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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____ TO ____
COMMISSION FILE NUMBER 0-27588
COVAD COMMUNICATIONS GROUP, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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<S><C> <C> <C>
DELAWARE 4813 77-0461529
(STATE OR OTHER JURISDICTION OF (PRIMARY STANDARD INDUSTRIAL (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) CLASSIFICATION CODE NUMBER) IDENTIFICATION NUMBER)
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2330 CENTRAL EXPRESSWAY
SANTA CLARA, CALIFORNIA 95050
(408) 844-7500
(ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, PAR VALUE $0.001 PER SHARE
(TITLE OF CLASS)
STOCK PURCHASE RIGHTS PURSUANT TO RIGHTS AGREEMENT
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was sold on March 24, 2000 as reported on the NASDAQ National Market, was
approximately $7,711,014,000. Shares of common equity held by each officer and
director and by each person who owns 5% or more of the outstanding common equity
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
APPLICABLE ONLY TO CORPORATE ISSUERS:
As of March 24, 2000, there were 97,992,295 shares outstanding of the
Registrant's Common Stock, including Class B Common Stock.
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PART I
ITEM 1. BUSINESS
THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS
INCLUDING, BUT NOT LIMITED TO, THOSE DISCUSSED IN "ITEM 7, MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS--RISK
FACTORS" AND ELSEWHERE IN THIS REPORT.
WE DISCLAIM ANY OBLIGATION TO UPDATE INFORMATION CONTAINED IN ANY
FORWARD-LOOKING STATEMENT. SEE "ITEM 7, MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS--FORWARD LOOKING STATEMENTS."
OVERVIEW
We are a leading provider of broadband communications services to Internet
service provider, enterprise, telecommunications carrier and other customers.
These services include a range of high-speed, high capacity Internet and network
access services using digital subscriber line (DSL) technology, and related
value-added services. Internet service providers purchase our services in order
to provide high-speed Internet access to their business and consumer end-users.
Enterprise customers purchase our services directly or indirectly from us to
provide employees with high-speed remote access to the enterprise's local area
network (RLAN access), which improves employee productivity and reduces network
connection cost. Telecommunications carrier customers purchase our services for
resale to their Internet service provider affiliates, Internet users and
enterprise customers.
As of December 31, 1999, we believe we have the nation's largest DSL
network with more than 1,100 operational central offices passing over at least
29 million homes and businesses. As of December 31, 1999, we had installed
57,000 DSL based high-speed access lines and received orders for our services
from 295 Internet service provider, enterprise, and telecommunications carrier
customers, including AT&T, Concentric Network, Flashcom, MindSpring, Oracle,
Prodigy, PSINet, Qwest, Stanford University, Sun Microsystems, UUNET and Verio.
By February 29, 2000, we had deployed our network in a total of 62
metropolitan statistical areas. When our 100 metropolitan statistical area
(MSA's) build-out is completed, which we expect to be by the end of 2000, our
network will pass a total of 46 million homes and businesses, representing 40%
of homes and 45% of businesses in the United States.
We plan to continue to pursue rapid network expansion and installation of
high-speed access lines. We also plan to develop a variety of services that are
enhanced or enabled by our expanding network by entering into business
arrangements with broadband-related service providers in order to bring a
variety of value-added service offerings to our customers and their end-users.
INDUSTRY BACKGROUND
GROWING MARKET DEMAND FOR BROADBAND COMMUNICATIONS BANDWIDTH SERVICES
High-speed connectivity has become important to small- and medium-sized
businesses and consumers due to the dramatic increase in Internet usage.
According to International Data Corporation, the number of Internet users
worldwide reached approximately 142 million in 1998 and is forecasted to grow to
approximately 502 million by 2003. The popularity of the Internet with consumers
has driven the rapid proliferation of the Internet as a commercial medium.
Businesses are increasingly establishing Web sites and corporate intranets and
extranets to expand their customer reach and improve their communications
efficiency. Consumers are increasingly using the Internet to carry out
commercial transactions. International Data estimates that the value of
goods and services
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sold world wide via the Internet will increase from $50 billion in 1998 to over
$1.3 trillion in 2003. Accordingly, to remain competitive, small- and
medium-sized businesses increasingly need high-speed Internet connections to
maintain complex Web sites, access critical business information and communicate
more effectively with employees, customers and business partners. Broadband
connections are also becoming increasingly important to businesses and consumers
as rich Internet content--such as multi-media advertising, news and
entertainment--and on-line consumer transactions and e-commerce become more
widely available and widely used.
The demand for broadband communications services for RLAN access is also
growing rapidly. Over the past ten years, high-speed local area networks have
become increasingly important to enterprises to enable employees to share
information, send e-mail, search databases and conduct business. We believe that
a large majority of personal computers used in enterprises are connected to
local area networks. Enterprises are now seeking to extend this same high-speed
connectivity to employees accessing the local area networks from home to improve
employee productivity and reduce operating costs. The number of home office
households on the Internet grew from 12.0 million at the end of 1997 to an
estimated 19.7 million by the end of 1999 and is expected to grow to 30.2
million households by 2002. Only 3.7% of these users currently access the
Internet through a broadband connection of any type.
As use of the Internet, intranets and extranets increases, we expect the
market size for both small- and medium-sized business and consumer Internet and
RLAN access to continue to grow rapidly causing the demand for broadband
communications services to also grow rapidly. However, the full potential of
Internet and local area network applications cannot be realized without removing
the performance bottlenecks of the existing public switched telephone network.
Increases in telecommunications bandwidth have significantly lagged improvements
in microprocessor performance over the last ten years. Since 1988,
microprocessor performance has improved nearly 80-fold, while the fastest
consumer modem connection has improved from 9.6 kilobits per second to 56.6
kilobits per second, a factor of six. According to industry analysts, there are
nearly 40 million personal computers in U.S. homes today, and most of them can
only connect to the Internet or their corporate local area network by low-speed
analog lines. Higher speed connections are available, including:
o INTEGRATED SERVICES DIGITAL NETWORKS - An ISDN line 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 compatible PBX systems.
o T1 LINE AND FRACTIONAL T1 - These are telephone industry
terms for a digital transmission link with a capacity of 1.544
megabits per second or portions thereof.
o FRAME-RELAY - A high-speed packet-switched data communications protocol.
o CABLE MODEM - Internet access over hybrid fiber coaxial cable.
While these services have recently experienced dramatic growth in the U.S.,
they are frequently expensive, complex to order, install and maintain, and in
some cases are not as widely available as DSL technology.
EMERGENCE OF DSL TECHNOLOGY
DSL technology first emerged in the 1990s and is commercially available
today to address 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 copper telephone lines from
analog modem speeds of 56.6 kilobits per second, for the fastest consumer
modems, and ISDN speeds of 128 kilobits per second to DSL speeds of up to 6
megabits per second depending on the length and condition of the copper line.
Recent advances in semiconductor technology and digital signal processing
algorithms and falling equipment prices have made the widespread deployment of
DSL technology more economical over time. We anticipate that equipment prices
will continue to fall as a result of continued advances in semiconductor
technologies and increases in equipment production volumes.
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Because DSL technology reuses the existing copper plant, it is
significantly less expensive to deploy on a broad scale than alternative
technologies, such as cable modems, wireless data and satellite data. As a
result, a significant portion of the investment in a DSL network is
success-based, requiring a comparatively lower initial fixed investment.
Subsequent variable investments in DSL technology are directly related to the
number of paying customers.
IMPACT OF REGULATORY DEVELOPMENTS
The passage of the 1996 Telecommunications Act created a legal framework
for competitive telecommunications companies to provide local analog and digital
communications services in competition with the traditional telephone companies.
The 1996 Telecommunications Act eliminated a substantial barrier to entry for
competitive telecommunications companies by enabling them to leverage the
existing infrastructure built by the traditional telephone companies, which
required a $200 billion investment by these telephone companies and their
ratepayers, rather than constructing a competing infrastructure at significant
cost. The 1996 Telecommunications Act requires traditional telephone companies,
among other things:
o to allow competitive telecommunications companies to lease telephone
wires on a line by line basis;
o to provide central office space for the competitive telecommunications
companies' DSL and other equipment required to connect to the leased
telephone wires;
o to lease access on their inter-central office fiber backbone to link
the competitive telecommunications companies' equipment; and
o to allow competitive telecommunications companies to electronically
connect into their operational support systems to place orders and
access their databases.
The 1996 Telecommunications Act, as interpreted by the Federal
Communications Commissions (FCC), in particular emphasized the need for
competition-driven innovations in the deployment of advanced telecommunications
services, such as DSL services.
OUR COMPETITIVE STRENGTHS
We were formed to capitalize on the substantial business opportunity
created by the growing demand for broadband Internet and network access, the
commercial availability of low-cost DSL technology and the passage of the 1996
Telecommunications Act. Key aspects of our solution to provide broadband
communications services include:
o an attractive value proposition that provides high-speed connections
at similar or lower prices than alternative high-speed technologies
currently available to customers;
o a rapid network deployment and service rollout with significant
increases in line installations to date;
o a widely available, continuously connected, secure network that
facilitates deployment of Internet and intranet applications; and
o a management team experienced in the data communications,
telecommunications and personal computer industries.
ATTRACTIVE VALUE PROPOSITION. We offer higher bandwidth digital connections
than alternative services at similar or lower prices that do not vary with
usage. For business Internet users, our high-end services offer bandwidth
comparable to that offered by T1 and frame-relay circuits at approximately 25%
of the cost. For the RLAN market, our mid-range services are three to six times
the speed of ISDN lines and up to ten times the speed of analog modems at
monthly rates similar to or lower than those for heavily used ISDN lines. We
believe that many of our enterprise customers can justify deploying lines to
their employees if their productivity improves by only a few hours per month
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based on increases in the number of hours worked and decreases in commute
time and time spent waiting for information. For consumer Internet users, our
consumer services are comparably priced to current cable modem services. Unlike
cable modems, the speed of our service does not decrease when more users are
added.
WE HAVE LEVERAGED OUR FIRST-MOVER ADVANTAGE TO RAPIDLY EXPAND OUR NETWORK
AND GROW OUR NUMBER OF LINES INSTALLED. We were the first to widely roll out DSL
services on a commercial basis, making DSL service available for purchase in the
San Francisco Bay Area in December 1997. We believe that we have leveraged our
first-mover advantage to rapidly expand our network into our targeted
metropolitan regions and grow our number of line installations. We believe we
have the nation's largest DSL network with more than 1,100 operational central
offices passing over more than 29 million homes and businesses. As of December
31, 1999, we had installed a total of 57,000 lines nationwide.
WIDELY AVAILABLE, ALWAYS-CONNECTED SECURE NETWORK. Our strategy of
providing blanket coverage in each region we serve is designed to ensure that
our services are available to the vast majority of our customers' end-users. Our
network provides 24-hour, always-on connectivity, unlike ISDN lines and analog
modems which require customers to dial-up each time for Internet or RLAN access.
Also, because we use dedicated connections from each end-user to the Internet
service provider or enterprise network, our customers can reduce the risk of
unauthorized access. These factors are important to our customers because any
Internet service they market to their end-users must actually be available for
them to purchase and be secure enough to not risk their own reputation or
business with any security lapses.
EXPERIENCED MANAGEMENT TEAM. Our management team includes individuals with
extensive experience in the data communications, telecommunications and personal
computer industries, including Robert Knowling, Jr., Chairman of the Board,
President and Chief Executive Officer (former Executive Vice President of
Operations and Technology at U S WEST Communications), Catherine Hemmer, Chief
Operations Officer (former Vice President, Network Reliability and Operations at
U S WEST Communications, Inc., former General Manager, Network Provisioning at
Ameritech Corporation and former Vice President, Network Services at MFS),
Robert Roblin, Executive Vice President, Sales and 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), Timothy
Laehy, Chief Financial Officer (former Vice President of Corporate Finance and
Treasurer of Leasing Solutions, Inc.), Robert Davenport, III, Executive Vice
President, Business Development (former Senior Vice President and Chief
Operating Officer of Tele-Communication, Inc.'s Internet Services subsidiary
TCI.NET), Joseph Devich, Executive Vice President, Corporate Services (former
Vice President, Operations and Technologies Staff of U S WEST Communications),
Charles Haas, Senior Vice President of Sales Development, Dhruv Khanna,
Executive Vice President, General Counsel and Secretary, Jane Marvin, Senior
Vice President of Human Resources (former Vice President of Human Resources for
the General Business Services unit of Ameritech Corporation), Terry Moya,
Executive Vice President, External Affairs (former Vice President & Chief
Financial Officer, Capital Management, Network Operations and Technologies at U
S West Communications, Inc), and Michael Lach, Executive Vice President,
Business Integration (former Vice President, Customer Provisioning and
Maintenance of Ameritech Corporation).
BUSINESS STRATEGY
Our objective is to become the leading nationwide provider of broadband
services and a critical element in the proliferation of e-commerce and other
applications that are enabled or enhanced by broadband communications. The key
elements of our strategy to achieve this objective are as follows:
EXPAND OUR NETWORK AND ROLL OUT SERVICE RAPIDLY IN OUR TARGETED
METROPOLITAN STATISTICAL AREAS. As of February 29, 2000, we introduced our
services in 62 of the top metropolitan statistical areas nationwide. We have
recently announced our plan to expand our services to a total of 100
metropolitan statistical areas by the end of 2000.
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In the aggregate, these 100 metropolitan statistical areas cover 40% of
homes and 50% of businesses in the United States. In addition, we have recently
begun to assess the regulatory and competitive environments in other countries.
PROVIDE PERVASIVE COVERAGE IN EACH METROPOLITAN STATISTICAL AREA. We are
pursuing a blanket coverage strategy of providing service in a substantial
majority of the central offices in each region that we enter since our Internet
service provider customers desire to market their Internet access services on a
region-wide basis. Blanket coverage is also important to our enterprise
customers since most of them desire to offer RLAN access to all employees
regardless of where they reside. In addition, we believe our presence in 100
metropolitan statistical areas will allow us to better serve our Internet
service provider, enterprise, telecommunications carrier and other customers.
These customers are increasingly seeking a single supplier in multiple
metropolitan areas.
ESTABLISH AND MAINTAIN SALES AND MARKETING RELATIONSHIPS WITH LEADING
INTERNET SERVICE PROVIDERS, TELECOMMUNICATIONS CARRIERS AND OTHER DSL RESELLERS.
We principally target Internet service providers, telecommunications carriers
and other DSL resellers that can offer their end-users cost and performance
advantages for Internet access using our services. We primarily provide
connections to Internet service providers, which in turn offer high-speed
Internet access using our network. In other cases, we provide wholesale DSL and
Internet access services for resale by our customers such as Prodigy and Juno
On-Line. In this way, we:
o carry the traffic of multiple Internet service providers,
telecommunications carriers and other customers in any region,
increasing our volume and reducing our costs;
o leverage our selling efforts through the sales and support staff of
these Internet service providers, telecommunications carriers and
other customers;
o offer Internet service providers, telecommunications carriers and
other customers an alternative, since the traditional telephone
company typically provides its own retail Internet access services in
competition with our customers; and
o provide Internet service providers, telecommunications carriers and
other customers a high-speed service offering to compete with
cable-based Internet access.
DEVELOP A NATIONAL BRAND. We believe that we can enhance our competitive
position and increase demand for our services by actively developing a positive
brand and image for our Company and our services through a combination of
television, print and radio advertisements on both a national and local basis.
In October 1999, we commenced a significant national advertising campaign in
pursuit of this strategy. This branding strategy has created the opportunity for
us to provide end-user leads to our existing customers.
DEVELOP AND COMMERCIALIZE VALUE-ADDED SERVICES. We intend to introduce
value-added services to our customers and leverage the value of the network
access we offer today. Offering services such as voice over DSL, DSL plus
International Protocol (DSL + IP), and our Virtual Broadband Service Provider
(VBSP)offering will allow us to bundle service offerings to our customers and
improve the quality of content delivery to their end-users as well as reduce
costs. We believe this is an important part of our strategy and will allow us to
build upon our success to date in adding and retaining subscribers.
ACQUIRE AND ENTER INTO BUSINESS ARRANGEMENTS WITH NETWORK AND
BROADBAND-RELATED SERVICE PROVIDERS. We believe that the pace of deployment of
our network can be increased by acquiring and entering into business
arrangements with other network service providers, some of which may be located
outside of the United States. We also believe our network deployment will enable
the delivery of a variety of broadband-related services and content that are
desired by our customers. We expect to make these services available to our
customers through acquiring and entering into business arrangements with leading
providers of broadband-related services or content. For example, we recently
acquired Laser Link.Net, Inc. This acquisition will allow us to better provide
DSL and IP services on a wholesale basis and better enable us to serve customers
who do not wish to maintain any network facilities.
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TAKE ADVANTAGE OF NEW REGULATORY DEVELOPMENTS. In late 1999, the FCC
required the major local phone companies to provide us, and other competitive
local carriers, with "line sharing." This would allow us to provide our services
over the same telephone wire used by the traditional telephone companies to
provide analog voice services. In addition, some of the Ameritech/SBC merger
conditions adopted by the FCC in October 1999 also contain provisions on line
sharing and provide for reductions in costs for telephone wires in certain
circumstances. In many cases, line sharing would allow us to provision our
asymmetric DSL services on the same telephone wire as the existing local phone
companies' voice service. Currently, we provide our DSL services over a separate
additional telephone wire. Asymmetric DSL and standard telephone service can
exist on a single line and most, if not all, of the traditional telephone
companies provision their own asymmetric services on the same line as existing
voice services.
We see line sharing as an extremely important opportunity for us for three
primary reasons. First, line sharing should significantly reduce the monthly
recurring charges we incur for telephone wires. Second, line sharing should
reduce the time it takes traditional telephone companies to deliver telephone
wires because the telephone wire will already exist. Third, line sharing should
resolve lack of telephone wire problems that we have encountered when ordering
telephone wires in some areas of the country. We are negotiating line sharing
arrangements with the major incumbent local telephone carriers, and have
implemented line sharing line sharing on a trial basis in the case of a few
lines. We expect the traditional local phone companies to implement line sharing
on a wide scale later this year.
OUR SERVICE OFFERINGS
We offer six business-grade services under the TeleSpeed brand to connect
our customers' end-users to our regional data centers and two consumer-grade
service offerings called TeleSurfer and TeleSurfer Pro. In March 2000, we
introduced two new services--DSL+IP and VBSP. We also offer business consumers
Virtual Private Network (VPN) technology over DSL. In addition, Internet service
provider and enterprise customers may purchase backhaul services from us to
connect their facilities to our regional data centers.
TELESPEED SERVICES
Our TeleSpeed services connect individual end-users on conventional
telephone wires to our DSL equipment in their serving central office and from
there to our network serving that metropolitan statistical area. A traditional
telephone company's infrastructure consists of numerous central offices which
are connected by a fiber optic backbone to a regional office that routes local
and long distance traffic. Each central office collects the individual telephone
wires from end-users' premises in the neighborhood.
The particular TeleSpeed service available to an end-user depends in large
part on the user's distance to the central office. We believe that substantially
all, if not all, of our potential end-users in our target markets generally can
be served with one of our services. We estimate that approximately 70% of
end-users are within 18,000 feet of a central office and can be served by at
least our TeleSpeed 384 service. However, the specific number of potential
end-users for the higher speeds will vary by central office and by region and
will be affected by line quality. The chart below compares the performance and
markets for each of our intraregional end-user services as of December 31, 1999:
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MAXIMUM MAXIMUM
SPEED TO SPEED FROM RANGE*
INTRAREGIONAL SERVICES END-USER END-USER (FEET) MARKET USAGE
- ---------------------- -------- -------- ----- ------------
TeleSpeed 144............144 Kbps 144Kbps 35,000 ISDN replacement
TeleSpeed 192............192 Kbps 192Kbps 18,000 Business Internet, RLAN
TeleSpeed 384........... 384 Kbps 384Kbps 18,000 Business Internet, RLAN
TeleSpeed 768 .........768 Kbps 768Kbps 13,500 Business Internet
TeleSpeed 1.1............1.1 Mbps 1.1Mbps 12,000 Business Internet
TeleSpeed 1.5........... 1.5 Mbps 384Kbps 15,000 High-speed Web access
* Estimated maximum distance from the end-user to the central office.
Prices for our end-user services may vary depending upon the performance
level of the service. For example, our TeleSpeed 144 and 192 services are our
lowest priced end-user services and our TeleSpeed 1.1 and 1.5 services are our
highest priced end-user services. Our prices also vary across regions and for
high volume customers that are eligible for volume discounts. See "Risk
Factors--We may experience decreasing prices for our services, which may impair
our ability to achieve profitability or positive cash flow" for a discussion of
the risks associated with our ability to sustain current price levels in the
future.
TELESPEED 144. Our TeleSpeed 144 service operates at up to 144 kilobits per
second in each direction, which is similar to the performance of an ISDN line.
This service, which can use existing ISDN equipment at the end-user site, is
targeted at the ISDN replacement market where its per month flat rate can
compare favorably to ISDN services from the traditional telephone company when
per-minute usage charges apply. It is also the service that we offer on
telephone wires that are either too long to carry our higher speed services or
are served by digital loop carrier systems or similar equipment where a
continuous copper connection is not available from the end-user site to a
central office.
TELESPEED 192. This service provides one and a half to three times the
performance of ISDN lines at similar or lower price points to heavily-used ISDN
lines.
TELESPEED 384. This service provides three to six times the performance of
ISDN lines at similar price points to heavily-used ISDN lines.
TELESPEED 768. This service provides one-half the bandwidth of a T1 data
circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 768
service is small businesses needing moderate speed access to the Internet but
who have previously been unable to afford the price of such service. The service
also competes favorably from a price/performance standpoint with traditional
fractional T1 and frame-relay services for these same customers.
TELESPEED 1.1. This service provides over two-thirds the bandwidth of a T1
data circuit at substantially less than one-half of the monthly price that we
estimate is typical for T1 service. The target market for the TeleSpeed 1.1
service is small businesses needing T1-level access to the Internet which have
previously been unable to afford the price of such service. The service also
competes favorably from a price/performance standpoint with traditional
fractional T1 and frame-relay services for these same customers.
TELESPEED 1.5. TeleSpeed 1.5 is an asymmetric service, i.e., with different
speeds to and from the end-user. This service is intended for end-users who
consume more bandwidth than they generate, and is especially useful for
accessing Web sites. The service also provides the highest performance of any
TeleSpeed service to stream video or other multimedia content to end-user
locations.
TELESPEED REMOTE. TeleSpeed Remote provides high-speed network access for
end-users located in remote regions to their corporate networks. This service is
targeted at businesses that want high-speed remote office
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connections at a lower cost than ISDN or frame-relay services. For example,
this service can provide a corporation's employees located in Boston high-speed
access to their corporate network located in San Francisco.
TELESURFER SERVICES
MAXIMUM MAXIMUM
SPEED TO SPEED FROM RANGE*
INTRAREGIONAL SERVICES END-USER END-USER (FEET) MARKET/USAGE
---------------------- -------- -------- ----- ------------
TeleSurfer ADSL 608 Kbps 128 Kbps 12,000 Consumer
TeleSurfer Pro ADSL 1.5 Mbps 384 Kbps 12,000 Consumer
* Estimated maximum distance from the end-user to the central office.
TELESURFER ADSL. This consumer-grade service is an asymmetric service,
offering 608 kilobits per second downstream and 128 kilobits per second
upstream. This service is the base consumer service. The target market for this
service is consumers using either dial-up analog or ISDN connections for web
browsers.
TELESURFER PRO ADSL. This is a premium consumer-grade asymmetric service,
offering 1.5 megabits per second downstream and 384 kilobits per second
upstream. The target market for this service is consumers using analog or ISDN
connections for web browsers.
DSL + IP. This service currently bundles Internet protocol services with
our existing TeleSurfer services. We also plan to offer it with our TeleSpeed
services. The additional Internet protocol services include end-user
authentication, authorization and accounting, Internet protocol address
assignment and management, domain name service and Internet protocol routing and
connectivity
VBSP. We plan to offer this additional service which provides a complete
solution for organizations and businesses that want to offer broadband
Internet services to their customers without having to develop their own
Internet capabilities. We will provide Internet services to end-users under the
brand name of our customer. Our Internet services will be a turnkey solution
that includes registration, connection and Internet software, web sites, network
authentication, electronic mail, billing and reporting, news and personal
web-space for end-users and end-user service and technical support.
VPN OVER DSL
In August 1999 we introduced our VPN over DSL service. This service uses
the public Internet backbone or a private data network, combined with DSL
connections, as a channel for sharing information and applications within a
closed circle of users in different locations. We offer two levels of VPN over
DSL service.
COVAD BRANCH OFFICE. This service is available for remote or branch offices
that require high-speed inter-office connectivity across multiple locations.
COVAD TELEWORKER. This service is available for telecommuters and other
remote users who secure access to their corporate network and the Internet from
home.
OTHER SERVICES
We also provide a DS3 backhaul service from our regional network to an
Internet service provider or enterprise customer site. This service aggregates
all individual end-users in a metropolitan statistical area and transmits the
packet information to the customer on a single high-speed line. The service
utilizes an asynchronous
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transfer mode (ATM) protocol that efficiently handles the high data rates
involved and operates at up to 45 megabits per second. In addition to monthly
service charges, we impose non-recurring order set-up charges for Internet
service provider and RLAN end-users for our DS3 backhaul service. Customers must
also purchase a DSL modem from us or a third party for each end-user of our
services.
CUSTOMERS
We offer our services to Internet service providers, enterprises,
telecommunications carriers and other DSL resellers. According to Claritas,
Inc., a leading provider of diagnostic databases, there are over 169,000
businesses in the U.S. with over 100 employees, of which we estimate
approximately 85,000 are in our 100 targeted metropolitan statistical areas. As
of December 31, 1999, we had installed 57,000 DSL lines and received orders for
our services from 295 Internet service provider, enterprise and
telecommunications carrier customers. The following is a list of selected
Internet service provider, enterprise, telecommunications carrier and other
customers:
<TABLE>
SELECTED INTERNET SERVICE PROVIDER CUSTOMERS SELECTED ENTERPRISE CUSTOMERS SELECTED TELECOMMUNICATIONS CARRIERS
- -------------------------------------------- ----------------------------- ------------------------------------
<S> <C> <C>
Concentric Network Corporation Apple Computer AT&T
Flashcom Inktomi e.spire
Juno Intel GST Telecommunications
MindSpring (Earthlink) Oracle Corporation IGC
PSINet Stanford University Qwest
Prodigy Sun Microsystems RCN Corporation
UUNET WebTV
Verio
</TABLE>
Our agreements with Internet service providers and other DSL resellers
generally have terms of one year and are nonexclusive. We do not require
Internet service providers to generate a minimum number of end-users and
generally grant volume discounts based on order volume. We serve Internet
service providers who provide their own Internet access service and have started
serving Internet service providers who choose to obtain access to the Internet
through us. In both cases, the Internet service providers purchase our services
on a wholesale basis and sell such services under their own brand.
Our practice with respect to our enterprise customers has been to enter
into an arrangement or a negotiated price to install the service initially to a
small number of end-users. An enterprise customer decides whether to implement a
broad rollout of our services after evaluating the results of this initial phase
of deployment. To date, a typical enterprise customer's initial phase of
deployment and its decision to roll out our service to additional end-users has
taken at least six months, and has generally taken longer than we originally
expected. As of December 31, 1999, a substantial majority of our enterprise
customers had not yet rolled out our services broadly to their employees.
We will not receive significant revenue from an enterprise customer until
and unless these rollouts occur. During the lengthy sales cycle for an
enterprise customer, we incur significant expenses in advance of the receipt of
revenues. We also enter into customer agreements with telecommunications
carriers, including competitive telecommunications companies and interexchange
carriers. Under these agreements our telecommunication carrier customers
typically resell our services to their new and existing customers. These
carriers currently market our Internet and RLAN services primarily to small,
medium and enterprise businesses that purchase voice services from them.
SALES AND MARKETING
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BUSINESS AND CONSUMER INTERNET. For the business and consumer Internet
access markets, we sell our service to Internet service providers,
telecommunications carriers and others. These customers can either combine
our lines with their Internet access services, or purchase wholesale Internet
access services from us, and resell the combination to their existing and new
end-users. We address these markets through sales and marketing personnel
dedicated to the Internet service provider sales channel. We supplement our
sales efforts to Internet service providers through training programs and
marketing programs that include promotions and sales incentives designed to
encourage the Internet service providers to sell our services instead of those
of our competitors. As of December 31, 1999, we had more than 225 Internet
service provider and telecommunications carrier customers with their own sales
personnel marketing Internet services.
REMOTE LOCAL AREA NETWORK. We market our RLAN services to businesses
through a direct sales force, augmented by marketing programs with value-added
resellers and interexchange carriers. The sales force is directed to deal
directly with the chief information officer and the telecommunications manager
responsible for remote access within an enterprise. We augment our sales efforts
to RLAN customers through partnerships with value-added resellers, including
systems integrators that can offer our TeleSpeed service as part of a complete
work-at-home solution to businesses.
THIRD-PARTY RELATIONSHIPS. A key element of our strategy is to enter into
relationships with leading telecommunications companies, including competitive
telecommunications carriers and interexchange carriers, pursuant to which those
companies resell our TeleSpeed and TeleSurfer services to their customers. For
example, we have entered into commercial agreements with each of AT&T, GST
Telecommunications, Qwest and RCN Corporation providing for the purchase and
resale of our services, primarily to their small business and enterprise
customers. In addition, in May 1999, we entered into a strategic relationship
with WebMD in which we will be WebMD's preferred provider of broadband
connectivity offering physician subscribers web-based multimedia and
communication services designed to enhance their practices. We believe that
these indirect sales channels will enable us to penetrate our target markets
more rapidly and eventually will generate the majority of sales of our services.
BRANDING AND MARKETING PROGRAMS. In October 1999 we commenced a branding
and advertising effort to educate the market about our broadband service
offerings and increase recognition of our brand. This program, which uses
television, print and radio advertising on both a national and regional basis,
is intended to inform the market about the availability of our service,
differentiate the products and services offered by our Company and simplify the
process through which these products and services are ordered.
We are also pursuing several types of joint marketing arrangements with our
Internet service provider, telecommunications carrier customers and other DSL
resellers. In addition, certain of our equipment suppliers have promoted our
services through seminars to corporate information technology managers in the
San Francisco Bay Area. We also support our sales efforts with marketing efforts
that include advertising programs through radio and other popular media,
attendance at trade shows and presentations at industry conferences. See "Risk
Factors--Our business will suffer if our Internet service providers,
telecommunications carriers and other third parties are not successful in the
marketing and sale of our services."
SERVICE DEPLOYMENT AND OPERATIONS
Internet service providers, telecommunications carriers and corporate
information technology managers typically have had to assemble their digital
communications connections using multiple service and equipment suppliers,
leading to additional work, cost and coordination problems. With our services,
we emphasize a one-stop service solution for our customers. This service
solution includes:
o extending our network to customers and end-users with various needs
and configuration requirements;
o end-user premise wiring and DSL modem configuration;
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o ongoing network monitoring and customer reporting;
o customer service and technical support; and
o operational support system.
EXTENDING OUR NETWORK TO CUSTOMERS AND END-USERS. We work with our Internet
service provider, enterprise, telecommunications carrier and other customers to
extend our network to each customer premise and each end-user premise by
ordering circuits from the traditional telephone company or a competitive
telecommunications company, interconnecting the customers and end-users to our
network, testing the circuits, configuring customer routers or switches and
end-user routers and monitoring the circuits from the network operations center.
END-USER PREMISES WIRING AND DSL MODEM CONFIGURATION. We use our own and
subcontracted field service crews and trucks to perform any required inside
wiring and to configure DSL modems at each end-user site.
