<PAGE>
Filed Pursuant to Rule 424(b)(4)
File No. 333-78483
8,400,000 Shares
[LOGO OF CONVERGENT COMMUNICATIONS APPEARS HERE]
Common Stock
----------------
This is an initial public offering of shares of common stock of Convergent
Communications, Inc. Convergent Communications is offering 7,676,729 of the
shares to be sold in this offering. The selling shareholders identified in this
prospectus are offering an additional 723,271 shares. Convergent Communications
will not receive any proceeds from the sale of shares sold by the selling
shareholders.
Prior to this offering, there has been no public market for the common stock.
The common stock has been approved for quotation on the Nasdaq National Market
under the symbol "CONV".
See "Risk Factors" beginning on page 8 to read about certain factors you
should consider before buying shares of the common stock.
----------------
Neither the Securities and Exchange Commission nor any other regulatory body
has approved or disapproved of these securities or passed upon the accuracy or
adequacy of this prospectus.
Any representation to the contrary is a criminal offense.
----------------
<TABLE>
<CAPTION>
Per Share Total
--------- ---------------
<S> <C> <C>
Initial public offering price..................... $15.00 $126,000,000.00
Underwriting discount............................. $ 1.05 $ 8,820,000.00
Proceeds, before expenses, to Convergent
Communications................................... $13.95 $107,090,369.55
Proceeds, before expenses, to the selling
shareholders..................................... $13.95 $ 10,089,630.45
</TABLE>
The underwriters may, under certain circumstances, purchase up to an
additional 1,260,000 shares from Convergent Communications at the initial
public offering price less the underwriting discount.
----------------
The underwriters expect to deliver the shares against payment in New York, New
York on July 23, 1999.
Goldman, Sachs & Co.
J.P. Morgan & Co.
Warburg Dillon Read LLC
William Blair & Company
----------------
Prospectus dated July 19, 1999.
<PAGE>
[OUTSIDE FRONT GATE ART]
[Cover page contains copy and photographs. Convergent Communications logo in
top left hand corner of the page. In the center of the page is a depiction of a
Cisco Systems, Inc. MGX-8850 switch containing caption with text in bullet
format: "Cisco Systems", "MGX-8850", "IP + ATM Network"; "ePOP(TM)' . The
switch is connected by a diagonal line to a picture of the world, showing North
and South America, in the top right hand corner of the page. Title caption
inside the picture with text "Outside Network". Under the caption is text in
bullet format:," "Internet Access"; "Frame Relay"; "ATM + IP"; "Intranet";
"Extranet"; "Public Switched Telephone Network"; "Long Distance"; "Local
Service"; "Enterprise Network Services"; "Managed Services"; "Professional
Services". Next to the picture of the switch is title caption with text "Inside
Network". The switch is connected by a diagonal line to a sphere. The diagonal
line has a caption above the line with text "e-link(TM) " and a caption below
the line with text "(DSL or T1)". The sphere is captioned with text "Integrated
Access Device". The sphere is connected to four pictures of products that
connect our network: (i) picture of video system with caption "IP Video"; (ii)
picture of switching device with caption "IP PBX"; (iii) picture of telephone
with caption "IP Telephony"; (iv) picture of computer on a desk with caption
"Data & Internet". Between the sphere captioned "Integrated Access Device" and
the picture of the computer on a desk are two additional spheres: the first
captioned with text "Routers"; the second captioned with text "Catalyst LAN
Switches & Hubs". In the bottom right hand corner of the page is the Cisco
Powered Network logo.]
<PAGE>
[INSIDE FRONT COVER SPREAD ART]
[Title caption with text "Convergent Communications' National IP/ATM Network
Deployment" and Convergent Communications(TM) logo at the top of the page.
Under the caption a map of the United States showing the following locations
Seattle; Portland; Boise; Salt Lake City; Santa Clara; Sacramento; Denver; Las
Vegas; Los Angeles; Irvine; San Diego; Phoenix; Alburquerque; Colorado Springs;
San Antonio; Houston; Dallas; Tulsa; Little Rock; New Orleans; Tampa; Miami;
Jacksonville; Birmingham; Atlanta; Nashville; Charlotte; Raleigh; Richmond;
Herndon; Baltimore; Newark; New York; Boston; Syracuse; Detroit; Chicago; St.
Louis; Milwaukee; Green Bay; Minneapolis; Des Moines; Omaha; Kansas City;
Indianapolis; Cincinnati; Louisville; Cleveland; Philadelphia; Pittsburgh.
Locations are connected by a network of lines showing current and planned
network connections. Key explains the diagram. Block graph with title caption
with text "ePOP(TM) 50-City Deployment" shows that in 1999, 16 cities will be
connected to our network and in 2000 and 2001 an additional 34 cities will be
connected to the network.]
<PAGE>
Internet Protocol
Internet Protocol or IP is a standard industry method of identifying,
tracking and reassembling packets of information transferred over multiple
communications networks, including the Internet.
PROSPECTUS SUMMARY
This summary highlights information contained later in this prospectus. You
should read the entire prospectus carefully, especially "Risk Factors"
beginning on page 8. All share and per share numbers reflect a reverse stock
split of one-for-two to be effected immediately prior to the closing of this
offering.
Overview of Our Company
We are a rapidly growing national provider of single-source data and voice
communications systems, services and solutions primarily to businesses with 25
to 500 employees. Inside our customers' premises we own communications networks
and provide professional services, such as the design, installation, management
and monitoring of those networks. Outside our customers' premises, we provide a
broad range of data and voice transport services. By operating networks both
inside and outside our customers' premises, and by offering a broad range of
data and voice products and services, we enable small and medium sized
businesses to use state-of-the-art communications solutions, including data and
voice networks based on Internet Protocol, electronic commerce, the Internet
and sophisticated communications systems. We intend to become the leading
provider of IP-based data and voice systems and services to small and medium
sized businesses.
We offer each of our products and services on
a stand-alone basis and are now also offering a
bundled communications solution under long-term
service agreements in which we own all or a
portion of the inside network and provide
professional services inside our customers'
premises and supply transport services outside
their premises. This comprehensive solution,
which we call Enterprise Network Services,
reduces our customers' capital needs, technical
staffing requirements and risks associated with
evolving communications technologies.
We are deploying Cisco Systems, Inc.'s multi-service data and voice switch in
each of the 35 metropolitan areas in which we currently operate and will also
deploy them in the 15 additional markets we expect to enter. We believe that
these next-generation switches will enable us to route our customers' external
communications traffic more efficiently and with lower capital outlay than with
traditional switches.
Our company was founded in 1995 by three experienced data and telephony
executives. Since our founding, we have raised more than $200 million of
capital and have acquired 14 businesses. Through a combination of these
acquisitions and internal growth, we have provided products or services to more
than 33,000 customers since January 1, 1998. Our staff of more than 1,000
employees includes approximately 425 data and voice technicians and
approximately 200 experienced sales professionals. We have grown our revenue to
an annualized run rate of more than $120 million based on our results for the
quarter ended March 31, 1999.
Our Market Opportunity
Spending on data products and services in the United States reached
approximately $98 billion in 1998 after several years of substantial growth
because of the growing importance of electronic communication and commerce.
Voice products such as corporate phone networks are becoming increasingly
complex as computer functionality is designed into telephones and as IP-based
products
3
<PAGE>
become more commonplace. We believe that sophisticated data and voice systems
such as IP-based integrated networks, wide area networks, intranets, extranets,
dedicated internet access and virtual private networks are becoming
increasingly critical to the success of small and medium sized businesses.
These businesses typically rely on their internal staff or on small, usually
local or regional, providers for data and voice system design, installation,
management and monitoring. Most of these businesses have limited capital which
they would prefer to deploy in their core operations rather than on
communication systems and networks, and most do not have the human resources to
effectively manage multiple suppliers who offer a wide range of systems and
solutions.
Our Solutions
Our solutions provide small and medium sized businesses an economical way to
manage their communications infrastructures and transport needs while providing
sophisticated capabilities more typically found in larger companies. The
combination of our focus on this market and our national scale enables us to be
a single-source provider of these advanced and integrated data and voice
solutions.
Our Business and Growth Strategies
Our business strategy is to:
.Target small and medium sized businesses
. Provide sophisticated, one-stop, integrated communications solutions
. Own the communications network inside our customers' enterprises
. Focus on solutions-based selling
. Provide preeminent, local customer care
. Capitalize on our operational support system
Our growth strategy is to:
. Leverage our existing customer base
. Deploy our Cisco powered multi-service switching architecture
. Increase higher-margin service revenue
. Sell IP-based integrated network solutions
. Pursue selected strategic acquisitions
4
<PAGE>
The Offering
<TABLE>
<S> <C>
Common stock offered by Convergent Communications...... 7,676,729 shares
Common stock offered by the selling shareholders....... 723,271 shares
Common stock to be outstanding after the offering...... 24,519,824 shares
Use of proceeds........................................ For general corporate purposes, including working
capital, capital expenditures, business acquisitions,
repayment of certain debt and to fund continued
operating losses. See "Use of Proceeds."
Nasdaq National Market symbol.......................... "CONV"
</TABLE>
In the above table and throughout this prospectus, unless otherwise
indicated, the number of shares of common stock that will be outstanding after
this offering is based on the number of shares of common stock outstanding as
of May 31, 1999, plus:
. the number of shares of common stock to be sold by Convergent
Communications in this offering; and
. 2,666,667 shares of common stock to be issued at the completion of this
offering upon the automatic conversion of all of our convertible
preferred stock sold in March 1999.
However, the number of shares of common stock outstanding as of May 31, 1999
excludes:
. 3,559,300 shares of common stock issuable upon exercise of stock
options. These options have a weighted average exercise price of $7.18
per share and individual exercise prices ranging from $2.00 to $20.00
per share;
. 6,503,982 shares of common stock issuable upon exercise of warrants with
a weighted average exercise price of $6.28 per share and individual
exercise prices ranging from $0.02 to $15.00 per share, see Description
of Capital Stock--Warrants; and
. 375,000 shares of common stock issuable upon exercise of warrants issued
in connection with the borrowing under the senior secured credit
facility with Goldman Sachs Credit Partners L.P. on June 4, 1999 with an
exercise price of $15.00 per share.
. 60,000 shares of common stock issuable in connection with a proposed
acquisition of assets of a data network integration company which is
scheduled to close in the third quarter of 1999.
. 575,000 shares of common stock issuable upon exercise for a warrant
issued to Cisco Systems, Inc. in July 1999 at an exercise price of
$15.00 per share.
Unless we indicate otherwise, the information in this prospectus assumes that
the underwriters will not exercise their overallotment option. The number of
shares sold by Convergent Communications may increase to the extent the selling
shareholders do not sell shares in this offering.
--------------------
Our principal executive offices are located at 400 Inverness Drive South,
Suite 400, Englewood, Colorado 80112. Our telephone number is (303) 749-3000.
We maintain a website at http://www.converg.com. Information contained in that
website is not part of this prospectus.
5
<PAGE>
SUMMARY FINANCIAL DATA
You should read the following summary financial data along with our
consolidated financial statements and accompanying notes and "Management's
Discussion and Analysis of Financial Condition and Results of Operations," all
of which appear later in this prospectus. The increase in revenue between the
second and third quarters of 1998 reflected in our Quarterly Operating Data is
largely due to the acquisition of Tie Communications, Inc.
As used in the tables below, and throughout this prospectus, EBITDA consists
of earnings before interest (net), income taxes, depreciation and amortization
and other income (expense). EBITDA is a measure commonly used to analyze
companies on the basis of operating performance. It is not a measure of
financial performance under generally accepted accounting principles ("GAAP")
and should not be considered as an alternative to net income (loss) as a
measure of performance or as an alternative to cash flow as a measure of
liquidity. Our measure of EBITDA may not be comparable to similarly titled
measures used by other companies.
<TABLE>
<CAPTION>
For the Three
For the Year Ended Months Ended
December 31, March 31,
------------------- -----------------
1997 1998 1998 1999
--------- --------- ------- --------
(in thousands)
<S> <C> <C> <C> <C>
Operating Statement Data:
Revenue................................ $ 10,210 $ 61,600 $ 6,523 $ 30,481
Cost of sales excluding depreciation... 7,368 43,703 4,798 20,073
Selling, general and administrative.... 10,983 47,862 6,062 23,338
Depreciation and amortization.......... 1,453 7,493 762 2,863
-------- --------- ------- --------
Operating loss....................... (9,594) (37,458) (5,099) (15,793)
Net loss............................... (9,655) (50,576) (5,111) (20,687)
Other Operating Data:
EBITDA................................. $ (8,141) $(29,965) $(4,337) $(12,930)
</TABLE>
<TABLE>
<CAPTION>
1997 1998 1999
------------------------------ --------------------------------- -------
1st 2nd 3rd 4th 1st 2nd 3rd 4th 1st
------ ------ ------ ------ ------ ------- ------- ------- -------
(in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Quarterly Operating
Data:
Revenue................. $ 598 $2,020 $3,144 $4,448 $6,523 $ 7,982 $22,316 $24,779 $30,481
Operating loss.......... (1,191) (1,546) (2,413) (4,445) (5,099) (6,691) (10,554) (15,114) (15,793)
Net loss................ (1,086) (1,586) (2,817) (4,166) (5,111) (11,169) (15,355) (18,941) (20,687)
EBITDA.................. (968) (1,313) (2,117) (3,744) (4,337) (5,500) (7,908) (12,220) (12,930)
</TABLE>
6
<PAGE>
The pro forma balance sheet information below reflects borrowings of $10.0
million under a senior secured credit facility with Goldman Sachs Credit
Partners L.P. which we entered into in June 1999.
The pro forma as adjusted balance sheet information below reflects this
adjustment and:
. the automatic conversion of our convertible preferred stock into
2,666,667 shares of common stock upon completion of this offering; and
. our receipt of net proceeds of $105.3 million from this offering, after
deducting the underwriting discount and estimated offering expenses
payable by us.
<TABLE>
<CAPTION>
As of March 31, 1999
------------------------------
Pro Forma
Actual Pro Forma As Adjusted
------- --------- -----------
(in thousands)
<S> <C> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and short-term
investments................................... $26,277 $35,807 $139,138
Restricted cash (1)............................ 52,825 52,825 52,825
Working capital................................ 22,366 31,896 137,173
Goodwill, net.................................. 49,035 49,035 49,035
Total assets................................... 199,325 209,325 312,656
Total debt..................................... 174,937 184,937 182,991
Total liabilities.............................. 221,264 231,264 229,318
Convertible preferred stock.................... 19,300 19,300 --
Shareholders' equity (deficit)................. (41,239) (41,239) 83,338
</TABLE>
- --------
(1) Approximately $48.6 million of this amount represents a portion of the
proceeds from the sale of our 13% Senior Notes which was deposited in an
escrow account to fund the first six interest payments on our 13% Senior
Notes, the first of which was paid in October 1998 and the second of which
was paid in April 1999.
7
<PAGE>
RISK FACTORS
An investment in our common stock involves a high degree of risk. Before you
invest in our common stock, you should consider carefully the risks described
below, together with all of the other information included in this prospectus.
Some of the information in this prospectus contains forward-looking
statements that involve substantial risks and uncertainties. You can identify
these statements by forward-looking words such as "may," "will," "expect,"
"anticipate," "believe," "estimate" and "continue" or similar words. You should
read statements that contain these words carefully because they: (1) discuss
our future expectations; (2) contain projections of our future results of
operations or of our financial condition; or (3) state other "forward-looking"
information. We believe that it is important to communicate our future
expectations to our investors. However, there may be events in the future that
we have not accurately predicted or over which we have no control. These events
may include our future operating results, our ability to implement our business
plan, our efforts to address Year 2000 issues and potential competition, among
other things. The risk factors listed in this section, as well as any
cautionary language in this prospectus, provide examples of risks,
uncertainties and events that may cause our actual results to differ materially
from the expectations we describe in our forward-looking statements. Before you
invest in our common stock, you should be aware that the occurrence of the
events described in these risk factors and elsewhere in this prospectus could
have a material adverse effect on our business, financial condition and results
of operations and on the price of our common stock.
We Have a Limited Operating History
We have only been operating since March 1996. Accordingly, we have a limited
operating history upon which an evaluation of our performance and prospects can
be based. We face all of the risks common to companies in their early stage of
development in an emerging industry, including:
.undercapitalization;
.cash shortages;
.high capital expenditures;
.an unproven business model;
.difficulties in managing rapid growth; and
.lack of sufficient customers, revenue, cash flow or EBITDA to be self-
sustaining.
In addition, since we are a new company, we have limited experience in
providing some of the products and services we currently offer, including
Internet access, web development and hosting services, electronic commerce
solutions, virtual private networks, frame relay and transport services. Our
failure to address any of the risks described above could have a material
adverse effect on our business, financial condition and results of operations
and on the price of our common stock.
We Have Experienced Increasing Negative EBITDA, Operating Losses and Net Losses
Since our formation we have generated larger negative EBITDA, operating
losses and net losses each quarter. For 1998, we had negative EBITDA of $30.0
million, an operating loss of $37.5 million and a net loss of $50.6 million.
For the first quarter of 1999, we had negative EBITDA of $12.9 million, an
operating loss of $15.8 million and a net loss of $20.7 million. These trends
will need to be reversed or our common stock will lose its value. We cannot
assure you that we will achieve or sustain positive EBITDA, operating income or
net income in the future. If we cannot, we may not be able to meet our working
capital requirements or pay interest on our debt, which would have a material
adverse effect on our business, financial condition and results of operations
and on the price of our common stock. See "--We May Require Significant Amounts
of Additional Capital" below and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
8
<PAGE>
We Have an Unproven Business Model
Our business strategy is unproven. To be successful, we must convince
prospective customers to entrust their data and voice operations to a company
without a long and proven track record. We are not aware of any companies that
have a directly comparable business. We cannot assure you that our services
will be widely accepted. The prices we charge for services and products may be
higher than those charged by our competitors. In addition, the prices of
communications services and products have fallen historically, and we expect
them to continue to fall. We may be required to reduce prices periodically to
respond to competition and to generate adequate sales volume. The failure to
achieve or sustain adequate pricing levels or to achieve or sustain a
profitable business would have a material adverse effect on our business,
financial condition and results of operations and on the price of our common
stock. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
Enterprise Network Services is a New Business Area
Currently there is no significant established market for Enterprise Network
Services. We have derived virtually all of our revenue from the sale of data
and voice products and services, not Enterprise Network Services. Our revenue
from the sale of Enterprise Network Services has been limited and we did not
have any revenue from these services until late 1997 and had only $2.0 million
of such revenue in 1998. We have now entered into long-term Enterprise Network
Services contracts with 23 customers, representing approximately $16.2 million
in contract value. We generated approximately $733,000 in revenue from
Enterprise Network Services contracts for the first quarter of 1999. We may not
be able to foresee future difficulties in providing these services. Although we
intend to substantially increase our revenue from our Enterprise Network
Services, there is limited historical information about our ability to enter
into and service these contracts. As a result, we have a limited basis upon
which you can evaluate our past or future performance. If we fail to develop a
market for our Enterprise Network Services, there will be a material adverse
effect on our business, financial condition and results of operations and on
the price of our common stock.
We Have Substantial Leverage and Debt Service Obligations
We have a significant amount of debt in relation to our equity. At March 31,
1999, we had $174.9 million in debt and a $41.2 million shareholders' deficit.
After this offering, we expect to have $183.0 million in debt and $83.3 million
in shareholders' equity. We expect to incur substantial additional debt. Our
relatively high leverage could negatively affect our company in a number of
ways, including:
. making it more difficult to obtain additional financing when needed for
our operations, acquisitions, expansions or financing our Enterprise
Network Services (a service offering in which we own communications
assets inside our customers' premises);
. limiting our flexibility in responding to downturns in the economy or in
our business;
. reducing funds available for other corporate purposes;
. placing us at a disadvantage compared to our competitors who have less
debt; and
. making it more difficult for us to pay our debts.
For example, our 13% Senior Notes require interest payments of $20.8 million
each year. Our operating loss in 1998 was $37.5 million and for the first
quarter of 1999 was $15.8 million. Due to our operating losses we placed
approximately $56.8 million of the proceeds from the sale of our 13% Senior
Notes into an escrow account to provide for the payment of interest on our 13%
Senior Notes through April 1, 2001. Thereafter, a significant portion of our
cash flow from operations, if any, will be dedicated to interest payments on
our debt, thereby reducing funds available for other corporate purposes.
9
<PAGE>
Any of the above described factors could have a material adverse effect on
our business, financial condition and results of operations and on the price of
our common stock.
We May Require Significant Amounts of Additional Capital
If we are not successful in implementing our business plan in a relatively
short period of time, we will need to raise additional funds from other
sources. In addition, we could require additional capital due to material
shortfalls in our operating and financial performance or if we are more
aggressive in our expansion than currently contemplated. We cannot assure you
that we will be successful in raising sufficient debt or equity capital on a
timely basis, on acceptable terms, or at all. If we fail to obtain any
necessary financing, we could be compelled to alter our business strategy,
delay or abandon some of our future plans or expenditures, sell assets or
default on interest payments on our debt. Any of these events would have a
material adverse effect on our business, financial condition and results of
operations and on the price of our common stock. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."
In July 1999, we entered into a $103.5 million equipment credit facility with
Cisco Systems Capital Corporation of which $23.0 million is currently
available. The Cisco facility contains certain customary covenants, including
financial maintenance covenants. Some of the financial maintenance covenants
are aggressive and may require us to accelerate our business plan or
renegotiate the covenants in the future in order to satisfy those covenants or
avoid a potential default under the facility. We cannot provide you any
assurance that we will be able to satisfy these financial maintenance
covenants.
We Face Risks Involving Acquired Businesses
We have grown rapidly over the past two years by acquiring other businesses.
We expect that a portion of our future growth will result from selective
strategic acquisitions. Growth through acquisitions entails numerous risks,
including:
. difficulties in assimilating the operations, personnel, products,
technologies and financial, computer, payroll and other systems of the
acquired businesses;
. diversion of resources from our existing businesses, including potential
distraction of our management team;
. entering geographic and business markets in which we have little or no
prior experience;
. unanticipated liabilities or contingencies of acquired businesses;
. dilution to existing shareholders if we use stock to acquire businesses;
. amortization of goodwill from acquired businesses, which will reduce our
earnings per share; and
. the potential loss of key employees or customers of the acquired
businesses.
We have encountered most of these issues in the past. For example, as a
result of our acquisitions, we currently have three different operational
support systems which we have not fully integrated, have issued approximately
2,500,000 shares of common stock and, at March 31, 1999, had $49.0 million of
goodwill, net of amortization, which is being amortized over 10 years. We may
encounter any of these issues in the future. In particular, we may issue common
stock to pay for acquisitions.
In August, 1998, we acquired substantially all the assets of Tie
Communications, Inc. which was a substantially larger business than we were.
Tie had 452 employees at June 30, 1998 and had 1997 revenue of $95.4 million
derived primarily from the sale of voice services and products. We had 274
employees at June 30, 1998, and had 1997 revenue of $10.2 million derived
primarily from the
10
<PAGE>
sale of data services and products. The Tie acquisition brought us into 24
additional geographic markets. We have not completed the integration of the Tie
business. In addition, part of Tie's operating system is not Year 2000
compliant. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Impact of the Year 2000 Issue." As a result, the risks
discussed above still apply to the Tie acquisition, particularly the risks of
assimilating operational support systems and the risks associated with entering
geographic markets in which we have little or no prior experience.
We cannot assure you that we will be able to integrate successfully any
businesses that we might acquire in the future or that we will be able to
complete the integration of Tie's business successfully. Our failure to do so
could have a material adverse effect on our business, financial condition and
results of operations and on the price of our common stock.
Our Switching Platform Has a Very Limited Performance History
Our multi-service data and voice switching platforms incorporate a number of
independent components manufactured by other companies. While all of the
components of our switching platforms have established histories of successful
performance as individual products, our unique integrated architecture has a
very limited operating history. We have deployed our switching platforms in
only three of our markets.
During the next 36 months, we intend to install 50 switching platforms that
will utilize a new switch being manufactured by Cisco Systems, Inc. Currently,
Cisco is the only manufacturer of this switch and we believe we will be the
first company to deploy this switch nationwide. Any failure by Cisco to provide
these switches to us on a timely basis would delay the roll-out of our data
service capabilities and our business plan.
If any of our switching platforms contain undetected design faults or "bugs,"
interruption of service to our customers or delay in our deployment could
negatively affect our financial performance. We cannot assure you that our
switching platforms will perform as expected or that we will be successful in
deploying them in all of our markets in a timely manner. These factors could
have a material adverse effect on our business, financial condition and results
of operations and on the price of our common stock.
We Face Risks Associated with Implementing Our Business and Growth Strategies
We are highly leveraged. Our high leverage makes our success, and the return
to our shareholders, extremely dependent on our ability to successfully
implement our business and growth strategies. We are expanding rapidly. This
expansion has increased our operating complexity and strains our management
resources. The successful expansion and development of our operations
(including the acquisition of additional businesses) depends on a number of
factors including our ability to:
. design, market and sell new products and services;
. maintain a high level of quality for our services and products while
controlling costs;
. develop new customer relationships and achieve a sufficient customer
base;
. increase brand recognition;
. access potential markets;
. identify, complete and integrate suitable acquisitions;
. obtain any required government authorizations, franchises and permits;
. hire and retain qualified personnel;
11
<PAGE>
. obtain financing; and
. install and operate our multi-service switching platform.
Our failure to accomplish any of the foregoing could have a material adverse
effect on our business, financial condition and results of operations and on
the price of our common stock.
We Are Still Developing Our Operational Support System
We are in the process of developing an advanced operational support system
which is designed to integrate all of our internal support systems and include
a full array of order management, customer service, billing and financial
applications. Our operational support system is designed to permit customer
care, sales engineering, service management, service delivery, accounting and
inventory sales management personnel to access a single customer record. We
believe that our operational support system is a critical element in providing
customer care. However, we have not completed the integration of all
applications that will be part of our operational support system. We also have
not completed the integration of some of our more recently acquired businesses,
including Tie Communications, with our operational support system. Our failure
to successfully and timely:
. implement all applications of our operational support system,
. integrate all the customer records and the billing, ordering, inventory,
management, accounting and other financial information systems of the
businesses we have acquired or will acquire onto our operational support
system,
. identify all of our information and processing needs,
. repair "bugs" and design defects that may exist in our operational
support system, and
. maintain and upgrade our operational support system as necessary,
could have a material adverse effect on our business, financial condition and
results of operations and on the price of our common stock.
Voice Over Internet Protocol is New Technology
We face risks in deploying voice over Internet Protocol technologies, which
are new, developing and unproven. We currently carry voice calls on some local
area networks, wide area networks, virtual private networks and the networks
inside the premises of our Enterprise Network Services customers through the
use of Internet Protocol. We plan to use Internet Protocol to carry all our
customers' voice calls on our network in the future. Traditionally, voice calls
have been transmitted by keeping a circuit or line between the people on the
call constantly open. This method of transmitting voice calls is inefficient
because during conversations there are pauses and periods of silence when the
capacity of the circuit is not being used. Voice over Internet Protocol
transmission is designed to eliminate this inefficiency. This technology breaks
the voice conversation into "packets" of information and sends those packets
over transmission lines individually. The packets are then re-assembled at or
near their destination so the parties are able to have a conversation. When the
parties on the call pause or are silent, there are no packets transmitted and
the transmission lines can be used for other purposes. This technology promises
to substantially reduce the cost of carrying voice conversations.
Voice over Internet Protocol transmission is under development, is extremely
complex and we are currently using it only to carry voice transmissions on the
local area networks, wide area networks, virtual private networks and the
networks inside the premises of our Enterprise Network
12
<PAGE>
Services customers. Some telecommunications companies (including ICG
Communications, Inc., IDT Corporation and RSL Communications Ltd.) are carrying
calls over similar technologies today and many others are developing this
technology (including Sprint Corporation). However, we believe that their
transmission quality for external calls over IP networks is not yet as good as
the quality of traditional voice transmission methods. Accordingly, there is a
risk that we will not be able to develop this technology well enough to be able
to use it for all of our customers' voice traffic and, therefore, will not be
able to enjoy the cost reductions it promises.
However, we are making a large capital investment in this new technology. The
50 switches we expect to buy from Cisco Systems, Inc. are designed to be able
to provide voice transmission over Internet Protocol. If we are not eventually
able to provide voice over IP transmission with these switches for all of our
customers' voice traffic, some of the value of our investment in these switches
may be lost. Furthermore, it is not clear today which of the emerging versions
of this technology will prevail. Many telecommunications companies have far
more experience with these types of issues than we do. Our failure to
successfully offer Internet Protocol transmission on our network for all our
customers' voice traffic could have a material adverse effect on our business,
financial condition and results of operations and on the price of our common
stock.
We Are Dependent Upon the Products and Services of Others
Successful operation of our business requires that we provide superior
products and services. Although we can exercise direct control over the
customer care and support services we provide, many of the products and
services we offer are provided by others. These products and services are
subject to physical damage, power loss, capacity limitations, software defects,
breaches of security (by such things as computer viruses and "hackers") and
other factors. These problems, even if not caused by us, could lead to a
decrease in our revenue and as a result could have a material adverse effect on
our business, financial condition and results of operations and on the price of
our common stock.
We Have a Long Sales Cycle and Upfront Expenses for Enterprise Network Services
The Enterprise Network Services solutions we offer have not historically been
available to small and medium sized businesses. As a result, making a sale
often requires a significant amount of time and upfront expense to educate
customers regarding the benefits of Enterprise Network Services. Potential
Enterprise Network Services customers tend to engage in extensive internal
reviews before deciding to engage us. Due to the long sales cycle, our revenues
may fluctuate substantially and any given period may include substantial
selling expenses without related revenue. These risks could have a material
adverse effect on our business, financial condition and results of operations
and on the price of our common stock.
There Are Credit Risks Associated with Leasing Equipment and with Providing
Enterprise Network Services
When a company agrees to become one of our Enterprise Network Services
customers, we purchase and own all or a portion of the customer's existing
communications equipment. We may also purchase and own additional
communications equipment and install it on the customer's premise. The customer
agrees to pay us a monthly charge for a fixed term, usually three to five
years. In addition, we provide leasing options for our customers who prefer to
lease our communications equipment rather than contract for our Enterprise
Network Services. If a customer defaults on a payment under an Enterprise
Network Services contract or a lease, we will have the right to remove our
property from the customer's premises. If we are forced to remove our equipment
due to a customer's failure to pay, there are likely to be substantial delays
and expenses in removing our equipment, and the equipment may be damaged or
become obsolete in the interim, thereby
13
<PAGE>
making it more difficult to reuse or resell the equipment. In addition, we may
not be able to resell the equipment at a price that allows us to recover our
cost. We have limited experience dealing with the risks posed by a payment
default, and such risks could have a material adverse effect on our business,
financial condition and results of operations and on the price of our common
stock.
Tie Communications Had Financial Problems in the Past
At the time we acquired the assets of Tie Communications, Tie was in
bankruptcy. Although we believe that Tie's previous financial difficulties were
the result of problems which we did not acquire, we cannot assure you that we
will be able to remedy all of the problems which led to Tie's bankruptcy. Tie
also had previously declared bankruptcy in 1991, primarily as a result of an
inability to service its indebtedness. If we fail to remedy Tie's financial
problems, it could have a material adverse effect on our business, financial
condition and results of operations and on the price of our common stock.
We Are Subject to Fluctuations in Our Financial Results
Our revenue and operating results have in the past varied and in the future
may vary significantly from quarter to quarter and from year to year as a
result of a number of factors. These factors may include:
. the size and timing of contracts for Enterprise Network Services;
. customer requirements;
. the ability to retain and expand sales to existing customers;
. our ability to maintain or increase current rates of sales productivity;
. the level of price and product competition; and
. the size and timing of future acquisitions.
As a result of all of these factors, it is possible that in any future quarter
our operating results could be below the expectations of securities analysts
and investors. In this event, there could be a material adverse effect on the
price of our common stock.
We Face Risks Selling Used Equipment We Purchase
Our Enterprise Network Services strategy includes purchasing our customers'
equipment, such as private branch exchanges (PBXs), computers and other data
and voice equipment. The equipment we purchase from customers may be replaced
by more technologically advanced equipment. To maintain our margins for
Enterprise Network Services, we will need to resell the used equipment. In
addition, we lease equipment to some of our customers, and that equipment may
also need to be sold at the end of the lease term. Some of the equipment may be
damaged or obsolete when we try to resell it. The pricing of our Enterprise
Network Service contracts and our leases is based on our assumptions regarding
timing and resale prices for this used equipment. However, we might not be able
to resell this used equipment in a timely manner at acceptable prices, and any
failure to do so could have a material adverse effect on our business,
financial condition and results of operations and on the price of our common
stock.
14
<PAGE>
Future Sales of Our Stock May Negatively Affect Our Stock Price
The market price of our common stock may fall as a result of sales of a large
number of shares in the market or the perception that such sales could occur.
At the closing of this offering, based on shares of common stock outstanding as
of May 31, 1999, plus 1,673,916 shares issued after May 31, 1999, as a result
of the exercise of warrants, there will be 26,193,740 shares of our common
stock outstanding. Of those shares, all of the shares sold in this offering
will be freely transferable without restriction under the Securities Act of
1933. Shares of common stock outstanding after this offering will be available
for sale in the public market, subject to applicable volume and manner of sale
restrictions under Rule 144, as follows:
<TABLE>
<CAPTION>
Number of
Date of Availability for Sale Shares
----------------------------- ----------
<S> <C>
Upon closing of this offering..................................... 9,379,111
180 days after the closing of this offering....................... 12,708,903
270 days after the closing of this offering....................... 4,105,726
----------
Total Additional Shares Available for Sale...................... 26,193,740
==========
</TABLE>
In addition, the holders of approximately 6.8 million shares of common stock
(including shares in the preceding table) and warrants to purchase common stock
have contractual registration rights with respect to their shares. For a more
complete discussion of these matters, see "Shares Eligible for Future Sale."
We Face Competition From Many Sources
We compete for business with many companies that have much greater financial
resources, are more geographically diverse, have better name recognition and
have larger customer bases than we do. Numerous competitors with long-standing
relationships with our potential customers offer one or more of the individual
products and services we offer. We expect that we will face substantial and
growing competition from a number of providers of data and voice networking and
transport services and products.
A continuing trend toward business combinations and alliances in the
telecommunications industry may create significant new competitors with
resources far greater than ours. Technological developments may allow other
companies to provide a single-source solution in competition with our product
offerings. Cisco and other hardware manufacturers have designed or are
designing multi-service data and voice switches that are or will be available
to other providers.
To the extent that competitors begin bundling components of our Enterprise
Network Services (including data networking and the provision of customer
premises equipment) into their own product offerings, we will face additional
competition.
In data services, we compete with, among others, International Network
Services, Inacom Corporation, CompuCom Systems, Inc. and Norstan Consulting,
Inc. In the frame relay services market, we compete with, among others, MCI
WorldCom, Inc., AT&T Corporation, Frontier Communications, and Qwest
Communications International, Inc. In data products, we compete with, among
others, U S WEST, Inc., CompuCom and Inacom.
In voice services, we have numerous competitors in the local and long-
distance markets. Our main competitors for local voice services include the
Regional Bell Operating Companies, as well as agents who resell Bell services,
AT&T, MCI WorldCom and ITC/\Deltacom, Inc. and other competitive local exchange
carriers. In the long-distance market, our competitors include MCI WorldCom,
Qwest, Sprint Corporation and AT&T. In voice products, we compete with, among
others, Norstan, Staples, Inc. and Advanced Telecommunications, Inc.
Intensifying competition could have a material adverse effect on our
business, financial condition and results of operations and on the price of our
common stock.
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<PAGE>
We Are Subject to FCC and State Public Utility Commission Regulations
We are subject to both federal and state regulation. In rendering our
interstate and international telecommunications services, we must comply with
federal telecommunications laws and regulations prescribed by the Federal
Communications Commission. At the state level, we are subject to regulation by
the various state public utility commissions.
Among other things, the Telecommunications Act of 1996 opened the local
telecommunications marketplace to competition, allowing companies like us to
compete with incumbent local exchange companies. The implementation of the
Telecommunications Act of 1996 is ongoing and is the subject of proceedings
before the FCC, the various state public utility commissions and the courts. As
a result, the regulatory framework that we operate under is unsettled. We could
also become subject to additional regulatory requirements as a result of a
change in our product offerings. If we are required to comply with new
regulations or new interpretations of existing regulations, this compliance
could have a material adverse effect on our business, financial condition and
results of operations and on the price of our common stock. See "Business--
Regulatory Environment."
Factors Exist Which Could Discourage an Acquisition of Our Company
There are several factors that could deter an attempt to acquire our company.
These factors reduce the chance that our shareholders will be able to sell
their shares in an acquisition. These factors include:
. the rights of the holders of our 13% Senior Notes to require us to
repurchase their Notes if anyone acquires more than 50% of our voting
stock;
. the ability of our board of directors to issue preferred stock without
any further approval being required from our shareholders;
. the concentration of ownership of our stock by our officers and directors
following the offering; and
. the "staggered" nature of our board of directors which results in
directors being elected for terms of three years.
See "Description of Indebtedness," "--Our Principal Shareholders Will Have
Significant Influence," and "Description of Capital Stock."
