Stock or
prevent the Company's stockholders from realizing a premium over the then
prevailing market prices for their shares of Common Stock. See "Management"
and "Principal Stockholders."
Year 2000 Issues
Many currently installed computer systems and software products are coded to
accept only two-digit entries in the date code field and cannot distinguish
21st century dates from 20th century dates. These date code fields will need
to distinguish 21st century dates from 20th century dates and, as a result,
many companies' software and computer systems may need to be upgraded or
replaced in order to comply with such "Year 2000" requirements. The Company
has reviewed its internally developed information technology systems and
programs and believes that its systems are Year 2000 compliant and that there
are no significant Year 2000 issues within the Company's systems or services.
The Company has not reviewed its non-information technology systems for Year
2000 issues relating to embedded microprocessors. To the extent that such
issues exist, these systems may need to be replaced or upgraded to become Year
2000 compliant. The Company believes that its non-information technology
systems will not present any significant Year 2000 issues, although there can
be no assurance in this regard. In addition, the Company utilizes third-party
equipment and software and interacts with ILECs that have equipment and
software that may not be Year 2000 compliant. Failure of such third-party or
ILEC equipment or software to operate properly with regard to the year 2000
and thereafter could require the Company to incur unanticipated expenses to
remedy any problems, which could have a material adverse effect on the
Company's business, prospects, operating results and financial condition.
Furthermore, the purchasing patterns of the Company's ISP 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 the Company's services,
which could have a material adverse effect on the Company's business,
prospects, operating results and financial condition. The Company, to date,
has not made any assessment of the Year 2000 risks associated with its third-
party or ILEC equipment or software or with its ISP and enterprise customers,
has not determined the risks associated with the reasonably likely worst-case
scenario and has not made any contingency plans to address such risks.
However, the Company intends to devise a Year 2000 contingency plan prior to
December 1999. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Year 2000 Issues."
No Prior Public Market; Determination of Offering Price; Possible Volatility
of Stock Price
Prior to this offering, there has been no public market for the Common
Stock, and there can be no assurance that an active public market for the
Common Stock will develop or be sustained after the offering. The initial
public offering price was determined by negotiation between the Company and
the Underwriters based upon several factors and may not be indicative of the
market price of the Common Stock after the offering. See "Underwriting" for a
discussion of the factors considered in determining the initial public
offering price. The trading price of the Common Stock could be subject to wide
fluctuations in response to factors such as actual or anticipated variations
in quarterly operating results, the addition or loss of customers or
subscribers, announcements of technological innovations, new products or
services by the Company or its competitors, changes in financial estimates or
recommendations by securities analysts, conditions or trends in the
telecommunications industry, growth of the Internet and online commerce
industries, announcements by the Company of significant acquisitions,
strategic partnerships, joint ventures or capital commitments, additions or
22
<PAGE>
departures of key personnel, future equity or debt financings, general market
and general economic conditions and other events or factors, many of which are
beyond the Company's control. In addition, in recent years the stock market
has experienced extreme price and volume fluctuations. These fluctuations have
had a substantial effect on the market prices for many emerging growth
companies, often unrelated to the operating performance of the specific
companies. Such market fluctuations could adversely affect the price of the
Common Stock.
Shares Eligible for Future Sale; Registration Rights
Sales of a substantial number of shares of Common Stock in the public market
following this offering, or the appearance that such shares are available for
sale, could adversely affect the market price for the Company's Common Stock.
The number of shares of Common Stock available for sale in the public market
is limited by restrictions under the Securities Act and lock-up agreements
under which the holders of all of the Company's outstanding shares of Common
Stock and options and warrants to purchase Common Stock have agreed not to
sell or otherwise dispose of any of their shares for a period of 180 days
after the date of this Prospectus without the prior written consent of Bear,
Stearns & Co. Inc. However, 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. Based on shares of Common Stock,
options and warrants outstanding as of December 31, 1998, the following shares
of Common Stock will be eligible for future sale. On the date of this
Prospectus, the 7,800,000 shares offered hereby will be eligible for sale in
the public market without restriction. An additional 31,820,159 shares will be
eligible for sale without restriction 180 days after the date of this
Prospectus, except that shares held by "affiliates" of the Company within the
meaning of Rule 144 under the Securities Act are subject to certain volume
limitations thereunder and registration rights. An additional 6,379,177 shares
of Common Stock issuable upon conversion of the Class B Common Stock will be
eligible for sale beginning in January 2000 subject to volume limitations
pursuant to Rule 144 and the exercise of registration rights. In addition, the
Company has 15,520,342 shares of Common Stock reserved for issuance pursuant
to options under its 1997 Stock Plan, of which 11,794,410 shares were subject
to outstanding options at January 20, 1999, and the Company has 5,188,764
shares underlying outstanding warrants. All of such outstanding options and
warrants are also subject to the 180 day lock-up.
The Company intends to register, following the effective date of this
offering, a total of 15,520,342 shares of Common Stock reserved for issuance
under the Company's 1997 Stock Plan and 1,000,000 shares of Common Stock
reserved for issuance under its 1998 Employee Stock Purchase Plan. Further,
upon expiration of the lock-up agreements referred to above, holders of
31,529,866 shares of Common Stock and holders of 6,379,177 shares of Class B
Common Stock will be entitled to certain registration rights with respect to
such shares. In addition, there are 5,188,764 shares underlying outstanding
warrants, including 5,053,764 shares issuable upon exercise of the High Yield
Warrants that will be eligible for resale upon expiration of their respective
one-year holding periods under Rule 144, subject to the exercise of
registration rights. If such holders, by exercising their registration rights,
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 the
Company's Common Stock. See "Description of Capital Stock--Registration
Rights" and "Shares Eligible for Future Sale."
Antitakeover Effects of Certain Charter and Bylaw Provisions and Delaware Law
The Company's 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 rights of the holders of
Common Stock will be subject to, and may be adversely affected by, the rights
of the holders of any Preferred Stock that may be issued in the future. 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 the outstanding voting stock of the Company. The Company's 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
23
<PAGE>
proposals. These provisions of the Company's charter and bylaws, as well as
Section 203 under the Delaware General Corporation Law to which the Company is
subject, could discourage potential acquisition proposals and could delay or
prevent a change of control of the Company. These provisions are intended to
enhance the likelihood of continuity and stability in the composition of the
Board of Directors and in the policies formulated by the Board of Directors
and to discourage certain types of transactions that may involve an actual or
threatened change of control of the Company. These provisions are designed to
reduce the vulnerability of the Company to an unsolicited acquisition proposal
and to discourage certain tactics that may be used in proxy fights. The
Indenture provides that in the event of certain changes in control of the
Company, each holder will have the right to require the Company to repurchase
such holder's Senior Discount Notes at a premium over the accreted value of
such debt. The provisions in the charter and bylaws and the Indenture could
have the effect of discouraging others from making tender offers for the
Company's shares and, as a consequence, they also may inhibit increases in the
market price of the Company's shares that could result from actual or rumored
takeover attempts. Such provisions also may have the effect of preventing
changes in the management of the Company. See "Description of Capital Stock--
Antitakeover Effects of Certain Provisions of Covad's Charter, Bylaws and
Delaware Law."
Dilution
Investors participating in this offering will incur immediate, substantial
dilution. To the extent outstanding warrants and options to purchase the
Company's Common Stock are exercised, there will be further dilution. In
addition, to the extent the Company issues additional equity securities to
fund future capital expenditures and working capital needs, investors
participating in this offering may experience further dilution. See "--
Substantial Future Capital Needs" and "Dilution."
Absence of Dividends
The Company has not declared or paid any dividends since its inception. The
Company currently anticipates that it will retain all of its future earnings
for use in the expansion and operation of its business and does not anticipate
paying any cash dividends in the foreseeable future. In addition, the
Company's existing financing arrangements restrict the payment of any
dividends. See "Dividend Policy."
24
<PAGE>
USE OF PROCEEDS
The net proceeds to the Company from the sale of the shares of Common Stock
offered hereby are estimated to be approximately $130.5 million ($150.2
million if the Over-Allotment Option is exercised in full) after deducting
underwriting discounts and commissions and estimated offering expenses.
The Company anticipates that the net proceeds of this offering, together
with the aggregate proceeds of $60 million from the investments by the
Strategic Investors, will be used to fund capital expenditures to be incurred
in the deployment of the Company's networks in existing and new regions, for
expenses associated with continued development and sales and marketing
activities, to fund operating losses, provide working capital and for general
corporate purposes. The Company believes that the net proceeds of this
offering, together with the aggregate proceeds from the investments by the
Strategic Investors, will be sufficient to fund the Company's aggregate
capital expenditures and working capital requirements, including operating
losses, through the end of 1999. The amounts actually expended by the Company
for these purposes will vary significantly depending upon a number of factors,
including future revenue growth, if any, capital expenditures and the amount
of cash generated by the Company's operations. Additionally, if the Company
determines it would be in its best interest, the Company may increase or
decrease the number, selection and timing of entry of its targeted regions.
Accordingly, the Company's management will retain broad discretion in the
allocation of such net proceeds. Although the Company may use a portion of the
net proceeds to pursue possible acquisitions of businesses, technologies or
products complementary to those of the Company in the future, there are no
present understandings, commitments or agreements with respect to any such
acquisitions. Pending use of such net proceeds for the above purposes, the
Company intends to invest such funds in short-term, interest-bearing,
investment-grade securities. See "Risk Factors--Substantial Future Capital
Requirements" and "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
DIVIDEND POLICY
The Company has not declared or paid any dividends since its inception. The
Company currently anticipates that it will retain all of its future earnings
for use in the expansion and operation of its business and does not anticipate
paying any cash dividends in the foreseeable future. The Company's future
dividend policy will be determined by its Board of Directors. The Company's
existing financing arrangements restrict the payment of any dividends. The
Company anticipates that it and its Subsidiaries will incur substantial
additional indebtedness, which is likely to be subject to additional
restrictions on dividends.
25
<PAGE>
CAPITALIZATION
The following table sets forth (A) the capitalization of the Company as of
September 30, 1998, (B) the pro forma capitalization of the Company after
giving effect to the automatic conversion of all shares of Preferred Stock
outstanding as of September 30, 1998 into Common Stock and assuming the
exercise for cash of warrants to purchase 1,800,000 shares of Common Stock
prior to the closing of this offering, (C) the pro forma capitalization of the
Company to reflect additionally the issuance of Preferred Stock to the
Strategic Investors and to give effect to the automatic conversion of such
shares into Class B Common Stock immediately prior to the closing of this
offering, and (D) the as adjusted capitalization of the Company to reflect
additionally the receipt of the estimated net proceeds from the sale of the
Common Stock in the offering after deducting underwriting discounts and
commissions and estimated offering expenses payable by the Company.
<TABLE>
<CAPTION>
As of September 30, 1998
-------------------------------------------
(A) (B) (C) (D)
Actual Pro Forma Pro Forma As Adjusted
-------- --------- --------- -----------
(in thousands)
<S> <C> <C> <C> <C>
Cash and cash equivalents......... $ 97,076 $ 97,082 $157,082 $287,546
======== ======== ======== ========
Long-term obligations:
Capital lease obligations
(including current portion)...... 634 634 634 634
13 1/2% Senior Discount Notes due
2008, net........................ 137,292 137,292 137,292 137,292
-------- -------- -------- --------
Total long-term obligations
(including current portion).... 137,926 137,926 137,926 137,926
Stockholders' equity (net capital
deficiency):
Preferred Stock, $0.001 par value;
no shares authorized, issued and
outstanding (A) actual; 5,000,000
shares authorized (B) pro forma,
(C) pro forma and (D) as
adjusted, no shares issued and
outstanding (B) pro forma, (C)
pro forma and (D) as adjusted.... -- -- -- --
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, (C) pro forma and (D) as
adjusted......................... 18 -- -- --
Common Stock, $0.001 par value;
65,000,000 shares authorized and
11,634,149 shares issued and
outstanding (A) actual;
200,000,000 shares authorized and
31,680,311 shares issued and
outstanding (B) pro forma and (C)
pro forma and 39,480,311 shares
issued and outstanding (D) as
adjusted(1)...................... 12 32 32 40
Class B-Common Stock, $0.001 par
value; no shares authorized,
issued and outstanding (A) actual
and (B) pro forma; 10,000,000
shares authorized (C) pro forma
and (D) as adjusted; 6,379,177
shares issued and outstanding (C)
pro forma and (D) as adjusted.... -- -- 6 6
Additional paid-in capital(2)..... 30,732 30,736 119,430 249,886
Deferred compensation............. (6,306) (6,306) (6,306) (6,306)
Accumulated deficit............... (30,873) (30,873) (30,873) (30,873)
-------- -------- -------- --------
Total stockholders' equity (net
capital deficiency)............ (6,417) (6,411) 82,289 212,753
-------- -------- -------- --------
Total capitalization.......... $131,509 $131,515 $220,215 $350,679
======== ======== ======== ========
</TABLE>
- --------
(1) Excludes (i) an aggregate of 15,520,342 shares of Common Stock reserved
for issuance under the Company's 1997 Stock Plan, of which 11,794,410
shares were subject to outstanding options at January 20, 1999 at a
weighted average exercise price of $3.29 per share, (ii) an aggregate of
1,000,000 shares of Common Stock reserved for issuance under the Company's
1998 Employee Stock Purchase Plan, (iii) 5,053,764 shares of Common Stock
issuable upon exercise of outstanding High Yield Warrants at December 31,
1998 at an exercise price of $.0033 per share, (iv) 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 (v) 59,372
shares of Common Stock to be issued as cumulated but unpaid dividends on
Preferred Stock as of the closing of this offering.
(2) The amounts under (C) pro forma and (D) as adjusted include the effect of
recording intangible assets of $28.7 million associated with the issuance
of Preferred Stock to the Strategic Investors. Such amounts will be
amortized over a period of three to six years.
26
<PAGE>
DILUTION
The pro forma net tangible book value of the Company as of September 30,
1998 was $45,285,000 or $1.19 per share of outstanding Common Stock after
giving effect to the conversion of the Company's Preferred Stock outstanding
as of September 30, 1998, the exercise for cash of warrants to purchase
1,800,000 shares of Common Stock prior to the consummation of this offering
and the issuance of Preferred Stock to the Strategic Investors after giving
effect to the automatic conversion of such shares to Class B Common Stock
immediately prior to the closing of this offering. The pro forma net tangible
book value per share represents the Company's total pro forma tangible assets
less total liabilities, divided by the pro forma number of shares of Common
Stock outstanding. Dilution per share represents the difference between the
amount per share paid by investors in this offering and the as adjusted pro
forma net tangible book value per share after the offering. After giving
effect to this offering resulting in estimated net proceeds to the Company of
approximately $130.5 million (after deducting underwriting discounts and
commissions and estimated offering expenses payable by the Company), the as
adjusted pro forma net tangible book value of the Company at September 30,
1998 would have been $175,749,000 or $3.83 per share. This represents an
immediate increase in the net tangible book value of $2.64 per share to
existing stockholders and an immediate dilution in net tangible book value of
$14.17 per share to new investors purchasing shares at the initial public
offering price. The following table illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Initial public offering price per share........................... $18.00
Pro forma net tangible book value per share as of September 30,
1998........................................................... $1.19
Increase per share attributable to new investors................ $2.64
-----
As adjusted pro forma net tangible book value per share after the
offering......................................................... $3.83
------
Dilution per share to new investors............................... $14.17
======
</TABLE>
The following table summarizes, on a pro forma basis as of September 30,
1998, the difference between the existing stockholders and new investors with
respect to the number of shares of Common Stock purchased from the Company,
the total consideration paid and the average price per share paid at the
initial public offering price of $18.00 per share (before deducting
underwriting discounts and commissions and estimated offering expenses payable
by the Company):
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
------------------ -------------------- Price Per
Number Percent Amount Percent Share
---------- ------- ------------ ------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockholders......... 38,059,488 83.0% $ 70,360,000 33.4% $ 1.85
New investors................. 7,800,000 17.0 140,400,000 66.6 18.00
---------- ---- ------------ ----
Total....................... 45,859,488 100% 210,760,000 100% 4.60
========== ==== ============ ====
</TABLE>
The foregoing table assumes no exercise of the Over-Allotment Option and no
exercise of stock options or warrants outstanding at December 31, 1998, other
than the exercise for cash of warrants to purchase 1,800,000 shares of Common
Stock prior to the consummation of this offering. At January 20, 1999, there
were options and warrants outstanding to purchase 16,983,174 shares of Common
Stock at a weighted average exercise price of $2.30 per share. To the extent
outstanding options and warrants are exercised, there will be further dilution
to new investors. See "Management."
27
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data should be read in
conjunction with the Company's Consolidated Financial Statements and the
related Notes thereto and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included herein. The consolidated
statement of operations data and the consolidated cash flow data for the year
ended December 31, 1997 and for the nine months ended September 30, 1998, and
the consolidated balance sheet data at December 31, 1997 and at September 30,
1998 are derived from, and are qualified by reference to, the audited
Consolidated Financial Statements and the related Notes thereto included
herein. The consolidated statement of operations data and consolidated cash
flow data for the three months ended September 30, 1998 are derived from
unaudited consolidated financial statements of the Company not included
herein. These unaudited financial statements include, in the opinion of
management, all adjustments, consisting of normal, recurring adjustments,
necessary for a fair presentation of the information set forth therein. The
consolidated results of operations for the three and nine months ended
September 30, 1998 are not necessarily indicative of future results. For the
nine months ended September 30, 1997, the Company had no revenues and total
expenses were not significant.
<TABLE>
<CAPTION>
Three Months
Year Ended Ended
December 31, September 30, Nine Months Ended
1997 1998 September 30, 1998
------------ ------------- ------------------
(unaudited)
(in thousands, except share
and per share amounts)
<S> <C> <C> <C>
Consolidated Statement of
Operations Data:
Revenues......................... $ 26 $ 1,565 $ 2,560
Operating expenses:
Network and product costs...... 54 1,355 2,316
Sales, marketing, general and
administrative................ 2,374 10,681 17,231
Amortization of deferred
compensation.................. 295 1,837 2,695
Depreciation and amortization.. 70 738 1,348
----------- ---------- ----------
Total operating expenses..... 2,793 14,611 23,590
----------- ---------- ----------
Income (loss) from operations.... (2,767) (13,046) (21,030)
Net interest income (expense).. 155 (3,511) (7,231)
----------- ---------- ----------
Net income (loss)................ $ (2,612) $ (16,557) $ (28,261)
=========== ========== ==========
Net income (loss) per common
share........................... $ (0.80) $ (2.75) $ (5.26)
Shares used in computing net
income (loss) per share.......... 3,271,546 6,011,610 5,374,924
Pro forma net income (loss) per
common share(1)................. $ (0.23) $ (0.64) $ (1.14)
Shares used in computing pro
forma net income (loss) per
share(1)........................ 11,522,916 26,057,772 24,844,824
Other Financial Data:
EBITDA(2)........................ $ (2,402) $ (10,471) $ (16,987)
Consolidated Cash Flow Data:
Provided by (used in) operating
activities...................... $ (1,895) $ (3,319) $ (4,196)
Provided by (used in) investing
activities...................... (2,494) (21,084) (33,464)
Provided by (used in) financing
activities...................... 8,767 (406) 130,358
</TABLE>
28
<PAGE>
<TABLE>
<CAPTION>
As of As of
December 31, September 30,
1997 1998
------------ -------------
(in thousands)
Consolidated Balance
Sheet Data:
<S> <C> <C>
Cash and cash
equivalents............ $4,378 $ 97,076
Net property and
equipment.............. 3,014 34,003
Total assets............ 8,074 144,622
Long-term obligations,
including current
portion................ 783 137,926
Total stockholders'
equity (net capital
deficiency)............ 6,498 (6,417)
</TABLE>
<TABLE>
<CAPTION>
As of As of
December 31, September 30,
1997 1998
------------ -------------
<S> <C> <C>
Other Operating Data:
Homes and businesses passed.......................... 278,000 3,302,000
Lines installed...................................... 26 1,948
</TABLE>
- --------
(1) The pro forma net loss per share assumes the conversion of the Preferred
Stock outstanding as of September 30, 1998 into Common Stock on a one-for-
one basis and reflects the exercise for cash of warrants to purchase
1,800,000 shares of Common Stock prior to the closing of this offering.
(2) EBITDA consists of net loss excluding net interest, taxes, depreciation
and amortization (including amortization of deferred compensation). EBITDA
is provided because it is a measure of financial performance commonly used
in the telecommunications industry. EBITDA is presented to enhance an
understanding of the Company's operating results and should not be
construed (i) as an alternative to operating income (as determined in
accordance with GAAP) as an indicator of the Company's operating
performance or (ii) as an alternative to cash flows from operating
activities (as determined in accordance with GAAP) as a measure of
liquidity. EBITDA as calculated by the Company may be calculated
differently than EBITDA for other companies. See the Company's
Consolidated Financial Statements and the related Notes thereto contained
elsewhere in this Prospectus.
29
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Consolidated
Financial Statements and the related Notes thereto included elsewhere in this
Prospectus. This discussion contains forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in the forward-looking statements as a result of
certain factors including, but not limited to, those discussed in "Risk
Factors," "Business" and elsewhere in this Prospectus. The Company disclaims
any obligation to update information contained in any forward-looking
statement. See "--Forward Looking Statements."