NETWORK MONITORING. We monitor our network from our network operations
center, which helps us to identify and correct network problems. We have also
developed network capability to provide Internet service provider, enterprise
and telecommunications carrier customers direct monitoring access of their
end-users for more efficient monitoring of their own network performance.
CUSTOMER REPORTING. We communicate regularly with our customers about the
status of their end-users. We also operate a toll-free customer care help line.
Additionally, we provide Web-based tools to allow individual Internet service
providers and enterprise information technology managers and telecommunications
carriers to monitor their end-users directly, to place orders for new end-users,
to enter trouble tickets on end-user lines and to communicate with us on an
ongoing basis.
CUSTOMER SERVICE AND TECHNICAL SUPPORT. We provide 24x7 on-line support to
our Internet service provider customers and enterprise information technology
managers. The Internet service provider and information technology manager and
telecommunications carriers serve as the initial contact for service and
technical support, and we provide the second level of support. For customers
using our VBSP ofering, we will provide the first level of support for their end
users.
OPERATIONAL SUPPORT SYSTEM. We have developed what we believe to be the
industry-leading operational support system for DSL networks. Our operational
support system is based on web interfaces and is highly automated. These
features are intended to and should allow us to scale our businesses rapidly
because they eliminate many manual processes such as line testing, network path
configuration, equipment configuration, order taking and verification, billing
and telephone wire supplier management.
NETWORK ARCHITECTURE AND TECHNOLOGY
The key design principles of our network attempt to provide the following
attributes which we believe are important requirements of our existing and
potential customers:
ROBUST NETWORK SECURITY. Modem access to enterprise networks presents
significant security risks, since any telephone can be used to attempt to access
such a network simply by dialing the telephone number. As a result, enterprises
expend significant effort and resources to prevent unauthorized access.
Enterprises also typically limit remote access users to reading e-mail or other
non-sensitive applications. Our network is designed to ensure secure
availability of all internal applications and information for remote locations.
Our permanent virtual circuit network architecture connects individual end-users
at fixed locations to a single enterprise, which reduces the possibility of
unauthorized access and allows our customers to safely transmit sensitive
information and applications over our TeleSpeed lines.
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<PAGE>
CONSISTENT AND SCALABLE PERFORMANCE. We believe that eventually public
packet networks will evolve to replace the over 40 million modems currently
connected to circuit switched networks that have been deployed in the U.S. As
such, we designed our network for scalability and consistent performance to all
users as the networks grow. We have designed a "star topology" network similar
to the most popular local area network architecture currently used in
high-performance enterprise networks. In this model, new capacity is added
automatically as each new user receives a new line. We also use asynchronous
transfer mode equipment in our network that implements packet switching directly
in silicon circuits rather than slower router-based designs that implement
switching in router software.
INTELLIGENT END-TO-END NETWORK MANAGEMENT. Because the customers' and
end-users' lines are continuously connected, they can also always be monitored.
We have visibility from the Internet service provider or enterprise site across
the network and into the end-user's home or business. Because our network is
centrally managed, we can identify and dynamically enhance network quality,
service and performance and address network problems promptly.
FLEXIBILITY. We have designed our network to be flexible in handling
various types of network traffic, starting with data, but able to accommodate
voice and video. This flexibility will allow us to directly offer, or enter into
arrangements with other entities to offer, not only value-added services such as
voice over DSL, but also control the prioritization of content delivery within
our national network.
The primary components of our network is the network operations center, our
high-speed private metropolitan networks, central office spaces, including
digital subscriber line access multiplexers (DSLAMs), copper telephone lines and
DSL modems.
NETWORK OPERATIONS CENTER. Our entire network is managed from the network
operations center. We provide end-to-end network management using advanced
network management tools on a 24x7 basis, which enhances our ability to address
performance or connectivity issues before they affect the end-user experience.
From the network operations center, we can monitor the equipment and circuits in
each metropolitan network (including the asynchronous transfer mode equipment),
each central office (including DSLAMs) and potentially individual end-user lines
(including the DSL modems). Presently, our network operations center is located
in the San Francisco Bay Area. We are currently in the process of building a
second network operations center on the East Coast.
PRIVATE METROPOLITAN NETWORK. We operate our own private metropolitan
network in each region that we enter. The network consists of high-speed
asynchronous transfer mode communications circuits that we lease to connect our
asynchronous transfer mode hubs, our equipment in individual central offices and
our Internet service provider, enterprise and telecommunications carrier
customers. This network operates at a speed of 45 to 155 megabits per second.
CENTRAL OFFICE SPACES. Through our interconnection agreements with the
traditional telephone companies, we seek to secure space in every central office
where we intend to offer service. These central office spaces are designed to
offer the same high reliability and availability standards as the traditional
telephone company's other central office space. We require access to these
spaces for our equipment and for persons employed by, or under contract with,
us. We place DSLAMs in our central office spaces to provide the high-speed DSL
signals on each copper line to our end-users. We expect to deploy up to 80
central office spaces in any metropolitan statistical area that we enter. As of
December 31, 1999, we had 1,100 central office spaces operational. In addition,
we have a significant number of additional spaces under construction as well as
other spaces on order from various traditional telephone companies. In December
1998, we entered into a professional service arrangement with Lucent
Technologies to augment and accelerate our ability to deploy our central office
facilities.
TELEPHONE WIRES. We lease the telephone wires running to end-users from the
traditional telephone companies under terms specified in our interconnection
agreements. We lease lines that, in numerous cases, must be specially
conditioned by the traditional telephone companies to carry digital signals,
usually at an additional charge relative to that for voice grade telephone
wires. The price we are obligated to pay for these lines currently varies from
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<PAGE>
$4 to $70 per month per line with additional one-time charges in some cases for
installation, modification or removal of lines.
DSL MODEMS AND ON-SITE CONNECTION. We buy our DSL modems from our suppliers
for resale to our Internet service provider or enterprise customers for use by
their end-users. We configure and install these modems along with any required
on-site wiring needed to connect the modem to the copper line leased from the
traditional telephone company. For the most part, the DSL modem and DSLAM
equipment used must come from the same vendor for all services, since there are
not yet interoperability standards for the equipment used in our higher-speed
services. We are also pursuing a program of ongoing network development. Our
service development and engineering efforts focus on the design and development
of new technologies and services to increase the speed, efficiency, reliability
and security of our network and to facilitate the development of network
applications by third parties that will increase the use of our network. See
"Risk Factors--The scalability and speed of our network remain largely
unproven."
COMPETITION
The markets for business and consumer Internet access and network access
services are intensely competitive. We expect that these markets will become
increasingly competitive in the future. The principal bases of competition in
our markets include:
o price/performance;
o breadth of service availability;
o reliability of service;
o network security;
o ease of access and use;
o content bundling;
o customer support;
o brand recognition;
o operating experience;
o relationships with Internet service providers and other third parties;
and
o capital resources.
We face competition from traditional telephone companies, cable modem
service providers, competitive telecommunications companies, traditional and new
national long distance carriers, Internet service providers, on-line service
providers and wireless and satellite service providers.
TRADITIONAL TELEPHONE COMPANIES. All of the largest traditional telephone
companies in our target markets have begun offering DSL services or have
announced their intention to provide DSL services in the near term. As a result,
the traditional telephone companies represent strong competition in all of our
target service areas, and we expect this competition to intensify. The
traditional telephone companies have an established brand name and reputation
for high quality in their service areas, possess sufficient capital to deploy
DSL equipment rapidly, own the
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<PAGE>
telephone wires themselves and can bundle digital data services with their
existing voice services to achieve economies of scale in serving their
customers. Certain of the traditional telephone companies have aggressively
priced their consumer DSL services as low as $19-$29 per month, placing pricing
pressure on our TeleSurfer services. The traditional telephone companies are
also in a position to offer service from central offices where we are unable to
secure space and offer service because of asserted or actual space restrictions.
CABLE MODEM SERVICE PROVIDERS. Cable modem service providers such as AT&T,
Road Runner and MediaOne (and their respective cable partners) are deploying
high-speed Internet access services over hybrid fiber coaxial cable networks.
Hybrid fiber coaxial cable is a combination of fiber optic and coaxial cable,
and has become the primary architecture utilized by cable operators in recent
and ongoing upgrades of their systems. Where deployed, these networks provide
similar and in some cases higher-speed Internet access than we provide. They
also offer these services at lower price points than our TeleSurfer services. We
believe the cable modem service providers face a number of challenges that
providers of DSL services do not face. For example, different regions within a
metropolitan statistical area may be served by different cable modem service
providers, making it more difficult to offer the blanket coverage required by
potential business customers. Also, much of the current cable infrastructure in
the U.S. must be upgraded to support cable modems, a process which we believe is
significantly more expensive and time-consuming than the deployment of DSL-based
networks.
COMPETITIVE TELECOMMUNICATIONS COMPANIES. Many competitive
telecommunications companies such as NorthPoint Communications, Rhythms
NetConnections and Network Access Solutions offer high-speed digital services
using a business strategy similar to ours. Some of these competitors have begun
offering DSL-based access services and others are likely to do so in the future.
Companies such as Teleport Communications Group, Inc. (acquired by AT&T), Brooks
Fiber Properties, Inc. (acquired by MCI WorldCom), MFS (acquired by MCI
WorldCom) and NEXTLINK Communications have extensive fiber networks in many
metropolitan areas, primarily providing high-speed digital and voice circuits to
large corporations. They also have interconnection agreements with the
traditional telephone companies pursuant to which they have acquired central
office space in many markets targeted by us. Further, certain of our customers
have made investments in our competitors.
NATIONAL LONG DISTANCE CARRIERS. Interexchange carriers, such as AT&T,
Sprint, MCI WorldCom and Qwest, have deployed large-scale Internet access
networks and ATM networks, sell connectivity to businesses and residential
customers, and have high brand recognition. They also have interconnection
agreements with many of the traditional telephone companies and a number of
spaces in central offices from which they are currently offering or could begin
to offer competitive DSL services.
INTERNET SERVICE PROVIDERS. Internet service providers such as BBN
(acquired by GTE), UUNET Technologies (acquired by MCI WorldCom), EarthLink
Network, Concentric Network Corporation, MindSpring Enterprises, Netcom On-Line
Communication Services (acquired by MindSpring Enterprises) and PSINet provide
Internet access to residential and business customers, generally using the
existing public switched telephone network at integrated services digital
network speeds or below. Some Internet service providers such as UCNET
Technologies in California and New York, HarvardNet Inc. and InterAccess have
begun offering DSL-based services. To the extent we are not able to recruit
Internet service providers as customers for our service, Internet service
providers could become competitive DSL service providers.
ON-LINE SERVICE PROVIDERS. On-line service providers include companies such
as AOL, Compuserve (acquired by AOL), MSN (a subsidiary of Microsoft Corp.) and
WebTV (a subsidiary of Microsoft Corp.) that provide, over the Internet and on
proprietary online services, content and applications ranging from news and
sports to consumer video conferencing. These services are designed for broad
consumer access over telecommunications-based transmission media, which enable
the provision of digital services to the significant number of consumers who
have personal computers with modems. In addition, they provide Internet
connectivity, ease-of-use and consistency of environment. Many of these on-line
service providers have developed their own access networks for modem
connections. If these on-line service providers were to extend their access
networks to DSL or other high-speed service technologies, they would become
competitors of ours.
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<PAGE>
WIRELESS AND SATELLITE DATA SERVICE PROVIDERS. Wireless and satellite data
service providers are developing wireless and satellite-based Internet
connectivity. We may face competition from terrestrial wireless services,
including two Gigahertz (Ghz) and 28 Ghz wireless cable systems (Multi-channel
Microwave Distribution System (MMDS) and Local Multi-channel Distribution System
(LMDS)), and 18 Ghz and 39 Ghz point-to-point microwave systems. For example,
the FCC is currently considering new rules to permit MMDS licensees to use their
systems to offer two-way services, including high-speed data, rather than solely
to provide one-way video services. The FCC also recently auctioned spectrum for
LMDS services in all markets. This spectrum is expected to be used for wireless
cable and telephony services, including high-speed digital services. In
addition, companies such as Teligent Inc., Advanced Radio Telecom Corp. and
WinStar Communications, Inc., hold point-to-point microwave licenses to provide
fixed wireless services such as voice, data and videoconferencing.
We also may face competition from satellite-based systems. Motorola
Satellite Systems, Inc., Hughes Communications (a subsidiary of General Motors
Corporation), Teledesic and others have filed applications with the FCC for
global satellite networks which can be used to provide broadband voice and data
services, and the FCC has authorized several of these applicants to operate
their proposed networks.
INTERCONNECTION AGREEMENTS WITH TRADITIONAL TELEPHONE COMPANIES
A critical aspect of our business is our interconnection agreements with
the traditional telephone companies. These agreements cover a number of aspects
including:
o the price we pay to lease access to the traditional telephone
company's telephone wires;
o the special conditioning the traditional telephone company provides on
certain of these lines to enable the transmission of digital signals;
o the price and terms of central office space for our equipment in the
traditional telephone company's central offices;
o the price we pay and access we have to the traditional telephone
company's transport facilities;
o the operational support systems and interfaces that we can use to
place orders, report network problems and monitor the traditional
telephone company's response to our requests;
o the dispute resolution process that we use to resolve disagreements on
the terms of the interconnection contract; and
o the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of the
traditional telephone company relationship.
As of December 31, 1999, we have entered into interconnection agreements
with or otherwise obtained interconnection rights from the different major
traditional telephone companies in all the states covering our existing 59
metropolitan statistical areas. Traditional telephone companies do not in many
cases agree to our requested provisions in interconnection agreements and we
have not consistently prevailed in obtaining all of our desired provisions in
such agreements either voluntarily or through the interconnection arbitration
process. We cannot be sure that we will be able to continue to sign
interconnection agreements with existing or other traditional telephone
companies. We are currently negotiating agreements with several traditional
telephone companies in order to expand our services into 100 targeted
metropolitan statistical areas. The traditional telephone companies are also
permitting competitive telecommunications companies to adopt previously signed
interconnection agreements. In certain instances, we have adopted the
interconnection agreement of another competitive telecommunications company.
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Other competitive telecommunications companies have also adopted the same or
modified versions of our interconnection agreements, and may continue to do so
in the future.
Many of our interconnection agreements have a term of three years. We will
have to renegotiate these agreements when they expire. Although we expect to
renew the interconnection agreements that require renewal and believe the 1996
Telecommunications Act and the agreements themselves limit the ability of
traditional telephone companies not to renew such agreements, we may not succeed
in extending or renegotiating our interconnection agreements on favorable terms.
Additionally, disputes have arisen and will likely arise in the future as a
result of differences in interpretations of the interconnection agreements. For
example, we are in litigation proceedings with certain of the traditional
telephone companies. These disputes have delayed our deployment of our network.
They have also adversely affected our service to our customers and our ability
to enter into additional interconnection agreements with the traditional
telephone companies in other states. Finally, the interconnection agreements are
subject to state commission, FCC and judicial oversight. These government
authorities may modify the terms of the interconnection agreements in a way that
hurts our business.
GOVERNMENT REGULATION
OVERVIEW. Our services are subject to a variety of federal regulations.
With respect to certain activities and for certain purposes, we have submitted
our operations to the jurisdiction of state and local authorities who may also
assert more extensive jurisdiction over our facilities and services. The FCC has
jurisdiction over all of our services and facilities to the extent that we
provide interstate and international services. To the extent we provide
identifiable intrastate services, our services and facilities are subject to
state regulations. In addition, local municipal government authorities also
assert jurisdiction over our facilities and operations. The jurisdictional reach
of the various federal, state and local authorities is subject to ongoing
controversy and judicial review, and we cannot predict the outcome of such
review.
FEDERAL REGULATION. We must comply with the requirements of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, as
well as the FCC's regulations under the statute. The 1996 Telecommunications Act
eliminates many of the pre-existing legal barriers to competition in the
telecommunications and video programming communications businesses, preempts
many of the state barriers to local telecommunications service competition that
previously existed in state and local laws and regulations, and sets basic
standards for relationships between telecommunications providers. The law
delegates to the FCC and the states broad regulatory and administrative
authority to implement the 1996 Telecommunications Act.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local telecommunications market. It does this by preempting certain
state and local laws that are barriers to competition and by requiring
traditional telephone companies to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, interexchange carriers and competitive
telecommunications companies such as us.
Regulations promulgated by the FCC under the 1996 Telecommunications Act
specify in greater detail the requirements of the 1996 Telecommunications Act
imposed on the traditional telephone companies to open their networks to
competition by providing competitors interconnection, central office space,
access to unbundled network elements, retail services at wholesale rates and
nondiscriminatory access to telephone poles, ducts, conduits, and rights-of-way.
The requirements enable companies such as us to interconnect with the
traditional telephone companies in order to provide local telephone exchange
services and to use portions of the traditional telephone companies' existing
networks to offer new and innovative services such as our TeleSpeed and
TeleSurfer services. In January 1999, the U.S. Supreme Court ruled on challenges
to the FCC regulations. Although the U.S. Supreme Court upheld most of the FCC's
authority and its regulations, it required the FCC to reexamine and redefine
which unbundled network elements the traditional telephone companies must offer.
The FCC issued its revised list of unbundled network elements in September 1999.
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The 1996 Telecommunications Act also allows the regional bell operating
companies (RBOCs), which are the traditional telephone companies created by
AT&T's divestiture of its local exchange business, to enter the long distance
market within their own local service regions upon meeting certain requirements.
The remaining RBOCs include BellSouth, Bell Atlantic Corporation, Ameritech
Corporation, U S WEST Communications, Inc. and SBC Communications, Inc. The
timing of the various RBOCs' entry into their respective in-region long distance
service businesses is extremely uncertain. In December 1999, Bell Atlantic's
application to provide in-region long distance services in New York state was
granted by the FCC. Given the FCC's grant of Bell Atlantic's application, the
FCC is likely to thereafter grant similar applications by Bell Atlantic and the
other RBOCs in other states. On January 10, 2000, Southwestern Bell Telephone
Company, a subsidiary of SBC, filed its application for FCC approval to provide
in-region long distance service in Texas. The FCC is expected to act on the
application before May 2000. The timing of the various RBOCs' in-region long
distance entry will likely affect the level of cooperation we receive from each
of the RBOCs. The approval of such entry will likely adversely affect the level
of cooperation.
In addition, the 1996 Telecommunications Act provides relief from the
earnings restrictions and price controls that have governed the local telephone
business for many years. Traditional telephone company tariff filings at the FCC
have been subjected to increasingly less regulatory review. However, precisely
when and to what extent the traditional telephone companies will secure pricing
flexibility or other regulatory freedom for their services is uncertain. For
example, under the 1996 Telecommunications Act, the FCC is considering
eliminating certain regulations that apply to the traditional telephone
companies' provision of services that are competitive with ours. The timing and
the extent of regulatory freedom and pricing flexibility and regulatory freedom
granted to the traditional telephone companies will affect the competition we
face from the traditional telephone companies' competitive services.
Further, the 1996 Telecommunications Act provides the FCC with the
authority to forbear from regulating entities such as us who are classified as
"non-dominant" carriers. The FCC has exercised its forbearance authority. As a
result, we are not obligated to obtain prior certificate approval from the FCC
for our interstate services or file tariffs for such services. We have
determined not to file tariffs for our interstate services. We provide our
interstate services to our customers on the basis of contracts rather than
tariffs. We believe that it is unlikely that the FCC will require us to file
tariffs for our interstate services in the future.
On March 18, 1999, the FCC announced that it was adopting rules to make it
easier and less expensive for competitive telecommunications companies to obtain
central office space and to require traditional telephone companies to make new
alternative arrangements for obtaining central office space. New entrants will
be able to locate all equipment necessary for interconnection, whether or not
such equipment has a switching function. The FCC's rules have not been uniformly
implemented. In the same announcement, the FCC provided notice of proposed
rule-making to determine whether carriers should be able to provide asymmetric
DSL over the same line over which traditional telephone companies provide voice
service. The notice sought comments on the operational, pricing, legal and
policy ramifications of mandating such line sharing. On November 18, 1999, the
FCC required the traditional local phone companies to provide us and other
competitive local carriers with line sharing access. If implemented by the
traditional local phone companies these rules could materially lower the price
we pay to lease access to the traditional telephone company's telephone wires.
While we believe that these rules are advantageous to us, the traditional
telephone companies may balk at, delay, or thwart the implementation of such
rules.
In March 2000, a federal appeals court struck portions of the FCC's new
rules, and has required the FCC to reconsider and review those rules. In
particular, the appeals court has required the FCC to revise its rules
concerning the types of equipment that we may collocate on the traditional
telephone company premises and the steps that traditional telephone companies
may take to separate their equipment from our equipment. The traditional
telephone companies may implement the court's ruling and any subsequent FCC
rules in a manner that impairs our ability to obtain collocation space and
collocate the equipment of our choice on their premises. Such actions by the
traditional
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telephone companies could adversely affect our business and disrupt our
existing network design, configuration and services.
Any changes in applicable federal law and regulations, in particular,
changes in its interconnection agreements with traditional telephone companies,
the prospective entry of the RBOCs into the in-region long distance business and
grant of regulatory freedom and pricing flexibility to the traditional telephone
companies, could harm our business.
STATE REGULATION. To the extent we provide identifiable intrastate services
or have otherwise submitted ourselves to the jurisdiction of the relevant state
telecommunications regulatory commissions, we are subject to such jurisdiction.
In addition, certain states have required prior state certification as a
prerequisite for processing and deciding an arbitration petition for
interconnection under the 1996 Telecommunications Act. As of December 31, 1999,
we were authorized under state law to operate as a competitive local exchange
carrier in 34 states, and intend to obtain authorization in the other states
necessary to cover our 100 targeted metropolitan statistical areas. We have
pending arbitration proceedings in different states for interconnection
arrangements with the relevant traditional telephone companies. We have
concluded arbitration proceedings in a number of states by entering into
interconnection agreements with the relevant traditional telephone companies. We
have filed tariffs in certain states for intrastate services as required by
state law or regulation. We are also subject to periodic financial and other
reporting requirements of these states with respect to our intrastate services.
The different state commissions have various proceedings to determine the
rates, charges and terms and conditions for unbundled network elements
(unbundled network elements are the various portions of a traditional telephone
company's network that a competitive telecommunications company can lease for
purposes of building a facilities-based competitive network, including telephone
wires, central office collocation space, inter-office transport, operational
support systems, local switching and rights of way), as well as the discount for
wholesale services that we purchase from the relevant traditional telephone
company. The rates set forth in our interconnection agreements are interim rates
and will be prospectively, and, in some cases, retroactively, affected by the
permanent rates set by the various state commissions for such unbundled network
elements as unbundled loops and interoffice transport. We have participated in
unbundled network element rate proceedings in several states in an effort to
reduce these rates. If any state commission decides to increase unbundled
network element rates our operating results could suffer. The applicability of
the various state regulations on our business and compliance requirements will
be further affected by the extent to which our services are determined to be
intrastate services. Jurisdictional determinations of our services as intrastate
services could harm our business.
LOCAL GOVERNMENT REGULATION. We may be required to obtain various permits
and authorizations from municipalities in which we operate our own facilities.
The issue of whether actions of local governments over the activities of
telecommunications carriers, including requiring payment of franchise fees or
other surcharges, pose barriers to entry for competitive telecommunications
companies which may be preempted by the FCC is the subject of litigation.
Although we rely primarily on the unbundled network elements of the traditional
telephone companies, in certain instances we deploy our own facilities,
including fiber optic cables, and therefore may need to obtain certain municipal
permits or other authorizations. The actions of municipal governments in
imposing conditions on the grant of permits or other authorizations or their
failure to act in granting such permits or other authorizations could harm our
business.
The foregoing does not purport to describe all present and proposed
federal, state and local regulations and legislation affecting the
telecommunications industry. Other existing federal regulations are currently
the subject of judicial proceedings, legislative hearings and administrative
proposals, which could change, in varying degrees, the manner in which
communications companies operate in the U.S. The ultimate outcome of these
proceedings and the ultimate impact of the 1996 Telecommunications Act or any
final regulations adopted pursuant to the 1996 Telecommunications Act or our
business cannot be determined at this time but may well be adverse to our
interests. We cannot predict the impact, if any, that future regulation or
regulatory changes may have on our business and we can give you no assurance
that such future regulation or regulatory changes will not harm our business.
See "Risk
19
<PAGE>
Factors--Rejections of our applications for central office space by
traditional telephone companies are likely to delay the expansion of our network
and the rollout of our services" and "Our services are subject to government
regulation, and changes in current or future laws or regulations could adversely
affect our business."
INTELLECTUAL PROPERTY
We regard certain aspects of our products, services and technology as
proprietary and attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
Currently we have one patent, a number of patent applications pending, and
intend to prepare additional applications and to seek additional patent
protection for our systems and services to the extent possible. These patents
may not be issued to us, and if issued, they may not protect our intellectual
property from competition which could seek to design around or invalidate these
patents.
Further, effective patent, copyright, trademark and trade secret protection
may be unavailable or limited in certain foreign countries. The global nature of
the Internet makes it virtually impossible to control the ultimate destination
of our proprietary information. Steps taken by us may not prevent
misappropriation or infringement of our intellectual property rights, and
litigation may be necessary in the future to enforce our intellectual property
rights to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others. Such litigation could result in substantial
costs and diversion of resources.
In addition, others may sue us with respect to infringement of their
intellectual property rights. We were recently sued by Bell Atlantic for an
alleged infringement of a patent issued to them in September 1998 entitled
"Variable Rate and Variable Mode Transmission System." On February 18, 2000, we
were granted a summary judgement ruling in the Bell Atlantic lawsuit. The court
ruled that we had not infringed on Bell Atlantic's patent. We anticipate that
Bell Atlantic may appeal this decision and, while we expect that we would
prevail on appeal, the outcome of such an appeal is inherently uncertain. Such
lawsuits, including an appeal in the Bell Atlantic lawsuit, could significantly
harm our business.
EMPLOYEES
As of December 31, 1999, we had 848 employees, excluding temporary
personnel and consultants. None of our employees are represented by a labor
union, and we consider our relations with our employees to be good. Our ability
to achieve our financial and operational objectives depends in large part upon
the continued service of our senior management and key technical, sales,
marketing, legal and managerial personnel, and our continuing ability to attract
and retain highly qualified technical, sales, marketing, legal and managerial
personnel. Competition for such qualified personnel is intense, particularly in
software development, network engineering and product management. In addition,
in the event that our employees unionize, we could incur higher ongoing labor
costs and disruptions in our operations in the event of a strike or other work
stoppage.
20
<PAGE>
ITEM 2. PROPERTIES
We are headquartered in Santa Clara, California in facilities consisting of
approximately 62,000 square feet pursuant to a lease that will expire on or
before July 14, 2002. We also lease office space in many of the metropolitan
statistical areas in which we conduct operations.
We have recently expanded our headquarters space in Santa Clara by leasing
additional office space, and have expanded our operational space with a new
facility lease in Denver, Colorado. Through a subsidiary, we have also acquired
land and are currently building a 100,000 square foot network operations center
in Prince Williams County, Virginia. We also lease central office space from the
traditional telephone company in each region that we operate or plan to operate
under the terms of our interconnection agreements and obligations imposed by
state public utilities commissions and the FCC. While the terms of these leases
are perpetual, the productive use of our central office space is subject to the
terms of our interconnection agreements which expire on or before March 2001. We
will increase our central office space as we expand our network geographically.
21
<PAGE>
ITEM 3. LEGAL PROCEEDINGS
We are engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with multiple traditional telephone companies.
These negotiations, arbitrations and proceedings concern the traditional
telephone companies' denial of physical central office space to us in certain
central offices, the cost and delivery of central office spaces, the delivery of
transmission facilities and telephone lines, billing issues and other
operational issues. For example, we are currently involved in commercial
arbitration proceedings with Pacific Bell over these issues. We have also filed
a lawsuit against Pacific Bell and certain of its affiliates, including SBC
Communications, in federal court. We are pursuing a variety of contract, tort,
and antitrust and other claims, such as violations of the Telecommunications
Act, in these proceedings. In November 1998, we prevailed in our commercial
arbitration proceeding against Pacific Bell. The arbitration panel found that
Pacific Bell breached its interconnection agreement with us and failed to act in
good faith on multiple counts. The arbitration panel ruled in favor of awarding
us direct damages, as well as attorneys' fees and costs of the arbitration.
Pacific Bell is currently attempting to have the decision vacated. Meanwhile,
the arbitration panel is evaluating our claim for additional damages.
We have also filed a lawsuit against Bell Atlantic and its affiliates
in federal court. We are pursuing antitrust and other claims in this lawsuit. In
addition, Bell Atlantic has separately filed suit against us asserting
infringement of a patent issued to them in September 1998 entitled "Variable
Rate and Variable Mode Transmission System." However, on February 18, 2000 the
court issued a summary judgement ruling holding that we had not infringed Bell
Atlantic's patent. We anticipate that Bell Atlantic may appeal this decision
and, while we expect that we would prevail on an appeal, the outcome of such an
appeal is inherently uncertain.
One of our former employees has filed a complaint against us in
California Superior Court, alleging that he was terminated wrongfully and is
entitled to commissions and other amounts arising from his employment with us.
We believe that we have valid reasons for his termination and that we do not owe
him any money, but litigation is unpredictable and there is no guarantee we will
prevail. Failure to resolve these various legal disputes and controversies
without excessive delay and cost and in a manner that is favorable to us could
significantly harm our business.
We are not currently engaged in any other legal proceedings that we
believe could have a material adverse effect on our business, prospects,
operating results and financial condition. We are, however, subject to state
commission, FCC and court decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the interpretation of
competitive telecommunications company interconnection agreements in general and
our interconnection agreements in particular. In some cases, we may be deemed to
be bound by the results of ongoing proceedings of these bodies or the legal
outcomes of other contested interconnection agreements that are similar to our
agreements. The results of any of these proceedings could harm our business.
22
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 1999, we did not submit any
matters to the vote of our security holders.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET PRICE INFORMATION AND DIVIDEND POLICY FOR OUR COMMON STOCK
Our Common Stock has been traded on the NASDAQ National Market under
the symbol "COVD" since January 22, 1999, the date of our initial public
offering. Prior to that time, there was no public market for our Common Stock.
The following table sets forth, for the period indicated, the high and low
closing sales prices for our Common Stock as reported by the NASDAQ National
Market. THESE PRICES HAVE BEEN SPLIT-ADJUSTED TO ACCOUNT FOR THE STOCK SPLIT IN
MAY, 1999.
HIGH LOW
---- ---
FISCAL YEAR ENDED DECEMBER 31, 1999:
First Quarter 47.50 12.00
Second Quarter 72.38 39.56
Third Quarter 67.50 37.31
Fourth Quarter 65.38 38.78
FISCAL YEAR ENDED DECEMBER 31, 2000:
First Quarter (Through March 24) 100.00 52.50
On March 24, 2000, the last reported sale price for our Common Stock on
the NASDAQ National Market was $78.69 per share. As of March 24, 2000, there
were 484 holders of record of our Common Stock, and there was one holder of
record of our Class B Common Stock. On March 7, 2000, we announced a 3-for-2
stock split, which will be effectuated through a stock dividend. Our Common
Stock will begin trading on a split-adjusted basis on April 3, 2000.
We have never declared or paid any dividends on our Common Stock. We
currently anticipate that we will retain all of our future earnings for use in
the expansion and operation of our business. Thus, we do not anticipate paying
any cash dividends on our Common Stock in the foreseeable future. Our future
dividend policy will be determined by our Board of Directors. In addition, the
indentures relating to our outstanding indebtedness restrict our payment of
dividends.