Our Success Depends on Our Executive Officers and Employees
Our success depends to a significant degree on the abilities and continued
efforts of our senior management. Our success also will depend on our ability
to attract, retain, and motivate qualified management, marketing, technical and
sales personnel. These people are in high demand and often have competing
employment opportunities. The labor market for engineers, technicians and sales
representatives who are skilled in both voice and data communications systems
is extremely competitive due to limited supply and we may lose key employees or
be forced to increase their compensation. Employee turnover could significantly
increase our training and other related employee costs. Additionally, there are
low levels of unemployment in many of the regions in which we operate. These
low levels of unemployment have led to pressure on wage rates, which can make
it more difficult and costly for us to attract and retain qualified employees.
The loss of key personnel, or the failure to attract additional personnel,
could have a material adverse effect on our business, financial condition and
results of operations and on the price of our common stock.
Our Principal Shareholders Will Have Significant Influence
Upon the completion of this offering, our officers and directors will
beneficially own approximately 28.96% of our common stock, including
approximately 12.36% beneficially owned by our three founding shareholders and
their families. Our founding shareholders and their families are parties to
16
<PAGE>
a voting agreement pursuant to which they have agreed to vote their common
stock as a group. Accordingly, our officers and directors, and particularly our
founding shareholders, are likely to continue to exercise substantial influence
over our business and the election of members of our board of directors. This
concentration of ownership may also delay or prevent an attempt to acquire our
company. See "Principal and Selling Shareholders."
We Face the Risk of System Failure
Our operations are dependent upon our ability to support our network
infrastructure and avoid damage from fires, earthquakes, floods, power losses,
telecommunications failures, network software flaws, transmission cable cuts
and similar unforeseen events. The occurrence of a natural disaster or other
unanticipated problems at our national operations center or any of our regional
centers could cause interruptions in our services. In addition, failures by our
service providers could cause interruptions in our services. Any damage or
failure that causes interruptions in our services could have a material adverse
effect on our business, financial condition and results of operations and on
the price of our common stock.
We Face Year 2000 Risks
The year 2000 issue is the result of computer programs having been written
using two digits rather than four to define the applicable year. This
programming defect could result in date-sensitive software recognizing a date
using "00" as the year 1900 rather than the year 2000. This error could result
in a system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices, provide data or voice services or engage in similar normal
business activities. We have identified portions of two of our systems acquired
in recent acquisitions that are not currently year 2000 ready. If our systems
or the systems of other companies on whose services we depend or with whom our
systems interface are not year 2000 ready when they need to be, any resulting
disruptions could have a material adverse effect on our business, financial
condition and results of operations and on the price of our common stock. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
In addition, spending on voice and data network equipment may decrease in the
second half of 1999 as customers focus on year 2000 readiness and systems
testing rather than investing in new products. As a result, our revenues from
the sale of voice and data products and network systems could be adversely
affected, which in turn could have a material adverse effect on our business,
financial condition and results of operation and on the price of our common
stock.
Terms of Our Indebtedness Restrict Our Corporate Activities
The terms of the indenture governing our 13% Senior Notes and our credit
facilities restrict, and in some cases significantly limit or prohibit our
ability and the ability of our subsidiaries to:
.pay dividends and make other distributions on capital stock and redeem
capital stock;
.incur additional indebtedness or refinance existing indebtedness;
.make prepayments of certain indebtedness;
.create liens on our assets;
.make investments;
.engage in transactions with shareholders and affiliates;
.engage in mergers and consolidations; and
.engage in sales of assets.
We cannot assure you that the covenants in our indenture or our credit
facilities will not adversely affect our ability to finance our future
operations or capital needs or to engage in other
17
<PAGE>
business activities that may be in the best interests of our shareholders. As a
result, these restrictive covenants could have a material adverse effect on our
business, financial condition and results of operations and on the price of our
common stock. See "Description of Indebtedness."
Possible Volatility of Our Stock Price
An active trading market for our common stock may not develop or be sustained
after this offering. Together with the underwriters, we will determine the
initial public offering price. The price at which our common stock will trade
after this offering is likely to be volatile and may fluctuate substantially
due to factors such as:
. our historical and anticipated quarterly and annual operating results;
. variations between our actual results and the expectations of investors
and analysts;
. announcements by us or others and developments affecting our business;
.investor perceptions of our company and comparable public companies; and
. conditions and trends in data and voice communications industries.
In particular, the stock market has from time to time experienced significant
price and volume fluctuations affecting the common stocks of communications
companies, like us. These fluctuations may result in a material decline in the
market price of our common stock.
We Do Not Expect to Pay Dividends
We have not declared or paid, and for the foreseeable future we do not
anticipate declaring or paying, dividends on our common stock. In addition, the
agreements governing our indebtedness, including the indenture for our 13%
Senior Notes and our credit facilities, limit our ability to pay dividends on
our common stock.
An Economic Downturn May Have an Adverse Effect on Our Company
If the general economic health of the United States declines from recent
historically high levels, or if companies fear such a decline is imminent,
companies may reduce expenditures for products and services such as ours. Any
decline or concern about an imminent decline in the economy could delay
decisions among our customers to utilize more of our products and services or
could delay decisions by prospective customers to make initial evaluations of
our services. These delays would have a material adverse effect on our
business, prospects, financial condition and results of operations and on the
price of our common stock.
Dilution
If you buy shares in this offering, you will incur immediate, substantial
dilution. To the extent outstanding warrants and options to purchase our common
stock are exercised or additional equity securities are issued at a price below
the price of a share in this offering, you may experience further dilution. See
"Dilution."
We May Face Potential Liability for Information Disseminated through Our
Network
The law relating to the liability of online service providers, private
network operators and Internet service providers for information carried on or
disseminated through their networks is currently unsettled. The potential
liability for material carried on or disseminated through our systems which
might include defamatory statements and materials infringing on copyrights,
could require us to implement measures to reduce our exposure to such
liability, which may require the expenditure of substantial resources or the
discontinuation of certain product or service offerings. In addition, the costs
incurred in defending against any claims and the potential adverse outcomes of
those claims could have a material adverse effect on our business, financial
condition and results of operations and on the price of our common stock.
18
<PAGE>
USE OF PROCEEDS
We will receive estimated net proceeds from this offering of approximately
$105.3 million ($122.9 million if the underwriters' over-allotment option is
exercised in full) after deducting the estimated underwriting discount and
offering expenses payable by us. We will use these proceeds for general
corporate purposes, including working capital requirements, capital
expenditures, acquisitions, debt payments and to fund continued operating
losses. In addition, we will use approximately $2.0 million to repay the
remaining balance of $456,000 on an 11% promissory note due July 1999 and
$1,490,000 on an 8% promissory note due February 2000. These notes were issued
in connection with the March 1999 acquisition of Kansas Communications, Inc.
Pending these uses, we intend to invest the net proceeds from this offering in
short-term, investment-grade, interest-bearing securities.
We will not receive any of the proceeds from the sale of 723,271 shares of
common stock by the selling shareholders. We will, however, pursuant to
contractual commitments with most of the selling shareholders, use
approximately $0.7 million of our proceeds to pay the underwriting discounts
applicable to the shares sold by the selling shareholders, as part of our
offering expenses. See "Underwriting."
CORPORATE INFORMATION
Convergent Communications, Inc. was founded in December 1995 and first
capitalized on March 1, 1996. References in this prospectus to "Convergent
Communications", "us", "we" and "our" refer to Convergent Communications, Inc.,
a Colorado corporation, and its subsidiaries.
Convergent Communications(TM), Enterprise Network Carrier(TM), Computer-
Telephony Integrated Support System(TM), Netnomics(TM), ePOP(TM),
converg.com(TM), Convergent Communications, Inc.'s logo and various other words
and logo marks are trademarks or service marks of Convergent Communications and
are the subject of pending trademark and servicemark applications in the United
States and other countries.
DIVIDEND POLICY
We have never paid cash dividends on our common stock. We currently intend to
retain future earnings, if any, to fund the development and growth of our
business. Therefore, we do not currently anticipate paying any dividends in the
foreseeable future. In addition, our credit facilities and the indenture
governing our 13% Senior Notes contain restrictions on our ability to pay
dividends or make payments or other distributions on our capital stock.
Currently, these restrictions prohibit the payment of dividends on our common
stock.
19
<PAGE>
DILUTION
For the calculations set forth below, the number of shares that will be
outstanding after this offering is based on the number outstanding as of March
31, 1999, plus the number of shares of common stock we will sell in this
offering and 2,666,667 shares of common stock to be issued upon the automatic
conversion of all of our convertible preferred stock at the completion of this
offering based upon an initial public offering price of $15.00 per share. In
addition, the number of outstanding shares assumes no exercise of stock options
or warrants. As of March 31, 1999, there were options and warrants outstanding
to purchase an aggregate of 9,791,769 shares of common stock at a weighted
average exercise price of $6.60 per share, with individual exercise prices
ranging from $0.02 to $20.00 per share. The exercise of these options and
warrants will result in further dilution to new investors.
Our pro forma negative net tangible book value at March 31, 1999 was $(81.3)
million or $(4.92) per share of outstanding common stock, after giving effect
to the conversion of our convertible preferred stock into 2,666,667 shares of
common stock and $10.0 million of borrowing in June 1999 under a senior secured
credit facility with Goldman Sachs Credit Partners L.P. The pro forma negative
net tangible book value per share represents our total tangible assets less
total liabilities, divided by 16,627,019 shares of common stock outstanding on
a pro forma basis before this offering. Dilution per share represents the
difference between the amount per share paid by investors in this offering and
the pro forma as adjusted net tangible book value per share after this
offering. After giving effect to the pro forma adjustments and the sale of the
shares of common stock by us at an initial public offering price of $15.00 per
share (less estimated underwriting discounts and commissions and expenses we
expect to pay in connection with this offering), our pro forma as adjusted net
tangible book value at March 31, 1999 would have been $23.5 million or $0.97
per share. This represents an immediate increase in the net tangible book value
of $5.89 per share to existing shareholders and an immediate dilution in the
net tangible book value of $14.03 per share to new investors purchasing shares
at the initial public offering price. The following table illustrates this per
share dilution:
<TABLE>
<S> <C> <C>
Initial public offering price per share....................... $15.00
Pro forma negative net tangible book value per share
as of March 31, 1999....................................... $(4.92)
Increase per share attributable to new investors............ $ 5.89
------
Pro forma as adjusted net tangible book value per share
after this offering........................................ $ 0.97
------
Dilution per share to new investors........................... $14.03
======
</TABLE>
The following table summarizes, on a pro forma as adjusted basis as of March
31, 1999, the difference between the existing shareholders and new investors
with respect to the number of shares of common stock purchased from us, the
total consideration paid to us and the average price per share paid, assuming
new investors pay $15.00 per share in this offering (before deducting estimated
underwriting discounts and commissions and other expenses in this offering):
<TABLE>
<CAPTION>
Shares Purchased Total Consideration
------------------ -------------------- Average Price
Number Percent Amount Percent per Share
---------- ------- ------------ ------- -------------
<S> <C> <C> <C> <C> <C>
Existing
shareholders(1)........ 16,627,019 68.4% $ 51,167,200 30.8% $ 3.08
New investors(1)........ 7,676,729 31.6 115,150,935 69.2 $15.00
---------- ----- ------------ -----
Total................. 24,303,748 100.0% $166,318,135 100.0%
========== ===== ============ =====
</TABLE>
- --------
(1) Sales by the selling shareholders in this offering will reduce the number
of shares held by existing shareholders to 15,903,748, or approximately
65.4% of the total number of shares of common stock outstanding after this
offering (or approximately 62.2% if the underwriters exercise their over-
allotment option in full), and will increase the number of shares held by
new investors to 8,400,000, or approximately 34.6% of the total number of
shares of common stock outstanding after this offering (or 9,660,000 shares
and approximately 39.8% if the underwriters exercise their over-allotment
option in full).
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<PAGE>
CAPITALIZATION
You should read this table in conjunction with our consolidated financial
statements and accompanying notes included elsewhere in this prospectus. The
following table sets forth our actual and as adjusted capitalization as of
March 31, 1999. Our pro forma capitalization reflects borrowings in June 1999
under the $10.0 million senior secured credit facility with Goldman Sachs
Credit Partners L.P. Our pro forma as adjusted capitalization also reflects:
. our receipt of estimated net proceeds of $105.3 million from the
sale of shares of common stock by us in this offering, and
. the automatic conversion of all shares of our convertible preferred
stock into 2,666,667 shares of common stock upon completion of this
offering.
<TABLE>
<CAPTION>
March 31, 1999
--------------------------------
Pro Forma
Actual Pro Forma As Adjusted
-------- --------- -----------
(in thousands, except share
amounts)
<S> <C> <C> <C>
Cash, cash equivalents and short-term
investments .................................. $ 26,277 $ 35,807 $139,138
Restricted cash(1)............................. 52,825 52,825 52,825
-------- -------- --------
Total restricted and non-restricted cash... $ 79,102 $ 88,632 $191,963
======== ======== ========
Long-term debt, less current portion(2)........ $154,594 $164,594 $164,594
Long-term capital leases, less current
portion(3).................................... 9,186 9,186 9,186
-------- -------- --------
Total long-term debt, less current
portion................................... 163,780 173,780 173,780
-------- -------- --------
Preferred stock, 1 million shares authorized,
800,000 shares of convertible preferred stock
issued and outstanding on an actual and pro
forma basis and no shares outstanding on a pro
forma as adjusted basis ...................... 19,300 19,300 --
Shareholders' equity:
Common shares, no par value, 100,000,000
shares authorized, 13,960,352 shares issued
and outstanding on an actual and pro forma
basis and 24,303,748 shares issued and
outstanding on a pro forma as adjusted
basis........................................ 27,806 27,806 152,383
Warrants(4)................................... 12,172 12,172 12,172
Accumulated other comprehensive income........ 12 12 12
Unearned compensation......................... (137) (137) (137)
Accumulated deficit........................... (81,092) (81,092) (81,092)
-------- -------- --------
Total shareholders' equity (deficit)....... (41,239) (41,239) 83,338
-------- -------- --------
Total capitalization..................... $141,841 $151,841 $257,118
======== ======== ========
</TABLE>
- --------
(1) Approximately $48.6 million of this amount represents a portion of the
proceeds from the sale of the 13% Senior Notes which was deposited into an
escrow account to fund the first six interest payments on the 13% Senior
Notes, the first of which was paid in October 1998 and the second in April
1999.
(2) Long-term debt net of unaccreted discount of $5.4 million relating to the
warrants which were attached to the 13% Senior Notes. Excludes the current
portion of approximately $5.4 million of long-term debt.
(3) Excludes the current portion of approximately $5.8 million of capitalized
leases.
(4) See "Description of Capital Stock--Warrants."
21
<PAGE>
SELECTED FINANCIAL DATA
The following selected financial data should be read along with our
consolidated financial statements and accompanying notes and "Management's
Discussion and Analysis of Financial Condition and Results of Operations," all
of which appear later in this prospectus. The selected financial data, except
for the operating statement data and other operating data for the three months
ended March 31, 1998 and 1999, have been derived from our consolidated
financial statements and the financial statements of our predecessor, which
have been audited by PricewaterhouseCoopers LLP, independent accountants. The
operating statement and other operating data for the three months ended March
31, 1998 and 1999 have been derived from our unaudited financial statements
included later in this prospectus. The operating results for the three months
ended March 31, 1999 are not necessarily indicative of the results that may be
expected for the full year. We prepared these unaudited financial statements on
the same basis as the audited statements and, in the opinion of our management,
made all adjustments, consisting of normal recurring adjustments, necessary for
a fair presentation of the financial position and results of operations for
those periods. On December 17, 1996, we acquired Integrated Communication
Networks, L.C., which is referred to as the "predecessor" for the period prior
to the acquisition. Convergent Communications, since March 1, 1996, together
with Integrated Communication Networks, L.C., since December 17, 1996, is
referred to as the "successor." Share and per share information is not
presented for the predecessor as they are not relevant due to the predecessor's
different capital structure.
<TABLE>
<CAPTION>
PREDECESSOR SUCCESSOR
----------------------------------------- ---------------------------------------------------------
For the Three
For the Year For the Year January 1, 1996 March 1, 1996 For the Year For the Year Months Ended
Ended Ended through through Ended Ended March 31,
December 31, December 31, December 16, December 31, December 31, December 31, -----------------
1994 1995 1996 1996 1997 1998 1998 1999
------------ ------------ --------------- ------------- ------------ ------------ ------- --------
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Operating Statement Data:
Revenue............ $ 988 $1,434 $1,496 $ 98 $ 10,210 $ 61,600 $ 6,523 $ 30,481
Cost of sales
excluding
depreciation...... 729 964 1,018 79 7,368 43,703 4,798 20,073
Selling, general
and
administrative.... 477 405 554 552 10,983 47,862 6,062 23,338
Depreciation and
amortization...... 106 127 124 41 1,453 7,493 762 2,863
------ ------ ------ ------- -------- -------- ------- --------
Total operating
expenses......... 1,312 1,496 1,696 672 19,804 99,058 11,622 46,274
Operating loss.... (324) (62) (200) (574) (9,594) (37,458) (5,099) (15,793)
Interest expense... (15) (17) (21) (1) (155) (17,502) (53) (5,937)
Interest income.... -- -- -- -- 251 4,632 31 951
Other income
(expense)......... (49) -- -- -- (156) (248) 10 92
------ ------ ------ ------- -------- -------- ------- --------
Net loss........... $ (388) $ (79) $ (221) $ (575) $ (9,655) $(50,576) $(5,111) $(20,687)
====== ====== ====== ======= ======== ======== ======= ========
Net loss per share
(basic and
diluted).......... $ (0.15) $ (0.92) $ (3.68) $(0.38) $ (1.48)
Weighted average
shares outstanding
(basic and
diluted).......... 3,887 10,461 13,732 13,479 13,943
Other Operating
Data:
Net cash provided
by (used in)
operating
activities........ $ (217) $ 60 $ (31) $ (242) $ (6,698) $(28,698) $(2,440) $(13,726)
Net cash used in
investing
activities........ (200) (8) (36) (1,446) (11,648) (94,647) 2,570 (20,437)
Net cash provided
by (used in)
financing
activities........ 427 (61) 91 4,849 15,852 148,274 (384) 18,958
EBITDA(1).......... (218) 65 (76) (534) (8,141) (29,965) (4,337) (12,930)
</TABLE>
- --------
(1) As used in this prospectus, EBITDA consists of earnings before interest
(net), income taxes, depreciation and amortization and other income
(expense). EBITDA is a measure commonly used to analyze companies on the
basis of operating performance. It is not a measure of financial
performance under GAAP and should not be considered as an alternative to
net income (loss) as a measure of performance or as an alternative to cash
flow as a measure of liquidity. Our measure of EBITDA may not be comparable
to similarly titled measures used by other companies.
22
<PAGE>
The following balance sheet data, except the data as of March 31, 1999, have
been derived from our consolidated financial statements and the financial
statements of our predecessor, which have been audited by
PricewaterhouseCoopers LLP, independent accountants. The balance sheet
information as of March 31, 1999 has been derived from our unaudited financial
statements included later in this prospectus, which have been prepared on the
same basis as the audited statements and, in the opinion of our management,
contain all adjustments, consisting of normal recurring adjustments, necessary
for a fair presentation of the financial position for that period.
The pro forma balance sheet information as of March 31, 1999 reflects
borrowings in June 1999 under the $10.0 million senior secured credit facility
with Goldman Sachs Credit Partner L.P.
The as adjusted balance sheet information as of March 31, 1999 below reflects
this adjustment and:
. the automatic conversion of our convertible preferred stock into
2,666,667 shares of common stock upon completion of this offering; and
. our receipt of estimated net proceeds of $105.3 million from this
offering, after deducting the underwriting discount and estimated
offering expenses payable by us.
<TABLE>
<CAPTION>
PREDECESSOR SUCCESSOR
------------------------- ---------------------------------------------------------------------
As of
March 31,1999
As of As of As of As of As of ------------------------------
December 31, December 31, December 31, December 31, December 31, Pro Forma
1994 1995 1996 1997 1998 Actual Pro Forma As Adjusted
------------ ------------ ------------ ------------ ------------ ------- --------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
(in thousands)
Balance Sheet:
Cash, cash equivalents
and short-term
investments............ $ 23 $13 $3,161 $ 8,039 $ 25,597 $26,277 $35,807 $139,138
Restricted cash(1)...... -- -- -- 406 51,350 52,825 52,825 52,825
Working capital......... 219 (10) 1,890 5,334 28,500 22,366 31,896 137,173
Goodwill, net........... 228 228 3,201 6,393 46,526 49,035 49,035 49,035
Total assets............ 1,012 797 9,887 24,922 185,656 199,325 209,325 312,656
Total debt.............. 456 440 1,456 1,933 168,268 174,937 184,937 182,991
Total liabilities....... 529 580 1,902 6,194 207,005 221,264 231,264 229,318
Convertible preferred... -- -- -- -- -- 19,300 19,300 --
Shareholders' equity
(deficit).............. 483 217 7,985 18,728 (21,349) (41,239) (41,239) 83,338
</TABLE>
- --------
(1) Approximately $48.6 million of this amount represents a portion of the
proceeds from the sale of our 13% Senior Notes which was deposited in an
escrow account to fund the first six interest payments on our 13% Senior
Notes, the first of which was paid in October 1998 and the second of which
was paid in April 1999.
23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The following discussion should be read along with the consolidated financial
statements and the accompanying notes included later in this prospectus. This
discussion includes forward-looking statements and is based on current
expectations which involve risks and uncertainties. Because of the uncertainty
of many factors, what actually occurs in the future may be very different from
what we project in our forward-looking statements. See "Risk Factors."
Overview
We are a rapidly growing national provider of single-source data and voice
communications systems, services and solutions primarily to businesses with 25
to 500 employees. Inside our customers' premises we own communications networks
and provide professional services, such as the design, installation, management
and monitoring of those networks. Outside our customers' premises we provide a
broad range of data and voice transport services. By operating networks, both
inside and outside our customers' premises, and by offering a broad range of
data and voice products and services, we enable small and medium sized
businesses to use state-of-the-art communications solutions, including data and
voice networks based on Internet Protocol, electronic commerce, the Internet
and sophisticated communications systems. We offer each of our products and
services on a stand-alone basis and are now also offering a bundled
communications solution, which we call Enterprise Network Services, in which we
design, install, own, manage and monitor the data and voice networks inside our
customers' premises and supply transport services outside our customers'
premises.
We were first capitalized in March 1996. Since that time, we have
successfully raised $204.5 million in capital, including $450,000 in founders'
capital, $24.0 million in two private placements of common stock in 1996 and
1997 (including an additional $450,000 from the founders), $160.0 million
through the 1998 sale of our 13% Senior Notes and related warrants and $20.0
million in a 1999 sale of our convertible preferred stock and warrants to
affiliates of Sandler Group. As a result of that investment in our convertible
preferred stock, we also have increased the borrowing capacity under our
existing Comdisco equipment lease facility by $20.0 million to a total of $30.0
million. In June 1999, we entered into a $10.0 million senior secured credit
facility with Goldman Sachs Credit Partners L.P.
In the last three years, we completed 14 strategic acquisitions, the most
significant of which was the 1998 acquisition of substantially all of the
assets of Tie Communications at a cost of approximately $51.4 million. With the
acquisition of these assets, we accelerated our growth by adding 24 new markets
and 452 employees with experience in voice products and services. This
acquisition also gave us the opportunity to cross-market our data products and
services, including Enterprise Network Services, to approximately 77,000
customers that purchased products or services from Tie in the past. In July
1999, we entered into a $103.5 million equipment facility with Cisco Systems
Capital Corporation of which $23.0 million is currently available.
We began offering Enterprise Network Services in December 1997 and have now
entered into long-term Enterprise Network Services contracts with 23 customers
with an aggregate of approximately 1,805 computers and telephones. We expect
these contracts to provide us with approximately $2.8 million in annual
contract revenue, and over their terms we expect them to produce total revenue
of approximately $16.2 million. Although these contracts may be canceled by the
customer, exposing us to risks related to remarketing our equipment,
cancellation requires payment of a fee designed to reimburse us for all or
substantially all of our costs incurred in entering into the contract. See
"Risk Factors--There Are Credit Risks Associated with Our Leasing Equipment and
with Enterprise Network Services."
24
<PAGE>
Description of Financial Components
We classify our business into five segments: data services, voice services,
Enterprise Network Services, data products and voice products.
Revenue and cost of sales. The following chart outlines the components of
revenue and the related cost of sales (excluding depreciation), by segment:
Revenue Cost of Sales (excluding depreciation)
------------------------------------ -----------------------------------
Data Services
Professional Services . engineer and technician
web design and hosting and network compensation and benefits
planning, design, maintenance, and
monitoring
Network Services . leased line costs of connecting
frame relay (ATM and IP a customer to a long distance or
switching), Internet access and local network
web hosting
. capacity charges that long
distance and local carriers,
Internet service providers and
others impose to use their
equipment and network
----------------
Voice Services
Professional Services
network planning, design, . engineer and technician
maintenance and monitoring compensation and benefits
Network Services . leased line facilities' costs of
long distance service, local connecting a customer to a long
telephone service and public phone distance or local network
service
. capacity charges that long
distance and local carriers,
Internet service providers and
others impose to use their
equipment and network
----------------
Enterprise Network Services . all the costs associated with
long-term contracts (typically all the data and voice products
three to five years) under which and services described in this
we own, manage and are table
responsible for all or a portion
of the network inside our
customers' premises
----------------
Data Products . cost of data network equipment
sale and installation of network . costs of installation, including
equipment technician compensation and
benefits
----------------
Voice Products
sale and installation of network . cost of voice network equipment
equipment . costs of installation, including
technician compensation and
benefits
25
<PAGE>
Selling, general and administrative expenses have increased significantly and
will continue to increase as we recruit additional management and support
personnel necessary for continued growth. The Tie acquisition contributed
substantially to this increase. However, we expect these expenses to decline as
a percentage of our revenue as we expand our customer base and begin selling
additional products and services in each of our markets.
. Sales and marketing expenses include commissions paid in connection with
our sales programs, marketing salaries and benefits, travel expenses,
trade show expenses, consulting fees and promotional costs. Also included
are the costs of soliciting potential customers such as telemarketing,
brochures, targeted advertising and promotional campaigns. We expect
these expenses to increase as we add additional sales and marketing
personnel and further implement our business plan.
. General and administrative expenses primarily consist of salaries and
related expenses of management and support services personnel, occupancy
fees, professional fees and general corporate and administrative
expenses. We also include costs associated with the development, support
and enhancements of our operational support software platform, to the
extent these costs are not capitalized.
Depreciation and amortization expense includes depreciation of property,
network and equipment (over two to five years), including our assets located
inside our customers' premises provided under Enterprise Network Services
contracts. Amortization expense includes the amortization of intangible assets
(over three to ten years), primarily goodwill (over ten years), that result
from business acquisitions. We had $49.0 million of goodwill, net of
amortization, on March 31, 1999. Depreciation and amortization will increase as
we install additional multi-service data and voice switching platforms and
expand our Enterprise Network Services business and as a result of amortization
of intangibles expected to result from future acquisitions.
Interest expense includes interest expense on our debt, including capital
leases. The majority of the interest expense is related to our 13% Senior Notes
which mature in 2008. Interest expense will increase as we continue to finance
a significant portion of our capital expenditures, including our purchase of
Cisco Systems' multi-service data and voice switches and additional Cisco
Systems equipment under our $103.5 million equipment facility with Cisco
Systems Capital Corporation.
Results of Operations
Management evaluates and makes operating decisions about each of our
operating segments based on a number of factors. Two of the more significant
factors we use in evaluating operating performance are: revenue and gross
margin before depreciation. We do not account for assets by business segment.
As a result, depreciation and amortization are not factors used by management
in evaluating the operating performance of our segments.
The percentages shown in the following table with respect to revenue
represent revenue for each business segment as a percentage of total revenue.
Other percentages shown, with the exception of totals, are a percentage of
revenue for the related segment.
26
<PAGE>
<TABLE>
<CAPTION>
March 1,
1996
through Year ended December 31, Three Months March 31,
December 31, ------------------------ -----------------------
1996 1997 1998 1998 1999
-------------- ----------- ----------- ---------- -----------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Revenue:
Data services.......... $ -- -- % $ 586 6% $ 3,620 6% $ 808 12% $ 2,119 7%
Voice services......... 58 59 2,203 22 22,299 36 883 14 12,458 41
Enterprise Network
Services.............. -- -- 6 -- 2,003 3 116 2 733 2
Data products.......... 40 41 6,657 65 20,892 34 4,462 68 7,162 24
Voice products......... -- -- 758 7 12,786 21 254 4 8,009 26
------- ----- ------- --- ------- --- ------ --- ------- ---
Total revenue.......... $ 98 100% $10,210 100% $61,600 100% $6,523 100% $30,481 100%
======= ===== ======= === ======= === ====== === ======= ===
Cost of sales excluding
depreciation:
Data services.......... $ -- -- % $ 51 9% $ 1,509 42% $ 361 45% $ 1,132 54%
Voice services......... 40 69 1,224 56 13,383 60 499 57 7,208 58
Enterprise Network
Services.............. -- -- 3 50 695 35 55 48 142 19
Data products.......... 39 99 5,601 84 18,642 89 3,722 84 6,367 89
Voice products......... -- -- 490 65 9,474 74 161 46 5,225 65
------- ------- ------- ------ -------
Total cost of sales ex-
cluding depreciation.. $ 79 81% $ 7,369 72% $43,703 71% $4,798 74% $20,074 66%
======= ======= ======= ====== =======
Gross margin before de-
preciation:
Data services.......... $ -- -- % $ 534 91% $ 2,111 58% 447 55% $ 987 46%
Voice services......... 17 31 979 44 8,916 40 384 43 5,250 42
Enterprise Network
Services.............. -- -- 3 50 1,308 65 61 52 591 81
Data products.......... 1 1 1,057 16 2,250 11 740 16 795 11
Voice products......... -- -- 268 35 3,312 26 93 54 2,784 35
------- ------- ------- ------ -------
Total gross margin
before depreciation... $ 18 19% $ 2,841 28% $17,897 29% $1,725 26% $10,407 34%
======= ======= ======= ====== =======
</TABLE>
Summary Quarterly Financial Data
The table below presents unaudited quarterly statement of operations data for
each of the last nine quarters through March 31, 1999. This information has
been derived from unaudited financial statements that have been prepared on the
same basis as the audited financial statements contained elsewhere in this
prospectus and, in our opinion, includes all adjustments, consisting only of
normal recurring adjustments, that are necessary for a fair presentation of the
information. You should read these unaudited quarterly results along with our
consolidated financial statements and the accompanying notes appearing later in
this prospectus. The operating results for any quarter are not necessarily
indicative of results for any future periods.
<TABLE>
<CAPTION>
1997 1998 1999
---------------------------------- ------------------------------------- ---------
1st 2nd 3rd 4th 1st 2nd 3rd(1) 4th 1st
------- ------- ------- ------- ------- -------- -------- -------- ---------
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Quarterly Operating
Data:
Revenue................. $ 598 $ 2,020 $ 3,144 $ 4,448 $ 6,523 $ 7,982 $ 22,316 $ 24,779 $ 30,481
Cost of sales excluding
depreciation........... 378 1,359 2,209 3,423 4,798 5,772 14,717 18,416 20,074
Selling, general and
administrative......... 1,188 1,974 3,052 4,769 6,062 7,710 15,507 18,583 23,337
Depreciation and
amortization........... 223 233 296 701 762 1,191 2,646 2,894 2,863
------- ------- ------- ------- ------- -------- -------- -------- ---------
Operating loss......... (1,191) (1,546) (2,413) (4,445) (5,099) (6,691) (10,554) (15,114) (15,793)
Net loss................ $(1,086) $(1,586) $(2,817) $(4,166) $(5,111) $(11,169) $(15,355) $(18,941) $(20,687)
======= ======= ======= ======= ======= ======== ======== ======== =========
EBITDA(2)............... $ (968) $(1,313) $(2,117) $(3,744) $(4,337) $ (5,500) $ (7,908) $(12,220) $(12,930)
======= ======= ======= ======= ======= ======== ======== ======== =========
</TABLE>
27
<PAGE>
- --------
(1) On August 1, 1998, we completed our largest acquisition to date when we
acquired substantially all of the assets of Tie Communications, Inc. for
$51.4 million, including $40.0 million in cash plus other costs and assumed
liabilities.
(2) As used in this prospectus, EBITDA consists of earnings before interest
(net), income taxes, depreciation and amortization and other income
(expense). EBITDA is a measure commonly used to analyze companies on the
basis of operating performance. It is not a measure of financial
performance under GAAP and should not be considered as an alternative to
net income (loss) as a measure of performance or as an alternative to cash
flow as a measure of liquidity. Our measure of EBITDA may not be comparable
to similarly titled measures used by other companies.
We have generated greater revenue in each successive quarter since our
inception, reflecting increases in the number of customers, mainly due to
acquisitions, and in sales to existing customers. Cost of sales excluding
depreciation has increased in every quarter, reflecting product and service
costs directly associated with revenue. Our selling, general and administrative
expenses have increased in every quarter and reflect sales and marketing costs
such as sales commissions, and the development and growth of regional and
corporate support staff. Depreciation and amortization has increased in each
quarter through December 31, 1998. The increases in depreciation are due to the
purchase of property, network and equipment inside and outside our customers'
premises associated with our expansion from one to 35 markets as of March 31,
1999, and due to the deployment of our multi-service data and voice switching
platform in three markets. The increases in amortization are due to the
increase in goodwill and other intangible assets resulting from the completion
of 13 acquisitions through March 31, 1999. We have also experienced increasing
operating and net losses every quarter. However, net loss has declined as a
percentage of revenue from 182% of revenue for the first quarter of 1997 to 68%
of revenue for the first quarter of 1999.
Three Months Ended March 31, 1998 Compared to Three Months Ended March 31, 1999
Revenue for the first quarter of 1999 was $24.0 million greater than revenue
for the first quarter of 1998. The increase in revenue was primarily due to the
addition of 27 new markets from 1998 to 1999. The increase in markets resulted
from acquisitions made between the end of the first quarter of 1998 and the
first quarter of 1999. The increase in revenue was also due to internal growth
of our operations and sales staff. Our most significant acquisition was the
acquisition of the assets of Tie Communications, which occurred in the third
quarter of 1998. The Tie acquisition contributed to the sizable increase in
voice product revenue and voice services revenue. The increase in data products
was primarily a result of the development and growth of existing markets and a
result of the expansion of data services markets from eight at March 31, 1998
to twelve at March 31, 1999. As a result of the Tie acquisition and our
continued strategy to increase our service offerings, our overall revenue mix
shifted from approximately 28% in services for the first three months of 1998
to 50% in services for the first three months of 1999.
Cost of sales excluding depreciation increased $15.3 million from the first
quarter of 1998 to the first quarter of 1999 and declined as a percentage of
total revenue from 74% for the first quarter of 1998 to 66% for the first
quarter of 1999. This decline as a percentage of total revenue is a reflection
of the decline in cost of product sales excluding depreciation, as a percentage
of product revenue, from 82% for the first quarter of 1998 to 76% for the first
quarter of 1999. This decrease as a percentage of product revenue is due to an
increase in sales of voice products which have a lower related cost of sales
excluding depreciation than data products. Cost of service sales excluding
depreciation as a percentage of service revenue increased from 51% for the
first quarter of 1998 to 55% for the first quarter of 1999. The increase in
cost of service sales excluding depreciation as a percentage of service revenue
was primarily due to an increase in voice services, primarily long-distance
services which have a higher related cost of sales excluding depreciation.
Selling, general and administrative expenses increased $17.2 million from the
first quarter of 1998 to the first quarter of 1999, but decreased as a
percentage of revenue from 93% to 77%. We expect selling, general and
administrative expenses to continue to decrease as a percentage of
28
<PAGE>
revenue as we expand our customer base and begin selling additional products
and services in each of our markets.
The $17.2 million increase was primarily a result of:
. the expansion from eight to 35 markets;
. the completion of five acquisitions (four in the last nine months of
1998 and one in the first three months of 1999);
. an increase from 209 employees at March 31, 1998 to 1,080 at March 31,
1999 (452 of which were hired as a result of the Tie acquisition); and
. continued growth of the support services organization required to
support expanding field operations, which accounted for approximately
$11.2 million or 48% of total selling, general and administrative
expenses for the three months ended March 31, 1999.
Depreciation and amortization expense increased approximately $2.1 million
from the first quarter of 1998 to the first quarter of 1999. This increase is a
direct result of increases of $23.7 million in property, network and equipment,
a $44.5 million increase in goodwill and a $1.7 million increase in other
intangible assets as a result of the five acquisitions completed between March
31, 1998 and March 31, 1999. As of March 31, 1999 we had $49.0 million in
goodwill, net of amortization, which is being amortized over ten years. The
increase in property, network and equipment is largely due to:
. the expansion from eight to 35 markets;
. the development and deployment of our multi-service data and voice
switching platform in three markets;
. continued development of our operational support system;
. the increase in assets managed under Enterprise Network Services
contracts; and
. office equipment and furniture related to the growth of our support
services organization.
Interest expense increased by approximately $5.9 million primarily as a
result of the April 1998 issuance of $160.0 million in principal amount of our
13% Senior Notes and warrants to purchase 864,000 shares of common stock.
Approximately $400,000 of this increase relates to accretion of the debt
discount resulting from the value assigned to the warrants and amortization of
debt issuance costs, neither of which are cash expenses. Interest expense also
increased as a result of assumed indebtedness from acquisitions, as well as
increased indebtedness under our equipment financing facilities with Comdisco
and Sun Financial Group, Inc. due to property, network and equipment purchased
for our networks both inside and outside our customers' premises.
Interest expense will increase as we continue to finance a significant
portion of our capital expenditures, including equipment purchased for
installation at our customers' offices in connection with the provision of
Enterprise Network Services.