Overview
Covad is a leading packet-based CLEC that provides dedicated high-speed
digital communications services using DSL technology to enterprise and ISP
customers. The Company introduced its services in the San Francisco Bay Area
in December 1997. The Company launched its services in the Los Angeles,
New York and Boston metropolitan areas in August 1998 and in the Washington,
D.C. and Seattle metropolitan areas in December 1998. In March 1998, the
Company raised approximately $135 million through the issuance of the Senior
Discount Notes to fund the deployment of its networks in the Initial Regions.
As a result of the strong market demand for high-speed digital communications
services, the Company has decided to increase to 22 the number of regions in
which it plans to build a network and offer its services. See "Risk Factors--
Dependence Upon Growth in Demand For DSL-Based Services."
During 1998, the Company expanded its network in the San Francisco Bay Area
and increased its sales and marketing efforts in that region, which resulted
in higher revenue in each successive month in 1998. As of December 31, 1998,
the Company's networks passed over 5.8 million homes and businesses, including
1.7 million in the San Francisco Bay Area. In addition, the Company currently
has installed over 4,000 lines.
In connection with the Company's expansion within existing regions and into
new regions, it expects to significantly increase its capital expenditures, as
well as its sales and marketing expenditures, to deploy its networks and
support additional subscribers in those regions. Accordingly, the Company
expects to incur substantial and increasing net losses for at least the next
several years. See "Risk Factors--Limited Operating History" and "--History
and Continuation of Operating Losses."
For each region, the Company has targeted three market segments: business
Internet, business RLAN and consumer Internet. Business Internet and consumer
Internet services are sold indirectly through ISPs. Business RLAN services are
sold directly to enterprise customers. Using the approach described below, the
Company has estimated the size of the addressable portion of these market
segments in its existing and targeted regions. No assurance can be given as to
the accuracy of the Company's estimates regarding the size of its addressable
market segments. See "Risk Factors--Dependence on Growth in Demand for DSL-
Based Services."
To determine the overall potential market, Covad specifically identified
each service area in which it plans to offer service and each CO within these
service areas. This determination was based primarily upon both business and
population demographics as well as Covad's desire to be in most COs in order
to provide blanket coverage in a region. To estimate the addressable market
for each market segment from the overall potential market, Covad 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 CO 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.
30
<PAGE>
RLAN Addressable Market: Based on an estimate of the number of households
served by the local CO 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 CO
that will be heavy online users and an estimate of the percentage of such
households that will purchase high-speed connectivity.
A key determinant of the Company's revenues will be its service penetration
into the addressable portion of these market segments. The market for DSL
communications services is nascent and estimates of penetration are
necessarily highly speculative. Notwithstanding the above, the Company
believes it can achieve its economic goals at market penetration rates of less
than 10% in its business Internet and RLAN markets and less than 4% in the
consumer Internet market. No assurance can be given that the Company will meet
its penetration estimates. See "Risk Factors--Dependence on Growth in Demand
for DSL-Based Services" and "--Intense Competition."
The Company derives revenue from (i) monthly recurring service charges for
connections from the end-user to the Company's facilities and for backhaul
services from the Company's facilities to the ISP or enterprise customer, (ii)
service activation, installation and other non-recurring charges and (iii) the
sale of CPE which the Company provides to its customers due to the general
unavailability of CPE through retail channels. The Company intends to sell and
install CPE at prices that will provide the Company with positive margins on
such sales and installations. The current prices for the Company's services
range from $90 per month for TeleSpeed 144 to $195 per month for TeleSpeed 1.1
and TeleSpeed 1.5, before volume discounts. To date, the Company has not
performed services under any agreements for volume discounts which are
material to its financial results. However, the Company expects prices for the
major components of both recurring and non-recurring revenues to decrease each
year in part due to the effects of future volume discounts. The Company
believes its revenues from the sale of CPE will decline over time as CPE
becomes more generally available. The Company expects that the prices it
charges to customers for CPE will decrease each year. See "Risk Factors--
Unproven Business Model and Pricing Sensitivity."
The Company's network and product costs include costs of recurring and
nonrecurring circuit fees charged to the Company by ILECs and other CLECs,
including installation, activation, monthly line costs, maintenance and repair
of circuits between and among the Company's DSLAMs and its RDCs, customer
backhaul, and subscriber lines. Other costs the Company incurs include those
for materials used by the Company in installation and the servicing of
customers and end-users, and the cost of CPE. As the Company's end-user base
grows, the largest element of network and product cost is expected to be the
ILECs' charges for the Company's leased copper lines.
The Company believes its regions will generate positive EBITDA (before
allocation of corporate overhead), on average, within 24 months of launching
service, based on the Company's current expectations regarding operating
expenses, customer subscription and retention rates and service pricing.
However, there can be no assurances in this regard, and the Company expects
that financial performance will vary from region to region and that the time
it will take for a region to generate positive EBITDA will range up to 48
months or longer, depending upon region-specific characteristics. Such
characteristics include the size of the addressable markets in a region and
competitive dynamics including, among other things, pricing, the number of
COs, the cost of necessary infrastructure to service a region, the timing of
market entry and the cost to access the ILEC's UNEs. As the Company continues
to develop its network within its targeted regions, positive EBITDA from more
developed regions is expected to be offset partially or completely by negative
EBITDA from less developed regions, costs associated with entering new regions
and corporate overhead. This trend is expected to continue until the Company
has a sufficiently large customer and end-user base to absorb operating costs
of new regions or the Company ceases entering new regions. See "Risk Factors--
History and Continuation of Operating Losses."
The development and expansion of the Company's business will require
significant expenditures. The principal capital expenditures incurred during
the buildup phase of any region involve the procurement, design and
construction of the Company's CO collocation cages, end-user DSL line cards,
and expenditures for other
31
<PAGE>
elements of the Company's network design, which includes an RDC in each
region. The average capital cost to deploy the Company's facilities in a CO,
excluding subscriber line cards, is expected to average approximately $85,000
per CO collocation facility. Following the buildout of its collocation
facilities, the major portion of the Company's capital expenditures is the
purchase of DSL line cards to support incremental subscribers. The Company
expects 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 the
Company's network, the Company will use its capital for marketing its
services, acquiring ISP and enterprise customers, and funding its customer
care and field service operations. The Company believes that the net proceeds
of this offering together with its existing capital resources will be
sufficient to fund the Company's aggregate capital expenditures and working
capital requirements, including operating losses, through the end of 1999. See
"Risk Factors--Substantial Future Capital Requirements."
The Company believes that it may take several months from the time a
customer is first contacted to the point at which it will be able to book and
invoice a customer for its services. In the case of ISP customers, this sales
cycle will depend on the time it takes the ISP to market and sell the
Company's services to its subscribers. In the case of enterprise customers,
the long sales cycle is partially due to the technical requirements that must
be satisfied before a customer's telecommunications manager will make the
Company's service widely available to the customer's employees. See "Risk
Factors--Lengthy Sales Cycle for Enterprise Customers."
The Company recently entered into strategic relationships with AT&T,
NEXTLINK and Qwest. As part of these strategic relationships, the Company
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 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. As a result, the Company expects 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, although there can be no assurance
in this regard. See "Risk Factors--Dependence Upon Indirect Sales Channels."
Results of Operations
The Company's operations from inception in October 1996 to December 1997
were limited principally to the development of the technology and activities
related to the commencement of its business operations. As a result, the
Company's revenues and expenditures during such periods are not indicative of
anticipated revenues which may be attained or expenditures which may be
incurred by the Company in future periods. In particular, the Company's
expenditure levels during the year ended December 31, 1997 do not reflect the
issuance of the Senior Discount Notes in March 1998 and the related interest
and amortization charges, which the Company expects will be approximately
$16.0 million during the year ending December 31, 1998 and will increase
annually thereafter to $36.9 million for the year ending December 31, 2004 and
will remain at that level through the maturity of the Senior Discount Notes in
March 2008. See "Risk Factors--Limited Operating History." The Company did not
have any revenue until the fourth quarter of 1997. As a result, any comparison
of the nine month period ended September 30, 1998 with the nine month period
September 30, 1997 is not meaningful.
Revenues
Revenues were $26,000 for the year ended December 31, 1997 and were $2.6
million for the nine months ended September 30, 1998. This increase was
attributable to increased customers and subscribers resulting from the
Company's increased sales and marketing efforts and the expansion of the
Company's network in the San Francisco Bay Area. As of September 30, 1998, the
Company had an installed base of over 1,900 end-user lines with a network that
passed approximately 3.3 million homes and businesses. The Company expects
revenues to increase in future periods as the Company expands its network
within its existing regions, deploys networks in new regions and increases its
sales and marketing efforts in all of its target regions.
32
<PAGE>
Network and Product Costs
Total network and product costs were approximately $54,000 for the year
ended December 31, 1997 and approximately $2.3 million for the nine months
ended September 30, 1998. This increase is attributable to the expansion of
the Company's network and increased orders resulting from the Company's sales
and marketing efforts. The Company expects aggregate line costs to increase
significantly in future periods due to increased sales activity and expected
revenue growth.
Sales, Marketing, General and Administrative Expenses
Sales, marketing, general and administrative expenses consist primarily of
salaries, expenses for the development of the Company's business, the
development of corporate identification, promotional and advertising
materials, expenses for the establishment of its management team, and sales
commissions. These expenses increased from $2.4 million for the year ended
December 31, 1997 to $17.2 million for the nine months ended September 30,
1998 as a result of increased headcount in all areas as the Company expanded
its sales and marketing efforts, expanded the deployment of its network and
built operational infrastructure. Sales, marketing, general and administrative
expenses are expected to increase significantly as the Company continues to
expand its business.
Deferred Compensation and Intangible Asset Amortization
Through September 30, 1998, the Company had recorded a total of $9.3 million
of deferred compensation, with an unamortized balance of $6.3 million on its
balance sheet as of September 30, 1998. This deferred compensation arose as a
result of the granting of stock options to employees with exercise prices per
share subsequently determined to be below the fair values per share for
accounting purposes of the Company's Common Stock at the dates of grant. The
deferred compensation is being amortized over the vesting period of the
applicable options, and resulted in a charge to operations of $295,000 during
the year ended December 31, 1997 and $2.7 million during the nine months ended
September 30, 1998. The total charge to operations during the year ending
December 31, 1998 for amortization of the deferred compensation associated
with the options granted through September 30, 1998 will approximate $4.1
million.
The Company intends to record intangible assets of $28.7 million associated
with the issuance of Preferred Stock to the Strategic Investors. Such amounts
will result in an annual amortization charge of 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
infrastructure equipment, (ii) depreciation of information systems, furniture
and fixtures, (iii) amortization of improvements to COs, RDC and NOC
facilities and corporate facilities and (iv) amortization of capitalized
software costs. Depreciation and amortization was approximately $70,000 for
the year ended December 31, 1997 and approximately $1.3 million for the nine
months ended September 30, 1998. The increase was due to the increase in
equipment and facilities placed in service throughout the period. The Company
expects depreciation and amortization to increase significantly as the Company
increases its capital expenditures to expand its network.
Net Interest Income and Expense
Net interest income and expense consists primarily of interest income on the
Company's cash balance and interest expense associated with the Company's
debt. For the year ended December 31, 1997, net interest income was
approximately $155,000, which was primarily attributable to the interest
income earned from the proceeds raised in the Company's Preferred Stock
financing in July 1997. Interest income for the nine months ended
September 30, 1998 was approximately $3.7 million and resulted primarily from
the investment of the proceeds raised in the issuance of the Company's Senior
Discount Notes in March 1998. Interest expense for the nine
33
<PAGE>
months ended September 30, 1998 was approximately $10.9 million and consisted
primarily of interest on the Senior Discount Notes and capital lease
obligations. The Company expects interest expense to increase significantly as
a result of the issuance of the Senior Discount Notes. The Senior Discount
Notes accrete to $260 million by March 15, 2003, and as a result, the Company
expects that annual interest charges (which includes amortization of debt
discount and debt issuance costs) relating to the accretion of the Senior
Discount Notes will be approximately $16.0 million during the year ending
December 31, 1998 and will increase to approximately $22.3 million for the
year ending December 31, 1999. Thereafter, the Company expects that interest
expense attributable to the Senior Discount Notes (including amortization of
debt discount and debt issuance costs) will increase to approximately $36.9
million for the year ending December 31, 2004 and will remain at that level
through maturity of the Senior Discount Notes in March 2008.
Income Taxes
Income taxes consist of federal, state and local taxes, when applicable. The
Company expects significant consolidated net losses for the foreseeable future
which should generate net operating loss ("NOL") carryforwards. However,
utilization of NOLs is subject to substantial annual limitations. In addition,
income taxes may be payable during this time due to operating income in
certain tax jurisdictions. Once the Company achieves operating profits and the
NOLs have been exhausted or have expired, the Company may experience
significant tax expense. The Company recognized no provision for taxes as it
operated at a loss throughout 1997 and through the nine months ended September
30, 1998.
Certain Pro Forma Financial Information
Giving pro forma effect to the issuance of the Senior Discount Notes as if
it had been consummated on January 1, 1997 and the related interest and
amortization charges relating to the Senior Discount Notes accruing from such
date through September 30, 1998, the Company's interest expense would have
been approximately $20.3 million and $17.1 million, net loss would have been
approximately $22.9 million and $34.4 million, and net loss per common share
would have been $(7.01) and $(6.40) for the year ended December 31, 1997 and
the nine months ended September 30, 1998, respectively. For purposes of such
pro forma calculation, the Company has assumed (i) no correlating additional
interest income attributable to interest earned on the cash proceeds from the
issuance of the Senior Discount Notes and (ii) no application of the use of
proceeds from such issuance for the Company's corporate purposes. Therefore,
the interest and amortization charges relating to the Senior Discount Notes
would have had a significant adverse effect on the Company's net loss and net
loss per share had the issuance occurred on January 1, 1997.
34
<PAGE>
Quarterly Financial Information
The following table sets forth certain consolidated statements of operations
data for the Company's most recent five quarters. This information has been
derived from the Company's unaudited consolidated financial statements. In
management's opinion, this unaudited information has been prepared on the same
basis as the annual consolidated financial statements and includes all
adjustments (consisting only of normal recurring adjustments) necessary for a
fair presentation of the information for the quarters presented. This
information should be read in conjunction with the Consolidated Financial
Statements and related Notes thereto included elsewhere in this Prospectus.
The operating results for any quarter are not necessarily indicative of
results for any future period.
<TABLE>
<CAPTION>
Three Months Ended
-----------------------------------------------------------
June
September 30, December 31, March 31, 30, September 30,
1997 1997 1998 1998 1998
------------- ------------ --------- ------- -------------
(in thousands)
<S> <C> <C> <C> <C> <C>
Revenues................ $ -- $ 26 $ 186 $ 809 $ 1,565
Operating expenses:
Network and product
costs................ 10 44 203 758 1,355
Sales, marketing,
general and
administrative....... 783 1,334 1,944 4,606 10,681
Amortization of
deferred
compensation......... 134 161 227 631 1,837
Depreciation and
amortization......... -- 70 164 446 738
----- ------- ------- ------- --------
Total operating
expenses........... 927 1,609 2,538 6,441 14,611
----- ------- ------- ------- --------
Income (loss) from
operations............. (927) (1,583) (2,352) (5,632) (13,046)
Net interest income
(expense).............. 80 75 (429) (3,291) (3,511)
----- ------- ------- ------- --------
Net income (loss)..... $(847) $(1,508) $(2,781) $(8,923) $(16,557)
===== ======= ======= ======= ========
</TABLE>
The Company has generated greater revenues in each successive month and
quarter in the last five quarters, reflecting increases in the number of
customers and subscribers. The Company's network and product costs have
increased in every quarter, reflecting costs associated with customer and
subscriber growth and the deployment of the Company's networks in existing and
new regions. The Company's selling, marketing, general and administrative
expenses have increased in every quarter and reflect sales and marketing costs
associated with the acquisition of customers and subscribers, including sales
commissions, and the development of regional and corporate infrastructure.
Depreciation and amortization has increased in each quarter, primarily
reflecting the purchase of equipment associated with the deployment of the
Company's networks. The Company has experienced increasing net losses on a
quarterly basis as it increased its capital expenditures and operating
expenses, and the Company expects to sustain increasing quarterly losses for
at least the next several years. See "Risk Factors--History and Continuation
of Operating Losses."
The Company's annual and quarterly operating results may fluctuate
significantly in the future as a result of numerous factors. Factors that may
affect the Company's operating results include the timing and ability of the
ILECs to provide and construct the required CO collocation facilities, the
rate at which customers subscribe to the Company's services, the prices the
customers pay for such services and end-user churn rates. The Company's
operating results are sensitive to the pricing of its services and volume
commitments from individual customers. The Company believes its financial
performance depends to a great extent on retaining ISP and enterprise
customers and on levels of subscriber churn, which can vary due to a variety
of sources, including relocation of end-users of ISP customers and employee
turnover within enterprise customers. Additionally, the Company does not
currently have long-term contracts with any of its customers, and there can be
no assurance that the Company's ISP and enterprise customers will not
experience substantial subscriber churn as a result of customers or
subscribers discontinuing the use of its services or switching to an
alternative service provider. Furthermore, the Company's operating results may
fluctuate depending on, among other things, (i) the success of the
35
<PAGE>
Company's relationships with AT&T, NEXTLINK and Qwest and other potential
third parties in generating significant subscriber demand, (ii) the ability of
the Company to deploy on a timely basis its services to adequately satisfy
such subscriber demand, (iii) the ability of the Company to maintain targeted
subscriber levels and (iv) the mix of line orders between consumer end-users
and business end-users (which typically have higher margins). Other factors
that may add to volatility in the Company's annual or quarterly operating
results include the amount and timing of capital expenditures and other costs
relating to the expansion of the Company's network, the introduction of new
services by the Company or its competitors, technical difficulties or network
downtime, general economic conditions and economic conditions specific to the
Company's industry, among other factors. There can be delays in the
commencement and recognition of revenue because the installation of
telecommunication lines to implement certain services has lead times that are
controlled by third parties. Many of these factors are outside the Company's
control. In addition, the Company plans to increase operating expenses to fund
operations, sales, marketing, general and administrative activities and
infrastructure, including increased expenses associated with its relationships
with AT&T, NEXTLINK and Qwest. To the extent that these expenses are not
accompanied by an increase in revenues, the Company could experience a
material adverse effect on its business, prospects, operating results and
financial condition. See "Risk Factors--Potential Fluctuations in Operating
Results."
Liquidity and Capital Resources
The Company's operations have required substantial capital investment for
the procurement, design and construction of the Company's CO collocation
cages, the purchase of telecommunications equipment and the design and
development of the Company's networks. Capital expenditures were approximately
$32.3 million for the first nine months of 1998. The Company expects that its
capital expenditures will be substantially higher in future periods in
connection with the purchase of infrastructure equipment necessary for the
development and expansion of its network and the development of new regions.
Since inception, the Company has financed its operations primarily through
private placements of $10.3 million of equity securities, $865,000 of lease
financings and $129.3 million in net proceeds raised from the issuance of the
Senior Discount Notes. As of September 30, 1998, the Company had an
accumulated deficit of $30.9 million, and cash and cash equivalents of $97.1
million.
Net cash used in the Company's operating activities was approximately $1.9
million and $4.2 million for the year ended December 31, 1997 and the nine
months ended September 30, 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 noncash expenses, increases in accounts payable
and accrued liabilities. Net cash used by the Company for acquisitions of
property and equipment was $2.3 million during the year ended December 31,
1997 and $32.3 million during the nine months ended September 30, 1998. 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 nine months ended September 30,
1998 was $130.4 million, which primarily related to the issuance of the Senior
Discount Notes and Series C Preferred Stock.
In January 1999, the Company 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.
The Company believes its current capital resources, including the proceeds
of this offering and the investments from the Strategic Investors, will be
sufficient to fund the Company's aggregate capital expenditures and working
capital requirements, including operating losses, through the end of 1999. The
Company expects to raise substantial additional financing during 1999 to fund
the growth of its operations, including funding the significant capital
expenditures and working capital requirements necessary for the Company to
provide services in a total of 22 markets. The Company expects to raise
additional capital during 1999 through the issuance of debt and possibly
equity securities, the timing of which will depend on market conditions, and
which could occur in the near term. There can be no assurance as to the
availability of any financing or the terms upon which
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such financing might be available. The Company expects 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 its networks.
The Company's future cash requirements for developing, deploying and enhancing
its networks and operating its business, as well as the Company's revenues,
will depend on a number of factors including (i) the number of regions
entered, the timing of entry and services offered; (ii) network development
schedules and associated costs due to issues including the physical
requirements of the CO collocation process; (iii) the rate at which customers
and subscribers purchase the Company's services and the pricing of such
services; (iv) the level of marketing required to acquire and retain customers
and to attain a competitive position in the marketplace; and (v) the rate at
which the Company invests in engineering and development and intellectual
property with respect to existing and future technology.
In addition, the Company may wish to selectively pursue possible
acquisitions of businesses, technologies or products complementary to those of
the Company in the future in order to expand its geographic presence and
achieve operating efficiencies. There can be no assurance that the Company
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. See "Risk
Factors--Substantial Future Capital Requirements."
Year 2000 Issues
Many currently installed computer systems and software products are coded to
accept only two-digit entries in the date code field and cannot distinguish
21st century dates from 20th century dates. These date code fields will need
to distinguish 21st century dates from 20th century dates and, as a result,
many companies' software and computer systems may need to be upgraded or
replaced in order to comply with such "Year 2000" requirements. The Company
has reviewed its internally developed information technology systems and
programs and believes that its systems are Year 2000 compliant and that there
are no significant Year 2000 issues within the Company's systems or services.