USES OF PROCEEDS FROM REGISTERED SECURITIES
Our initial public offering of Common Stock was effected through a
Registration Statement on Form S-1 (File No. 333-63899) that was declared
effective by the SEC on January 21, 1999 and pursuant to which we sold an
aggregate of 8,970,000 shares of our Common Stock. The managing underwriters for
our initial public offering were Bear, Stearns & Co. Inc., BT Alex. Brown,
Donaldson, Lufkin & Jenrette, and Goldman, Sachs & Co. These underwriters
received $10,046,400 in underwriting discounts and commissions and our other
expenses in connection with the initial public offering were approximately $1.2
million.
As of December 31, 1999, we had used the estimated aggregate net
proceeds of $150 million from our initial public offering as follows:
23
<PAGE>
<TABLE>
<S> <C>
Construction of plant, building and facilities:................................. 0
Purchase and installation of machinery and equipment............................ $61,734,000
Purchases of real estate:....................................................... 0
Acquisition of other businesses:................................................ 0
Repayment of indebtedness:...................................................... 0
Working capital:................................................................ $63,634,000
Temporary investments (short term, interest bearing treasury securities......... 0
Other purposes:................................................................. $25,102,000
</TABLE>
The foregoing amounts represent our best estimate of our use of
proceeds for the period indicated. No such payments were made to our directors
or officers or their associates, holders of 10% or more of any class of our
equity securities or to our affiliates.
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data for the years ended
December 31, 1997, 1998 and 1999 have been derived from our audited Consolidated
Financial Statements and the related Notes, which are included elsewhere in this
Annual Report on Form 10-K. You should read the following selected consolidated
financial data together with "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and our Consolidated Financial Statements
and the related Notes included elsewhere in this Report on Form 10-K.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------
1997 1998 1999
---- ---- ----
(DOLLARS IN THOUSANDS)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
<S> <C> <C> <C>
Revenues .................................................... $ 26 $ 5,326 $ 66,488
Operating expenses: .............................................
Network and product costs................................. 54 4,562 55,347
Sales, marketing, general and administrative.............. 2,374 31,043 140,372
Amortization of deferred compensation...................... 295 3,997 4,768
Depreciation and amortization.............................. 70 3,406 37,602
---------------- ---------------- -----------------
Total operating expenses............................. 2,793 43,008 238,089
---------------- ---------------- -----------------
Loss from operations............................................. (2,767) (37,682) (171,601)
Net interest expense....................................... 155 (10,439) (23,796)
---------------- ---------------- -----------------
Net loss .................................................... $ (2,612) $ (48,121) $ (195,397)
================ ================ =================
Net loss per share............................................... $ (.80) $ (8.43) $ (2.74)
================ ================ =================
OTHER FINANCIAL DATA:
EBITDA(1)........................................................ $ (2,402) $ (30,154) $ (129,486)
Capital expenditures............................................. 2,253 59,503 207,830
</TABLE>
24
<PAGE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
----------------------------------------------------
1997 1998 1999
---- ---- ----
CONSOLIDATED BALANCE SHEET DATA:
<S> <C> <C> <C>
Cash and cash equivalents and short-term investments............. $ 4,378 $ 64,450 $ 767,357
Net property and equipment....................................... 3,014 59,145 237,542
Total assets .................................................... 8,074 139,419 1,147,606
Long-term obligations, including current portion................. 783 142,879 375,049
Total stockholders' equity (net capital deficiency) ............. 6,498 (24,706) 690,291
<CAPTION>
AS OF DECEMBER 31,
----------------------------------------------------
1997 1998 1999
---- ---- ----
OTHER OPERATING DATA:
<S> <C> <C> <C>
Homes and businesses passed...................................... 278,000 6,023,217 29,000,000
Lines installed.................................................. 26 3,922 57,000
</TABLE>
- -----------
(1) EBITDA consists of net loss excluding net interest, taxes, depreciation and
amortization, non-cash stock based compensation and other non-operating
income or expenses. 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 our operating results and should
not be construed (i) as an alternative to operating income (as determined
in accordance with generally accepted accounting principals ("GAAP")) as an
indicator of our 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 us may be calculated
differently than EBITDA for other companies. See our Consolidated Financial
Statements and the related Notes thereto contained elsewhere in this Annual
Report on Form 10-K.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with the consolidated financial
statements and the related notes thereto included elsewhere in this Report on
Form 10-K. This discussion contains forward-looking statements the accuracy of
which involves risks and uncertainties. Our actual results could differ
materially from those anticipated in the forward-looking statements for many
reasons including, but not limited to, those discussed in "Risk Factors" and
elsewhere in this Report on Form 10-K. We disclaim any obligation to update
information contained in any forward-looking statement. See "--Forward Looking
Statements."
OVERVIEW
We are a leading provider of broadband communications services to
Internet service provider, enterprise and telecommunications carrier, and other
customers. Since March 1998, we have raised $1,580.4 million of gross proceeds
from debt and equity financings to fund the deployment and expansion of our
network to date, we offer our services in 59 metropolitan statistical areas. We
plan to build our network and offer our services in a total of 100 metropolitan
statistical areas nationwide. As of December 31, 1999, our network passed 29
million homes and businesses, and we had installed 57,000 end-user lines.
In connection with our expansion within existing metropolitan
statistical areas and into new metropolitan statistical areas, we expect to
significantly increase our capital expenditures, as well as our sales and
marketing expenditures, to deploy our network and support additional end-users
in those regions. Accordingly, we expect to incur substantial and increasing net
losses for at least the next several years.
We derive revenue from:
25
<PAGE>
o monthly recurring service charges for connections from the
end-user to our facilities and for backhaul services from our
facilities to the Internet service provider or enterprise
customer;
o service order set-up and other non-recurring charges; and
o the sale of customer premise equipment that we provide to our
customers due to the general unavailability of customer premise
equipment through retail channels.
We expect prices for the major components of both recurring and
non-recurring revenues to decrease each year in part due to the effects of
competitive pricing and future volume discounts. We believe our revenues from
the sale of customer premise equipment will decline over time, as customer
premise equipment becomes more generally available. We expect that the prices we
charge to customers for customer premise equipment will decrease each year.
The following factors comprise our network and service costs:
o MONTHLY NON-RECURRING AND RECURRING CIRCUIT FEES. We pay
traditional telephone companies and other competitive
telecommunications companies non-recurring and recurring fees for
services including installation, activation, monthly line costs,
maintenance and repair circuits between and among our digital
subscriber line access multiplexers and our regional data
centers, customer backhaul, and end-user lines. As our end-user
base grows, we expect that the largest element of network and
product cost will be the traditional telephone companies' charges
for our leased telephone wires; and
o OTHER COSTS. Other costs that we incur include those for
materials in installation and the servicing of customers and
end-users, and the cost of customer premise equipment.
The development and expansion of our business will require significant
expenditures. The principal capital expenditures incurred during the buildup
phase of any metropolitan statistical area involve the procurement, design and
construction of our central office cages, end-user DSL line cards, and
expenditures for other elements of our network design. Currently, the average
capital cost to deploy our facilities in a central office, excluding end-user
line cards, is approximately $85,000 per central office facility. This cost may
vary in the future due to the quantity and type of equipment we initially deploy
in a central office facility as well as regulatory limitations imposed on the
traditional phone companies relative to pricing of central office space,
including cageless physical collocation. Following the build-out of our central
office space, the major portion of our capital expenditures is the purchase of
DSL line cards to support incremental end-users. We expect that the average cost
of such line cards will decline over the next several years. Network
expenditures will continue to increase with the number of end-users. However,
once an operating region is fully built out, a substantial majority of the
regional capital expenditures will be tied to incremental customer and end-user
growth. In addition to developing our network, we will use our capital for
marketing our services, acquiring Internet service provider, enterprise, and
telecommunication carrier customers, and funding our customer care and field
service operations.
In connection with rolling out service on a national basis we have
commenced a branding campaign to differentiate our service offerings in the
marketplace. As a result, we expect our selling, general and administrative
expenses to increase significantly in future periods as we implement increased
marketing efforts as part of the campaign.
RECENT DEVELOPMENTS
On January 28, 2000, the Company completed a private placement of
$425.0 million aggregate principal amount of the Company's 12% senior notes (the
"2000 notes") due 2010. The 2000 notes are unsecured senior obligations of the
Company maturing on February 15, 2010 and are redeemable at the option of the
Company any
26
<PAGE>
time after February 15, 2005 at stated redemption prices plus accrued and unpaid
interest thereon. Net proceeds from the 2000 notes were approximately $413.3
million, after discounts, commissions and other transaction costs of
approximately $11.7 million. The discount and debt issuance costs are being
amortized over the life of the 2000 notes. The notes were sold in a private
placement under Rule 144A and Regulation S under the Securities Act of 1933, as
amended.
We are currently aware of a Staff Accounting Bulletin entitled SAB 101
"Revenue Recognition in Financial Statements," which was issued in December 1999
by the Securities and Exchange Commission. SAB 101 provides that, in certain
circumstances, revenues which are received in the first month of a contract
might have to be recognized over an extended period of time, instead of in the
first month of the contract. Due to complications surrounding the implementation
of SAB 101, the SEC in March 2000 deferred the implementation date of certain
provisions of SAB 101 until the quarter ended June 30, 2000, with retroactive
application to transactions entered into during the quarter ended March 31,
2000. This extension will allow us and other companies impacted by this Bulletin
adequate time to fully understand the broader implications of SAB 101 and to
respond accordingly. We believe that based on the current guideline, our revenue
recognition policy is in accordance with generally accepted accounting
principles and we believe that the adoption of the SAB will not have an impact
on our consolidated financial statements.
The Company has filed a registration statement covering an offer to
exchange new registered 12% senior notes due February 15, 2010 for all
outstanding 12% senior notes due February 15, 2010.
On February 15, 2000 our Board of Directors adopted a Stockholder
Protection Rights Plan under which stockholders received one right for each
share of the Company's Common Stock or Class B Common Stock owned by them. The
rights become exercisable, in most circumstances, upon the accumulation by a
person or group of 15% or more of the Company's outstanding shares of Common
Stock. Each right entitles the holder to purchase from the Company, as provided
by the Stockholder protection Rights Agreement, one one-thousandth of a share of
Participating Preferred Stock, par value $.001 per share, for $400.00 subject to
adjustment.
On March 7, 2000, we announced a 3-for-2 stock split, which will be
effectuated through a stock dividend. Our Common Stock will begin trading on a
split-adjusted basis on April 3, 2000.
On March 20, 2000 we completed the acquisition of Laser Link.Net, Inc.,
a leading provider of branded Internet access, based in Media, Pennsylvania.
Under the acquisition agreement we will issue 4.3 million shares of Common Stock
for all Laser Link.Net, Inc. outstanding shares, plus assumption of all
outstanding debt. We anticipate that this acquisition will allow us to provide a
turnkey broadband access solution to companies and affinity groups who want to
offer broadband Internet services to their customers, members, or affiliates.
Laser Link.Net, Inc. currently provides a similar service using dial-up access.
RESULTS OF OPERATIONS
Results of operations for the three years ended December 31, 1999 are
as follows:
REVENUES
We recorded revenues of $66.5 million for the year ended December 31,
1999, $5.3 million for the year ended December 31, 1998 and $26,000 for the year
ended December 31, 1997. The increase in revenues in all periods is attributable
to growth in the number of customers and end-users resulting from our increased
sales and marketing efforts and the expansion of our national network. We expect
revenues to increase in future periods as we expand our network within our
existing regions, deploy networks in new regions and increase our sales and
marketing efforts in all of our regions.
27
<PAGE>
NETWORK AND PRODUCT COSTS
We recorded network and product costs of $55.3 million for the year
ended December 31, 1999, $4.6 million for the year ended December 31, 1998 and
$54,000 for the year ended December 31, 1997. The increase in network costs in
all periods is attributable to the expansion of our network and increased orders
resulting from our sales and marketing efforts. We expect network and product
costs to increase significantly in future periods due to increased sales
activity and expected revenue growth.
SALES, MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES
Sales, marketing, general and administrative expenses were $140.4
million for the year ended December 31, 1999, $31.0 million for the year ended
December 31, 1998 and $2.4 million for the year ended December 31, 1997. Sales,
marketing and general and administrative expenses consist primarily of salaries,
expenses for the development of our business, the development of corporate
identification, promotional and advertising materials, expenses for the
establishment of our management team, and sales commissions. The increase in
sales, marketing, general and administrative expense for all years is
attributable to growth in headcount in all areas of our Company, continued
expansion of our sales and marketing efforts, deployment of our network,
expansion of our facilities and building of our operating infrastructure. In
addition, in 1999 sales, marketing, general and administrative increased over
1998 due to our advertising campaign initiated in 1999. Sales, marketing,
general and administrative expenses are expected to increase significantly as we
continue to expand our business.
DEFERRED COMPENSATION
Through December 31, 1999, we recorded a total of approximately $15.6
million of deferred compensation, with an unamortized balance of approximately
$6.5 million remaining on our December 31, 1999 consolidated balance sheet.
Deferred compensation is a result of us granting stock options to our employees,
certain of our directors, and certain contractors with exercise prices per share
below the fair values per share for accounting purposes of our Common Stock at
the dates of grant. We are amortizing the deferred compensation over the vesting
period of the applicable option using a graded vesting method. Amortization of
deferred compensation was $4.8 million for the year ended December 31, 1999,
$4.0 million for the year ended December 31, 1998, and $295,000 for the year
ended December 31, 1997.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization includes:
o depreciation of network costs and related equipment;
o depreciation of information systems, furniture and fixtures;
o amortization of improvements to central offices, regional data
centers and network operations center facilities and corporate
facilities;
o amortization of capitalized software costs; and
o amortization of intangible assets.
In January 1999, we recorded intangible assets of $28.7 million from
the issuance of preferred stock to AT&T Ventures, NEXTLINK and Qwest.
Amortization of these assets was $8.2 million during the year ended December 31,
1999, and is included in depreciation and amortization on the accompanying
consolidated statement of operations. Annual amortization of these assets will
be approximately $8.4 million in each of the years in the two-year period ending
December 31, 2001, decreasing to approximately $1.2 million per year for each
subsequent year through the year ending December 31, 2004.
Depreciation and amortization was approximately $37.6 million for the
year ended December 31, 1999, $3.4 for the year ended December 31, 1998, and
$70,000 for the year ended December 31, 1997. The increase for both
28
<PAGE>
years was due to the addition of equipment and facilities placed in service
throughout the year as well as amortization of intangible assets recorded in
1999. We expect depreciation and amortization to increase significantly as we
increase our capital expenditures to expand our network.
NET INTEREST INCOME AND EXPENSE
Net interest income and expense consists primarily of interest income
on our cash balance, cash equivalents, and short term investments, offset by
interest expense associated with our debt. Net interest expense for the years
ended December 31, 1999, 1998, and 1997 was $23.8 million, $10.4 million and
($155,000), respectively. Net interest expense during these periods consisted
primarily of interest expense on our 13 1/2% Senior Discount Notes due 2008
issued in March 1998 (the "1998 notes") and our 12 1/2% senior notes due 2009
issued in February 1999 (the "1999 notes") and capital lease obligations. Net
interest expense was partially offset by interest income earned primarily from
the investment of the proceeds raised from the issuance of the 1998 notes and
the 1999 notes as well as our initial public offering and our issuance of
preferred stock to AT&T Ventures, NEXTLINK and Qwest. We expect interest expense
to increase significantly over time, primarily because the 1998 notes and 1999
notes mature in 2008 and 2009, respectively, and because we issued $425.0
million of new long-term debt in January 2000.
INCOME TAXES
Income taxes consist of federal, state and local taxes, where
applicable. We expect significant consolidated net losses for the foreseeable
future which should generate net operating loss carry forwards. However, our
ability to use net operating losses may be subject to annual limitations. In
addition, income taxes may be payable during this time due to operating income
in certain tax jurisdictions. In the future, if we achieve operating profits and
the net operating losses have been exhausted or have expired, we may experience
significant tax expense. We made no provision for taxes because we operated at a
loss for the years ended December 31, 1999, 1998 and 1997.
QUARTERLY FINANCIAL INFORMATION
The following table presents certain unaudited consolidated statements
of operations data for our most recent eight quarters. This information has been
derived from our unaudited consolidated financial statements. In our 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
included elsewhere in this Report. The operating results for any quarter are not
necessarily indicative of results for any future period.
<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1998 1998 1998 1998 1999 1999 1999 1999
---- ---- ---- ---- ---- ---- ---- ----
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenues $ 186 $ 809 $ 1,565 $ 2,766 $ 5,596 $ 10,833 $ 19,141 $ 30,918
Operating Expenses:
Network and products
costs 203 758 1,355 2,246 4,960 10,565 16,694 23,128
Sales, marketing,
general and
administrative 1,944 4,606 10,681 13,812 18,113 24,976 37,697 59,841
Amortization of
deferred
compensation 227 631 1,837 1,302 1,653 1,234 1,008 618
Depreciation and
amortization 164 446 738 2,058 4,647 8,671 10,593 13,691
-------- -------- --------- --------- ------- -------- -------- ---------
Total operating
expenses 2,538 6,441 14,611 19,418 29,373 45,446 65,992 97,278
-------- -------- --------- --------- ------- -------- -------- ---------
Loss from operations (2,352) (5,632) (13,046) (16,652) (23,777) (34,613) (46,851) (66,360)
Net interest income
(expense) (429) (3,291) (3,511) (3,208) (5,127) (7,239) (7,254) (4,176)
-------- -------- --------- --------- ------- -------- -------- ---------
Net loss $(2,781) $(8,923) $(16,557) $(19,860) $28,904) $(41,852) $(54,105) $(70,536)
======== ======== ========= ========= ======= ======== ======== =========
Net loss per share $ (0.39) $ (1.11) $(1.84) $ (1.83) $ (0.56) $ (0.61) $(0.70) $ (0.80)
======== ======== ========= ========= ======= ======== ======== =========
</TABLE>
We have generated increasing revenues in each of the last eight quarters,
reflecting increases in the number of customers and end-users. Our network and
product costs have increased in every quarter, reflecting costs associated with
customer and end-user growth and the deployment of our networks in existing and
new regions. Our selling, marketing, general and administrative expenses have
increased in every quarter and reflect sales and marketing costs associated with
the acquisition of customers and end-users, 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 our networks. We have experienced
increasing net losses on a quarterly basis as we increased operating expenses
and increased depreciation as a result of increased capital expenditures, and we
expect to sustain increasing quarterly losses for at least the next several
years. See "Risk Factors--We have a history of losses and expect increasing
losses in the future." Our annual and quarterly operating results may fluctuate
significantly in the future as a result of numerous factors. Factors that may
affect our operating results include:
o the willingness, timing and ability of traditional telephone
companies to provide us with central office space;
o the rate at which traditional telephone companies can provide us
telephone wires over which we sell our service;
o the rate at which customers subscribe to our services;
o decreases in the prices for our services due to competition,
volume-based pricing and other factors;
o our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and limit end-user churn
rates;
o the success of our relationships with strategic partners, and
other potential third parties in generating significant
subscriber demand;
o the ability to deploy on a timely basis our services to
adequately satisfy end-user demand;
o delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead
times that are controlled by traditional telephone companies and
other third parties;
o the mix of line orders between consumer end-users and business
end-users (which typically have higher margins);
29
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o the amount and timing of capital expenditures and other costs
relating to the expansion of our network;
o the ability to develop and commercialize new services by us or
our competitors;
o the impact of regulatory developments, including interpretations
of the 1996 Telecommunications Act; and
o our ability to successfully operate our network.
Many of these factors are outside of our control. In addition, we plan
to increase operating expenses to fund operations, sales, marketing, general and
administrative activities and infrastructure, including increased expenses
associated with our relationships with strategic partners. If these expenses are
not accompanied by an increase in revenues, we could experience a material
adverse effect on our business, prospects, operating results and financial
condition and our ability to service and repay our indebtedness. See "Risk
Factors--Our operating results are likely to fluctuate in future periods and,
therefore, are difficult to predict."
LIQUIDITY AND CAPITAL RESOURCES
Our operations have required substantial capital investment for the
procurement, design and construction of our central office cages, the purchase
of telecommunications equipment and the design and development of our network.
Capital expenditures were approximately $207.8 million for the year ended
December 31, 1999. We expect that our capital expenditures will be substantially
higher in future periods in connection with the purchase of infrastructure
equipment necessary for the development and expansion of our network and the
development of new regions. We started a branding campaign in October 1999 to
increase recognition of our name which we expect will incur substantial
additional expenses over the next twelve months.
From our inception through December 31, 1999, we financed our
operations primarily through private placements of $10.6 million of equity
securities, $129.3 million in net proceeds raised from the issuance of the 1998
notes, $150.2 million in net proceeds raised from our initial public offering,
$60.0 million in net proceeds raised from strategic investors, $205.0 million in
net proceeds raised from the issuance of the 1999 notes and $568.8 million in
net proceeds from a secondary offering. As of December 31, 1999, we had an
accumulated deficit of $246.1 million, and cash and cash equivalents and
short-term investments of $767.4 million.
On January 28, 2000, the Company completed a private placement of
$425.0 million aggregate principal amount of the Company's 12% senior notes (the
"2000 notes") due 2010. The 2000 notes are unsecured senior obligations of the
Company maturing on February 15, 2010 and are redeemable at the option of the
Company any time after February 15, 2005 at stated redemption prices plus
accrued and unpaid interest thereon. Net proceeds from the 2000 notes were
approximately $413.3 million, after discounts, commissions and other transaction
costs of approximately $11.7 million. The discount and debt issuance costs are
being amortized over the life of the 2000 notes.
Net cash used in our operating activities was $102.8 million for the
year ended December 31, 1999. The net cash used for operating activities during
this period was primarily due to net losses and increases in current assets,
offset by non-cash expenses and increases in accounts payable and accrued
liabilities. Net cash used in our investing activities was $736.1 million for
the year ended December 31, 1999. The net cash used for investing activities
during this period was primarily due to purchases of property and equipment, the
purchase of $74.1 million of restricted investments which were hedged as
collateral for the payment of the first six scheduled interest payments on the
1999 notes, an aggregate of $32.2 million in equity investments made in WebMD,
Inc., Efficient Networks, Inc., Akamai Inc., iBeam Broadcasting Corporation, and
Cedent Corporation.
Net cash provided by financing activities for the year ended December
31, 1999 was $990.5 million which primarily related to the following:
30
<PAGE>
o 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.
o Net proceeds of $150.2 million from our initial public offering
of 13,455,000 split-adjusted shares our Common Stock at a
split-adjusted initial public offering price of $12.00 per share.
o Net proceeds of $205.0 million from the issuance of the 1999
notes with an aggregate principal amount of $215.0 million.
o Net proceeds of $568.8 million from the issuance of 13,655,000
shares of stock in our secondary offering of $43.00 per share.
Net cash provided by financing activities was partially offset by an
estimated $680,000 in offering costs applicable to our secondary offering of
7,500,000 shares in June 1999 for which we received no proceeds. We believe that
our current cash and cash equivalents and short-term investments will be
sufficient to meet our anticipated cash needs for working capital and capital
expenditures for at least the next twelve months.
We expect to experience substantial negative cash flow from operating
activities and negative cash flow before financing activities for at least the
next several years due to continued development, commercial deployment and
expansion of our network. We may also make investments in and acquisitions of
businesses that are complementary to ours to support the growth of our business.
Our future cash requirements for developing, deploying and enhancing our network
and operating our business, as well as our revenues, will depend on a number of
factors including:
o the number of regions entered, the timing of entry and services
offered;
o network development schedules and associated costs;
o the rate at which customers and end-users purchase our services
and the pricing of such services;
o the level of marketing required to acquire and retain customers
and to attain a competitive position in the marketplace;
o the rate at which we invest in engineering and development of
intellectual property with respect
o existing and future technology; and
o unanticipated opportunities.
We will be required to raise additional capital, the timing and amount
of which we cannot predict. We expect to raise additional capital through debt
or equity financings, depending on market conditions, to finance the continued
development, commercial deployment and expansion of our network and for funding
operating losses or to take advantage of unanticipated opportunities. If we are
unable to obtain required additional capital or are required to obtain it on
terms less satisfactory than we desire, we may be required to delay the
expansion of our business or take or forego actions, any or all of which could
harm our business.
In addition, we have and may continue to selectively pursue possible
acquisitions of or investments in businesses, technologies or products
complementary to ours in the future in order to expand our geographic presence
and achieve operating efficiencies. We may not have sufficient liquidity, or we
may be unable to obtain additional debt or equity financing on favorable terms
or at all, in order to finance such an acquisition or investment.
31
<PAGE>
YEAR 2000 ISSUES
Many currently installed computer systems and software products are
coded to accept only two-digit entries in the date code field and cannot
distinguish 21st century dates from 20th century dates. These date code fields
will need to distinguish 21st century dates from 20th century dates and, as a
result, many companies' software and computer systems may need to be upgraded or
replaced in order to comply with such "Year 2000" requirements.
We have reviewed our internally developed information technology
systems and programs and believe that our systems are Year 2000 compliant and
that there are no significant Year 2000 issues within our systems or services.
We have not reviewed our non-information technology systems for Year 2000 issues
relating to embedded microprocessors. To the extent that such issues exist,
these systems may need to be replaced or upgraded to become Year 2000 compliant.
We believe that our non-information technology systems will not present any
significant Year 2000 issues, although there can be no assurance in this regard.
In addition, we utilize third-party equipment and software and interact with
traditional telephone companies that have equipment and software that may not be
Year 2000 compliant. Failure of such third-party or traditional telephone
company equipment or software to operate properly with regard to the year 2000
and thereafter could require us to incur unanticipated expenses to remedy any
problems, which could have a material adverse effect on our business, prospects,
operating results and financial condition.
To date, we have not experienced any problems in complying with Year
2000 requirements, nor have we experienced any operational difficulties related
to Year 2000 issues.
FORWARD-LOOKING STATEMENTS
The statements contained in this Report on Form 10-K that are not
historical facts are "forward- looking statements" (as such term is defined in
Section 27A of the Securities Act and Section 21E of the Exchange Act), which
can be identified by the use of forward-looking terminology such as "estimates,"
"projects," "anticipates," "expects," "intends," "believes," or the negative
thereof or other variations thereon or comparable terminology, or by discussions
of strategy that involve risks and uncertainties. Examples of such
forward-looking statements include but are not limited to:
o our plans to expand our existing networks or to commence service
in new metropolitan statistical areas;
o estimates regarding the timing of launching our service in new
metropolitan statistical areas;
o expectations regarding the time frames, rates, terms and
conditions for implementing line sharing;
o expectations regarding the extent to which enterprise customers
roll out our service;
o expectations regarding our relationships with our strategic
partners and other potential third parties;
o expectations as to pricing for our services in the future;
o expectations as to the impact of our TeleSurfer service offerings
on our margins;
o the possibility that we may obtain significantly increased sales
volumes;
o the impact of our national advertising campaign on brand
recognition and operating results;
32
<PAGE>
o the plans to make strategic investments and acquisitions and the
affect of such investments and acquisitions;
o estimates of future operating results;
o plans to develop and commercialize value-added services;
o our anticipated capital expenditures;
o plans to enter into business arrangements with broadband-related
service providers;
o expectations regarding the commencement of our voice service; and
o the effect of regulatory reform and regulatory litigation; and
other statements contained in this Report regarding matters that
are not historical facts.
These statements are only estimates or predictions and cannot be relied
upon. We can give no assurance that future results will be achieved. Actual
events or results may differ materially as a result of risks facing us or
actual results differing from the assumptions underlying such statements. Such
risks and assumptions that could cause actual results to vary materially from
the future results indicated, expressed or implied in such forward-looking
statements include our ability to:
o successfully market our services to current and new customers;
o generate customer demand for our services in the particular
regions where we plan to market services;
o achieve favorable pricing for our services;
o respond to increasing competition;
o manage growth of our operations; and
o access regions and negotiate suitable interconnection agreements
with the traditional telephone companies, all in a timely manner,
at reasonable costs and on satisfactory terms and conditions
consistent with regulatory, legislative and judicial
developments.
All written and oral forward-looking statements made in connection with
this Report on Form 10-K which are attributable to us or persons acting on our
behalf are expressly qualified in their entirety by the "Risk Factors" and other
cautionary statements included in this Report on Form 10-K We disclaim any
obligation to update information contained in any forward-looking statement.
RISK FACTORS
OUR BUSINESS IS DIFFICULT TO EVALUATE BECAUSE WE HAVE A LIMITED OPERATING
HISTORY
We were incorporated in October 1996 and introduced our services
commercially in the San Francisco Bay Area in December 1997. Because of our
limited operating history, you have limited operating and financial data upon
which to evaluate our business. You should consider that we have the risks of an
early stage company in a new and rapidly evolving market. To overcome these
risks, we must:
33
<PAGE>
o rapidly expand the geographic coverage of our services;
o attract and retain customers within our existing and in new
metropolitan statistical areas;
o increase awareness of our services;
o respond to competitive developments;
o continue to attract, retain and motivate qualified persons;
o continue to upgrade our technologies in response to competition
and market factors;
o manage our traditional telephone company suppliers;
o rapidly install high-speed access lines;
o effectively manage the growth of our operations; and
o deliver additional value-added services to our customers without
causing existing customers to cease reselling our services or
reducing the volume or rate of growth of sales of our services.
WE HAVE A HISTORY OF LOSSES AND EXPECT INCREASING LOSSES IN THE FUTURE
We have incurred substantial losses and experienced negative cash flow
each fiscal quarter since our inception. As of December 31, 1999, we had an
accumulated deficit of approximately $246.1 million. We intend to increase our
capital expenditures and operating expenses in order to expand our business. As
a result, we expect to incur substantial additional net losses and substantial
negative cash flow for the next several years due to continued development,
commercial deployment and expansion of our network. We may also make investments
in and acquisitions of businesses that are complementary to ours to support the
growth of our business. Our future cash requirements for developing, deploying
and enhancing our network and operating our business, as well as our revenues,
will depend on a number of factors including:
o the number of regions entered, the timing of entry and services
offered;
o network development schedules and associated costs;
o the rate at which customers and end-users purchase our services
and the pricing of such services;
o the level of marketing required to acquired and retain customers
and to attain a competitive position in the market place;
o the rate at which we invest in engineering and development and
intellectual property with respect to existing and future
technology; and
o unanticipated opportunities.
In addition, we expect our net losses to increase in the future due to
interest and amortization charges related to our 1998 notes, our 1999 notes and
our 2000 notes, and the amortization charges related to our issuance of
preferred stock to AT&T Ventures and two affiliated funds ("AT&T Ventures"),
NEXTLINK and Qwest in January 1999. For example:
34
<PAGE>
o Interest and amortization charges relating to the 1998 notes were
approximately $22.3 million during the year ending December 31,
1999. These charges will increase each year until the year ending
December 31, 2004, during which period the interest and
amortization charges will be approximately $36.9 million. This
increase is due to the accretion of the 1998 notes to $260
million through March 2003.
o Interest and amortization charges relating to the 1999 notes were
approximately $24.8 million during the year ending December 31,
1999 and will increase slightly each year to approximately $29.3
million during the year ending December 31, 2008.
o Interest and amortization charges relating to the 2000 notes will
be approximately $48.2 million during the year ending December
31, 2000 and will be $52.2 million each following year through
the maturity of the notes in February 2010.
o We recorded intangible assets of $28.7 million associated with
the issuance of our preferred stock to AT&T Ventures, NEXTLINK
and Qwest. Amortization charges relating to our preferred stock
issuance were approximately $8.2 million during the year ending
December 31, 1999. These amounts will result in an annual
amortization charge of approximately $8.4 million in each of the
years in the two-year period ending December 31, 2001.