Interest income increased approximately $919,000 primarily as a result of the
temporary investment of the remaining proceeds of the offering of our 13%
Senior Notes and warrants and the proceeds from the sale of convertible
preferred stock in March 1999, prior to using the proceeds in our business.
Other income (expense), which consists of miscellaneous other non-operating
types of income and expenses, increased by approximately $82,000 from a net
other income of approximately $10,000 for the first quarter of 1998 to a net
other income of $92,000 for the first quarter of 1999.
29
<PAGE>
Net loss increased approximately $15.6 million as a result of the factors
discussed above.
Year Ended December 31, 1997 Compared to the Year Ended December 31, 1998
Revenue increased by $51.4 million in 1998 to approximately six times 1997
revenue. The increase in revenue was primarily due to our expansion from eight
markets at December 31, 1997 to 32 markets at December 31, 1998, as a result of
the six acquisitions we completed during the year. The increase in revenue was
also due to internal growth of our operations and sales staff. The most
significant acquisition was the acquisition of the assets of Tie, which
occurred in the third quarter of 1998. The Tie acquisition contributed most of
the sizable increase in voice product revenue and an even greater increase in
voice services revenue. The increase in data products was primarily a result of
the development and growth of existing markets and a full year of operations in
1998 compared to a partial year of operations in 1997 for those markets we
entered in late 1997. As a result of the Tie acquisition and our strategy to
increase our service offerings, our overall revenue mix shifted from
approximately 27% in services in 1997, to 45% in services in 1998.
Cost of sales excluding depreciation increased $36.3 million from 1997 to
1998. While it declined slightly as a percentage of total revenue from 72% in
1997 to 71% in 1998, cost of service sales excluding depreciation as a
percentage of service revenue increased from 46% in 1997 to 56% in 1998. The
increase as a percentage of service revenue was primarily due to a shift in
service mix to services such as long-distance which have a higher related cost
of sales excluding depreciation. Cost of product sales excluding depreciation,
as a percentage of product revenue, remained relatively constant, increasing
from 82% in 1997 to 83% in 1998.
Selling, general and administrative expenses increased $36.9 million from
1997 to 1998, but decreased as a percentage of revenue from 108% in 1997 to 78%
in 1998. We expect selling general and administrative expenses to continue to
decrease as a percentage of revenue as we expand our customer base and begin
selling additional products and services in each of our markets.
The $36.9 million increase was primarily a result of:
. the expansion from eight to 32 markets;
. the completion of six acquisitions, including the assets of Tie;
. an increase from 165 employees at December 31, 1997 to 877 at December
31, 1998 (452 of which were hired as a result of the Tie acquisition);
and
. continued growth of the support services organization required for
expanding field operations, which accounted for approximately $20.2
million or 42% of total selling, general and administrative expenses for
1998.
Depreciation and amortization expense increased approximately $6.0 million
from 1997 to 1998. This increase was a direct result of an increase of $22.7
million in property, network and equipment from 1997 to 1998 and an increase in
goodwill (before 1998 amortization) of $42.6 million and other intangible
assets of $1.7 million as a result of the six acquisitions completed in 1998.
As of December 31, 1998 we had $46.5 million in goodwill, net of amortization,
which will be amortized over the next ten years. The increase in property,
network and equipment is largely due to:
. the expansion from eight to 32 markets;
. the development and deployment of our multi-service data and voice
switching platform in three markets;
. continued development of our operational support system;
30
<PAGE>
. the increase in assets managed under Enterprise Network Services
contracts; and
. office equipment and furniture related to the growth of our support
services organization.
Interest expense increased by approximately $17.3 million primarily as a
result of the April 1998 issuance of our $160 million in principal amount of
13% Senior Notes and warrants to purchase 864,000 shares of common stock.
Approximately $1.2 million of this increase relates to accretion of the debt
discount resulting from the value assigned to the warrants and amortization of
debt issuance costs, neither of which are cash expenses. Interest expense also
increased as a result of assumed indebtedness from acquisitions, as well as
increased indebtedness under our equipment financing facilities with Comdisco
and Sun Financial Group, Inc. due to property, network and equipment purchased
for our networks both inside and outside our customers' premises.
Interest expense will increase as we continue to finance a significant
portion of our capital expenditures, including equipment purchased for
installation at our customers' offices in connection with the provision of
Enterprise Network Services.
Interest income increased approximately $4.4 million primarily as a result of
the temporary investment of the proceeds of the offering of our 13% Senior
Notes and warrants, prior to the use of these proceeds in our business.
Other income (expense) increased from net other expense of $156,000 in 1997
to net other expense of $248,000 in 1998. Other income (expense) primarily
consisted of losses on disposal of assets and miscellaneous other non-operating
types of income and expense.
Net loss increased approximately $40.9 million as a result of the factors
discussed above.
Period Ended December 31, 1996 Compared to the Year Ended December 31, 1997
Revenue increased $10.1 million from 1996 to 1997. The 1997 revenue includes
a full year of operations. In comparison, there were only 15 days of revenue-
generating operations in 1996. Also, we completed five acquisitions in 1997,
which added $2.9 million in revenue and expanded our operations from two to
eight markets.
Cost of sales excluding depreciation increased $7.3 million from 1996 to
1997. Cost of sales excluding depreciation as a percentage of revenue declined
from 81% in 1996 to 72% in 1997 because of a change in our service offering
from public telephone services in 1996 to sales of other data and voice
products and services in 1997.
Selling, general and administrative expenses increased $10.4 million from
1996 to 1997. The increase was primarily a result of:
. the expansion from two to eight markets;
. the completion of five acquisitions;
. an increase from 22 employees at December 31, 1996 to 165 at December 31,
1997; and
. the building of our support services organization to support anticipated
growth in field operations which accounted for approximately $7.3 million
or 67% of total selling, general and administrative expenses for 1997.
Depreciation and amortization expense increased approximately $1.4 million
from 1996 to 1997. This increase was a result of assets purchased and developed
as part of our expansion from two to eight markets and capitalized costs
associated with the development of our operational
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support system. In addition, an increase in goodwill derived from the five
acquisitions we completed in 1997 resulted in an increase in the amortization
of goodwill.
Interest expense increased by approximately $155,000 as a result of assumed
indebtedness from acquisitions and capital purchases through our equipment
leasing facility with Sun Financial Group, Inc.
Interest income increased by approximately $251,000 as a result of the
temporary investment of funds received in our private equity offerings in
February and October of 1997.
Other expense (net) increased by approximately $156,000 primarily consisting
of losses on disposal of assets and miscellaneous other non-operating types of
expenses.
Net loss increased approximately $9.1 million as a result of the factors
discussed above.
Liquidity and Capital Resources
Since inception, we have funded our net losses and capital expenditures
through financing activities as outlined in the following table in addition to
borrowings under our credit facilities. In the table below, net proceeds equals
the gross proceeds of the offering less advisors' fees, underwriting discounts
and other expenses associated with the offering.
<TABLE>
<CAPTION>
Securities Sold Gross Proceeds Net Proceeds
-------------------------------------------------- -------------- ------------
<S> <C> <C>
Initial sale of 3,750,000 shares of common stock
to founders
(April through October 1996)..................... $ 450,000 $ 450,000
3,500,000 shares of common stock and warrants to
purchase 1,750,000 shares (December 1996 through
February 1997)................................... 7,000,000 6,295,794
3,410,000 shares of common stock and warrants to
purchase 1,705,000 shares (October through
November 1997)................................... 17,050,000 15,339,787
13% Senior Notes and warrants to purchase 864,000
shares (April 1998).............................. 160,000,000 152,377,955
Sale of 800,000 shares of Series A Convertible
Preferred Stock and warrants to purchase 958,333
shares (March 1999).............................. 20,000,000 19,300,000
------------ ------------
Total funds raised............................. $204,500,000 $193,763,536
============ ============
</TABLE>
Our principal uses of cash are to fund working capital requirements, capital
expenditures, business acquisitions, operating losses and interest expense. We
expect that our expansion will require additional capital expenditures and
direct operating costs and expenses. As a result, we expect to incur net losses
for the next 36 months. However, if our customer base grows and we are
successful in offering all of our data services and products, we believe
revenue will increase in larger proportion than operating expenses.
As of March 31, 1999, we had current assets of $79.9 million, including cash
and cash equivalents of $10.4 million, short-term investments of $15.9 million
and restricted cash of $20.8 million, and working capital of $22.4 million. In
addition, we also had $32.0 million in non-current restricted cash. The
majority of our restricted cash, along with the interest we earn on this cash,
will be used to make the interest payments through April 2001 on our 13% Senior
Notes. We invest excess funds in short-term investments until these funds are
needed for debt payments, capital investments, acquisitions and operations of
the business.
Cash Flows From Operating Activities. Operating activities used cash of
approximately $13.5 million for the first quarter of 1999, $28.7 million during
1998 and $6.7 million during 1997. Cash
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used in operating activities for the first quarter of 1999 was primarily due to
the net loss of $15.6 million and an increase of $2.3 million in trade accounts
receivable. Those uses of cash were partially offset by an increase in accrued
interest of $5.2 million, depreciation and amortization of $2.9 million and
other non-cash expenses and changes in working capital. While cash used by
operating activities increased by $22.0 million from 1997 to 1998, the
percentage increase in cash used in operating activities is significantly less
than the percentage increase in net loss. In addition, cash used in operating
activities was 47% of revenue in 1998 compared to 66% of revenue in 1997. The
majority of the increase from 1997 to 1998 was due to an increase in trade
accounts receivable of approximately $11.0 million and a $40.9 million increase
in the operating loss, which were partially offset by an increase in trade
accounts payable of approximately $12.4 million, an increase of $5.2 million of
accrued interest expense, and non-cash expenses such as depreciation and
amortization and other changes in working capital. Cash used in operating
activities during 1997 was primarily due to our net loss of $9.7 million,
partially offset by non-cash expenses such as depreciation and amortization and
changes in working capital.
Cash Flows From Investing Activities. Investing activities used cash of $20.6
million during the first quarter of 1999, $94.6 million during 1998 and $11.6
million during 1997. Cash used in investing activities during the first quarter
of 1999 primarily consisted of short-term investments and restricted cash of
$17.3 million, business combinations of $1.5 million and capital expenditures
of $1.1 million. An additional $2.3 million of capital expenditures were
financed under our financing facilities. Cash used in investing activities
during 1998 consisted primarily of restricted cash investments in U.S.
government securities of $50.9 million in connection with the sale of our 13%
Senior Notes, acquisitions of $42.4 million ($40.0 million of which was used
for the Tie acquisition) and capital expenditures of $6.9 million. These cash
uses were partially offset by maturing short-term investments of $7.4 million.
Cash used for investing activities during 1997 consisted of $7.4 million used
for short-term investments, $2.0 million in capital expenditures and $1.5
million for business combinations.
In August 1998, we completed the acquisition of substantially all the assets
of Tie. The purchase price consisted of $40.0 million in cash and the
assumption of certain liabilities, which, with legal and professional and other
costs resulted in a total purchase price of approximately $51.4 million.
In February 1999, we acquired the assets and assumed certain liabilities of
Kansas Communications, Inc. ("KCI"). KCI was a telecommunications equipment
provider and integrator. The purchase price consisted of $1.5 million in cash,
$4.5 million in notes payable due between July 1999 and February 2000, 24,925
shares of our common stock and assumed liabilities of $2.4 million. Upon the
completion of the sale of our convertible preferred stock and related warrants
in March 1999, $1.5 million of the notes payable were paid. Upon the completion
of an equity or debt financing with net proceeds in excess of $25.0 million, an
additional $2.0 million of the notes payable will become due. It is anticipated
that they will be repaid with a portion of the proceeds of this offering.
In April 1999, we completed the acquisition of BSSi Innovations, Inc.
("BSSi"). BSSi was a provider of data network integration services based in
Chicago, Illinois. The purchase price consisted of $455,000 in cash, 37,000
shares of our common stock and assumed debt of approximately $525,000. An
additional 10,000 shares may be issued if certain financial conditions are met.
In June 1999, we signed a letter of intent to purchase the assets of a
provider of data network integration services based in Dallas, Texas. The
purchase price is expected to consist of $1,025,000 in cash and $900,000 in
shares of common stock (valued at the initial public offering price). We expect
to consummate this purchase in the third quarter.
Cash Flows From Financing Activities. Financing activities provided cash of
approximately $19.0 million during the first quarter of 1999, $148.3 million
during 1998 and $15.9 million during
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<PAGE>
1997. Cash provided by financing activities during the first quarter of 1999
consisted of approximately $19.3 million in net proceeds from the sale of our
convertible preferred stock and $1.0 million in new borrowings, which was
partially offset by approximately $1.3 million in payments on long-term
borrowings. Cash provided by financing activities during 1998 consisted of
approximately $152.4 million in net proceeds from the sale of our 13% Senior
Notes and warrants, which was partially offset by approximately $4.3 million in
payments on long-term borrowings. In 1997 cash flows from financing activities
consisted of $17.3 million in net proceeds from the sale of shares of our
common stock and warrants, which was partially offset by approximately $1.4
million in debt repayments.
In November 1997, we entered into an agreement with Comdisco, Inc. through
which we can receive up to $50.0 million of equipment lease financing. At
December 31, 1998, $10.0 million of financing was available to us under this
facility. As a result of the sale of our convertible preferred stock and
warrants, an additional $20.0 million became available under the facility. As
of March 31, 1999, a total of approximately $10.2 million had been utilized and
$19.8 million was available. This facility will expire on June 30, 2000. The
remaining $20.0 million will become available upon the satisfaction of
additional conditions. See "Description of Indebtedness."
On April 2, 1998, we completed the offering of our 13% Senior Notes, in the
aggregate principal amount of $160.0 million and warrants to purchase 864,000
shares of common stock. At the closing, we invested $56.8 million of the
proceeds from that offering in U.S. government securities which were placed in
an escrow account and pledged to secure the 13% senior notes. The scheduled
maturity of principal and interest on the securities in the escrow account will
be sufficient to pay the first six interest payments on our 13% Senior Notes,
of which two have been made as of April 1, 1999. We received approximately
$95.6 million after deducting offering costs of approximately $7.6 million and
funding the escrow account. The 13% Senior Notes contain certain covenants that
restrict our ability to incur additional debt and make certain payments,
including dividends. See "Description of Indebtedness."
In March 1999, we sold to affiliates of the Sandler Group 800,000 shares of
our convertible preferred stock and warrants to purchase 958,333 shares of our
common stock, for total consideration of $20.0 million. The proceeds from the
sale, net of related offering costs, were approximately $19.3 million. See
"Certain Relationships and Related Transactions."
In June 1999, we entered into, and borrowed the full amount under, a $10.0
million senior secured credit facility with Goldman Sachs Credit Partners L.P.
The proceeds of this facility will be used for working capital and other
general corporate purposes. We cannot re-borrow amounts repaid under this
facility. In connection with this facility, we also issued to Goldman Sachs
Credit Partners L.P. a warrant to acquire 375,000 shares of common stock at an
exercise price of $15.00 per share.
In July 1999, we entered into a six-year $103.5 million credit facility with
Cisco Systems Capital Corporation. This credit facility will provide the
financing for the purchase and installation of our Cisco Systems, Inc. powered
multi-service data and voice switching platform and for other Cisco equipment.
Under the terms of this agreement, Cisco Systems, Inc. also received a warrant
to purchase 575,000 shares of our common stock. The warrant has an exercise
price of $15.00 per share and is exercisable for three years from the date of
issuance. The facility will be available in three tranches over a three year
period with quarterly payments due over three years beginning one year from the
availability of each tranche. The credit facility contains very aggressive
financial covenants which may require us to accelerate our business plan or
renegotiate the covenants in the future in order to satisfy those covenants or
avoid a potential default under the credit facility.
We have an agreement with Sun Financial Group, Inc., a subsidiary of GATX
Capital Corporation, that was used to finance our internal capital needs under
which $4.8 million was outstanding on March 31, 1999.
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<PAGE>
Future Capital Requirements. We have significant debt in relation to our
equity. At March 31, 1999, we had $174.9 million in debt and $41.2 million in
shareholders' deficit, which includes paid-in capital of $40.0 million, but
excluded $19.3 million in convertible preferred stock (which will be converted
into common stock upon the closing of this offering). Our business plan will
continue to require a substantial amount of capital to fund our expansion of
existing markets and acquisitions. Our business plan includes the following:
. deploying our multi-service data and voice switching platform in all of
our markets and providing an IP/ATM network connecting our switches;
. funding the purchase, installation and ownership of the internal networks
of our Enterprise Network Services customers (which includes providing
these customers with all necessary hardware, software, transmission
facilities and management, maintenance and monitoring services);
. continuing to develop customer care and sales organizations;
. continuing to develop our operational support system; and
. funding operating losses and debt service requirements.
In addition, we will continue to evaluate acquisitions and investments.
Completing additional acquisitions and investments could require us to spend a
portion of our cash, compel us to raise additional capital sooner and issue
additional capital stock.
We estimate that our existing funds at March 31, 1999, the proceeds of this
offering, our available borrowing and lease financing capacity and the expected
proceeds from the exercise of warrants expiring in July 1999 will be sufficient
to meet our capital requirements for the foreseeable future. We could, however,
require additional capital sooner due to material shortfalls in our operating
and financial performance or if we are more aggressive in our expansion than
currently contemplated. We cannot be certain that we would be successful in
raising sufficient debt or equity capital to fund our operations on a timely
basis or on acceptable terms. If needed financing were not available on
acceptable terms, we could be compelled to alter our business strategy, delay
or abandon some of our future plans or expenditures or fail to make interest
payments on our debt. Any of these events would have a material adverse effect
on our business, financial condition, results of operations and liquidity and
on the price of our common stock.
Recently Adopted Accounting Standards
Effective January 1, 1998 we adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income." This statement established
standards for reporting and display of comprehensive income and its components.
Comprehensive income generally includes changes in separately reported
components of equity along with net income.
We have adopted Statement of Financial Accounting Standards No. 131,
"Disclosure about Segments of an Enterprise and Related Information" for the
year ended December 31, 1998. We have disclosed the business segments that we
operate in along with the financial information that management uses in
measuring the operating performance of those segments and for allocating
resources to each segment as required by this statement. The adoption of this
statement had no effect on our results of operations, financial position or
cash flows.
The American Institute of Certified Public Accountants issued Statement of
Position 98-5, "Reporting on the Costs of Start-Up Activities" ("SOP 98-5").
SOP 98-5 provides guidance on the financial reporting of start-up costs and
organization costs. It requires cost of start-up activities and organization
costs to be expensed as incurred and is effective for financial statements for
fiscal years beginning after December 15, 1998, though early adoption is
encouraged. We have adopted SOP
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98-5 for fiscal year ended December 31, 1998. The amount of start-up costs
written off as a result of the adoption of SOP 98-5 was not material.
Impact of the Year 2000 Issue
The year 2000 issue generally describes the various problems that may result
from the improper processing of dates and date-sensitive calculations by
computers and other equipment as a result of computer hardware and software
using two digits to identify the year in a date. Those computers and software
will need to be upgraded or replaced to accept four digit dates to distinguish
dates in the 21st century from dates in the 20th century. The problem could
result in system failures or miscalculations and cause disruptions in
operations including, among other things, the inability to process
transactions, send invoices, provide data and voice communications services or
engage in similar normal business activities.
State of Readiness. We have created a task force (consisting of
representatives from our information technology, product management, sales and
marketing, finance and legal departments) that evaluates our internal and
external systems as they relate to year 2000 issues. We have reviewed our
critical internal systems, including our systems for customer billing, customer
service and financial reporting. We have obtained year 2000 readiness
certifications from most manufacturers and suppliers of our internal systems.
Any internal systems which were identified as having a potential problem have
already been replaced or are in the process of being replaced or modified.
Except for portions of two systems relating to order entry procedures which we
acquired in two of our more recent acquisitions (Tie and KCI), we believe that
our internal systems are year 2000 ready. We are in the process of upgrading
the two systems to make them year 2000 ready based upon the manufacturers'
recommendation, which should be completed by the third quarter of 1999.
We continue to assess internal non-information technology systems and
external systems, including systems used by manufacturers and suppliers of
computer equipment, software programs, telephone systems, data systems, systems
comprising our enterprise networks and equipment used to provide services to
our customers.
To date, we have not identified any year 2000 issues with third-parties which
could have a material adverse effect on our business. We may identify a
significant internal or external year 2000 issue in the future which, if not
remediated in a timely manner, could have a material adverse effect on our
business, financial condition and results of operations.
Costs. We have not incurred any significant costs in identifying year 2000
issues other than the opportunity cost of the time spent by our personnel. We
do not anticipate any significant further costs in identifying year 2000
issues. Programming costs associated with upgrading the two non-ready systems
are estimated to be approximately $500,000. We have prepared contingency plans,
including manual order entry procedures and identification of potential
software modifications, in the event that there are delays in upgrading the
non-ready systems. Costs associated with our contingency plans, which we do not
believe would be material, could include the hiring of additional personnel to
process orders and implement software modifications. The exact amount of the
costs associated with our contingency plans cannot be determined at this time
as a result of not knowing the number of additional personnel that may need to
be hired.
Risks of Year 2000 Issues. Based on our assessments to date, we believe that
we will not experience any material disruption in internal systems or
information processing as a result of year 2000 issues. However, almost all of
our systems and products relating to our internal and external systems and
products are manufactured or supplied by third parties which are outside of our
control. Although we have taken steps that we believe should have identified
potential year 2000 issues, if some or all of our internal or external systems
and products fail, or if any critical systems are
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<PAGE>
overlooked or are not year 2000 ready in a timely manner, there could be a
material adverse effect on our business, financial condition and results of
operations and on the price of our common stock. In addition, if a critical
provider of services, such as those providers supplying electricity, water or
other services, or a vendor or manufacturer supplying products or services sold
to our customers, experiences difficulties resulting in disruption of services
to us or the sale of malfunctioning products to our customers, there could be a
material adverse effect on our business financial condition, results of
operations and on the price of our common stock. Potential risks include:
. the disruption of utility services resulting in a closure of the affected
facility for the duration of the disruption;
. the disruption of data or voice services we provide to our customers;
. the inability to process customer billing accurately or in a timely manner;
. the inability to provide accurate financial reporting to management,
auditors, investors and others;
. litigation costs associated with potential suits from customers and
investors; and
. delays in implementing other projects as a result of work by internal
personnel on year 2000 issues.
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BUSINESS
Introduction
We are a rapidly growing national provider of single-source data and voice
communications systems, services and solutions primarily to businesses with 25
to 500 employees. Inside our customers' premises we own communications networks
and provide professional services, such as the design, installation, management
and monitoring of those networks. Outside our customers' premises, we provide a
broad range of data and voice transport services. By operating networks both
inside and outside our customers' premises, and by offering a broad range of
data and voice products and services, we enable small and medium sized
businesses to use state-of-the-art communications solutions, including data and
voice networks based on Internet Protocol, electronic commerce, the Internet
and sophisticated communications systems. We intend to become the leading
provider of IP-based data and voice products and services to small and medium
sized businesses.
We offer each of our products and services on Internet Protocol
a stand alone basis and are now also offering a -----------------
bundled communications solution under long-term Internet Protocol or IP is a
service agreements in which we own all or a standard industry method of
portion of the inside network and provide identifying, tracking and
professional services inside our customers' reassembling packets of
premises and supply transport services outside information transferred over
their premises. This comprehensive solution, multiple communications
which we call Enterprise Network Services, networks, including the
reduces our customers' capital needs, technical Internet.
staffing requirements and risks associated with
evolving communications technologies.
We are deploying Cisco Systems, Inc.'s multi-service data and voice switch in
each of the 35 metropolitan areas in which we currently operate and will also
deploy them in the 15 additional markets we expect to enter. We believe that
these next-generation switches will enable us to route our customers' external
communications traffic more efficiently and with lower capital outlay than with
traditional switches.
Over the last three years, we have:
. rapidly established a nationwide presence in 35 metropolitan areas;
. grown our customer base and provided our products and services to more than
33,000 customers since January 1, 1998, either directly or through businesses
we have acquired;
. increased sales to $61.6 million in 1998 from $10.2 million in 1997 and
$98,000 in 1996;
ATM
. raised $204.5 million in debt and equity ---
offerings; Asynchronous Transfer Mode
(or ATM) is a high-speed
technology used to transport
. completed 14 acquisitions; aninformation in packets. ATM
packets are fixed in size and
. designed and are in the process of assembling allow the transport of size-
IP/ATM network that will connect our multi- intensive and time-sensitive
service data and voice switching platforms and applications, such as video
carry our customers' traffic using ATM and voice, quickly and
technology; efficiently.
. grown our employee base to more than 1,000 and
assembled an experienced sales, technical and
management team;
. devoted significant resources to the
development, testing and implementation of our
operational support system; and
. developed, tested and implemented our national
network operations center.
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Our Market Opportunity
Sophisticated data and voice communications solutions such as IP-based
integrated networks, wide area networks, intranets, extranets, dedicated
Internet access and virtual private networks are becoming increasingly critical
to small and medium sized businesses. According to published reports:
. in 1999, the number of small businesses in the United States is expected
to exceed 7.4 million, of which 81% are expected to use personal
computers, and 59% are expected to have access to the Internet;
. there are more than 86,500 middle market companies (100 to 1,000
employees) in the United States which spend a total of $57.1 billion
annually on information system products and services;
. in 1998, total revenue from the sale of data products and services in
the United States was $98 billion, with data and network services
revenue accounting for approximately $22 billion;
. the value of goods and services sold worldwide through the Internet is
projected to increase from $12 billion in 1997 to over $400 billion in
2002; and
. Internet Protocol is expected to be the dominant protocol in 83% of
enterprise local area networks in 1999.
Small and medium sized businesses today generally purchase their
communications products and services from several, usually local or regional,
suppliers. We believe those potential customers will increasingly seek single-
source solutions providers for their communications needs because of:
. the cost and difficulty of maintaining in-house technical expertise,
including the technical expertise required to integrate IP-based data
and voice systems;
. the need for small and medium sized businesses to focus on and deploy
their limited capital resources in their core operations rather than on
network communications systems;
. the large number of manufacturers of data and voice equipment and the
variety of options and features available on these products;
. the opportunity for the Internet and electronic commerce to enhance the
reach and productivity of small and medium sized businesses;
. the large number of Internet and other communications service providers
and the variety of pricing options available from them; and
. rapid changes in and increasing complexity of computing, data networking
and voice products.
We believe that the national systems integrators, outsourcers, data
technology companies and telecommunications providers have not focused on
selling products and services to small and medium sized businesses and that
regional providers that do serve these businesses do not offer the same level
of sophisticated state-of-the-art products and services as national providers.
In addition, we believe that these regional providers do not offer a complete
package of integrated data and voice systems, services and solutions to these
small and medium sized businesses.
Our Solutions
We offer advanced communications solutions--ones that have traditionally been
readily available only to large enterprises--to small and medium sized
businesses. The combination of our focus on this market and our national scale
enables us to design sophisticated data and voice systems and solutions
tailored to these small and medium sized businesses.
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Our services utilize the data and voice networks, inside and outside of our
customers' enterprises.
. Inside our customers' enterprises we own networks and design, install,
manage, maintain and monitor our customers' networks (local area
networks, wide area networks, computers, private branch exchanges, key
systems, handsets, etc.). The IP-based integrated data and voice network
solutions that we provide (including internal voice over IP networks),
and which we expect will become a larger portion of our business, can
significantly reduce overall network administration and capital costs
for our customers.
. Outside our customers' enterprises, we provide data transport services,
Internet access, long-distance services and local phone services. As we
build our IP/ATM network, we will migrate many of these services to our
own network.
With one of our solutions, Enterprise Network Services, or ENS, we own all or
a portion of the data and voice communications systems inside our customers'
enterprises. Using these inside networks, we provide comprehensive data and
voice communications solutions to our customers that reduce their capital
expenditures, technical staffing requirements and risks associated with quickly
evolving communications technologies.
Because we provide solutions both inside and outside our customers'
enterprises, we are an "Enterprise Network Carrier" and allow our customers to
focus their efforts on their core businesses.
Our Business Strategy
Our business strategy is designed to generate a broad source of stable and
recurring revenue. In implementing this strategy, we will:
Target Small and Medium Sized Businesses. The small and medium sized
business market has historically been underserved by national systems
integrators, outsourcers, data technology companies and telecommunications
providers, even though many small and medium sized businesses demand high-
performance communications solutions. Because we are focused on this
market, we have developed systems, services and solutions that are well
suited for the financial resources, growth characteristics, technological
sophistication and other needs of small and medium sized businesses.
Provide Sophisticated, One-Stop, Integrated Communications Solutions.
Most small and medium sized businesses do not have the internal capability
or capital required to deploy, fully utilize and effectively manage
evolving data and voice systems. We are increasingly able to respond to
substantially all of our customers' communications needs and offer
equipment leasing and maintenance contracts. This comprehensive approach is
designed to reduce the complexity and expense of owning and operating
communications networks for our customers. Our solutions are designed to
facilitate the migration of traditional communications systems to
integrated IP-based data and voice networks.
Own the Communications Network Inside Our Customers' Enterprises. Through
our Enterprise Network Services, we seek to own the data and voice networks
inside our customers' premises and provide these networks to our customers
along with management, maintenance and monitoring services under long-term
service agreements. This approach is designed to:
. allow our customers to focus on their core business and outsource
their communications needs;
. capture a large portion of our customers' communications spending;
. reduce customer turnover;
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. generate high-margin revenue; and
. enhance our opportunities to sell additional products, systems and
service upgrades to existing customers.
Focus on Solutions-Based Selling. We market our systems and services,
such as Enterprise Network Services, as solutions to business problems
rather than as stand-alone products. We do so by marketing to the senior
management and principals of our potential customers, providing them with
an analysis of the benefits of our complete solutions.
Provide Preeminent, Local Customer Care. We strive to provide best-in-
care service by offering our customers immediate and around-the-clock
access to our customer care staff. Our approximately 240 customer care
specialists are trained in all aspects of the systems, services and
solutions offered in their market.
Capitalize on Our Operational Support System. Our operational support
system is designed to provide comprehensive, real-time customer information
and enable our customer support representatives to respond promptly to
inquiries, provide greater quality customer care, build customer loyalty
and identify opportunities to sell additional products and services.
However, we are still developing our operational support system, see "Risk
Factors--We Are Still Developing Our Operational Support System."
Our Growth Strategy
Our growth strategy is to:
Leverage Our Existing Customer Base. More than 28,000 businesses have
purchased voice services or products since January 1, 1998 from us or a
business that we have acquired. We are now marketing Enterprise Network
Services and our other advanced data products and services to certain of
these voice customers.
Deploy Our Cisco Powered Multi-Service Switching Architecture. We believe
that our Cisco powered switching platform provides similar functionality at
a lower capital and operating cost than traditional switching platforms.
Installing these switches should also improve our operating margins on our
transport services as we switch more of our customers' traffic ourselves.
Increase Our Higher-Margin Service Revenue. We intend to increase the
portion of our revenue that is derived from providing services, especially
professional services, Enterprise Network Services, and long-term
maintenance agreements, each of which has a higher gross margin than
systems and product sales.
Sell IP-based Integrated Network Solutions. We currently sell IP-based
integrated network solutions, including enterprise systems, data services
and internal voice over IP services, and expect that an increasing portion
of our sales will be derived from these systems and services in the future.
These products are attractive to our customers because:
. consolidation of enterprise data and voice networks can reduce staffing
needs and operational complexity;
. IP-based products can be managed and configured centrally;
. data and voice communications services delivered over facilities
using an IP/ATM network generally are less expensive; and
. these products permit the migration of core applications (such as e-
mail and e-commerce) onto shared servers, reducing costs.
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Make Selective Strategic Acquisitions. We have made and will continue to
make acquisitions of companies that have experience in providing data and
voice systems, services and solutions and companies that will help us
expand our technical expertise and geographic coverage.
Our Products and Services
Our broad range of services, products and solutions include:
Data Services
. Data Network Professional Services. We design, install, manage, maintain
and monitor networks and systems including local area networks, wide
area networks and integrated IP-based networks.
. Internet Access. We currently offer Internet access services in Denver,
Des Moines and Santa Clara using interconnections with UUNet. We will
also be connecting our network to three primary Internet gateways
located at Herndon, VA, Santa Clara, CA, and Chicago, IL.
. Web Development and Hosting Services. We provide web site hosting
services, custom web site design, web site maintenance, ongoing
consulting services, and web site co-location.
. Electronic Commerce Solutions. We develop e-commerce applications for our
customers that enable them to sell products and services over the
Internet.
Frame Relay
-----------
. Virtual Private Networks. We are developing
virtual private network services, which are Frame relay is a high-
designed to provide secure transmission of our speed service which
customers' data over the Internet. These transports information
networks are the basis for intranet and in packets of varying
extranet services. Intranets are business sizes. Frame relay is a
networks that rely on Internet-based highly reliable digital
technologies to provide secure links between service, efficient at
different offices of the same enterprise. handling high-speed,
Extranets expand the network to selected "bursty" data over wide
business partners through secured links on the area networks.
Internet.
. Transport Services. We are developing an DSL
asynchronous transfer mode (ATM) service in ---
conjunction with our development and Digital Subscriber Line
deployment of a national IP/ATM network. We (or DSL) enables high-
also provide managed frame relay services to speed local data
our customers allowing them to transmit data, transport over the
voice and video traffic on a single digital existing copper wire
facility. We are currently testing various infrastructure.
types of digital subscriber line, or DSL,
services with a leading provider. Once we select a primary provider of
digital subscriber line services, we will begin providing those
transport services to our customers.
Voice Services
. Voice Network Professional Services. We provide voice network design,
maintenance and management, and assist our customers with adding and
moving phone lines.
42
<PAGE>
. Long Distance Services. We provide resold inter-state and intra-state
long distance services. We also provide enhanced services such as toll-
free calling services and travel card services.
. Local Phone Services. We provide resold local phone services.
Enterprise Network Services. We provide Enterprise Network Services solutions
under long-term service agreements in which we purchase, own, manage, maintain
and monitor all or a portion of the data and voice network inside our
customers' premises. Our customers pay a monthly service fee for our services
and the use of our network inside and outside their premises. We believe this
service offering to be particularly attractive to our small and medium sized
business customers because it:
. lowers their all-in cost of network ownership;
. reduces their risks and burdens associated with owning, operating and
maintaining data and voice networks;
. replaces costly and unpredictable capital outlays with stable and
predictible monthly expenses; and
. reduces their need to employ costly and difficult-to-recruit information
technology personnel.
Data Products. We are a provider of products from a large variety of
suppliers needed to create data networks including routers, hubs, bridges,
multiplexers, switches, servers, personal computers, and other equipment. We
also market integrated IP-based private branch exchanges, or PBXs, and a broad
range of other IP-based devices.
Voice Products. We are a provider of voice network products such as private
branch exchanges, key systems (smaller versions of PBXs), handsets, voice
messaging systems and call management software.
Equipment Leasing. In addition to the sale of these products and services, we
provide leasing options to our customers for their data and voice products. We
use our existing credit arrangements, or obtain new credit facilities, to
provide these options to our customers. We believe that these services enhance
our ability to attract customers and act as their single-source provider. We
also believe that these services allow us to maintain contact with customers
and provide us with the opportunity to sell additional products and services to
them.
We have limited experience providing certain of these services described
above. See "Risk Factors--We Have a Limited Operating History," "Risk Factors--
Enterprise Network Services is a New Business Area" and "Risk Factors--Voice
Over Internet Protocol is a New Technology."
Sales and Marketing
Since January 1, 1998, we have provided our products or services to more than
33,000 businesses, either directly or through businesses we have acquired. We
are selling all of our data systems and services in twelve of our markets and
our voice systems and services in all of our markets except Boise. We are
developing additional data, Internet and ENS expertise in the markets in which
we do not currently offer those products and services. We anticipate being able
to provide all of our products and services in an additional six of our markets
by the end of 1999, and in all of our existing markets by the second half of
2002.
43
<PAGE>
Our Sales Team. We sell our systems, services and solutions through our staff
of approximately 200 sales representatives and approximately 450 technicians in
49 offices in our 35 markets. Our sales force is supervised by area and
regional general managers, each of whom has responsibility for all sales
functions in one of our geographic regions. A significant portion of the
compensation of the sales force is tied to annual goal and quota programs with
incentive bonuses paid based on gross margin (rather than revenue) targets set
by us.
Selling Our Enterprise Network Services. We market our Enterprise Network
Services to the upper level management of our current and potential customers
as a business solution rather than a technology solution. Our sales teams seek
to demonstrate to the business decision makers the quantifiable benefits of not
owning their inside communications networks and allowing us to own and manage
the communications networks inside their premises. The analyses we use to
accomplish this task include:
. Vendor Cost-Efficiency Analysis. A field audit of a customer's past
communications bills for a variety of services from outside vendors
identifies the total cost for these services, vendor billing errors,
services billed but not provided, or services paid for but not utilized.
. Network Analysis. A physical audit of a customer's communications
network assets quantifies the capital a customer has invested in its
communications network and the costs associated with future upgrades to
the customer's network to meet its growing needs, and identifies design
flaws in the customer's network.
. Resource and Skill Set Analysis. An audit of internal resources required
to maintain the customer's communications network quantifies the labor
costs and identifies the skill sets required to achieve the customer's
stated business goals.
. Security Analysis. An audit of a customer's network determines the
vulnerability of a customer's proprietary information to hackers and
competitors.
. The Convergent Communications Solution. A custom-tailored proposal that
presents our advanced communications solution to the customer's data and
voice requirements.