The Company has not reviewed its non-information technology systems for Year
2000 issues relating to embedded microprocessors. To the extent that such
issues exist, these systems may need to be replaced or upgraded to become Year
2000 compliant. The Company believes that its non-information technology
systems will not present any significant Year 2000 issues, although there can
be no assurance in this regard. In addition, the Company utilizes third-party
equipment and software and interacts with ILECs that have equipment and
software that may not be Year 2000 compliant. Failure of such third-party or
ILEC equipment or software to operate properly with regard to the year 2000
and thereafter could require the Company to incur unanticipated expenses to
remedy any problems, which could have a material adverse effect on the
Company's business, prospects, operating results and financial condition.
Furthermore, the purchasing patterns of the Company's ISP 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 the Company's services,
which could have a material adverse effect on the Company's business,
prospects, operating results and financial condition. The Company, to date,
has not made any assessment of the Year 2000 risks associated with its third-
party or ILEC equipment or software or with its ISP and enterprise customers,
has not determined the risks associated with the reasonably likely worst-case
scenario and has not made any contingency plans to address such risks.
However, the Company intends to devise a Year 2000 contingency plan prior to
December 31, 1999. See "Risk Factors--Year 2000 Issues."
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; provided,
however, that the safe
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harbor provisions of Section 27A and Section 21E are not applicable to any
"forward looking" statements made in connection with the initial issuance of
Common Stock offered pursuant to this Prospectus, although such provisions are
applicable to such statements made in connection with the resales of such
shares of Common Stock. These forward-looking statements, such as the
Company's plans to expand its existing network or to commence service in new
areas, the market opportunity presented by the Company's target regions,
estimates regarding the timing of launching its service in new regions,
expectations regarding the extent to which enterprise customers roll out the
Company's service, expectations regarding the Company's relationships with
AT&T, NEXTLINK, Qwest and other potential third parties, expectations as to
pricing for the Company's services in the future, statements regarding
development of the Company's business, the estimate of market sizes and
addressable markets for the Company's services and products, the estimates of
future operating results, including the estimates of the time needed to
achieve positive EBITDA, the Company's 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,
are only estimates or predictions and cannot be relied upon. No assurance can
be given that future results will be achieved; actual events or results may
differ materially as a result of risks facing the Company or actual results
differing from the assumptions underlying such statements. Such risks and
assumptions that could cause actual results to vary materially from the future
results indicated, expressed or implied in such forward-looking statements
include, but are not limited to, the Company's ability to successfully market
its services to current and new customers, generate customer demand for its
services in the particular regions where it plans to market services, achieve
acceptable pricing for its services, respond to increasing competition, manage
growth of the Company's operations, access regions and negotiate suitable
interconnection agreements with the ILECs, all in a timely manner, at
reasonable costs and on satisfactory terms and conditions, as well as
regulatory, legislative and judicial developments. All written and oral
forward-looking statements made in connection with this Prospectus which are
attributable to the Company or persons acting on its behalf are expressly
qualified in their entirety by the "Risk Factors" and other cautionary
statements included in this Prospectus. The Company disclaims any obligation
to update information contained in any forward-looking statement.
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BUSINESS
The following discussion contains forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those anticipated in the forward-looking statements as a result of
certain factors including, but not limited to, those discussed in "Risk
Factors" and elsewhere in this Prospectus. The Company disclaims 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
Covad is a leading packet-based CLEC that provides dedicated high-speed
digital communications services using DSL technology to 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 LANs to improve employee productivity and reduce operating costs. The
Company believes its services offer a superior value proposition as compared
to currently available high-speed Internet and RLAN access alternatives. The
Company's services are provided over standard copper telephone lines at speeds
of up to 1.5 Mbps, approximately 25 times the speed available through a 56.6
Kbps modem. The Company currently has installed over 4,000 DSL lines and
received orders for its services from approximately 100 ISP and enterprise
customers, including Cisco Systems, Concentric Network, Epoch Networks,
Oracle, PeopleSoft, Stanford University, Verio and Whole Earth Networks.
The Company introduced its services in the San Francisco Bay Area in
December 1997. The Company launched its services in the Los Angeles, New York
and Boston metropolitan areas in August 1998 and in the Washington, D.C. and
Seattle metropolitan areas in December 1998. In March 1998, the Company raised
approximately $135 million through the issuance of the Senior Discount Notes
to fund the deployment of its networks in the Initial Regions. As a result of
the strong market demand for high-speed digital communications services, the
Company has decided to increase to 22 the number of regions in which it plans
to build its networks and offer its services. The Company estimates that when
complete, its networks in these 22 regions will enable the Company to provide
service to over 28 million homes and businesses in 28 of the top 50 MSAs in
the United States.
The Company recently entered into strategic relationships with AT&T,
NEXTLINK and Qwest. As part of these strategic relationships, the Company
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 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.
The Company believes that its business model offers attractive economics.
Through its use of DSL technology, the Company 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. Accordingly, the Company believes it can achieve
positive EBITDA with fewer customers than companies offering such alternative
technologies. See "Risk Factors--History and Continuation of Operating
Losses."
Industry Background
Growing Market Demand for High-Speed Digital Communications Bandwidth
High-speed connectivity has become important to small- and medium-sized
businesses due to the dramatic increase in Internet usage. According to IDC,
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
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with consumers has driven the rapid proliferation of the Internet as a
commercial medium, as businesses establish Web sites and corporate intranets
and extranets to expand their customer reach and improve their communications
efficiency. IDC 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 with
employees, customers and business partners more efficiently. 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 LANs have become
increasingly important to enterprises to enable employees to share
information, send e-mail, search databases and conduct business. The Company
believes that a large majority of personal computers used in enterprises are
connected to LANs. Enterprises are now seeking to extend this same high-speed
connectivity to employees accessing the LAN 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 businesses continue to increase their use of the Internet, intranets and
extranets, the Company expects the market size for both small- and medium-
sized business Internet access 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 LAN 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 LAN by low-speed analog lines.
Higher speed connections are available, including ISDN, Frame Relay and T1
lines, and this segment has recently experienced dramatic growth in the U.S.
However, these alternatives 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 ("DSP")
algorithms have made the deployment of DSL technology on a widespread basis
more economical, with equipment prices falling by up to 75% over the last two
years. The Company anticipates 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 existing alternative high-speed
digital communication 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, as such networks require a comparatively lower
initial fixed investment, and the subsequent variable investments in DSL
electronics are directly related to the number of paying customers.
In January 1998, a number of companies, including Intel, Compaq Computer
Corp., Microsoft Corp. and certain of the major ILECs, jointly announced the
formation of the Universal ADSL Working Group
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("UAWG"). The goal of UAWG is to publish a standard specification for a low-
cost, consumer oriented ADSL hardware and software solution. Since the Company
is a purchaser of ADSL equipment and a service provider, the Company has
joined the UAWG and supports its objectives. The Company believes that the
efforts of the UAWG will lead to lower cost and more standardized ADSL
hardware and software products. An initial draft of the specification was
approved in June 1998 and a draft standard was adopted in October 1998. Aimed
at consumers, the so-called G.lite specification has a maximum data throughput
rate of 1.5 Mbps incoming and 512 Kbps outgoing.
Impact of the Telecommunications Act of 1996
The passage of the 1996 Act created a legal framework for CLECs to provide
local analog and digital communications services in competition with the
ILECs. The 1996 Act eliminated a substantial barrier to entry for CLECs by
enabling them to leverage the existing infrastructure built by the ILECs,
which required a $200 billion investment by ILECs and ILEC ratepayers, rather
than constructing a competing infrastructure at significant cost. The 1996 Act
requires ILECs, among other things, to allow CLECs to lease copper lines on a
line by line basis, to collocate equipment, including DSL equipment, in the
ILECs' COs to connect to these lines, to lease access on the ILECs' inter-CO
fiber backbone to link the CLECs' equipment and to use the ILECs' own OSS to
place orders and access the ILECs' databases. The 1996 Act in particular
emphasized the need for competition-driven innovations in the deployment of
advanced telecommunications services, such as the Company's DSL services.
The Covad Solution
Covad was formed to capitalize on the substantial business opportunity
created by the growing demand for high-speed digital communications, the
commercial availability of low cost DSL technology and the passage of the 1996
Act. Key aspects of the Company's solution to provide high-speed digital
communications services include: (i) an attractive value proposition that
provides high-speed connections at similar or lower prices than alternative
high-speed technologies currently available to customers; (ii) a widely
available, always-connected, secure network that facilitates deployment of
Internet and intranet applications; and (iii) a management team experienced in
the data communications, telecommunications and personal computer industries.
Attractive Value Proposition. The Company offers higher bandwidth digital
connections than alternative services at similar or lower prices that do not
vary with usage. For business Internet users, the Company's high-end services
offer comparable bandwidth to T1 and Frame Relay circuits at approximately 25%
of the cost. For the RLAN market, the Company's 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.
The Company believes that many of its 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, the Company expects that it will offer G.lite compatible services at
prices comparable to prices offered by cable modem services today.
Widely Available, Always-Connected, Secure Network. The Company's strategy
of providing blanket coverage in each region it serves is designed to ensure
that the Company's services are available to the vast majority of its
customers' end-users. The Company's network provides 24-hour, always-on
connectivity, unlike ISDN lines and analog modems which require customers to
connect to the Internet or their LAN for each use. Also, because the Company
uses dedicated connections from each end-user to the ISP or enterprise
network, its customers can reduce the risk of unauthorized access.
Experienced Management Team. The Company's 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,
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Vice President of Sales, and Dhruv Khanna, Vice President, General Counsel and
Secretary (all of whom worked at Intel), Timothy Laehy, Chief Financial
Officer, Treasurer and Vice President, Finance (former Vice President of
Corporate Finance and Treasurer of Leasing Solutions, Inc.), Rex Cardinale,
Vice President of Engineering (former General Manager of the cc:Mail division
of Lotus Development Corporation), Catherine Hemmer, Vice 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),
Walter Pienkos, Vice President of Human Resources and Administration (former
Vice President of Administration at Netpower, Inc. and MIPS Computer Systems)
and Robert Roblin, 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). The
Company has also hired Regional General Managers to cover all 22 of its
regions who collectively have over 210 years of telecommunications service
experience.
Business Strategy
Covad's objective is to become the leading provider of DSL-based high-speed
digital communication services in each region it enters. The Company's Initial
Regions consist of San Francisco, Los Angeles, New York, Boston, Seattle and
Washington, D.C. The Company introduced its services in the San Francisco Bay
Area in December 1997, in the Los Angeles, New York and Boston regions in
August 1998 and in the Washington, D.C. and Seattle metropolitan areas in
December 1998. As a result of the strong market demand for high-speed digital
communications services, the Company has decided to increase to 22 the number
of regions in which it plans to build its networks and offer its services. The
key elements of the Company's strategy which it has deployed in the San
Francisco Bay Area and its other Initial Regions and which it plans to deploy
in each additional region it enters are as follows:
Secure CLEC Status and Sign Interconnection Agreements in the Top U.S.
Markets. To provide its services, the Company obtains CLEC status in each
state that it enters and signs interconnection agreements with the relevant
ILECs. To date, the Company is authorized under state law to operate as a CLEC
in 19 states, has pending applications in seven additional states and intends
to obtain authorization in the other states necessary to cover the Company's
22 target regions. In the aggregate, the Company's 22 existing and target
regions represent over 40% of the U.S. population. The Company has entered
into interconnection agreements with six different major ILECs in the majority
of the states covering the Company's 22 target markets and is negotiating
interconnection agreements with ILECs in the remaining states. The Company
believes it has gained a competitive advantage by rapidly securing CLEC status
and signing interconnection agreements in multiple regions.
Enter and Roll Out Service Rapidly in These Markets. The Company seeks to be
the first CLEC to enter and roll out service broadly in its target regions in
order to: (i) secure CO collocation space prior to competitors; (ii) secure
and retain customers before significant DSL competition arises; (iii) maintain
advantages over competitors through superior coverage and high customer
satisfaction; and (iv) build the largest volume and market share in order to
allow the Company to reduce the costs and prices of its services and, where it
is first to market, maintain its leadership position.
Provide Pervasive Coverage. The Company is pursuing a blanket coverage
strategy of providing service in a substantial majority of the COs in each
region that it enters since the Company's ISP customers desire to market their
Internet access services on a region-wide basis. Blanket coverage is also
important to the Company's 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, the Company believes its presence in
22 markets will allow it to better serve its ISP and enterprise customers
which are increasingly seeking a single supplier in multiple metropolitan
areas.
Focus on Packet Data Services. Although the Company is authorized to provide
both data and voice services, it is presently focusing exclusively on packet
data services and does not currently plan to offer analog
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voice services. The Company believes that it 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 ISPs and Enterprises that Can Provide a Large Number of
End-Users. The Company targets ISPs that can offer their end-users cost and
performance advantages for Internet access using the Company's services. Over
100 ISPs currently resell the Company's services. The Company's direct sales
force also specifically targets enterprises that it estimates to have over 500
existing ISDN or analog modem-based RLAN users. The Company believes it offers
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 it uses DSL technology,
a significant portion of the Company's capital expenditures are success-based.
The Company estimates that approximately 50% of its cumulative capital
expenditures over the next five years will be for DSL equipment that is
directly related to the Company's end-user subscription rate.
Establish Relationships with ISPs and Other Industry Participants. The
Company does not provide Internet access directly to any of its customers.
Instead, the Company provides connections to ISPs, which in turn offer high-
speed Internet access using the Company's network. In this way, the Company:
(i) carries the traffic of multiple ISPs in any region, increasing its volume
and reducing its costs; (ii) leverages its selling efforts through the sales
and support staff of these ISPs; (iii) offers ISPs a non-competitive transport
alternative, since the ILEC typically provides its own Internet access
services in competition with ISPs; and (iv) provides ISPs a high-speed service
offering to compete with cable-based Internet access.
The Company also believes that it is developing a service offering that will
be increasingly attractive to IXCs and other CLECs. As the Company rolls out
its network in 22 markets nationwide, it can increasingly serve as a single
packet network service provider to other telecommunications service companies
who seek to offer packet based services to their customers. Also, the Company
can carry the traffic of multiple IXC and CLEC partners 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 ILEC in every region in which they would like
to offer service. Finally, since the Company's networks serve predominately
small business and residential end-users, these networks are complementary to
the large business focused networks of these IXCs and other CLECs. The Company
believes that these are some of the reasons AT&T, NEXTLINK and Qwest have
entered into relationships with the Company. The Company is currently
discussing relationships with other IXCs and other CLECs and intends to
continue these discussions as its networks are deployed in its 22 target
markets.
Provide a Superior Product and Service Solution. The Company believes that
it can build a significant competitive position by providing a comprehensive
product and service solution to its customers. The Company undertakes to
provide all of the necessary product and service elements required to
establish and maintain digital services in its target markets including: (i)
managing the ILEC's installation and testing of copper lines used for its
service; (ii) installing any in-building wiring required to initiate service;
(iii) selling, configuring and installing the DSL modem required at each end-
user site; (iv) providing 24 hour, seven days a week ("24x7") monitoring of
each end-user line; and (v) designing and provisioning an enterprise's overall
RLAN network including equipment selection, programming and troubleshooting.
Covad's Product and Service Offerings
Covad currently offers six flat rate digital services under the TeleSpeed
brand to connect its customers' end-users to Covad's RDCs. In addition, ISP
and enterprise customers may purchase backhaul services from the Company to
connect their facilities to Covad's RDC.
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TeleSpeed Services
The Company's TeleSpeed services connect individual end-users on
conventional copper lines to Covad DSL equipment in their serving CO and from
there to the Covad packet digital network serving that metropolitan area. An
ILEC's infrastructure consists of numerous COs which are connected by a fiber
optic backbone to a regional office that routes local and long distance
traffic. Each CO collects the individual copper lines from end- users'
premises in the neighborhood.
The six TeleSpeed services are TeleSpeed 144, TeleSpeed 192, TeleSpeed 384,
TeleSpeed 768, TeleSpeed 1.1 and TeleSpeed 1.5. The chart below compares the
pricing, performance and markets for each of these services as of December 31,
1998. The particular TeleSpeed service available to an end-user depends on the
user's distance to the CO. The Company believes that substantially all of its
potential end-users in its target markets can be served with one of the
Company's services. The Company estimates that approximately 70% of end-users
are within 18,000 feet of a CO and can be served by at least the Company's
TeleSpeed 384 service. The Company also believes at least a majority of
potential end-users will be able to obtain the Company's highest speed service
offering. However, the specific number of potential users for the higher
speeds will vary by CO and by region and will be affected by line quality.
<TABLE>
<CAPTION>
Speed
Speed to From Price* Range**
Service End-user End-User ($/month) (feet) Market/Usage
- ------------------------ -------- -------- --------- ------- ------------------------------------
<S> <C> <C> <C> <C> <C>
TeleSpeed 144........... 144 Kbps 144 Kbps $ 90 35,000 ISDN replacement, non-standard lines
TeleSpeed 192........... 192 Kbps 192 Kbps $ 90 18,000 RLAN, business Internet
TeleSpeed 384........... 384 Kbps 384 Kbps $125 18,000 RLAN, business Internet
TeleSpeed 768........... 768 Kbps 768 Kbps $160 13,500 Business Internet
TeleSpeed 1.1........... 1.1 Mbps 1.1 Mbps $195 12,000 Business Internet
TeleSpeed 1.5........... 1.5 Mbps 384 Kbps $195 15,000 High-speed Web access
</TABLE>
- --------
* Current list prices for Boston, Los Angeles, New York, Washington, D.C. and
the San Francisco Bay Area. List prices are lower in Seattle and for high
volume customers and may be different in other regions. See "Risk Factors--
Unproven Business Model and Pricing Sensitivity" for a discussion of the
risks associated with the Company's ability to sustain current price levels
in the future.
**Estimated maximum distance from the end-user to the CO.
TeleSpeed 144. Covad's 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 ILEC when per-minute usage charges
apply. It is also the service that Covad offers on copper lines that are
either too long to carry the Company's higher speed services or are served by
DLCs or similar equipment where a continuous copper connection is not
available from the end-user site to the CO.
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. The Company expects TeleSpeed 192 to be deployed within the RLAN
market.
TeleSpeed 384. This service provides three to six times the performance of
ISDN at similar price points to heavily-used ISDN lines. The Company expects
TeleSpeed 384 to be deployed within the RLAN market.
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 the
Company estimates 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.
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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 the
Company estimates 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 the Company's only 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.
Backhaul Services
Covad provides two backhaul services from its regional network to an ISP 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. Covad's 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. The
price is $975 per month.
Covad DS3. The Company's DS3 backhaul service is targeted to large ISPs and
enterprises with up to 1,000 end-users. The service utilizes an ATM protocol
that efficiently handles the high data rates involved and operates at up to 45
Mbps. The price is $4,000 per month.
Activation Services
In addition to monthly service charges, Covad has a one-time activation
charge of $325 for ISP and RLAN end-users. The Company also charges $2,500 for
DS1 and $7,500 for DS3 activation. Customers must also purchase a DSL modem,
currently $399 to $600, from the Company or a third party for each end-user of
the TeleSpeed 144 service, or from the Company for $400 to $550 for higher
speed TeleSpeed services. Fees and charges described herein are subject to
change.
Covad's Regional Rollout
As part of the Company's strategy to become a leading provider of DSL high-
speed digital communications services in the U.S., the Company intends to
build networks and offer services in 22 regions. The Company introduced its
services in the San Francisco Bay Area in December 1997, in the Los Angeles,
New York and Boston metropolitan areas in August 1998 and in the Washington,
D.C. and Seattle metropolitan areas in December 1998. As a result of the
strong market demand for high-speed digital communications services, the
Company has increased its target markets to the following 22 regions:
<TABLE>
<CAPTION>
West Central East
------------- ----------- ----------------
<S> <C> <C>
Los Angeles Austin Atlanta
Phoenix Chicago Baltimore
Portland Dallas Boston
Sacramento Denver Miami
San Diego Detroit New York
San Francisco Houston Philadelphia
Seattle Minneapolis Raleigh
Washington, D.C.
</TABLE>
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Customers
The Company offers its services to ISPs 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 the Company
estimates that 34,000 are in the Company's Initial Regions and approximately
71,000 are in all of the Company's 22 targeted regions. Covad has entered into
service agreements with more than 200 ISP and enterprise customers. The Company
currently has over 4,000 end-user lines in operation with approximately 100 ISP
and enterprise customers, and the Company is in the initial stages of
provisioning backhaul service and end-user lines with approximately 100
additional ISP and enterprise customers located principally in the regions
recently entered into by the Company. The following is a list of selected ISP
and enterprise customers:
<TABLE>
<CAPTION>
Selected ISP Customers Selected Enterprise Customers
---------------------- -----------------------------
<S> <C>
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 Inc.
Verio Inc. Tandem Computers
Whole Earth Networks WebTV
</TABLE>
The Company's agreements with ISPs generally have terms of one year and
provide for cooperative advertising of the TeleSpeed brand. The agreements are
nonexclusive and do not require the ISP to have a minimum number of TeleSpeed
users. See "Risk Factors--Dependence Upon Indirect Sales Channels."