OUR OPERATING RESULTS ARE LIKELY TO FLUCTUATE IN FUTURE PERIODS AND, MAY FAIL TO
MEET THE EXPECTATIONS OF SECURITIES ANALYSTS AND INVESTORS
Our annual and quarterly operating results are likely to fluctuate
significantly in the future as a result of numerous factors, many of which are
outside of our control. These factors include:
o the timing and willingness of traditional telephone companies to
provide us with central office space and the prices, terms and
conditions on which they make available the space to us;
o the amount and timing of capital expenditures and other costs
relating to the expansion of our network and the marketing of our
services;
o delays in the commencement of operations in new regions and the
generation of revenue because certain network elements have lead
times that are controlled by traditional telephone companies and
other third parties;
o the ability to develop and commercialize new services by us or
our competitors;
o the ability to deploy on a timely basis our services to
adequately satisfy end-user demand;
o our ability to successfully operate our network;
o the rate at which customers subscribe to our services;
o decreases in the prices for our services due to competition,
volume-based pricing and other factors;
o our ability to retain Internet service provider, enterprise and
telecommunications carrier customers and limit end-user churn
rates;
o the mix of line orders between consumer end-users and business
end-users (which typically have higher margins);
35
<PAGE>
o the success of our relationships with AT&T, NEXTLINK, Qwest and
WebMD and other potential third parties in generating significant
end-user demand;
o the development and operation of our billing and collection
systems and other operational Systems and processes;
o the rendering of accurate and verifiable bills by our traditional
telephone company suppliers and resolution of billing disputes;
o the incorporation of enhancements, upgrades and new software and
hardware products into our network and operational processes that
may cause unanticipated disruptions; and
o the interpretation and enforcement of regulatory developments and
court rulings concerning the 1996 Telecommunications Act,
interconnection agreements and the anti-trust laws.
As a result, it is likely that in some future quarters our operating
results will be below the expectations of securities analysts and investors. If
this happens, the trading price of our Common Stock would likely decline.
WE CANNOT PREDICT WHETHER WE WILL BE SUCCESSFUL BECAUSE OUR BUSINESS STRATEGY IS
LARGELY UNPROVEN
We believe that we were the first competitive telecommunications
company to widely provide high-speed Internet and network access using DSL
technology. To date, our business strategy remains significantly unproven. To be
successful, we must develop and market services that achieve broad commercial
acceptance by Internet service provider, enterprise and telecommunications
carrier customers in our targeted metropolitan statistical areas. Because our
business and the demand for high-speed digital communications services are in
the early stages of development, we are uncertain whether our services will
achieve broad commercial acceptance.
It is uncertain whether our strategy of selling and providing our
service through the Internet service providers, telecommunication carriers and
others will be successful. This strategy creates marketing, operational and
other challenges and complexities that are less likely to appear in the case of
a single entity providing integrated DSL and ISP services. For example, cable
modem service providers, such as Excite@Home and Time Warner, market, sell and
provide high-speed services, Internet access and content services on an
integrated basis. Also, our new DSL + IP and VBSP services may adversely affect
our relationship with our current ISP customers, since we will be providing some
of the services that they provide. We do not anticipate that this will have a
substantial adverse effect on our relationship with our ISP customers because we
will be able to provide our ISP customers with these additional services at a
lower cost then they would pay if they developed these additional services
internally.
Two recently-announced mergers and acquisitions--between America Online
and Time Warner, and between NEXTLINK and Concentric Network--highlight a
growing trend among service providers and telecommunications carriers to combine
the marketing, selling and provision of high-speed data transmission services,
Internet access and content services. While we do not believe that such combined
entities providing integrated services will adversely affect our business, no
assurance can be given that such combinations will not ultimately have such an
adverse effect. Further, no assurance can be given that additional acquisitions
of Internet service providers by traditional and local competitive
telecommunications carriers, and other strategic alliances between such
entities, will not harm our business.
In light of our acquisition of Laser Link.Net, Inc. and other changes
we have made in our business to provide Internet access services on a wholesale
basis to Internet service providers, such as Prodigy and Juno On-Line, some of
our existing Internet service provider customers may perceive us as a potential
or actual competitor instead of as a supplier. Such Internet service providers
may therefor reduce the volume or the rate of growth of the sales of our
services, or may cease to resell our services. No assurance can be given that
our provision of additional services, even on a wholesale-only basis, will not
alienate some or all of our existing customers and thus harm our business.
36
<PAGE>
WE MAY EXPERIENCE DECREASING PRICES FOR OUR SERVICES, WHICH MAY IMPAIR OUR
ABILITY TO ACHIEVE PROFITABILITY OR POSITIVE CASH FLOW
We may experience decreasing prices for our services due to
competition, volume-based pricing, an increase in the proportion of our revenues
generated by our consumer services and other factors. Currently, we charge
higher prices for some of our services than some of our competitors do for their
similar services. As a result, we cannot assure you that our customers and their
end-user customers will select our services over those of our competitors. In
addition, prices for digital communications services in general have fallen
historically, and we expect this trend to continue. We have provided and expect
in the future to provide price discounts to customers that commit to sell our
services to a large number of their end-user customers. Our consumer-grade
services have lower prices than our business-grade services. As a result,
expected increases in the percentage of our revenues which we derive from our
consumer services will likely reduce our overall profit margins. We also expect
to reduce prices periodically in the future to respond to competition and to
generate increased sales volume. As a result, we cannot predict whether demand
for our services will exist at prices that enable us to achieve profitability or
positive cash flow.
OUR OPERATING RESULTS WILL SUFFER IF OUR ENTERPRISE CUSTOMERS DO NOT ROLL OUT
OUR SERVICES FOLLOWING THEIR INITIAL PHASE OF DEPLOYING OUR SERVICES.
Our practice with respect to our enterprise customers has been to enter
into an arrangement to install our service initially for a small number of
end-users. An enterprise customer decides whether to implement a broad roll out
of our services after evaluating the results of this initial phase of
deployment. Based on our experience to date, we believe that an enterprise
customer's initial phase of deployment and its decision to roll out our service
to additional end-users has taken at least six months, and has generally taken
longer than we originally expected. As of December 31, 1999, a substantial
majority of our enterprise customers had not yet rolled out our services broadly
to their employees, and it is not certain when such rollouts will occur, if at
all. We will not receive significant revenue from enterprise customers until and
unless these rollouts occur. During this lengthy sales cycle we incur
significant expenses in advance of the receipt of revenues. Therefore, if
enterprise customers to roll out our services, it will have a materially adverse
effect on our business, prospects, operating results and financial condition.
OUR BUSINESS WILL SUFFER IF OUR INTERNET SERVICE PROVIDERS, TELECOMMUNICATIONS
CARRIERS AND OTHER THIRD PARTIES ARE NOT SUCCESSFUL IN MARKETING AND SELLING OUR
SERVICES
We market our Internet access services through Internet service
providers, telecommunications carriers and other customers for resale to their
business and consumer end-users. To date, a limited number of Internet service
providers have accounted for the significant majority of our revenues. As a
result, a significant reduction in the number of end-users or revenues provided
by one or more of our key Internet service providers could materially harm our
operating results in any given period. We expect that our Internet service
provider customers and telecommunications carriers will account for the majority
of our future market penetration and revenue growth. Our agreements with our
customers are generally non-exclusive. Many of our customers also resell
services offered by our competitors. In addition, a number of our customers have
committed to provide large numbers of end-users in exchange for price discounts.
If our customers do not meet their volume commitments or otherwise do not sell
our services to as many end-users as we expect, our business will suffer.
In addition, we entered into commercial agreements with each of AT&T,
NEXTLINK and Qwest and more recently with WebMD. Our agreements with AT&T,
NEXTLINK and Qwest provide for the purchase and resale of our services,
primarily to their small business and enterprise customers. Our agreement with
WebMD provides that we will be WebMD's preferred provider of broadband
connectivity offering physician subscribers web-based multimedia and
communication services designed to enhance their practices. To date, these
relationships have not generated significant line orders. We cannot predict the
number of line orders that AT&T, NEXTLINK, Qwest or WebMD will generate, if any,
or whether line orders will be below our expectations. In addition, these and
future relationships we may establish with other third parties may not result in
significant line orders or revenues.
37
<PAGE>
OUR FAILURE TO MANAGE OUR GROWTH EFFECTIVELY MAY DELAY OUR NETWORK EXPANSION AND
SERVICE ROLLOUT
Our strategy is to significantly expand our network within our existing
metropolitan statistical areas and to deploy our network in substantially all of
our 100 targeted metropolitan statistical areas by the end of 2000. The
execution of this strategy involves:
o obtaining the required government authorizations;
o identifying, accessing and initiating service in key central
offices within existing and target regions;
o designing, maintaining and upgrading adequate operational
support, billing and collection systems;
o obtaining central office space and maintaining connections
between central offices;
o obtaining phone lines and electronic ordering facilities from our
traditional telephone company suppliers on a timely basis; and
o entering into and renewing interconnection agreements with the
appropriate traditional telephone companies on satisfactory terms
and conditions.
38
<PAGE>
To accomplish this strategy, we must, among other things:
- market to and acquire a substantial number of customers and end-users;
- continue to implement and improve our operational, financial and
management information systems, including our client ordering,
provisioning, dispatch, trouble ticketing and other operational
systems as well as our billing, accounts receivable and payable
tracking, collection, fixed assets and other financial management
systems;
- hire and train additional qualified management and technical
personnel;
- manage and resolve any disputes which may arise with our traditional
telephone company suppliers;
- establish and maintain relationships with third parties to market and
sell our services, install network equipment and provide field
service; and
- continue to expand and upgrade our network infrastructure.
We may be unable to do these things successfully. As a result, we may be
unable to deploy our network as scheduled or achieve the operational growth
necessary to achieve our business strategy.
Our growth has placed, and is expected to continue to place, significant
demands on our management and operational resources. We expect to continue to
significantly increase our employee base to support the deployment of our
network. We also expect to implement system upgrades, new software systems and
other enhancements, which could cause disruption and dislocation in our
business. If we are successful in implementing our marketing strategy, we may
have difficulty responding to demand for our services and technical support in a
timely manner and in accordance with our customers' expectations. We expect
these demands to require the addition of new management personnel and the
increased outsourcing of Company functions to third parties. We may be unable to
do this successfully, in which case we could experience a reduction in the
growth of our line orders and therefore our revenues.
In February to March 2000, we deployed new software systems that caused
some disruption to our business while enhancing the productivity and efficiency
of certain operational practices. Future changes in our processes that
39
<PAGE>
we introduce or we are required to introduce as a result of our arrangements
with the traditional telephone companies could cause similar or more serious
disruption to our ability to provide our services and to our overall business.
Thus far we have electronically linked our own ordering software systems to
the software systems of only one of the traditional telephone companies. Such
electronic linkage is essential for us to successfully place a large volume of
orders for access to telephone wires. There is no assurance that we will be
successful in electronically linking our software system to those of all of the
traditional telephone companies who we rely on for the supply of access to their
telephone wires. Our failure to electronically link our systems with those of
all major traditional telephone companies would severely harm our ability to
provide our services in large volume to our customers.
REJECTIONS OF OUR APPLICATIONS FOR CENTRAL OFFICE SPACE BY TRADITIONAL TELEPHONE
COMPANIES ARE LIKELY TO DELAY THE EXPANSION OF OUR NETWORK AND THE ROLL OUT OF
OUR SERVICES
We must secure physical space from traditional telephone companies for our
equipment in their central offices in order to provide our services in our
targeted metropolitan statistical areas. In the past, we have experienced
rejections of our applications to secure this space in many central offices, and
we continue to receive rejections in some central offices.
We expect that, as we proceed with our deployment, we will face additional
rejections of our applications for central office space in our other targeted
metropolitan statistical areas. These rejections have in the past resulted, and
could in the future result, in delays and increased expenses in the rollout of
our services in our targeted metropolitan statistical areas, including delays
and expenses associated with engaging in legal proceedings with the traditional
telephone companies. This has harmed our business and is likely to continue to
harm our business in the future periods.
We face other challenges in dealing with the traditional telephone
companies:
- there may be real limitations on the availability of central office
space in certain central offices;
- they frequently claim lack of available facilities when asked
by us to provide connections between central offices and telephone
wires to end-users;
- they frequently fail to promise delivery of, and actually deliver,
properly connected telephone wires to our end-users on time;
- they frequently do not cooperate in providing us with relevant
telephone wire information such as the length of the wire;
- they frequently do not deploy and provide us with integrated
software systems that allow us to seamlessly place large volumes of
orders for telephone lines; and
- they frequently do not cooperate in maintaining and resolving problems
relating to delivery of telephone lines.
We are engaged in a variety of negotiations, regulatory disputes and legal
actions to resolve these situations. We may be unable to resolve these matters
successfully.
The FCC has been reviewing the policies and practices of the traditional
telephone companies with the goal of facilitating the efforts of competitive
telecommunications companies to obtain central office space and telephone wires
more easily and on more favorable terms. On March 31, 1999, the FCC adopted
rules to make it easier and less expensive for competitive telecommunications
companies to obtain central office space and to require traditional telephone
companies to make new alternative arrangements for obtaining central office
space. However, the FCC's
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new rules have not been uniformly implemented in a timely manner, may not
ultimately enhance our ability to obtain central office space, and have been
subject to litigation.
Moreover, in March 2000, a federal appeals court struck portions of the
FCC's new rules, and has required the FCC to reconsider and review those rules.
In particular, the appeals court has required the FCC to revise its rules
concerning the types of equipment that we may collocate on the traditional
telephone company premises and the steps that traditional telephone companies
may take to separate their equipment from our equipment. The traditional
telephone companies may implement the court's ruling and any subsequent FCC
rules in a manner that impairs our ability to obtain collocation space and
collocate the equipment of our choice on their premises. Such actions by the
traditional telephone companies could adversely affect our business and disrupt
our existing network design, configuration and services.
CHARGES FOR UNBUNDLED NETWORK ELEMENTS ARE OUTSIDE OF OUR CONTROL BECAUSE THEY
ARE PROPOSED BY THE TRADITIONAL TELEPHONE COMPANIES AND ARE SUBJECT TO COSTLY
REGULATORY APPROVAL PROCESSES
Traditional telephone companies provide the unbundled DSL-capable lines or
telephone wires that connect each end-user to our equipment located in the
central offices. The 1996 Telecommunications Act generally requires that charges
for these unbundled network elements be cost-based and nondiscriminatory. The
nonrecurring and recurring monthly charges for DSL-capable lines (telephone
wires) that we require vary greatly. These rates are subject to the approval of
the state regulatory commissions. The rate approval processes for DSL-capable
lines and other unbundled network elements typically involve a lengthy review of
the rates proposed by the traditional telephone companies in each state. The
ultimate rates approved typically depend on the traditional telephone company's
initial rate proposals and the policies of the state public utility commission.
These rate approval proceedings are time-consuming and expensive. Consequently,
we are subject to the risk that the non-recurring and recurring charges for
DSL-capable lines and other unbundled network elements will increase based on
rates proposed by the traditional telephone companies and approved by state
regulatory commissions from time to time, which would harm our operating
results.
THE FAILURE OF TRADITIONAL TELEPHONE COMPANIES TO ADEQUATELY PROVIDE
TRANSMISSION FACILITIES AND PROVISION TELEPHONE WIRES IS LIKELY TO IMPAIR OUR
ABILITY TO INSTALL LINES AND ADVERSELY AFFECT OUR GROWTH RATE
We interconnect with and use traditional telephone companies' networks to
service our customers. This presents a number of challenges because we depend on
traditional telephone companies:
- to use their technology and capabilities to meet certain
telecommunications needs of our customers and to maintain our service
standards;
- to cooperate with us for the provision and maintenance of transmission
facilities; and
- to provide the services and network components that we order,
for which they depend significantly on unionized labor. Labor issues
have in the past, and may in the future, hurt the telephone companies'
performance.
Our dependence on the traditional telephone companies has caused and could
continue to cause us to encounter delays in establishing our network and
providing higher speed DSL services. We rely on the traditional telephone
companies to provision telephone wires to our customers and end-users. We must
establish efficient procedures for ordering, provisioning, maintaining and
repairing large volumes of DSL capable lines from the traditional telephone
companies. We must also establish satisfactory electronic billing and payment
arrangements with the traditional telephone companies. We may not be able to do
these things in a manner that will allow us to retain and grow our customer and
end-user base.
It has been and continues to be our experience that, at any given time, one
or more of the traditional telephone companies will fail to deliver the central
office space, transmission facilities, telephone wires or other
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elements, features and functions that our business requires. For example, the
traditional telephone companies currently are significantly impairing our
ability to efficiently install our services, and this has adversely affected the
growth in the volume of orders we receive. The failure of the traditional
telephone companies to consistently and adequately deliver operable telephone
wires to us on time has significantly contributed to an increase in the backlog
of uninstalled orders. The continued inadequate performance of the traditional
telephone companies could slow the growth in our revenues and reduce the growth
in orders placed by our customers, which could materially harm our business.
On November 18, 1999, the FCC decided that the traditional local telephone
companies must provide us and other competitive local exchange carriers with
access to line sharing. This would allow us to provide our services over the
same telephone wire used by the traditional telephone companies to provide
analog voice services. The FCC has directed the traditional local telephone
companies to enter into agreements with competitors, such as ourselves, and take
the necessary steps to provide such access by mid-2000. However, it is unclear
whether the traditional telephone companies will provide us with such access in
a meaningful way this year.
The rates, terms and conditions of line sharing access have not yet been
mutually agreed to between the traditional local phone companies and us. State
commissions have not yet arbitrated disputes or set line sharing rates in
connection with failed negotiations between traditional local phone companies
and us. The efforts of traditional local telephone companies to provide us with
line sharing may inadvertently or purposefully cause disruption and dislocation
to our existing processes for obtaining full telephone lines and our ability to
provide our services.
WE DEPEND ON THE TRADITIONAL TELEPHONE COMPANIES FOR THE QUALITY AND
AVAILABILITY OF THE TELEPHONE WIRES THAT WE USE
We depend significantly on the quality and availability of the traditional
telephone companies' telephone wires, shared lines and the traditional telephone
companies' maintenance of such wires. We may not be able to obtain the telephone
wires and the services we require from the traditional telephone companies at
satisfactory quality levels, rates, terms and conditions. Our inability to do so
could delay the expansion of our network and degrade the quality of our services
to our customers.
OUR BUSINESS WILL SUFFER IF OUR INTERCONNECTION AGREEMENTS ARE NOT RENEWED OR IF
THEY ARE MODIFIED ON UNFAVORABLE TERMS
We are required to enter into and implement interconnection agreements in
each of our targeted metropolitan statistical areas with the appropriate
traditional telephone companies in order to provide service in those regions. We
have not yet entered into all of the interconnection agreements we require to
complete our 100 metropolitan statistical area build-out. We may be unable to
timely enter into these agreements, which is prerequisite for us to provide
service in those areas. Many of our existing interconnection agreements have a
maximum term of three years. Therefore, we will have to renegotiate these
agreements with the traditional telephone companies when they expire. We may not
succeed in extending or renegotiating them on favorable terms or at all.
Additionally, disputes have arisen and will continue to arise in the future
as a result of differences in interpretations of the interconnection agreements.
For example, we are in litigation proceedings with certain of the traditional
telephone companies. These disputes have delayed the deployment of our network,
and resolution of the litigated matters will cause us ongoing expenditure of
money and management time. They may have also negatively affected our service to
our customers and our ability to enter into additional interconnection
agreements with the traditional telephone companies in other states. In
addition, the interconnection agreements are subject to state commission, FCC
and judicial oversight. These government authorities may modify the terms of the
interconnection agreements in a way that harms our business.
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THE MARKETS WE FACE ARE HIGHLY COMPETITIVE AND WE MAY NOT BE ABLE TO COMPETE
EFFECTIVELY, ESPECIALLY AGAINST ESTABLISHED INDUSTRY COMPETITORS WITH
SIGNIFICANTLY GREATER FINANCIAL RESOURCES
The markets we face for business and consumer Internet access and RLAN
access services are intensely competitive. We expect that these markets will
become increasingly competitive in the future. In addition, the traditional
telephone companies dominate the current market and have a monopoly on telephone
wires. We pose a competitive risk to the traditional telephone companies and, as
both our competitors and our suppliers, they have the ability and the motivation
to harm our business. We also face competition from cable modem service
providers, competitive telecommunications companies traditional and new national
long distance carriers, Internet service providers, on-line service providers
and wireless and satellite service providers. Many of these competitors have
longer operating histories, greater name recognition, better strategic
relationships and significantly greater financial, technical or marketing
resources than we do. As a result, these competitors:
- may be able to develop and adopt new or emerging technologies and
respond to changes in customer requirements or devote greater
resources to the development, promotion and sale of their products and
services more effectively than we can;
- may form new alliances and rapidly acquire significant market share;
and
- 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.
The intense competition from our competitors, including the traditional
telephone companies, the cable modem service providers and the competitive
telecommunications companies could harm our business.
The traditional telephone companies represent the dominant competition in
all of our target service areas, and we expect this competition to intensify.
For example, they 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 telephone wires and can bundle digital data services
with their existing analog voice services to achieve economies of scale in
serving customers. Certain of the traditional telephone companies have
aggressively priced their consumer DSL services as low as $19-$29 per month,
placing pricing pressure on our TeleSurfer services. While we may be allowed to
provide our data services over the same telephone wires that they provide analog
voice services, we may be unable to obtain this ability. Even if we do obtain
this ability, there is no assurance that we will be permitted to provide our
services in this manner without running into operational or technical obstacles;
including those created by the traditional telephone companies. Further, they
can offer service to end-users from certain central offices where we are unable
to secure central office space and offer service. Accordingly, we may be unable
to compete successfully against the traditional telephone companies.
Cable modem service providers, such as Excite@Home and MediaOne (and their
respective cable partners), are deploying high-speed Internet access services
over coaxial cable networks. Where deployed, these networks provide similar, and
in some cases, higher-speed Internet access and RLAN access than we provide.
They also offer these services at lower price points than our TeleSurfer
services. As a result, competition with the cable modem service providers may
have a significant negative effect on our ability to secure customers and may
create downward pressure on the prices we can charge for our services.
Many competitive telecommunications companies offer high-speed data
services using a business strategy similar to ours. Some of these competitors
have begun offering DSL-based access services and others are likely to do so in
the future. In addition, some competitive telecommunications companies have
extensive fiber networks in many metropolitan areas primarily providing
high-speed digital and voice circuits to large corporations, and have
interconnection agreements with traditional telephone companies pursuant to
which they have acquired central office space in many of our existing and target
markets. Further, certain of our customers have made investments in our
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competitors. As a result of these factors, we may be unsuccessful in generating
a significant number of new customers or retaining existing customers.
OUR LEVERAGE IS SUBSTANTIAL AND WILL INCREASE, MAKING IT MORE DIFFICULT TO
RESPOND TO CHANGING BUSINESS CONDITIONS
After giving effect to the issuance of the 2000 notes, as of December 31,
1999, on a pro forma basis, we had approximately $800.0 million of long-term
obligations (including current portion), which consists primarily of the 1998
notes, the 1999 notes and the 2000 notes. Because the 1998 notes accrete to $260
million through March 2003, we will become increasingly leveraged until then,
whether or not we incur new indebtedness in the future. We may also incur
additional indebtedness in the future, subject to certain restrictions contained
in the indentures governing the 1998 notes, the 1999 notes and the 2000 notes,
to finance the continued development, commercial deployment and expansion of our
network and for funding operating losses or to take advantage of unanticipated
opportunities. The degree to which we are leveraged could have important
consequences. For example, it could:
- materially limit or impair our ability to obtain additional
financing or refinancing in the future for working capital, capital
expenditures, acquisitions, general corporate purposes or other
purposes;
- require us to dedicate a substantial portion of our cash flow to the
payment of principal and interest on our indebtedness, which reduces
the availability of cash flow to fund working capital, capital
expenditures, acquisitions, general corporate purposes or other
purposes;
- limit our ability to redeem the 1998 notes, the 1999 notes and the
2000 notes in the event of a change of control; and
- increase our vulnerability to economic downturns, limit our ability to
withstand competitive pressures and reduce our flexibility in
responding to changing business and economic conditions.
WE WILL REQUIRE A SIGNIFICANT AMOUNT OF CASH TO SERVICE OUR INDEBTEDNESS; OUR
ABILITY TO GENERATE CASH DEPENDS ON MANY FACTORS BEYOND OUR CONTROL
We expect to continue to generate substantial net losses and negative cash
flow for at least the next several years. We may be unable to maintain a level
of cash flow from operations sufficient to permit us to pay the principal and
interest on our current indebtedness and the 2000 notes, and any additional
indebtedness we may incur. The 1998 notes accrete to $260 million through March
2003 and we must begin paying cash interest on those notes in September 2003. In
addition, we began paying cash interest on the 1999 notes in August 1999 and
will begin paying cash interest on the 2000 notes in August 2000. We have
provided for the first six payments on the 1999 notes by setting aside
approximately $74.1 million in government securities to fund such payments.
Our ability to make scheduled payments with respect to indebtedness will
depend upon, among other things:
- our ability to achieve significant and sustained growth in cash flow;
- the rate and success of the commercial deployment of our network;
- successful operation of our network;
- the market acceptance, customer demand, rate of utilization and
pricing for our services;
- our ability to successfully complete development, upgrades and
enhancements of our network;
- and our ability to complete additional financings, as necessary.
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Each of these factors is affected by economic, financial, competitive and
other factors, many of which are beyond our control. If we are unable to
generate sufficient cash flow to service our indebtedness, we may have to reduce
or delay network deployments, restructure or refinance our indebtedness or seek
additional equity capital, strategies that may not enable us to service and
repay our indebtedness. Any failure to satisfy our obligations with respect to
the 1998 notes, the 1999 notes or the 2000 notes at or before maturity would be
a default under the related indentures and could cause a default under
agreements governing our other indebtedness. If such defaults occur, the holders
of the indebtedness would have enforcement rights, including the right to
accelerate payment of the entire amount of the debt and the right to commence an
involuntary bankruptcy proceeding against us.
OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS
We regard certain aspects of our products, services and technology as
proprietary. We attempt to protect them with patents, copyrights, trademarks,
trade secret laws, restrictions on disclosure and other methods. These methods
may not be sufficient to protect our technology. We also generally enter into
confidentiality or license agreements with our employees and consultants, and
generally control access to and distribution of our documentation and other
proprietary information. Despite these precautions, it may be possible for a
third party to copy or otherwise obtain and use our products, services or
technology without authorization, or to develop similar technology
independently.
Currently, we have been issued one patent and we have a number of
additional patent applications pending. We intend to prepare additional
applications and to seek patent protection for our systems and services. These
patents may not be issued to us. If issued, they may not protect our
intellectual property from competition. Competitors could seek to design around
or invalidate these patents.
Effective patent, copyright, trademark and trade secret protection may be
unavailable or limited in certain foreign countries. The global nature of the
Internet makes it virtually impossible to control the ultimate destination of
our proprietary information. The steps that we have taken may not prevent
misappropriation or infringement of our technology. Litigation may be necessary
in the future to enforce our intellectual property rights, to protect our trade
secrets or to determine the validity and scope of the proprietary rights of
others. Such litigation could result in substantial costs and diversion of
resources and could harm our business.
In addition, others may sue us with respect to infringement of their
intellectual property rights. Last year we were sued by Bell Atlantic for an
alleged infringement of a patent issued to them September 1998 entitled
"Variable Rate and Variable Mode Transmission System." Although the court
recently held that we do not infringe Bell Atlantic's patent, Bell Atlantic is
seeking reconsideration of this ruling and this ruling is still subject to
appeal. As litigation is inherently unpredictable, there is no guarantee that we
will prevail on a motion for reconsideration or on an appeal of this ruling. An
unfavorable outcome on appeal of this ruling, or in any other lawsuit that may
be brought against us, could limit our ability to provide all our services and
require us to pay damages, which could significantly harm our business.
WE WILL NEED ADDITIONAL FUNDS IN THE FUTURE IN ORDER TO CONTINUE TO GROW OUR
BUSINESS
We believe our current capital resources combined with the proceeds of this
offering will be sufficient for our funding and working capital requirements for
the deployment and operation of our network for at least the next twelve months.
Thereafter, we may be required to raise additional capital through the issuance
of debt or equity financings. We may choose to raise additional capital sooner,
depending on market conditions. The actual amount and timing of our future
capital requirements will depend upon a number of factors, including:
- the number of geographic areas targeted and entered and the timing of
entry and services offered;
- network deployment schedules and associated costs;
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- the rate at which customers and end-users purchase our services and
the pricing of such services;
- the level of marketing required to acquire and retain customers and to
attain a competitive position in each region we enter;
- the rate at which we invest in engineering and development and
intellectual property with respect to existing and future technology;
and
- investment opportunities in complementary businesses, acquisitions or
other opportunities.
We also may be unsuccessful in raising sufficient capital at all or on
terms that we consider acceptable. If this happens, our ability to continue to
expand our business or respond to competitive developments would be impaired.
In addition, indentures governing our existing indebtedness contain
covenants that may restrict our business activities and our ability to raise
additional funds. As a result, we may not be able to undertake certain
activities which management believes are in our best interest to develop our
business. We also may be unable to raise as much additional funding through the
issuance of debt securities as we may need in the future. This could require us
to raise funding through the issuance of equity securities or amend our
indentures, which we may be unable to do on acceptable terms.
THE SCALABILITY AND SPEED OF OUR NETWORK REMAIN LARGELY UNPROVEN
As of February 29, 2000, we had deployed our network in a total of 62
metropolitan statistical areas, many of which have been deployed only in the
last several months. As a result, the ability of our DSL networks and
operational support systems to connect and manage a substantial number of online
end-users at high speeds is still unknown. Consequently, there remains a risk
that we may not be able to scale our network and operational support systems up
to our expected end-user numbers while achieving superior performance. Peak
digital data transmission speeds currently offered across our DSL networks are
1.5 megabits per second downstream. However, the actual data transmission speeds
over our network could be significantly slower and will depend on a variety of
factors, including:
- the type of DSL technology deployed;
- the distance an end-user is located from a central office;
- the configuration of the telecommunications line being used;
- quality of the telephone wires provisioned by traditional telephone
companies; and
- our operational support systems which manage our network.
As a result, our network may be unable to achieve and maintain the
highest possible digital transmission speed. Our failure to achieve or maintain
high-speed digital transmissions would significantly reduce customer and
end-user demand for our services.
INTERFERENCE IN THE TRADITIONAL TELEPHONE COMPANIES' COPPER PLANT COULD DEGRADE
THE PERFORMANCE OF OUR SERVICES
Certain tests indicate that some types of DSL technology may cause
interference with, and be interfered with by other signals present in a
traditional telephone company's copper plant, usually with lines in close
proximity. In addition, if and when we obtain line sharing from the traditional
local telephone companies, our deployment of our ADSL data services could
interfere with the voice services of the traditional local telephone companies
carried over the same line or adjacent lines. If it occurs, such interference
could cause degradation of performance of our services or the services of the
traditional local telephone companies and render us unable to offer our services
on selected
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lines. The amount and extent of such interference will depend on the condition
of the traditional telephone company's copper plant and the number and
distribution of DSL and other signals in such plant and cannot now be
ascertained.
When interference occurs, it is difficult to detect. The procedures to
resolve interference issues between competitive telecommunications companies and
traditional telephone companies are still being developed and may not be
effective. In the past we have agreed to interference resolution procedures with
certain traditional telephone companies. However, we may be unable to
successfully negotiate similar procedures with other traditional telephone
companies in future interconnection agreements or in renewals of existing
interconnection agreements. In addition, the failure of the traditional
telephone companies to take timely action to resolve interference issues could
harm the provision of our services. If our TeleSpeed and TeleSurfer services
cause widespread network degradation or are perceived to cause that type of
interference, actions by the traditional telephone companies or state or federal
regulators could harm our reputation, brand image, service quality, customer
satisfaction and retention, and overall business. Moreover, ostensible
interference concerns have in the past been, continue to currently and may in
the future be used by the traditional telephone companies as a pretext to delay
the deployment of our services and otherwise harm our business.