As part of our solution, we conclude by providing a comparative "total cost of
ownership analysis." This analysis is an economic comparison of our solution to
the customer's current communications network and management approach. The
comparison includes the potential cash infusion the customer will receive from
the sale of its network assets to us and the potential reduction in expenses
associated with reducing personnel and outside vendor costs.
Marketing. We use a variety of marketing programs and media to raise
awareness of our systems, services and solutions and to generate sales leads
and opportunities. In addition, sales leads often come from our existing
satisfied customers. Our programs include:
. advertising in newspapers, magazines and trade journals;
. advertising on radio;
. sending direct mail solicitations;
. conducting business seminars;
. participating in trade shows;
. cross selling products and services to the more than 81,000 customers
who have previously purchased voice products or services from us or
companies we have acquired; and
. creating alliances and lead referral agreements with key vendors and
suppliers.
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<PAGE>
One of our marketing alliances is with Strategic Healthcare Solutions, LLC
("SHS"). SHS is a network systems consulting firm that provides their
consulting services to the healthcare industry. Under our agreement, SHS
markets and sells our Enterprise Network Services to customers in the
healthcare industry.
Customers and Markets
Our Customers. We have provided our products and services to more than 33,000
customers since January 1, 1998, either directly or through businesses we have
acquired. Although our focus is on small and medium sized businesses, we have
provided products and services to local or regional offices of the following
nationally recognized entities:
<TABLE>
<S> <C>
American Stores, including: Federal Bureau of Land Management
Acme Markets Franklin Covey
Jewel Osco Kiewit Construction
Lucky Stores Motorola Employees Credit Union--West
Osco Drug State of Georgia Board of Regents (Peachnet)
Save-on Drug Stores
</TABLE>
Our Markets. We currently provide our products and services in 35
metropolitan areas and we intend to expand into an additional 15 markets over
the next two years. Our existing markets are:
[MAP OF THE UNITED STATES APPEARS HERE]
Customer Care and Operations Support
Our Customer Care Staff. Our sales and customer support functions are highly
integrated. Our 240 customer care specialists are trained in all aspects of the
systems, services and solutions offered in their markets. Our integrated
approach allows us to pursue our goal of providing best-in-care service
starting with the initial customer contact and continuing throughout the life
of the account.
45
<PAGE>
Commitment to Superior Service. In order to provide superior service we:
. Act Immediately. Our employees are specialists who will begin
troubleshooting immediately to resolve any problem and can often reach a
conclusion during the initial contact. Our national customer care center
provides additional around-the-clock support, 365 days a year and the
seven regional customer care centers are staffed nine hours a day, five
days a week to handle the anticipated workload.
. Provide a Single Point of Contact. Our customers can call a single toll-
free number for assistance in solving most problems. Because our
customer care teams are trained in the entire suite of communication
systems and services we offer, they are able to assist customers in
solving problems that may involve more than one product or service.
Our Operational Support System. Our operational support system is designed to
integrate all of our internal support services. This integration will permit
customer care, sales engineering, service management, service delivery,
accounting and inventory sales management personnel to access a single customer
record. Accordingly, a customer will be able to get support for any of our
products and services with one phone call. By providing comprehensive, real-
time customer information, this system is designed to enable our customer
support representatives to respond faster to inquiries, provide greater quality
customer care, and identify more opportunities to sell additional products and
services.
We are in the process of adding additional functionality to our operational
support system, including improved order entry systems, dispatch and other
logistics functions, improved trouble ticket systems and contract management
features. These enhancements are designed to increase our efficiency in
supporting our existing voice product and service customers and to increase our
sales of data products and services to them. See "Risk Factors--We Are Still
Developing Our Operational Support System."
National Network Operations Center. Our national network operations center
provides customer support and proactive and fully redundant network monitoring
systems. These systems provide us the ability to monitor all types of network
and customer elements installed in the field. We currently monitor
approximately 3,500 devices, including routers, hubs, servers, switches,
desktop computers, printers and other peripheral devices and track over 12,500
elements of those devices on a continuous basis. For these devices, our system
provides:
. logical depictions of our customers' networks for quick isolation of
trouble;
. graphical presentations of equipment locations by bay, shelf and card
for quick identification;
. remote connection and testing capability; and
. network administration to manage bandwidth and configure and manage
equipment.
Network Architecture
Our Cisco Powered Multi-Service Data and Voice Switching Platform. Our multi-
service data and voice switching platform, which we call our Enterprise Point
of Presence, or ePOP, is designed to carry data and voice traffic on a single
digital connection. Unlike traditional switches, which are designed to
transport only specific types of data or voice services, our switching platform
acts as both a data and voice service aggregation point for our customers and a
dissemination point to facilities-based providers of data transport, Internet
services and voice services. This architecture is more efficient and requires
substantially less capital to deploy than the combination of traditional
switches necessary to carry the same types of traffic.
46
<PAGE>
We have already installed and are carrying customer data and voice traffic
over three ePOPs. We designed, assembled and installed these three ePOPs by
combining a number of independent components manufactured by other companies.
These ePOPs supported our initial launch of our integrated data and voice
services in these markets. This initial launch enabled us to more rapidly build
our ENS sales effort, coordinate our customer care activities, and roll out our
integrated operational support system.
During the next 36 months, we intend to deploy 50 ePOPs using Cisco Systems,
Inc.'s multi-service data and voice switches. We believe that these switches
will offer the same functionality as traditional switches at a lower capital
and operating cost and allow us to integrate the capabilities of IP and ATM
onto our ePOP. Cisco will support our ePOP deployment schedule by providing us
with additional personnel and professional services. Our agreement with Cisco
makes us a Cisco Powered Network Partner, which is a designation that
recognizes a select group of service providers who are committed to providing
high-performance reliable networking services. In addition, we have obtained a
$103.5 million credit facility with Cisco Systems Capital Corporation to obtain
financing for the purchase and installation of the additional ePOPs and the
purchase of other Cisco equipment. See "Risk Factors--Our Switching Platform
Has a Very Limited Performance History," and "Description of Indebtedness--
Cisco Systems Capital Corporation Facility."
Planned IP/ATM Network. Our network will connect our ePOPs and carry our
customers' traffic using Internet Protocol, asynchronous transfer mode
technology and other traditional transmission methods. We will lease fiber
capacity from other carriers and install our equipment at the connection
points. Our IP/ATM network will be connected to three regional Internet
aggregation gateways located in Herndon, VA, Chicago, IL, and Santa Clara, CA.
These gateways will provide redundant connectivity to the Internet, improve
throughput speed and allow private and public connections over the same
customer connection. We expect to have 16 ePOPs connected via our IP/ATM
network during 1999.
We carry voice calls on the local area networks, wide area networks, virtual
private networks and the networks inside the premises of our Enterprise Network
Services customers through the use of Internet Protocol. We plan to use
Internet Protocol to carry all of our customers' voice calls on our network in
the future. Traditionally, voice calls have been transmitted by keeping a
circuit or line between the people on the call constantly open. This method of
transmitting voice calls is inefficient because during conversations there are
pauses and periods of silence when the capacity of the circuit is not being
used. Voice over Internet Protocol transmission is designed to eliminate this
inefficiency. This technology breaks the voice conversation into "packets" of
information and sends those packets over transmission lines individually. The
packets are then re-assembled at or near their destination, so the parties are
able to have a conversation. When the parties on the call pause or are silent,
there are no packets transmitted and the transmission lines can be used for
other purposes. This technology promises to substantially reduce the cost of
carrying voice conversations. However, there are risks associated with adopting
this new and developing technology. See "Risk Factors--Voice Over Internet
Protocol is a New Technology."
Acquisitions
Since our inception, we have completed 14 acquisitions that have aided in
establishing our operations in 28 of our 35 markets and have added to our
skills and areas of expertise. We are expanding the product and service
offerings available to the acquired sales and field personnel, thereby creating
new sales opportunities. We expect to continue to make selective acquisitions
to expand our expertise and broaden our geographic coverage.
The key factors we have and will continue to use in evaluating potential
acquisitions are:
. cross-selling and up-selling opportunities;
47
<PAGE>
. size and quality of the acquired customer base;
. acceleration of our new market entry or expansion of existing markets;
. additions to our sales force and technical personnel;
. costs of acquisition; and
. historical and projected financial performance.
The Tie Acquisition. On August 1, 1998, we completed our largest acquisition
to date when we acquired substantially all the assets of Tie Communications for
$51.4 million, including $40.0 million in cash consideration plus other costs
and assumed liabilities. Tie was a debtor-in-possession under the U.S.
Bankruptcy Code at the time. We acquired these assets to accelerate our growth,
expand our service offerings and add to our skill base. The Tie acquisition
provided us with 24 new markets and 452 employees with experience in voice
products and services. The strong consultative sales organization we acquired
from Tie, which remains largely intact, used a marketing approach similar to
our own. Their expertise in selling and servicing complex voice products
complements our historical strength in data networking products and services.
The acquisition is also attractive because of the opportunity to market our
data systems, services and solutions to Tie's voice customers.
Market Environment
Although several larger data and voice companies have entered or will enter
our market, we believe that we will be successful because:
. we have expertise in providing integrated data and voice systems,
services and solutions specifically tailored to the needs of small and
medium sized business;
. we provide broad product and service offerings with a suitable solution
and price point for nearly every business in our target market;
. we have already established a sizeable customer base and a well trained
technical staff;
. we are focused on providing extremely high quality customer service and
technical support;
. we are willing to lease our network solutions to our customers; and
. we intend to continue to offer new systems, services and solutions to
enable small and medium sized businesses to take advantage of leading
technology.
We expect that we will face growing competition from a number of systems
integrators, outsourcers, data technology companies and telecommunications
providers, among others. Although we do not believe that a significant number
of other companies are providing Enterprise Network Services solutions or a
comparable range of data and voice systems, services and solutions to small and
medium sized businesses, we do face intense competition in each of our
individual product and service offerings. See "Risk Factors--We Face
Competition From Many Sources."
Regulatory Environment
Overview. Some of our offerings are subject to federal and state regulation.
At the federal level, we are subject to the Communications Act of 1934 and the
regulations of the Federal Communications Commission (FCC) to the extent that
we provide interstate and international telecommunications services. At the
state level, we are subject to state laws and the jurisdiction of the state
public utility commissions. The degree of regulation varies from state to
state.
The regulation of telecommunications services at all levels is in flux in the
aftermath of the Telecommunications Act of 1996, which comprehensively amended
the Communications Act of 1934
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<PAGE>
to promote competition in all areas of telecommunications. The
Telecommunications Act of 1996 amendments eliminated many legal barriers to
competition in various telecommunications marketplaces and set many of the
basic terms governing the relationships between competing telecommunications
carriers, particularly in the provision of local telephone service. The
implementation of the Telecommunications Act of 1996 is ongoing. It is the
subject of numerous administrative proceedings both before the FCC and the
various state public utility commissions, and litigation in both the federal
and state courts. These proceedings could, to varying degrees, significantly
alter the regulatory landscape. We cannot predict the outcome of any of these
proceedings or whether they will adversely affect our business.
Federal Regulation. Our interstate and international "telecommunications
services", like those of all carriers, are subject to the regulations of the
FCC. By contrast, our "information services" offerings, network design and
maintenance services, network management services, and web page development and
hosting services are not regulated. Also unregulated is the equipment that we
provide to our customers to use with our telecommunications services, although,
as discussed below, the FCC does require that equipment connected to the public
network meet certain technical standards.
There is some ambiguity regarding the regulatory status of certain of our
services. While we regard those services as unregulated, to date there has been
no ruling on their status by the FCC. It is possible that the FCC will
ultimately rule that they are telecommunications services and therefore are
subject to regulation. For example, under the current regulatory structure, we
believe our national IP/ATM network is an information service, and therefore
exempt from regulation. However, the regulatory classification of voice
communications using IP or ATM technology is in a state of flux, and there is a
possibility that voice communications using IP or ATM technology will be
subject to regulation in the near future. A determination that voice
communications using IP or ATM technologies are not information services could
make them significantly less competitive.
The FCC has established different levels of regulation for dominant and
nondominant carriers. The regional Bell operating companies, GTE, and other
incumbent local exchange telephone companies are classified as dominant. All
other carriers, including us, are classified as nondominant. As a nondominant
carrier, we are subject to much less regulation than are the dominant carriers.
Among other things, the FCC does not regulate the rates that we charge for our
interstate and international services or require us to obtain authorization in
advance for the installation, acquisition or operation of our domestic network
facilities.
The FCC has also decided that nondominant carriers should not file tariffs
setting forth their rates for interstate services. That ruling, however, has
been stayed pending the resolution of a court challenge. Until the stay is
lifted, we are required to file tariffs for our interstate services, including
resold long-distance, frame relay, and operator services. If and when the
decision not to require the filing of tariffs becomes effective, we could
benefit from the decrease in compliance costs and the elimination of delays in
getting new products and services to market.
Regardless of our nondominant status, we must comply with the provisions of
the Communications Act of 1934 pertaining to common carriers. We are subject to
the general requirement that the rates, terms, and conditions of our services
be "just and reasonable" and we may not make any "unjust or unreasonable"
discrimination in our rates, terms, and conditions. The FCC has the authority
to enforce our compliance with these requirements.
We offer some services that are subject to specific regulatory requirements,
including operator services and public phone service. With respect to our
operator services, we are required to disclose to callers that they may obtain
a rate quote before placing a call and must file informational tariffs
49
<PAGE>
with the FCC containing detailed information about our rates. With respect to
our public phone services, the FCC requires us to post certain consumer
information at each public phone location.
The FCC also requires that equipment that is connected to the public switched
telephone network will not harm the network. The products we install must meet
the FCC's technical standards. While we are ultimately responsible for ensuring
that our equipment complies with federal network standards, as a practical
matter, the burden of compliance lies with our suppliers.
While the FCC recently ruled that calls to the Internet are interstate calls
and thus subject to the FCC's jurisdiction, the FCC currently does not regulate
the Internet and has said that it will refrain from doing so in the future. We
cannot assure you, however, as to the degree of the FCC's regulation of the
Internet in the future, or its effect on our website hosting and other
Internet-related products or services. Potential negative effects could include
the increased costs to comply with any regulations which are imposed and delays
in getting new products and services to market.
In addition to regulating interstate and international telecommunications
services, the FCC also has a significant new role under the Telecommunications
Act of 1996 in overseeing the opening of the intrastate telecommunications
marketplace to competition. The FCC has issued an extensive framework of rules
governing the terms under which incumbent local exchange companies are required
to open their networks to competing providers. Among other things, the
incumbent local exchange companies must allow competitors to interconnect with
their networks and must make their retail services available to competitors at
wholesale rates for resale. We have taken advantage of these rules to enter the
local telecommunications marketplace by reselling incumbent local exchange
companies' services. Numerous parties have challenged various portions of the
resale regulations both before the FCC and in the courts, including the
discounts at which the local exchange companies must make their services
available to us for resale. If the discounts available to us are decreased as a
result of those challenges, it would affect our costs of providing local
telephone service.
State Regulation. Some of our resold local and long-distance services are
classified as intrastate and therefore are subject to state regulation. In most
states in which we do business, we are required to obtain a certificate of
public convenience and necessity and operating authority for the sale of long
distance and local phone services. In addition, we are often required to file
tariffs setting forth the terms, conditions, and prices for services which are
classified as intrastate, particularly local exchange services.
The state public utility commissions also must approve the agreements that we
enter into allowing us to purchase the retail services of the incumbent local
exchange carriers at a discount for resale.
Our Regulatory Status. We are authorized by the FCC to provide resold
international services. We also have tariffs on file with the FCC for
interstate long distance services, frame relay services and operator services.
At the state level, we are authorized to provide intrastate long distance
services in 36 states and are certified to provide local telephone services in
seven states. We anticipate being certified to provide local telephone services
in an additional 36 states by the end of 1999.
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<PAGE>
Employees
As of March 31, 1999, we had 1,080 full-time employees, none of whom are
currently represented by unions.
<TABLE>
<CAPTION>
Number of
Job Description Employees
----------------------------------------------- ---------
<S> <C>
Sales Representatives and Sales Management..... 197
Technical Staff................................ 444
Customer Care.................................. 239
Information Technology......................... 44
Support Services............................... 156
-----
1,080
=====
</TABLE>
Employee Retention. We believe that our ability to implement our business
plan and continue to grow will depend in large part on our ability to continue
to attract and retain qualified employees. In addition to fixed base
compensation, employees at all levels participate in our incentive compensation
plan. All employees are eligible to receive cash bonuses, while management may
receive bonuses including both cash and shares of our common stock. In
addition, we offer a comprehensive benefits package including a 401(k) plan
with a discretionary company match of shares of our common stock, insurance,
cafeteria plan, tuition reimbursement, and, for upper management, a deferred
compensation plan.
Office Facilities
We lease sales and support facilities in each of our markets. Our principal
corporate and support facilities are also leased, and are as follows:
<TABLE>
<CAPTION>
Location Size (sq. ft) Lease Expiration Use of Facility
- -------- ------------- ----------------- -------------------------------------------
<S> <C> <C> <C>
Englewood, Colorado 28,488 April 30, 2003 Headquarters and support services
Englewood, Colorado 16,700 November 30, 2000 National Operations Center and
Denver operations
Englewood, Colorado 33,832 February 28, 2002 Information systems, information technology
and other support services
Overland Park, Kansas 32,044 November 30, 1999 Short-term offices for support services
</TABLE>
Legal Proceedings
We are involved in legal proceedings, none of which we believe, if decided
adversely to us, would have a material adverse effect on our business,
financial condition or results of operations.
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MANAGEMENT
Our executive officers and directors are set forth below. Our directors have
staggered terms, with three classes of directors serving terms as set forth
below or until the director's death, resignation or removal.
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<C> <C> <S>
John R. Evans(1)............... 44 Chief Executive Officer, Chairman and
Director
Keith V. Burge(1).............. 45 President, Chief Operating Officer and
Director
Philip G. Allen(2)............. 52 Executive Vice President, Secretary and
Director
Spencer I. Browne(3)........... 49 Director
Roland E. Casati(2)............ 68 Director
Michael J. Marocco(2).......... 40 Director
Richard G. Tomlinson, 63 Director
Ph.D.(3)......................
Martin E. Freidel.............. 35 Executive Vice President, General
Counsel and Assistant Secretary
John J. Phibbs................. 37 Executive Vice President, Chief
Financial Officer and Treasurer
</TABLE>
(1) Class I Director (term expires 2001)
(2) Class II Director (term expires 2000)
(3) Class III Director (term expires 2002)
John R. Evans has served as the Chief Executive Officer and Chairman of the
Board of Directors since our founding. Prior to this, he served as the Chief
Financial Officer and Executive Vice President of ICG Communications, Inc.
("ICG") from 1991 until December 1995. Before joining ICG, Mr. Evans held
various senior accounting and treasury management positions for five years with
Northern Telecom Canada Ltd., including strategic financial planning, analysis
and budgeting, and held various audit and management information systems
positions during six years with Coopers & Lybrand.
Keith V. Burge has served as the President, Chief Operating Officer and a
member of the Board of Directors since 1996. Prior to this, he was the founder,
President, Chief Executive Officer and Chief Operating Officer of Fiber Optic
Technologies, Inc., a leading national network services integrator specializing
in the design, implementation and support of high-speed data communication
infrastructures, from 1986 to 1995. Fiber Optic Technologies became a
subsidiary of ICG in 1992 and Mr. Burge continued to serve as its President
until 1995. Before founding Fiber Optic Technologies, Mr. Burge was employed by
Digital Equipment Corporation for nine years, where, from 1983 to 1986, he was
a senior sales executive.
Philip G. Allen has served as Executive Vice President, Secretary and a
member of the Board of Directors since our founding. Prior to this, he was the
Vice President of Investor Relations and Corporate Communications for ICG from
1992 to 1995. Before joining ICG, Mr. Allen was President of Allen & Company
Business Communications, a communications company specializing in business
development and the design and production of marketing materials in the
communications field. Mr. Allen was also an advisor to senior management at
what is now Ameritech Corporation and U S WEST from 1976 to 1986, where he
worked in various media relations, public policy and executive support areas.
Spencer I. Browne is a member of the Board of Directors, and was elected to
that position in 1998. He is a principal and founder of Strategic Asset
Management, LLC, a consulting company that
52
<PAGE>
assists small and medium sized companies in obtaining financing. Mr. Browne was
a director, president and chief operating officer of M.D.C. Holdings, Inc. from
1989 to 1996. He was also a co-founder, director and chief executive officer of
Asset Investors Corporation and Commercial Assets. He is also a director of
Altiva Financial Corporation and Annaly Mortgage Management, Inc.
Roland E. Casati has been a Director since 1997. He has developed in excess
of three million square feet of office buildings in and around Chicago,
Illinois, during the past 35 years. For the last 15 years, Mr. Casati has been
a venture capitalist. Mr. Casati is also a director for Adams Golf.
Michael J. Marocco was elected to our Board of Directors in 1998. He is a
managing director of Sandler Capital Management. Mr. Marocco joined Sandler in
1989 and is currently responsible for analyzing, structuring and managing
Sandler's private equity investments. Before joining Sandler, Mr. Marocco held
various positions at Morgan Stanley & Co. Incorporated, including a fixed
income research analyst specializing in companies in the communications
industry and vice president in the Communications Industries group. Mr. Marocco
is also a director of Source Media, Inc.
Richard G. Tomlinson, Ph.D. has served as a Director since 1997, and is also
the President of Connecticut Research, Inc., a management consulting company
founded in 1986 which serves the telecommunications, electric utility and
computer industries. He has published numerous marketing studies, venture
analyses and technical papers, is a contributing author for several books and
holds five patents. Before founding Connecticut Research, Inc., he was the Vice
President for Strategic Planning of United Technologies Communications Co.
Inc., a subsidiary of United Technologies Building Systems Co. His career at
United Technologies Corporation spanned 20 years, including 16 years at the UTC
Research Laboratory where he was a Senior Principal Scientist.
Martin E. Freidel has been Executive Vice President, General Counsel and
Assistant Secretary since 1997. He previously served as Special Counsel to the
law firm of Miller & Welch, LLC in Denver, Colorado, where he also acted as our
Associate General Counsel. From December 1992 until December 1996, Mr. Freidel
was Vice President and General Counsel at ICG and its predecessors. Before
joining ICG, Mr. Freidel served as Vice President--Regulatory for LDDS
Communications, Inc. (now MCI WorldCom) ("LDDS") and Vice President and General
Counsel for MidAmerican Technologies, Inc., MidAmerican Communications, Inc.
and Republic Telecom Services, Inc., which were purchased by LDDS in 1991.
John J. Phibbs has been Executive Vice President, Chief Financial Officer and
Treasurer since 1997. He previously served as our Vice President of Finance and
Administration. Before joining us, Mr. Phibbs held various financial positions
from 1991 through February 1997 with ICG, including Vice President--Accounting
and Vice President--Financial Planning and Analysis. From 1985 to 1991, Mr.
Phibbs was employed in various financial positions at Lockheed Martin
Corporation and McDonnell Douglas Corporation.
----------------
In addition to the Executive Officers listed above, the following individuals
are senior management of our operating subsidiaries, Convergent Communications
Services, Inc. ("CCSI") and Convergent Capital Corporation ("CCC").
<TABLE>
<CAPTION>
Name Position
---- --------
<C> <S>
W. Wood Alberts................ Vice President, Enterprise Network Services for CCSI
Michael R. Dozier.............. Executive Vice President of Market Operations for
CCSI
Michael P. Dykstra............. Senior Vice President of Information Technology and
Chief Information Officer of CCSI
John C. Herbers................ Senior Vice President of Internet Services for CCSI
</TABLE>
53
<PAGE>
<TABLE>
<CAPTION>
Name Position
---- --------
<C> <S>
Brian J. McManus............... Executive Vice President of Internal Operations and
Chief Technical Officer of CCSI
Murray R. Smith................ Executive Vice President of Sales and Marketing of
CCSI
Christopher R. Sullivan........ President and Chief Operating Officer for CCC
Gregory R. Tennant............. Vice President of Network Services for CCSI
</TABLE>
W. Wood Alberts is Vice President of Enterprise Network Services for CCSI and
has served as such since April 1997. Before joining CCSI, he held a variety of
management positions including three years as Division Manager, with
ServiceMaster.
Michael R. Dozier has been Executive Vice President of Market Operations of
CCSI since 1998. He previously served in various capacities at Tie
Communications including Chief Operating Officer and President from June 1997
to August 1998, Executive Vice President from December 1996 to May 1997, and
Vice President of Value Added Services for Tie from May 1995 to November 1996.
Michael P. Dykstra has been Senior Vice President of Information Technology
and Chief Information Officer of CCSI since 1998. He previously served as Vice
President at CSX Technology in Jacksonville, Florida from 1995 to 1998 where he
was responsible for the administration of strategic planning, commercial
planning, and commercial and enterprise services. Previously, he was a Director
in the Management Consulting Division at Price Waterhouse L.L.P. from 1987 to
1995.
John C. Herbers has been Senior Vice President of Internet Services for CCSI
since 1998. Prior to joining CCSI, he served as President of Network Computer
Solutions ("NCS"), a provider of network integration services from May 1996 to
February 1998. Prior to NCS, Mr. Herbers served for three years as President of
U.S. Operations and Senior Vice President of Halozone Technologies Worldwide,
an environmental services company.
Brian J. McManus has been Executive Vice President of Internal Operations and
Chief Technical Officer of CCSI since 1997. He previously served as Director of
Information Systems at ICG from 1992 to 1996.
Murray R. Smith was hired as Executive Vice President of Sales and Marketing
of CCSI in 1999. He previously served from 1992 to 1996 as Director of Field
Marketing--Business Services for MCI, where he was responsible for the
development, rollout, follow up and support of all corporate product
introductions, competitive marketing programs, promotion programs, customer
base programs and marketplace intelligence. From 1996 until joining us, Mr.
Smith was Vice President of Corporate Services for KN Energy of Denver,
Colorado.
Christopher R. Sullivan is the President and Chief Operating Officer for CCC.
He has served in that capacity since 1998. Before joining CCC, he was corporate
counsel at GATX/Sun Financial from 1997 to 1998. Prior to 1997, he was Vice
President of the law firm of Malloy & Sullivan, Lawyers P.C.
Gregory R. Tennant is the Vice President of Network Services for CCSI. Mr.
Tennant has been with CCSI since 1998. Prior to that, he served as Director of
Data Services for Intermedia Communications with responsibilities for frame
relay, ATM, Internet access and web hosting, management services and
collocation services from 1995 to 1998. Before that, he was a Senior Strategic
Marketing Manager for AT&T Paradyne Corporation.
54
<PAGE>
Director Compensation
Our Directors are reimbursed for certain reasonable expenses incurred in
attending Board or committee meetings. In addition, non-employee Directors are
compensated $1,000 per day for on-site meetings and $250 for teleconference
meetings. Non-employee Directors also receive options to purchase 2,500 shares
of our common stock per quarter for each quarter that they serve as a Director.
Audit Committee
We have an Audit Committee that:
. monitors our financial reporting and our internal and external audits;
. reviews and approves material accounting policy changes;
. monitors internal accounting controls;
. recommends the engagement of independent auditors;
. reviews transactions between our company and our officers or Directors;
and
. performs other duties when requested by the Board of Directors.
Messrs. Browne, Evans and Dr. Tomlinson are members of the Audit Committee.
Compensation Committee
We also have a Compensation Committee that reviews and approves the
compensation and benefits paid to our executive officers, and administers our
employee stock option plans. Messrs. Marocco, Browne and Evans are members of
the Compensation Committee.
55
<PAGE>
EXECUTIVE COMPENSATION
The following table sets forth in summary form the compensation earned by our
Chief Executive Officer and our four other highest paid executive officers.
<TABLE>
<CAPTION>
Long-Term
Annual Compensation Compensation
------------------------------------- Securities
Name and Principal Other Annual Underlying All Other
Position Year Salary(1) Bonus(2) Compensation(3) Options(4) Compensation(5)
- ------------------ ---- --------- -------- --------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
John R. Evans........... 1996 $ 6,250 -- -- 100,000 --
Chairman and Chief 1997 $150,000 $75,000 $12,781 -- $81,579
Executive Officer 1998 $200,000 $87,500 $14,799 50,000 $97,100
Keith V. Burge.......... 1996 $ 5,417 -- -- 100,000 --
President and Chief 1997 $130,000 $65,000 $ 8,625 -- $71,944
Operating Officer 1998 $180,000 $78,750 $ 9,775 50,000 $88,350
Philip G. Allen......... 1996 $ 4,167 -- -- 100,000 --
Executive Vice 1997 $100,000 $50,000 $12,172 -- $55,735
President and Secretary 1998 $150,000 $32,813 $ 9,000 50,000 $42,413
Martin E. Freidel....... 1997 $ 36,939(6) $19,569 $ 2,199 150,000 $21,445
Executive Vice 1998 $139,583(6) $54,688 $ 6,000 -- $64,132
President, General
Counsel and Asst
Secretary
John J. Phibbs.......... 1997 $ 95,833(7) $32,383 $ 5,000 150,000 $29,134
Executive Vice 1998 $137,500(7) $33,268 $ 6,250 -- $41,338
President, Chief
Financial Officer and
Treasurer
</TABLE>
- --------
(1) During 1996, we were in our initial formation stage and the executive
officers did not receive salaries for their services until December 16,
1996.
(2) Includes the 50% of the individual's bonus under his employment agreement
which was paid in cash, plus, in the case of Mr. Phibbs, a signing bonus of
$8,425. Each of the individuals received the remaining 50% of his bonus in
shares of our common stock, valued at fair market value, which amount is
reflected under "All Other Compensation".
(3) Includes automobile allowance and other fringe benefit payments.
(4) Amounts listed are shares of our common stock underlying options granted,
which vest over five years. Twenty percent of the options to purchase
shares vest on each anniversary of the date of grant.
(5) Includes contributions to our 401(k) Plan and 50% of the bonus payments
made under the individual's employment agreement which were deferred and
paid in shares of our common stock which is held under our deferred
compensation plan. These shares are held in a "rabbi trust" for a period we
and the employee specify, which cannot be less than one year. The number of
shares held for the benefit of the officers are as follows: Mr. Evans,
23,260; Mr. Burge, 20,826; Mr. Allen, 13,543; Mr. Phibbs, 9,169; and Mr.
Freidel, 9,794.
(6) Mr. Freidel's employment commenced on September 15, 1997. His base salary
was $125,000 per year and increased to $175,000 on September 15, 1998.
(7) Mr. Phibbs' employment commenced on March 3, 1997. His base salary was
$130,000 per year and increased to $175,000 on November 1, 1998.
56
<PAGE>
OPTION GRANTS TABLE
<TABLE>
<CAPTION>
Percent Potential Realizable Value
Number of of Total at Assumed Annual Rates
Securities Options of Stock Price Appreciation
Underlying Granted Exercise for Option Term(2)
Options to Price Expiration ---------------------------
Name Year Granted(1) Employees Per Share Date 5% 10%
---- ---- ---------- --------- --------- ---------- ---------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
John R. Evans........... 1996 100,000 11.0% $ 2.20 12/15/2001 $ 35,000 $ 102,000
1997 -- -- -- -- -- --
1998 50,000 3.0% $11.00 4/13/2008 $ 264,000 $ 747,000
Keith V. Burge.......... 1996 100,000 11.0% $ 2.20 12/15/2001 $ 35,000 $ 102,000
1997 -- -- -- -- -- --
1998 50,000 3.0% $11.00 4/13/2008 $ 264,000 $ 747,000
Philip G. Allen......... 1996 100,000 11.0% $ 2.20 12/15/2001 $ 35,000 $ 102,000
1997 -- -- -- -- -- --
1998 50,000 3.0% $11.00 4/13/2008 $ 264,000 $ 747,000
Martin E. Freidel....... 1997 150,000 7.9% $ 5.00 9/15/2007 $ 472,000 $ 1,195,000
John J. Phibbs.......... 1997 150,000 7.9% $ 2.00 3/3/2007 $ 189,000 $ 478,000
</TABLE>
- --------
(1) 20% of the options to purchase shares of our common stock vest on each
anniversary of the date of grant.
(2) Potential realizable value is based on an assumption that the price per
share of our common stock appreciates annually at the rate shown
(compounded annually) from the date of grant until the end of the option
term. Potential realizable value is shown net of the exercise price. These
rates of appreciation are provided in accordance with the Securities and
Exchange Commission regulations and do not represent our estimate or
projection of the future common stock price.
AGGREGATED OPTION FISCAL YEAR-END VALUES
<TABLE>
<CAPTION>
Number of Securities Including Value of Unexercised In-The-Money
Unexercised Options At Fiscal Year-End Options At Fiscal Year-End
Name Exercisable/Unexercisable Exercisable/Unexercisable(1)
---- -------------------------------------- ---------------------------------
<S> <C> <C>
John R. Evans........... 40,000/110,000 $312,000/$468,000
Keith V. Burge.......... 40,000/110,000 $312,000/$468,000
Philip G. Allen......... 40,000/110,000 $312,000/$468,000
Martin E. Freidel....... 30,000/120,000 $240,000/$960,000
John J. Phibbs.......... 30,000/120,000 $150,000/$600,000
</TABLE>
- --------
(1) Based on an assumed fair market value of our common stock as of December
31, 1998.
Employment Agreements
We have employment agreements with each of our executive officers.
Each of Messrs. Evans', Burge's and Allen's employment agreement was
originally executed effective December 15, 1996 and provides for an initial
term of five years. Mr. Evans currently receives a base salary of $300,000, Mr.
Burge currently receives a base salary of $275,000, and Mr. Allen currently
receives a base salary of $165,000. They also receive a car allowance, benefit
package and an incentive bonus of up to 100% of their respective base salaries
for Messrs. Evans and Burge, and up to 75% of his base salary for Mr. Allen.
The incentive bonus is determined by our Compensation Committee. If we
terminate the employment agreement without cause, or if the employee terminates
as a result of a change in control, the employee is entitled to continue to
receive his salary and benefits for a period of 24 months, as well as accrued
bonus and the immediate vesting of all options granted to the employee. In
addition, each of Messrs. Evans, Burge and Allen is subject to covenants not to
compete with our business or interfere with our business and employee
relationships.
57
<PAGE>
Mr. Phibbs' employment agreement is effective as of March 3, 1997 and
provides for a term of four years. Mr. Freidel's employment agreement is
effective as of September 15, 1997 and provides for an initial term of five
years. Each of Mr. Phibbs and Mr. Freidel receive an annual base salary of
$175,000. In addition, each receives a car allowance, benefit package and an
incentive bonus of up to 75% of their base salary. The incentive bonus is
determined by our Compensation Committee. If we terminate the employment
agreement without cause, the employee is entitled to continue to receive his
salary and benefits for a period of 24 months. In the event of termination
because of a change in control, the employee is entitled to continue to receive
his salary and benefits for a period of 24 months as well as accrued bonus and
immediate vesting of all options.
Stock Option Plans
We have adopted stock option plans for our employees and Directors. The
following table provides summary information about our stock option plans as of
May 31, 1999:
<TABLE>
<CAPTION>
Shares Authorized Options Outstanding Options Exercisable
----------------- ------------------- -------------------
<S> <C> <C> <C>
1996 Plan............ 1,350,000 1,065,500 429,500
1997 Plan............ 600,000 467,000 105,900
1998 Plan............ 1,750,000 1,680,300 195,400
1999 Plan............ 750,000 346,500 12,500
--------- --------- -------
Total.............. 4,450,000 3,559,300 743,300
========= ========= =======
</TABLE>
The stock option plans include the following terms:
. all employee options vest 20% each year over five years from the date of
grant;
. the exercise prices of options granted must be at least equal to the fair
market value of our common stock on the date of grant;
. options have a maximum term of ten years;
. if an employee owns more than 10% of our outstanding common stock, then
the exercise price of the option must be at least 110% of the fair market
value of a share of our common stock on the date of grant, and the
maximum term of the option is five years; and
. the aggregate fair market value of the common stock, determined at the
time the option is granted, for which incentive stock options become
exercisable by an employee during any calendar year is limited to
$100,000.
Our stock option plans are administered by our Compensation Committee. They
determine additional conditions of the options granted, including the exercise
price and the number of shares to grant. Options cannot be transferred and they
can only be exercised by the person who received the grant. Outstanding options
have exercise prices from $2.00 to $20.00.
401(k) Plan
We also provide our employees with a 401(k) plan. Eligible employees may
voluntarily elect to have up to 15% of their salaries (subject to the maximum
amount allowed under Federal law) deducted from their earnings and contributed
to the 401(k) plan. Contributions are invested in several alternatives selected
by the employee. At the end of each quarter, we determine whether or not to
match our employees' contributions. The maximum amount of our matching
contribution would be 6% of an employee's contribution. If we decide to match
our employees' contributions, we contribute shares of our common stock into the
401(k) plan. The value of our common stock is determined by an independent
valuation at the end of each quarter. Shares of common stock that we contribute
into
58
<PAGE>
the 401(k) plan are fully vested when they are issued. As of May 31, 1999 we
had issued a total of 144,500 shares of stock into the 401(k) Plan.
Incentive Compensation Plan
We have also adopted an Incentive Compensation Plan for most of our
employees. Eligible employees may receive a payment based in part upon their
individual performance during the preceding fiscal year as measured against
predetermined objectives and in part upon our performance during the same
period. For director-level employees and above, 50% of the employee's incentive
compensation must be taken in the form of common stock. The stock portion can
be deferred pursuant to our Deferred Compensation Plan.