The Company's practice with respect to its 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 the Company's 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 the
Company's service to additional end users has taken at least six months, and
has generally taken longer than the Company originally expected. As of December
31, 1998, substantially all of the Company's enterprise customers had not yet
rolled out the Company's services broadly to their employees, and it is not
certain when such rollouts will occur, if at all. The Company will not receive
significant revenue from an enterprise customer until and unless these rollouts
occur. During the lengthy sales cycle for an enterprise customer, the Company
incurs significant expenses in advance of the receipt of revenues. Therefore,
any continued or ongoing failure for any reason of enterprise customers to roll
out the Company's services will have a material adverse effect on the Company's
business, prospects, operating results and financial condition. See "Risk
Factors--Lengthy Sales Cycles for Enterprise Customers."
Sales and Marketing
Business and Consumer Internet. For the business and consumer Internet access
markets, the Company sells its service to ISPs that combine the Company's lines
with their Internet access services and resell the combination to their
existing and new end-users. The Company addresses these markets through sales
and marketing personnel dedicated to the ISP sales channel. The Company
supplements its sales efforts to ISPs through training programs and marketing
programs that include promotions and sales incentives designed to encourage the
ISPs to sell the Company's services instead of those of its competitors. As of
December 31, 1998,
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the Company had more than 100 ISP customers with their own sales personnel
marketing Internet services. See "Risk Factors--Dependence Upon Indirect Sales
Channels."
Remote LAN. The Company markets its 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 deals directly with the
chief information officer and the telecommunications manager responsible for
remote access within an enterprise. The Company augments its sales efforts to
its RLAN customers through partnerships with value added resellers, including
systems integrators that can offer the Company's TeleSpeed service as part of
a complete work-at-home solution to businesses.
Third Party Relationships. A key element of the Company's strategy is to
enter into relationships with leading telecommunications companies, including
CLECs and IXCs, in which those companies resell the Company's TeleSpeed
services to their customers. For example, the Company recently entered into
commercial agreements with each of AT&T, NEXTLINK and Qwest providing for the
purchase, marketing and resale of the Company's services, primarily to their
small business and enterprise customers. The Company believes that these
indirect sales channels will enable the Company to penetrate its target
markets more rapidly and eventually will generate the majority of sales of the
Company's services. See "Risk Factors--Dependence Upon Indirect Sales
Channels."
The Company is also pursuing several types of joint marketing arrangements
with its ISP and enterprise customers. For example, the Company provides its
ISP customers with market development funds for the promotion of the TeleSpeed
service. In addition, certain of the Company's equipment suppliers have
promoted the Company's services through seminars to corporate communications
managers in the San Francisco Bay Area. The Company also supports its 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
ISPs 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
its TeleSpeed service, the Company emphasizes a one-stop total service
solution for its customers. This service solution includes: customer
installation, end-user line installation, end-user premises wiring and modem
configuration, ongoing network monitoring, customer reporting and customer
service and technical support.
Customer Installation. The Company works with its ISP and enterprise
customers to establish all required connectivity and configuration of the
backhaul connection from the customer to Covad's network. The Company orders
the backhaul circuit for the customer, tests the installed circuit, assists
the customer in configuring the router or switch that terminates the backhaul
circuit and monitors this circuit from the NOC.
End-User Line Installation. The Company orders all end-user connections from
the ILECs, monitors the ILECs' performance, tests the installed lines and
monitors the end-user lines from the NOC.
End-User Premises Wiring and Modem Configuration. The Company uses its own
and subcontracted installation crews and trucks to install any required inside
wiring at each end-user site. The Company's installation crews also configure
and install end-user modems with information specific to each ISP and
enterprise.
Network Monitoring. The Company monitors its network from the NOC on a
continuous basis, which often enables the correction of potential network
problems before a customer or end-user is affected. The
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<PAGE>
Company has also developed network capability to provide ISP and enterprise
customers direct monitoring access of their end-users for more efficient
monitoring of their own network performance.
Customer Reporting. The Company communicates regularly with its customers
about the status of their end-users. The Company also operates a toll-free
customer care help line. Additionally, the Company provides Web-based tools to
allow individual ISPs 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 the Company on an ongoing
basis.
Customer Service and Technical Support. The Company provides 24x7 service
and technical support to its ISP customers and enterprise communications
managers. The ISP and communications manager serve as the initial contact for
service and technical support with the Company providing the second level of
support. By avoiding the higher cost of providing direct end-user support, the
Company believes it can grow its customer base more rapidly with lower
customer support costs.
Network Architecture and Technology
The key design principles of the Covad 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. The Covad network is designed to provide
enhanced security to ensure secure availability of all internal applications
and information for remote locations. The Company's 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 the Company's customers to safely transmit sensitive information and
applications over the Company's TeleSpeed lines.
Consistent and Scalable Performance. The Company believes 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, the Company designed its network for scalability and consistent
performance to all users as the network grows. The Company has designed a
"star topology" network similar to the most popular LAN 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. The Company also uses Asynchronous Transfer Mode ("ATM") equipment in
its 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 "always-on," they can also always be monitored. The Company
has visibility from the ISP or enterprise site across the network and into the
end-user's home or business. Because its network is centrally managed, the
Company can identify and dynamically enhance network quality, service and
performance and address network problems promptly.
The primary components of the Company's network are the NOC, RDCs, its high-
speed private metropolitan networks, CO collocation spaces (including DSLAMs),
copper telephone lines and DSL modems.
NOC. The entire Covad network is managed from the NOC. The Company provides
end-to-end network management using advanced network management tools on a
24x7 basis, which enhances its ability to address performance or connectivity
issues before they affect the end-user experience. From the NOC, the Company
can monitor the equipment and circuits in each metropolitan network (including
the ATM equipment), each CO
48
<PAGE>
(including the DSLAMs) and individual end-user lines (including the DSL
modems). Currently, the NOC is collocated with the Company's San Francisco Bay
Area RDC. See "Risk Factors--Risk of System Failure."
RDCs. The RDCs act as service hubs for each metropolitan area the Company
enters. Data and network management traffic from each CO is collected at the
RDC and switched to the Company's NOC. The Company designs the RDC for high
availability including battery backup power, redundant equipment and active
network monitoring.
Private Metropolitan Network. The Company operates its own private
metropolitan network in each region that it enters. The network consists of
high-speed ATM communications circuits that the Company leases to connect its
RDCs, its equipment in individual COs and its enterprise and ISP customers.
This network operates at a speed of 45 to 155 Mbps.
Collocation Spaces. Through its interconnection agreements with the ILECs,
the Company seeks to secure collocation space in every CO where it desires to
offer service. These collocation spaces are designed to offer the same high
reliability and availability standards as the ILEC's other CO space. The
Company requires access to these collocation spaces for its equipment and for
persons employed by, or under contract with, the Company. The Company places
DSLAMs in its collocation spaces to provide the high-speed DSL signals on each
copper line to its end-users. The Company expects to deploy 40 to 250 CO
spaces in any metropolitan area that it enters. Currently, the Company has
approximately 165 CO spaces operational. In addition, the Company has a
significant number of additional spaces under construction as well as other
spaces on order from various ILECs. In December 1998, the Company entered into
a professional service arrangement with Lucent Technologies to augment and
accelerate its ability to deploy its collocation facilities.
Copper Telephone Lines. The Company leases the copper telephone lines
running to end-users from the ILEC under terms specified in its
interconnection agreements. The Company leases lines that, in numerous cases,
must be specially conditioned by the ILEC to carry digital signals, usually at
an additional charge relative to that for voice grade copper lines. The price
the Company is 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. The Company buys its DSL modems from
its suppliers for resale to its ISP or enterprise customers for use by their
end-users. The Company configures and installs these modems along with any
required on-site wiring needed to connect the modem to the copper line leased
from the ILEC. Currently, the DSL modem and DSLAM equipment used must come
from the same vendor for all services, except the equipment used in the
Company's TeleSpeed 144 services, since there are not yet interoperability
standards for the equipment used in the Company's higher-speed services.
The Company is also pursuing a program of ongoing network development. The
Company's 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 the Covad network and to facilitate
the development of network applications by third parties that will increase
the use of the Company's network. See "Risk Factors--Unproven Network
Scalability and Speed."
Competition
The markets for business and consumer Internet transport and RLAN access
services are intensely competitive and the Company expects that such markets
will become increasingly competitive in the future. The Company's most
immediate potential competitors are the ILECs, CMSPs, IXCs, FCLECs, ISPs,
OSPs, WSDSPs and other CLECs. Many of these competitors are offering, or may
soon offer, technologies and services that directly compete with some or all
of the Company's high-speed digital services. Such technologies include ISDN,
DSL, wireless data and cable modems. The principal bases of competition in the
Company's markets include transmission speed, reliability of service, breadth
of service availability, price/performance, network security, ease of access
and use, content bundling, customer support, brand recognition, operating
experience, capital
49
<PAGE>
availability and exclusive contracts. The Company believes that it compares
unfavorably with its competitors with regard to, among other things, brand
recognition, operating experience, exclusive contracts, and capital
availability. Many of the Company's competitors and potential competitors have
substantially greater resources than the Company and there can be no assurance
that the Company will be able to compete effectively in its target markets.
Incumbent Local Exchange Carriers. All of the largest ILECs present in the
Company's target markets are conducting technical and/or market trials or have
entered into commercial deployment of the DSL-based services. The Company
recognizes that each ILEC has the potential to quickly overcome many of the
issues that the Company believes have slowed wide deployment of DSL services
by ILECs in the past. The ILECs currently represent and will in the future
increasingly represent strong competition in all of the Company's target
service areas. The ILECs 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 ILECs have aggressively priced
their consumer ADSL services as low as $30-$40 per month, placing pricing
pressure on the Company's TeleSpeed services. The ILECs are in a position to
offer service from COs where the Company is unable to secure collocation space
and offer service because of asserted or actual space restrictions, which
provides the ILECs with a potential competitive advantage compared with the
Company. Accordingly, the Company may be unable to compete successfully
against the ILECs, and any failure to do so would materially and adversely
affect the Company's business, prospects, operating results and financial
condition. See "Risk Factors--Intense Competition."
Cable Modem Service Providers. CMSPs 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 the Company provides. They also offer these services at lower
price points than the Company's TeleSpeed services and target residential
consumers, as well as business customers. They achieve these lower price
points in part by offering a consumer grade of service, which shares the
bandwidth available on the cable network among multiple end-users. This
architecture is well-suited to compete with the Company's consumer Internet
market but is less well-suited to the Company's markets for business Internet
access and RLAN access where guaranteed bandwidth, symmetric upstream and
downstream bandwidth and network security issues are more important than in
the consumer market. In addition, different regions within a metropolitan area
may be served by different CMSPs, 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 the Company believes is significantly
more expensive and time-consuming than the deployment of DSL-based networks.
Actual or prospective CMSP competition may have a significant negative effect
on the ability of the Company to secure customers and may create downward
pressure on the prices the Company can charge for its services.
National Long Distance Carriers. IXCs, such as AT&T, Sprint, MCI and Qwest
have deployed large-scale Internet access networks and ATM networks, sell
connectivity to businesses and residential customers, and have high brand rec-
ognition. They also have interconnection agreements with many of the ILECs and
a number of collocation spaces from which they are currently offering or could
begin to offer competitive DSL services.
Fiber-Based CLECs. Companies such as Teleport Communications Group, Inc.
(TCG) (acquired by AT&T), Brooks Fiber Properties, Inc. (acquired by WorldCom)
and MFS (acquired by 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
ILECs pursuant to which they have acquired collocation space in many markets
targeted by Covad. 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.
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Internet Service Providers. ISPs such as BBN (acquired by GTE), UUNET
Technologies (acquired by 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
ISPs such as UUNET Technologies in California and New York, HarvardNet Inc.
and InterAccess have begun offering DSL-based services. To the extent the
Company is not able to recruit ISPs as customers for its service, ISPs could
become DSL service providers competitive with the Company.
Online Service Providers. OSPs include companies such as America Online
("AOL"), 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 OSPs
have developed their own access networks for modem connections. If these OSPs
were to extend their access networks to DSL or other high-speed service
technologies, they would become competitors of the Company.
Wireless and Satellite Data Service Providers. WSDSPs are developing
wireless and satellite-based Internet connectivity. The Company 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.
The Company 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 CLECs. Other companies such as Rhythms NetConnections and NorthPoint
Communications offer high-speed digital services using a business strategy
similar to that of the Company. The 1996 Act specifically grants any and all
CLECs the right to negotiate interconnection agreements with the ILEC.
Further, the 1996 Act allows CLECs to enter into interconnection agreements
which are identical in all respects to those of the Company. The Company has
already had an interconnection agreement copied in this manner.
As a first mover in selected markets that it enters, the Company seeks 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. The Company
may not be able to achieve these benefits if substantial competition from any
of the foregoing competitors exists or develops in the Company's markets.
Interconnection Agreements with ILECs
A critical aspect of the Company's business is its interconnection
agreements with the ILECs. These agreements cover a number of aspects
including: (i) the price the Company pays to lease access to the ILEC's
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copper lines; (ii) the special conditioning the ILEC provides on certain of
these lines to enable the transmission of DSL signals; (iii) the price and
terms for collocation of Company equipment in the ILEC's COs; (iv) the price
paid by the Company and access the Company has to the ILEC's transport
facilities; (v) the ability of the Company to access conduits and other rights
of way the ILEC has to construct its own network facilities; (vi) the OSS and
interfaces that the Company can use to place orders and trouble reports and
monitor the ILEC's response to Company requests; (vii) the dispute resolution
process the ILEC and the Company use to resolve disagreements on the terms of
the interconnection contract; and (viii) the term of the interconnection
agreement, its transferability to successors, its liability limits and other
general aspects of the ILEC and Company relationship.
To date, the Company has entered into interconnection agreements with six
different major ILECs in the majority of the states covering the Company's
target markets. ILECs do not in many cases agree to the Company's requested
provisions in interconnection agreements and the Company has not consistently
prevailed in obtaining all of its desired provisions in such agreements either
voluntarily or through the interconnection arbitration process. There can be
no guarantee that the Company will be able to continue to sign interconnection
agreements with existing or other ILECs. The Company is currently negotiating
agreements with several ILECs in its 22 announced regions which are necessary
before the Company can expand its services into these metropolitan areas
served by such ILECs. The ILECs are also permitting CLECs to adopt previously
signed interconnection agreements. In certain instances, the Company has
adopted the interconnection agreement of another CLEC. Other CLECs have also
adopted the same or modified versions of the Company's interconnection
agreements, and may continue to do so in the future.
The Company's interconnection agreements have a maximum term of three years,
requiring the Company to renegotiate its existing agreements in the future.
Although the Company expects to renew its interconnection agreements and
believes the 1996 Act limits the ability of ILECs not to renew such
agreements, there can be no assurance that existing or new agreements will be
extended or renegotiated on terms favorable to the Company. Additionally, the
Company's interconnection agreements are subject to interpretation by both
parties and there may arise differences in interpretation that cannot be
resolved on favorable terms to the Company. Finally the interconnection
agreements are subject to state commission, FCC and judicial oversight. There
can be no assurance that these bodies will not modify the terms or prices of
the Company's interconnection agreements in ways that adversely affect the
Company's business, prospects, operating results and financial condition.
Government Regulation
Overview. The Company's services are subject to a variety of federal
regulations. With respect to certain activities and for certain purposes, the
Company has submitted its operations to the jurisdiction of state and local
authorities who may also assert more extensive jurisdiction over the
facilities and services of the Company. The FCC has jurisdiction over all
services and facilities of the Company to the extent that the Company provides
interstate and international services. To the extent the Company provides
identifiable intrastate services, the Company's services and facilities are
subject to state regulations. In addition, local municipal government
authorities also assert jurisdiction over the Company's facilities and
operations. The jurisdictional reach of the various federal, state and local
authorities is subject to ongoing controversy and judicial review, and the
Company cannot predict the outcome of such review.
Federal Regulation. The Company's provision of its services must comply with
the requirements of the Communications Act of 1934, as amended by the 1996
Act, as well as the FCC's regulations under the statute. The 1996 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 Act.
Among other things, the 1996 Act removes barriers to entry in the local
telecommunications market by preempting state and local laws that are barriers
to competition and by requiring ILECs to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, IXCs and CLECs such as the Company.
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Regulations promulgated by the FCC under the 1996 Act specify in greater
detail the requirements of the 1996 Act imposed on the ILECs, among other
things, to open their networks to competition by providing competitors
interconnection, collocation space, access to UNEs, retail services at
wholesale rates and nondiscriminatory access to telephone poles, ducts,
conduits, and rights-of-way. As a result of these changes, companies such as
Covad are now able to interconnect with the ILECs in order to provide local
telephone exchange services and to use portions of the ILECs' existing network
to offer new and innovative services such as those the Company is currently
offering. Numerous parties have appealed certain aspects of these regulations.
The appeals have been consolidated and have been reviewed by the U.S. Court of
Appeals for the Eighth Circuit, which has overruled certain of the FCC's
pricing, UNE combination, nondiscrimination and other regulations and upheld
others. The Eighth Circuit Court's ruling has been appealed to the U.S.
Supreme Court which has agreed to accept the case for review. Covad has
entered into competitive interconnection agreements using the federal
guidelines established in the FCC's interconnection order, which agreements
may be modified to conform to the Court of Appeals rulings and any subsequent
rulings of the U.S. Supreme Court.
The 1996 Act also allows the RBOCs to enter the long distance market within
their own local service regions upon meeting certain requirements. 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 the Company receives from each of the RBOCs. The December 31, 1997
Ruling declared that the portions of the 1996 Act subjecting RBOCs to a prior
FCC approval process in order to provide interLATA services within their
respective regions are unconstitutional. On September 4, 1998, the United
States Court of Appeals for the Fifth Circuit affirmed the constitutionality
of the state and FCC approval process for RBOC in-region long distance entry.
This decision was appealed to the U.S. Supreme Court, and in January 1999 the
U.S. Supreme Court declined to hear the appeal.
In addition, the 1996 Act provides relief from the earnings restrictions and
price controls that have governed the local telephone business for many years.
ILEC tariff filings at the FCC have been subjected to increasingly less
regulatory review. However, precisely when and to what extent the ILECs will
secure pricing flexibility or other regulatory freedom for their services is
uncertain. For example, under the 1996 Act, the FCC is considering eliminating
certain regulations that apply to the ILEC's provision of services that are
competitive with those of the Company. The timing and the extent of regulatory
freedom and pricing flexibility and regulatory freedom granted to the ILECs
will affect the competition the Company faces from the ILECs' competitive
services.
Further, the 1996 Act provides the FCC with the authority to forbear from
regulating entities such as the Company who are classified as "non-dominant"
carriers. The FCC has exercised its forbearance authority. As a result, the
Company is not obligated to obtain prior certificate approval from the FCC for
its interstate services or file tariffs for such services. The Company has
determined not to file tariffs for its interstate services. The Company
provides its interstate services to its customers on the basis of contracts
rather than tariffs. The Company believes that it is unlikely that the FCC
will require the Company to file tariffs for its interstate services in the
future.
Finally, the 1996 Act allows the FCC to take explicit regulatory action in
order to encourage the deployment of advanced services to all Americans. In
August 1998 the FCC released an Order and a Notice of Proposed Rulemaking
proposing additional regulations it believes are required to ensure this goal.
These rules would place conditions on the ability of the ILECs to offer DSL
services on an unregulated basis through a separate affiliate. In addition,
the FCC has proposed rules that would provide the Company an enhanced ability
to gain collocation space in ILEC COs. While the Company believes that these
proposed rules are advantageous to the Company, there can be no guarantee that
the actual regulations, when and if implemented, will enhance the Company's
ability to compete.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with ILECs, the prospective entry of
the RBOCs into the in-region long distance business and grant of regulatory
freedom and pricing flexibility to the ILECs, could have a material adverse
impact on the Company's business prospects, operating results and financial
condition.
53
<PAGE>
State Regulation. To the extent the Company provides identifiable intrastate
services or has otherwise submitted itself to the jurisdiction of the relevant
state telecommunications regulatory commissions, the Company is 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 Act. To date, the Company is
authorized under state law to operate as a CLEC in 19 states, has pending
applications in seven additional states, and intends to obtain authorization
in the other states necessary to cover the Company's 22 target regions. The
Company has pending two arbitration proceedings in two different states for
interconnection arrangements with the relevant ILECs. The Company has
concluded arbitration proceedings in a number of states by entering into
interconnection agreements with the relevant ILECs. The Company has filed
tariffs in certain states for intrastate services as required by state law or
regulation. The Company is also subject to periodic financial and other
reporting requirements of these states with respect to its intrastate
services.
The different state commissions have various proceedings to determine the
rates, charges and terms and conditions for UNEs, as well as the discount for
wholesale services purchased by the Company from the relevant ILEC. The rates
set forth in the Company's 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 UNEs as
unbundled loops and interoffice transport. The Company has participated in UNE
rate proceedings in the states of California and Washington in an effort to
reduce these rates. Any state commission rate determinations to increase UNE
rates could have a material adverse effect on the Company's business,
prospects, operating results and financial condition.
The applicability of the various state regulations on the Company's business
and compliance requirements will be further affected to the extent to which
the Company's services are determined to be intrastate services.
Jurisdictional determinations of the Company's services as intrastate services
could have a material adverse effect on the Company's business, prospects,
operating results and financial condition.