A SYSTEM FAILURE COULD DELAY OR INTERRUPT SERVICE TO OUR CUSTOMERS
Our operations depend upon our ability to support our highly complex
network infrastructure and avoid damage from fires, earthquakes, floods, power
losses, excessive sustained or peak user demand, telecommunications failures,
network software flaws, transmission cable cuts and similar events. The
occurrence of a natural disaster or other unanticipated problem at our network
operations center or any our regional data centers could cause interruptions in
our services. Additionally, failure of a traditional telephone company or other
service provider, such as competitive telecommunications companies, to provide
communications capacity that we require, as a result of a natural disaster,
operational disruption any other reason, could cause interruptions in our
services. Any damage or failure that causes interruptions in our operations
could harm our business.
A BREACH OF NETWORK SECURITY COULD DELAY OR INTERRUPT SERVICE TO OUR CUSTOMERS
Our network may be vulnerable to unauthorized access, computer viruses and
other disruptive problems. Internet service provider, telecommunications carrier
and corporate networks have in the past experienced, and may in the future
experience, interruptions in service as a result of accidental or intentional
actions of Internet users, current and former employees and others. Unauthorized
access could also potentially jeopardize the security of confidential
information stored in the computer systems of our customers and the customers'
end-users. This might result in liability to our customers and also might deter
potential customers. We intend to implement security measures that are standard
within the telecommunications industry and newly developed security measures. We
have not done so yet and may not implement such measures in a timely manner.
Moreover, if and when implemented, such measures may be circumvented, and
eliminating computer viruses and alleviating other security problems may require
interruptions, delays or cessation of service to our customers and such
customers' end-users, which could harm our business.
WE DEPEND ON A LIMITED NUMBER OF THIRD PARTIES FOR EQUIPMENT SUPPLY AND
INSTALLATION
We rely on outside parties to manufacture our network equipment. This
equipment includes:
- digital subscriber line access multiplexers;
- customer premise equipment modems;
- network routing and switching hardware;
- network management software;
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- systems management software; and
- database management software.
As we sign additional service contracts, we will need to increase
significantly the amount of manufacturing and other services supplied by third
parties in order to meet our contractual commitments. For example, we have a
service arrangement with Lucent Technologies Inc. to increase our ability to
install our central office facilities and associated equipment.
We have in the past experienced supply problems with certain of our
vendors. These vendors may not be able to meet our needs in a satisfactory and
timely manner in the future. In addition, we may not be able to obtain
additional vendors when needed. We have identified alternative suppliers for
technologies that we consider critical. However, it could take us a significant
period of time to establish relationships with alternative suppliers for
critical technologies and substitute their technologies into our network.
Our reliance on third-party vendors involves additional risks, including:
- the absence of guaranteed capacity; and
- reduced control over delivery schedules, quality assurance, production
yields and costs.
The loss of any of our relationships with these suppliers could harm our
business.
OUR SUCCESS DEPENDS ON OUR RETENTION OF CERTAIN KEY PERSONNEL, OUR ABILITY TO
HIRE ADDITIONAL KEY PERSONNEL AND THE MAINTENANCE OF GOOD LABOR RELATIONS
We depend on the performance of our executive officers and key employees.
In particular, our senior management has significant experience in the data
communications, telecommunications and personal computer industries, and the
loss of any of them could negatively affect our ability to execute our business
strategy. Additionally, we do not have "key person" life insurance policies on
any of our employees.
Our future success also depends on our continuing ability to identify,
hire, train and retain other highly qualified technical, sales, marketing, legal
and managerial personnel in connection with our expansion within our existing
regions and the deployment, legal and marketing of our network into targeted
regions. Competition for such qualified personnel is intense. This is
particularly the case in software development, network engineering and product
management. We also may be unable to attract, assimilate or retain other highly
qualified technical, operations, sales, marketing and managerial personnel. Our
business will be harmed if we cannot attract the necessary technical, sales,
marketing and managerial personnel. In addition, in the event that our employees
unionize, we could incur higher ongoing labor costs and disruptions in our
operations in the event of a strike or other work stoppage.
WE HAVE AND MAY MAKE ACQUISITIONS OF COMPLEMENTARY TECHNOLOGIES OR BUSINESSES IN
THE FUTURE, WHICH MAY DISRUPT OUR BUSINESS AND BE DILUTIVE TO OUR EXISTING
STOCKHOLDERS
In addition to our acquisition of Laser Link.Net, Inc., we intend to
consider acquisitions of businesses and technologies in the future on an
opportunistic basis. Acquisitions of businesses and technologies involve
numerous risks, including the diversion of management attention, difficulties in
assimilating the acquired operations, loss of key employees from the acquired
company, and difficulties in transitioning key customer relationships. In
addition, these acquisitions may result in dilutive issuances of equity
securities, the incurrence of additional debt, large one-time expenses and the
creation of goodwill or other intangible assets that result in significant
amortization expense. Any of these factors could materially harm our business or
our operating results in a given period.
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AN ECONOMIC DOWNTURN COULD ADVERSELY IMPACT DEMAND FOR OUR SERVICES
In the last few years the general health of the economy, particularly the
California economy, has been relatively strong and growing, a consequence of
which has been increasing capital spending by individuals and growing companies
to keep pace with rapid technological advances. To the extent the general
economic health of the United States or of California declines from recent
historically high levels, or to the extent individuals or companies fear such a
decline is imminent, such individuals and companies may reduce, in the near
term, expenditures such as those for our services. Any such decline or concern
about an imminent decline could delay decisions among certain of our customers
to roll out our services or could delay decisions by prospective customers to
make initial evaluations of our services. Such delays would have a material
adverse effect on our business, prospects, operating results and financial
condition.
OUR STOCK PRICE HAS BEEN AND IS LIKELY TO CONTINUE TO BE VOLATILE
The trading price of our Common Stock has been and is likely to continue to
be highly volatile. Our stock price could fluctuate widely in response to
factors such as the following:
- actual or anticipated variations in quarterly operating results;
- announcements of new products or services by us or our competitors or
new competing technologies;
- the addition or loss of ISP or enterprise customers or subscribers;
- changes in financial estimates or recommendations by securities
analysts,
- the adoption of new, or changes in existing, accounting rules,
guidelines and practices, which may materially impact our financial
statements and may materially alter the expectations of securities
analysts or investors;
- conditions or trends in the telecommunications industry, including
regulatory developments;
- growth of the Internet and online commerce industries;
- announcements by us of significant acquisitions, strategic
partnerships, joint ventures or capital commitments;
- additions or departures of key personnel;
- future equity or debt offerings or our announcements of such
offerings;
- general market and general economic conditions; and
- other events or factors, many of which are beyond our control.
With respect to changes in accounting rules, guidelines or practices, Staff
Accounting Bulletin 101 ("SAB 101") entitled "Revenue Recognition in Financial
Statements," was issued in December 1999 by the Securities and Exchange
Commission. SAB 101 provides that, in certain circumstances, revenues which are
received in the first month of a contract might have to be recognized over an
extended period of time, instead of in the first month of the contract. While we
believe that SAB 101 will not have a material impact on our financial
statements, the full impact of SAB 101 on us has not yet been determined.
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FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE
Sales of a substantial number of shares of our Common Stock in the public
market, or the appearance that such shares available for sale, could adversely
affect the market price for our Common Stock. As of March 24, 2000, we will have
95,600,104 shares of Common Stock outstanding (not including our Class B Common
Stock). We have a significant number of shares which are not currently publicly
traded but are available for immediate resale to the public, subject to certain
volume limitations and under the securities laws and lock-up arrangements. We
also have 2,951,588 shares of our Common Stock remaining that are reserved for
issuance pursuant to options under our 1997 Stock Plan, of which 17,744,288
shares were subject to outstanding options at March 24, 2000. We have also
reserved 1,500,000 shares of Common Stock for issuance under our 1998 Employee
Stock Purchase Plan. Shares underlying vested options are generally eligible for
immediate resale in the public market.
Furthermore, a significant portion of our stockholders have certain
registration rights with respect to their shares, including the holders of our
Class B Common Stock with respect to the 3,588,286 shares of Common Stock
issuable upon conversion of their Class B Common Stock. Our Class B Common Stock
is convertible into Common Stock beginning January 2000.
ANTITAKEOVER EFFECTS OF CERTAIN CHARTER AND BYLAW PROVISIONS, DELAWARE LAW, OUR
INDENTURES AND STOCKHOLDER PROTECTION RIGHTS PLAN
Our Board of Directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any further vote
or action by the stockholders. The issuance of preferred stock, while providing
desirable flexibility in connection with possible acquisitions and other
corporate purposes, could have the effect of making it more difficult for a
third party to acquire a majority of our outstanding voting stock. Our charter
and bylaws provide for a classified board of directors, limitations on the
ability of stockholders to call special meetings and act by written consent, the
lack of cumulative voting for directors and procedures for advance notification
of stockholder nominations and proposals. These provisions, as well as Section
203 under the Delaware General Corporation Law to which we are subject, could
discourage potential acquisition proposals and could delay or prevent a change
of control.
The indentures relating to the 1998 notes, 1999 notes and 2000 notes
provide that, in the event of certain changes in control, each holder of the
notes will have the right to require us to repurchase such holder's notes at a
premium over the aggregate principal amount or the accreted value, as the case
may be, of such debt. In addition, our Stockholder Protection Rights Plan
contains provisions that make a hostile takeover prohibitively expensive and, in
effect, requires interested suitors to cooperate with the Board of Directors
prior to acquiring more than 15% of the Company. There is no guarantee that the
Stockholder Protection Rights Plan will not discourage takeover attempts which
would otherwise result in a premium to our stockholders.
The provisions in the charter, bylaws, indentures and Stockholder
Protection Rights Plan could have the effect of discouraging others from making
tender offers for our shares and, as a consequence, they also may inhibit
increases in the market price of our shares that could result from actual or
rumored takeover attempts. Such provisions also may have the effect of
preventing changes in our management.
WE MAY MAKE ACQUISITIONS OF TECHNOLOGIES OR BUSINESSES WHICH MAY DISRUPT OUR
BUSINESS AND BE DILUTIVE TO OUR EXISTING STOCKHOLDERS
We intend to consider acquisitions of businesses and technologies in the
future on an opportunistic basis. Acquisitions of businesses and technologies
involve numerous risks, including the diversion of management attention,
difficulties in assimilating the acquired operations, loss of key employees from
the acquired company, and difficulties in transitioning key customer
relationships. In addition, these acquisitions may result in dilutive issuances
of equity securities, the incurrence of additional debt, large one-time expenses
and the creation of goodwill or other
50
<PAGE>
intangible assets that result in significant amortization expense. Any of these
factors could materially harm our business or our operating results in a given
period or could cause our stock price to decline.
OUR FAILURE AND THE FAILURE OF THIRD PARTIES TO BE YEAR 2000 COMPLIANT COULD
NEGATIVELY IMPACT OUR BUSINESS
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code filed and cannot distinguish
21st century dates from 20th century dates. These date code fields will need to
distinguish 21st century dates from 20th century dates and, as a result, many
companies' software and computer systems may need to be upgraded or replaced in
order to comply with such "Year 2000" requirements.
We have reviewed our internally developed information technology systems
and programs and believe that our systems are Year 2000 compliant and that there
are not significant Year 2000 issues within our systems or services. We have not
reviewed our non-information technology systems for Year 2000 issues relating to
embedded microprocessors. To the extent that such issues exist, these systems
may need to be replaced or upgraded to become Year 2000 compliant. We believe
that our non-information technology systems will not present any significant
Year 2000 issues, although there can be no assurance in this regard. In
addition, we utilize third-party equipment and software and interact with
traditional telephone companies that have equipment and software that may not be
Year 2000 compliant. Failure of such third-party or traditional telephone
company equipment or software to operate properly with regard to the year 2000
and thereafter could require us to incur unanticipated expenses to remedy any
problems, which could have a material adverse effect on our business, prospects,
operating results and financial condition.
To date, we have not experienced any problems in complying with Year 2000
requirements, nor have we experienced any operational difficulties related to
Year 2000 issues.
THE BROADBAND COMMUNICATIONS INDUSTRY IS UNDERGOING RAPID TECHNOLOGICAL CHANGES,
AND NEW TECHNOLOGIES MAY BE SUPERIOR TO THE TECHNOLOGY WE USE
The broadband communications industry is subject to rapid and significant
technological change, including continuing developments in DSL technology, which
does not presently have widely accepted standards, and alternative technologies
for providing broadband communications such as cable modem technology. As a
consequence:
- we will rely on third parties, including some of our
competitors and potential competitors, to develop and provide us with
access to communications and networking technology;
- our success will depend on our ability to anticipate or adapt to new
technology on a timely basis; and
- we expect that new products and technologies will emerge that
may be superior to, or may not be compatible with, our products and
technologies.
If we fail to adapt successfully to technological changes or fail to obtain
access to important technologies, our business will suffer.
OUR STRATEGY DEPENDS ON GROWTH IN DEMAND FOR DSL-BASED SERVICES
The demand for high-speed Internet and RLAN access is in the early stages
of development. As a result, we cannot predict the rate at which this demand
will grow, if at all, or whether new or increased competition will result in
satisfying all demand. Various providers of high-speed digital communications
services are testing products from various suppliers for various applications.
We do not know whether DSL will offer the same or more attractive
price-performance characteristics. Critical issues concerning commercial use of
DSL for Internet and RLAN access, including security, reliability ease and cost
of access and quality of service remain unresolved and may impact the
51
<PAGE>
growth of such services. If the demand for our services grows more slowly than
we anticipate or is satisfied by competitors, our ability to achieve revenue
growth and positive cash flow will be harmed.
WE MUST COMPLY WITH FEDERAL AND STATE TAX AND OTHER SURCHARGES ON OUR SERVICE
THE LEVELS OF WHICH ARE UNCERTAIN
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate services and intrastate services. Interstate
surcharges include Federal Universal Service Fees, Common Carrier Regulatory
Fees and TRS Fund fees. In addition, state regulators impose similar surcharges
and fees on intrastate services. The division of our services between interest
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 their jurisdictions could cause our payment
obligations, pursuant to the relevant surcharges, to increase. In addition,
pursuant to periodic revisions by state and federal regulators of the applicable
surcharges, we may be subject to increases in the surcharges and fees currently
paid.
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN CURRENT OR
FUTURE LAWS OR REGULATIONS COULD ADVERSELY AFFECT OUR BUSINESS
Our services are subject to federal, state and local government
regulations. The 1996 Telecommunications Act, which became effective in February
1996, introduced widespread changes in the regulation of the telecommunications
industry, including the digital access services segment in which we operate. The
1996 Telecommunications Act eliminates many of the pre-existing legal barriers
to competition in the telecommunications services business and sets basic
criteria for relationships between telecommunications providers.
Among other things, the 1996 Telecommunications Act removes barriers to
entry in the local exchange telephone market by preempting state and local laws
that restrict competition by providing competitors interconnection, access to
unbundled network elements and retail services at wholesale rates. The FCC's
primary rules interpreting the 1996 Telecommunications Act, which were issued on
August 8, 1996, have been reviewed by the U.S. Court of Appeals for the Eighth
Circuit and the U. S court of Appeals for the District of Columbia, which has
overruled certain of the FCC's rules. While the U.S. Supreme Court overruled the
Eighth Circuit in January 1999 and upheld the FCC rules, the District of
Columbia's ruling remains intact. We have entered into competitive
interconnection agreements using the federal guidelines established in the FCC's
first interconnection order. In September 1999, the FCC, in response to the
Supreme Court decision in January 1999, issued new definitions of unbundled
network elements.
We have not entered into interconnection agreements that take advantage
of these new federal guidelines. We anticipate that traditional and local
telephone companies will challenge these new definitions in regulatory
proceedings. In addition, the FCC's pricing method for unbundled network
elements is under review at the Eighth Circuit. Any unfavorable decisions by the
courts, the FCC or state telecommunications regulatory commissions could harm
our business.
In August 1998, the FCC proposed new rules that would allow traditional
telephone companies to provide their own DSL services free from traditional
telephone company regulation through a separate affiliate. The provision of DSL
services by an affiliate of a traditional telephone company not subject to such
regulation could harm our business.
Moreover, in March 2000, a federal appeals court struck portions of the
FCC's new rules, and has required the FCC to reconsider and review those rules.
In particular, the appeals court has required the FCC to revise its rules
concerning the types of equipment that we may collocate on the traditional
telephone company premises and the steps that traditional telephone companies
may take to separate their equipment from our equipment. The traditional
telephone companies may implement the court's ruling and any subsequent FCC
rules in a manner that impairs our ability to obtain collocation space and
collocate the equipment of our choice on their premises. Such actions by the
52
<PAGE>
traditional telephone companies could adversely affect our business and disrupt
our existing network design, configuration and services.
Changes to current regulations, the adoption of new regulations by the FCC
or state regulatory authorities, court decisions or legislative initiatives,
such as changes to the 1996 Telecommunications Act, could harm our business. For
further details of the government regulation to which we are subject see
"Business--Government Regulation."
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to financial market risk, including changes in interest and
marketable equity security prices, relates primarily to our investment portfolio
and outstanding debt obligations. We typically do not attempt to reduce or
eliminate our market exposure on our investment securities because a substantial
majority of our investments are in fixed-rate, short-term securities. We do not
have any derivative instruments. The fair value of our investment portfolio or
related income would not be significantly impacted by either a 100 basis point
increase or decrease in interest rates due mainly to the fixed-rate, short-term
nature of the substantial majority of our investment portfolio. In addition,
substantially all of our outstanding indebtedness as of December 31, 1999,
including our 1998 notes, our 1999 notes and our 2000 notes, is fixed-rate debt.
53
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders of
Covad Communications Group, Inc.
We have audited the accompanying consolidated balance sheets of Covad
Communications Group, Inc. as of December 31, 1998 and 1999, and the related
consolidated statements of operations, stockholders' equity (net capital
deficiency), and cash flows for each of the three years in the period ended
December 1999. Our audits also included the financial statement schedule listed
in the Index at Item 14(a). These consolidated financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 consolidated financial statements referred to herein
present fairly, in all material respects, the consolidated financial position of
Covad Communications Group, Inc. as of December 31, 1998 and 1999, and the
consolidated results of its operations and its cash flows for each of the three
years ended December 31, 1999 in conformity with accounting principles generally
accepted in the United States. Also, in our opinion, the financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly in all material respects, the information set forth
therein.
/S/ ERNST & YOUNG LLP
---------------------
Walnut Creek, California
January 21, 2000, except for Note 9,
as to which the date is March 20, 2000
54
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
ASSETS
<TABLE>
DECEMBER 31,
---------------------
1998 1999
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents................................................. $ 64,450 $ 216,038
Accounts receivable, net of allowances for uncollectibles of $220 and
$2,857 at December 31, 1998 and 1999.................................... 1,933 15,393
Short-term investments.................................................... - 551,319
Unbilled revenue.......................................................... 663 5,419
Inventories, net of reserves of $0 and $735 at December 31, 1998 and 1999. 946 8,547
Prepaid expenses.......................................................... 1,183 6,048
Other current assets...................................................... 514 1,219
---------- ----------
Total current assets.................................................. 69,689 803,983
PROPERTY AND EQUIPMENT:
Networks and communication equipment...................................... 55,189 233,260
Computer equipment........................................................ 4,426 24,057
Furniture and fixtures.................................................... 1,119 4,383
Leasehold improvements.................................................... 1,887 6,884
Land...................................................................... - 1,120
---------- ----------
62,621 269,704
Less accumulated depreciation and amortization............................ (3,476) (32,162)
---------- ----------
Net property and equipment............................................ 59,145 237,542
OTHER ASSETS:
Restricted cash........................................................... 225 63,308
Deposits.................................................................. 337 1,131
Deferred debt issuance costs, net......................................... 8,112 12,369
Deferred charge, net...................................................... - 20,529
Other long term assets.................................................... 1,911 8,744
---------- ----------
Total other assets.................................................... 10,585 106,081
---------- ----------
Total assets.......................................................... $139,419 $1,147,606
========== ==========
LIABILITIES AND
STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
CURRENT LIABILITIES:
Accounts payable.......................................................... $ 14,975 $ 41,126
Unearned revenue.......................................................... 551 5,238
Accrued network costs..................................................... 1,866 8,798
Other accrued liabilities................................................. 3,854 27,104
Current portion of capital lease obligations.............................. 263 268
---------- ----------
Total current liabilities............................................. 21,509 82,534
Long-term debt, net of discount........................................... 142,300 374,737
Long-term capital lease obligations....................................... 316 44
---------- ----------
Total liabilities............................................... 164,125 457,315
Commitments and contingencies (see notes 4 and 8)
STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY):
Preferred stock ($0.001 par value):
Authorized shares--30,000,000 at December 1998, and 1999
Issued and outstanding shares--18,246,162 at December 31, 1998 and 0 at
December 31, 1999 18 -
Common Stock ($0.001 par value):
Authorized shares--65,000,000 at December 31, 1998 and 190,000,000 at
December 31, 1999
Issued and outstanding shares--17,660,996 at December 31, 1998 and
88,220,877 at December 31, 1999 12 82
Common Stock - Class B ($0.001 par value)
Authorized shares - 0 at December 31, 1998 and 10,000,000 at
December 31, 1999
Issued and outstanding shares - 0 at December 31, 1998 and 6,379,177 at
December 31, 1999 - 6
Additional paid-in capital................................................ 30,685 851,589
Deferred compensation..................................................... (4,688) (6,513)
Accumulated other comprehensive income, net of tax effect................. - 91,257
Accumulated (deficit) .................................................... (50,733) (246,130)
---------- ----------
Total stockholders' equity (net capital deficiency)..................... (24,706) 690,291
---------- ----------
Total liabilities and stockholders' equity (net capital deficiency)..... $ 139,419 $1,147,606
========== ==========
</TABLE>
See Notes to Consolidated Financial Statements
55
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN 000'S, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
YEAR ENDED DECEMBER 31,
-------------------------------------
1997 1998 1999
------------ ----------- ----------
<S> <C> <C> <C>
Revenues.......................................................... $ 26 $ 5,326 $ 66,488
Operating expenses:
Network and product costs.................................... 54 4,562 55,347
Sales, marketing, general and administrative................. 2,374 31,043 140,372
Amortization of deferred compensation........................ 295 3,997 4,768
Depreciation and amortization................................ 70 3,406 37,602
------------ ----------- -----------
Total operating expenses................................ 2,793 43,008 238,089
------------ ----------- -----------
Loss from operations.............................................. (2,767) (37,682) (171,601)
Interest income (expense):
Interest income.............................................. 167 4,778 20,676
Interest expense............................................. (12) (15,217) (44,472)
------------ ----------- -----------
Net interest income (expense)................................ 155 (10,439) (23,796)
------------ ----------- -----------
Net loss.......................................................... (2,612) (48,121) (195,397)
Preferred dividends............................................... --- --- (1,146)
------------ ----------- -----------
Net loss available to Common Stock holders........................$ (2,612) $ (48,121) $(196,543)
============ =========== ===========
Net loss per share................................................ $ (0.80) $ (8.43) $ (2.74)
============ =========== ===========
Weighted average shares used in computing net loss per share...... 3,271,546 5,708,535 71,765,208
============ =========== ===========
</TABLE>
See Notes to Consolidated Financial Statements
56
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
(AMOUNTS IN 000'S, EXCEPT SHARE AMOUNTS)
<TABLE>
TOTAL
ACCUMULATED STOCKHOLDERS'
ADDITIONAL OTHER EQUITY (NET
CONVERTIBLE PAID-IN DEFERRED COMPREHENSIVE ACCUMULATED CAPITAL
PREFERRED STOCK COMMON STOCK CAPITAL COMPENSATION INCOME DEFICIT DEFICIENCY)
----------------- ----------------- --------- ------------- ------ ------- ---------
SHARES AMOUNT SHARES AMOUNT
---------- ------ ---------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Initial issuance of Common Stock.. -- $ -- 18,000,000 $ 12 $ 38 $ -- $ -- $ -- $ 50
Repurchase of Common Stock........ -- -- (3,615,444) (3) (7) -- -- -- (10)
Issuance of Common Stock.......... -- -- 2,657,250 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 -- -- -- -- -- 295 -- -- 295
Net loss.......................... -- -- -- -- -- -- -- (2,612) (2,612)
---------- ------ ---------- ------- ---------- ----------- ------------ ----------- -----------
Balances at December 31, 1997..... 17,750,001 18 17,041,806 11 9,692 (611) -- (2,612) 6,498
Issuance of Common Stock.......... -- -- 619,190 1 570 -- -- -- 571
Issuance of Series B Preferred Stock 100,002 -- -- -- 100 -- -- -- 100
Issuance of Series C Preferred Stock 396,159 -- -- -- 1,100 -- -- -- 1,100
Issuance of Common Stock warrants as
part of debt offering issuance costs -- -- -- -- 2,928 -- -- -- 2,928
Issuance of Common Stock warrants
Pursuant to debt offering -- -- -- -- 8,221 -- -- -- 8,221
Deferred compensation............. -- -- -- -- 8,074 (8,074) -- -- --
Amortization of deferred compensation -- -- -- -- -- 3,997 -- -- 3,997
Net loss.......................... -- -- -- -- -- -- -- (48,121) (48,121)
---------- ------ ---------- ------- ---------- ----------- ------------ ----------- -----------
Balances at December 31, 1998.....(18,246,162) 18 17,660,996 12 30,685 (4,688) -- (50,733) (24,706)
Issuance of Common Stock.......... -- -- 32,666,659 33 725,708 -- -- -- 725,741
Issuance of Common Stock upon
exercise of warrants........... -- -- 10,434,921 10 (5) -- -- -- 5
Issuance of Series C and
D Preferred Stock................. 6,379,177 6 -- -- 59,994 -- -- -- 60,000
Deferred charge related to issuance
of Series C and D Preferred Stock -- -- -- -- 28,700 -- -- -- 28,700
Conversion of Series A, Series B and
Series C Preferred Stock to
Common Stock....................(18,246,162) (18)27,369,243 27 (9) -- -- -- --
Conversion of Series C1 and D1
Preferred stock.................. (6,379,177) (6) 6,379,177 6 -- -- -- -- --
Preferred dividends............... -- -- 89,058 -- (77) -- -- -- (77)
Conversion of convertible
Preferred Stock.................. -- -- -- -- -- -- --
Deferred compensation............. -- -- -- -- 6,593 (6,593) -- -- --
Amortization of deferred compensation -- -- -- -- -- 4,768 -- -- 4,768
Unrealized gains (losses) on investments -- -- -- -- -- -- 91,257 -- 91,257
Net loss.......................... -- -- -- -- -- -- -- (195,397) (195,397)
--------------------- ----------- ---------- -------------------- -------------------- ---------
Balances at December 31, 1999..... -- -- 94,600,054 $ 88 $ 851,589 $ (6,513) $ 91,257 $ (246,130) $ 690,291
========== ====== ========== ======= ========== =========== ============ =========== ==========
</TABLE>
See Notes to Consolidated Financial Statements
57
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN 000'S)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1997 1998 1999
---- ----- ----
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss................................................................ $ (2,612) $ (48,121) $ (195,397)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization...................................... 70 3,406 37,602
Loss on disposition of equipment................................... - - 358
Amortization of deferred compensation.............................. 295 3,997 4,768
Accreted interest and amortization of debt discount and deferred
debt issuance costs................................................ - 16,009 20,269
Net changes in operating assets and liabilities:
Accounts receivable........................................... (25) (1,908) (13,460)
Unbilled revenue.............................................. (4) (659) (4,756)
Inventories................................................... (43) (903) (7,601)
Prepaid expenses and other current assets..................... (369) (1,328) (5,570)
Accounts payable.............................................. 651 14,324 26,151
Unearned revenue.............................................. 7 544 4,687
Other current liabilities..................................... 135 5,585 30,182
------------ ------------ ------------
Net cash used in operating activities .................................. (1,895) (9,054) (102,767)
INVESTING ACTIVITIES:
Purchase of restricted investment....................................... (210) (15) (73,435)
Redemption of restricted investments ................................... - - 13,214
Purchase of investments................................................. - (460,062)
Deposits ........................................................... (31) (306) (794)
Long-term assets........................................................ - (1,428) (6,833)
Purchase of property and equipment...................................... (2,253) (59,503) (208,186)
------------ ------------ ------------
Net cash used in investing activities .................................. (2,494) (61,252) (736,096)
FINANCING ACTIVITIES:
Net proceeds from issuance of long-term debt and warrants............... - 129,328 205,049
Principal payments under capital lease obligations...................... (48) (238) (267)
Proceeds from Common Stock issuance, net of repurchase.................. 108 571 725,746
Proceeds from preferred stock issuance.................................. 8,707 1,200 60,000
Offering costs related to Common Stock offering......................... - (483) (77)
------------ ------------ ------------
Net cash provided by financing activities............................... 8,767 130,378 990,451
------------ ------------ ------------
Net increase in cash and cash equivalents............................... 4,378 60,072 151,588
Cash and cash equivalents at beginning of year.......................... - 4,378 64,450
------------ ------------ ------------
Cash and cash equivalents at end of year................................ $ 4,378 $ 64,450 $ 216,038
============ ============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the year for interest............................. $ 9 $ 99 $ 13,257
============ ============ ============
SUPPLEMENTAL SCHEDULE ON NON-CASH INVESTING AND FINANCING ACTIVITIES:
Equipment purchased through capital lease.......................... $ 831 $ 34 $ -
============ ============ ============
Warrants issued for equity commitment.............................. $ - $ 2,928 $ -
============ ============ ============
See Notes to Consolidated Financial Statements
</TABLE>
58
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS
Covad Communications Group, Inc. (the "Company") is a high-speed Internet
and network access provider offering digital subscriber line ("DSL") services to
Internet Service Provider ("ISP") and enterprise customers. ISPs purchase the
Company's services in order to provide high-speed Internet access to their
business and consumer end-users. Enterprise customers purchase the Company's
services to provide employees with remote access to their Local Area Networks to
improve employee productivity and reduce operating costs. The Company's services
are provided over standard copper telephone lines at considerably faster speeds
than available through a standard modem.
The Company's operations are subject to significant risks and uncertainties
including competitive, financial, developmental, operational, growth and
expansion, technological, regulatory, and other risks associated with an
emerging business.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
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.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results may differ materially from
those estimates.
INITIAL PUBLIC OFFERING
In January 1999, the Company completed an initial public offering of
13,455,000 shares of Common Stock at a purchase price of $18 per share. Net
proceeds to the Company aggregated approximately $150.2 million. In connection
with the offering, all of the preferred stock outstanding automatically
converted into 33,748,420 shares of Common Stock. The Company's Board of
Directors and stockholders also approved an amendment to the Company's Articles
of Incorporation to increase the total number of shares which the Company is
authorized to issue to 205,000,000 shares, of which 200,000,000 is Common Stock
and 5,000,000 is preferred stock.
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. Revenue recognized for which the customer has not been
billed is recorded as unbilled revenue until the period such billings are made.
Amounts billed in advance of providing services are recorded as unearned revenue
until the period such services are provided. For the year ended December 31,
1998, one customer accounted for approximately 17% of the Company's revenue. For
the year ended December 31, 1999, two customers accounted for 15% and 14%
percent of the Company's revenues.
59
<PAGE>
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments, with a maturity of
three months or less from the date of original issuance, to be cash equivalents.
RESTRICTED CASH
As of December 31, 1998, the Company had $225,000, in commercial deposits
held in the Company's name but restricted as security for certain of the
Company's capital lease financing arrangements. As of December 31, 1999, the
Company had $63,308,000 (net of an unrealized loss of $918,000) in U.S. Treasury
investments and commercial deposits for the payment of interest on the Company's
1999 notes and as security for certain lease financing arrangements.