Deferred Compensation Plan
Our Deferred Compensation Plan allows management employees the option to
defer the common stock portion of their compensation to be paid at a future
date. This plan requires us to issue shares of common stock into a trust
account which will then be distributed to the employee at a specified date in
the future, which cannot be less than one year from the deferral date. As of
May 31, 1999, 142,096 shares of common stock are being held in the trust
account.
59
<PAGE>
PRINCIPAL AND SELLING SHAREHOLDERS
The following table summarizes certain information regarding the beneficial
ownership of our common stock as of July 19, 1999, by (i) each of our directors
and officers, (ii) each person who we know beneficially owns more than 5% of
our common stock (iii) all of our officers and directors as a group and (iv)
the selling shareholders as a group. Options, warrants exerciseable within 60
days and the convertible preferred stock are expressed in terms of common share
equivalents. Percentage ownership is calculated by dividing (i) the sum of the
number of shares owned by the shareholder plus the number of shares the
shareholder would receive after exercising options and warrants exercisable
within sixty (60) days of the date of this prospectus (shares issued after
exercising options and warrants are called "conversion shares"), by (ii) the
total number of common shares of stock outstanding as of July 19, 1999 plus the
shareholder's conversion shares. References to Other Shares are shares held in
our 401(k) plan, our Deferred Compensation Plan trust account, and the maximum
number of shares issuable upon conversion of our convertible preferred stock.
<TABLE>
<CAPTION>
Total Shares Total Shares
Beneficially Beneficially
Shares of owned prior to Shares Owned After the
Common Stock the Offering Sold Offering
Beneficially Other ----------------- in the -----------------
Name and Address Owned Options Warrants Shares Number Percent Offering Number Percent
---------------- ------------ ------- --------- ---------- --------- ------- --------- --------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
John R. Evans
(1)(2)(3).............. 3,180,000 50,000 14,795 23,260 3,432,015 21.57% -- 3,432,015 13.07%
Keith V. Burge (1)(3)... 3,180,000 50,000 14,795 20,827 3,432,015 21.57% -- 3,432,015 13.07%
Philip G. Allen
(1)(3)................. 3,180,000 50,000 14,795 13,543 3,432,015 21.57% -- 3,432,015 13.07%
Spencer I. Browne (4).. 77,500 5,000 12,500 -- 95,000 * -- 95,000 *
Roland E. Casati........ 375,000 25,000 257,358(5) 66,667(5) 724,025 4.47% -- 724,025 2.73%
Michael J.
Marocco (6)........... 600,000 5,000 769,733(5) 2,141,866(5) 3,516,599 18.74% -- 3,516,599 13.04%
Dr. Richard G.
Tomlinson............. 30,000 20,000 810 -- 50,810 * -- 50,810 *
Martin E. Freidel (7)... 33,700 60,000 -- 9,794 103,494 * -- 103,494 *
John J. Phibbs.......... -- 60,000 -- 9,169 69,169 * -- 69,169 *
Sandler Group (8)....... 600,000 -- 800,208(5) 2,226,666(5) 3,626,874 19.22% -- 3,626,844 13.44%
First Continental Group,
L.C. (9)............... 902,500 -- -- -- 902,500 5.70% -- 902,500 3.45%
All Officers and
Directors
as a group
(9 persons)............ 4,296,200 325,000 1,084,787 2,285,124 7,991,111 41.06% -- 7,991,111 28.96%
145 selling
shareholders,
each of whom will be
selling less than 1% of
the outstanding common
stock (10)............. 2,568,306 14,100 1,103,750 -- 3,686,156 21.73% 723,271 2,962,885 10.85%
</TABLE>
- --------
* Less than 1%
(1) Messrs. Evans, Burge and Allen and their spouses have agreed that the
shares of common stock that they beneficially own will be voted together
pursuant to a voting agreement. The voting agreement states that the
majority vote of the parties will dictate how all of the shares
beneficially owned by the parties are voted. As a result, each party to the
voting agreement is deemed to beneficially own all the shares beneficially
owned by the other parties. If such attribution of beneficial ownership
were not deemed to occur, the total beneficial ownership of each individual
would be 1,083,055 shares owned for Mr. Evans, 1,215,622 shares owned for
Mr. Burge, and 1,133,338 shares owned for Mr. Allen. The address for these
individuals is 400 Inverness Drive South, Suite 400, Englewood, CO 80112.
(2) Includes 102,500 shares held in trusts for the benefit of Mr. Evans'
children because Mr. Evans has voting rights over those shares.
60
<PAGE>
(3) Includes 250,000 shares held by the holder's spouse.
(4) As Mr. Browne is a principal of Strategic Asset Management, LLC, this
number includes 42,500 shares and warrants to purchase 20,000 shares owned
by that firm.
(5) Consists of the shares of common stock issuable upon (i) conversion of
shares of convertible preferred stock issued in March 1999 and (ii)
exercise of the related warrants.
(6) Includes 406,820 shares owned by 21st Century Communications Partners,
L.P., 138,420 shares owned by 21st Century Communications T-E Partners,
L.P. and 54,760 shares owned by 21st Century Communications Foreign
Partners, L.P., as well as shares and warrants to purchase shares held by
Sandler Capital Partners IV, L.P.; Sandler Capital Partners IV FTE, L.P.
and MJM Associates, L.P. over which Mr. Marocco has voting power. Mr.
Marocco disclaims beneficial ownership in these shares, except to the
extent of his equity interest in them.
(7) Includes 30,500 shares owned by Freidel Development International, LLC, as
Mr. Freidel has voting power over these shares.
(8) The address for Sandler Group is 767 5th Avenue, 45th Floor New York, NY
10153.
(9) The address for First Continental Group, L.C. is 3818 N.W. 92nd Place Polk
City, IA 50226.
(10) The number of shares to be sold by the selling shareholders in this
offering may be reduced to the extent any selling shareholder fails to
deliver its shares or any required documentation prior to the closing of
the offering.
61
<PAGE>
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In August 1998, our operating subsidiary, Convergent Communications Services,
Inc., entered into a Strategic Alliance Agreement with Strategic Healthcare
Solutions, LLC ("SHS"). The agreement is a two year agreement and provides for
the payment of a monthly fee and commissions to SHS for new Enterprise Network
Services customers in the healthcare industry that are introduced to us by SHS
and that become customers. Under the agreement, we issued a warrant to SHS
which entitles SHS to receive up to a maximum of 131,250 shares of our common
stock at an exercise price of $12.00 per share. The warrant includes
performance objectives which are reviewed semi-annually. If SHS does not meet
those performance objectives, all or a portion of the shares available for
exercise is reduced. As of May 31, 1999, 32,812 shares had been canceled due to
SHS's failure to meet the performance objective. The warrant is not exercisable
until August 1, 2000 and expires August 1, 2003. Spencer I. Browne is a
principal of Strategic Asset Management which has an ownership interest in
Strategic Healthcare Solutions.
In March 1999, we sold to one of our directors and various affiliates of the
Sandler Group 800,000 shares of our convertible preferred stock and warrants
for net proceeds of $19.3 million. Our convertible preferred stock is
convertible into 2,666,667 shares of our common stock and the warrants entitle
the holders to purchase an aggregate of 958,333 shares of our common stock at
an exercise price of $15.00 per share. The warrants have a term of five years.
See "Description of Capital Stock -- Preferred Stock" and "Description of
Capital Stock -- Warrants." One of our directors, Michael Marocco, is a
principal of several of the entities in the Sandler Group and is deemed to be
the beneficial owner of 646,560 shares of convertible preferred stock and
related warrants. Roland Casati, one of our directors, purchased 20,000 shares
of convertible preferred stock and related warrants at the same time.
62
<PAGE>
DESCRIPTION OF CAPITAL STOCK
Authorized Stock
The authorized capital stock of Convergent Communications, Inc. consists of
100 million shares of common stock, no par value, and 1,000,000 shares of
preferred stock, no par value. All of the issued and outstanding capital stock
is fully paid and nonassessable. The following summary of our common stock and
preferred stock is qualified by reference to our Articles of Incorporation a
copy of which has been filed as an exhibit to the Registration Statement of
which this prospectus forms a part.
Preferred Stock
We are authorized to issue up to 1,000,000 shares of preferred stock, of
which 800,000 have been designated as Series A Convertible Preferred Stock. All
of the convertible preferred stock are issued and outstanding.
In March 1999, we sold to various affiliates of the Sandler Group 800,000
shares of convertible preferred stock and warrants. The convertible preferred
stock will convert into 2,666,667 shares of common stock upon the closing of
this offering.
Our Board of Directors is authorized, subject to any limitations prescribed
by Colorado law, to issue shares of preferred stock in one or more series, to
establish from time to time the number of shares to be included in each such
series, to establish or alter the voting powers, designations, preferences and
other rights, or the qualifications, limitations or restrictions thereof, and
to increase (but not above the total number of authorized shares of the class)
or decrease (but not below the number of shares of such series then
outstanding) the number of shares of any such series without any further vote
or action by the shareholders. Our Board of Directors is also authorized to
issue preferred stock with voting, conversion and other rights and preferences
that could adversely affect your voting power or other rights, as a holder of
common stock. Although we have no current plans to issue any such shares, the
issuance of preferred stock or of rights to purchase preferred stock could have
the effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire us. Such an issuance
could also dilute your voting power or other incidents of ownership as a holder
of common stock.
Common Stock
As of May 31, 1999, there were 14,176,431 shares of common stock outstanding
held by approximately 500 shareholders. In addition there are options, warrants
and other convertible securities outstanding that, if exercised or converted,
would cause the issuance of an additional 10,104,948 shares of common stock,
subject to further adjustment based on the offering price of shares to be sold
in this offering. See "--Warrants." As a holder of common stock, you would be
entitled to receive ratable dividends in respect of common stock when and as
declared by the Board of Directors and to one vote for each share held of
record on each matter submitted to a vote of shareholders. We do not, however,
expect to pay dividends for the foreseeable future and are currently prevented
from doing so by the indenture governing our 13% Senior Notes. If we liquidate,
or dissolve, you would be entitled to share ratably in all assets remaining
after payments to creditors and other payments required by law. You would have
no preemptive rights and no rights to convert your common stock into any other
securities.
Warrants
Our outstanding warrants to purchase shares of common stock consist of the
following as of May 31, 1999:
. warrants to purchase 2,091,429 shares of common stock issued in
connection with a private round of financing from December 1996 through
February 1997, expiring November 2001, 1,748,929 of which are at an
exercise price of $3.00 and 342,500 of which are at an exercise price of
$2.40;
63
<PAGE>
. warrants to purchase 1,984,830 shares of common stock issued in
connection with a private round of financing from October through
November 1997, 1,683,750 of which are at an exercise price of $7.50 per
share, expiring July 1999 (1,638,500 of which were exercised as of July
14, 1999) and 301,080 of which are at an exercise price of $6.00 per
share and expire in November 2002;
. warrants to purchase 40,285 shares of common stock at an exercise price
of $6.00 per share, expiring May 2002, issued in connection with the Sun
Financial facility in May 1997;
. warrants to purchase 166,666 shares of common stock at an exercise price
of $6.00 per share, expiring November 2007 which were issued in November
1997, and warrants to purchase 200,000 shares of common stock at an
exercise price of $10.00 per share, expiring March 2009, issued in March
1999, all of which were issued in connection with our Comdisco facility;
. warrants to purchase 25,000 shares of common stock at an exercise price
of $15.00 per share, expiring December 1999, issued in connection with
an acquisition;
. warrants to purchase 75,000 shares of common stock at an exercise price
of $10.00 per share, expiring in August 2008 issued in August 1998 to
Clay Biddinger for consulting services rendered;
. warrants to purchase 98,437 shares of common stock at an exercise price
of $12.00 per share, expiring in August 2003, issued in August 1998 to
Strategic Healthcare Solutions for services rendered;
. warrants to purchase 864,000 shares of common stock at an exercise price
of $0.02 per share, expiring April 2008, issued in April 1998 connection
with our 13% Senior Notes; and
. warrants to purchase 958,333 shares of common stock, issued in March
1999 in connection with the sale of our convertible preferred stock and
expire March 2004.
In addition, warrants to purchase 375,000 shares of common stock at an
exercise price of $15.00 per share, expiring on the earlier of (i) the third
anniversary of the closing of this offering and (ii) June 3, 2003, were issued
in June 1999 in connection with the Goldman Sachs Credit Partners L.P. senior
secured credit facility. In July 1999, we also issued warrants to purchase
575,000 shares of common stock at an exercise price of $15.00 per share,
expiring July 23, 2004, to Cisco Systems, Inc. in connection with a credit
facility.
We have described options to purchase common stock that we have granted to
various officers, directors and employees under the heading "Management."
Registration Rights
Before March 1999, holders of approximately 8.8 million shares of common
stock and warrants to purchase approximately 4.4 million shares of common stock
had contractual rights to require us to register their shares (either as a
result of demand or piggy-back registration rights). In March 1999, we offered
to each of these holders (other than the holders of warrants to purchase
864,000 shares of common stock issued in connection with the 13% Senior Notes)
the opportunity to include a portion of their respective share holdings in this
offering and the potential to include the rest of their shares in any
subsequent offering, in exchange for a lock-up of their shares for 180 to 270
days following this offering, and a waiver of all of their registration rights.
Of the holders from whom we requested waivers, holders of all but 310,000
shares of common stock and warrants to purchase 155,000 shares of common stock
have signed these waivers. With respect to these holders who have not signed
waivers, and whose piggy-back registration rights require that we offer to
include their shares in this offering, we will include their shares in this
offering subject to the terms of their registration rights.
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<PAGE>
Also in March 1999, we issued 800,000 shares of our convertible preferred
stock which will be automatically converted into 2,666,667 shares of common
stock, and warrants to purchase 958,333 shares of common stock. All of these
holders have registration rights, and we did not seek waivers from these
holders in connection with this offering, however, all of these holders have
agreed to lock up their shares for a period of 180 days from the date after
completion of this offering. In addition, the warrants we issued in connection
with the Goldman Sachs Credit Partners L.P. senior credit facility have
registration rights.
As a result, the following registration rights exist with respect to our
common stock:
. 13% Senior Note Warrants--After 180 days following this offering,
holders of warrants to purchase 864,000 shares of common stock have
the ability, upon the request of holders of a majority of the
warrants, to require us to register their shares. They also may
include the common shares in a "piggy-back" registration when we file
another registration statement covering the sale of common stock (or
like security) (other than a registration statement on Form S-4 or S-
8, a registration statement covering sales solely to existing
shareholders, a registration statement filed pursuant to a demand
registration by these holders or relating to any offering of common
stock or like security under any benefit plan, employee compensation
plan or employee or director stock purchase plan.)
. Series A Convertible Preferred Stock and Warrants--After the 180-day
lock up period following this offering, holders of these shares (to
be converted into 2,666,667 shares of common stock) and warrants
(exercisable for 958,333 shares of common stock) have the ability,
upon the request of holders of at least 33% of these securities, to
require us to register their shares of common stock. They may also
include the common shares in a piggy-back registration when we file
another registration statement covering the sale of common stock,
except for registration statements:
. filed on Form S-4 or S-8;
. covering sales solely to existing shareholders;
. filed within 180 days of this offering, unless it includes
holders of existing registration rights who are not affiliates
or affiliates who are selling more than 10% of the shares they
beneficially own; and
. filed as a result of the demand rights associated with the 13%
Senior Note Warrants if such rights allow underwriters to
exclude other shares, unless holders of such warrants
otherwise agree.
. Goldman Sachs Credit Partners L.P. Warrants--After the 180-day lock
up period following this offering, holders of these warrants have the
ability, upon the request of holders of a majority of the warrants,
to require us to register their shares of common stock issuable upon
exercise of the warrants. They may also include the common shares in
a piggy-back registration when we file another registration statement
covering the sale of common stock, except for registration
statements:
. filed as a result of the demand registration rights associated
with the 13% Senior Note warrants or the Series A convertible
preferred stock and warrants unless holders of such securities
and warrants otherwise agree.
. filed on Form S-4 or S-8;
. covering sales solely to existing shareholders; and
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<PAGE>
. filed within 180 days of this offering, unless it includes
holders of existing registration rights who are not affiliates
or affiliates who are selling more than 10% of the shares they
beneficially own.
. Cisco Systems, Inc. -- Cisco has non-transferable piggy-back
registration rights which allow Cisco to include the common shares
issuable the upon exercise of the warrant in registration statements
we file covering the sale of common stock, except for registration
statements:
. filed as a result of the demand registration rights associated
with the 13% Senior Note Warrants, the Series A convertible
preferred stock and warrants, and the Goldman Sachs Credit
Partners L.P. warrants unless holders of such securities
otherwise agree;
. filed on Form S-4 or S-8;
. covering sales solely to existing shareholders; and
. filed within 180 days of this offering, unless it includes
holders of existing registration rights who are not affiliates
or affiliates who are selling more than 10% of the shares they
beneficially own.
. 1997 Private Placement Units--Holders of these securities who have not
executed the waivers described above have piggy-back registration
rights which allow them to include shares of common stock held by
them in registration statements we file. Approximately 27,500 of the
shares sold by selling shareholders in this offering are sold as a
result of the exercise of these rights. After the closing of this
offering, holders of up to 360,000 shares (including shares issuable
upon exercise of warrants) will have these piggy-back rights.
. 1996 Private Placement Units--A holder of 100,000 shares of these
securities who has not executed the waiver described above has
piggy-back registration rights which allow that holder to include
those shares of common stock in registration statements that we
file.
Limitation of Directors' Liability
Our Articles of Incorporation eliminate, subject to certain exceptions, the
personal liability of our directors for monetary damages for their breach of
fiduciary duty. However, these provisions do not eliminate or limit the
personal liability of directors for the following:
. any breach of the director's duty of loyalty;
. acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
. unlawful corporate distributions; or
. any transaction from which a director derives an improper personal
benefit.
These provisions will limit the remedies available to you as a shareholder.
If you are dissatisfied with a decision of the Board of Directors protected by
this provision your only remedy may be to bring a suit to prevent the action of
the Board. This remedy may not be effective in many situations because
shareholders are often unaware of a transaction or event before Board action
relating to that transaction or event. In these cases, the shareholders could
be injured by a Board's decision and have no effective remedy.
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<PAGE>
Our Articles of Incorporation also provide that we will indemnify our
directors and officers to the fullest extent permitted by Colorado law. We have
been advised that, in the opinion of the Securities and Exchange Commission,
indemnification for liabilities under the Securities Act is against public
policy and is unenforceable.
Transfer Agent
American Stock Transfer & Trust Co. acts as the registrar and transfer agent
for our common stock.
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<PAGE>
DESCRIPTION OF INDEBTEDNESS
13% Senior Notes due 2008
On April 2, 1998, we sold units which consisted of, in the aggregate,
$160,000,000 principal amount of 13% Senior Notes, and warrants to purchase
864,000 shares of common stock at $0.02 per share. On December 1, 1998, we
issued in an offering registered under the Securities Act of 1933 an aggregate
principal amount of $160,000,000 13% Senior Notes in exchange for all the
unregistered 13% Senior Notes issued on April 2, 1998. All of the 13% Senior
Notes are still outstanding.
The 13% Senior Notes are governed by the terms of an indenture. The material
terms of the indenture are described below. As a summary, the following
discussion necessarily omits many of the details of the indenture. A copy of
the indenture has been filed as an exhibit to the Registration Statement of
which this prospectus is a part.
We used approximately $56.8 million of the net proceeds of the sale of the
13% Senior Notes to purchase Treasury securities which were placed in an escrow
account. The principal and interest payments on these Treasury securities will
be sufficient to make the first six semi-annual interest payments on the 13%
Senior Notes, the first two of which have been paid. Interest on the 13% Senior
Notes accrues at a rate of 13% per year, and is payable semiannually in arrears
on each April 1 and October 1.
Optional Redemption
The 13% Senior Notes are redeemable, in whole or in part, at any time on or
after April 1, 2003 at our option at the redemption prices (expressed as
percentages of principal amount) set forth below, plus accrued and unpaid
interest to the redemption date, if redeemed during the 12-month period
beginning April 1 of the years indicated below:
<TABLE>
<CAPTION>
Year Redemption Price
---- ----------------
<S> <C>
2003...................................................... 106.50%
2004...................................................... 104.33%
2005...................................................... 102.17%
2006 and thereafter....................................... 100.00%
</TABLE>
However, on or before April 1, 2001, we may, at our option, redeem up to 35%
of the aggregate principal amount of 13% Senior Notes originally issued
(provided at least 65% of the aggregate principal amount of the 13% Senior
Notes remains outstanding), at a redemption price of 113% of their principal
amount plus accrued and unpaid interest. However, we can redeem the 13% Senior
Notes in this manner only with the net proceeds of one or more underwritten
public offerings of common stock, or one or more sales of common stock to
certain types of investors engaged in the same industry and having a net worth
in excess of $1 billion, and in each case, only if the net proceeds from such
offering or sale are in excess of $50 million.
Change of Control
If a change of control (as defined in the indenture) occurs, we must make an
offer to purchase all outstanding 13% Senior Notes then outstanding at a
purchase price equal to 101% of their principal amount plus accrued and unpaid
interest. This requirement could deter a change of control transaction in which
shareholders could receive a premium.
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<PAGE>
Covenants Restricting Our Actions
The indenture for our 13% Senior Notes contains covenants which prohibit or
restrict our ability to:
. incur indebtedness;
. make investments and other payments;
. sell assets;
. enter into transactions with affiliates;
. issue or sell capital stock of our subsidiaries;
. engage in businesses other than telecommunications; and
. designate subsidiaries as unrestricted.
As a result of these covenants, we will not be able to pay dividends for the
foreseeable future. For a complete description of these covenants you may refer
to the indenture, which has been filed as an exhibit to this registration
statement.
Events of Default
The following are "events of default" under the indenture:
. default in the payment of interest on the 13% Senior Notes when it
becomes due and payable which default continues for a period of 30
days or more; if such a default occurs before April 1, 2001, there
will be no 30 day grace or cure period;
. default in the payment of the principal of, or premium, if any, on
the 13% Senior Notes when due;
. default in the performance, or breach, of covenants relating to
changes of control, consolidations, mergers or asset sales;
. default in the performance, or breach, of any other covenant in the
indenture which is continued for a period of 30 days or more after
written notice to us;
. failure to perform any term, covenant, condition or provision of
one or more classes or issues of indebtedness in an aggregate
principal amount of $5.0 million or more, and either (a) such
indebtedness is already due and payable in full or (b) such failure
results in the acceleration of the maturity of such indebtedness;
. one or more final non-appealable judgments, orders or decrees for
the payment of money of $5.0 million or more, either individually
or in the aggregate, shall be entered against us and is not
discharged, and 60 days shall have passed without such judgment
being stayed;
. a bankruptcy, insolvency, reorganization or receivership or similar
proceedings with respect to us or one of our significant
subsidiaries; or
. we assert or acknowledge in writing that the security agreement
relating to the escrow account is invalid or unenforceable.
Comdisco Facility
In November 1997, we entered into a $50.0 million agreement with Comdisco,
Inc., a computer and telecommunications equipment leasing and financing
company. The agreement provides for lease financing of equipment. Under the
agreement, we can either lease equipment from Comdisco's inventory or issue
purchase orders to third-party vendors on behalf of Comdisco and lease the
purchased equipment from Comdisco. Comdisco receives a security interest in the
equipment leased. As of March 31, 1999, there is $10.2 million utilized and
$19.8 million available under the agreement, which expires on June 30, 2000.
The remaining $20.0 million will become available upon the satisfaction of
additional conditions.
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<PAGE>
In addition, we are required to issue a warrant to acquire common stock in an
amount equal to ten percent (10%) of the available facility, divided by the
exercise price per share. The exercise price per share is equal to the price
paid by investors in recent equity offerings and will, in no event, be less
than $6.00 per share. The warrants will be issued in three installments based
upon amounts available under the facility. On November 19, 1997, we issued a
warrant for the purchase of 166,666 shares of common stock at an exercise price
of $6.00 per share for the first $10.0 million of the facility, and on March
22, 1999, we issued a warrant for the purchase of 200,000 shares of common
stock at an exercise price of $10.00 per share for the next $20.0 million of
the facility.
Sun Financial Facility
In May 1997, we entered into a master equipment lease with Sun Financial
Group, Inc., a subsidiary of GATX Capital Corporation, to lease equipment,
facilities and related items for our internal expansion as well as equipment to
be used for customer installations. We have $4.8 million of this credit
facility outstanding at March 31, 1999. The facility is secured by a $100,000
standby letter of credit. We also issued a warrant to Sun Financial Group, Inc.
for the purchase of 40,285 shares of common stock at an exercise price of
$6.00.
Goldman Sachs Credit Partners L.P. Senior Secured Credit Facility
In June 1999, we entered into a $10.0 million senior secured credit facility
with Goldman Sachs Credit Partners L.P., under which our operating subsidiary,
Convergent Communications Services, Inc. and our leasing subsidiary, Convergent
Capital Corporation borrowed an aggregate of $10.0 million. The proceeds from
this facility may be used for working capital and other general corporate
purposes. We have agreed to guaranty our subsidiaries' obligations under this
facility. We have granted to Goldman Sachs Credit Partners L.P. a security
interest in, among other things, our eligible accounts receivable, inventory
held for sale (except inventory subject to purchase money indebtedness) and
intellectual property. In addition, the facility is secured by a pledge to
Goldman Sachs Credit Partners L.P. of all of the capital stock of our
subsidiaries.
The facility contains extensive affirmative and negative covenants, including
among others, covenants relating to leverage, revenue and cash flow and certain
limits on, among other things, dividends and other restricted payments,
incurrence of indebtedness, capital expenditures, liens, mergers and
consolidations, asset sales, investments and transactions with affiliates. The
facility also contains customary events of default provisions, including upon a
change of control.
In connection with the facility, we also issued a warrant to Goldman Sachs
Credit Partners L.P. to acquire 375,000 shares of common stock at an exercise
price of $15.00 per share. Goldman Sachs Credit Partners L.P. may exercise the
warrant, in whole or in part, at any time after the earlier of (i) consummation
of this offering or (ii) October 2, 1999. The warrant contains demand and piggy
back registration rights. See "Description of Capital Stock--Registration
Rights."
Cisco Systems Capital Corporation Facility
In July 1999, we entered into a $103.5 million equipment facility with Cisco
Systems Capital Corporation under which our operating subsidiary, Convergent
Communications Services, Inc. can purchase Cisco Systems' equipment, including
equipment for use in our enterprise networks and the switches and other
equipment for our ePOP. The facility is secured by a first priority security
interest in the assets that are purchased using the facility. We have also
guaranteed our subsidiary's obligations under this facility.
The facility is available for use in three tranches. $23.0 million is
currently available, $34.5 million will be available on the first anniversary
of the facility and the remaining $46.0 million will be
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<PAGE>
available on the second anniversary of the facility. The facility includes
customary financial covenants and event of default provisions, including upon a
change of control. The credit facility contains very aggressive financial
covenants which may require us to accelerate our business plan or renegotiate
the covenants in the future in order to satisfy those covenants or avoid a
potential default under the credit facility.
In connection with the facility, we also issued a warrant to Cisco Systems,
Inc. to acquire 575,000 shares of common stock at an exercise price of $15.00
per share. Cisco Systems may exercise the warrant at any time after the earlier
of (i) consummation of this offering or(ii) December 16, 1999. The warrant
contains piggyback registration rights and expires in July 2002.
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<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of this offering, based on shares of common stock outstanding
at May 31, 1999, we will have outstanding 26,193,740 shares of common stock
(including 1.7 million shares issued after May 31,1999 as a result of the
exercise of warrants) assuming no exercise of the Underwriters' over-allotment
option and no exercise of any other outstanding options or warrants. Of these
shares, the 8.4 million shares sold in this offering will be freely tradable
without restriction under the Securities Act unless purchased by our
"affiliates", as that term is defined in Rule 144 under the Securities Act. Of
the remaining shares, a total of approximately 17.2 million shares held by
existing stockholders are subject to lock-up agreements.
All of our executive officers, directors and certain shareholders are subject
to lock-up agreements providing that they will not to offer, sell, contract to
sell, grant any option to purchase or otherwise dispose of any shares for a
period of 180 days from the date of the closing of this offering. This group
holds a total of approximately 17.2 million shares. As a result of these lock-
up agreements, notwithstanding possible earlier eligibility for sale under the
provisions of Rules 144 and 701 of the Securities Act, none of these shares can
be sold until 181 days after the date of the closing of this offering. In
addition, a total of approximately 4.1 million shares held by existing
stockholders are subject to an additional 90-day lock-up period (until 270 days
after the closing of this offering). There are approximately 1.0 million shares
of common stock not subject to lock-up agreements at all. We also have entered
into an agreement with the underwriters that we will not offer, sell or
otherwise dispose of common stock for a period of 180 days from the date of
completion of this offering without their consent.
As a result, beginning 181 days after the closing of this offering
approximately 22.1 million shares (including the shares sold in the offering)
will be eligible for sale in the public market, and beginning 271 days after
the closing of this offering, all of our shares will be eligible for sale in
the public market, subject in each case to certain volume limitations and the
expiration of applicable holding periods under Rule 144. Of these shares,
approximately 9.7 million have been held for more than two years, and therefore
may be freely tradeable under Rule 144 unless held by affiliates. Affiliates
hold approximately 7.2 million of these shares.
In general, under Rule 144, a person (or persons whose shares are aggregated)
who has beneficially owned "restricted shares" for at least one year (including
the holding period of any prior owner except an affiliate) would be entitled to
sell within any three-month period a number of shares that does not exceed the
greater of (1) 1% of the number of shares of common stock then outstanding
(which will equal approximately 240,000 shares immediately after this offering)
or (2) the average weekly trading volume of our common stock during the four
calendar weeks preceding the filing of a Form 144 with respect to such sale.
Sales under Rule 144 are also subject to certain manner of sale provisions and
notice requirements and to the availability of current public information about
the Company. Under Rule 144(k), a person who is not deemed to have been an
affiliate of the Company at any time during the three months preceding a sale,
and who has beneficially owned the shares proposed to be sold for at least two
years (including the holding period of any prior owner except an affiliate), is
entitled to sell such shares without complying with the manner of sale, public
information, volume limitation or notice provisions of Rule 144. Unless
affiliates sell in a registered public offering, sales by them made while they
our an affiliate or within three months after they cease being an affiliate,
will still be subject to the volume restrictions notice above.
Rule 701 permits resales of shares in reliance upon Rule 144 but without
compliance with certain restrictions, including the holding period requirement,
of Rule 144. Any of our employees, officers, directors or consultants who
purchased his or her shares pursuant to a written compensatory plan or contract
may be entitled to rely on the resale provisions of Rule 701. Rule 701 permits
affiliates to sell their Rule 701 shares under Rule 144 without complying with
the holding period
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<PAGE>
requirements of Rule 144. Rule 701 further provides that non-affiliates may
sell such shares in reliance on Rule 144 without having to comply with the
holding period, public information, volume limitation or notice provisions of
Rule 144.
As discussed more fully in the section entitled "Description of Capital
Stock," there are approximately 8.4 million shares of common stock issuable
upon exercise of warrants and options granted by the Company. Of the shares
which could be issued upon exercise of these warrants and options,
approximately 4.6 million would be subject to a lock-up period for 180 days
after the closing of this offering, of which approximately 0.9 million would be
subject to a lock-up period for an additional 90 days (270 days after the
closing of this offering). Approximately 3.8 million would be freely tradable
in the public market immediately upon exercise, subject to the applicable
volume and holding period requirements of Rule 144.
In addition, and also as discussed more fully in the section entitled
"Description of Capital Stock," holders of approximately 6.8 million shares of
common stock (including shares issuable upon exercise of outstanding warrants)
have the right to cause us to file a registration statement relating to the
resale of their shares (either as a result of demand or piggy-back registration
rights.) All shares covered by such a registration statement would be freely
tradable in the public market.
As part of our growth strategy, we pursue making strategic selective
acquisitions. We may in the future issue shares of common stock to pay part of
the purchase price for these acquisitions. These shares may also have the
benefit of registration rights.
LEGAL MATTERS
The validity of the shares of common stock being offered will be passed on
for us by Gibson, Dunn & Crutcher LLP. The partner of Gibson, Dunn & Crutcher
LLP in charge of the engagement owns 10,000 shares of common stock. Certain
legal matters will be passed on for the underwriters by Shearman & Sterling.
EXPERTS
The consolidated balance sheets of Convergent Communications, Inc., as of
December 31, 1997 and 1998, and the related consolidated statements of
operations, shareholders' equity (deficit) and cash flows for the period from
January 1, 1996 to December 16, 1996, March 1, 1996 through December 31, 1996
and the years ended December 31, 1997 and 1998, included in this Registration
Statement, have been so included in reliance on the report of
PricewaterhouseCoopers LLP, independent accountants, given on the authority of
said firm as experts in accounting and auditing.
The consolidated balance sheets of Tie Communications, Inc. as of December
31, 1995, 1996 and 1997 and July 31, 1998, and the related consolidated
statements of operations, stockholder's equity (deficit) and cash flows for the
two months ended December 31, 1995, the years ended December 31, 1996 and 1997
and the seven months ended July 31, 1998, included in this Registration
Statement, have been so included in reliance on the report of
PricewaterhouseCoopers LLP, independent accountants, given on the authority of
said firm as experts in accounting and auditing.
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AVAILABLE INFORMATION
We have filed with the U.S. Securities and Exchange Commission a registration
statement on Form S-1 under the Securities Act with respect to the offer of
common stock hereby. This prospectus does not contain all of the information
set forth in the registration statement and the exhibits and schedules thereto.
For further information with respect to us, please refer to the registration
statement, including the exhibits and schedules thereto, which may be inspected
without charge and copied at prescribed rates at the Public Reference Section
of the Commission at Room 1024, 450 Fifth Street, N.W., Washington, D.C. 20549
and at the Commission's regional offices at 7 World Trade Center, Suite 1300,
New York, New York 10048, and Northwestern Atrium Center, 500 West Madison
Street, Suite 140, Chicago, Illinois 60661. The Commission maintains a website
that contains reports, proxy and information statements and other information
filed electronically with the Commission at http://www.sec.gov.
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INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Convergent Communications, Inc.
Report of Independent Accountants........................................ F-2
Consolidated Balance Sheets as of December 31, 1997 and 1998 and March
31, 1999................................................................ F-3
Consolidated Statements of Operations for the period from January 1, 1996
to December 16, 1996, the period from inception (March 1, 1996) to
December 31, 1996, the years ended December 31, 1997 and 1998 and the
three months ended March 31, 1998 and 1999.............................. F-4
Consolidated Statements of Shareholders' Equity (Deficit) for the period
from January 1, 1996 to December 16, 1996, the period from inception
(March 1, 1996) to December 31, 1996, the years ended December 31, 1997
and 1998 and the three months ended March 31, 1999...................... F-5
Consolidated Statements of Cash Flows for the period from January 1, 1996
to December 16, 1996, the period from inception (March 1, 1996) to
December 31, 1996, the years ended December 31, 1997 and 1998 and the
three months ended March 31, 1998 and 1999.............................. F-6
Notes to Consolidated Financial Statements............................... F-8
Pro Forma Combined Financial Statement
Pro Forma Combined Financial Statement................................... F-28
Pro Forma Combining Statement of Operations for the year ended December
31, 1998................................................................ F-29
Notes to Pro Forma Combining Statement of Operations..................... F-30
</TABLE>
F-1
<PAGE>
Report of Independent Accountants
To the Board of Directors of
Convergent Communications, Inc.
The reverse stock split described in Note 17 to the consolidated financial
statements has not been consummated at June 24, 1999. When it has been
consummated, we will be in the position to file the following report:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of shareholders' equity (deficit) and of
cash flows present fairly, in all material respects, the financial position of
Convergent Communications, Inc. at December 31, 1997 and 1998, and the results
of their operations and their cash flows for the period January 1, 1996 to
December 16, 1996, the period from inception (March 1, 1996) to December 31,
1996 and the years ended December 31, 1997 and 1998, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of Convergent Communication's management; our responsibility is
to express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with generally accepted
auditing standards which 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, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for the opinion expressed above.
As explained in Note 1 to the financial statements, the Successor Company
purchased all of the net assets of the Predecessor Company as of December 17,
1996. The transaction was accounted for as a purchase whereby the purchase
price was allocated to the assets and liabilities of the Predecessor based on
their estimated fair values as of December 17, 1996. Accordingly, the financial
statements of the Successor Company are not comparable to those of the
Predecessor.