Local Government Regulation. The Company in certain instances may be
required to obtain various permits and authorizations from municipalities in
which it operates its own facilities. Whether various actions of local
governments over the activities of telecommunications carriers such as the
Company, including requiring payment of franchise fees or other surcharges,
pose barriers to entry for CLECs which may be preempted by the FCC is the
subject of litigation. Although the Company relies primarily on the UNEs of
the ILECs, in certain instances the Company deploys its 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 the Company's business,
prospects, operating results and financial condition.
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 Act or any final regulations adopted pursuant to
the 1996 Act on the Company or its business cannot be determined at this time
but may well be adverse to the Company's interests. The Company cannot predict
the impact, if any, that future regulation or regulatory changes may have on
its business and there can be no assurance that such future regulation or
regulatory changes will not have a material adverse effect on the Company's
business, prospects, operating results and financial condition. See "Risk
Factors--Uncertain Availability of Collocation Space and Dependence on ILECs
to Provide Collocation Space and Collocation Facilities" and "--Government
Regulation and Current Industry Litigation."
Intellectual Property
The Company regards its products, services and technology as proprietary and
attempts to protect it with copyrights, trademarks, trade secret laws,
restrictions on disclosure and other methods. There can be no assurance
54
<PAGE>
these methods will be sufficient to protect the Company's technology. The
Company also generally enters into confidentiality or license agreements with
its employees and consultants, and generally controls access to and
distribution of its documentation and other proprietary information. Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use the Company's products, services or technology without
authorization, or to develop similar technology independently. Currently the
Company has five patent applications and intends to prepare additional
applications and to seek patent protection for its systems and services to the
extent possible. There is no assurance that the Company will obtain any issued
patents or that any such patents would protect the Company's 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, and the
global nature of the Internet makes it virtually impossible to control the
ultimate destination of the Company's proprietary information. There can be no
assurance that the steps taken by the Company will prevent misappropriation or
infringement of its technology. In addition, litigation may be necessary in
the future to enforce the Company's intellectual property rights, to protect
the Company's 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
the Company's business, prospects, operating results and financial condition.
Employees
As of December 31, 1998, the Company had 335 employees (excluding temporary
personnel and consultants), employed in engineering, sales, marketing,
customer support and related activities, and general and administrative
functions. None of the Company's employees is represented by a labor union,
and the Company considers its relations with its employees to be good. The
Company's ability to achieve its financial and operational objectives depends
in large part upon the continued service of its senior management and key
technical, sales, marketing and managerial personnel, and its continuing
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
The Company maintains a Board of Advisors and conducts meetings of this
advisory group for two days each quarter. The Board of Advisors gives the
Company guidance on issues such as developments in communications equipment
technology, network design strategy, regulatory matters, the competitive
landscape, marketing of the Company's 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 the Company. Below is a list of
the Company's 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 ISP in California.
Duncan Davidson is a founder of the Company 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 (PACIT).
Robert Hawk is a member of the Company's 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.
55
<PAGE>
Daniel Lynch is a member of the Company's Board of Directors. For a
description of his professional background, see "Management--Directors and
Executive Officers."
Frank Marshall is a member of the Company's 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.
Facilities
The Company is 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. The Company also leases office space in
each of its Initial Regions. The Company is in the process of acquiring office
space for regional headquarters for each of its additional target regions. In
addition, the Company's San Francisco Bay Area RDC consists of approximately
2,000 square feet and is located in San Jose, California, which the Company
occupies under a ten-year lease with two five-year renewal options. Currently,
and until a permanent location is secured, the Company utilizes a portion of
the San Francisco Bay Area RDC space to operate its NOC. The Company also
leases collocation space in COs from the ILEC in each region that it operates
or plans to operate under the terms of its 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 the Company's
collocation facilities are subject to the terms of its interconnection
agreements which expire on or before March 2001. The Company will increase its
collocation space as it expands its network in the San Francisco Bay Area and
other regions.
Legal Proceedings
The Company is engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with multiple ILECs. These negotiations,
arbitrations and proceedings concern the ILECs' denial of physical collocation
space to the Company in certain COs, the cost and delivery of collocation
spaces, the delivery of transmission facilities and telephone lines, billing
issues and other operational issues. For example, the Company is currently
involved in commercial arbitration proceedings with Pacific Bell and U S WEST
Communications over these issues. The Company has also filed a lawsuit against
Pacific Bell in the Federal District Court in the Northern District of
California. The Company is pursuing a variety of contract, tort, antitrust and
other claims, such as violations of the Telecommunications Act in these
proceedings. In November 1998, the Company prevailed in its commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with Covad and failed to
act in good faith on multiple counts. The arbitration panel ruled in favor of
awarding Covad direct damages, as well as attorneys fees and costs of the
arbitration. Failure to resolve the various legal disputes and controversies
between the Company and the various ILECs without excessive delay and cost and
in a manner that is favorable to the Company 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 1996 Act, the
interpretation of CLEC interconnection agreements in general and the Company's
interconnection agreements in particular. In some cases, the Company may be
deemed to be bound by the results of ongoing proceedings of these bodies or
the legal outcomes of other contested interconnection agreements that are
similar to the Company's agreements. The results of any of these proceedings
could have a material adverse effect on the Company's business, prospects,
operating results and financial condition.
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<PAGE>
MANAGEMENT
Directors and Executive Officers
Set forth below are the names, ages, and positions of the directors and
executive officers of the Company. All directors hold office until their
successors are duly elected and qualified and all executive officers hold
office at the pleasure of the Board of Directors.
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<S> <C> <C>
Robert Knowling, Jr. ... 43 President, Chief Executive Officer and Director
Charles McMinn.......... 46 Chairman, Board of Directors
Timothy Laehy........... 42 Chief Financial Officer, Treasurer and Vice President, Finance
Rex Cardinale........... 46 Vice President, Engineering
Charles Haas............ 39 Vice President, Sales
Catherine Hemmer........ 40 Vice President, Operations
Dhruv Khanna............ 39 Vice President, General Counsel and Secretary
Walter Pienkos.......... 52 Vice President, Administration
Robert Roblin........... 46 Vice President, Marketing
Robert Hawk............. 59 Director
Henry Kressel........... 64 Director
Joseph Landy............ 37 Director
Daniel Lynch............ 57 Director
Frank Marshall.......... 51 Director
Rich Shapero............ 50 Director
</TABLE>
Robert Knowling, Jr. has served as the Company's President, Chief Executive
Officer and a member of the Company's 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., an
RBOC. 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 and 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, through November 1994. 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 a founder of the Company and has been the Chairman of the
Board of Directors since July 1998. He served as the Company's President,
Chief Executive Officer and a member of its 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.
57
<PAGE>
Timothy Laehy joined the Company in August 1997 as its Chief Financial
Officer, Treasurer and Vice President, Finance. Prior to joining the Company,
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 through 1991, Mr. Laehy served as senior associate at
Recovery Equity Partners, a private venture capital investment fund. From 1985
through 1990, he served in various capacities at Guarantee Acceptance Capital
Corporation, an investment bank, Liberty Mutual Insurance Company and Union
Carbide Corporation.
Rex Cardinale has served as the Company's Vice President, Engineering since
June 1997. 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 roles at Rolm Corporation.
Charles Haas is a founder of the Company. He served as the Company's Vice
President, Sales and Marketing from May 1997 until November 1998 and has
served as Vice President, Sales since that date. 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 the Company's Residential Broadband strategy for telephone and
satellite companies (DSL, Fiber-to-the-Curb and satellite modems).
Catherine Hemmer joined the Company in August 1998 as its Vice President,
Operations. From 1996 to August 1998, she was Vice President, Network
Reliability and Operations at U S WEST Communications, Inc., an RBOC. 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 a founder of the Company and has served as the Company's
Vice President, General Counsel and Secretary since October 1996. 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.
Walter S. Pienkos has served as the Company's Vice President, Administration
since May 1998. Prior to joining the Company, Mr. Pienkos was the Vice
President of Administration and a founder of NetPower, a Windows NT
workstation and server manufacturer, from February 1993 to May 1998. From 1987
through 1992, he served as Vice President of Administration at MIPS Computer
Systems. Prior to that time, he spent 15 years at Hewlett Packard in a variety
of management positions, most recently as Hewlett Packard's Corporate
Personnel Manager.
Robert Roblin has served as Vice President, Marketing at the Company since
November 1998. Prior to joining the Company, 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
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the Consumer Division of IBM 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 the Company's 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 the Company's 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 the Company's 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 the Company's 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 the Company's 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 the Company's 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.
59
<PAGE>
Classified Board
Effective upon the closing of this offering, the Board will be divided into
three classes, with the term of office of the first class (which will consist
of Messrs. Lynch and Shapero) to expire at the first annual meeting of
stockholders after this offering which is expected to occur in 2000; the term
of office of the second class (which will consist of Dr. Kressel and Messrs.
Marshall and McMinn) to expire at the second annual meeting of stockholders
after this offering; the term of office of the third class (which will consist
of Messrs. Hawk, Knowling and Landy) to expire at the third annual meeting of
stockholders after this offering. Thereafter, each such term will expire at
each third succeeding annual meeting of stockholders held after such meeting.
See "Description of Capital Stock--Antitakeover Effects of Certain Provisions
of Covad's Charter, Bylaws and Delaware Law."
Board Committees
In April 1998, the Board established an Audit Committee and a Compensation
Committee. The Audit Committee consists of Messrs. Landy and Lynch, both of
whom are outside directors of the Company. The Audit Committee recommends
engagement of the Company's independent auditors and approves the services
performed by such auditors and reviews and evaluates the Company's accounting
policies and its systems of internal accounting controls. The Compensation
Committee consists of Dr. Kressel and Mr. Shapero, both of whom are outside
directors of the Company. The Compensation Committee makes recommendations to
the Board of Directors in connection with matters of compensation, including
determining the compensation of the Company's executive officers.
Compensation Committee Interlocks and Insider Participation
No interlocking relationship exists between the Board or the Compensation
Committee and the board of directors or compensation committee of any other
company, nor has any such interlocking relationship existed in the past. Dr.
Kressel and Mr. Shapero are affiliated with Warburg and Crosspoint,
respectively, which are parties along with the Company to a Series C Preferred
Stock and Warrant Subscription Agreement dated February 23, 1998. See "Certain
Relationships and Related Transactions."
Director Compensation
Except for grants of stock options subject to vesting and restricted stock
subject to repurchase, directors of the Company generally do not receive
compensation for services provided as a director or committee member. The
Company does not pay additional amounts for committee participation or special
assignment of the Board of Directors, except for reimbursement of their
expenses in attending Board and committee meetings.
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<PAGE>
Executive Compensation
Summary Compensation Table
The following table sets forth certain information concerning compensation
during the years ended December 31, 1997 and 1998 of each person who served as
the Company's Chief Executive Officer or one of the four other most highly
compensated executive officers (collectively, the "Named Executive Officers")
during the year ended December 31, 1998.
<TABLE>
<CAPTION>
Annual Long-Term
Compensation Compensation
-------------------- ---------------------
Name and Principal Securities Underlying All Other
Position Year Salary Bonus Options/SARs Compensation(1)
- ------------------ ---- -------- -------- --------------------- ---------------
<S> <C> <C> <C> <C> <C>
Robert Knowling, Jr.,
President and Chief
Executive Officer(2)... 1998 180,768 750,000 2,100,000 196
1997 -- -- -- --
Charles McMinn,
Chairman, Board of
Directors(3)........... 1998 $167,019 $ 15,764 -- $286
1997 87,500(4) -- -- 126
Rex Cardinale, Vice
President, Engineering. 1998 144,451 15,764 -- 281
1997 73,233(4) -- -- 126
Charles Haas, Vice
President, Sales....... 1998 133,615 15,962 -- 269
1997 70,000(4) -- -- 126
Dhruv Khanna, Vice
President, General
Counsel and Secretary.. 1998 133,615 15,943 -- 269
1997 70,000(4) -- -- 126
Timothy Laehy, Chief
Financial Officer,
Treasurer and
Vice President,
Finance................ 1998 129,327 16,189 -- 269
1997 45,000(4) -- -- 126
</TABLE>
- --------
(1) The dollar amount in this column represents premium payments made by the
Company with respect to life insurance policies.
(2) Mr. Knowling assumed the offices of President and Chief Executive Officer
in July 1998.
(3) Mr. McMinn stepped down as President and Chief Executive Officer in July
1998 and assumed the position of Chairman of the Board.
(4) Based on annual salaries of $150,000 and $140,000 for Messrs. McMinn and
Cardinale, respectively, and $120,000 for Messrs. Haas, Khanna and Laehy.
Option Grants in Last Fiscal Year
The following table sets forth information regarding stock options granted
during the fiscal year ended December 31, 1998 to Robert Knowling, Jr.,
President and Chief Executive Officer of the Company. Stock options were not
granted to any other Named Executive Officer during the fiscal year ended
December 31, 1998.
Option Grants in Fiscal 1998
<TABLE>
<CAPTION>
Potential Realizable
Value at Assumed
Annual Rates
of Stock Price
Appreciation for
Individual Grants(1) Option Term ($)(3)
--------------------------------------------------- ---------------------
Number of Percent of Total
Securities Options Granted Exercise
Underlying to Employees in Price Per
Options Fiscal 1998 Share Expiration
Name Granted(#)(1) (%)(2) ($) 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) Such options become exercisable over a four-year period, with 12.5% of the
shares subject to such options vesting on the six month anniversary of the
grant date and the remainder vesting in 42 equal monthly
61
<PAGE>
installments. All such options have a term of eight years, subject to
earlier termination in certain situations related to termination of
employment. See "1997 Stock Plan."
(2) Based on an aggregate of 9,352,978 options to purchase Common Stock of the
Company granted during the fiscal year ended December 31, 1998 under the
Company's 1997 Stock Plan.
(3) Potential realizable values are net of exercise price, but before taxes
associated with exercise. Amounts represent hypothetical gains that could
be achieved for the options if exercised at the end of the option term.
The assumed 5% and 10% rates of stock price appreciation are provided in
accordance with the rules of the Securities and Exchange Commission and do
not represent the Company's estimate or projection of the future Common
Stock price.
Aggregated Option Exercises in Last Fiscal Year and Year-End Option Values
The following table sets forth the number and value of shares of Common
Stock underlying the unexercised options held by Robert Knowling, Jr.,
President and Chief Executive Officer of the Company. As of the fiscal year
ended December 31, 1998, no stock options have been granted to any other Named
Executive Officer.
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised
Underlying In-the-Money Options
Unexercised Options at at December 31,
December 31, 1998 1998(1)
------------------------- ---------------------
Name Exercisable Unexercisable Exercised Unexercised
- ---- ----------- ------------- --------- -----------
<S> <C> <C> <C> <C>
Robert Knowling, Jr. ........... -- 2,100,000 -- $35,700,000
</TABLE>
- --------
(1) Calculated on the basis of the fair market value of the Company's Common
Stock based on an initial public offering price of $18.00, less the
aggregate exercise price.
Employment Agreements and Change in Control Arrangements
The Company has entered into a written employment agreement with Robert
Knowling, Jr., the Company's Chief Executive Officer (the "Knowling Employment
Agreement"). The employment commencement date for Mr. Knowling was July 7,
1998. Pursuant to the Knowling Employment Agreement, Mr. Knowling receives
compensation in the form of an annual base salary of $400,000 and an annual
minimum bonus of $250,000. Mr. Knowling received (i) a signing bonus of
$1,500,000, one half of which was paid on commencement of employment, and the
remaining half of which will be paid on the earlier of the one year
anniversary of employment or a change of control (as defined in the Knowling
Employment Agreement), and (ii) stock options to purchase 2,100,000 shares of
Common Stock at an exercise price of $1.00 per share. If the Company
terminates Mr. Knowling's employment relationship without Cause (as such term
is defined in the Knowling Employment Agreement), or if Mr. Knowling resigns
for Good Reason (as such term is defined in the Knowling Employment
Agreement), the Company must continue to pay Mr. Knowling's annual base salary
and targeted bonus for a period of two years after the date of termination;
provided Mr. Knowling does not become employed by a direct competitor of the
Company. During the term of his employment, Mr. Knowling agrees to be bound by
customary confidentiality provisions. Pursuant to the Knowling Employment
Agreement, in August 1998 the Company loaned Mr. Knowling $500,000 pursuant to
a secured promissory note that bears no interest during his employment, 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."
The Company has entered into written employment agreements with Dhruv Khanna
and Rex Cardinale (the "Employees") whereby the Company has 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 $160,000, respectively and bonuses to be
determined by the Board of Directors or the Compensation Committee. The
employment commencement date for both Messrs. Khanna and Cardinale was July
15, 1997. During the two-year term, the Employee can only be terminated for
cause (as defined in the agreement), at which time the Employee is only
eligible for benefits in accordance with the Company's established policies.
After the two-year term, either the Employee or the Company may terminate the
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employment relationship with or without cause. If the Company terminates the
Employee's employment relationship without cause, the Company must continue to
pay to the Employee such salary and benefits as he received immediately before
termination for a period of six months after the date of termination. Under
the employment agreements, the Employees agree, during the terms of their
employment with the Company, not to (i) open or operate a business which is
then in competition with the Company, (ii) act as an employee, agent, advisor
or consultant of any then existing competitor of the Company, or (iii) take
any action to divert business from the Company or influence any existing
customer of the Company to cease doing business with the Company or to alter
its then existing business relationship with the Company.
With respect to all options granted under the Company's 1997 Stock Plan, in
the event of a merger of the Company with or into another corporation
resulting in a change of control involving a shift in 50% or more of the
voting power of the Company, or the sale of all or substantially all of the
assets of the Company, 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."
The Company has also entered into restricted stock purchase agreements with
certain officers and directors of the Company. The Common Stock issued
pursuant to the restricted stock purchase agreements are subject to a
repurchase right on the part of the Company that is subject to vesting. The
agreements 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
The Company's 1997 Stock Plan (the "1997 Stock Plan") was adopted by the
Board of Directors and the stockholders in July 1997 and was amended in
January 1998, April 1998, August 1998 and December 1998. The number of shares
of Common Stock which are reserved for issuance under the 1997 Stock Plan is
15,520,342 shares, plus an annual increase to be added on January 1 of each
year beginning in 2000, equal to the lesser of (i) 3% of the outstanding
shares on such date or (ii) an amount determined by the Board. The annual
increase is subject to adjustment upon changes in capitalization of the
Company. 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 January 20,
1999, options to purchase an aggregate of 11,794,410 shares were outstanding
and 2,326,083 shares remained available for future grants.
The 1997 Stock Plan is administered by the 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 share of Company Common Stock previously issued and sold
or any option previously granted under the 1997 Stock Plan. The Company may
grant each optionee a maximum of 2,000,000 shares covered by option during a
fiscal year. The Company may grant up to an additional 2,000,000 shares
covered by option in connection with an optionee's initial employment with the
Company. 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 an
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employee, director or consultant of the Company, 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 the Company a repurchase
option exercisable upon the voluntary or involuntary termination of the
purchaser's employment or consulting relationship with the Company for any
reason (including death or disability). The purchase price for shares
repurchased pursuant to Restricted Stock Purchase Agreements will be the
original price paid by the purchaser and may be paid by cancellation of any
indebtedness of the purchaser to the Company. Repurchase options lapse at a
rate determined by the administrator.
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 the 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
the 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 the
Company's 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 of a merger of the Company
with or into another corporation resulting in a change of control involving a
shift in 50% or more of the voting power of the Company, or the sale of all or
substantially all of the assets of the Company, 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 that the successor corporation refuses to assume or substitute
the options.
1998 Employee Stock Purchase Plan
The Company's 1998 Employee Stock Purchase Plan (the "1998 Purchase Plan")
was adopted by the Board of Directors in December 1998, and approved by the
stockholders in January 1999. A total of 1,000,000 shares of Common Stock has
been reserved for issuance under the 1998 Purchase 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. As of the date of this Prospectus, no
shares have been issued under the 1998 Purchase Plan.
The 1998 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 such offering period which
commences on the first trading day on or after the effective date of this
Offering and ends on the last trading day on or before October 31, 2000.
Employees are eligible to participate if they are customarily employed by
the Company or any participating subsidiary 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 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 the capital stock of the Company, or (ii) to
the extent that his or her rights to purchase stock under all employee stock
purchase plans of the Company accrues at a rate which exceeds $25,000 worth of
stock for each calendar year. The 1998 Purchase Plan permits participants to
purchase 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
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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 Common Stock at the end of each purchase period. The price of stock
purchased under the 1998 Purchase Plan is generally 85% of the lower of the
fair market value of the 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 offering period, and they will be paid
their payroll deductions to date. Participation ends automatically upon
termination of employment with the Company.
Rights to purchase stock granted under the 1998 Purchase Plan are not
transferable by a participant other than by will, the laws of descent and
distribution, or as otherwise provided under the 1998 Purchase Plan. The 1998
Purchase Plan provides that, in the event of a merger of the Company with or
into another corporation or a sale of substantially all of the Company's
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.
The Board of Directors has the authority to amend or terminate the 1998
Purchase Plan, except that no such action may adversely affect any outstanding
rights to purchase stock under the 1998 Purchase Plan, provided that the Board
of Directors may terminate an offering period on any exercise date if the
Board determines that the termination of the 1998 Purchase Plan is in the best
interests of the Company and its stockholders. Notwithstanding anything to the
contrary, the Board of Directors may in its sole discretion amend the 1998
Purchase 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 the Board of Directors,
the 1998 Purchase Plan will terminate automatically ten years from the
effective date of this Offering.