CONCENTRATION OF CREDIT RISK AND CREDIT RISK EVALUATIONS
Financial instruments that potentially subject the Company to
concentrations of credit risk consist principally of cash and cash equivalents,
restricted cash, short-term investments and accounts receivable. The Company's
cash and investment policies limit cash equivalents, restricted cash and
short-term investments to short-term, investment grade instruments. Cash and
cash equivalents, restricted cash and short-term investments are held with
various domestic financial institutions with high credit standing. The Company
has not experienced any significant losses on its cash and cash equivalents,
restricted cash or short-term investments. The company conducts business with
companies in various industries, primarily in the United States. Concentrations
of credit risk with respect to accounts receivable are limited due to the large
number of customers comprising the Company's customer base. In addition, the
Company typically offers its customers credit terms. The Company performs
ongoing credit evaluations of its customers' financial condition and generally
does not require collateral. Allowances are maintained for potential credit
issues and such losses to date have been within management's expectations
INVENTORIES
Inventories are stated at the lower of cost or market and consist primarily
of customer premise equipment. Costs are based on the "first-in, first-out"
method.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost and depreciated using the
straight-line method over the following estimated useful lives:
<TABLE>
<S> <C>
Leasehold improvements................................ 15 years or life of the lease
Electronic communication equipment.................... 2 to 5 years
Furniture and fixtures................................ 3 to 7 years
Computer equipment.................................... 3 years
Office equipment...................................... 2 to 5 years
Computer software..................................... 2 to 7 years
</TABLE>
SOFTWARE DEVELOPMENT COSTS
The Company capitalizes costs associated with the design, deployment and
expansion of the Company's network including internally and externally developed
software. In accordance with Financial Accounting Standard Board No. 86 "
Software Development Costs" ("FAS 86") and Statement of Position 98-1 "
Accounting for Costs of Computer Software Developed or Obtained for Internal
Use" ("SOP 98-1"), respectively. Costs incurred subsequent to the establishment
of technological feasibility are capitalized and amortized over the estimated
lives of the related
60
<PAGE>
products. Technological feasibility is established upon completion of a working
model. Capitalized external software costs include the actual costs to purchase
software from vendors. Capitalized internal software costs generally include
personnel and related costs incurred in the enhancement and implementation of
purchased software packages. Capitalized internal labor costs for the years
ending December 31, 1997, 1998 and 1999 were $139,000, $3,063,000 and
$15,733,000, respectively. Capitalized interest cost for the years ending
December 31, 1997, 1998 and 1999 were none, $908,000 and $2,756,000,
respectively.
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.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company accounts for employee stock options using the intrinsic value
method in accordance with Accounting Principles Board Opinion No. 25 ("APB 25")
and makes the pro forma disclosures required by Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("FAS
123")
ADVERTISING COSTS
The Company expenses the costs of advertising as incurred. Advertising
expense for the years ended December 31, 1997, 1998 and 1999 was $120,000,
$1,500,000 and $25,798,000, respectively.
INCOME TAXES
Due to the Company's overall loss position, there is no provision for
income taxes for 1997, 1998 or 1999.
The tax benefits associated with employee stock options provide a deferred
tax benefit of $14.5 million for the year-ended December 31, 1999. The deferred
tax benefit has been offset by a valuation allowance and will be credited to
additional paid-in capital when realized.
The reconciliation of income tax computed at the US federal statutory
rate to income tax expense is as follows:
<TABLE>
December 31,
-------------------------------------------------
1997 1998 1999
---- ---- ----
<S> <C> <C> <C>
Federal at 34%, statutory............. $ (757,000) $ (16,363,000) (66,435,000)
Nondeductible interest............... - 911,000 2,050,000
Losses with no current benefits 757,000 15,436,000 64,306,000
Other................................. - 16,000 79,000
----------------- ---------------- ----------------
Provision............................. $ - $ - $ -
================= ================ ================
</TABLE>
Deferred income taxes reflect the net tax effect of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and amounts used for income tax purposes.
Significant components of the Company's deferred tax assets are as follows:
61
<PAGE>
<TABLE>
<CAPTION>
December 31,
----------------------------------
1998 1999
---- ----
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards................... $ 16,000,000 45,462,000
Accrued interest................................... -- 15,977,000
Other.............................................. 2,500,000 1,846,000
------------- --------------
Total Net deferred tax assets...................... 18,500,000 63,285,000
------------- --------------
Valuation allowance..................................... (18,500,000) (26,782,000)
------------- --------------
Total tax deferred assets -- 36,503,000
Unrealized gain on investments -- (36,503,000)
------------- --------------
Net deferred tax assets................................. $ -- --
============= ==============
</TABLE>
Realization of the Company's deferred tax assets is dependent upon future
earnings, if any, the timing and amount of which are uncertain. Accordingly, the
net deferred tax assets have been fully offset by a valuation allowance. The
valuation allowance increased by $8,282,000 during 1999.
As of December 31, 1999, the Company had federal net operating loss
carryforwards for federal tax purposes of approximately $219.5 million which
expire in the years 2012 through 2019, if not utilized. The Company also had net
operating losses carryforwards for state income tax purposes of approximately
$122.3 million expiring in year 2004, if not utilized.
The utilization of the net operating loss is subject to a substantial
annual limitation due to the "change in ownership" provisions of the Internal
Revenue Code of 1986, as amended, and similar state provisions. The annual
limitation may result in the expiration of net operating losses and credits
before utilization. Significant components of the Company's deferred tax assets
and liabilities for federal and state income taxes are as follows:
FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used to estimate the fair value
for financial instruments:
CASH, CASH EQUIVALENTS AND RESTRICTED CASH. The fair values were estimated
based on quoted market prices.
SHORT TERM INVESTMENT. The fair values of short-term investments were
estimated based on quoted market prices.
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, 1998 and 1999, fair value approximates
recorded value.
LOSS PER SHARE
Basic loss 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, after giving consideration to shares subject to repurchase,
outstanding during the period.
Diluted loss per share is determined in the same manner as basic loss per
share except that the number of shares is increased assuming exercise of
dilutive stock options and warrants using the treasury stock method. The diluted
loss per share amount is the same as basic loss per share which has not been
reported because the Company has a net loss and the impact of the assumed
exercise of the stock options and warrants and the assumed is not dilutive.
62
<PAGE>
The consolidated financial statements applicable to the prior periods have
been restated to reflect a three-for-two stock split effective May 1999.
The following table presents the calculation of basic and diluted net
income (loss) per share (in thousands, except share and per share amounts):
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------
1997 1998 1999
( IN 000'S, EXCEPT SHARE AND PER SHARE
AMOUNTS)
<S> <C> <C> <C>
Net loss............................................................. $ (2,612) $ (48,121) $ (195,397)
Preferred dividends.................................................. -- -- (1,146)
------------ ------------ -----------
Net loss available to common stockholders............................ $ (2,612) $ (48,121) $ (196,543)
============ =========== ===========
Basic and diluted:
Weighted average shares of Common Stock outstanding............. 11,021,269 11,505,307 77,117,104
Less: Weighted average shares subject to repurchase............. 7,749,723 5,796,772 5,351,896
----------- ------------- -----------
Weighted average shares used in computing basic and diluted net
loss per share.................................................. 3,271,546 5,708,535 71,765,208
Basic and diluted net loss per share................................. $ (0.80) $ (8.43) $ (2,74)
============ ========== ===========
</TABLE>
If the Company had reported net income, the calculation of historical
diluted earnings per share would have included an additional 5,716,125,
28,854,864 and 17,678,449 common equivalent shares related to the outstanding
stock options and warrants not included above (determined using the treasury
stock method) for the years ended December 31, 1997, 1998 and 1999,
respectively.
KEY SUPPLIERS
The Company is dependent on limited source suppliers for certain equipment
used to provide its services. The Company has generally been able to obtain an
adequate supply of equipment. In addition, the Company believes that there are
alternative suppliers for the equipment used to provide its services. However,
an extended interruption in the supply of equipment currently obtained from
limited source suppliers could adversely affect the Company's business and
results of operations.
ACCOUNTS RECEIVABLE ALLOWANCE
The Company's reserve for uncollectible accounts receivable was $220,000
and $2,857,000 at December 31, 1998 and 1999, respectively. No significant
charges were made against this reserve as of December 31, 1999.
BUSINESS SEGMENTS
The company has adopted Statement of Financial Accounting Standards No.
131, " Disclosures about Segments of an Enterprise and Related Information"
("FAS 131") which establishes standards for reporting information about
operating segments in annual financial statements. It is also establishes
standards for related disclosures about products and services, geographic areas
and major customers. For management purposes, the Company is viewed as one
entity with a Chief Executive Officer ("CEO"), who is the Chief Operating
Decision Maker as defined by the FAS 131. The Company's management relies on an
internal management accounting system. Financial position and results of
operations for the entity, are provided to the CEO as noted in the Accompanying
Financial Statement. The Company's management makes financial decisions and
allocates resources based on the information it receives from this internal
system. Effective January 2000 the Company has initiated Financial Reporting on
a segmented basis in accordance with FAS 131.
63
<PAGE>
RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS:
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 133, " Accounting for Derivative
Instruments and Hedging Activities" ("FAS 133"), which establishes accounting
and reporting standards for derivative instruments and activities. FAS 133
requires that an entity recognize all derivatives as either assets or
liabilities in the balance sheet and measure those instruments at fair value.
The Company will be required to adopt FAS 133 effective January 1, 2001.
Management of the Company does not believe the adoption of this statement will
have a material effect on the Company's consolidated financial position, results
of operations or cash flows.
SHORT-TERM INVESTMENTS
At December 31, 1999, all of the Company's investments were classified as
available for sale. Investments were also classified as short-term, as their
maturing date was less than one year from the balance sheet date. Management
determines the appropriate classification of investments at the time of purchase
and reevaluates such designation at the end of each period. Unrealized gains and
losses on short-term investments as of December 31, 1999, are included as a
separate component of stockholders' equity, net of any related tax effect. The
amount of realized gains or losses for the years ended December 31, 1997, 1998
and 1999 was not significant.
The following table summarizes the Company's investments:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
DECEMBER 31, 1999, Cost Gains Losses Value
- ------------------ ---- ----- ------ -----
(Amounts in $000's)
<S> <C> <C> <C> <C>
Commercial paper.............................. $373,007 $ 125 -- $373,132
Corporate notes............................... 53,767 -- (596) 53,171
Equity securities............................. 32,200 92,816 -- 125,016
-------- --------- -------- ----------
Total available for sale securities.... ...... $458,974 $92,941 $(596) $551,319
======== ========= ======== ==========
</TABLE>
The company also had a net unrealized loss of $168,000 on cash and cash
equivalents and an unrealized loss of $918,000 on long term U.S. Treasury
investments, classified as restricted cash on the accompanying consolidated
balance sheet.
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 131/2% Senior
Discount Notes due 2008 (the "1998 notes") and one warrant, initially
exercisable to purchase 19.4376 shares of Common Stock, $0.001 par value, of the
Company (the "Unit Warrants"). Net proceeds from the 1998 Private Offering were
approximately $129.6 million, after transaction costs of approximately $5.5
million.
The principal amount of the 1998 notes will accrete from the date of
issuance at the rate of 131/2% per annum through March 15, 2003, compounded
semi-annually, and thereafter bear interest at the rate of 131/2% per annum,
payable semi-annually, in arrears on March 15 and September 15 of each year,
commencing on September 15, 2003. The 1998 notes are unsecured senior
obligations of the Company that will mature on March 15, 2008. The 1998 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 1998 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 1998 notes. Debt issuance
costs were incurred through the issuance of additional warrants
64
<PAGE>
associated with the commitment of equity by certain investors. The debt issuance
costs are also being amortized over the life of the 1998 notes. For the years
ended December 31, 1998 and 1999, the accretion of the 1998 notes and the
amortization of debt discount and debt issuance costs was $16.0 million and
$22.3 million, respectively, of which $15.1 million and $21.0 million,
respectively, is included in interest expense and $900,000 and $1.3 million,
respectively, is capitalized in property, plant and equipment.
The Unit Warrants have ten year terms, have exercise prices of $0.0022 per
share (subject to adjustment in certain events), contain net exercise provisions
and are currently exercisable.
On February 18, 1999, the Company completed the issuance of $215.0 million
senior debt notes (the "1999 notes"). Net proceeds from the 1999 notes were
approximately $205.0 million after transaction costs of approximately $9.9
million, which are being amortized over the life of the notes. Amortization
expense related to the transaction cost was $827,000 for year ended December 31,
1999. The principal amount of the 1999 notes bears interest at the rate of 12
1/2% per annum through February 15, 2009, compounded semi-annually, and
thereafter bears interest at the rate of 12 1/2% per annum, payable
semi-annually, in arrears on February 15 and August 15 of each year, commencing
on August 15, 1999. The 1999 notes are unsecured senior obligations of the
Company that will mature on February 15, 2009. The notes will be redeemable at
the option of the Company at any time after February 15, 2004 at stated
redemption prices plus accrued and unpaid interest thereon.
The Company purchased approximately $74.1 million of government securities
from the net proceeds, representing sufficient funds to pay the first six
scheduled interest payments on the 1999 notes. These government securities are
pledged as security for repayment of interest on the 1999 notes.
On June 1, 1999, the Company completed an offer to exchange all outstanding
12 1/2% senior notes due February 15, 2009 for 12 1/2% senior notes due February
15, 2009, which have been registered under the Securities Act of 1933.
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 $865,000 as of December 31,
1998 and 1999, and was equivalent to the fair value of the assets leased.
Future minimum lease payments under capital leases are as follows:
<TABLE>
YEAR ENDING DECEMBER 31,
<S> <C>
2000................................. $ 294,000
2001................................. 44,000
2002................................. 4,000
Thereafter........................... --
------------
342,000
Less amount representing interest.... (30,000)
Less current portion................. (268,000)
------------
Total long-term portion.............. $ 44,000
============
</TABLE>
Accumulated amortization for equipment under capital leases is reflected in
accumulated depreciation and amortization for property and equipment.
65
<PAGE>
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>
YEAR ENDING DECEMBER 31,
<S> <C>
2000..................................... 5,852,000
2001..................................... 5,713,000
2002..................................... 5,023,000
2003..................................... 3,875,000
2004..................................... 3,292,000
Thereafter............................... 2,326,000
----------------
Total................ $ 26,081,000
================
</TABLE>
Rental expense on operating leases totaled $131,000, $1,507,000 and
$4,302,000 for the years ended December 31, 1997, 1998, and 1999, respectively.
5. STOCKHOLDERS' EQUITY
COVAD COMMUNICATIONS GROUP, INC.
STRATEGIC INVESTMENT
In January 1999, the Company entered into strategic relationships with AT&T
Corp. ("AT&T"), NEXTLINK Communications, Inc. ("NEXTLINK") and Qwest
Communications Corporation ("Qwest"). As part of these strategic relationships,
the Company received equity investments totaling approximately $60 million. The
Company recorded intangible assets of $28.7 million associated with these
transactions which will be amortized over periods of three to six years. For the
year ended December 31, 1999, amortization expense totaled $8.2 million.
INITIAL PUBLIC OFFERING
On January 27, 1999, the Company completed the initial public offering
(IPO) of 13,455,000 shares of the Company's Common Stock at a price of $12.00
per share. Net proceeds to the Company from the offering were $150.2 million
after deducting underwriting discounts and commissions and offering expenses
payable by the Company. As a result of the offering, 27,369,243 shares of the
Common Stock and 6,379,177 shares of the Class B Common Stock (which are
convertible into 9,568,765 shares of Common Stock) were issued upon the
conversion of Preferred Stock, 89,058 shares of Common Stock were issued for
cumulative but unpaid dividends on Series A and Series B Preferred Stock and
2,699,626 shares of Common Stock were issued upon the exercise of common
warrants.
SECONDARY OFFERING
On June 23, 1999, the Company completed a public offering of 8,625,000
shares of Common Stock sold by certain stockholders of the Company. The Company
did not sell any shares in this offering. Accordingly, there were no net
proceeds to the Company from this offering. The Company incurred offering
expenses of approximately $600,000.
On November 3, 1999 the Company completed a public offering of 14,950,000
shares of Common Stock sold by the Company and certain stockholders of the
Company. The net proceeds to the Company from this offering were $568.8 million
after deducting underwriting discounts and commissions and offering expenses.
COMMON STOCK
66
<PAGE>
Shares of Common Stock outstanding at December 31, 1998, and December 31,
1999, were 11,773,997 and 88,220,877 shares, respectively, of which 4,773,083
and 5,351,896 shares, respectively, remain subject to repurchase provisions
which generally lapse over a four-year period from the date of issuance.
Common Stock reserved for future issuance as of December 31, 1999 is as
follows:
<TABLE>
<S> <C>
Outstanding options................. 16,348,422
Options available for grant......... 1,270,053
Employee stock purchase plan........ 1,915,224
Warrants outstanding................ 1,330,027
--------------
Total...................... 20,863,726
==============
</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 "Equity Commitment"). 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 2,541,222 shares of the Company's Common Stock at a
purchase price of $0.0022 per share (the "Common Warrants"). In January 1999,
the Company completed an alternative equity financing and, as a result, the
Equity Commitment will not be called (see Note 9).
On April 24, 1998, the Subscription Agreement was amended pursuant to an
Assignment and Assumption Agreement between the Company, the Series C Investors,
and a director of the Company whereby the Series C Investors assigned to the
director of the Company their obligation to purchase 36,015 shares of Series C
Preferred Stock and 29,559 Series C Warrants for an aggregate purchase price of
$100,000. On the same date, the director purchased 36,015 shares of Series C
Preferred Stock. As a result of this amendment, the aggregate obligation of the
Series C Investors to purchase Series C Preferred Stock and Series C Warrants
was reduced from 5,764,143 shares to 5,728,128 shares, and from 4,729,500 shares
to 4,699,941 shares, respectively, for an aggregate purchase price of $15.9
million, reduced from $16.0 million.
THE STOCK PURCHASE
On March 11, 1998, an investor in the Company purchased 360,144 shares of
Series C Preferred Stock and Series C Warrants to purchase an aggregate of
295,500 shares of Series C Preferred Stock for an aggregate 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 158,778 shares of Common Stock at a purchase price
of $0.0022 per share.
PREFERRED STOCK DIVIDENDS
The holders of Series A, Series B and Series C were entitled to receive in
any fiscal year, dividends at the rate of $0.0167 per share, $0.04 per share and
$0.2233 per share, respectively, payable in preference and priority to any
payment of dividends on Common Stock. The rights to such dividends were
cumulative and accrue to the holders to the extent they were not declared or
paid and were payable, in cash or Common Stock, only in the event of a
liquidation, dissolution or winding up of the Company, or other liquidity event
(as defined in the Certificate of
67
<PAGE>
Incorporation). The cumulative dividends at December 31, 1998 and December 31,
1999 for Preferred Stock were approximately $1,085,000 and $ 1,146,000,
respectively, which were converted into 89,058 shares of Common Stock in
connection with the IPO.
6. EMPLOYEE BENEFIT PLANS
DEFINED CONTRIBUTION PLAN
Effective September 1, 1997, the Company adopted a defined contribution
retirement plan under Section 401(k) of the Internal Revenue Code which covers
substantially all employees. Eligible employees may contribute amounts to the
plan, via payroll withholding, subject to certain limitations. The Company does
not match contributions by plan participants.
1998 EMPLOYEE STOCK PURCHASE PLAN
In January 1999, the Company adopted the 1999 Employee Stock Purchase Plan.
The Company has reserved a total of 2,250,000 shares of Common Stock for
issuance under the plan. Eligible employees may purchase Common Stock at 85% of
the lesser of the fair market value of the Company's Common Stock on the first
day of the applicable twenty-four month offering period or the last day of the
applicable six month purchase period.
STOCK OPTION PLANS
In 1997, the Company adopted the Covad Communications Group, Inc. 1997
Stock Plan (the "Plan"). The Plan provides for the grant of stock purchase
rights and options to purchase shares of Common Stock to employees and
consultants from time to time as determined by the Board of Directors. The
options expire from two to eight years after the date of grant. As of December
31, 1999 the Plan has reserved 23,280,513 shares of the Company's Common Stock
for sale and issuance under the Plan at prices to be determined by the Board of
Directors.
The following table summarizes stock option activity for the year ended
December 31, 1997, 1998 and December 31, 1999:
<TABLE>
<CAPTION>
NUMBER OF
SHARES OF OPTION PRICE
COMMON STOCK PER SHARE
------------ --------------------------
<S> <C> <C> <C>
Granted................................................... 5,765,625 $0.033 - $ 0.05
Exercised................................................. (9,000) -- $ 0.03
Cancelled................................................. (40,500) $0.033 - $ 0.05
-------------------- ---------------------------
Balance as of December 31, 1997........................... 5,716,125 $0.033 - $ 0.05
Granted................................................... 14,051,970 $ 0.10 - $ 8.16
Exercised................................................. (311,242) $0.033 - $ 0.67
Cancelled................................................. (1,085,153) $0.033 - $ 7.93
-------------------- ----------------------------
Balance as of December 31, 1998........................... 18,371,700 $0.033 - $ 8.16
Granted .................................................. 5,849,772 $0.001 - $67.00
Exercised ................................................ (5,341,789) $0.001 - $57.25
Cancelled ................................................ (2,531,261) $0.022 - $65.13
-------------------- ----------------------------
Balance as of December 31, 1999........................... 16,348,422 $0.001 - $67.00
==================== =============================
</TABLE>
68
<PAGE>
The following is a summary of the status of stock options outstanding
at December 31, 1999:
<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>
$0.01 - $9.50 11,006,418 6.1 $1.71 2,395,128 $1.57
$9.50 - $19.00 1,136,210 7.0 $11.33 217,658 $11.33
$19.00 - $28.50 17,076 7.1 $27.92 1,838 $27.92
$28.50 - $38.00 23,000 7.1 $31.44 3,668 $31.36
$38.00 - $47.50 1,962,837 7.4 $42.62 111,227 $42.57
$47.50 - $57.00 1,169,948 7.5 $51.75 43,666 $54.31
$57.00 - $66.50 1,023,183 7.3 $61.03 101,212 $60.34
$66.50 - $76.00 9,750 5.6 $67.00 1,621 $67.00
-------------- ------------------- --------------- ---------------- ---------------------
16,348,422 6.5 $14.69 2,876,018 $6.85
-------------- ------------------- --------------- ---------------- ---------------------
</TABLE>
During the year ended December 31, 1997, the Company recorded deferred
compensation of $906,000 as a result of granting stock options and issuing
restricted stock with exercise or issue prices per share below the revised fair
value per share of the Company's Common Stock at the date of grant or issuance.
This amount was recorded as a reduction of stockholders' equity and is being
amortized as a charge to operations over the vesting period of the applicable
options using a graded vesting method. Such amortization was $295,000 for the
year ended December 31, 1997. During the year ended December 31, 1998, the
Company recorded additional deferred compensation of approximately $8.1 million.
Amortization of deferred compensation during this same period was approximately
$4.0 million. During the year ended December 31, 1999, the Company recorded
additional deferred compensation of approximately $6.6 million. Amortization of
deferred compensation during this same period was approximately $4.8 million.
STOCK-BASED COMPENSATION
Pro forma information regarding the results of operations and net loss per
share is required by FAS 123, which also requires that the information be
determined as if the Company had accounted for its employee stock options using
the fair value method of FAS 123. The fair value of each option granted is
estimated on the date of grant using the Black Scholes valuation model.
The Company has elected to follow APB 25 and related interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FAS 123 requires the use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercised price of the Company's employee
stock options equals the market price of the underlying stock on the date of
grant, no compensation expense is recognized.
The option valuation models were developed for use in estimating the fair
value of traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions, including the expected life of the option. Because the
Company's employee stock options have characteristics significantly different
from those of traded options and because changes in the subjective input
assumptions can materially affect the fair value of the estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
69
<PAGE>
For the years ended December 31, 1997, 1998 and 1999, the fair value of the
Company's stock-based awards to employees was estimated using the following
weighted average assumptions:
<TABLE>
<CAPTION>
1997 1998 1999
---- ------ ----
<S> <C> <C> <C>
Expected life of options in years............ 4.0 4.0 4.0
Volatility................................... 123.5% 123.5 % 123.5 %
Risk-free interest rate...................... 7.0% 7.0 % 7.0 %
Expected dividend yield...................... 0.0% 0.00% 0.00%
</TABLE>
The weighted average fair value of stock options granted during the years
ended December 31, 1997, 1998 and 1999 was $0.17, $1.37 and $14.69 per share,
respectively. For pro forma purposes, the estimated fair value of the Company's
stock-based awards to employees is amortized over the options' vesting period
which would result in an increase in net loss of approximately $12,000,
$1.7 million and $35.2 million for the years ended December 31, 1997, 1998 and
1999, respectively. The result of applying FAS 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
$0.20 per share and $0.49 per share for the year ended December 31, 1998 and
1999, respectively.
The pro forma impact of options on the net loss for the years ended
December 31, 1997, 1998, and 1999 is not representative of the effects on net
loss for future years, as future years will include the effects of additional
years of stock option grants.
7. RELATED PARTY TRANSACTIONS
The Company purchases equipment from a supplier which is partially owned by
an investor in the Company. Purchases from this supplier totaled $85,000,
$5,844,000 and $45,695,000 for the years ending December 31, 1997, 1998 and
1999, respectively. During 1999, an unrelated party acquired this supplier, as
such, the Company had no financial interest in them by year end December 31,
1999. In addition, the Company acquired an interest in a new supplier. Purchases
from this new supplier totaled $3,401,000 for the year ended December 31, 1999.
8. LEGAL PROCEEDINGS
The Company is engaged in a variety of negotiations, arbitrations and
regulatory and court proceedings with multiple traditional telephone companies.
These negotiations, arbitrations and proceedings concern the traditional
telephone companies' denial of physical central office space to the Company in
certain central offices, the cost and delivery of central office spaces, the
delivery of transmission facilities and telephone lines, billing issues and
other operational issues. For example, the Company is currently involved in
commercial arbitration proceedings with Pacific Bell over these issues. The
Company has also filed a lawsuit against Pacific Bell and certain of its
affiliates, including SBC Communications, in federal court. The Company is
pursuing a variety of contract, tort, and 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 the Company and failed to act in good faith on
multiple counts. The arbitration panel ruled in favor of awarding the Company
direct damages, as well as attorneys fees and costs of the arbitration. Pacific
Bell is currently attempting to have the decision vacated. Meanwhile, the
arbitration panel is evaluating the Company's claim for additional damages.
The Company also filed a lawsuit against Bell Atlantic and its affiliates
in federal court and is pursuing antitrust and other claims in this lawsuit. In
addition, Bell Atlantic has separately filed suit against the Company asserting
infringement of a patent issued to them in September 1998 entitled "Variable
Rate and Variable Mode
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<PAGE>
Transmission System." However, on February 18, 2000 the court issued a summary
judgement ruling holding that the Company had not infringed Bell Atlantic's
patent. The Company anticipates that Bell Atlantic may appeal this decision and,
while the Company expects that it would prevail on an appeal, the outcome of
such an appeal is uncertain.
A former employee of the Company has filed a complaint against the Company
in California Superior Court, alleging that he was terminated wrongfully and is
entitled to commissions and other amounts arising from his employment. The
Company believes that it has valid reasons for his termination and does not owe
him any money, but litigation is unpredictable and there is no guarantee the
Company will prevail. Failure to resolve these various legal disputes and
controversies without excessive delay and cost and in a manner that is
favorable, could significantly harm the business.
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 subject to
state commission, FCC and court decisions as they relate to the interpretation
and implementation of the 1996 Telecommunications Act, the interpretation of
competitive telecommunications company 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 our agreements. The results of any of these proceedings could
harm the business.
9. SUBSEQUENT EVENTS
On January 28, 2000, the Company completed a private placement of $425.0
million aggregate principal amount of the Company's 12% senior notes (the "2000
notes") due 2010. The 2000 notes are unsecured senior obligations of the Company
maturing on February 15, 2010 and are redeemable at the option of the Company
any time after February 15, 2005 at stated redemption prices plus accrued and
unpaid interest thereon. Net proceeds from the 2000 notes were approximately
$413.3 million, after discounts, commissions and other transaction costs of
approximately $11.7 million. The discount and debt issuance costs are being
amortized over the life of the 2000 notes. These notes were sold in a private
placement under Rule 144A and Regulation S under the Securities Act of 1933, as
amended.
The Company has filed a registration statement covering an offer to
exchange new registered 12% senior notes due February 15, 2010 for all
outstanding 12% senior notes due February 15, 2010.
On February 15, 2000 the Company's Board of Directors adopted a Stockholder
Protection Rights Plan under which stockholders received one right for each
share of the Company's Common Stock or Class B Common Stock owned by them. The
rights become exercisable, in most circumstances, upon the accumulation by a
person or group of 15% or more of the Company's outstanding shares of Common
Stock. Each right entitles the holder to purchase from the Company, as provided
by the Stockholder protection Rights Agreement, one one-thousandth of a share of
Participating Preferred Stock, par value $.001 per share, for $400.00 subject to
adjustment.
On March 7, 2000, the Company announced a 3-for-2 stock split, which will
be effectuated through a stock dividend. The Company's Common Stock will begin
trading on a split adjusted basis on April 3, 2000.
On March 20, 2000 the Company completed the acquisition of LaserLink.net,
a leading provider of branded internet access, based in Media, Pennsylvania in a
transaction to be accounted for as a purchase. Under the acquisition agreement,
the Company will issue 4.3 million shares of Common Stock for all LaserLink.net
outstanding shares, plus assumption of all outstanding debt. The Company
anticipates that this acquisition will allow the Company to provide a turnkey
broadband access solution to companies and affinity groups who want to offer
broadband internet services to their customers, members, or affiliates.
LaserLink.net currently provides a similar service using dial-up access. The
total consideration related to the acquisition, which is subject to
finalization, approximates $372.0 million.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
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There have been no changes in or disagreements with accountants on
accounting or financial disclosure matters during the Company's two most recent
fiscal years.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
<TABLE>
Our directors and executive officers, and their respective ages as of March 15, 2000, are as follows:
NAME AGE POSITION
- ----------------------------------------- --- -----------------------------------------------------
<S> <C> <C>
Robert Knowling, Jr. ..................... 44 Chairman of the Board, President and Chief Executive Officer
Timothy Laehy............................. 43 Chief Financial Officer
Robert Davenport, III .................... 40 Executive Vice President, Business Development
Catherine Hemmer.......................... 41 Chief Operating Officer
Robert Roblin............................. 47 Executive Vice President, Sales and Marketing
Joseph Devich............................. 42 Executive Vice President, Corporate Services
Dhruv Khanna.............................. 39 Executive Vice President, General Counsel and Secretary
Jane Marvin............................... 40 Senior Vice President, Human Resources
Terry Moya................................ 41 Senior Vice President, External Affairs
Michael Lach.............................. 38 Executive Vice President, Business Integration
Robert Hawk............................... 60 Director
Hellene Runtagh........................... 51 Director
Daniel Lynch.............................. 58 Director
Frank Marshall............................ 52 Director
Rich Shapero.............................. 51 Director
</TABLE>
ROBERT KNOWLING, JR. has been our President, Chief Executive Officer and a
member of our Board of Directors since July 1999. As of September 1999, he
became chairman of the Board of Directors. From October 1997 through July 1998,
Mr. Knowling served as the Executive Vice President of Operations and
Technologies at U S WEST Communications, Inc. In this capacity, Mr. Knowling was
responsible for planning, delivering and maintaining high-quality
telecommunications services for more than 25 million customers in 14 Western and
Midwestern states. From March 1996 through September 1997, he served as Vice
President of Network Operations at U S WEST Communications, Inc. From November
1994 through March 1996, he served as Vice President of Network Operations for
Ameritech Corporation. Mr. Knowling began his career in 1977 at Indiana Bell
where he progressed through a variety of assignments in operations, engineering
and marketing. When Indiana Bell became a part of Ameritech Corporation, Mr.