PricewaterhouseCoopers LLP
Denver, Colorado
March 5, 1999, except for
Note 16, as to which the date is April 29, 1999
F-2
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31,
------------------------- March 31,
1997 1998 1999
----------- ------------ ------------
(unaudited)
<S> <C> <C> <C>
Assets
Current assets:
Cash and cash equivalents............ $ 667,344 $ 25,597,461 $ 10,392,752
Short-term investments............... 7,371,303 -- 15,884,601
Restricted cash...................... -- 20,800,000 20,800,000
Trade accounts receivable, net of
allowance for doubtful accounts of
$21,389, $1,908,811 and $2,932,559,
respectively........................ 2,075,150 17,661,220 20,750,560
Inventory............................ 230,809 6,826,732 9,026,881
Prepaid expenses, deposits and other
current assets...................... 218,349 2,134,210 2,995,457
----------- ------------ ------------
Total current assets................ 10,562,955 73,019,623 79,850,251
----------- ------------ ------------
Property, network and equipment....... 5,448,183 28,139,460 31,882,773
Less accumulated depreciation......... (610,386) (4,882,832) (6,353,628)
----------- ------------ ------------
Total property, network and
equipment.......................... 4,837,797 23,256,628 25,529,145
Restricted cash....................... 405,816 30,549,658 32,024,750
Goodwill, net of amortization of
$475,052, $2,967,283 and $4,174,400,
respectively......................... 6,392,600 46,526,288 49,035,071
Other intangible assets, net of
amortization of $358,486, $1,470,363
and $1,880,211, respectively......... 1,728,575 10,281,016 10,365,858
Investments and other assets.......... 994,426 1,225,626 1,231,792
Leases receivable, net of current
portion.............................. -- 796,790 1,288,573
----------- ------------ ------------
Total assets........................ $24,922,169 $185,655,629 $199,325,440
=========== ============ ============
Liabilities and Shareholders' Equity
(Deficit)
Current liabilities:
Trade accounts payable............... $ 2,040,457 $ 15,061,514 $ 15,795,372
Accrued compensation................. 1,467,587 4,583,140 6,564,699
Accrued interest..................... -- 5,214,133 10,414,133
Other accrued liabilities............ 691,781 8,666,182 7,728,239
Deferred revenue and customer
deposits............................ 61,545 5,211,748 5,824,101
Current portion of notes payable..... 163,220 603,919 5,358,614
Current portion of capital leases.... 804,138 5,179,251 5,798,921
----------- ------------ ------------
Total current liabilities........... 5,228,728 44,519,887 57,484,079
Long-term notes payable, less current
portion.............................. 378,761 153,730,573 154,594,138
Long-term capital leases, less current
portion.............................. 586,950 8,754,054 9,185,791
----------- ------------ ------------
Total liabilities................... 6,194,439 207,004,514 221,264,008
----------- ------------ ------------
Commitments (Note 8)
Convertible preferred stock........... -- -- 19,300,000
Shareholders' equity (deficit):
Common stock, no par value, 100
million shares authorized,
13,429,500, 13,924,135 and
13,960,350 issued and outstanding,
respectively........................ 24,004,297 27,486,554 27,806,290
Warrants............................. 4,773,751 11,719,399 12,171,879
Treasury stock....................... -- (501,674) (501,674)
Deferred compensation obligation..... -- 501,674 501,674
Accumulated other comprehensive
income.............................. (16,864) -- 11,700
Unearned compensation................ (204,750) (150,150) (136,500)
Accumulated deficit.................. (9,828,704) (60,404,688) (81,091,937)
----------- ------------ ------------
Total shareholders' equity
(deficit).......................... 18,727,730 (21,348,885) (41,238,568)
----------- ------------ ------------
Total liabilities and shareholders'
equity (deficit)................... $24,922,169 $185,655,629 $199,325,440
=========== ============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PREDECESSOR
------------
January
1, 1996
through
December 16,
1996
------------
<S> <C>
Data and voice service revenue............ $1,495,977
Data and voice product revenue............ --
----------
Total revenue........................... 1,495,977
----------
Cost of sales excluding depreciation...... 1,018,494
Selling, general and administrative....... 554,109
Depreciation and amortization............. 124,086
----------
Total operating expenses................ 1,696,689
----------
Operating loss............................ (200,712)
Interest expense.......................... (20,588)
Interest income........................... --
Other income (expense).................... --
----------
Net loss................................ (221,300)
Other comprehensive income, Unrealized
holding gains on securities.............. --
----------
Comprehensive loss........................ $ (221,300)
==========
Net loss per share (basic and diluted)....
Weighted average shares outstanding (basic
and diluted).............................
- --------------------------------------------------
<CAPTION>
SUCCESSOR
-------------------------------------------------------------------
For the For the
March 1, 1996 year ended three months
through December 31, ended March 31,
December 31, -------------------------- --------------------------
1996 1997 1998 1998 1999
------------- ------------ ------------- ------------ -------------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Data and voice service revenue............ $ 57,754 $ 2,794,777 $ 27,922,022 $ 1,807,073 $ 15,310,576
Data and voice product revenue............ 39,987 7,415,247 33,678,089 4,715,792 15,170,290
------------- ------------ ------------- ------------ -------------
Total revenue........................... 97,741 10,210,024 61,600,111 6,522,865 30,480,866
------------- ------------ ------------- ------------ -------------
Cost of sales excluding depreciation...... 79,459 7,368,509 43,703,183 4,798,024 20,073,569
Selling, general and administrative....... 552,092 10,982,769 47,861,785 6,061,845 23,337,581
Depreciation and amortization............. 40,698 1,453,019 7,493,613 762,439 2,862,892
------------- ------------ ------------- ------------ -------------
Total operating expenses................ 672,249 19,804,297 99,058,581 11,622,308 46,274,042
------------- ------------ ------------- ------------ -------------
Operating loss............................ (574,508) (9,594,273) (37,458,470) (5,099,443) (15,793,176)
Interest expense.......................... (884) (155,450) (17,501,512) (52,568) (5,936,665)
Interest income........................... -- 251,290 4,632,420 31,478 950,646
Other income (expense).................... -- (156,346) (248,422) 9,867 91,946
------------- ------------ ------------- ------------ -------------
Net loss................................ (575,392) (9,654,779) (50,575,984) (5,110,666) (20,687,249)
Other comprehensive income, Unrealized
holding gains on securities.............. -- -- -- 57,690 11,700
------------- ------------ ------------- ------------ -------------
Comprehensive loss........................ $(575,392) $(9,654,779) $(50,575,984) $(5,052,976) $(20,675,549)
============= ============ ============= ============ =============
Net loss per share (basic and diluted).... $ (0.15) $ (0.92) $ (3.68) $ (0.38) $ (1.48)
============= ============ ============= ============ =============
Weighted average shares outstanding (basic
and diluted)............................. 3,887,325 10,460,784 13,731,734 13,479,233 13,942,617
- --------------------------------------------------
============= ============ ============= ============ =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (DEFICIT)
<TABLE>
<S> <C>
Predecessor
Balance, January 1, 1996............................................. $ 216,833
Net loss allocated to members....................................... (221,300)
---------
Contributions from members.......................................... 214,128
---------
Balance, December 16, 1996........................................... $ 209,661
=========
</TABLE>
<TABLE>
<CAPTION>
Accumulated
Deferred Other Com-
Common Common Treasury Compensation Unearned prehensive
Shares Stock Warrants Stock Obligation Compensation Income
---------- ----------- ----------- --------- ------------ ------------ -----------
<S> <C> <C> <C> <C> <C> <C> <C>
Successor
Balance, March
1, 1996........ -- $ -- $ -- $ -- $ -- $ -- $ --
Conversion from
Subchapter
S corporation.. -- (401,467) -- -- -- -- --
Initial sale of
stock to
founders....... 3,750,000 450,000 -- -- -- -- --
Sale of stock in
private
placement...... 2,369,762 4,587,525 152,000 -- -- -- --
Offering costs.. -- (411,310) -- -- -- -- --
Stock issued in
acquisition of
ICN............ 1,750,000 3,500,000 -- -- -- -- --
Compensation.... -- 282,267 -- -- -- -- --
Net loss........ -- -- -- -- -- -- --
---------- ----------- ----------- --------- -------- --------- -------
Balance,
December 31,
1996........... 7,869,762 8,007,015 152,000 -- -- -- --
Sale of stock in
private
placement...... 4,530,237 15,845,915 3,414,560 -- -- -- --
Offering costs.. -- (2,780,400) 777,291 -- -- -- --
Stock issued to
SONeTech....... 187,500 375,000 -- -- -- -- --
Stock issued in acquisitions.. 437,500 2,112,500 -- -- -- -- --
Exercise of
stock options.. 475,000 261,750 -- -- -- (204,750) --
Stock
purchases...... (100,000) (12,000) -- -- -- -- --
Compensation.... 29,500 194,517 -- -- -- -- --
Warrants........ -- -- 429,900 -- -- -- --
Other comprehensive income:
Unrealized loss on securities.. -- -- -- -- -- -- (16,864)
Net loss........ -- -- -- -- -- -- --
---------- ----------- ----------- --------- -------- --------- -------
Balance,
December 31,
1997........... 13,429,499 24,004,297 4,773,751 -- -- (204,750) (16,864)
Common stock
issued for:
401(k) match.... 68,997 435,894 -- -- -- -- --
Payments to
consultants.... 10,166 55,000 -- -- -- -- --
Correction of
private
placement...... 10,000 -- -- -- -- -- --
Business
combinations... 240,000 2,266,400 -- -- -- -- --
Exercise of
stock options.. 43,500 16,500 -- -- -- -- --
Exercise of
warrants....... 34,975 129,235 (20,635) -- -- -- --
Compensation.... 86,996 579,228 -- -- -- 54,600 --
Deferred stock
compensation... -- -- -- (501,674) 501,674 -- --
Warrants issued in private
placement...... -- -- 6,886,400 -- -- -- --
Warrants issued to consultants.. -- -- 79,883 -- -- -- --
Other comprehensive income:
Reclassification
adjustment for
loss included
in net loss.... -- -- -- -- -- -- 16,864
Net loss........ -- -- -- -- -- -- --
---------- ----------- ----------- --------- -------- --------- -------
Balance, December
31, 1998....... 13,924,133 $27,486,554 $11,719,399 $(501,674) $501,674 $(150,150) $ --
Common stock issued for:
401(k) match (unaudited).. 21,217 169,736 -- -- -- -- --
Business combinations
(unaudited)... 15,000 150,000 -- -- -- -- --
Compensation (unaudited).. -- -- -- -- -- 13,650 --
Warrants issued in connection
with financing (unaudited).. -- -- 452,480 -- -- -- --
Other comprehensive income:
Unrealized loss on securities
(unaudited)... -- -- -- -- -- -- 11,700
Net loss
(unaudited).... -- -- -- -- -- -- --
---------- ----------- ----------- --------- -------- --------- -------
Balance, March 31, 1999
(unaudited).... 13,960,350 $27,806,290 $12,171,879 $(501,674) $501,674 $(136,500) $11,700
========== =========== =========== ========= ======== ========= =======
<CAPTION>
Accumulated
Deficit Total
------------- -------------
<S> <C> <C>
Successor
Balance, March
1, 1996........ $ -- $ --
Conversion from
Subchapter
S corporation.. -- (401,467)
Initial sale of
stock to
founders....... -- 450,000
Sale of stock in
private
placement...... -- 4,739,525
Offering costs.. -- (411,310)
Stock issued in
acquisition of
ICN............ -- 3,500,000
Compensation.... -- 282,267
Net loss........ (173,925) (173,925)
------------- -------------
Balance,
December 31,
1996........... (173,925) 7,985,090
Sale of stock in
private
placement...... -- 19,260,475
Offering costs.. -- (2,003,109)
Stock issued to
SONeTech....... -- 375,000
Stock issued in acquisitions.. -- 2,112,500
Exercise of
stock options.. -- 57,000
Stock
purchases...... -- (12,000)
Compensation.... -- 194,517
Warrants........ -- 429,900
Other comprehensive income:
Unrealized loss on securities.. -- (16,864)
Net loss........ (9,654,779) (9,654,779)
------------- -------------
Balance,
December 31,
1997........... (9,828,704) 18,727,730
Common stock
issued for:
401(k) match.... -- 435,894
Payments to
consultants.... -- 55,000
Correction of
private
placement...... -- --
Business
combinations... -- 2,266,400
Exercise of
stock options.. -- 16,500
Exercise of
warrants....... -- 108,600
Compensation.... -- 633,828
Deferred stock
compensation... -- --
Warrants issued in private
placement...... -- 6,886,400
Warrants issued to consultants.. -- 79,883
Other comprehensive income:
Reclassification
adjustment for
loss included
in net loss.... -- 16,864
Net loss........ (50,575,984) (50,575,984)
------------- -------------
Balance, December
31, 1998....... $(60,404,688) $(21,348,885)
Common stock issued for:
401(k) match (unaudited).. -- 169,736
Business combinations
(unaudited)... -- 150,000
Compensation (unaudited).. -- 13,650
Warrants issued in connection
with financing (unaudited).. -- 452,480
Other comprehensive income:
Unrealized loss on securities
(unaudited)... -- 11,700
Net loss
(unaudited).... (20,687,249) (20,687,249)
------------- -------------
Balance, March 31, 1999
(unaudited).... $(81,091,937) $(41,238,568)
============= =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PREDECESSOR SUCCESSOR
--------------- -------------------------------------------------------------------
For the year ended For the three months
December 31, ended March 31,
-------------------------- -------------------------
January 1, 1996 March 1, 1996
through through
December 16, December 31,
1996 1996 1997 1998 1998 1999
--------------- ------------- ------------ ------------ ----------- ------------
(Unaudited)
<S> <C> <C> <C> <C> <C> <C>
Cash flows from operating activities
Net loss........................... $ (221,300) $ (575,392) $ (9,654,779) $(50,575,984) $(5,110,666) $(20,687,249)
Adjustments to reconcile net loss
to net cash used in operating
activities:
Depreciation and amortization...... 124,076 40,698 1,453,019 7,493,613 762,439 2,862,892
Amortization of deferred financing
costs and accretion of debt
discount.......................... -- -- -- 1,162,465 -- 400,927
Provision for uncollectable
accounts.......................... 3,802 -- -- 196,532 -- 902,468
Stock compensation expense......... -- 282,267 194,517 633,828 27,300 13,650
401k contributions through the
issuance of stock................. -- -- -- 435,894 -- 169,736
Warrants issued for the payment of
consulting fees................... -- -- -- 79,883 -- --
Loss from sale of equipment........ 312 -- 50,751 -- -- --
Other.............................. -- -- 40,000 -- -- --
Change in working capital (net of
acquisitions):
Trade accounts receivable......... 61,535 (97,741) (1,527,544) (10,969,753) (2,333,283) (2,275,973)
Inventory......................... -- -- (230,809) (2,068,102) 21,106 439,135
Prepaid expenses, deposits and
other current assets............. 1,107 (51,697) (43,420) (870,269) (299,099) (565,651)
Trade accounts payable............ 10,341 56,278 1,326,723 12,357,189 1,906,273 (421,975)
Accrued compensation.............. -- -- 1,467,587 2,591,776 799,600 1,630,229
Accrued interest.................. -- -- -- 5,214,133 -- 5,200,000
Deferred revenue and customer
deposits......................... -- -- 61,545 3,299,802 33,956 (205,321)
Other accrued liabilities......... (10,544) 103,731 164,127 2,321,332 1,752,207 (979,918)
----------- ----------- ------------ ------------ ----------- ------------
Net cash used in operating
activities........................ (30,671) (241,856) (6,698,283) (28,697,661) (2,440,167) (13,517,050)
Cash flows from investing activities
Additions of property and
equipment......................... (35,742) (28,713) (2,042,203) (6,877,095) (1,711,759) (1,074,597)
Acquisitions, net of cash
acquired.......................... -- (1,157,304) (1,542,208) (42,364,328) (424,302) (1,500,000)
Short-term investments............. -- -- (7,388,167) 7,388,167 4,926,509 (15,872,901)
Restricted cash.................... -- -- (405,816) (50,943,842) (3,482) (1,475,092)
Leases receivable.................. -- -- -- (1,174,302) -- (700,262)
Intangible and other assets........ (115) (259,637) (269,425) (675,206) (217,245) (22,865)
----------- ----------- ------------ ------------ ----------- ------------
Net cash used in investing
activities........................ $ (35,857) $(1,445,654) $(11,647,819) $(94,646,606) $ 2,569,721 $(20,645,717)
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
<TABLE>
<CAPTION>
PREDECESSOR SUCCESSOR
--------------- -------------------------------------------------------------
For the year ended For the three months
December 31, ended March 31,
------------------------ ---------------------
January 1, 1996 March 1, 1996
through through
December 16, December 31,
1996 1996 1997 1998 1998 1999
--------------- ------------- ---------- ------------ -------- -----------
(Unaudited)
<S> <C> <C> <C> <C> <C> <C>
Cash flows from
financing activities
Proceeds from senior
notes and warrants,
net................... $ -- $ -- $ -- $152,377,955 $ -- $ --
Proceeds from sale of
convertible preferred
stock................. -- -- -- -- -- 19,300,000
Payments on notes
payable............... (9,214) -- (317,927) (1,397,043) (166,805) (29,743)
Payments on capital
leases................ -- -- -- (2,940,834) (231,776) (1,298,042)
Proceeds from
borrowings............ 100,000 -- -- 109,206 -- 985,843
Proceeds from initial
capital
contributions......... -- 450,000 -- -- -- --
Proceeds from sale of
common stock, net..... -- 4,398,897 17,257,366 -- -- --
Payment of note to
former owner of ICN... -- -- (1,000,000) -- -- --
Cash paid to retire
indebtedness of
predecessor company... -- -- (132,380) -- -- --
Proceeds from exercise
of stock options and
warrants.............. -- -- 57,000 125,100 14,500 --
Repurchase of common
shares................ -- -- (12,000) -- -- --
------- ---------- ---------- ------------ -------- -----------
Net cash provided by
financing activities.. 90,786 4,848,897 15,852,059 148,274,384 (384,081) 18,958,058
------- ---------- ---------- ------------ -------- -----------
Net increase (decrease)
in cash and cash
equivalents............ 24,258 3,161,387 (2,494,043) 24,930,117 (254,527) (15,204,709)
Cash and cash
equivalents at
beginning of period.... 13,438 -- 3,161,387 667,344 667,344 25,597,461
------- ---------- ---------- ------------ -------- -----------
Cash and cash
equivalents at end of
period................ $37,696 $3,161,387 $ 667,344 $ 25,597,461 $412,817 $10,392,752
======= ========== ========== ============ ======== ===========
Supplemental disclosure
of other cash and non-
cash investing and
financing activities:
Acquisition of
equipment through the
assumption of capital
lease obligations..... $ -- $ -- $1,674,596 $ 13,038,529 $537,500 $ 2,281,484
Interest paid.......... $18,190 $ -- $ 144,782 $ 11,124,914 $ 97,958 $ 335,738
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-7
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Basis of Presentation:
References in these footnotes to "Convergent Communications," "us," "we," and
"our" refer to Convergent Communications, Inc. and its subsidiaries.
Convergent Communications, Inc. is a single-source provider of data and voice
communications systems, services and solutions to small and medium sized
businesses. We design, build, install, manage and monitor data and telephony
networks inside enterprises and provide external network services such as data
transport long distance, and local service and Internet access. We offer these
products and services on a stand-alone basis or as part of a bundled offering
that can include owning an enterprise's internal data and voice networks. We
are also installing a multi-functional data and voice switch in each of the
markets in which we operate to efficiently handle our customers' traffic. We
provide the following products and services:
. Data Services
. Voice Services
. Enterprise Network Services
. Data Products
. Voice Products
In November 1996, we consummated a private placement offering (the "Private
Placement") and on December 17, 1996 we acquired all of the assets of
Integrated Communication Networks, L.C. ("ICN") in exchange for cash, notes and
shares of common stock. This acquisition has been treated as a business
combination accounted for by the purchase method of accounting. The
accompanying consolidated financial statements include the accounts of ICN from
December 17, 1996, the effective date of the acquisition. For purposes of
identification and description, ICN is referred to as the "Predecessor" for the
period prior to the acquisition. In these financial statements the term
"Successor" is used to refer to us since our inception and to ICN since
December 17, 1996 (see Note 3).
Our ultimate success depends upon, among other factors, establishment of our
nationwide network, funding the development of our enterprise networks,
continuing to develop our customer care and sales organizations, integrating
acquired businesses, attracting and retaining customers, continuing to develop
and integrate our operational support system and other back office systems,
responding to competitive developments, continuing to attract, retain and
motivate qualified personnel, and continuing to upgrade our technologies and
commercialize our services incorporating such technologies. There is no
assurance that we will be successful in addressing these matters and failure to
do so could have a material adverse effect on our business prospects, operating
results and financial condition. Our business plan will continue to require a
substantial amount of capital to fund our expansion of our existing and
acquired markets. As we continue to expand our business, we will seek
additional sources of financing to fund our development. If we are unsuccessful
in obtaining such financing, we would be compelled to alter our business
strategy or delay or abandon some of our future plans.
2. Summary of Significant Accounting Policies:
Principles of Consolidation:
The accompanying consolidated financial statements include our accounts and
the accounts of our wholly-owned subsidiaries. All intercompany amounts and
transactions have been eliminated.
F-8
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Unaudited Financial Information:
The interim consolidated financial statements as of March 31, 1999 and for
the three months ended March 31, 1998 and 1999 and related disclosures included
herein are unaudited, but reflect, in the opinion of our management, all
adjustments (which include only normal recurring adjustments) necessary to
fairly present the results for all of these periods. All disclosures subsequent
to March 5, 1999, other than Note 16, are unaudited.
Use of Estimates:
Our management is required to make estimates and assumptions in order to
prepare the financial statements in conformity with generally accepted
accounting principles. These estimates and assumptions affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and also affect the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
Cash and Cash Equivalents:
We consider all highly liquid investments with an original maturity of three
months or less to be cash equivalents.
Short-term Investments:
Short-term investments are classified as available-for-sale securities at
December 31, 1998. Gains or losses on the sale of short-term investments are
recognized on the specific identification method. Unrealized gains or losses
are treated as a separate component of shareholders' equity until the security
that the unrealized gain or loss was recorded on is sold. Other than in
restricted cash, we had no short-term investments at December 31, 1998, as none
of our investments had original maturities greater than three months.
Restricted Cash:
Restricted cash primarily represents funds held in collateral accounts for
paying semi-annual interest payments on the 13% Senior Notes through April 1,
2001. The cash is invested in U.S. Government Securities, which mature semi-
annually on October 1 and April 1 through April 1, 2001 (see Note 7).
Restricted cash also represents cash used to collateralize letters of credit,
which are held as collateral for certain of our office leases, capital lease
obligations and performance bonds. The amounts invested are classified as held
to maturity and carried at amortized cost which approximates fair value.
Fair Value of Financial Instruments:
The carrying amounts reported in the balance sheets for cash and cash
equivalents, short-term investments, accounts receivable, accounts payable and
short-term borrowings approximate fair value because of the immediate or short-
term maturity of these financial instruments. The carrying amounts reported for
long-term debt other than the 13% Senior Notes approximate fair value based
upon management's best estimates of what interest rates would be available for
the same or similar instruments. The 13% Senior Notes are publicly traded
securities. The quoted fair market value and the carrying amount of the 13%
Senior Notes at December 31, 1998 are as follows:
F-9
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
<TABLE>
<CAPTION>
Carrying Fair Market
Amount Value
------------ -----------
<S> <C> <C>
13% Senior Notes.................................... $160,000,000 $76,800,000
============ ===========
</TABLE>
Property, Network and Equipment:
Property, network and equipment are recorded at cost. Depreciation is
computed using the straight-line method over the estimated useful lives of the
assets or the lease term if shorter, which range from two to five years.
Expenditures which significantly increase asset values or extend useful lives
are capitalized. Maintenance and repairs are expensed as incurred. When
property, network and equipment is retired, sold or otherwise disposed of, the
cost and related accumulated depreciation are removed from the accounts, and
resulting gains and losses are reflected in operations.
Inventory:
Inventory primarily consists of new and refurbished equipment for resale and
is valued at the lower of cost or market using the first-in, first-out method.
We evaluate the need for reserves associated with obsolete and excess
inventory.
Intangible Assets:
Intangible assets consist of the following:
. Goodwill represents the excess purchase price over the net assets
acquired in acquisitions and is being amortized over ten years.
. Customer lists were obtained through business combinations and are being
amortized over five years.
. Debt offering costs represent costs incurred in connection with an
offering of 13% senior notes (see Note 7) and are being amortized over
the term of the notes, ten years.
. Deferred finance costs are costs associated with obtaining certain
financing arrangements and are amortized over the life of the financing
arrangement, three years.
. Site location contracts are exclusive rights to operate public telephones
at various locations we acquired through business combinations. The site
location contracts are being amortized over the average lives of the
contracts, primarily three years.
. Software license fees represent proprietary rights to software associated
with our public telephones which are being amortized over five years, the
estimated life of the related equipment.
We periodically evaluate the carrying amount of our intangible assets based
on undiscounted cash flows, or other indicators of fair value, to determine
whether adjustments to these amounts are required.
Long-Lived Assets:
We evaluate the recoverability of long-lived assets in accordance with
Statement of Financial Accounting Standards No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-
F-10
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Lived Assets to be Disposed Of" ("SFAS 121"). SFAS 121 requires an evaluation
of indicators of impairment and future undiscounted cash flows to be generated
by those assets. Impairment is measured as the amount by which the asset's
carrying amounts exceed the future discounted cash flows estimated to be
generated by those assets. We do not believe an impairment exists as of
December 31, 1998.
Investments:
Investments consist of ownership interests of less than 20% in unrelated
entities and are accounted for using the cost method.
Software:
We capitalize certain costs of developing software for internal use. Such
costs are amortized on a straight line basis over three years, which is the
estimated useful life of the software. In March 1998, the AICPA issued
Statement of Position No. 98-1, "Accounting for the Cost of Computer Software
Developed or Obtained for Internal Use" ("SOP 98-1"). SOP 98-1 provides
guidance regarding the conditions under which the costs of internal-use
software should be capitalized, and is effective for financial statements for
years beginning after December 15, 1998. We do not expect the adoption of SOP
98-1 to have a material effect on our financial statements.
Revenue Recognition:
Revenue is recognized for product sales when the product is shipped. Revenues
from non-recurring services are recognized when the services are provided.
Revenue for long-term service and maintenance contracts is recognized over the
term of the contract as the services are provided. Revenue from reselling of
long distance service is recognized at the time of performance based on
customer usage.
Deferred Revenue:
Deferred revenue represents the unearned portion of revenue related to our
long-term service and maintenance contracts, which is recognized over the term
of the contract, generally one year.
Income Taxes:
Deferred tax assets and liabilities are recognized for future tax
consequences attributable to the differences between the financial statement
carrying value of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured by using enacted tax
rates that are applicable to the future years in which deferred tax assets or
liabilities are expected to be realized or settled. The effect of a change in
tax rates on deferred tax assets and liabilities is recognized in net earnings
in the period in which the tax rate change is enacted. We establish a valuation
allowance when it is more likely than not that a deferred tax asset will not be
recovered.
Stock-Based Compensation:
We use the intrinsic value method under Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," to account for our employee
stock-based compensation plans. We account for options and warrants granted to
non-employees in accordance with Statement of Financial Accounting Standards
No. 123 "Accounting for Stock-Based Compensation" ("SFAS
F-11
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
123"), which requires that we recognize an expense based on the fair value of
the option or warrant at the time of grant.
Concentrations of Credit Risk:
We sell products and services to small and medium sized businesses on open
account and do not obtain collateral for our receivables. We believe our
reserves for potential credit losses are adequate and we perform on-going
credit evaluations. To date, we have not experienced any significant credit
losses.
All of our cash, cash equivalents and investments are maintained at a single
financial institution, certain accounts are over insurable limits. The
investments consist of high-quality commercial paper.
Reclassifications:
Certain reclassifications have been made to the prior year data to make it
consistent with the 1998 presentation. These reclassifications had no impact on
net loss.
Recently Adopted Accounting Standards:
Effective January 1, 1998 we adopted Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income." This statement established
standards for reporting and display of comprehensive income and its components.
Comprehensive income generally includes changes in separately reported
components of equity along with net income.
We have adopted Statement of Financial Accounting Standards No. 131,
"Disclosure about Segments of an Enterprise and Related Information" for the
year ended December 31, 1998. We have disclosed the business segments that we
operate in along with the financial information that management uses in
measuring the operating performance of those segments and for allocating
resources to each segment as required by this statement (Note 10). The adoption
of this statement had no effect on our results of operations, financial
position or cash flows.
The American Institute of Certified Public Accountants issued Statement of
Position 98-5, "Reporting on the Costs of Start-Up Activities"("SOP 98-5"). SOP
98-5 provides guidance on the financial reporting of start-up costs and
organization costs. It requires cost of start-up activities and organization
costs to be expensed as incurred and is effective for financial statements for
fiscal years beginning after December 15, 1998, early adoption is encouraged.
We have adopted SOP 98-5 for fiscal year ended December 31, 1998. The amount of
start-up costs written off as a result of the adoption of this SOP was not
material.
3. Acquisitions:
Integrated Communication Networks, L.C. In December 1996, we acquired
Integrated Communication Networks, L.C. (ICN), a public telephone service
provider. We paid $1,232,300 in cash, issued a $1,000,000 promissory note and
issued 1,750,000 shares of our common stock valued at $3,500,000 for total
consideration of $5,732,300. The note was paid in January 1997.
Communication Services of Iowa, Inc. In April 1997, we acquired Communication
Services of Iowa, Inc. (CSI), an Iowa reseller of telephony keyboard PBX
telephone equipment to businesses. We paid $100,000 cash, issued a $100,000
one-year promissory note at 8% and issued 25,000
F-12
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
shares of our common stock valued at $50,000 for total consideration of
$250,000. The note was paid in March 1998.
A.T.T.ex Corporation. In September 1997, we acquired A.T.T.ex Corporation
(A.T.T.ex) of Des Moines, Iowa, a telecommunications service company that
provided direct telephony service support to corporate customers. The purchase
price consisted of $450,000 in cash and the issuance of 37,500 shares of our
common stock valued at $187,500 for total consideration of $537,500.
Vital Integration Solutions, Inc. In September 1997, we acquired Vital
Integration Solutions, Inc. (Vital) of Des Moines, Iowa and Omaha, Nebraska, a
full service integration solutions provider which specialized in comprehensive
information management and networking solutions. Vital provided its clients
with the hardware, software and integration services necessary to build
information systems and networks. We paid $500,000 in cash and issued 375,000
shares of our common stock valued at $1,875,000 for total consideration of
$2,375,000.
Telephone Communications Corporation. In February 1998, we acquired the
assets and assumed certain liabilities of Telephone Communications Corporation
("TCC") of Vail, Colorado. TCC was a long distance switchless reseller
providing 1+, 0+, 800, and Calling Card services to cities such as Dillon,
Frisco and the Vail Valley. We paid $400,000 in cash, issued a $200,000 one-
year note at 8% and issued 5,000 shares of our common stock which for purchase
accounting purposes were assigned a value of $8.00 per share. We also assumed a
note with National Network Corporation of approximately $287,000, which was
paid in April 1998. Total consideration for the purchase was $927,000. We
negotiated an early discounted payoff of the $200,000 note in the total amount
of $180,000 (including accrued interest of $2,250) in May 1998.
Network Computer Solutions, LLC. In February 1998, we acquired the assets and
assumed certain liabilities of Network Computer Solutions ("NCS") of Greenwood
Village, Colorado. NCS provided network integration services. We paid $500,000
in cash, issued 50,000 shares of our common stock which for purchase accounting
purposes were assigned a value of $8.00, assumed liabilities of $438,372 and
paid a finders fee of $150,000 for total consideration of $1,488,372.
Communication Services of Colorado. In May 1998, we completed a merger with
Communication Services of Colorado ("CSC") of Englewood, Colorado. CSC was a
long distance switchless reseller providing 1+, 0+, 800, and Calling Card
services. The purchase price consisted of $475,000 in cash, the issuance of a
$530,000 one-year note at 8% and assumed liabilities of $341,054 for total
consideration of $1,346,054.
HH&H Communications Technologies, Inc. In May 1998, we completed the
acquisition of the assets and certain liabilities of HH&H Communications
Technologies, Inc. ("CTI"), a voice equipment provider in Texas. We paid
$200,000 in cash, issued 15,000 shares of our common stock, which for
accounting purposes were assigned a value of $8.50 per share, and assumed
liabilities of $151,383 for total consideration of $478,883.
CMB Holdings, Inc. d/b/a Independent Equipment Company. In June 1998, we
completed the acquisition of substantially all of the assets of CMB Holdings,
Inc. d/b/a Independent Equipment Company ("IEC"), an equipment remarketer in
Florida. The purchase price consisted of the issuance of 170,000 shares of our
common stock, which for accounting purposes were assigned a value of $10.00 per
share, for total consideration of $1.7 million.
F-13
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Tie Communications, Inc. Effective August 1, 1998 we completed the
acquisition of substantially all the assets and certain of the liabilities of
Tie Communications, Inc. ("Tie"). The purchase price consisted of $40.0 million
in cash and the assumption of certain liabilities, which with legal and
professional and other costs resulted in a total purchase price of
approximately $51.4 million. Tie was a telecommunications equipment provider
and a nationwide reseller of long-distance service.
We accounted for these acquisitions as business combinations, which were
accounted for by the purchase method of accounting. We valued the acquisitions
at the fair market value of the consideration given. With regard to our common
stock and warrants, we determined the fair market value based upon a number of
factors including a market analysis of publicly traded companies and a
discounted cash flow analysis. An option pricing model was also used to value
our warrants. In connection with the acquisitions, the excess of consideration
given over the fair market value of the net assets acquired is being amortized
on a straight line basis over the estimated life of the intangible assets
acquired which is five to ten years. The accompanying financial statements
include the accounts of the acquired companies from the effective dates of the
acquisitions.
In addition to the business acquisitions previously discussed, we have also
completed purchases of certain assets of other companies as follows:
Big Planet, Inc. In October 1997, we acquired certain assets and assumed
certain liabilities of Big Planet, Inc., of Portland, Oregon. Big Planet is an
Internet service provider (ISP) offering a full range of Internet services,
including Internet access, Web hosting, maintenance, and site design. We paid
$250,000 in cash for the assets and the assumption of certain trade payables.
Sigmacom Corporation. In December 1997, we acquired certain data integration
assets of Sigmacom Corporation. Sigmacom is a systems integrator for corporate
audio, video and data communications, providing state-of-the-art systems that
combine telecommunications and computer network technologies. Sigmacom is also
developing Internet application software for financial institutions such as
credit unions. We paid $875,000 in cash and issued Sigmacom a warrant to
purchase 25,000 shares of our common stock at an exercise price of $15.00 per
share, which expires in December 1999. We valued the warrants, at an aggregate
value of $30,000 utilizing an option pricing model and a number of factors
including a market analysis of publicly traded companies and a discounted cash
flow analysis. We also acquired a minority interest in Sigmacom's software
development business to which we allocated $350,000 of the purchase price.
The consideration paid for acquisitions in 1996, 1997 and 1998, and the
allocation of such consideration to the acquired assets and assumed liabilities
is as follows:
<TABLE>
<CAPTION>
1996 1997 1998
---------- ---------- -----------
<S> <C> <C> <C>
Cash paid, net of cash acquired.......... $1,157,304 $1,542,208 $42,364,328
Common stock issued to the former
owners.................................. 3,500,000 2,112,500 2,266,400
Notes payable and liability to former
owners.................................. 1,000,000 100,000 907,500
Receivable eliminated through the
acquisition of ICN...................... 75,000 -- --
Warrants issued.......................... -- 55,000 --
---------- ---------- -----------
Total amount to be allocated......... $5,732,304 $3,809,708 $45,538,228
========== ========== ===========
</TABLE>
F-14
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
<TABLE>
<S> <C> <C> <C>
Allocation to acquired assets and
assumed liabilities:
Goodwill............................ $3,212,608 $3,384,168 $42,544,447
Accounts receivable................. 50,164 399,700 4,812,849
Inventory........................... -- 115,971 4,586,188
Equipment........................... 1,904,796 355,959 2,945,343
Customer lists...................... -- -- 1,683,696
Prepaid expenses, deposits and other
current assets..................... 7,262 3,950 669,110
Investments......................... -- 350,000 --
Site contracts...................... 656,682 -- --
Software license.................... 496,643 -- --
Accounts payable and accrued
liabilities........................ (140,107) (636,747) (6,804,169)
Deferred revenue, net of costs...... -- -- (1,911,946)
Debt................................ (455,744) (163,293) (2,987,290)
---------- ---------- -----------
Amounts allocated..................... $5,732,304 $3,809,708 $45,538,228
========== ========== ===========
</TABLE>
On a pro forma basis, as though the above combinations had taken place at the
beginning of the periods presented, revenue, net loss and net loss per share
would have been as follows (unaudited):
<TABLE>
<CAPTION>
1997 1998
------------ ------------
<S> <C> <C>
Revenue......................................... $118,964,021 $109,666,921
Net loss........................................ $(26,068,210) $(59,462,317)
Net loss per share.............................. $ (2.37) $ (4.27)
Weighted average shares......................... 10,981,658 13,923,401
</TABLE>
4. Short-Term Investments:
All of our short-term investments as of December 31, 1997 are classified as
available for sale. The investments had an amortized cost basis of $7,388,167
at December 31, 1997 and a fair value of $7,371,303 at December 31, 1997. The
unrealized loss at December 31, 1997 related to these investments which matured
in 1998 was $16,864.
5. Leases Receivable:
Our wholly owned subsidiary, Convergent Capital Corporation ("CCC"), leases
data and telephony equipment to our customers under direct financing leases.
The receivables, which are due over two to five years are collateralized by the
equipment being leased. The current portion of leases receivable is included in
other current assets. The components of leases receivable and the future
minimum payments receivable are as follows:
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Receivable:
1999......................................................... $ 468,189
2000......................................................... 402,864
2001......................................................... 266,832
2002......................................................... 174,728
2003......................................................... 78,670
----------
Gross receivables.............................................. 1,391,283
</TABLE>
F-15
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Unearned income................................................ (216,981)
---------
Lease receivables.............................................. 1,174,302
Less: current portion.......................................... (377,512)
---------
Long-term lease receivables.................................... $ 796,790
=========
</TABLE>
6. Property, Network and Equipment:
Property, network and equipment consists of the following:
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1998
---------- -----------
<S> <C> <C>
Office furniture and equipment...................... $2,908,261 $14,057,009
Network equipment................................... 2,256,942 12,906,012
Leasehold improvements.............................. 56,559 938,645
Company vehicles.................................... 226,421 237,794
---------- -----------
5,448,183 28,139,460
Less accumulated depreciation....................... (610,386) (4,882,832)
---------- -----------
Net property, network and equipment................. $4,837,797 $23,256,628
========== ===========
</TABLE>
Depreciation expense was $70,739 for the period from January 1, 1996 to
December 16, 1996, $5,365 for the period from inception to December 31, 1996,
$515,317 for the year ended December 31, 1997 and $4.3 million for the year
ended December 31, 1998.