Management Bonus Plan
On July 22, 1998, the Company's Board approved its Executive Bonus
Performance Plan. Under the Plan, each officer of the Company 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
The Company's Amended and Restated Certificate of Incorporation limits the
liability of directors to the maximum extent permitted by Delaware law, and
the Company's Bylaws provide that the Company shall indemnify its directors
and officers and may indemnify its other employees and agents to the fullest
extent permitted by law. The Company has also entered into agreements to
indemnify its directors and executive officers, in addition to the
indemnification provided for in the Company's Bylaws. The Company believes
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 director, officer, employee or agent of
the Company in which indemnification will be required or permitted. The
Company is not aware of any threatened litigation or proceeding that might
result in a claim for such indemnification. Insofar as indemnification for
liabilities arising under the Securities Act may be permitted to directors,
officers or persons controlling the Company pursuant to the foregoing
provisions, the Company has been informed that, in the opinion of the SEC,
such indemnification 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, the Company entered into a Series C Preferred Stock
and Warrant Subscription Agreement (the "Subscription Agreement") with Warburg
and Crosspoint pursuant to which Warburg and Crosspoint 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 has agreed either to call this commitment or to
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 securities that are pari passu (equal)
with, or more favorable to the Company than, the Series C Preferred Stock as
set forth in the Company's Amended Certificate of Incorporation (as currently
in effect) requires approval by the disinterested directors of the Company. A
proposed alternate equity financing providing for a price per share of less
than $2.7767 or securities whose terms are less favorable to the Company than
the Series C Preferred Stock requires unanimous approval by the Company's
entire Board of Directors. In consideration of this commitment, the Company
issued to Warburg and Crosspoint 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"). The parties have agreed that the AT&T
Ventures and NEXTLINK stock purchases constitute an alternate equity
financing; therefore, the Company will not issue and sell the Series C
Preferred Stock and Series C Warrants to Warburg and Crosspoint. Messrs. Henry
Kressel and Joseph Landy, directors of the Company, are affiliated with
Warburg, and Mr. Shapero, also a director of the Company, is affiliated with
Crosspoint.
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement between the Company, Warburg, Crosspoint
and Mr. Hawk (the "Assignment and Assumption Agreement") whereby Warburg and
Crosspoint assigned to Mr. Hawk their obligation to purchase 36,015 shares of
Series C Preferred Stock and 29,559 Series C Warrants for an aggregate
purchase price of $100,001.65. On the same date, Mr. Hawk purchased 36,015
shares of 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 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. On the same date, the Amended and Restated
Stockholder Rights Agreement dated March 11, 1998 (the "Stockholder Rights
Agreement") was amended to add Mr. Hawk as a party.
The Common Warrants issued upon the signing of the Subscription Agreement
have five-year terms (but must be exercised prior to the closing of an initial
public offering of equity securities by the Company), have purchase prices of
$0.0033 per share, are immediately exercisable and contain net exercise
provisions.
On March 11, 1998, the Company amended the Stockholder Rights Agreement
among it and certain of its stockholders, including all of the holders of the
outstanding Preferred Stock, to extend the rights held by Warburg, Crosspoint
and Intel to the Common Warrants, the Series C Preferred Stock and the Series
C Warrants issued or issuable to Warburg, Crosspoint and Intel pursuant to the
Subscription Agreement.
The Intel Stock Purchase
Pursuant to the Subscription Agreement, Intel purchased 360,144 shares of
Series C Preferred Stock and Series C Warrants to purchase an aggregate of
295,500 shares of Series C Preferred Stock for an aggregate purchase price of
$1.0 million concurrently with the closing of the issuance of the Senior
Discount Notes; provided, that the Company does not have any obligation to
issue such Series C Warrants to Intel until such time as Warburg and
Crosspoint fund their respective commitments under the Subscription Agreement.
The parties have agreed that the offering contemplated by this Prospectus
constitutes an alternate equity financing; therefore the Company will not
issue the Series C Warrants to Intel. In connection with its agreement to
purchase such Series C Preferred Stock and Series C Warrants, the Company
issued to Intel Common Warrants to purchase an aggregate of 105,852 shares of
Common Stock at a purchase price of $0.0033 per share.
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Transactions in Connection with the Formation of the Delaware Holding Company
The Company originally was incorporated in California as Covad Communication
Company ("Covad California") in October 1996. In July 1997, the Company was
incorporated in Delaware as part of its strategy to operate through a holding
company structure and to conduct substantially all of its operations through
subsidiaries. To effect the holding company structure, in July 1997 the
Company entered into an Exchange Agreement (the "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 Common Stock and Preferred Stock in the Company, so that after
giving effect to the exchange Covad California became a wholly-owned
Subsidiary of the Company. In addition, the Company entered into an Assumption
Agreement pursuant to which the Company 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 consultants of
the Company.
In connection with the Exchange Agreement, Messrs. McMinn, Khanna and Haas,
officers of the Company, each exchanged 3,000,000 shares of Common Stock of
Covad California, originally purchased for $0.0042 per share, for a like
number of shares of Common Stock of the Company pursuant to restricted stock
purchase agreements. In addition, Mr. Lynch, a director of the Company,
exchanged 144,000 shares of Common Stock of Covad California, originally
purchased for $0.0333 per share, for a like number of shares of Common Stock
of the Company 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 of the assets of the Company or a shift in 50% or more of
the voting power of the Company. The Company's 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, the Company issued 1,125,000 shares of Common Stock to Mr.
Cardinale, an officer of the Company, for a purchase price of $0.0333 per
share. On August 30, 1997, the Company issued 345,000 shares of Common Stock
to Mr. Laehy, an officer of the Company, for $0.05 per share. On October 14,
1997, the Company issued 144,000 shares of Common Stock to Mr. Marshall, a
director of the Company, for a purchase price of $0.05 per share. On April 24,
1998, the Company issued 96,000 shares of Common Stock to Mr. Hawk, a director
of the Company, for a purchase price of $0.6667 per share. On August 28, 1998,
the Company issued 40,000 shares of Common Stock to Mr. Hawk for a purchase
price of $5.75 per share. The shares of 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 shares
of Series A Preferred Stock of the Company pursuant to the Exchange Agreement.
Issuance of Series B Preferred Stock
In July 1997, the Company sold an aggregate of 17,000,001 shares of Series B
Preferred, of which 12,000,000 shares were sold to Warburg, 3,000,000 shares
were sold to Crosspoint and 2,000,001 shares were sold to Intel. The purchase
price of the Series B Preferred was $0.50 per share. A portion of the purchase
price of the Series B Preferred 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 the Company's Board of Directors, are
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affiliated with Warburg. Mr. Shapero, who currently serves on the Company's
Board of Directors, is affiliated with Crosspoint. See "Management--Directors
and Executive Officers."
On February 12, 1998, the Company sold an additional 100,002 shares of
Series B Preferred at a purchase price of $1.00 per share to Mr. Marshall, a
director of the Company. For a description of the rights and preferences of
the Series B Preferred, see "Description of Capital Stock--Preferred Stock."
The Strategic Investments and Relationships
In January 1999, the Company received equity investments from AT&T Ventures,
NEXTLINK and Qwest. AT&T Ventures purchased an aggregate of 1,500,583 shares
of Series C-1 Preferred Stock at $2.7767 per share and an aggregate of
1,157,408 shares of 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 Series C-1
Preferred Stock at $2.7767 per share and 925,926 shares of Series of D-1
Preferred Stock at $18.00 per share, representing an investment of $20
million. Qwest purchased 900,349 shares of Series C-1 Preferred Stock at
$2.7767 per share and 694,445 shares of Series D-1 Preferred Stock at $18.00
per share, representing an aggregate investment of $15 million. Upon
completion of this offering, the Series C-1 Preferred Stock will convert into
Class B Common Stock on a one-for-one basis. The Series D-1 Preferred Stock
will also convert into Class B Common Stock at that time on a one-for-one
basis. The Strategic Investors have each agreed not to transfer any Series C-1
Preferred Stock, Series D-1 Preferred Stock or Class B Common Stock to any
non-affiliated third party until January 2000. The Strategic Investors have
also each agreed not to acquire more than 10% of the voting stock of the
Company without the consent of the Company until January 2002. In addition,
until January 2002, each of the Strategic Investors has agreed to vote any
voting securities it holds as recommended by the Board of Directors. See
"Description of Capital Stock--Class B Common Stock."
Concurrently with these strategic equity investments, AT&T, NEXTLINK and
Qwest entered into commercial agreements with the Company providing for the
purchase, marketing and resale of the Company's services at volume discounts,
purchase by the Company 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. The Company cannot
predict the number of line orders that AT&T, NEXTLINK or Qwest will generate,
if any, whether line orders will be below the Company's, AT&T's, NEXTLINK's or
Qwest's expectations or whether AT&T, NEXTLINK or Qwest will discontinue
selling the Company's services entirely.
Equipment Lease Financing
Through September 30, 1998, the Company has 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. ("Charter
Financial"). Through September 30, 1998, the Company has made total payments
of approximately $241,000 to Charter Financial on these obligations. Warburg,
a principal stockholder of the Company, owns a majority of the capital stock
of Charter Financial. The Company believes that the terms of the lease
financing with Charter Financial were completed at rates similar to those
available from alternative providers. The Company's belief that the terms of
the sale lease-back arrangement are similar to those available from
alternative providers is based on the advice of its officers who reviewed at
least two alternative proposals and who reviewed and negotiated the terms of
the arrangement with Charter Financial.
Vendor Relationship
Crosspoint, a principal stockholder of the Company, owns approximately 12%
of the capital stock of Diamond Lane, a vendor of the Company. The Company's
payments to Diamond Lane through September 30, 1998 totaled approximately
$1,492,000. The Company believes 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 the Company's management team's
experience in obtaining vendors and the fact that the Company sought
competitive bidders before entering into the relationship with Diamond Lane.
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Registration Rights
Certain holders of Common Stock and Common Stock issuable upon conversion of
the Preferred Stock are entitled to registration rights. See "Description of
Capital Stock--Registration Rights."
Employment Agreements
The Company has entered into employment agreements with certain of its
officers. See "Management--Employment Agreements and Change in Control
Arrangements."
Employee Loans
In August 1998, the Company loaned Robert Knowling, Jr., the Company's Chief
Executive Officer, the principal amount of $500,000 pursuant to a Note Secured
by Deed of Trust (the "Knowling Note"), which was secured by certain real
property of Mr. Knowling. The entire principal balance of the Knowling Note
becomes due and payable in one lump sum on August 14, 2002. No interest is
charged on the Knowling Note. The Knowling Note has provisions for forgiveness
based on continued employment and is subject to acceleration in certain
events.
In October 1998, the Company loaned Catherine Hemmer, the Company's Vice
President, Operations, and her husband, an employee of the Company (the
"Hemmers"), the principal amount of $600,000 pursuant to a Note Secured By
Deed of Trust (the "Hemmer Note"), which was secured by certain real property
of the Hemmers. The outstanding principal balance of the Hemmer 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 Hemmer
Note. The Hemmer Note has provisions for forgiveness based upon continued
employment of each of the Hemmers with the Company and is subject to
acceleration in certain events.
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PRINCIPAL STOCKHOLDERS
The following table sets forth certain information regarding ownership of
the Company's Common Stock (after giving effect to the issuance of 1,800,000
shares of Common Stock upon exercise of warrants prior to the closing of the
offering, the conversion of outstanding Preferred Stock into Common Stock, and
excluding Common Stock that will be issued upon the closing of this offering
pursuant to cumulative dividend rights of the Preferred Stock) as of December
31, 1998 by (i) each Named Executive Officer, (ii) each director of the
Company, (iii) all executive officers and directors as a group, and (iv) all
persons who directly own 5% or more of the Company's Common Stock.
<TABLE>
<CAPTION>
Number of
Shares Percentage Beneficially Owned(1)
Beneficially ----------------------------------------
Beneficial Owner Owned(1) Before Offering After Offering
---------------- ------------ ---------------- ----------------
<S> <C> <C> <C>
Robert Knowling Jr.(2).. 306,250 * *
Charles McMinn(3)....... 3,030,000 9.5% 7.7%
Robert Hawk(4).......... 176,515 * *
Henry Kressel(5)........ 13,355,319 42.0 33.7
Joseph Landy(5)......... 13,355,319 42.0 33.7
Daniel Lynch(6)......... 460,500 1.5 1.2
Frank Marshall(6)....... 260,502 * *
Rich Shapero(7)......... 3,338,829 10.5 8.4
Rex Cardinale........... 1,125,000 3.5 2.8
Charles Haas(8)......... 3,030,000 9.5 7.7
Dhruv Khanna(9)......... 3,030,000 9.5 7.7
Timothy Laehy........... 345,000 1.1 *
All executive officers
and directors as a
group(10).............. 28,888,669 88.6 71.3
Warburg, Pincus
Ventures, L.P. (11).... 13,355,319 42.0 33.7
Crosspoint Venture
Partners 1996 (12)..... 3,338,829 10.5 8.4
Intel Corporation (13).. 2,465,997 7.8 6.2
</TABLE>
- --------
* Less than 1% of the outstanding voting stock.
(1) Based on 31,820,159 shares of Common Stock outstanding as of December 31,
1998. Does not include 6,379,177 shares of Class B Common Stock to be
issued to the Strategic Investors upon the closing of this offering on
conversion of Series C-1 Preferred Stock and Series D-1 Preferred Stock
acquired by them in January 1999. The Class B Common Stock is non-voting.
See "Certain Relationships and Related Transactions--The Strategic
Investments and Relationships" and "Description of Capital Stock--Class B
Common Stock." Beneficial ownership is determined in accordance with the
rules of the Securities and Exchange Commission. In computing the
aggregate number of shares beneficially owned by the individual
stockholders and groups of stockholders described above and the
percentage ownership of such individuals and groups, shares of Common
Stock subject to options or warrants that are currently exercisable or
exercisable within 60 days of December 31, 1998 are deemed outstanding.
Such shares, however, are not deemed outstanding for the purposes of
computing the percentage ownership of the other stockholders or groups of
stockholders. 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.
(2) Consists of 306,250 shares of Common Stock subject to options exercisable
within 60 days of December 31, 1998.
(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. Also adjusted to reflect the sale by Mr.
McMinn of 120,000 shares of Common Stock at $18.00 per share in a
separate transaction expected to be completed immediately following the
closing of this offering.
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(4) Includes 4,500 shares of Common Stock subject to options exercisable
within 60 days of December 31, 1998.
(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 16,500 shares of Common Stock subject to options exercisable
within 60 days of December 31, 1998.
(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) Adjusted to reflect the sale by Mr. Haas of 120,000 shares of Common
Stock at $18.00 per share in a separate transaction expected to be
completed immediately following the closing of this offering.
(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. Also adjusted to reflect the sale by Mr. Khanna of 120,000
shares of Common Stock at $18.00 per share in a separate transaction
expected to be completed immediately following the closing of this
offering.
(10) Includes 392,004 shares of Common Stock subject to options and 1,694,148
shares of Common Stock subject to warrants exercisable within 60 days of
December 31, 1998.
(11) Includes 1,355,319 shares to be issued upon exercise of a warrant prior
to the closing of this offering. The sole general partner of Warburg 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, directors of the
Company, 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.
(12) Includes 338,829 shares to be issued upon exercise of a warrant prior to
the closing of this offering. Mr. Shapero, a director of the Company, 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.
(13) Includes 105,852 shares to be issued upon exercise of a warrant prior to
the closing of this offering. The address of Intel is 2200 Mission
College Boulevard, Mail Stop SC4-210, Santa Clara, CA 95052-8199.
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DESCRIPTION OF CAPITAL STOCK
The following summary of the terms of the Company's capital stock does not
purport to be complete and is qualified in its entirety by reference to the
actual terms of the capital stock contained in the Company's Amended and
Restated Certificate of Incorporation and other agreements referenced below
which are filed as exhibits to the Registration Statement of which this
Prospectus is a part. The following summary gives effect to the conversion of
all outstanding shares of Preferred Stock into Common Stock upon the closing
of this offering and the amendment and restatement of the Company's Amended
and Restated Certificate of Incorporation immediately following the closing of
this offering.
Upon the closing of this offering, the authorized capital stock of the
Company, after giving effect to the amendment of the Company's Amended and
Restated Certificate of Incorporation, will consist 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 December 31, 1998, there were 51 holders of record
of Common Stock. The Common Stock and Preferred Stock each have a par value of
$0.001 per share. As of December 31, 1998, there were 31,820,159 shares of
Common Stock outstanding, after giving effect to the issuance of 1,800,000
shares of Common Stock upon exercise of warrants that terminate upon the
closing of the offering. No shares of Preferred Stock will be outstanding upon
completion of this offering. As of January 20, 1999, options to purchase
11,794,410 shares of Common Stock at a weighted average exercise price of
$3.29 per share were outstanding. In January 1999 the Company issued Preferred
Stock which will be converted into 6,379,177 shares of Class B Common Stock
upon the closing of this offering.
Common Stock
The holders of Common Stock are entitled to one vote per share on all
matters to be voted upon by the stockholders. Subject to preferences that may
be applicable to 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. See "Dividend Policy." In the event of a
liquidation, dissolution or winding up of the Company, the holders of Common
Stock are entitled to share ratably in all assets remaining after payment of
liabilities, subject to prior distribution rights of Preferred Stock, if any,
then outstanding. 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, and the shares of Common Stock offered hereby
will, upon the closing of the offering, be fully paid and non-assessable.
Class B Common Stock
The rights of holders of Class B Common Stock are identical to the rights of
holders of Common Stock except that the holders of 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 the voting stock of the Company, or will automatically convert into
Common Stock upon transfer after such date to a third party.
Preferred Stock
Upon the closing of this offering, all outstanding shares of Preferred Stock
will automatically be converted into shares of Common Stock and Class B Common
Stock. See Notes 6 and 10 of Notes to Consolidated Financial Statements for a
description of the currently outstanding 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 and 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
preference, sinking fund terms and the number of shares constituting any
series or the designation of such series, without any further vote or action
by the stockholders. The Board of Directors, without stockholder approval, can
issue additional Preferred Stock with voting and conversion rights which could
adversely affect the voting power of the holders of Common Stock. The issuance
of Preferred Stock could have the effect of delaying, deferring or preventing
a change in control of the Company. The Company has no present plan to issue
any shares of Preferred Stock.
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Warrants
In connection with the issuance of the Senior Discount Notes in March 1998,
the Company issued the High Yield Warrants to purchase an aggregate of
5,053,764 shares of Common Stock of the Company with exercise prices of
$0.0033 per share. The High Yield Warrants became exercisable on September 15,
1998 and automatically expire on March 15, 2008. The Company also issued to a
consultant a five-year warrant to purchase 135,000 shares with an exercise
price of $1.00 per share. Such warrant is immediately exercisable.
Registration Rights
Pursuant to the Stockholder Rights Agreement, holders of 31,529,866 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
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 Company is so advised by
the managing underwriter, if any, therefor 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 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,
among the Company and Bear, Stearns & Co. Inc. and BT Alex. Brown
Incorporated, holders of the Warrants are entitled to certain registration
rights with respect to the shares of Common Stock issuable upon exercise of
the 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 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 Company is so advised
by the managing underwriter, if any, therefor 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, the Company's Board of Directors, without stockholder
approval, has the authority under the Company's Amended and Restated
Certificate of Incorporation 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 holders of
Common Stock and could be issued with terms calculated to delay or prevent a
change of control of the Company or make removal of management more difficult.
Election and Removal of Directors. Effective upon the closing of this
offering, the Company's charter and Bylaws provide for the division of the
Company's 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 the Company's stockholders. 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 the 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 directors. See "Management--Classified
Board."
Stockholder Meetings and Written Consent. Under the Company's Bylaws, the
stockholders may not call a special meeting of the stockholders of the
Company. Rather, only the Board of Directors, the Chairman of the Board and
the President may call special meetings of stockholders. The Company's Amended
and Restated Certificate of Incorporation provides that stockholders may not
act by written consent and, accordingly, stockholders can only act at a
meeting.
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Requirements for Advance Notification of Stockholder Nominations and
Proposals. The Company's 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. The Company is subject
to Section 203 of the Delaware General Corporation Law ("Section 203"), which
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 (i) 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, (ii) 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 (iii) 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, and an "interested
stockholder" is generally a person who, together with affiliates and
associates of such person, (i) owns 15% or more of the corporation's voting
stock or (ii) 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 the
Company.
Transfer Agent and Registrar
BankBoston, N.A. is the transfer agent and registrar for the Company's
Common Stock.
SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, there has been no public market for the Common Stock
of the Company. Future sales of substantial amounts of Common Stock in the
public market could adversely affect market prices prevailing from time to
time. Sales of substantial amounts of Common Stock of the Company in the
public market after the restrictions lapse could adversely affect the
prevailing market price and the ability of the Company to raise equity capital
in the future.