Knowling assumed positions of increasing responsibility in marketing, product
development, large business marketing and network operations, including service
on Ameritech Corporation's re-engineering breakthrough development team. As lead
architect of the Ameritech Corporation transformation, Mr. Knowling reported
directly to the Chairman.
TIMOTHY LAEHY joined us in August 1997. He served as our Chief Financial
Officer, Treasurer and Vice President, Finance until February 1999 and has
served as our Chief Financial Officer since that date. Prior to joining us, Mr.
Laehy served as Vice President, Corporate Finance and Treasurer of Leasing
Solutions, Inc., a computer equipment leasing company, from February 1991 to
August 1997. From 1990 to 1991, Mr. Laehy served as a senior associate with
Recovery Equity Partners, a private venture capital investment fund. From 1985
to 1990, he served in various capacities at Guarantee Acceptance Capital
Corporation, an investment bank, Liberty Mutual Insurance Company and Union
Carbide Corporation.
ROBERT DAVENPORT, III joined us in January 1999. He served as our Vice
President, Business Development until February 1999 and has served as our
Executive Vice President, Business Development since that date. Prior to
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joining us, Mr. Davenport was Senior Vice President and Chief Operating Officer
at Tele-Communications, Inc.'s Internet Services subsidiary, TCI.NET from 1997
to 1999. Between 1995 and 1997, Mr. Davenport was with Tele-Communications,
Inc., as Vice President, Finance and Development for the Telephony Services
subsidiary. From 1992 to 1995, he was Managing Partner of RD Partners, LLC, a
private investment firm focused on leveraged equity investments.
CATHERINE HEMMER joined us in August 1998. She served as our Vice
President, Operations until February 1999 and has as our President, Network
Services from February 1999 to September 1999. Since September 1999, she has
served as Chief Operating Officer. From 1996 to August 1998, she was Vice
President, Network Reliability and Operations at U S WEST Communications, Inc.
From 1995 to 1996, she served as General Manager, Network provisioning at
Ameritech Services, Inc., a telecommunications company. From 1987 to 1995, she
served in various capacities, including Vice President, Network Services, at MFS
Telecom, Inc. From 1987 to 1988, she served in various management roles at MCI
Communications providing management information system suppport for Network
Operations Organization.
ROBERT ROBLIN joined us in November 1998. He served as our Vice President,
Marketing until February 1999 and has served as our Executive Vice President,
sales and Marketing since that date. Prior to joining us, he was Executive Vice
President of Marketing at Adobe Systems, Inc. from 1996 to November 1998. From
1994 to 1996, Mr. Roblin served as Vice President and General Manager of
Marketing of the Consumer Division of IBM 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.
JOSEPH DEVICH joined us in August 1998. He served as Vice President and
General Manager of our Western Region until February 1999 and served as
President and General Manager of the Western Region from February 199 to
September 1999. Since September 1999, he has served as Executive Vice President,
Corporate Services. Prior to joining us, from November 1996 to August 1998, Mr.
Devich was Vice President, Operations and Technologies Staff of U S West
Communications, where he served on the strategic leadership council and was
responsible for leading staff support functions, methodical and procedural
process support, result reporting and analysis, systems planning an integration,
customer value analysis, disaster recovery/business continuity planning, network
security, supplier management and operations strategy planning. From August 1986
to November 1996, Mr. Devich worked in several capacities at Ameritech
Corporation, included Manger of Product Management - Technical Support, and
Director in areas of customer support in the large business market, service
reliability within customer business services, process improvement of network
operations and network provisioning.
DHRUV KHANNA is one of our founders. He served as our Vice President,
General Counsel and Secretary from October 1996 until February 1999 and has
served as our Executive, Vice President, General Counsel and Secretary since
that date. He was an in-house counsel for Intel's communications products
division and its Senior Telecommunications Attorney between 1993 and 1996.
Between 1987 and 1993, Mr. Khanna was an associate at Morrison & Foerster where
his clients included Teleport Communications Group (now AT&T), McCaw Cellular
Communications, Inc. (now AT&T Wireless), and Southern Pacific Telecom (now
Qwest). Mr. Khanna has extensive experience with regulatory matters, litigation
and business transactions involving the RBOCs and other telecommunications
companies. While at Intel, he helped shape the computer industry's positions on
the Telecommunications Act of 1996 and the FCC's rules implementing the 1996
Act.
JANE MARVIN joined the Company in April 1999 as the Company's Senior Vice
President, Human Resources. Prior to joining the Company, from August 1995 to
April 1999, Ms. Marvin was Vice President, Human Resources for the General
Business, Small Business and Enhanced Business Services units and Director,
Leadership and Executive Development of Ameritech Corporation. In these
capacities, she re-engineered and streamlined multiple HR processes and drove
corporate-wide change initiatives. From 1991 to 1995, Ms. Marvin was Human
Resources Director with the Pepsi Cola Company, a division of Pepsico Inc.,
where she improved business processes in the
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areas of recruitment, selection, training, and compensation. From 1984 to 1991,
Ms. Marvin worked in progressively broader HR leadership roles at Data General
Corporation, a provider of enterprise hardware and software solutions.
TERRY MOYA joined the Company in July 1999 as the Company's Senior Vice
President, External Affairs. Prior to joining the Company, from January 1999 to
July 1999, Mr. Moya served as Vice President & Chief Financial Officer, Capital
Management, Network/Operations and Technologies at U S WEST Communications, Inc.
From August 1998 to January 1999, Mr. Moya served as Vice President, Operations
for U S WEST Communications, Inc., where he managed over $2 billion in capital
expenditures and over $320 million in engineering and construction transaction
costs. From February 1997 to August 1998, Mr. Moya served as Vice President,
Construction, Operations and Technologies and led the outside plant construction
contracting organization for U S WEST Communications, Inc. From August 1992 to
February 1997, Mr. Moya spent time in over a half dozen foreign countries
establishing and improving several different lines of business for U S WEST
Communications, Inc. These countries include Poland, Russia, the Czech Republic,
Hungary, Brazil and the United Kingdom. Prior to August 1992, Mr. Moya was at
KPMG Peat Marwick in New Orleans.
MICHAEL LACH joined the Company in January 2000 as the Company's Executive
Vice President, Business Integration. Prior to joining the Company, from May
1997 to December 1999, Mr. Lach was Vice President, Customer Provisioning and
Maintenance of Ameritech Corporation, where he was responsible for the
installation and repair of residential phone lines across a five-state region.
From October 1995 to May 1997, Mr. Lach was General Manager, Network Operations
West of Ameritech Corporation, where he was responsible for provisioning and
maintaining central offices and the transport network in a three state region.
From September 1994 to October 1995, Mr. Lach was Division Manager, Technical
Support of Ameritech Corporation, where he supported the development and
implementation of new products for residential and business customers. From
March 1993 to August 1994, Mr. Lach was Director, Business Development for
Siemens Stromberg-Carlson. From January 1984 to February 1993, Mr. Lach served
in various management roles with Ameritech Corporation relating to its network.
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ROBERT HAWK has served as a member of our Board of Directors since
April 1998. Mr. Hawk is President of Hawk Communications and recently retired as
President and Chief Executive Officer of U S WEST Multimedia Communications,
Inc., where he headed the cable, data and telephony communications business from
May 1996 to April 1997. He was president of the Carrier Division of U S West
Communications, a regional telecommunications service provider, from September
1990 to May 1996. Prior to that time, Mr. Hawk was Vice President of Marketing
and Strategic Planning for CXC Corporation. Prior to joining CXC Corporation,
Mr. Hawk was director of Advanced Systems Development for AT&T/American Bell. He
currently serves on the boards of Xylan Corporation, PairGain Technologies,
Inc., COM21, Concord Communications, Radcom, Efficient Networks and several
privately held companies.
HELLENE RUNTAGH has served as a member of the Company's Board of
Directors since November 3, 1999. Ms. Runtagh has served as Executive Vice
President of Universal Studios since January 1999. In this capacity, she is
responsible for overseeing the activities of the Universal Studios Operations
Group, Universal Studios Consumer Products Group, Universal Studios Corporate
Marketing and Sponsorships, and the Spencer Gift retail operations, Universal
Studios' worldwide information technology, and Seagram's global sourcing and
real estate operations. From February 1997 to January 1999, she held the
position of Senior Vice President of Reengineering Effort at Universal.
Previously, Ms. Runtagh spent 25 years at General Electric, where she served as
President and Chief Executive Officer of GE Information Services from 1989 to
1996 and held general management roles with GE's capital and software
businesses.
DANIEL LYNCH has served as a member of our Board of Directors since
April 1997. Mr. Lynch is also a founder of CyberCash, Inc. and has served as
chairman of its board of directors since August 1994. From December 1990 to
December 1995, he served as Chairman of the board of directors of Softbank
Forums, a provider of education and conference services for the information
technology industry. Mr. Lynch founded Interop Company in 1986, which is now a
division of ZD Comdex and Forums. Mr. Lynch is a member of the Association for
Computing Machinery and the Internet Society. He is also a member of the Board
of Trustees of the Santa Fe Institute, the Bionomics Institute and CommerceNet.
He previously served as Director of the Information Processing Division for the
Information Sciences Institute in Marina del Rey, where he led the Arpanet team
that made the transition from the original NCP protocols to the current TCP/IP
based protocols. He has served as a member of the Board of Dirctors of Exodus
Communications since January 1998. Mr. Lynch previously served as a member of
The Board of Directors at UUNET Technologies from April 1994 until August 1996.
FRANK MARSHALL has served as a member of our Board of Directors since
October 1997. Mr. Marshall currently serves on the board of directors of
PMC-Sierra Inc. and several private companies. Mr. Marshall also serves on the
technical advisory board of several high technology private companies. He is a
member of the InterWest Partners Advisory Committee and a Venture Partner at
Sequoia Capital. From 1992 to 1997, Mr. Marshall served as Vice President of
Engineering and Vice President and General Manager, Core Business Unit of Cisco
Systems Inc. From 1982 to 1992, he served as Senior Vice President, Engineering
at Convex Computer Corporation.
RICH SHAPERO has served as a member of our Board of Directors since
July 1997. Mr. Shapero has been a general partner of Crosspoint Venture
Partners, L.P., a venture capital investment firm, since April 1993. From
January 1991 to June 1992, he served as Chief Operating Officer of Shiva
Corporation, a computer network company. Previously, he was a Vice President of
Sun Microsystems, Senior Director of Marketing at AST, and held marketing and
sales positions at Informatics General Corporation and UNIVAC's Communications
Division. Mr. Shapero serves as a member of the board of directors of Sagent
Technology, Inc. and several privately held companies.
CLASSIFIED BOARD
The Board of Directors is divided into three classes. The term of
office and directors consisting of each class is as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
CLASS DIRECTORS TERM OF OFFICE
CLASS I Danial Lynch o expires at the annual meeting of stockholders in 2000 and at
Rich Shaperoh each third succeeding annual meeting thereafter
CLASS II Frank Marshall o expires at the annual meeting of stockholders in 2001 and at
Hellene Runtach each third succeeding annual meeting thereafter
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<PAGE>
CLASS III Robert Hawk o expires at the annual meeting of stockholders in 2001 and
Robert Knowling, Jr at each third succeeding annual meeting thereafter
</TABLE>
The classification of directors has the effect of making it more difficult
to change the composition of the Board of Directors.
BOARD COMMITTEES
In April 1999, our Board of Directors established an Audit Committee
and a Compensation Committee. The Audit Committee consists of two of our outside
directors, Mr. Hawk and Ms. Runtagh. The Audit Committee's primary
responsibilities include:
o conducting a post-audit review of the financial statements and
audit findings;
o reviewing our independent auditors proposed audit scope and
approach; and
o reviewing on a continuous basis the adequacy of our system of
internal accounting controls.
The Compensation Committee consists of two of our outside directors,
Mr. Shapero and Ms. Runtagh. The primary responsibilities of the Compensation
Committee include:
o reviewing and determining the compensation policy for our executive
officers and directors, and other employees as directed by the
Board of Directors;
o reviewing and determining all forms of compensation to be provided
to our executive officers; and
o reviewing and making recommendations to our Board of Directors
regarding general compensation goals and guidelines for our
employees and the criteria by which bonuses to our employees are
determined.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No member of our Board of Directors or of its Compensation Committee
serves as an executive officer of any entity that has one or more of our
executive officers serving as members of its board of directors or board of
director's compensation committee. No such interlocking relationship has existed
in the past. See "Item 13, Certain Relationships and Related Transactions" for a
description of transactions between us and entities affiliated with members of
our Compensation Committee.
DIRECTOR COMPENSATION
Except for grants of stock options subject to vesting and restricted
stock subject to repurchase, our directors generally do not receive compensation
for services provided as a director. We do not pay additional amounts for
committee participation or special assignments of our Board of Directors, except
for reimbursement of expenses in attending Board of Directors and committee
meetings.
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth certain information with respect to
compensation awarded to, earned by or paid to each person who served as the
Company's Chief Executive Officer or was one of the Company's four other most
highly compensated executive officer (collectively, the "Named Executive
Officers") during the fiscal year ended December 31, 1999. All numbers of shares
have been adjusted in the light of the 3-for-2 stock split, effected in the form
of a stock dividend, effective April 3, 2000.
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<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
ANNUAL COMPENSATION LONG-TERM COMPENSATION
------------------------- ---------------------------------------------
RESTRICTED SECURITIES
FISCAL STOCK UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS AWARDS($) OPTIONS/SARS(#) COMPENSATION
- --------------------------- ---- ------ ----- --------- --------------- ------------
<S> <C> <C> <C> <C> <C> <C>
Robert Knowling, Jr., 1999 $ 399,996 $ 500,000 -- -- $ 750,420(8)
Chairman, Board of Directors, 1998 $ 180,768 $ 250,000 -- 4,725,000 $ 750,343(9)
President and Chief Executive 1997 -- -- -- -- --
Officer(1)
Robert Roblin, 1997 $ 232,692 $ 140,250 $ 882,500(7) -- $ 405(10)
Executive Vice President, 1999 $ 21,154(3) $ 9,493 -- 562,500 $ 74(10)
and Marketing 1998 -- -- -- -- --
Catherine Hemmer, 1999 $ 180,769 $ 109,500 $ 882,500(7) -- $ 240(10)
Chief Operating Officer 1998 $ 58,359(4) $56,000 -- 437,713 $ 84,363(11)
1997 -- -- -- -- --
Joseph Devich, 1999 $ 167,308 $ 101,250 -- -- $ 210(10)
Executive Vice President, 1998 $ 52,981(5) $ 20,137 -- -- $ 76,961(12)
Corporate Services 1997 -- -- -- -- --
Robert Davenport, III 1999 $ $ 91,667 -- -- $ 171(10)
Executive Vice President, 1998 -- -- -- -- --
Business Development 1997 -- -- -- -- --
</TABLE>
- -----------------
(1) In September 1999, Mr. Knowling became Chairman of the Company's Board of
Directors.
(2) Pro rated based on an annual salary of $400,000 from hiring date of July 8,
1998.
(3) Pro rated based on an annual salary of $220,000 from hiring date of
November 16, 1998.
(4) Pro rated based on an annual salary of $150,000 from hiring date of August
10, 1998.
(5) Pro rated based on an annual salary of $150,000 from hiring date of August
13, 1998.
(6) Pro rated based on an annual salary of $200,000 from hiring date of January
20, 1999.
(7) This value is based upon the split-adjusted closing price of $29.416 for
30,000 post-split shares granted on November 3, 1999 to Mr. Roblin and Ms.
Hemmer. As of December 31, 1999, all of these shares were unvested and
valued at $1,118,750 based on a split-adjusted closing price of $37.29.
Twenty-five percent of these shares will vest on the four consecutive
anniversaries of the grant date.
(8) Includes $750,000 for the final installment of Mr. Knowling's sign-on bonus
as well as $420 for term life insurance premium.
(9) Includes $750,000 for the first installment of Mr. Knowling's sign-on bonus
as well as $343 for term life insurance premium.
(10) _____ The dollar amount in this column represents premium payments the
Company made for executive's term life insurance policies.
(11) Includes a payment of $84,275 as a sign-on bonus as well as $88 for term
life insurance premium.
(12) Includes a payment of $76,883 as a sign-on bonus as well as $78 for term
life insurance premium.
OPTION / SAR GRANTS IN LAST FISCAL YEAR
The following table sets forth information regarding stock options
granted to Named Executive Officers during the fiscal year ended December 31,
1999. During the last fiscal year, Mr. Davenport was the only Named Executive
Officer to receive any such grant. All numbers of shares have been adjusted in
light of the 3-for-2 stock split, effected in the from of a stock dividend,
effective March 31, 2000.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
--------------------------------------------------------- POTENTIAL REALIZABLE
PERCENT OF VALUE AT ASSUMED
NUMBER OF TOTAL ANNUAL RATES OF STOCK
SECURITIES OPTIONS GRANTED EXERCISE PRICE APPRECIATION
UNDERLYING TO EMPLOYEES PRICE FOR OPTION TERM($)(3)
OPTIONS IN FISCAL PER EXPIRATION ----------------------
NAME GRANTED(#)(1) 1999(%)(2) SHARE($) DATE 5% 10%
- ----------------------------------- ------------- ---------------- --------- ---------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Robert Davenport, III.............. 450,001 5.13% $ 7.53 1/20/2007 $ 1,623,354 $ 3,888,215
</TABLE>
- -------------------
(1) These options become exercisable over a four-year period, with 12.5% of the
option shares vesting on the six-month anniversary of the grant date and the
remainder vesting in 42 equal monthly installments. All the options have a term
of eight years, subject to earlier termination in certain situations related to
termination of employment. See "--1997 Stock Plan."
(2) Based on options covering an aggregate of 8,774,658 shares (split-adjusted)
the Company granted during 1999 pursuant to the Company's 1997 Stock Plan.
(3) These amounts represent hypothetical gains that could be achieved for the
options if exercised at the end of the option term. The potential realizable
values are calculated by assuming that the Company's Common Stock appreciates at
the annual rate shown, compounded annually, from the date of grant until
expiration of
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<PAGE>
the granted options. The assumed 5% and 10% rates of stock price
appreciation are mandated by the rules of the Securities and Exchange Commission
and do not represent the Company's estimate or projection of future stock price
growth.
AGGREGATED OPTION / SAR EXERCISES IN LAST FISCAL YEAR AND YEAR-END OPTION / SAR
VALUES
The following table sets forth the information with respect to the
exercise of stock options during the year ended December 31, 1999 and the number
and year-end value of shares of the Company's Common Stock underlying the
unexercised options held by the Named Executive Officers. None of the Named
Executive Officers exercised or held stock appreciation rights during the year
ended December 31, 1999. All figures in this table have been adjusted in light
of the March 31, 2000 stock split, effected in the form of a stock dividend.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
SHARES UNDERLYING VALUE OF UNEXERCISED
ACQUIRED UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS AT
ON DECEMBER 31, 1999 DECEMBER 31, 1999
EXERCISE VALUE ---------------------------- --------------------------------
NAME (#) REALIZED ($) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- --------------------- -------- ------------ ----------- ------------- ---------------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Robert Knowling, Jr. 491,250 $ 1,088,437 3,145,312 $ 40,105,898.20 $115,896,027.95
Robert Roblin 22,500 $ 582,575.00 129,843 410,152 $ 4,384,437.41 $ 13,849,862.47
Catherine Hemmer 54,000 $ 91,902 291,811 $ 3,192,316.10 $ 10,136,396.75
Joseph Devich 54,129 $ 39,800 177,862 $ 2,073,745.85 $ 9,267,351.35
Robert Davenport, III -- -- 68,750 231,251 $ 3,066,536.48 $ 10,314,758.22
</TABLE>
EMPLOYMENT AGREEMENTS AND CHANGE IN CONTROL ARRANGEMENTS
We have entered into a written employment agreement with Robert
Knowling, Jr., our President and Chief Executive Officer. The agreement provides
that Mr. Knowling will receive compensation in the form of a $400,000 annual
base salary and a $250,000 minimum annual bonus. Mr. Knowling received (i) a
signing bonus of $1,500,000, one half of which was paid when he began working
for us, and the remaining half of which was paid (July 1999), and (ii) stock
options to purchase 3,150,000 shares of our Common Stock at an exercise price of
$0.67 per share. If we terminate Mr. Knowling's employment relationship without
cause (as that term is defined in the agreement), or if Mr. Knowling resigns for
good reason (as that term is defined in the agreement), we must continue to pay
Mr. Knowling's annual salary and targeted bonus for a period of two years after
the date of termination so long as Mr. Knowling does not become employed by one
of our direct competitors. Mr. Knowling has agreed to be bound by customary
confidentiality provisions during the term of his employment. As provided in the
agreement, in August 1999 we loaned Mr. Knowling $500,000 pursuant to a
promissory note that is secured by a First deed of Trust and that bears no
interest during his employment. The loan has provisions for forgiveness based on
continued employment and matures in four years, subject to acceleration in
certain events. See "Item 13, Certain Relationships and Related
Transactions--Employee Loans."
With respect to all options granted under our 1997 Stock Plan, in the
event that we merge with or into another corporation resulting in a change of
control involving a shift in 50% or more of the voting power of our capital
stock, or the sale of all or substantially all of our assets, the options will
fully vest and become exercisable one year after the change of control or
earlier in the event the individual is constructively terminated or terminated
without cause or in the event the successor corporation refuses to assume the
options. See "--1997 Stock Plan."
We have also entered into restricted stock purchase agreements with
certain of our officers and directors. The shares of our Common Stock issued
pursuant to these restricted stock purchase agreements are subject to our right
of repurchase which lapses in accordance with the vesting schedule of the
agreements. The agreements also include similar provisions to the stock options,
providing for accelerated vesting in the event of a change of control. See "Item
13, Certain Relationships and Related Transactions--Issuance of Common Stock."
1997 STOCK PLAN
Our 1997 Stock Plan was adopted by our Board of Directors and the
stockholders in July 1997. The number of shares of our Common Stock which are
reserved for issuance under the 1997 Stock Plan is 23,280,513 shares, plus an
annual increase beginning in January 2000, equal to the lesser of (i) 3% of the
outstanding shares on such date or (ii) an amount determined by our Board of
Directors. The annual increase is subject to adjustment upon changes in our
capitalization. The 1997 Stock Plan provides for the granting to employees
(including officers and directors) of qualified "incentive stock options" within
the meaning of Section 422 of the Internal Revenue Code of 1986, as amended (the
"Code"), and for the granting to employees (including officers and directors)
and consultants of nonstatutory stock options. The 1997 Stock Plan also provides
for the granting of stock purchase rights ("SPRs"). As of March 24, 2000,
options to purchase an aggregate of 17,744,288 shares were outstanding and
2,951,588 shares remained available for future grants.
The 1997 Stock Plan is administered by our Board of Directors or a
committee appointed by the Board of Directors. The administrator of the 1997
Stock Plan has the power to determine the terms of the options or SPRs granted,
including the exercise price of the option or SPR, the number of shares subject
to each option or SPR, the exercisability thereof, and the form of consideration
payable upon such exercise. In addition, the administrator has the authority to
amend, suspend or terminate the 1997 Stock Plan, provided that no such action
may affect any shares of our Common Stock previously issued and sold or any
option previously granted under the 1997 Stock Plan. We may grant each optionee
a maximum of 2,000,000 shares covered by option during a fiscal year and an
additional 2,000,000 shares covered by option in connection with an optionee's
initial employment. Options generally vest at a rate of 12.5% of the shares
subject to the option on the date six months following the grant date and 1/48th
of the shares subject to the option at the end of each one-month period
thereafter and generally expire eight years from the date of grant.
Options and SPRs granted under the 1997 Stock Plan generally are not
transferable by the optionee, and each option and SPR is exercisable during the
lifetime of the optionee only by such optionee. Options granted under the 1997
Stock Plan generally must be exercised within thirty days after the end of
optionee's status as our employee, director or consultant, or within twelve
months after such optionee's termination by death or disability, but in no event
later than the expiration of the option's term.
In the case of SPRs, unless the administrator determines otherwise,
restricted stock purchase agreements must grant us a repurchase option
exercisable upon the voluntary or involuntary termination of the purchaser's
service for any reason, including death or disability. The purchase price for
shares repurchased pursuant to the restricted stock purchase agreements will be
the original price paid by the purchaser and may be paid by cancellation of any
indebtedness owed to us by the purchaser. Repurchase options lapse at a rate
determined by the administrator.
The exercise price of all incentive stock options granted under the
1997 Stock Plan must be at least equal to the fair market value of our Common
Stock on the date of grant. The exercise price of nonstatutory stock options and
SPRs granted under the 1997 Stock Plan is determined by the administrator, but
with respect to nonstatutory stock options intended to qualify as
"performance-based compensation" within the meaning
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of Section 162(m) of the Code, the exercise price must be at least equal to the
fair market value of our Common Stock on the date of grant. With respect to any
participant who owns stock possessing more than 10% of the voting power of all
classes of our outstanding capital stock, the exercise price of any incentive
stock option granted must be at least equal to 110% of the fair market value on
the grant date and the term of such incentive stock option must not exceed five
years. The term of all other options granted under the 1997 Stock Plan may not
exceed ten years.
All stock options and restricted stock grants to officers, employees,
directors and consultants provide that in the event we merge with or into
another corporation resulting in a change of control involving a shift in 50% or
more of the voting power of our capital stock, or the sale of all or
substantially all of our assets, the options will fully vest and become
exercisable one year after the change of control. In the event the individual is
constructively terminated or terminated without cause or in the event that the
successor corporation refuses to assume or substitute the options, the options
will fully vest and become exercisable at that time.
1998 EMPLOYEE STOCK PURCHASE PLAN
The 1998 Employee Stock Purchase Plan was adopted by the Company's
Board of Directors in December 1998, and approved by the stockholders in January
1999. A total of 2,250,000 post-split shares of the Company's Common Stock have
been reserved for issuance under this plan, plus annual increases equal to the
lesser of (i) 2% of the outstanding shares on such date or (ii) an amount
determined by the Board of Directors. To date, 334,776 post-split shares have
been issued under the 1998 Employee Stock Purchase Plan.
The 1998 Employee Stock Purchase Plan, which is intended to qualify
under Section 423 of the Internal Revenue Code of 1986, as amended (the "Code"),
contains consecutive, overlapping, twenty-four month offering periods. Each
offering period includes four six-month purchase periods. The offering periods
generally start on the first trading day on or after May 1 and November 1 of
each year, except for the first offering period which commenced on the first
trading day after the Company's initial public offering on January 22, 1999, and
ends on the last trading day on or before October 31, 2000.
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Employees are eligible to participate if they are customarily employed
by the Company or any of the Company's participating subsidiaries for at least
20 hours per week and more than five months in any calendar year. However, no
employee may be granted a right to purchase stock under the 1998 Employee Stock
Purchase Plan (i) to the extent that, immediately after the grant of the right
to purchase stock, the employee would own stock possessing 5% or more of the
total combined voting power or value of all classes of the Company's capital
stock, or (ii) to the extent that his or her rights to purchase stock under all
the Company's employee stock purchase plans accrues at a rate which exceeds
$25,000 worth of stock for each calendar year. The 1998 Employee Stock Purchase
Plan permits participants to purchase the Company's Common Stock through payroll
deductions of up to 12% of the participant's "compensation." Compensation is
defined as the participant's base straight time gross earnings and commissions
but excludes payments for overtime, shift premium, incentive compensation,
incentive payments, bonuses and other compensation. The maximum number of shares
a participant may purchase during a single purchase period is 5,000 shares.
Amounts deducted and accumulated by the participant are used to
purchase shares of the Company's Common Stock at the end of each purchase
period. The price of stock purchased under the 1998 Employee Stock Purchase Plan
is generally 85% of the lower of the fair market value of the Company's 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.
Rights to purchase stock granted under the 1998 Employee Stock Purchase
Plan are not transferable by a participant other than by will, the laws of
descent and distribution, or as otherwise provided under the plan. The 1998
Employee Stock Purchase Plan provides that, in the event the Company merges with
or into another corporation or sell 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 Company's Board of Directors has the authority to amend or
terminate the 1998 Employee Stock Purchase Plan, except that no such action may
adversely affect any outstanding rights to purchase stock under the Employee
Stock plan. The Company's Board of Directors may terminate an offering period on
any exercise date if it determines that the termination of the plan is in the
Company's best interests and the best interest of the Company's stockholders.
The Board of Directors may in its sole discretion amend the plan to the extent
necessary and desirable to avoid unfavorable financial accounting consequences
by altering the purchase price for any offering period, shortening any offering
period or allocating remaining shares among the participants. Unless sooner
terminated by the Company's Board of Directors, the plan will automatically
terminate ten years from the effective date of the Company's initial public
offering.
LIMITATION ON LIABILITY AND INDEMNIFICATION MATTERS
Our Amended and Restated Certificate of Incorporation limits the
liability of our directors to the maximum extent permitted by Delaware law, and
our Bylaws provide that we will indemnify our directors and officers and may
indemnify our other employees and agents to the fullest extent permitted by law.
We have also entered into agreements to indemnify our directors and executive
officers, in addition to the indemnification provided for in our Bylaws. We
believe that these provisions and agreements are necessary to attract and retain
qualified directors and executive officers. At present, there is no pending
litigation or proceeding involving any of our directors, officers, employees or
agents in which indemnification will be required or permitted. We are not aware
of any threatened litigation or proceeding that might result in a claim for such
indemnification. We have been informed that, in the opinion of the Securities
and Exchange Commission, the indemnification of directors, officers or persons
that control us for liabilities arising under the Securities Act pursuant to the
above mentioned provisions is against public policy as expressed in the
Securities Act and is therefore unenforceable.
SECTION 16 (A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Based solely upon a review of reports received by the Company during or
with respect t the year ended December 31, 1999 pursuant to Rule 16a-3(e) of the
Securities exchange Act of 1934, as amended (the "Exchange Act"), all required
reports on Form 3, Form 4 and Form 5 were timely filed by the Company's
directors, officers and 10% stockholders.
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ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information regarding ownership
of our Common Stock as of March 20, 2000 by:
(i) each Named Executive Officer;
(ii) each of our directors;
(iii) all of our executive officers and directors as a group; and
(iv) all persons who directly own 5% or more of our Common Stock.
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, California 95050. As of March 1, 2000, there were
144,412,857 shares (on a post-split basis) of Common Stock outstanding, which
excludes 1,594,794 outstanding shares of the Company's non-voting Class B Common
Stock which are convertible into 3,588,286 split-adjusted shares of Common Stock
upon transfer to a third party. Share ownership in each case includes shares
issuable upon exercise of outstanding options and warrants that are exercisable
within 60 days of March 20, 2000 as described in the footnotes below. Percentage
ownership is calculated pursuant to SEC Rule 13d-3(d)(1). Such shares issuable
pursuant to such options are deemed outstanding for computing the percentage
ownership of the person holding such options but are not deemed outstanding for
the purposes of computing the percentage ownership of any other person. All
figures are shown on a post-split basis in light of the 3-for-2 stock split,
effective April 3, 2000.
<TABLE>
<CAPTION>
NUMBER OF
SHARES PERCENTAGE
BENEFICIALLY BENEFICIALLY
BENEFICIAL OWNER OWNED OWNED
- ------------------------------------------------------------------------------------- ----------- -------------
<S> <C> <C>
Putnam Investments, Inc.(1).......................................................... 11,467,869 7.9%
Robert Knowling Jr.(2)............................................................... 1,638,685 1.1%
Robert Roblin(3)..................................................................... 176,946 *
Catherine Hemmer(4).................................................................. 137,860 *
Joseph Devich(5)..................................................................... 161,305 *
Robert Davenport, III(6)............................................................. 88,123 *
Robert Hawk(7)....................................................................... 229,858 *
Daniel Lynch(8)...................................................................... 309,415 *
Frank Marshall(9).................................................................... 594,357 *
Rich Shapero(10)..................................................................... 4,374 *
Hellene Runtagh(11).................................................................. 10,498 *
All current executive officers and directors as a group (15 persons)................. 9,133,170 6.3%
</TABLE>
- --------------------
* Represents beneficial ownership of less than 1% of the Company's
outstanding voting stock.