We enter into capital leases for various equipment. Equipment under capital
leases is as follows:
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1998
---------- -----------
<S> <C> <C>
Network equipment................................... $ -- $11,865,309
Furniture and equipment............................. 1,674,596 4,020,300
---------- -----------
1,674,596 15,885,609
Less accumulated depreciation....................... (338,199) (2,906,152)
---------- -----------
$1,336,397 $12,979,457
========== ===========
</TABLE>
7. Notes Payable and Capital Leases:
Notes Payable
Notes payable consist of the following:
<TABLE>
<CAPTION>
December 31,
-----------------
1997 1998
---- ------------
<S> <C> <C>
13% Senior Notes payable, (i) below................... $-- $153,630,080
Note payable for acquisition, interest at 8%,
principal and accrued interest due May 1999.......... -- 530,000
</TABLE>
F-16
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
<TABLE>
<CAPTION>
December 31,
-----------------------
1997 1998
--------- ------------
<S> <C> <C>
Note payable assumed in acquisition, interest
at 9.75%, payable in monthly installments of
$2,257, through May 2000...................... -- 35,707
Notes payable for vehicles, interest rates
ranging from 6.9% to 11.2%, payable in monthly
installments totaling $5,848 through June
2002, (ii) below.............................. 147,746 138,705
Note payable, interest at 4%, payable in
monthly installments of $1,963 through
September 2014, (iii) below................... 287,565 --
Note payable for acquisition, interest at 8%,
principal and accrued interest due March
1998.......................................... 106,670 --
--------- ------------
541,981 154,334,492
Less current portion........................... (163,220) (603,919)
--------- ------------
Long term portion.............................. $ 378,761 $153,730,573
========= ============
</TABLE>
- --------
(i) On April 2, 1998 we completed a private offering of $160.0 million of 13%
Senior Notes and 640,000 warrants to purchase 864,000 of our common shares.
The 13% Senior Notes mature on April 1, 2008 and interest is payable semi-
annually in arrears on April 1 and October 1 of each year beginning October
1, 1998. At the same time as the closing of the 13% Notes Offering, we
deposited U.S. Government Securities in a collateral account. The amount
deposited in the collateral account together with the interest earned on
those securities, will be enough to pay the first six interest payments on
the 13% Senior Notes. The first payment was made on October 1, 1998. The
13% Senior Notes contain certain covenants that restrict our ability to
incur additional debt and to make certain payments, including dividends.
Each Warrant entitles the holder to purchase 1.35 shares of our common
stock at an exercise price of $0.02 per share. The Warrants are currently
exercisable and expire on April 1, 2008. Each Warrant was assigned a value
of $10.76 using an option pricing model, a market analysis of publicly
traded companies and a discounted cash flow analysis. The proceeds that
were attributable to the Warrants were treated as a discount to the 13%
Senior Notes and allocated to shareholders' equity. We received proceeds
approximately of $95.6 million after deducting offering costs of
approximately $7.6 million and making the deposit of $56.8 million into the
collateral account. As of December 31, 1998 the amount outstanding, net of
the unaccreted discount of $6.4 million resulting from the allocation of
the warrants, was $153.6 million.
(ii) In June 1997, we obtained a one-year renewable line of credit with General
Motors Acceptance Corporation in the amount of $538,000 to acquire
vehicles for operations. Advances under the line are payable over a four
to five year term. We have used $155,521 of this credit facility of which
$94,893 was outstanding at December 31, 1997 and $115,803 was outstanding
at December 31, 1998. We do not anticipate additional borrowings under
this facility.
(iii) This note was paid in April 1998.
Scheduled maturities on debt outstanding are as follows:
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Due in:
1999........................................................... $603,919
2000........................................................... 58,388
2001........................................................... 37,918
</TABLE>
F-17
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
2002......................................................... 4,187
2003......................................................... --
Thereafter................................................... 160,000,000
------------
160,704,412
Less unaccreted discount..................................... (6,369,920)
------------
Total debt................................................. $154,334,492
============
</TABLE>
Capital Leases
Some of our equipment and equipment used by our customers is leased under
capital leases. The following is a schedule of the minimum lease payments under
capital leases together with the present value of the minimum lease payments.
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Due in:
1999........................................................... $ 6,082,644
2000........................................................... 5,440,318
2001........................................................... 3,596,597
2002........................................................... 529,588
2003........................................................... 218,450
-----------
Total minimum lease payments................................... 15,867,597
Less amount representing interest.............................. (1,934,292)
-----------
Present value of minimum lease payments........................ 13,933,305
Less current portion........................................... (5,179,251)
-----------
Long-term portion.............................................. $ 8,754,054
===========
</TABLE>
Comdisco Facility. In November 1997 we entered into an agreement with
Comdisco, Inc. ("Comdisco") which provides for up to $50 million of equipment
lease financing. At December 31, 1998, $10.0 million of the $50.0 million was
available for us to use of which $7.6 million was being utilized. The agreement
expires on June 30. The last $20.0 million will be available if we meet certain
financial criteria.
The Comdisco facility is collateralized by the equipment being financed. In
addition, we are required to issue a warrant to acquire shares of our common
stock in an amount equal to ten percent (10%) of the facility, divided by the
exercise price per share. The exercise price per share is equal to the price
paid by investors in recent equity offerings, not less than $6.00 per share.
The warrants will be issued in three installments based upon amounts available
under the facility. We issued a warrant in 1997 for the purchase of 166,666
shares of our common stock at an exercise price of $6.00 per share for the
first $10 million of the facility. The warrants were valued utilizing an option
pricing model, and a number of factors including a market analysis of publicly
traded companies and a discounted cash flow analysis. The warrants are being
amortized into interest expense over three years.
Sun Financial Facility. In May 1997, we entered into a Master Equipment Lease
with Sun Financial Group, Inc. to lease equipment, facilities and related items
for our internal expansion as
F-18
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
well as equipment to be used for customer installations. The facility is
collateralized by a $100,000 standby letter of credit. In connection with the
establishment of the facility, we issued a warrant to Sun Financial Group, Inc.
for the purchase of 40,285 shares of our common stock at an exercise price of
$6.00 per share. We valued the warrant utilizing an option pricing model and a
number of other factors including a market analysis of publicly traded
companies and a discounted cash flow analysis. The warrant is being amortized
into interest expense over three years. We had amounts outstanding under this
facility of $1.4 million as of December 31, 1997 and $4.4 million as of
December 31, 1998.
8. Commitments:
We lease a portion of our buildings and equipment under operating leases.
Future minimum payments under operating leases are as follows:
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Due in:
1999............................................................ $ 4,961,985
2000............................................................ 3,943,432
2001............................................................ 3,245,816
2002............................................................ 2,442,580
2003............................................................ 1,076,301
Thereafter...................................................... 205,596
-----------
$15,875,710
===========
</TABLE>
Rent expense under operating leases was $45,874 for the period from January
1, 1996 to December 16, 1996, $17,927 for the period from inception to December
31, 1996, $431,930 for the year ended December 31, 1997 and $4.3 million for
the year ended December 31, 1998.
9. Shareholders' Equity (Deficit):
We have 1,000,000 shares of preferred stock authorized none of which were
outstanding as of December 31, 1998 and 800,000 of which were outstanding as of
March 31, 1999.
In connection with the acquisition of certain assets of Sigmacom (Note 3), we
issued warrants to purchase 25,000 shares of our common stock exercisable at
$15.00 per share through December 1999.
On October 31, 1996, we entered into an exclusive engineering and consulting
agreement with Services-oriented Open Network Technologies, Inc. ("SONeTech")
for engineering services to our internal engineering staff relating solely to
the initial configuration of the architecture of the E-POP(TM) network strategy
and the development of service logic for our call processing design. We issued
187,500 shares of our common stock in exchange for a 10% equity interest in
SONeTech and an exclusive engineering and consulting agreement. We will be
entitled to reacquire a portion of our common stock that was issued to SONeTech
at the original price of $0.12 per share if SONeTech terminates the agreement.
In February 1997, we completed the second of two tranches of an offering of
an aggregate of 3,500,000 units. Each of the units consisted of one share of
common stock and a warrant to purchase one-half share of common stock (the
first tranche of 2,369,762 units closed in late 1996). The units were sold at a
price of $2.00 each. The warrants entitle the holders to purchase 1,750,000
shares of common stock for a price of $3.00 per share for five years from the
date of the offering.
F-19
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
We also issued warrants to purchase 370,625 of our common shares to the
placement agents, which are exercisable at $2.40 per share through November 7,
2001.
In October 1997, we completed an offering of 3,410,000 units consisting of
one share of our common stock and a warrant to purchase one-half share of our
common stock. The units were sold at a price of $5.00 each. The warrants
entitle the holders to purchase 1,705,000 shares of our common stock for a
price of $7.50 per share, beginning in November 1998 through July 14, 1999. The
proceeds, net of related offering costs, were approximately $15.2 million. We
also issued warrants to purchase 307,930 of our common shares to the placement
agents exercisable at $6.00 per share beginning in May 1998 through November
14, 2002.
In connection with the signing of financing agreements with Comdisco, Inc.
and Sun Financial, we granted Comdisco, Inc. warrants to purchase 166,666
shares of our common stock and granted Sun Financial warrants to purchase
40,285 shares of our common stock. All of these warrants are exercisable at
$6.00 per share. The Comdisco warrants are currently exercisable and expire on
the earlier of (i) November 2007, or (ii) five years following an initial
public offering of our common stock. The Sun Financial warrants are exercisable
beginning in May 1998 and expire in May 2002.
In August 1998, we entered into a consulting agreement under which the
consultant recruited senior management personnel on behalf of our wholly-owned
subsidiary, Convergent Capital Corporation. As a result of the services
performed under this agreement, we issued warrants to the consultant to
purchase 62,500 shares of our common stock at $10.00 per share. The warrants
are currently exercisable and expire on August 3, 2008. We valued the warrants
using an option pricing model and recognized consulting expense of $79,883.
Certain holders of our common stock and the holders of certain warrants have
the right to demand that we file a registration statement to register their
shares and the shares underlying their warrants in 1999.
Stock Option Plans:
We have adopted the 1996 and 1997 Incentive and Non-Statutory Option Plans
and the 1998 Stock Option Plan (the "Plans") which authorize us to grant up to
3,700,000 shares of our common stock to employees, consultants and directors
under incentive stock options within the meaning of Section 422A of the
Internal Revenue Code of 1986, as amended, and to grant non-statutory stock
options.
The Plans require that the exercise price of options we grant must be at
least equal to the fair market value of a share of our common stock on the date
of the grant and must be exercisable over a period of up to ten years. However,
if an employee owns more than 10% of our outstanding common stock, then the
exercise price of an incentive option must be at least 110% of the fair market
value of a share of our common stock on the date of grant and must be
exercisable over a period of five years. All of our options vest over five
years.
The Plans are administered by our Board of Directors or a committee thereof
which determines the terms of the options granted, including the exercise
price, the number of shares of our common stock subject to the option, and the
terms and conditions of exercise. No option granted under the Plan is
transferable by the optionee other than by will or the laws of descent and
distribution and each option is exercisable during the lifetime of the optionee
only by such optionee.
F-20
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In May 1997, we accelerated the vesting provisions related to options of
certain employees to purchase 475,000 shares with an exercise price of $0.12
per share and all of the options were exercised. The underlying shares are
subject to a repurchase agreement over a five year period whereby we can
repurchase a portion of the shares upon termination of employment. The amount
available for repurchase is reduced by 20% each year of employment. In late
1997, we repurchased 100,000 shares for $0.12 per share, upon the termination
of one of the exercising employees. The repurchased shares are included in the
authorized but unissued shares of common stock. At December 31, 1998,
approximately 185,000 shares were no longer subject to repurchase.
<TABLE>
<CAPTION>
Weighted Weighted
Average Average
Number of Exercise Grant Date
Shares Price Fair Value
--------- -------- ----------
<S> <C> <C> <C>
Outstanding at March 1, 1996.................. -- $ -- $ --
Granted
At market value........................... 392,500 2.18 0.40
Below market value........................ 512,500 0.12 0.92
Exercised................................... -- -- --
Canceled.................................... -- -- --
--------- ----- -----
Outstanding at December 31, 1996.............. 905,000 1.02 --
Granted
Above market value........................ 1,405,000 3.60 0.52
At market value........................... 492,500 3.90 1.12
Exercised................................... (475,000) 0.12 --
Canceled.................................... (6,000) 2.66 --
--------- ----- -----
Outstanding at December 31, 1997.............. 2,321,500 3.38 --
Granted
Above market value........................ 1,319,000 11.26 0.16
At market value........................... 320,500 7.48 1.74
Exercised................................... (43,500) 0.38 --
Canceled.................................... (634,750) 5.26 --
--------- ----- -----
Outstanding at December 31, 1998.............. 3,282,750 $6.50 $ --
========= ===== =====
</TABLE>
The following table indicates the number of shares exercisable and the
weighted average exercise prices at December 31:
<TABLE>
<CAPTION>
1996 1997 1998
---- ------- -------
<S> <C> <C> <C>
Options exercisable.................................... -- 172,500 495,050
Weighted average exercise price........................ -- $ 2.58 $ 3.32
</TABLE>
F-21
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
At December 31, 1998, the range of exercise prices and weighted average
remaining contractual life for options outstanding was as follows:
<TABLE>
<CAPTION>
Option Price Weighted Average
Number of Shares Range Remaining Contractual Life
---------------- ---------------- --------------------------
<S> <C> <C>
1,119,000........................ $2.00 to $2.20 6.6 years
459,000.......................... $4.00 to $5.00 8.6 years
466,250.......................... $6.00 8.9 years
479,750.......................... $10.00 to $11.00 7.7 years
758,750.......................... $12.00 9.8 years
</TABLE>
If the compensation cost for the Plan was determined based on the fair value
at the grant dates for awards using the method prescribed by SFAS 123, our pro
forma net loss and net loss per share would have been as follows:
<TABLE>
<CAPTION>
For the period
from Inception
through Year ended December 31,
December 31, -------------------------
1996 1997 1998
-------------- ----------- ------------
<S> <C> <C> <C>
Net loss:
As reported...................... $(575,392) $(9,654,779) $(50,575,984)
Pro-forma........................ $(575,808) $(9,703,446) $(50,957,542)
Net loss per share:
As reported...................... $ (0.15) $ (0.92) $ (3.68)
Pro-forma........................ $ (0.15) $ (0.93) $ (3.71)
</TABLE>
The fair value of each option grant is estimated on the date of grant using
the minimum value method with the following assumptions:
<TABLE>
<CAPTION>
For the
period from
Inception
through Year ended December 31,
December 31, ------------------------
1996 1997 1998
------------ ----------- -----------
<S> <C> <C> <C>
Dividend yield......................... -- -- --
Risk-free interest rate................ 6.06-6.48% 5.65-6.84% 5.38-5.71%
Expected lives......................... 5 years 5 years 5 years
</TABLE>
Because the determination of the fair value of all options granted if we
become a public entity will include an expected volatility factor in addition
to the factors described in the table above and, because additional option
grants are expected to be made the above pro forma disclosures are not
necessarily representative of pro forma effects on net income to be reported
for future years.
We recognized compensation expense for employee stock grants and stock
options of $282,267 for the period ended December 31, 1996, $194,517 for the
year ended December 31, 1997 and $633,828 for the year ended December 31, 1998.
10. Business Segments:
We classify our business into five fundamental areas: data services, voice
services, ENS, data products and voice products. Senior management evaluates
and makes operating decisions about
F-22
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
each of these operating segments based on a number of factors. We do not
account for assets by business segment and, therefore, depreciation and
amortization are not factors used in evaluating operating performance. Two of
the most significant factors used in evaluating the operating performance are:
revenue and gross margin before depreciation as presented below:
<TABLE>
<CAPTION>
March 1, 1996 Three Months ended March
through Year ended December 31, 31,
December 31, ------------------------- -------------------------
1996 1997 1998 1998 1999
------------- ----------- ------------ ----------- ------------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Revenue:
Data services......... $ -- $ 585,385 $ 3,620,222 $ 808,015 $ 2,118,940
Voice services........ 57,754 2,203,182 22,298,886 882,667 12,458,199
ENS................... -- 6,210 2,002,914 116,391 733,437
Data products......... 39,987 6,656,813 20,892,491 4,462,299 7,161,752
Voice products........ -- 758,434 12,785,598 253,493 8,008,538
--------- ----------- ------------ ----------- ------------
Total............... 97,741 10,210,024 61,600,111 6,522,865 30,480,866
--------- ----------- ------------ ----------- ------------
Gross margin before
depreciation:
Data services......... -- 534,020 2,111,684 446,731 987,008
Voice services........ 17,739 979,225 8,915,797 383,400 5,250,256
ENS................... -- 3,266 1,307,685 61,374 591,455
Data products......... 543 1,056,705 2,249,700 740,389 794,861
Voice products........ -- 268,299 3,312,062 92,946 2,783,717
--------- ----------- ------------ ----------- ------------
Total............... 18,282 2,841,515 17,896,928 1,724,841 10,407,297
--------- ----------- ------------ ----------- ------------
Reconciliation to net
loss:
Selling, general and
administrative....... (552,092) (10,982,769) (47,861,785) (6,061,845) (23,337,581)
Depreciation and
amortization......... (40,698) (1,453,019) (7,493,613) (762,439) (2,862,892)
--------- ----------- ------------ ----------- ------------
Operating loss...... (574,508) (9,594,273) (37,458,470) (5,099,443) (15,793,176)
Interest expense...... (884) (155,450) (17,501,512) (52,568) (5,936,665)
Interest income....... -- 251,290 4,632,420 31,478 950,646
Other income
(expense)............ -- (156,346) (248,422) 9,867 91,946
--------- ----------- ------------ ----------- ------------
Net loss............ $(575,392) $(9,654,779) $(50,575,984) $(5,110,666) $(20,687,249)
========= =========== ============ =========== ============
</TABLE>
11. Deferred Compensation:
We have a Deferred Compensation plan whereby certain management employees can
elect to defer a portion of their compensation which will be paid in shares of
our common stock at a future date. The plan requires that we issue shares of
common stock into a rabbi trust which will then be distributed to the employee
at a specified date in the future not less than one year from the deferral
date. We have recorded the deferred compensation amount as treasury stock (for
accounting purposes) and as a deferred compensation obligation in the
shareholders' equity (deficit) section of the balance sheet. As of December 31,
1998, 77,172 shares of our common stock are being held in the rabbi trust.
F-23
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. Income Taxes:
We were originally organized as an S corporation under the provisions of
Section 1361 of the Internal Revenue Code. As an S corporation, we were not
subject to tax on our income; rather our shareholders were taxed on their share
of the taxable income, whether or not the income was distributed. Effective
December 5, 1996, we rescinded our S Corporation election under the Internal
Revenue Code and became subject to tax on our income. No pro forma tax benefit
has been provided for either the Convergent or ICN as Predecessor due to their
continuing losses.
The Predecessor was a limited liability company which was treated as a
partnership for taxation purposes.
For federal income tax purposes we had net operating loss carryforwards of
$44.9 million as of December 31, 1998. Section 382 of the Internal Revenue Code
places certain limitations on the annual amount of net operating loss
carryforwards which can be utilized if certain changes in ownership occur. As a
result, our ability to use these net operating loss carryforwards, which will
begin to expire in 2011, may be limited.
The components of the net deferred tax assets are as follows:
<TABLE>
<CAPTION>
December 31,
-------------------------
1997 1998
----------- ------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards................ $ 3,461,765 $ 17,057,862
Deferred revenue................................ -- 1,924,474
Accrued vacation and bonus...................... -- 1,342,101
Intangibles..................................... -- 548,919
Allowance for doubtful accounts................. 8,127 527,977
Property and equipment.......................... 112,106 462,333
Self-insurance and warranty liabilities......... -- 448,705
Original issue discount......................... -- 384,006
Valuation allowance............................. (3,581,998) (22,696,377)
----------- ------------
Total net deferred tax assets................. $ -- $ --
=========== ============
</TABLE>
The increase in the valuation allowance of $3.5 million in 1997 and $19.1
million in 1998 are due to increased losses during each year. We have recorded
a full valuation allowance on the net deferred tax assets due to continuing
losses.
Our actual income taxes differed from the expected federal statutory rate of
34% as follows:
<TABLE>
<CAPTION>
March 1, 1996 Year ended
through December 31,
December 31, ----------------
1996 1997 1998
------------- ------ ------
<S> <C> <C> <C>
Statutory tax rate......................... 34 % 34 % 34 %
State taxes, net of federal benefit........ 4 4 4
Valuation allowance........................ (38) (38) (38)
--- ------ ------
Effective tax rate......................... -- % -- % -- %
=== ====== ======
</TABLE>
F-24
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
13. Net Loss Per Share:
The net loss available to common shareholders consists of the following:
<TABLE>
<CAPTION>
March 1, 1996 Three Months ended March
through Year ended December 31, 31,
December 31, ------------------------- -------------------------
1996 1997 1998 1998 1999
------------- ----------- ------------ ----------- ------------
(Unaudited)
<S> <C> <C> <C> <C> <C>
Net loss................ $ (575,392) $(9,654,779) $(50,575,984) $(5,110,666) $(20,687,249)
The weighted average
shares consist of the
following:
Weighted average
common shares used
for basic earnings
per share............ 3,887,325 10,460,784 13,731,734 13,479,233 13,942,617
Warrants.............. -- -- -- -- --
Stock options......... -- -- -- -- --
Weighted average
common shares used
for fully diluted
earnings per share... 3,887,325 10,460,784 13,731,734 13,479,233 13,942,617
---------- ----------- ------------ ----------- ------------
Anti-dilutive weighted
average options and
warrants not
included............. 153,590 3,826,517 6,975,055 6,467,562 8,866,478
========== =========== ============ =========== ============
</TABLE>
14. Employee Benefit Plans:
We adopted an employee benefit 401(k) plan for all employees effective March
1, 1997. Under the plan, employees may voluntarily elect to have up to 15% of
their salaries deducted from earnings and placed in the plan. We may elect to
match up to 6% of the employee contributions by contributing our common stock
to the plan. Our contributions are determined on a quarterly basis and the
number of shares to be contributed is based upon the estimated fair value of
the stock at the end of each quarter. During 1998 we contributed $182,792 of
our common stock for the year ended December 31, 1997 match and contributed
$253,102 of our common stock for the first and second quarters of 1998. An
additional $800,000 was accrued as of December 31, 1998 for the third and
fourth quarter 1998 match, which will be contributed in 1999.
15. Related Party Transactions:
In August 1998, we entered into a two year agreement with Strategic
Healthcare Solutions, LLC ("SHS") under which SHS was engaged to provide new
customers in the healthcare industry to us. One of our directors is a principal
of Strategic Asset Management which has an ownership interest in SHS. Under the
agreement, we pay SHS a monthly fee and commissions (an aggregate of
approximately $125,000 in 1998). In addition, we issued a warrant to SHS which
entitles them to
F-25
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
purchase up to a maximum of 131,250 shares of our common stock at an exercise
price of $12.00. The warrant includes performance objectives which are reviewed
semiannually. If SHS does not meet those performance objectives, all or a
portion of the shares available for each six-month period (32,812 shares) is
reduced. The warrant is not exercisable until August 1, 2000 and expires
August 1, 2003. For the first six-month period of the agreement which ended
February 1, 1999, SHS did not meet the performance objectives and as a result,
the 32,812 shares applicable to that period were canceled.
Pursuant to the terms of a non-cancelable license fee related to proprietary
telecommunications equipment technology, ICN paid monthly license fees of
$2,500 and management fees of $1,200 to a shareholder of ICN. During the period
from January 1, 1996 through December 16, 1996, ICN incurred costs of $44,400
under these arrangements.
One of our Directors was a Principal and owner of Shepherd Financial Group.
Shepherd Financial Group received total compensation of approximately $1.5
million and was issued 219,000 warrants to purchase our common stock in
exchange for placement agent services provided to us in connection with private
placements of our common stock in 1996 and 1997. The Director was also a
Principal and owner of Shepherd Capital Group, which was paid approximately
$0.5 million for financial advisory services provided to us during 1997.
16. Subsequent Events:
In February 1999, we acquired the assets and assumed certain liabilities of
Kansas Communications, Inc. (KCI). KCI was a telecommunications equipment
provider and integrator. The purchase price consisted of $1.5 million in cash,
$4.5 million in notes payable and 24,925 shares of our common stock (which may
be increased pursuant to certain financial adjustments) which for purchase
accounting purposes were assigned a value of $10.00 per share, and assumed
liabilities of $2.4 million for total consideration of $8.6 million. Upon the
completion of equity or debt financing with net proceeds in excess of $25.0
million, $3.5 million of the notes payable would become due.
On March 17, 1999, we executed an agreement pursuant to which various
affiliates of the Sandler/21st Century Group agreed to purchase 800,000 shares
of Series A Convertible Preferred Stock and warrants to purchase a maximum of
1,000,000 shares of our common stock. We sold 640,000 shares of Convertible
Preferred A Stock and warrants to purchase a maximum of 800,000 shares of our
common stock on March 17, 1999 for total consideration of $16.0 million. The
balance of the shares and warrants were purchased for $4.0 million on March 31,
1999. Each share of Series A Convertible Preferred Stock will automatically
convert into common stock upon a public offering which provides gross proceeds
to us in excess of $50.0 million. At the public offering, each share of Series
A Convertible Preferred Stock will convert into a minimum of 2.5 and a maximum
of 3.57 shares of common stock, depending on the price of common stock in the
public offering. The warrants entitle the holder to purchase one share of our
common stock at an exercise price of $15.00 per share for a period of five
years. The number of shares issuable upon exercise of the warrants are subject
to adjustment based upon the initial public offering price. The proceeds from
the sales, net of related offering costs, were approximately $19.3 million. One
of our directors, Michael Marocco, is a principal of several of the entities in
the Sandler/21st Century Group.
In April 1999, we completed the acquisition of BSSi Innovations, Inc. (BSSi).
BSSi was a provider of data network integration services based in Chicago,
Illinois. The purchase price consisted of $455,000 in cash, 37,000 shares of
our common stock which for accounting purposes were
F-26
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
assigned a value of $10.00 per share and assumed liabilities of approximately
$24,925 for total consideration of $1.5 million. An additional 10,000 shares
may be issued if certain financial conditions are met.
17. Unaudited Subsequent Events:
In July 1999 we expect to complete a one-for-two reverse split of our common
stock. The accompanying consolidated financial statements have been restated
for all periods presented to reflect the reverse stock split.
In June 1999, we entered into a $10.0 million senior secured credit facility
with Goldman Sachs Credit Partners L.P., under which our operating subsidiary,
Convergent Communications Services, Inc. and our leasing subsidiary, Convergent
Capital Corporation borrowed an aggregate of $10.0 million. The proceeds from
this facility may be used for working capital and other general corporate
purposes. We have agreed to guaranty our subsidiaries obligations under this
facility. To secure repayment of the proceeds, Goldman Sachs Credit Partners
L.P. has a security interest in, among other things, our eligible accounts
receivable, inventory held for sale (except inventory subject to purchase money
indebtedness) and intellectual property. In addition, the facility is secured
by a pledge to Goldman Sachs Credit Partners L.P. of all of the capital stock
of our subsidiaries.
In July 1999, we entered into a $103.5 million equipment facility with Cisco
Systems Capital Corporation for the purchase of Cisco equipment, including
Cisco's IP + ATM switches to be installed in our multi-service switching
platforms (which we call our ePOP). Currently, $23.0 million of that facility
is available.
F-27
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
PRO FORMA COMBINED FINANCIAL STATEMENT
Effective August 1, 1998, Convergent Communications acquired substantially
all of the assets and certain liabilities of Tie Communications, Inc. (Tie).
Consideration for the purchase consisted of (i) $40.0 million in cash (ii) the
assumption of certain liabilities, which, together with legal and professional
and other costs resulted in a total purchase price of approximately $51.4
million. The acquisition has been accounted for using the purchase method of
accounting.
The following unaudited Pro Forma Combining Statement of Operations for the
year ended December 31, 1998 assumes that the acquisition of Tie occurred on
January 1, 1998. The information for Tie presented in the Pro Forma Combining
Statement of Operations consists of historical amounts through the acquisition
date of August 1, 1998. The results of operations from the closing date are
included in our historical financial statements. Although we have completed or
are in the process of completing other acquisitions, the operations of those
business are not significant to the pro forma combined total assets or
operations and, accordingly, the effects of these acquisitions have not been
included in the accompanying Pro Forma Combining Statement of Operations.
The unaudited Pro Forma Combining Statement of Operations should be read in
conjunction with the historical audited financial statements and related notes
of Convergent and Tie included later in this prospectus. The unaudited
Combining Pro Forma Statement of Operations is not necessarily indicative of
the results that actually would have occurred had the pro forma transactions
been consummated at the dates indicated, nor is it necessarily indicative of
our future operating results.
F-28
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
PRO FORMA COMBINING STATEMENT OF OPERATIONS
For the Year Ended December 31, 1998 (unaudited)
<TABLE>
<CAPTION>
Historical(1)
-------------------------------
Convergent Tie
Communications, Communications, Pro Forma Pro Forma
Inc. Inc. Adjustments(2) Combined
--------------- --------------- -------------- ---------
(amounts in thousands, except per share amounts)
<S> <C> <C> <C> <C>
Revenues................ $ 61,600 $ 46,472 $ -- $108,072
Cost of sales excluding
depreciation........... 43,703 36,616 -- 80,319
Selling, general and
administrative......... 47,862 15,775 -- 63,637
Depreciation and
amortization........... 7,493 2,909 620(a) 11,022
Reorganization expense.. -- 1,439 -- 1,439
Other operating
expense................ -- 1,000 -- 1,000
-------- -------- ----- --------
Operating loss.......... (37,458) (11,267) (620) (49,345)
Interest income
(expense) and other.... (13,118) (2,185) 967(b) (14,336)
-------- -------- ----- --------
Income (loss) from
continuing operations
before income taxes.... (50,576) (13,452) 347 (63,681)
Income tax benefit...... -- 4,064 -- 4,064
-------- -------- ----- --------
Income (loss) from
continuing operations.. $(50,576) $ (9,388) $(347) $(59,617)
======== ======== ===== ========
Net loss per share
(basic and diluted).... $ (3.68) $ (4.34)
======== ========
Weighted average shares
outstanding (basic and
diluted)............... 13,732 13,732
======== ========
</TABLE>
See the accompanying notes to pro forma combining statement of operations.
F-29
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO PRO FORMA COMBINING STATEMENT OF OPERATIONS
Basis of Presentation:
(1) The unaudited Pro Forma Combining Statement of Operations for the year
ended December 31, 1998 includes historical results of operations for the
Convergent Communications for the entire year and through the acquisition date
of August 1, 1998 for Tie.
(2) The following pro forma adjustments have been made to the unaudited
combined pro forma financial statements of Convergent Communications and Tie.
(a) Amortization of step-up of intangibles recorded for the Tie acquisition
on a straight-line basis over 10 years, net of the amortization expense
of intangibles not purchased, which were being amortized on a straight-
line basis over 10 years. Also, included in this adjustment is the
elimination of the historical depreciation on property, plant and
equipment based primarily on straight-line depreciation over periods
from 3 to 10 years. Offsetting this elimination is the addition of
depreciation based on Convergent Communication's periods of
depreciation, 2 to 5 years.
(b) Adjustment to interest expense for debt of Tie which was not assumed in
the acquisition.
F-30
<PAGE>
FINANCIAL STATEMENTS FOR TIE/COMMUNICATIONS, INC.
Effective August 1, 1998, Convergent Communications acquired substantially
all the assets of Tie/Communications, Inc., which was a debtor-in-possession
operating under Chapter 11 of the United States Bankruptcy Code. Convergent
Communications did not acquire all the liabilities of Tie and did not acquire
the corporation in which Tie's business had been conducted and as to which the
financial statements on the following pages relate.
INDEX TO TIE COMMUNICATIONS, INC. FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Tie Communications, Inc.
Report of Independent Accountants....................................... TIE-3
Consolidated Balance Sheets as of December 31, 1995, 1996 and 1997 and
July 31, 1998.......................................................... TIE-4
Consolidated Statements of Operations for the two months ended December
31, 1995, years ended December 31, 1996 and 1997 and the seven months
ended July 31, 1998.................................................... TIE-6
Consolidated Statements of Changes in Stockholders' Equity (Deficit) for
the two months ended December 31, 1995, years ended December 31, 1996
and 1997 and the seven months ended July 31, 1998...................... TIE-7
Consolidated Statements of Cash Flows for the two months ended December
31, 1995, years ended December 31, 1996 and 1997 and the seven months
ended July 31, 1998.................................................... TIE-8
Notes to Consolidated Financial Statements.............................. TIE-9
</TABLE>
TIE-1
<PAGE>
[THIS PAGE INTENTIONALLY LEFT BLANK]
TIE-2
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholder of
Tie/communications, Inc.
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in stockholder's
equity/(deficit) and of cash flows present fairly, in all material respects,
the financial position of Tie/communications, Inc. (a wholly-owned subsidiary
of TIE Acquisition Co. and a Debtor-in-Possession) at December 31, 1995,
December 31, 1996, December 31, 1997 and July 31, 1998 and the results of its
operations and its cash flows for the period from November 1, 1995 through
December 31, 1995, the years ended December 31, 1996 and 1997, and the seven
months ended July 31, 1998, in conformity with generally accepted accounting
principles. These financial statements are the responsibility of TIE's
management; our responsibility is to express an opinion on these financial
statements based on our audits. We conducted our audits of these statements in
accordance with generally accepted auditing standards which 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, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above.
The accompanying financial statements have been prepared assuming TIE will
continue as a going concern. As discussed in Note 1 to the financial
statements, TIE has experienced net losses since its inception and is not in
compliance with certain provisions in its loan agreement with a financial
institution. Additionally, on April 10, 1998, TIE filed a voluntary petition
(as a debtor-in-possession) for relief under Chapter 11 of Title 11 of the
United States Bankruptcy Code. Effective August 1, 1998, TIE sold substantially
all of its operating assets to a third party. The accompanying financial
statements do not reflect the sale of substantially all of the assets to and
the assumption of certain liabilities by the third party. These uncertainties
raise substantial doubt about TIE's ability to continue as a going concern. The
accompanying financial statements do not include any adjustments which may
result from the outcome of these uncertainties.