Upon the completion of this offering, the Company will have 45,999,336
shares of Common Stock outstanding. Of these shares, the 7,800,000 shares sold
in this offering will be freely tradable without restriction under the
Securities Act, unless held by "affiliates" of the Company, as that term is
defined in Rule 144 under the Securities Act. An additional 6,379,177 shares
of Common Stock issuable upon conversion of the Class B Common Stock will be
eligible for sale beginning in January 2000 subject to volume limitations
pursuant to Rule 144 and the exercise of Registration Rights. The remaining
31,820,159 shares of Common Stock held by existing stockholders as of December
31, 1998 were issued and sold by the Company in reliance on exemptions from
the registration requirements of the Securities Act. These shares may be sold
in the public market only if registered, or pursuant to an exemption from
registration such as Rule 144, 144(k) or 701 under the Securities Act. The
Company's directors, executive officers, all other stockholders and all option
and warrant holders, who in the aggregate hold all of the shares of Common
Stock or securities convertible into Common Stock of the Company outstanding
immediately prior to the completion of this offering, are subject to lock-up
agreements under which they have agreed not to directly or indirectly, offer,
sell, contract to sell, grant any option to purchase, pledge or otherwise
dispose of, or, in any manner, transfer all or a portion of the economic
consequences associated with the ownership of any shares of Common Stock or
any securities convertible into
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or exercisable or exchangeable for Common Stock beneficially owned by them for
a period of 180 days after the date of this Prospectus, without the prior
written consent of Bear, Stearns & Co. Inc. However, 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. The Company has
entered into a similar agreement, except that the Company may grant options
and issue stock under its 1997 Stock Plan and 1998 Purchase Plan and upon
exercise of warrants outstanding on the date of this Prospectus, and may issue
stock in connection with strategic relationships and in connection with
acquisitions of businesses, technologies or products complementary to those of
the Company, so long as the recipients of such stock agree to be bound by a
lock-up agreement for the remainder of the 180-day lock-up period.
Upon expiration of the lock-up agreements and based on shares outstanding as
of December 31, 1998, approximately 31,820,159 shares of Common Stock will
become eligible for immediate public resale, subject in some cases to volume
limitations pursuant to Rule 144. An additional 6,379,177 shares of Common
Stock issuable upon conversion of the Class B Common Stock will be eligible
for sale in January 2000 subject to volume limitation pursuant to Rule 144 and
the exercise of registration rights. In addition, 31,529,866 of the shares
outstanding immediately following the completion of this offering will be
entitled to registration rights with respect to such shares upon the release
of lock-up agreements. The number of shares sold in the public market could
increase if such rights are exercised.
As of January 20, 1999, 11,794,410 shares were subject to outstanding
options under the Company's 1997 Stock Plan and 5,188,764 shares were subject
to outstanding warrants to purchase Common Stock. All of these shares are
subject to the lock-up agreements described above. The Company also has
adopted its 1998 Purchase Plan and reserved 1,000,000 shares for issuance
thereunder. Approximately 90 days after the date of this Prospectus, the
Company intends to file a Registration Statement on Form S-8 covering shares
issuable under the Company's 1998 Purchase Plan and 1997 Stock Plan (including
shares subject to then outstanding options under such plan), thus permitting
the resale of such shares in the public market without restriction under the
Securities Act after expiration of the applicable lock-up agreements. In
addition, the holders of the warrants to purchase 5,053,764 shares of Common
Stock are entitled to certain registration rights with respect to such shares.
See "Description of Capital Stock--Registration Rights."
In general, under Rule 144 as currently in effect, a person (or persons
whose shares are aggregated) who has beneficially owned shares for at least
one year (including the holding period of any prior owner, except an
affiliate) is entitled to sell in a "broker's transaction" or to market
makers, within any three-month period commencing 90 days after the date of
this Prospectus, a number of shares that does not exceed the greater of
(i) one percent of the number of shares of Common Stock then outstanding or
(ii) the average weekly trading volume of the Common Stock during the four
calendar weeks preceding the required filing of a Form 144 with respect to
such sale. Sales under Rule 144 are generally subject to certain manner of
sale provisions and notice requirements and to the availability of current
public information about the Company. Under Rule 144(k), a person who is not
deemed to have been an affiliate of the Company at any time during the 90 days
preceding a sale, and who has beneficially owned the shares proposed to be
sold for at least two years, is entitled to sell such shares without having to
comply with the manner of sale, public information, volume limitation or
notice provisions of Rule 144. Under Rule 701 under the Securities Act,
persons who purchase shares upon exercise of options granted prior to the
effective date of this offering are entitled to sell such shares 90 days after
the effective date of this offering in reliance on Rule 144, without having to
comply with the holding period requirements of Rule 144 and, in the case of
non-affiliates, without having to comply with the public information, volume
limitation or notice provisions of Rule 144.
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UNDERWRITING
The underwriters named below (the "Underwriters") have severally agreed,
subject to the terms and conditions of the Underwriting Agreement, to purchase
from the Company the number of shares of Common Stock set forth opposite their
names below:
<TABLE>
<CAPTION>
Underwriters Number of Shares
------------ ----------------
<S> <C>
Bear, Stearns & Co. Inc. ................................. 1,446,250
BT Alex. Brown Incorporated............................... 1,446,250
Donaldson, Lufkin & Jenrette Securities Corporation....... 1,446,250
Goldman, Sachs & Co. ..................................... 1,446,250
BancBoston Robertson Stephens Inc......................... 130,000
CIBC Oppenheimer Corp..................................... 130,000
Deutsche Bank Securities Inc.............................. 130,000
Hambrecht & Quist LLC..................................... 130,000
ING Baring Furman Selz LLC................................ 130,000
J.P. Morgan Securities Inc................................ 130,000
Prudential Securities Incorporated........................ 130,000
Salomon Smith Barney Inc.................................. 130,000
Warburg Dillon Read LLC................................... 130,000
Friedman, Billings, Ramsey & Co., Inc..................... 65,000
Gerard Klauer Mattison & Co., Inc......................... 65,000
Gruntal & Co., L.L.C...................................... 65,000
Hagerty, Stewart & Associates, Inc........................ 65,000
Hoak Breedlove Wesneski & Co.............................. 65,000
Josephthal & Co. Inc...................................... 65,000
Kaufman Bros., L.P........................................ 65,000
C.L. King & Associates, Inc............................... 65,000
Legg Mason Wood Walker, Incorporated...................... 65,000
Needham & Company, Inc.................................... 65,000
Sutro & Co. Incorporated.................................. 65,000
C.E. Unterberg, Towbin.................................... 65,000
Wheat First Securities, Inc............................... 65,000
---------
Total................................................... 7,800,000
=========
</TABLE>
Subject to the terms and conditions of the Underwriting Agreement, the
Underwriters have agreed to purchase all of the shares of Common Stock being
sold pursuant to the Underwriting Agreement if any are purchased (excluding
shares covered by the Over-Allotment Option).
The Underwriters have advised the Company that the Underwriters propose to
offer the Common Stock to the public initially at the public offering price
set forth on the cover page of this Prospectus and to certain dealers at such
price less a concession of not more than $0.68 per share. Additionally, the
Underwriters may allow, and such dealers may reallow, a discount of not more
than $0.10 per share on sales to certain other dealers. After the initial
public offering, the public offering price and other selling terms may be
changed by the Underwriters.
At the Company's request, the Underwriters have reserved for sale at the
initial public offering price up to 780,000 shares of Common Stock offered
hereby for certain individuals and entities who have expressed an interest in
purchasing such shares of Common Stock in the offering. The number of shares
available for sale to the general public will be reduced to the extent such
persons purchase such reserved shares. Any reserved shares not so purchased
will be offered by the Underwriters to the general public on the same basis as
other shares offered hereby.
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The Company has granted to the Underwriters an option to purchase up to
1,170,000 additional shares of Common Stock at the initial public offering
price, less the underwriting discount set forth on the cover page of this
Prospectus, solely to cover over-allotments, if any. This option may be
exercised in whole or in part at any time within 30 days after the date of
this Prospectus. To the extent that the Underwriters exercise this option,
each Underwriter will have a firm commitment, subject to certain conditions,
to purchase a number of shares of Common Stock proportionate to such
Underwriter's purchase obligations set forth in the foregoing table.
The offering of the shares is made for delivery, when, as and if accepted by
the Underwriters and subject to prior sale and to withdrawal, cancellation or
modification of the offering without notice. The Underwriters reserve the
right to reject an order for the purchase of shares in whole or in part.
The officers, directors, stockholders and option holders of the Company, who
in the aggregate own all of the issued and outstanding shares of Common Stock
or securities convertible into Common Stock of the Company outstanding
immediately prior to the completion of this offering, have agreed that they
will not, without the prior written consent of Bear, Stearns & Co. Inc.,
directly or indirectly, offer, sell, contract to sell, grant any option to
purchase, pledge or otherwise dispose of, or, in any manner, transfer all or a
portion of the economic consequences associated with the ownership of any
shares of Common Stock or any securities convertible into or exercisable or
exchangeable for Common Stock beneficially owned by them during the 180 day
period following the date of this Prospectus. The Company has agreed that it
will not, without the prior written consent of Bear, Stearns & Co. Inc.,
offer, sell or otherwise dispose of any shares of Common Stock, options or
warrants to acquire shares of securities exchangeable for or convertible into
shares of Common Stock during the 180 day period following the date of this
Prospectus, except that the Company may issue shares of Common Stock and
options to purchase Common Stock under its 1997 Stock Plan and its 1998
Purchase Plan and upon exercise of warrants outstanding on the date of this
Prospectus, and may issue stock in connection with strategic relationships and
in connection with acquisitions of businesses, technologies or products
complementary to those of the Company, so long as the recipients of such stock
agree to be bound by a lock-up agreement for the remainder of the 180-day
lock-up period.
The Company has agreed to indemnify the Underwriters against certain civil
liabilities, including liabilities under the Securities Act and to contribute
to payments the Underwriters may be required to make in respect thereof.
Prior to the offering, there has been no public market for the Common Stock.
The initial public offering price for the Common Stock was determined by
negotiation among the Company and the Underwriters. Among the factors
considered in determining the initial public offering price were prevailing
market and economic conditions, revenues and operating results of the Company,
market valuations of other companies engaged in the telecommunications
industry, estimates of the business potential and prospects of the Company,
the present state of the Company's operations, the Company's management and
other factors deemed relevant. The negotiated initial public offering price
may bear no relationship to the price at which the Common Stock trades after
the offering. The Common Stock has been approved for quotation on the Nasdaq
National Market under the symbol "COVD."
The Underwriters have advised the Company that, pursuant to Regulation M
promulgated under the Exchange Act, certain persons participating in the
offering may engage in transactions, including stabilizing bids, syndicate
covering transactions or the imposition of penalty bids, which may have the
effect of stabilizing or maintaining the market price of the Common Stock at a
level above that which might otherwise prevail in the open market. A
"stabilizing bid" is a bid for or the purchase of the Common Stock on behalf
of the Underwriters for the purpose of pegging, fixing or maintaining the
price of the Common Stock. A "syndicate covering transaction" is the bid for
or the purchase of the Common Stock on behalf of the Underwriters to reduce a
short position created in connection with the offering. The Underwriters may
also cover all or a portion of such short position by exercising the Over-
Allotment Option. A "penalty bid" is an arrangement permitting the
Underwriters to reclaim the selling
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concession otherwise accruing to an Underwriter or syndicate member in
connection with the offering if the Common Stock originally sold by such
Underwriter or syndicate member is purchased by the Underwriters in a
syndicate covering transaction and has therefore not been effectively placed
by such Underwriter or syndicate member. The Underwriters have advised the
Company that such transactions may be effected on the Nasdaq National Market
or otherwise and, if commenced, may be discontinued at any time.
The Underwriters do not intend to confirm sales for accounts over which they
exercise discretionary authority.
Bear, Stearns & Co. Inc. and BT Alex. Brown Incorporated acted as initial
purchasers of the Senior Discount Notes in March 1998, for which Bear, Stearns
& Co. Inc. and BT Alex. Brown Incorporated received usual and customary fees.
LEGAL MATTERS
The validity of the shares of Common Stock offered hereby will be passed
upon for the Company by Wilson Sonsini Goodrich & Rosati, P.C., Palo Alto,
California. Certain legal matters in connection with this offering will be
passed upon for the Underwriters by Latham & Watkins, San Francisco,
California.
EXPERTS
The consolidated financial statements of the Company as of December 31, 1997
and September 30, 1998 and for the year ended December 31, 1997 and the nine
months ended September 30, 1998, appearing in this Prospectus and Registration
Statement, have been audited by Ernst & Young LLP, independent auditors, as
set forth in their report thereon appearing elsewhere herein, and are included
in reliance upon such report given upon the authority of such firm as experts
in accounting and auditing.
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ADDITIONAL INFORMATION
This Prospectus constitutes a part of a registration statement on Form S-1
(together with all amendments thereto, the "Registration Statement") filed by
the Company with the SEC under the Securities Act. This Prospectus, which
forms a part of the Registration Statement, does not contain all the
information set forth in the Registration Statement, certain parts of which
have been omitted in accordance with the rules and regulations of the SEC.
Reference is hereby made to the Registration Statement and related exhibits
and schedules filed therewith for further information with respect to the
Company and the Shares offered hereby. Statements contained herein concerning
the provisions of any document are not necessarily complete and, in each
instance, reference is made to the copy of such document filed as an exhibit
to the Registration Statement or otherwise filed by the Company with the SEC
and each such statement is qualified in its entirety by such reference. The
Registration Statement and the exhibits and schedules thereto may be inspected
and copied at the public reference facilities maintained by the SEC at 450
Fifth Street, NW, Washington, D.C. 20594, and at the following regional
offices of the SEC: New York Regional Office, Seven World Trade Center, New
York, New York 10048, and Chicago Regional Office, 500 West Madison Street,
Chicago, Illinois 60661. Copies of such reports and other information may be
obtained from the Public Reference Section of the SEC: 450 Fifth Street, NW,
Washington, D.C. 20549, upon payment of the prescribed fees.
The Company is currently subject to the periodic reporting and other
information requirements of the Exchange Act, and in accordance therewith
files reports and other information with the SEC. Such reports and other
information may be inspected and copied at the public reference facilities
maintained by the SEC at 450 Fifth Street, NW, Washington, D.C. 20594, and at
the following regional offices of the SEC: New York Regional Office, Seven
World Trade Center, New York, New York 10048, and Chicago Regional Office,
500 West Madison Street, Chicago, Illinois 60661. Copies of such reports and
other information may be obtained from the Public Reference Section of the
SEC: 450 Fifth Street NW, Washington, D.C. 20549, upon payment of the
prescribed fees. The SEC maintains a Web site that contains reports and
information statements and other information regarding registrants that file
electronically with the SEC. Copies of such documents may be obtained from the
SEC's Internet address at http://www.sec.gov.
79
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED FINANCIAL STATEMENTS
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors............................................ F-2
Consolidated Balance Sheets as of December 31, 1997 and September 30,
1998..................................................................... F-3
Consolidated Statements of Operations for the year ended December 31, 1997
and the nine months ended September 30, 1997 (unaudited) and 1998........ F-4
Consolidated Statements of Stockholders' Equity (Net Capital Deficiency)
for the year ended December 31, 1997 and the nine months ended September
30, 1998................................................................. F-5
Consolidated Statements of Cash Flows for the year ended December 31, 1997
and the nine months ended September 30, 1997 (unaudited) and 1998........ F-6
Notes to Consolidated Financial Statements................................ F-7
</TABLE>
F-1
<PAGE>
REPORT OF 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 September 30, 1998, and
the related consolidated statements of operations, stockholders' equity (net
capital deficiency), and cash flows for the year ended December 31, 1997 and
the nine months ended September 30, 1998. 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 financial position of Covad Communications
Group, Inc. as of December 31, 1997 and September 30, 1998, and the
consolidated results of its operations and its cash flows for the year ended
December 31, 1997 and the nine months ended September 30, 1998, in conformity
with generally accepted accounting principles.
/s/ Ernst & Young LLP
San Jose, California
October 16, 1998
F-2
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(Amounts in 000's, except share and per share amounts)
<TABLE>
<CAPTION>
Pro Forma
Stockholders'
Equity
(Net Capital
Deficiency)
December 31, September 30, September 30,
1997 1998 1998
------------- ------------- -------------
(Restated)(1) (Unaudited)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............ $ 4,378 $ 97,076
Accounts receivable, net of
allowances for uncollectibles of $0
and $75............................. 25 1,062
Unbilled revenue..................... 4 450
Inventories.......................... 43 868
Prepaid expenses..................... 52 722
Other current assets................. 317 446
------- --------
Total current assets............... 4,819 100,624
Property and equipment:
Networks and communication equipment. 2,185 30,321
Computer equipment................... 600 3,660
Furniture and fixtures............... 185 890
Leasehold improvements............... 114 550
------- --------
3,084 35,421
Less accumulated depreciation and
amortization........................ (70) (1,418)
------- --------
Net property and equipment......... 3,014 34,003
Other assets:
Restricted cash...................... 210 233
Deposits............................. 31 282
Deferred debt issuance costs (net)... -- 8,304
Other long term assets............... -- 1,176
------- --------
Total other assets................. 241 9,995
------- --------
Total assets....................... $ 8,074 $144,622
======= ========
LIABILITIES AND STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable..................... $ 651 $ 8,777
Unearned revenue..................... 7 290
Accrued network costs................ 58 1,238
Other accrued liabilities............ 77 2,808
Current portion of capital lease
obligations......................... 229 254
------- --------
Total current liabilities.......... 1,022 13,367
Long-term debt (net of discount)..... -- 137,292
Long-term capital lease obligations.. 554 380
------- --------
Total liabilities.................. 1,576 151,039
Stockholders' equity (net capital
deficiency):
Preferred stock ($0.001 par value)
(pro forma--unaudited):
Authorized shares--5,000,000
Issued and outstanding--none........ -- -- --
Convertible preferred stock ($0.001
par value):
Authorized shares--30,000,000 (none
pro forma--unaudited)
Issued and outstanding shares--
17,750,001 and 18,246,162 at
December 31, 1997 and September 30,
1998, respectively (none pro
forma--unaudited).................. 18 18 --
Common stock ($0.001 par value):
Authorized shares--65,000,000
(150,000,000 pro forma--unaudited)
Issued and outstanding shares--
11,361,204 and 11,634,149 at
December 31, 1997 and September 30,
1998, respectively (31,680,311
shares pro forma--unaudited)....... 11 12 32
Additional paid-in capital........... 9,692 30,732 30,736
Deferred compensation................ (611) (6,306) (6,306)
Retained earnings (deficit).......... (2,612) (30,873) (30,873)
------- -------- -------
Total stockholders' equity (net
capital deficiency)................ 6,498 (6,417) $(6,411)
------- -------- =======
Total liabilities and stockholders'
equity (net capital deficiency).... $ 8,074 $144,622
======= ========
</TABLE>
- --------
(1) See Note 7.
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>
Nine Months Ended
September 30,
Year Ended -----------------------
December 31, 1997 1997 1998
----------------- ----------- ----------
(Restated)(1) (Unaudited)
<S> <C> <C> <C>
Revenues............................. $ 26 $ -- $ 2,560
Operating expenses:
Network and product costs.......... 54 10 2,316
Sales, marketing, general and
administrative.................... 2,374 1,040 17,231
Amortization of deferred
compensation...................... 295 134 2,695
Depreciation and amortization...... 70 -- 1,348
----------- ---------- ----------
Total operating expenses......... 2,793 1,184 23,590
----------- ---------- ----------
Income (loss) from operations........ (2,767) (1,184) (21,030)
Interest income (expense):
Interest income.................... 167 80 3,673
Interest expense................... (12) -- (10,904)
----------- ---------- ----------
Net interest income (expense)...... 155 80 (7,231)
----------- ---------- ----------
Net income (loss).................... $ (2,612) $ (1,104) $ (28,261)
=========== ========== ==========
Net income (loss) per common share... $ (0.80) $ (0.37) $ (5.26)
Weighted average shares used in
computing net loss per share........ 3,271,546 3,009,329 5,374,924
Pro forma net income (loss) per
common share........................ $ (0.23) $ (0.14) $ (1.14)
Weighted average shares used in
computing pro forma net loss per
share............................... 11,522,916 8,059,696 24,844,824
</TABLE>
- --------
(1) See Note 7.
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.................. -- -- 272,945 1 301 -- -- 302
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... -- -- -- -- 8,390 (8,390) -- --
Amortization of deferred
compensation........... -- -- -- -- -- 2,695 -- 2,695
Net loss................ -- -- -- -- -- -- (28,261) (28,261)
---------- ---- ---------- ---- ------- ------- -------- --------
Balance at September 30,
1998................... 18,246,162 $ 18 11,634,149 $ 12 $30,732 $(6,306) $(30,873) $ (6,417)
========== ==== ========== ==== ======= ======= ======== ========
</TABLE>
- -------
(1) See Note 7.