(1) Based on a Form 13G filed February 17, 2000 with the Securities and
Exchange Commission by Marsh & McLennan Companies, Inc. and its direct and
indirect wholly-owned subsidiaries, Putnam Investments, Inc., Putnam
Investment Management, Inc. and The Putnam Advisory Company, Inc.
(2) Includes 1,605,561 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(3) Includes 176,436 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(4) Includes 137,499 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(5) Includes 122,175 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(6) Includes 88,123 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(7) Includes 24,624 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(8) Includes 309,415 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(9) Includes 44,874 shares of Common Stock subject to options exercisable
within 60 days of March 20, 2000.
(10) Includes 4,374 shares of Common Stock subject to options exercisable within
60 days of March 20, 2000.
(11) Includes 3,748 shares of Common Stock subject to options exercisable within
60 days of March 20, 2000.
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ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
SERIES C PREFERRED STOCK AND WARRANT SUBSCRIPTION AGREEMENT
On February 20, 1999, we entered into a Series C Preferred Stock and
Warrant Subscription Agreement (the "Subscription Agreement") with Warburg and
Crosspoint. Under this agreement, Warburg and Crosspoint unconditionally agreed
to purchase an aggregate of 5,764,143 shares of our Series C Preferred Stock and
warrants to purchase an aggregate of 4,729,500 shares of our Series C Preferred
Stock for an aggregate purchase price of $16.0 million at a date that we were to
determine but, in any event, not later than March 11, 1999. We agreed to either
call this commitment or complete an alternate equity financing of at least $16.0
million by March 11, 1999. A proposed alternate equity financing providing for a
price per share greater than or equal to $2.7767 and including securities that
are equal in right with, or more favorable to us than, our Series C Preferred
Stock as set forth in our Amended and Restated Certificate of Incorporation
required approval by a majority of our disinterested directors. A proposed
alternate equity financing providing for a price per share of less than $2.7767
or involving securities whose terms are less favorable to us than our Series C
Preferred Stock required unanimous approval by our entire Board of Directors. In
consideration of this commitment, we issued to Warburg and Crosspoint warrants
to purchase an aggregate of 1,694,148 shares of our Common Stock at a purchase
price of $0.0033 per share. The parties have agreed that the AT&T Ventures and
NEXTLINK stock purchases constitute an alternate equity financing. As a result,
we did not issue and sell our Series C Preferred Stock and warrants to purchase
Series C Preferred Stock to Warburg and Crosspoint. Messrs. Henry Kressel and
Joseph Landy, two of our former directors, are affiliated with Warburg, and Mr.
Shapero, one of our current directors is affiliated with Crosspoint.
On April 24, 1999, the Subscription Agreement was amended pursuant to
an Assignment and Assumption Agreement to which we were a party along with
Warburg, Crosspoint and Mr. Hawk. By the terms of this agreement, Warburg and
Crosspoint assigned to Mr. Hawk their obligation to purchase 36,015 shares of
our Series C Preferred Stock and 29,559 warrants to purchase Series C Preferred
Stock for an aggregate purchase price of $100,001.65. On the same date, Mr. Hawk
purchased 36,015 shares of our Series C Preferred Stock at a price per share of
$2.7767. As a result of this amendment, the aggregate obligation of Warburg and
Crosspoint to purchase our Series C Preferred Stock and warrants to purchase
Series C Preferred Stock was reduced from 5,764,143 shares to 5,728,128 shares
and from 4,729,500 shares to 4,699,941 shares, respectively, for an aggregate
purchase price of $15.9 million (reduced from $16.0 million). On the same date,
the Amended and Restated Stockholder Rights Agreement dated March 11, 1999 (the
"Stockholder Rights Agreement") was amended to add Mr. Hawk as a party.
The warrants to purchase our Common Stock issued upon the signing of
the Subscription Agreement had five-year terms (but had to be exercised prior to
the closing of our initial public offering), had purchase prices of $0.0022 per
share were immediately exercisable and contained net exercise provisions. Prior
to our initial public offering, Warburg and Crosspoint exercised their warrants
to purchase Series C Preferred Stock for 2,032,605 and 508,243 shares
of our Common Stock.
On March 11, 1999, we amended the Stockholder Rights Agreement to which
we and certain of our stockholders are a party, to extend the rights held by
Warburg, Crosspoint and Intel to our warrants to purchase Common Stock, Series C
Preferred Stock and warrants to purchase Series C Preferred Stock issued or
issuable to Warburg, Crosspoint and Intel pursuant to the Subscription
Agreement.
THE INTEL STOCK PURCHASE
As provided in the Subscription Agreement, Intel purchased 360,144
shares of our Series C Preferred Stock and warrants to purchase 295,500 shares
of our Series C Preferred Stock for an aggregate purchase price of $1.0 million
concurrently with the closing of the issuance of the 1998 13 1/2 % Senior
Discount Notes due 2008 issued in March 1998. We did not have any obligation to
issue the warrants to purchase Series C Preferred Stock to Intel until such time
as Warburg and Crosspoint funded their respective commitments under the
Subscription Agreement. The parties agreed that our initial public offering
constituted an alternate equity financing and, therefore, we will not issue the
warrants to purchase Series C Preferred Stock to Intel. In connection with its
agreement to purchase such Series C Preferred Stock and warrants to purchase
Series C Preferred Stock, we issued to Intel Common Warrants to purchase an
aggregate of 158,778 shares of our Common Stock at a purchase price of $0.0022
per share. Prior to our initial public offering, Intel exercised their warrants
for 158,778 shares of our Common Stock.
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TRANSACTIONS IN CONNECTION WITH THE FORMATION OF THE DELAWARE HOLDING COMPANY
We were originally incorporated in California as Covad Communication
Company ("Covad California") in October 1996. In July 1997, we were incorporated
in Delaware as part of our strategy to operate through a holding company
structure and to conduct substantially all of our operations through
subsidiaries. To effect the holding company structure, in July 1997 we entered
into an Exchange Agreement with the existing holders of the Common Stock and
Series A Preferred Stock of Covad California to acquire all of such stock in
exchange for a like number of shares of our Common and Preferred Stock, so that
after giving effect to the exchange Covad California became our wholly-owned
subsidiary. In addition, we entered into an Assumption Agreement pursuant to
which we assumed certain outstanding obligations of Covad California, including
a $500,000 demand note issued to Warburg and certain commitments to issue stock
options to two of our consultants.
In connection with the Exchange Agreement, one of our former officers,
Mr. Charles McMinn, and two of our current officers, Messrs. Khanna and Haas,
each exchanged 4,500,000 shares of Common Stock of Covad California, originally
purchased for $0.0028 per share, for a like number of our shares of Common Stock
pursuant to restricted stock purchase agreements. In addition, Mr. Lynch, one of
our directors, exchanged 216,000 shares of Common Stock of Covad California,
originally purchased for $0.0222 per share, for a like number of our shares of
Common Stock pursuant to a restricted stock purchase agreement. The Common Stock
issued to Messrs. McMinn, Khanna, Haas and Lynch are generally subject to
vesting over a period of four years. This vesting is subject to acceleration
upon a change of control involving a merger, sale of all or substantially all
our assets or a shift in 50% or more of the voting power of our capital stock.
Our repurchase rights lapse one year after the change of control or earlier in
the event the individual is constructively terminated or terminated without
cause, or in the event the successor corporation refuses to assume the
agreements.
ISSUANCE OF COMMON STOCK
On July 15, 1997, we issued 1,687,500 shares of our Common Stock to Mr.
Cardinale, one of our former officers, for a purchase price of $0.0333 per
share. On August 30, 1997, we issued 517,500 shares of our Common Stock to Mr.
Laehy, one of our officers, for $0.0333 per share. On October 14, 1997, we
issued 216,000 shares of our Common Stock to Mr. Marshall, one of our directors,
for a purchase price of $0.0333 per share. On April 24, 1998, we issued 144,000
shares of our Common Stock to Mr. Hawk, one of our directors, for a purchase
price of $0.444 per share. On August 28, 1998, we issued 60,000 shares of our
Common Stock to Mr. Hawk for a purchase price of $3.8333 per share. On November
3, 1999, we issued 20,000 Shares of Common Stock to Cathy Hemmer, one of our
officers, for a purchase price of $0.001 per share. On November 3, 1999, we
issued 20,000 shares of our common stock to Rob Roblin, one of our officers, for
the purchase price of $0.001 per share. On April 15, 1999, we issued 12,000
shares of our Common Stock to Jane Marvin, one of our Officers, for a purchse
price of $0.001 per share. The shares of our Common Stock issued to Messrs.
Cardinale, Laehy, Marshall and Hawk were issued pursuant to restricted stock
purchase agreements which contain vesting and change of control provisions
similar to those contained in the above-described restricted stock purchase
agreements of Messrs. McMinn, Khanna, Haas and Lynch.
ISSUANCE OF SERIES A PREFERRED STOCK
On June 30, 1997 Covad California issued 150,000 shares of Series A
Preferred Stock to each of Messrs. McMinn, Khanna and Haas and 300,000 shares of
Series A Preferred Stock to Mr. Lynch for a purchase price of $0.3333 per share.
In July 1997, these shares were exchanged for a like number of our shares of
Series A Preferred Stock pursuant to the Exchange Agreement.
ISSUANCE OF SERIES B PREFERRED STOCK
In July 1997, we sold an aggregate of 17,000,001 shares of our Series B
Preferred Stock, of which 12,000,000 shares were sold to Warburg, 3,000,000
shares were sold to Crosspoint and 2,000,001 shares were sold to Intel. The
purchase price of our Series B Preferred Stock was $0.50 per share. A portion of
the purchase price of the Series B Preferred Stock was paid by cancellation of a
$500,000 demand note issued to Warburg in June 1997. Messrs. Kressel and Landy,
each of whom formerly served as members of our Board of Directors, are
affiliated with Warburg. Mr. Shapero, who currently serves on our Board of
Directors, is affiliated with Crosspoint. On February 12, 1998, we sold
additional 100,002 shares of Series B Preferred Stock at a purchase price of
$1.00 per share to Mr. Marshall, one of our directors.
THE STRATEGIC INVESTMENTS AND RELATIONSHIPS
In January 1999, we received equity investments from AT&T Ventures,
NEXTLINK and Qwest. AT&T Ventures purchased an aggregate of 1,500,583 shares of
our Series C-1 Preferred Stock at $2.7767 per share and an aggregate of
1,157,408
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shares of our Series D-1 Preferred Stock at $18.00 per share. These purchases
represent an aggregate investment of $25 million, of which $11 million was
invested by AT&T Venture Fund II, LP and $14 million was invested by the two
affiliated funds. NEXTLINK purchased 1,200,466 shares of our Series C-1
Preferred Stock at $2.7767 per share and 925,926 shares of our Series D-1
Preferred Stock at $18.00 per share, representing an investment of $20 million.
Qwest purchased 900,349 shares of our Series C-1 Preferred Stock at $2.7767 per
share and 694,445 shares of our Series D-1 Preferred Stock at $18.00 per share,
representing an aggregate investment of $15 million. At the completion of our
initial public offering, our Series C-1 Preferred Stock converted into our Class
B Common Stock on a one-for-one basis. The Series D-1 Preferred Stock also
converted into our Class B Common Stock at that time on a one-for-one basis. The
Strategic Investors have each agreed not to transfer any of our Series C-1
Preferred Stock, Series D-1 Preferred Stock or Class B Common Stock to any
non-affiliated third party until January 2000. The Strategic Investors have also
each agreed not to acquire more than 10% of our voting stock without our consent
until January 2002. In addition, until January 2002, each of the Strategic
Investors has agreed to vote any voting securities it holds as recommended by
our Board of Directors.
Concurrently with these strategic equity investments, we entered into
commercial agreements with AT&T, NEXTLINK and Qwest. These agreements provide
for the purchase, marketing and resale of our services at volume discounts, our
purchase of fiber-optic transport bandwidth at volume discounts, collocation of
network equipment and development of new DSL services. These agreements have
terms ranging from six months to several years subject to earlier termination in
certain circumstances. We cannot predict the number of line orders that AT&T,
NEXTLINK or Qwest will generate, if any, whether line orders will be below our
expectations or the expectations of, AT&T, NEXTLINK or Qwest or whether AT&T,
NEXTLINK or Qwest will discontinue selling our services entirely.
EQUIPMENT LEASE FINANCING
Through December 31, 1999, we have incurred a total of $865,000 of
equipment lease financing obligations (including principal and interest) through
a sale lease-back transaction with Charter Financial, Inc. ("Charter
Financial"). Through December 31, 1999, we have made total payments of
approximately $525,000 to Charter Financial on these obligations. Warburg, one
of our principal stockholders, owns a majority of the capital stock of Charter
Financial. We believe that the terms of the lease financing with Charter
Financial were completed at rates similar to those available from alternative
providers. Our belief that the terms of the sale lease-back arrangement are
similar to those available from alternative providers is based on the advice of
our officers who reviewed at least two alternative proposals and who reviewed
and negotiated the terms of the arrangement with Charter Financial.
VENDOR RELATIONSHIP
Crosspoint, one of our principal stockholders, owns approximately 12%
of the capital stock of Diamond Lane, one of our vendors. Our payments to
Diamond Lane through December 31, 1999 totaled approximately $51,539,000. We
believe that the terms of its transactions with Diamond Lane were completed at
rates similar to those available from alternative vendors. This belief is based
on our management team's experience in obtaining vendors and the fact that we
sought competitive bidders before entering into the relationship with Diamond
Lane.
EMPLOYEE LOANS
In August 1998, the Company loaned Robert Knowling, Jr., the Company's
Chairman of the Board, President and Chief Executive Officer, pursuant to his
employment agreement the principal amount of $500,000 pursuant to a Note Secured
by Deed of Trust, which was secured by certain real property of Mr. Knowling.
The entire principal balance of this note becomes due and payable in one lump
sum on August 14, 2002. No interest is charged on the note. This note has
provisions for forgiveness based on continued employment and is subject to
acceleration in certain events.
In August 1998, the Company loaned Joseph Devich, one of the Company's
officers, the principal amount of $200,000 pursuant to a note secured by Deed of
Trust, which was secured by certain real property of Mr. Devich. The outstanding
principal balance of this note becomes due and payable in four equal
installments commencing August 13, 1999, with the last installment due on August
13, 2002. No interest is charged on the note. This note has provisions for
forgiveness based on continued employment and is subject to acceleration in
certain events.
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In October 1998, the Company loaned Catherine Hemmer,one of the
Company's officers, and her husband, one of the Company's employees, the
principal amount of $600,000 pursuant to a Note Secured By Deed of Trust, which
was secured by certain real property of the Hemmers. The outstanding principal
balance of this note becomes due in four equal annual installments commencing
August 10, 1999, with the last installment due on August 10, 2002. No interest
is charged on the note. This note has provisions for forgiveness based upon
continued employment of each of the Hemmers and is subject to acceleration in
certain events.
In April 1999, the Company committed to extend a loan to Jane Marvin,
one of the Company's officers, in the principal amount of $510,000 for the
purchase of a principal residence. The loan, at Ms. Marvin's discretion, may or
may not be secured by such principal residence. When extended to Ms. Marvin, the
loan will provide that the principal balance will be due and payable in four
equal annual installments beginning at the first year anniversary of the
commencement of Ms. Marvin's employment, and, if secured by her principal
residence, no interest will be charged for the loan. Furthermore, the loan will
be forgiven based upon her continued employment and is subject to acceleration
in certain events. In addition, in December 1999, the Company loaned Ms. Marvin
$80,705.46 pursuant to a note secured by a pledge of shares of the Company's
Common Stock. The entire principal balance of this note becomes due and payable
in one lump sum on the earlier to occur of October 2000 or the sale of the
pledged shares. Interest is payable on the note at a rate of 5.89% per annum,
compounded semi-annually.
In May 1999, the Company loaned Robert Davenport, one of the Company's
officers, the principal amount of $600,000 for the purchase of a principal
residence. The loan is secured by such principal residence. The outstanding
principal balance of this note becomes due in four equal installments commencing
January 20, 2000, with the last installment due on January 20, 2003. No interest
is charged on the note. The note has provisions for forgiveness based upon
continued employment and is subject to acceleration in certain events.
In January 2000, the Company committed to extend a loan to Michael
Lach, one of the Company's officers, in the principal amount of $200,000, for
the purchase of a principal residence. The loan will be secured by such
principal residence. The loan will provide that the principal balance will be
due and payable in four equal annual installments, beginning at the first year
anniversary of the commencement of Mr. Lach's employment. No interest will be
charged on this loan. The loan will have provisions for forgiveness based on
continued employment and is subject to acceleration in certain events.
85
<PAGE>
COVAD COMMUNICATIONS GROUP, INC.
GLOSSARY OF TERMS
ACCESS LINE--A circuit that connects a telephone end-user to the ILEC
Central Office.
ANALOG MODEM--A telecommunications device that allows the communication
of digital information over analog telephone lines and through the public
switched telephone network by translating such information in a way that
simulates and uses only the bandwidth of normal voice transmissions.
ASYNCHRONOUS TRANSFER MODE (ATM)--A standard packet-switching protocol
that segments digital information into 53-byte cells (each cell has a 5-byte
standard packet-switching header and 48 bytes of data) that are switched very
quickly throughout a network over virtual circuits. ATM is able to accommodate
multiple types of media (voice, video, data).
BANDWIDTH--Refers to the maximum amount of data that can be transferred
through a computer's backplane or communication channel in a given time. It is
usually measured in Hertz for analog communications and bits per second for
digital communication.
CENTRAL OFFICE--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.
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.
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.
FRAME-RELAY--A high-speed packet-switched data communications protocol.
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.
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 Central
Office, or (ii) virtual, in which the CLEC leases a facility, similar to that
which it might build, to effect a presence in the ILEC Central Office.
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
86
<PAGE>
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, Central Office collocation space,
inter-office transport, operational support systems, local switching and rights
of way.
87
<PAGE>
PART IV
ITEM 14. FINANCIAL STATEMENT SCHEDULES, REPORTS ON FORM 8-K AND EXHIBITS
(a) The following documents are filed as part of this Form 10-K:
(1) FINANCIAL STATEMENTS. The following Financial Statements of Covad
Communications Group, Inc. and Report of Independent Auditors are
filed as part of this report.
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity (Net Capital
Deficiency)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULES. Financial statement schedules not
filed herein are omitted because of the absence of conditions
under which they are required or because the information called
for is shown in the exhibits or the consolidated financial
statements and notes thereto.
(b) Reports on Form 8-K:
None
(c) Exhibits:
EXHIBIT
NUMBER DESCRIPTION
------ -----------
2.1(1) Agreement and Plan of Merger Among Covad Communications Group, Inc.,
LightSaber Acquisition Co. and LaserLink.Net, Inc., dated as of
March 8, 2000.
3.2(2) Amended and Restated Certificate of Incorporation of the Registrant,
as currently in effect.
3.4(2) Bylaws, as currently in effect.
4.1(2) Indenture dated as of March 11, 1998 between the Registrant and The
Bank of New York, including form of 13 1/2% Senior Discount Note Due
2008.
4.3(2) Warrant Agreement dated as of March 11, 1998 between the Registrant
and the Bank of New York.
4.4(2) Warrant Registration Rights Agreement dated as of March 11, 1999
among the Registrant and Bear, Stearns & Co. Inc. and BT Alex. Brown
Incorporated.
4.5(2) Specimen 13 1/2% Senior Discount Note Due 2008, Series B.
4.6(2) Amended and Restated Stockholders Rights Agreement dated
March 11, 1998 among the Registrant and certain of its stockholders.
4.7(3) Indenture dated as of February 18, 1999 between the Registrant
and The Bank of New York, including form of 12 1/2% Senior Note Due
2009.
4.9(3) Specimen 12 1/2% Senior Note Due 2009.
4.10(4) Indenture dated as of January 28, 2000 between the Registrant and
The United States Trust Company of New York, including form of 12%
Senior Note Due 2010.
4.11(4) Registration Rights Agreement dated as of January 28, 2000, between
the Registrant and Bear, Stearns & Co., Inc.
4.12(4) Specimen 12% Senior Note Due 2010.
IV-1
<PAGE>
EXHIBIT
NUMBER DESCRIPTION
------ -----------
4.13(5) Stockholder Protection Rights Agreement dated February 15, 2000.
10.1(2) Form of Indemnification Agreement entered into between the
Registrant and each of the Registrant's executive officers and
directors.
10.5(2) Series C Preferred Stock and Warrant Subscription Agreement dated as
of February 20, 1998 among the Registrant, Warburg, Pincus Ventures,
L.P., Crosspoint Venture Partners 1996 and Intel Corporation, as
amended by the Assignment and Assumption Agreement and First
Amendment to the Series C Preferred Stock and Warrant Subscription
Agreement dated as of April 24, 1998 among the Registrant, Warburg,
Crosspoint and Robert Hawk.
10.6(2) Employment Agreement dated June 21, 1999 between the Registrant and
Robert E. Knowling, Jr.
10.7(2) Sublease Agreement dated July 6, 1998 between Auspex Systems, Inc.
and the Registrant with respect to Registrant's facilities in Santa
Clara, California.
10.8(2) 1998 Employee Stock Purchase Plan and related agreements, as
currently in effect.
10.10(2) Form of Warrant to purchase Common Stock issued by the Registrant on
February 20, 1998 to Warburg, Pincus Ventures, L.P., Crosspoint
Ventures Partners 1996 and Intel Corporation.
10.11(2) Note Secured by Deed of Trust dated October 7, 1998 issued by
Catherine A. Hemmer and John J. Hemmer in favor of the Registrant.
10.12(2) 1997 Stock Plan and related option agreement, as currently in
effect.
10.13(2) Series C-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.14(2) Series D-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 among the Registrant, AT&T Venture Fund II, LP and two
affiliated funds.
10.15(2) Series C-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 between the Registrant and NEXTLINK Communications, Inc.
10.16(2) Series D-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 between the Registrant and NEXTLINK Communications, Inc.
10.17(2) Series C-1 Preferred Stock Purchase Agreement dated as of December
30, 1998 between the Registrant and U.S. Telesource, Inc.
10.18(2) Series D-1 Preferred Stock Purchase Agreement dated as of January
19, 1998 between the Registrant and U.S. Telesource, Inc.
11.1 Statement of Computation of Per Share Earnings.
21.1 Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, independent auditors.
24.1 Power of Attorney (Included on Page IV-3).
27.1 Financial Data Schedules.
- ---------------------------
(1) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form 8-K as originally filed on March 23,
2000 and as subsequently amended.
(2) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-1 (File No. 333-63899) as originally
filed on September 21, 1998 and as subsequently amended.
(3) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-4 (File No. 333-75955) as originally
filed on April 9, 1999 and as subsequently amended.
(4) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-4 (File No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.
(5) Incorporated by reference to Exhibit 4.1 filed with our Registration
Statement on Form 8-A as originally filed on February 22, 2000 and as
subsequently amended.
IV-2
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
COVAD COMMUNICATIONS GROUP, INC.
By: /s/ ROBERT KNOWLING, JR.
--------------------------------
Robert Knowling, Jr.
Chairman, Board of Directors,
President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Robert Knowling, Jr. and Timothy Laehy and each
of them, jointly and severally, his attorneys-in-fact, each with full power of
substitution, for him in any and all capacities, to sign any and all amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitute or substitutes, may do or cause to be done
by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant on March 30, 2000 in the capacities indicated.
SIGNATURE TITLE
/s/ Robert Knowling, Jr. Chairman, Board of Directors,
- ---------------------------------- President and Chief Executive Officer
Robert Knowling, Jr. (Principal Executive Officer)
/s/ Timothy Laehy Chief Financial Officer (Principal
- ---------------------------------- Financial and Accounting Officer)
Timothy Laehy
/s/ Robert Hawk Director
- ----------------------------------
Robert Hawk
/s/ Hellene Runtagh Director
- ----------------------------------
Hellene Runtagh
/s/ Daniel Lynch Director
- ----------------------------------
Daniel Lynch
/s/ Frank Marshall Director
- ----------------------------------
Frank Marshall
/s/ Rich Shapero Director
- ----------------------------------
Rich Shapero
IV-3
<PAGE>
EXHIBIT INDEX
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
<S> <C>
EXHIBIT
NUMBER DESCRIPTION
------ -----------
2.1(1) Agreement and Plan of Merger Among Covad Communications Group, Inc., Lightsaber Acquisition Co. and LaserLink. Net,
Inc., dated as of March 8, 2000.
3.2(2) Amended and Restated Certificate of Incorporation of the Registrant, as currently in effect.
3.4(2) Bylaws, as currently in effect.
4.1(2) Indenture dated as of March 11, 1998 between the Registrant and The Bank of New York, including form of 13-1/2% Senior
Discount Note Due 2008.
4.3(2) Warrant Agreement dated as of March 11, 1998 between the Registrant and The Bank of New York.
4.4(2) Warrant Registration Rights Agreement dated as of March 11, 1999 among the Registrant and Bear, Stearns & Co. Inc. and
BT Alex.Brown Incorporated.
4.5(2) Specimen 13 1/2% Senior Discount Note Due 2008, Series B.
4.6(2) Amended and Restated Stockholders Rights Agreement dated March 11, 1998 among the Registrant and certain of its
stockholders.
4.7(3) Indenture dated as of February 18, 1999 between the Registrant and The Bank of New York, including form of 12 1/2%
Senior Note Due 2009.
4.9(3) Specimen 12 1/2% Senior Note Due 2009.
4.10(4) Indenture dated as of January 28, 2000 between the Registrant and The United States Trust Company of New York,
including form of 12% Senior Note Due 2010.
4.11(4) Registration Rights Agreement dated as of January 28, 2000, between the Registrant and Bear, Stearns & Co., Inc.
4.12(4) Specimen 12% Senior Note Due 2010.
4.13(5) Stockholder Protection Rights Agreement dated February 15, 2000.
10.1(2) Form of Indemnification Agreement entered into between the Registrant and each of the Registrant's executive officers
and directors.
10.5(2) Series C Preferred Stock and Warrant Subscription Agreement dated as of February 20, 1998 among the Registrant,
Warburg, Pincus Ventures, L.P., Crosspoint Venture Partners 1996 and Intel Corporation, as amended by the Assignment
and Assumption Agreement and First Amendment to the Series C Preferred Stock and Warrant Subscription Agreement dated
as of April 24, 1998 among the Registrant, Warburg, Crosspoint and Robert Hawk.
10.6(2) Employment Agreement dated June 21, 1999 between the Registrant and Robert E. Knowling, Jr.
10.7(2) Sublease Agreement dated July 6, 1998 between Auspex Systems, Inc. and the Registrant with respect to Registrant's
facilities in Santa Clara, California.
10.8(2) 1998 Employee Stock Purchase Plan and related agreements, as currently in effect.
10.10(2) Form of Warrant to purchase Common Stock issued by the Registrant on February 20, 1998 to Warburg, Pincus Ventures,
L.P., Crosspoint Ventures Partners 1996 and Intel Corporation.
10.11(2) Note Secured by Deed of Trust dated October 7, 1998 issued by Catherine A. Hemmer and John J. Hemmer in favor of the
Registrant.
10.12(2) 1997 Stock Plan and related option agreement, as currently in effect.
10.13(2) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the Registrant, AT&T Venture Fund
II, LP and two affiliated funds.
10.14(2) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 among the Registrant, AT&T Venture Fund
II, LP and two affiliated funds.
10.15(2) Series C-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the Registrant and NEXTLINK
Communications, Inc.
10.16(2) Series D-1 Preferred Stock Purchase Agreement dated as of December 30, 1998 between the Registrant and NEXTLINK
Communications, Inc.
<PAGE>
10.17(2) Series C-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the Registrant and U.S. Telesource,
Inc.
10.18(2) Series D-1 Preferred Stock Purchase Agreement dated as of January 19, 1998 between the Registrant and U.S. Telesource,
Inc.
11.1 Statement of Computation of Per Share Earnings.
21.1 Subsidiaries of the Registrant.
23.1 Consent of Ernst & Young LLP, independent auditors.
24.1 Power of Attorney (Included on Page IV-3).
27.1 Financial Data Schedules.
</TABLE>
----------------------------------------
(1) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form 8-K as originally filed on March 23,
2000 and as subsequently amended.
(2) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-1 (File No. 333-63899) as originally
filed on September 21, 1998 and as subsequently amended.
(3) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-4 (File No. 333-75955) as originally
filed on April 9, 1999 and as subsequently amended.
(4) Incorporated by reference to the exhibit of corresponding number filed with
our Registration Statement on Form S-4 (File No. 333-30360) as originally
filed on February 14, 2000 and as subsequently amended.
(5) Incorporated by reference to Exhibit 4.1 filed with our Registration
Statement on Form 8-A as originally filed on February 22, 2000 and as
subsequently amended.
<PAGE>
EXHIBIT 11.1
Statement of Computation of Per Share Earnings
<TABLE>
<CAPTION>
- ---------------------------------- ---------------------- ---------------------- -----------------------
1997 1998 1999
- ---------------------------------- ---------------------- ---------------------- -----------------------
<S> <C> <C> <C>
Net Loss $ (2,612,000) $ (48,121,000) $ (195,397,000)
- ---------------------------------- ---------------------- ---------------------- -----------------------
Preferred Dividend (1,146,000)
- ---------------------------------- ---------------------- ---------------------- -----------------------
Net Loss Available to Common
Shareholders $ (2,612,000) $ (48,121,000) $ (196,543,000)
- ---------------------------------- ---------------------- ---------------------- -----------------------
Weighted Average Shares
Outstanding in computing net loss
per share 3,271,546 5,708,535 71,765,208
- ---------------------------------- ---------------------- ---------------------- -----------------------
Net Loss per Share $ (0.80) $ (8.43) $ (2.74)
- ---------------------------------- ---------------------- ---------------------- -----------------------
</TABLE>
<PAGE>
EXHIBIT 21.1
Subsidiaries of the Registrant
Covad Communications Company, a California corporation
DIECA Communications Company, a Virginia corporation
Covad Communications Investment Corp., a Delaware corporation
Lightsaber Acquisition Co., a Delaware corporation
<PAGE>
EXHIBIT 23.1
Consent of Independent Public Accountants
We consent to the incorporation by reference in the registration statement
on Form S-8/S-3 (File No. 333-81755) of Covad Communications Group, Inc.,
relating to the 1997 Stock Plan and the 1998 Employee Stock Purchase Plan, of
our reports dated March 30, 2000 on the financial statements of Covad
Communications Group, Inc., which reports appear in the Annual Report on Form
10-K of Covad Communications Group, Inc., for the fiscal year ended December 31,
1999.
Ernst & Young LLP
Walnut Creek, California
March 20, 2000
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<CASH> 216,038
<SECURITIES> 551,319
<RECEIVABLES> 15,393
<ALLOWANCES> 2,857
<INVENTORY> 8,547
<CURRENT-ASSETS> 803,983
<PP&E> 269,704
<DEPRECIATION> 32,162
<TOTAL-ASSETS> 1,147,606
<CURRENT-LIABILITIES> 82,534
<BONDS> 0
0
0
<COMMON> 851,677
<OTHER-SE> (161,386)
<TOTAL-LIABILITY-AND-EQUITY> 1,147,606
<SALES> 66,488
<TOTAL-REVENUES> 66,488
<CGS> 238,089
<TOTAL-COSTS> 238,089
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 23,796
<INCOME-PRETAX> (195,397)
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> (1,146)
<NET-INCOME> (196,543)
<EPS-BASIC> (2.74)
<EPS-DILUTED> (2.74)
</TABLE>