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>
Nine Months Ended
Year Ended September 30,
December 31, --------------------
1997 1997 1998
------------- ----------- --------
(Restated)(1) (Unaudited)
<S> <C> <C> <C>
Operating activities:
Net loss................................... $(2,612) $(1,104) $(28,261)
Reconciliation of net loss to net cash
provided by (used in) operating
activities:
Depreciation and amortization............ 70 -- 1,348
Amortization of deferred compensation.... 295 134 2,695
Accreted interest and amortization of
debt discount and deferred debt issuance
costs................................... -- -- 10,809
Net changes in current assets and
liabilities:
Accounts receivable.................... (25) -- (1,037)
Inventories............................ (43) -- (825)
Other current assets................... (373) (32) (1,245)
Accounts payable....................... 651 662 8,126
Unearned revenue....................... 7 -- 283
Other current liabilities.............. 135 35 3,911
------- ------- --------
Net cash used in operating activities ..... (1,895) (305) (4,196)
Investing activities:
Purchase of restricted investment.......... (210) -- (23)
Deposits................................... (31) (47) (251)
Long term receivable....................... -- -- (887)
Purchase of property and equipment......... (2,253) (1,104) (32,303)
------- ------- --------
Net cash used in investing activities ..... (2,494) (1,151) (33,464)
Financing activities:
Net proceeds from issuance of long-term
debt and warrants......................... -- -- 129,328
Principal payments under capital lease
obligations............................... (48) -- (183)
Proceeds from common stock issuance, net of
repurchase................................ 108 100 302
Proceeds from preferred stock issuance..... 8,707 8,707 1,200
Offering costs related to common stock
offering.................................. -- -- (289)
------- ------- --------
Net cash provided by financing activities.. 8,767 8,807 130,358
------- ------- --------
Net increase in cash and cash equivalents.. 4,378 7,351 92,698
Cash and cash equivalents at beginning of
period.................................... -- -- 4,378
------- ------- --------
Cash and cash equivalents at end of year... $ 4,378 $ 7,351 $ 97,076
======= ======= ========
Supplemental disclosures of cash flow
information:
Cash paid during the year for interest... $ 9 $ -- $ 78
======= ======= ========
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 7.
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 Company was organized in October 1996. On July 16,
1997, Covad Communications Group, Inc. (the "Company") was incorporated in the
state of Delaware. Simultaneous with the Company's incorporation, an exchange
agreement was executed which effectively made Covad Communications Company a
wholly-owned subsidiary of the Company.
The Company is a packet-based Competitive Local Exchange Carrier that
provides dedicated high-speed digital communication services using Digital
Subscriber Line ("DSL") technology to enterprise and Internet Service Provider
customers. 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. ISPs purchase the Company's services
in order to provide high-speed Internet access to their business and consumer
end-users. 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 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 consolidated financial statements and related footnotes as of and for
the nine months ended September 30, 1997 are unaudited, but include all
adjustments (consisting of normal recurring adjustments) that the Company
considers necessary for a fair presentation of financial position and
operating results.
The accompanying statements of operations, stockholders' equity, and cash
flows for the year ended December 31, 1997 and the nine months ended September
30, 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. Payments received in advance of providing services
are recorded as unearned revenue until the period such services are provided.
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.
F-7
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
D. Restricted Cash
As of December 31, 1997 and September 30, 1998, the Company had $210,000 and
$233,000, respectively, in commercial deposits held in the Company's name but
restricted as security for certain of the Company's capital lease
arrangements.
E. Inventories
Inventories are stated at the lower of cost or market. 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......................... 5 to 7 years
Computer equipment............................. 3 years
Office equipment............................... 2 to 5 years
Computer software.............................. 3 to 7 years
</TABLE>
The Company capitalizes costs associated with the design and implementation
of the Company's network including internally and externally developed
software. Capitalized external software costs include the actual costs to
purchase existing software from vendors. Capitalized internal software costs
generally include personnel costs incurred in the enhancement and
implementation of purchased software packages. As of December 31, 1997 and
September 30, 1998, total capitalized internal costs were $139,000 and
$1,454,000, respectively.
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
From January 1, 1997 to June 30, 1997, Covad Communications Company was an S
Corporation under the provisions of the Internal Revenue Code. Effective June
30, 1997, Covad Communications Company terminated its S Corporation status and
became a C Corporation, and on July 16, 1997 Covad Communications Company
became a wholly-owned subsidiary of the Company. Under S Corporation
provisions, income or losses of Covad Communications Company were reported by
the stockholders on their individual federal and state income tax returns, and
Covad Communications Company did not pay income taxes or receive income tax
benefits.
The Company accounts for income taxes under the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes"
which provides for the establishment of deferred tax assets and liabilities
for the net tax effects of temporary differences between the carrying amounts
of assets and liabilities for financial reporting purposes and the amounts
used for income tax purposes. As of December 31, 1997, the Company had
deferred tax assets of approximately $820,000 primarily related to federal and
California net operating loss carryforwards. The net deferred tax asset has
been fully offset by a valuation allowance. The
F-8
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
federal and California net operating loss carryforwards of approximately
$2,062,000 at December 31, 1997, expire in 2012 and 2005, respectively. For
the nine months ended September 30, 1998, the Company has incurred additional
operating losses which are expected to generate net operating loss
carryforwards for the 1998 tax year. Utilization of the net operating losses
is subject to a substantial annual limitation provided by the Internal Revenue
Code of 1986 and similar state provisions. The annual limitation may result in
the expiration of net operating losses before utilization.
I. Use of Estimates in the Preparation of Financial Statements
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 and
accompanying notes. Actual results could differ from those estimates.
J. Fair Value of Financial Instruments
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," which are effective for the
Company's December 31, 1997 financial statements, 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 September 30, 1998, fair value
approximates recorded value.
K. Earnings (Loss) Per Share
In March 1997, SFAS No. 128 "Earnings Per Share" ("SFAS 128") was issued
specifying the computation, presentation, and disclosure requirements for
earnings per share for publicly held entities. This statement is effective for
financial statements for both interim and annual periods ending after December
15, 1997. The Company has applied the provisions of SFAS 128.
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
F-9
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
the impact of the assumed exercise of the stock options and warrants and the
assumed preferred stock conversion is not dilutive.
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. The pro
forma net loss per share assumes the conversion of the Preferred Stock and the
exercise for cash of warrants to purchase 1,800,000 shares of Common Stock
immediately prior to the consummation of the Company's initial public offering
of Common Stock.
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 and pro
forma net income (loss) per share (in thousands, except share and per share
amounts):
<TABLE>
<CAPTION>
Nine Months Ended
Year Ended September 30,
December 31, ------------------------
1997 1997 1998
------------ ----------- -----------
(Unaudited)
<S> <C> <C> <C>
Net income (loss)........................ $ (2,612) $ (1,104) $ (28,261)
Basic and diluted:
Weighted average shares of common stock
outstanding........................... 11,021,269 10,892,714 11,446,004
Less: Weighted average shares subject
to repurchase......................... 7,749,723 7,883,385 6,071,080
----------- ----------- -----------
Weighted average shares used in computing
basic and diluted net income (loss) per
share................................... 3,271,546 3,009,329 5,374,924
=========== =========== ===========
Basic and diluted net income (loss) per
share................................... $ (0.80) $ (0.37) $ (5.26)
=========== =========== ===========
Pro forma (unaudited):
Shares used above........................ 3,271,546 3,009,329 5,374,924
Pro forma adjustment to reflect weighted
effect of assumed conversion of
convertible preferred stock............. 8,251,370 5,050,367 18,124,845
Pro forma adjustment to reflect weighted
effect of assumed exercise of common
warrants................................ -- -- 1,345,055
----------- ----------- -----------
Shares used in computing pro forma basic
and diluted net income (loss) per common
share................................... 11,522,916 8,059,696 24,844,824
=========== =========== ===========
Pro forma basic and diluted net income
(loss) per share........................ $ (0.23) $ (0.14) $ (1.14)
=========== =========== ===========
</TABLE>
L. Concentration of Credit Risk
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. The Company has incurred no bad debt
losses through September 30, 1998.
2. Debt
On March 11, 1998, the Company completed a private placement (the "1998
Private Offering") through the issuance of 260,000 units (the "Units"), each
unit consisting of $1,000 in principal amount at maturity of 13 1/2% Senior
Discount Notes due 2008 (the "Notes") and one warrant, initially exercisable
to purchase 19.4376 shares of common stock, $0.001 par value, of the Company
(the "Unit Warrants"). Net proceeds from the 1998 Private Offering were
approximately $129.6 million, after transaction costs of approximately $5.5
million.
F-10
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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. Additional debt
issuance costs were incurred through the issuance of warrants associated with
the commitment of equity by certain investors. The debt issuance costs are
also being amortized over the life of the Notes. For the nine months ended
September 30, 1998, the accretion of the Notes and the amortization of debt
discount and debt issuance costs was $10.8 million and is included in interest
expense in the accompanying consolidated financial statements.
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 September 30, 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>
Period
Ending
December 31,
------------
<S> <C>
1998........................................................... $ 81,000
1999........................................................... 331,000
2000........................................................... 294,000
2001........................................................... 44,000
2002........................................................... 4,000
Thereafter..................................................... --
---------
754,000
Less amount representing interest.............................. (120,000)
Less current portion........................................... (254,000)
---------
Total long-term portion........................................ $ 380,000
=========
</TABLE>
Accumulated amortization for equipment under capital leases is reflected in
accumulated depreciation and amortization for property and equipment.
F-11
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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>
Period Ending
December 31,
-------------
<S> <C>
1998.......................................................... $ 701,000
1999.......................................................... 2,508,000
2000.......................................................... 2,105,000
2001.......................................................... 2,159,000
2002.......................................................... 1,436,000
Thereafter.................................................... 858,000
----------
Total..................................................... $9,767,000
==========
</TABLE>
Rental expense on operating leases totaled $131,000 and $744,000 for the
year ended December 31, 1997 and the nine months ended September 30, 1998,
respectively.
5. Other Assets and Other Liabilities
On December 30, 1997, the Company entered into a capital lease agreement
(see Note 3) with a principal balance of $316,000. As of December 31, 1997,
this amount had not yet been received into the Company's bank account and is,
therefore, included as part of other current assets on the balance sheet.
6. 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 September 30, 1998, were 11,361,204
and 11,634,149 shares, respectively, of which 7,033,107 and 5,375,583 shares,
respectively, remain subject to repurchase provisions which generally lapse
over a four year period from the date of issuance.
Common Stock reserved for future issuance as of September 30, 1998 is as
follows:
<TABLE>
<S> <C>
Convertible preferred stock..................................... 18,246,162
Outstanding and reserved options................................ 13,878,555
Outstanding warrants............................................ 6,988,764
----------
Total......................................................... 39,113,481
==========
</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, September 30,
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 September 30, 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 September 30,
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 September 30, 1998............. -- --
--- ---
$18 $18
=== ===
</TABLE>
Equity Commitment
On February 20, 1998, the Company entered into a Series C Preferred Stock
and Warrant Subscription Agreement (the "Subscription Agreement") with certain
of its investors (the "Series C Investors") pursuant to which the Series C
Investors have unconditionally agreed to purchase an aggregate of 5,764,143
shares of Series C Preferred Stock and warrants to purchase an aggregate of
4,729,500 shares of Series C Preferred Stock (the "Series C Warrants") for an
aggregate purchase price of $16.0 million at a date to be determined by the
Company but no later than March 11, 1999. The Company either has agreed to
call 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").
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 Series C Warrants issuable in connection with the closing of the Equity
Commitment will have five-year terms, have an exercise price of $2.7767 per
share of Series C Preferred Stock (subject to adjustment in certain events),
are immediately exercisable and contain a net exercise provision. The Common
Warrants issued upon the signing of the Subscription Agreement have five-year
terms (but must be exercised prior to the closing of an initial public
offering of equity securities by the Company), have exercise prices of $0.0033
per share, are immediately exercisable and contain net exercise provisions.
F-13
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Stock Purchase
On March 11, 1998, an investor in the Company purchased 360,144 shares of
Series C Preferred Stock and Series C Warrants to purchase an aggregate of
295,500 shares of Series C Preferred Stock for an aggregate purchase price of
$1.0 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 Attributes
The holders of Series A, Series B and Series C are entitled to receive in
any fiscal year, dividends at the rate of $0.0167 per share, $0.04 per share
and $0.2233 per share, respectively, payable in preference and priority to any
payment of dividends on Common Stock. The rights to such dividends are
cumulative and accrue to the holders to the extent they are not declared or
paid and are payable, 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 September 30, 1998 for Preferred Stock were
$318,250 and $887,830, respectively, none of which has been declared or paid.
Subject to certain adjustments as set forth in the Certificate of
Incorporation, each share of Series A, Series B and Series C is convertible
into one share of Common Stock. Each share of Series A, Series B and Series C
is entitled to the number of votes equal to the number of shares of Common
Stock in which such shares of Series A, Series B and Series C, respectively,
could be converted.
In the event of any liquidation or dissolution or winding up of the Company,
either voluntary or involuntary, the holders of Series A, Series B and Series
C are entitled to receive, in addition to the cumulated and unpaid dividends,
$0.3333, $0.50 and $2.7767 per share, respectively (the "Initial Preference"),
until, with respect to Series A and Series B only, a "Liquidation Preference
Threshold" is met based on a formula as set forth in the Certificate of
Incorporation. After payment of these preferences, any remaining amounts are
distributed to the holders of Series A, Series B, Series C and Common Stock on
a pro rata basis based on the number of shares of Common Stock held by each
holder on an as-converted basis. If the "Liquidation Preference Threshold" is
met, the Initial Preference is eliminated with respect to Series A and Series
B only.
7. Stock Options
In 1997, the Company adopted the Covad Communications Group, Inc. 1997 Stock
Plan (the "Plan"). The Plan provides for the grant of stock purchase rights
and options to purchase shares of Common Stock to employees and consultants
from time to time as determined by the Board of Directors. The options expire
from two to eight years after the date of grant. As of September 30, 1998 the
Plan has reserved 13,970,250 shares of the Company's Common Stock for sale and
issuance under the Plan at prices to be determined by the Board of Directors.
The following is a summary of the status of stock options outstanding at
September 30, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
- ------------------------------------------------------- ------------------------
Weighted- Weighted- Weighted-
Exercise Number of Average Average Number of Average
Price Range Shares Life Remaining Exercise Price Shares Exercise Price
----------- --------- -------------- -------------- --------- --------------
<S> <C> <C> <C> <C> <C>
$0.033-$0.667. 6,835,793 7.08 years $0.276 1,291,659 $0.091
$1.00-$1.627.. 2,870,029 7.83 years $1.168 26,029 $1.627
$5.75......... 1,506,428 7.92 years $5.750 -- --
$7.38-$7.93... 569,250 8.00 years $7.546 1,000 $7.930
</TABLE>
F-14
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table summarizes stock option activity for the year ended
December 31, 1997 and the nine months ending September 30, 1998:
<TABLE>
<CAPTION>
Number of
Shares of Option Price
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.......................................... 8,377,356 $0.10 -$7.93
Exercised........................................ (85,695) $0.033-$0.667
Forfeited........................................ (314,911) $0.05 -$7.38
---------- -------------
Balance as of September 30, 1998................. 11,781,500 $0.033-$7.93
========== =============
</TABLE>
The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees," ("APB 25") and related
interpretations in accounting for its employee stock options and the
disclosure only provisions of SFAS No. 123, "Accounting and Disclosure of
Stock-Based Compensation," ("SFAS 123"). Under APB 25, compensation expense is
recognized based on the amount by which the fair value of the underlying
common stock exceeds the exercise price of stock options at the date of grant.
As 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
nine months ended September 30, 1998, the Company recorded additional deferred
compensation of approximately $8.4 million. Amortization of deferred
compensation during this same period was $2.7 million.
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 the nine months ended September 30,
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 the nine months ended September 30, 1998 was $0.26
and $1.49 per share, respectively. For pro forma purposes,
F-15
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 $313,000 for the year ended December
31, 1997 and nine months ended September 30, 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 $0.06 per share for the
nine months ended September 30, 1998.
8. Legal Proceedings
The Company is engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with multiple 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 (COs), the cost and delivery of 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. Year 2000 Compliant (unaudited)
The Company has reviewed its internally developed information technology
systems and programs and believes that its systems are Year 2000 compliant and
that there are no significant Year 2000 issues within the Company's systems or
services. The Company has not reviewed its non-information technology systems
for Year 2000 issues relating to embedded microprocessors. To the extent that
such issues exist, these systems may need to be replaced or upgraded to become
Year 2000 compliant. The Company believes that its non-information technology
systems will not present any significant Year 2000 issues, although there can
be no assurance in this regard. In addition, the Company utilizes third-party
equipment and software and interacts with ILECs that have equipment and
software that may not be Year 2000 compliant. Failure of such third-party or
ILEC equipment or software to operate properly with regard to the year 2000
and thereafter could require the Company to incur unanticipated expenses to
remedy any problems, which could have a material adverse effect on the
Company's business, prospects, operating results and financial condition.
Furthermore, the purchasing patterns of the Company's ISP 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 the Company's services,
which could have a material adverse effect on the Company's business,
prospects, operating results and financial condition. The Company, to date,
has not made any assessment of the Year 2000 risks associated with its third-
party or ILEC equipment or software or with its ISP and enterprise customers,
has not determined the risks associated with the reasonably likely worst-case
scenario and has not made any contingency plans to address such risks.
However, the Company intends to devise a Year 2000 contingency plan prior to
December 1999.
F-16
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
10. Subsequent Event (unaudited)
In December 1998 and 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.
F-17
<PAGE>
APPENDIX
COVAD COMMUNICATIONS GROUP, INC.
GLOSSARY OF TERMS
Access Line--A circuit that connects a telephone end-user to the ILEC CO.
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 protocol that segments digital
information into 53-byte cells (5-byte header and 48-byte payload) that are
switched throughout a network over virtual circuits. 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.
CO (Central Office)--ILEC facility where subscriber lines are joined to
switching equipment.
CLEC (Competitive Local Exchange Carrier)--Category of telephone service
provider (carrier) that offers services similar to those of the ILEC, as
allowed by recent changes in telecommunications law and regulation. A CLEC may
also provide other types of services such as long distance, Internet access
and entertainment.
CLEC 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 ILEC and other CLECs. 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.
CPE--Customer Premise Equipment.
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 ILEC'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
ADSL which is interoperable with full rate ADSL but is not as fast. The
specification is intended to reduce the installation complexity and cost of a
consumer DSL solution.
HFC (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. An HFC architecture generally
utilizes fiber optic wire between the headend and the nodes and coaxial wire
from nodes to individual end-users.
ILEC (Incumbent Local Exchange Carrier)--The local exchange carrier that was
the monopoly carrier in a region, prior to the opening of local exchange
services to competition.
A-1
<PAGE>
ILEC Collocation--A location serving as the interface point for a CLEC
network's interconnection to that of the ILEC. Collocation can be (i)
physical, in which the CLEC places and directly maintains equipment in the
ILEC CO, or (ii) virtual, in which the CLEC leases a facility, similar to that
which it might build, to effect a presence in the ILEC CO.
Interconnection (Co-Carrier) Agreement--A contract between an ILEC and a
CLEC for the interconnection of the two networks and CLEC access to ILEC UNEs.
These agreements set out the financial and operational aspects of such
interconnection and access.
ISP (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 CLECs.
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)--ILECs 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.
UNEs (Unbundled Network Elements)--The various portions of an ILEC's network
that a CLEC can lease for purposes of building a facilities-based competitive
network, including copper lines, CO collocation space, inter-office transport,
operational support systems, local switching and rights of way.
A-2
<PAGE>
[TELESPEED SERVICE GRAPHIC]
First Header: The TeleSpeed Service.
Second Header: Covad Regional Network.
Description: Graphic illustration of Covad's Network Operations Centre
connected by lines representing the Company's DSL subscriber lines to graphic
illustrations of two homes, a business, a corporation and an internet service
provider. The graphic illustration of the corporation is connected to the
graphic illustration of the internet service provider by a shaded area
imprinted with "www" representing the Internet.
Caption: Advantages: FAST--Enables high-speed downloading of Web pages and
files. ALWAYS ON--No dial-up process required. SECURE--A dedicated connection
to the home or business.
<PAGE>
================================================================================
No dealer, salesperson or any other person has been authorized to give any in-
formation or to make any representation in connection with the offer other than
those contained in this Prospectus, and, if given or made, such information or
representation must not be relied upon as having been authorized by the Company
or any underwriter. This Prospectus does not constitute an offer to sell or the
solicitation of any offer to buy any security other than those to which it re-
lates, nor does it constitute an offer to sell, or the solicitation of an offer
to buy, to any person in any jurisdiction in which such offer or solicitation
is not authorized, or in which the person making such offer or solicitation is
not qualified to do so, or to any person to whom it is unlawful to make such
offer or solicitation. Neither the delivery of this Prospectus nor any offer or
sale made hereunder shall, under any circumstances, create any implication that
there has been no change in the affairs of the Company since the date hereof or
that the information contained herein is correct as of any time subsequent to
the date hereof.
---------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary........................................................ 3
Risk Factors.............................................................. 9
Use of Proceeds........................................................... 25
Dividend Policy........................................................... 25
Capitalization............................................................ 26
Dilution.................................................................. 27
Selected Consolidated Financial Data...................................... 28
Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................... 30
Business.................................................................. 39
Management................................................................ 57
Certain Relationships and Related Transactions............................ 66
Principal Stockholders.................................................... 70
Description of Capital Stock.............................................. 72
Shares Eligible for Future Sale........................................... 74
Underwriting.............................................................. 76
Legal Matters............................................................. 78
Experts................................................................... 78
Additional Information.................................................... 79
Index to Financial Statements............................................. F-1
Glossary.................................................................. A-1
</TABLE>
================================================================================
================================================================================
7,800,000 Shares
[LOGO OF COVAD COMMUNICATIONS GROUP, INC. APPEARS HERE]
Covad Communications Group, Inc.
Common Stock
---------------
PROSPECTUS
---------------
Bear, Stearns & Co. Inc.
BT Alex. Brown
Donaldson, Lufkin & Jenrette
Goldman, Sachs & Co.
January 21, 1999
================================================================================