PricewaterhouseCoopers LLP
Kansas City, Missouri
September 4, 1998
TIE-3
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ --------
<S> <C> <C> <C> <C>
ASSETS
Current assets
Cash.......................... $ 1,812 $ 469 $ 326 $ 650
Accounts receivable, net of
allowance of $1,640, $1,126,
$1,914 and $2,517,
respectively................. 11,131 10,659 12,041 8,508
Inventories, net of reserves
of $4,664, $4,932, $2,273 and
$2,520, respectively......... 6,540 8,789 5,447 4,782
Prepaid expenses.............. 833 801 541 1,032
Net assets held for sale...... 9,196 -- -- --
Other current assets.......... 1,922 1,961 819 1,182
Deferred tax asset............ -- -- -- 6,892
------- ------- ------- -------
Total current assets....... 31,434 22,679 19,174 23,046
Property and equipment, net... 1,596 1,792 4,597 3,428
Excess purchase price over
fair value of net assets
acquired, net................ 28,209 28,623 25,246 20,731
Equipment credit receivable... 1,500 -- -- --
Debt issuance costs, net...... 543 622 64 --
Other assets.................. 1,104 1,886 619 519
------- ------- ------- -------
Total assets............... $64,386 $55,602 $49,700 $47,724
======= ======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
TIE-4
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
CONSOLIDATED BALANCE SHEETS--(Continued)
<TABLE>
<CAPTION>
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ --------
<S> <C> <C> <C> <C>
LIABILITIES AND STOCKHOLDER'S
EQUITY/(DEFICIT)
Liabilities subject to
compromise................... $ -- $ -- $ -- $ 38,779
Liabilities not subject to
compromise
Current liabilities:
Note payable and current
maturities of long-term
debt:
Related parties............. -- 1,515 5,734 --
Other....................... -- 15,896 16,913 1,644
Advance from Convergent
Communications Services,
Inc.......................... -- -- -- 15,917
Accounts payable.............. 3,720 7,770 12,583 4,458
Accrued wages and benefits.... 3,897 2,922 3,369 2,667
Restructuring reserve......... 2,399 1,684 523 --
Other accrued expenses:
Related parties............. -- 136 2,418 --
Other....................... 7,418 5,873 6,001 6,634
Deferred service revenue...... 6,625 6,114 5,538 2,186
Income taxes payable.......... 1,732 1,114 939 33
------- ------- -------- --------
Total current
liabilities.............. 25,791 43,024 54,018 72,318
Long-term debt:
Related parties.............. 10,000 10,000 10,000 --
Other........................ 20,000 59 2,325 1,495
Other non-current
liabilities.................. 1,339 117 58 --
------- ------- -------- --------
Total liabilities......... 57,130 53,200 66,401 73,813
Commitments and contingencies
Stockholder's equity/(deficit)
Series A preferred stock..... -- -- 9 9
Common stock................. -- -- 102 102
Additional paid-in capital... 7,833 7,753 7,642 7,642
Accumulated deficit.......... (577) (5,351) (24,454) (33,842)
------- ------- -------- --------
Total stockholder's
equity/(deficit)......... 7,256 2,402 (16,701) (26,089)
------- ------- -------- --------
Total liabilities and
stockholder's
equity/(deficit)......... $64,386 $55,602 $ 49,700 $ 47,724
======= ======= ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
TIE-5
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Period from Seven
November 1, Months
1995 through Year Ended Year Ended Ended
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ --------
<S> <C> <C> <C> <C>
Net revenue:
Equipment.................. $ 7,302 $45,114 $ 40,338 $ 17,258
Services................... 7,562 45,111 43,390 21,334
Other...................... 1,499 6,332 11,646 7,880
------- ------- -------- --------
16,363 96,557 95,374 46,472
Cost of sales:
Equipment.................. 5,502 32,706 32,767 15,250
Services................... 4,620 28,518 28,362 14,115
Other...................... 663 2,467 8,230 7,251
------- ------- -------- --------
10,785 63,691 69,359 36,616
Gross margin:
Equipment.................. 1,800 12,408 7,571 2,008
Services................... 2,942 16,593 15,028 7,219
Other...................... 836 3,865 3,416 629
------- ------- -------- --------
5,578 32,866 26,015 9,856
Selling, general and
administrative expenses..... 4,837 28,944 33,667 15,775
Depreciation and
amortization................ 712 4,632 4,851 2,909
Reorganization expenses...... -- -- -- 1,439
Other operating expenses..... -- 706 893 1,000
------- ------- -------- --------
Operating income/(loss)...... 29 (1,416) (13,396) (11,267)
Interest expense:
Related parties (contractual
interest at July 31, 1998
was $2,965)................. -- 1,443 2,997 832
Other........................ 560 1,588 2,517 1,295
Other expenses, net.......... 38 291 158 58
------- ------- -------- --------
Loss before income taxes..... (569) (4,738) (19,068) (13,452)
Provision for (benefit from)
income taxes................ 8 36 35 (4,064)
------- ------- -------- --------
Net loss..................... $ (577) $(4,774) $(19,103) $ (9,388)
======= ======= ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
TIE-6
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY/(DEFICIT)
<TABLE>
<CAPTION>
Preferred Stock,
$0.01 par,
Common Stock, Common Stock, Common Stock, 1,000,000 Series A
$0.01 par, $0.10 par, $0.01 par, 8.0785%
100 shares 10,000,000 shares 15,000,000 shares cumulative,
authorized authorized authorized shares authorized Additional
------------- ------------------ ----------------- ------------------- paid-in Accumulated
Shares Amount Shares Amount Shares Amount Shares Amount capital deficit Total
------ ------ ---------- ------ ---------- ------ ---------- -------- ---------- ----------- --------
(dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at
November 1,
1995............ -- $-- 3,988,392 $ 398 -- $-- -- $ -- $15,727 $ -- $ 16,125
Recapitalization
due to merger
with TIE Merger
Co.............. 100 -- (3,988,392) (398) -- -- -- -- (7,894) -- (8,292)
Net loss for the
period from
November 1, 1995
through December
31, 1995........ -- -- -- -- -- -- -- -- -- (577) (577)
---- ---- ---------- ----- ---------- ---- ---------- ------- ------- -------- --------
Balance at
December 31,
1995............ 100 -- -- -- -- -- -- -- 7,833 (577) 7,256
Return of equity
to TIE
Acquisition
Co.............. -- -- -- -- -- -- -- -- (80) -- (80)
Net loss for the
year ended
December 31,
1996............ -- -- -- -- -- -- -- -- -- (4,774) (4,774)
---- ---- ---------- ----- ---------- ---- ---------- ------- ------- -------- --------
Balance at
December 31,
1996............ 100 -- -- -- -- -- -- -- 7,753 (5,351) 2,402
Recapitalization.. (100) -- -- 10,200,000 102 940,000 9 (111) -- --
Net loss for the
year ended
December 31,
1997............ -- -- -- -- -- -- -- -- -- (19,103) (19,103)
---- ---- ---------- ----- ---------- ---- ---------- ------- ------- -------- --------
Balance at
December 31,
1997............ -- -- -- -- 10,200,000 102 940,000 9 7,642 (24,454) (16,701)
Net loss for the
seven month
period ended
July 31, 1998... -- -- -- -- -- -- -- -- -- (9,388) (9,388)
---- ---- ---------- ----- ---------- ---- ---------- ------- ------- -------- --------
Balance at July
31, 1998........ -- $-- -- $ -- 10,200,000 $102 940,000 $ 9 7,642 $(33,842) $(26,089)
==== ==== ========== ===== ========== ==== ========== ======= ======= ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
TIE-7
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Period from Seven
November 1, 1995 Year Ended Year Ended Months Ended
through December December 31, December 31, July 31,
31, 1995 1996 1997 1998
---------------- ------------ ------------ ------------
(dollars in thousands)
<S> <C> <C> <C> <C>
Cash flows from
operating activities:
Net loss................ $ (577) $ (4,774) $(19,103) $(9,388)
Adjustments to
reconcile net loss to
cash flows utilized
for operating
activities:
Depreciation and
amortization.......... 712 4,632 4,851 2,909
Provision for doubtful
accounts.............. (53) 788 717 635
Deferred income taxes.. -- -- -- (4,085)
Changes in working
capital, net:
Accounts receivable... (1,459) (316) (2,099) 2,899
Inventories........... 486 (924) 3,342 665
Prepaid expenses...... (268) 32 260 (491)
Other current assets.. (282) 203 993 (376)
Accounts payable...... 484 4,050 4,810 4,366
Accrued wages and
benefits............. (475) (975) 568 (662)
Restructuring
reserve.............. (101) (1,941) (991) (37)
Other accrued
expenses............. 605 (1,508) 2,701 4,613
Deferred service
revenue.............. (60) (511) (576) (635)
Income taxes payable.. 24 (1,716) (175) 22
Other.................. -- -- 2,175 94
------- -------- -------- -------
Cash provided by
(utilized for)
operating activities... (964) (2,960) (2,527) 529
Cash flows from
investing activities:
Purchases of property
and equipment.......... (123) (2,556) (1,075) (23)
Proceeds from sales of
property and
equipment.............. -- 265 518 --
Proceeds from sale of
assets held for sale... -- 8,456 -- --
Other................... (131) (1,793) (58) --
------- -------- -------- -------
Cash provided by
(utilized for)
investing activities... (254) 4,372 (615) (23)
Cash flows from
financing activities:
Net borrowings
(repayments) under
revolving lines of
credit................. -- 15,838 (307) (7,811)
Proceeds from advances
from Convergent
Communications
Services, Inc.......... -- -- -- 15,197
Cash contributed by TIE
Acquisition Co......... 2,353 -- -- --
Proceeds from note with
affiliate.............. 1,515 4,500 --
Proceeds from borrowing
from former majority
stockholder............ 400 -- --
Repayment of note with
affiliate.............. -- -- (300) --
Repayment of term loan.. -- -- -- (7,000)
Repayment of bridge loan
facility............... -- (20,000) -- --
Return of equity to TIE
Acquisition Co......... -- (80) -- --
Capitalized lease
payments............... -- (28) (894) (568)
Payment of long-term tax
liability.............. (296) -- -- --
------- -------- -------- -------
Cash provided by
(utilized for)
financing activities... 2,457 (2,755) 2,999 (182)
======= ======== ======== =======
Net increase/(decrease)
in cash................ 1,239 (1,343) (143) 324
======= ======== ======== =======
Cash at beginning of the
period................. 573 1,812 469 326
======= ======== ======== =======
Cash at end of the
period................. $ 1,812 $ 469 $ 326 $ 650
======= ======== ======== =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
TIE-8
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS
(dollars in thousands, except share related data)
1. Nature of Business and Going Concern Uncertainty
Nature of business
Tie/communications, Inc. (together with its subsidiaries, "TIE") is engaged
in the sale, installation and servicing of telecommunications products and
services including the resale of long distance services. TIE's principal
products are multi-featured, fully electronic, digitally controlled key
systems, private automated branch exchange ("PABX") systems and hybrid
telephone systems, voice response and processing products with computer
telephone integration hardware and software, video conferencing systems and
network services including long distance products as well as pre-owned phone
systems, which are primarily for business use. TIE's products also include
other peripheral data and telecommunications products.
TIE resells long distance services to its customers under separate reseller
agreements with certain major interexchange carriers. By offering both premise-
based telecommunications equipment and services along with competitive resold
long distance services, TIE delivers a single point of contact for the
telecommunications needs of its customers which is a valuable and beneficial
service for its small to medium commercial customers.
TIE's core business sells, installs and services its products through a U.S.
network of approximately 40 sales, service and warehouse facilities located
throughout major U.S. metropolitan areas.
Going concern uncertainty
The accompanying consolidated financial statements have been prepared
assuming that TIE continues as a going concern, which contemplates continuity
of operations and realization of assets and liquidation of liabilities in the
ordinary course of business. TIE was not in compliance with certain of the
restrictive covenants contained in the loan and security agreement with one of
its lenders throughout 1996, 1997 and 1998. These events of noncompliance
indicated that the related obligations were callable by the lender.
Additionally, TIE has a working capital deficit of $49,272 as of July 31, 1998
and has generated net losses of $33,842 since its inception in October 1995
resulting in a stockholder's deficit of $26,089 as of July 31, 1998.
On April 10, 1998, TIE filed a voluntary petition for relief under Chapter 11
of Title 11 of the United States Bankruptcy Code (the Bankruptcy Code) in the
United States Bankruptcy Court for the Central District of California (the
Bankruptcy Court), Case No. SA 98-15547-JB. TIE is currently operating its
business as a debtor-in-possession pursuant to Sections 1107(a) and 1108 of the
Bankruptcy Code and is subject to the jurisdiction of the Bankruptcy Court.
Since filing the petition for relief, TIE has reported reorganization expenses
relating to professional and legal fees of $1,439.
On June 16, 1998, TIE entered into an asset purchase agreement with
Convergent Communications Services, Inc. for the acquisition of substantially
all of the assets and the assumption of certain liabilities for a cash payment
of $40 million. The agreement was subject to the approval of the Bankruptcy
Court, which was obtained on July 20, 1998. Pursuant to the asset purchase
agreement, on July 31, 1998, the purchase price for the acquisition was
delivered to an escrow agent and was partially used to repay TIE's indebtedness
under the loan and security agreement referred to above. The sale transaction
closed effective August 1, 1998. See Note 15.
TIE-9
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
As a result of the filing under Chapter 11 of the Bankruptcy Code and related
circumstances, including TIE's leveraged financial structure, the substantial
recurring net losses and working capital and stockholder's deficits and the
disposition of substantially all of TIE's assets, the realization of any
remaining assets and liquidation of remaining liabilities is subject to
significant uncertainty.
While under the protection of Chapter 11 of the Bankruptcy Code, TIE may sell
or otherwise dispose of assets, and liquidate or settle liabilities, for
amounts other than those reflected in the accompanying financial statements.
Further, a plan of reorganization could materially change the amounts reported
in such financial statements, which do not give effect to all adjustments of
the carrying value of assets or liabilities that might be necessary as a
consequence of a confirmed plan of reorganization.
2. Significant Accounting Policies
Principles of consolidation
The consolidated financial statements include the accounts of TIE and its
majority-owned subsidiaries. During 1996, all of TIE's active subsidiaries
merged into TIE. All significant intercompany accounts and transactions have
been eliminated.
Basis of presentation
The accompanying financial statements do not reflect sale of substantially
all of the assets to and the assumption of certain liabilities by Convergent
Communications Services, Inc. effective August 1, 1998. See Note 15.
Reclassifications
Certain amounts in 1995 financial statements have been reclassified to
conform to the current year's presentation.
Revenue recognition
Revenue from equipment sales and installation service work to end users is
recognized at the time of its completion. Deferred service revenue from
maintenance contracts is amortized in equal increments over the terms of the
contracts which are generally for one year. Revenue from the reselling of long
distance service is recognized at the time of the performance and the cost
associated for providing those services is charged to cost of sales.
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 could differ from those estimates.
Accounts receivable
Accounts receivable represent billed and accrued receivables for equipment
sales, installation service work and long distance reseller services. These
receivables are unsecured. TIE provides
TIE-10
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
allowances for returns, billing adjustments and doubtful accounts equal to the
estimated losses expected to be sustained.
Inventories
Inventories, which consist primarily of new and refurbished equipment for
resale, are valued at the lower of cost or net realizable value, using the
first-in, first-out method. TIE provides reserves for estimated losses related
to excess and obsolete inventory.
Warranty claims
TIE accrues for warranty expense in the period that the related revenue is
recognized based upon historical experience.
Property and equipment
Property and equipment primarily consist of equipment that is of an
administrative nature such as office furniture and computers, which are not
used to generate revenues are recorded at cost. At the time fixed assets are
sold or otherwise disposed of, the cost and related accumulated depreciation
are removed from the accounts and the resulting gain or loss, if any, is
included in the determination of income. Maintenance and repair costs are
expensed as incurred.
Depreciation and amortization are provided on the straight-line method over
the estimated useful lives of the assets. Leasehold improvements and equipment
under capital leases are capitalized and amortized over the lesser of their
estimated useful lives or the lives of the related leases.
<TABLE>
<CAPTION>
Assigned
Life
----------
<S> <C>
Building......................................................... 30 years
Equipment........................................................ 3-9 years
Leasehold improvements........................................... 1-5 years
Furniture and fixtures........................................... 3-10 years
</TABLE>
Liabilities subject to compromise
In accordance with Statement of Position 90-7 (SOP 90-7), Financial Reporting
by Entities in Reorganization Under the Bankruptcy Code, prepetition
liabilities which are unsecured or estimated to be undersecured are classified
as liabilities subject to compromise. The accrual of interest on such
liabilities has been discontinued for periods after April 10, 1998.
Intangible assets
Excess purchase price over fair value of net assets acquired and the
identifiable intangible assets are being amortized over their estimated useful
life of 10 years. The principal identifiable intangible assets are TIE's
installed customer base and its tradename. Accumulated amortization as of
December 31, 1995, December 31, 1996, December 31, 1997 and July 31, 1998 was
$384, $3,336, $6,195 and $7,863, respectively. TIE periodically assesses the
realizability of the excess purchase price over fair value of net assets
acquired based upon estimated fair value.
TIE-11
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
Debt issuance costs
Debt issuance costs are capitalized and amortized as interest expense using
the effective interest method over the lives of the related debt. Accumulated
amortization as of December 31, 1995, December 31, 1996, December 31, 1997 and
July 31, 1998 was $188, $894, $1,496 and $1,541, respectively.
Impairment of long-lived assets
TIE assesses its long-lived assets to be held and used for impairment
whenever events or changes in circumstances indicate that the carrying amount
of such assets (or group of assets) may not be recoverable. Impairment is
determined to exist if the estimated future cash flows (undiscounted and
without interest charges) is less than carrying value. The amount of any
impairment then recognized would be calculated as the difference between
carrying value and fair value. With respect to assets to be disposed of,
impairment is measured as the excess of carrying value over fair value less
cost of disposal.
Income taxes
TIE accounts for income taxes under Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109), which is an
asset and liability method of accounting for income taxes. Under this method,
deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply in the years in which those temporary differences are
expected to be recovered or settled. A valuation allowance is recorded for
deferred tax assets which management determines are more likely than not
unrealizable. TIE joins in the filing of a consolidated federal income tax
return with TIE Acquisition Co., with the tax liability allocated on a separate
company basis.
Stock options
TIE accounts for stock options granted to employees and non-employee
directors using the intrinsic value method as prescribed by Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees"
(APB 25). In October 1995, the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 123, "Accounting for Stock-
Based Compensation" (SFAS No. 123) which permits companies to use either the
APB 25 intrinsic value method or the fair value method as prescribed by SFAS
No. 123, but encourages companies to adopt the fair value method. Companies
electing to use the APB 25 method are required to disclose pro forma net income
(if materially different from net income as reported) in the notes to the
financial statements, as if they had adopted the SFAS No. 123 fair value
method. TIE accounts for stock options issued to parties other than employees
and non-employee directors using the SFAS No. 123 fair value method.
3. Fair Value Of Financial Instruments
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair
Value of Financial Instruments," requires disclosure of fair value information
about financial instruments,
TIE-12
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
whether or not recognized in the balance sheet, for which it is practicable to
estimate that value. Fair values are based on settlements using present value
or other valuation techniques.
TIE's financial instruments include cash, accounts receivable and payable,
debt and irrevocable standby letters of credit ($172, $464, $685 and $0 as of
December 31, 1995, December 31, 1996, December 31, 1997 and July 31, 1998,
respectively). Management believes the fair values of the cash and accounts
receivable and payable approximate their respective carrying values because of
their short term nature. Management does not believe that it is practicable to
estimate the fair values of the debt or irrevocable standby letters of credit
because of the uncertainty surrounding TIE's financial status as described in
Note 1.
4. Property And Equipment
Property and equipment consists of the following:
<TABLE>
<CAPTION>
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ ---------
<S> <C> <C> <C> <C>
Land....................... $ 10 $ 10 $ 10 $ 10
Buildings.................. 123 123 123 123
Equipment.................. 1,316 2,101 1,790 1,814
Leasehold improvements..... 52 91 426 436
Furniture and fixtures..... 235 232 239 239
Equipment under capital
leases.................... -- 145 4,629 4,629
Construction in progress... -- 139 20 20
------- ------- ------- ------
1,736 2,841 7,237 7,271
Less accumulated
depreciation and
amortization (including
$0, $12, $1,007 and $1,915
of accumulated
amortization related to
equipment under capital
leases)................... 140 1,049 2,640 3,843
------- ------- ------- ------
$ 1,596 $ 1,792 $ 4,597 $3,428
======= ======= ======= ======
</TABLE>
(dollars in thousands, except share related data)
Depreciation expense (including amortization of equipment under capital
leases) aggregated $140, $921, $1,704 and $1,193 for the period from November
1, 1995 through December 31, 1995, and the years ended December 31, 1996 and
December 31, 1997 and the seven months ended July 31, 1998, respectively.
Depreciation expense represents depreciation on plant and equipment that is
primarily of an administrative nature such as office furniture and computers,
which are not used to generate revenues.
TIE-13
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
5. Debt
Debt consists of the following:
<TABLE>
<CAPTION>
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ --------
<S> <C> <C> <C> <C>
Subordinated promissory
note to related party..... $ 10,000 $ 10,000 $ 10,000 $10,000
Bank revolving credit
facility.................. -- 8,838 8,531 --
Bank term loan facility.... 20,000 7,000 7,000 --
Subordinated demand notes
payable to related party.. -- 1,515 5,734 5,734
Capitalized lease
obligations............... -- 117 3,707 3,139
--------- --------- --------- -------
30,000 27,470 34,972 18,873
Less current maturities of
long-term debt............ -- 17,411 22,647 17,378
--------- --------- --------- -------
Long-term debt............. $ 30,000 $ 10,059 $ 12,325 $ 1,495
========= ========= ========= =======
</TABLE>
In connection with the acquisition discussed in Note 9, TIE Acquisition Co.
borrowed $20,000 under a bank loan facility agreement, as amended, which bore
interest at the prime rate, as defined, plus 2.5% and was secured by TIE's
stock acquired by TIE Acquisition Co. The principal and interest on the loan
were due and repaid 90 days after the stock tender offer (January 16, 1996).
Concurrent with the merger described in Note 9, TIE entered into a $10,000
subordinated promissory note payable to TIE Acquisition Co. Interest is payable
monthly at the rate of 10%. The note is due and payable in full on February 15,
1999. Interest expense was $53, $1,017, $1,014 and $281 for the period from
November 1, 1995 through December 31, 1995, and the years ended December 31,
1996 and December 31, 1997 and the seven months ended July 31, 1998,
respectively. In accordance with SOP 90-7, the accrual of interest on this note
was discontinued after April 10, 1998. The unrecorded interest expense was $308
for the period from April 10 through July 31, 1998.
In January 1996, TIE entered into a Loan and Security Agreement with a bank
(the "Agreement"), which consisted of two facilities: a $20,000 revolving
credit facility and a $5,000 term loan facility. The Agreement was subsequently
amended to decrease the revolving credit facility to $18,000 and increase the
term loan facility to $7,000. The revolving credit facility terminates on
December 1, 1998, but shall be automatically extended for successive one-year
periods unless either the lender or the borrower provides to the other written
notice of termination not less than 60 days prior to the then effective
termination date. The revolving credit facility bears interest, at TIE's
option, at either the prime rate plus 1% or LIBOR plus 3.25% (9.5% at December
31, 1997). The advances available under this facility are limited to specified
percentages of eligible accounts receivable and inventory. The term loan
facility expired on January 31, 1998 and bore interest at LIBOR plus 4%
(9.6875% at December 31, 1997). The proceeds from these two facilities were
used to retire the $20,000 bank bridge loan utilized for the acquisition in
November 1995. The obligations under this Agreement are secured by
substantially all of TIE's assets as well as TIE Acquisition Co.'s
stockholdings in TIE and other assets which have been pledged by certain
related parties. Effective February 1, 1998, the interest rate of each of these
facilities increased 2% due to TIE's failure to pay the term loan when it
became due.
TIE-14
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
The Agreement contains numerous financial and operating covenants, including,
among other things, requirements that TIE maintain certain financial ratios and
restrictions on the ability of TIE to (i) incur indebtedness or create liens,
(ii) make certain capital expenditures and lease payments, and (iii) make
certain restricted distributions and payments. During 1996, 1997 and 1998, TIE
violated certain financial covenants of the Agreement. See Note 1.
In accordance with the bankruptcy filing, TIE repaid the term loan and the
revolving credit facility with operating cash receipts during the second
quarter of 1998. A debtor-in-possession loan was established with the bank on
April 10, 1998 to provide for TIE's operating expenses. The loan was secured by
TIE's accounts receivable and bore interest at 10.5%. Pursuant to the asset
purchase agreement on July 31, 1998 the purchase price for the acquisition was
delivered to an escrow account and was partially used to repay TIE's
indebtedness under the debtor-in-possession loan.
In February 1996, TIE entered into a $1,515 subordinated demand note payable
to SP Investments, Inc., a related party. Interest on this note was initially
payable quarterly in arrears at an annual rate equal to the greater of 12% or
the prime rate plus 5%. Effective January 1997 and July 1997, the note was
amended to increase the interest rate to 20% and 30%, respectively. Interest
expense for the years ended December 31, 1996 and 1997 and for the seven months
ended July 31, 1998 was $185, $444 and $126, respectively. Also in 1997, TIE
entered into three additional demand notes payable to SP Investments, Inc.
totaling $4,500. Interest on these notes is payable at an annual rate of 30%
and is payable on demand. Interest expense related to these notes aggregated
$507 and $344 for the year ended December 31, 1997 and for the seven months
ended July 31, 1998. In accordance with SOP 90-7, the accrual of interest on
these notes was discontinued after April 10, 1998. The unrecorded interest
expense was $530 for the period from April 10 through July 31, 1998.
During 1997, TIE also entered into various collateral guarantee fee
arrangements with certain members of management and shareholders of TIE
Acquisition Co. The agreements call for individuals to be compensated for
personal assets used to guarantee certain debt of TIE. As of December 31, 1997
and July 31, 1998, a liability of $1,005 and $1,086 has been recorded for these
fees and the related expense has been recorded in interest expense.
Interest expense included in the Consolidated Statements of Operations for
the period from November 1, 1995 through December 31, 1995, for the years ended
December 31, 1996 and 1997, and for the seven months ended July 31, 1998
includes non-cash interest expense of $188, $528, $602 and $45, respectively,
representing amortization of debt issuance costs as described in Note 2.
TIE-15
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
TIE entered into various capital lease agreements during 1997 of which each
had a lease period of three years. Three agreements were entered into for the
sale and simultaneous leaseback of equipment and software, with aggregate lease
payments totaling $1,798. Three lease agreements were entered into for the
purchase of office furniture and other equipment, with aggregate lease payments
totaling $698. In addition, TIE entered into six lease agreements for equipment
with aggregate lease payments totaling $1,988. At July 31, 1998, the future
minimum lease payments under capital leases were as follows:
<TABLE>
<S> <C>
Five months ending December 31, 1998................................. $ 939
Year ending December 31:
1999............................................................... 1,645
2000............................................................... 899
------
Total minimum rentals............................................ 3,483
Less amount representing interest.................................... 344
------
Present value of minimum rentals..................................... $3,139
======
</TABLE>
6. Liabilities Subject to Compromise
Certain prepetition liabilities, which may be impaired, have been classified
as liabilities subject to compromise in the Chapter 11 reorganization
proceedings and include the following estimated amounts at July 31, 1998:
<TABLE>
<S> <C>
Debt instruments:
Subordinated promissory note payable to TIE Acquisition Co........ $10,000
Subordinated demand notes payable to a related party.............. 5,734
-------
Total debt instruments.......................................... 15,734
-------
Accounts payable.................................................... 12,490
Other accrued expenses:
Related party..................................................... 3,478
Other............................................................. 2,947
Deferred service revenue............................................ 2,716
Restructuring reserve............................................... 486
Income taxes payable................................................ 928
-------
Total........................................................... $38,779
=======
</TABLE>
TIE-16
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
7. Income Taxes
The components of the income tax provision for the period from November 1,
1995 through December 31, 1995, for the years ended December 31, 1996 and 1997,
and for the seven months ended July 31, 1998 are as follows:
<TABLE>
<CAPTION>
Period from
November 1, 1995 Seven Months
through Year Ended Year Ended Ended
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
---------------- ------------ ------------ ------------
<S> <C> <C> <C> <C>
Current tax expense
(benefit):
Federal............... $-- $-- $-- $ --
State................. 8 36 35 21
Deferred tax expense
(benefit):
Federal............... -- -- -- (3,472)
State................. -- -- -- (613)
---- ---- ---- -------
$ 8 $ 36 $ 35 $(4,064)
==== ==== ==== =======
</TABLE>
The differences between TIE's provision for income taxes and income taxes
based upon the federal statutory rate are:
<TABLE>
<CAPTION>
Period from
November 1, 1995 Seven Months
through Year Ended Year Ended Ended
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
---------------- ------------ ------------ ------------
<S> <C> <C> <C> <C>
Income tax (benefit)
computed at the
statutory federal
rate................... $(193) $(1,150) $(6,070) $(3,753)
Changes resulting from:
Changes in the
valuation allowance
for deferred income
tax assets allocated
to income taxes...... 54 796 5,563 (697)
Nondeductible
amortization of
excess purchase price
over fair value of
net assets acquired.. 130 353 457 226
Other................. 17 37 85 160
----- ------- ------- -------
$ 8 $ 36 $ 35 $(4,064)
===== ======= ======= =======
</TABLE>
TIE-17
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
The significant components of TIE's deferred income tax balances are as
follows:
<TABLE>
<CAPTION>
December 31, December 31, December 31, July 31,
1995 1996 1997 1998
------------ ------------ ------------ --------
<S> <C> <C> <C> <C>
Net operating loss
carryover................ $ 3,728 $ 5,747 $ 17,787 $ 21,551
Accounts and notes
receivable............... 749 536 766 978
Inventories............... 2,556 2,523 1,346 1,499
Property and equipment.... 8 105 145 160
Accrued expenses and other
liabilities.............. 2,420 1,773 1,468 1,612
Deferred revenue.......... 109 80 -- --
Equipment credit
receivable............... (600) -- -- --
Other..................... -- (48) -- --
8,970 10,716 21,512 25,800
Valuation allowance....... (8,970) (10,716) (21,512) (18,908)
------- -------- -------- --------
Net deferred income tax
balance.................. $ -- $ -- $ -- $ 6,892
======= ======== ======== ========
</TABLE>
TIE has net operating loss carryovers of $53,060. TIE's ability to utilize
these operating loss carryovers incurred prior to the acquisition was
materially limited due to the change of ownership which occurred in 1995. Due
to these limitations, the amount of future taxable income which can be offset
by federal operating losses incurred prior to November 1, 1995, is
approximately $533 annually ($7,018 in the aggregate).
In addition to the annual limitation on the utilization of the pre-
acquisition operating loss carryforwards, taxable gains on the sale of assets
whose value exceeded their tax bases at November 1, 1995 can be offset by the
pre-acquisition operating loss carryforwards to the extent that such built-in
gains are recognized during a period of five years following the acquisition
(see Note 9). TIE has unrecognized built-in gains in excess of its net
operating loss at the time of the acquisition. Federal operating loss
carryforwards are scheduled to expire between 2005 and 2018.
Pursuant to SFAS No. 109, excess purchase price over the fair value of net
assets acquired was reduced by $2,807 for the tax benefit recognized due to the
reduction of the valuation allowance for the future utilization of pre-
acquisition operating loss carryforwards.
TIE has a $912 tax liability recorded relating to a negotiated settlement
with the Internal Revenue Service and with certain states for tax years through
December 31, 1986. TIE was entitled to make payments of the federal and state
tax liabilities over a period of six years due to a Chapter 11 bankruptcy
reorganization in 1991. The outstanding balance accrues interest at the six
month U.S. Treasury Bill rate.
8. Employee Benefit Plan
TIE's Profit Sharing and Savings Plan (the "Plan") allows participating
employees to authorize payroll deferrals of up to 16% of their total
compensation and to contribute such amounts to the Plan. Under the Plan, TIE
matches a portion of a participant's contribution equal to 50% of that portion
of a participant's deferred compensation which does not exceed 6% of the
participant's eligible compensation. During the period from November 1, 1995
through December 31, 1995, TIE's contributions were $75. During the years ended
December 31, 1996 and December 31, 1997 and the
TIE-18
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
seven months ended July 31, 1998, TIE did not meet its contribution
requirements due to financial difficulties. As of December 31, 1996, December
31, 1997, and July 31, 1998, $461, $933 and $1,200, respectively, were due to
the Plan and have been recorded in the accompanying financial statements.
9. Stockholder's Equity/(deficit)
Acquisition and merger
On October 18, 1995, TIE Acquisition Co. entered into a stock tender offer
with the former stockholders of TIE and acquired 3,749,587 shares
(approximately 94%) of the outstanding common stock for $8.60 per share (the
"Acquisition").
The aggregate consideration for TIE amounted to $36,125 including financing
debt issuance and acquisition costs and $8.60 per share for untendered shares.
The purchase price exceeded the estimated fair market value of the net
identifiable assets by $28,501, and the Acquisition has been accounted for
under the purchase method of accounting.
On December 13, 1995, TIE Acquisition Co. contributed cash and the TIE common
stock it held to TIE Merger Co. (a wholly-owned subsidiary of TIE Acquisition
Co.). In conjunction with the contributions, TIE Acquisition Co. made a payment
of $1,800 to repay TIE's note payable to the former majority stockholder and
TIE Merger Co. assumed certain TIE Acquisition Co. accrued liabilities,
including liabilities amounting to $1,992 for untendered TIE common stock (the
shares were converted into the right to receive $8.60 per share upon surrender
of the corresponding stock certificates) and TIE Acquisition Co.'s $20,000 bank
debt, which is secured by all TIE's outstanding stock. In addition, TIE Merger
Co. entered into a long-term note payable with TIE Acquisition Co. for $10,000.
The note payable corresponds with the notes payable entered into by TIE
Acquisition Co. in connection with the tender offer for TIE's stock.
Also effective December 13, 1995, TIE Merger Co. was merged into TIE (the
"Merger"). In conjunction with the Merger, all shares of TIE's common stock
were canceled and extinguished. After the Merger, TIE had 100 shares of $0.01
par value common stock authorized, issued and outstanding, all of which were
owned by TIE Acquisition Co.
Recapitalization
In January 1997, TIE amended its Restated Certificate of Incorporation to
increase the number of authorized shares of common stock, par value of one cent
($.01), to fifteen million shares and authorized five million shares of
preferred stock, par value of one cent ($.01). The amendment further designated
one million shares of the preferred stock to be Series A 8.0785% Cumulative
Preferred Stock (the Series A Preferred Stock), without voting rights.
In connection with the increase in authorized shares of stock, TIE was
recapitalized by substituting, for the 100 shares of TIE's then issued and
outstanding common stock, 10,200,000 shares of common stock, par value of one
cent ($.01) and 940,000 shares of Series A 8.0785% Cumulative Preferred Stock.
TIE-19
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
Dividends on the Series A Preferred Stock accrue at a rate per annum of
8.0785% of the liquidation preference thereof ($10.51 per share) and are
payable semi-annually on October 18 and April 18 of each year.
Each Series A Preferred Stock dividend shall be fully cumulative and shall
accrue (whether or not earned or declared) without interest from the first day
of issuance of the Series A Preferred Stock. No dividends on the Series A
Preferred Stock were declared or paid during 1997 or 1998. As of December 31,
1997 and July 31, 1998, the accumulated dividends on the Series A Preferred
Stock approximated $713 and $1,156.
Upon a liquidation, winding up or dissolution of the affairs of TIE, whether
voluntary or involuntary, the holders of the Series A Preferred Stock are
entitled to be paid $10.51 per share, plus all accrued and unpaid dividends
(whether or not earned or declared) before any assets of TIE shall be
distributed to holders of TIE common stock.
Additionally, at the option of TIE, the Series A Preferred Stock may be
redeemed at any time in whole or in part at a cash redemption price of $10.51
per share plus accrued and unpaid dividends to the scheduled redemption date.
Stock options
In January 1997, TIE established the Tie Communications, Inc. Employees'
Stock Incentive Plan (National Plan), the Tie Communications, Inc. Employees'
Stock Incentive Plan (California Plan) and the Tie Communications, Inc. Non-
Employee Directors' Stock Option Plan which provide for the availability of
1,800,000; 180,000 and 220,000 shares, respectively, of TIE's common stock for
the grant of awards to TIE employees or non-employee directors. Awards granted
under these plans may take the form of stock options or stock appreciation
rights (SARs). The option exercise price and SAR initial value under these
plans must be at least equal to the fair market value of the underlying shares
of common stock on the date of grant (110% of the underlying fair market value
in the case of a ten percent shareholder). Plan participants vest in their
awards (generally over five years) and such awards expire (generally 10 years
after the grant date) as determined by a committee of TIE board of directors.
A summary of stock option activity under these plans is presented in the
table below:
<TABLE>
<CAPTION>
Shares underlying options for the Shares underlying options for the
year ended December 31, 1997 seven months ended July 31, 1998
--------------------------------- ---------------------------------
<S> <C> <C>
Outstanding at January
1...................... -- 966,500
Granted................. 1,324,000 --
Exercised............... -- --
Canceled................ (357,500) (134,000)
--------- --------
Outstanding............. 966,500 832,500
========= ========
Exercisable............. 88,800 232,500
========= ========
</TABLE>
The exercise price for all options outstanding and vested is $1.00 per share.
Under SFAS No. 123, companies must either record compensation expense based
on the estimated grant date fair value of stock options granted or disclose the
impact (if material) on net
TIE-20
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
income as if they had adopted the fair value method. TIE's pro forma net loss
as if expense was recorded using SFAS No. 123 was $19,168 and $9,424 for the
year ended December 31, 1997 and the seven months ended July 31, 1998.
The weighted average fair value of options granted in 1997 was $.27 per
share. The fair value of each option grant was estimated on the date of grant
using the Black-Scholes option pricing model with the following weighted
average assumptions:
<TABLE>
<S> <C>
Expected option term................................................. 5 years
Dividend yield....................................................... 0%
Risk free interest rate.............................................. 6.29%
</TABLE>
Due to the fact that TIE's common stock is not publicly traded, volatility
was not considered in TIE's calculations of fair value of stock options issued
to employees and non-employee directors.
The weighted average remaining life of the options at July 31, 1998 was 8.75
years.
During 1997, TIE entered into a consulting agreement with Burton Training
Group (Burton), which is owned by a former member of TIE's Board of Directors.
The agreement, which expired June 30, 1998, calls for Burton to provide
consulting services to TIE. Under this agreement, Burton was paid $272 during
the year ended December 31, 1997, and is eligible to earn options to purchase
up to 60,000 shares of TIE's common stock based on the formula specified in the
agreement. As of July 31, 1998, none of these options had been earned.
10. Restructuring Reserve
On November 1, 1995, TIE announced a restructuring plan in which numerous
field activities would be centralized in order to streamline operations and
increase productivity. The restructuring involved the centralization of all
accounting, dispatch, order entry and customer service related functions. As of
November 1, 1995, TIE established a restructuring reserve of $2,500, which was
increased by $1,226 in 1996 and decreased by $170 in 1997 to complete the
previously announced restructuring. Amounts reserved for restructuring at
November 1, 1995 and December 31, 1996 resulted in adjustments to goodwill from
the purchase of TIE. The reserve was established primarily to support
severance, outplacement, relocation, travel and legal fees associated with
centralization. The centralization, under which TIE terminated 153 employees,
was completed during 1997. The amounts remaining in the reserve relate to
termination benefits to be paid. The following amounts had been charged against
the reserve:
<TABLE>
<CAPTION>
Year Ended
December Seven Months
31, Ended
----------- July 31,
1996 1997 1998
------ ---- ------------
<S> <C> <C> <C>
Termination benefits.... $1,200 $714 $ 37
Relocation.............. 364 65 --
Early termination of
lease and service
agreements............. 346 178 --
Other................... 132 35 --
</TABLE>
11. Discontinued Operations
On May 1, 1996, TIE sold the assets and liabilities of its TAI
Telecommunications Accessories division in Canada to Norelco Telecom LTD. for
$529. On May 23, 1996, TIE sold the assets and
TIE-21
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
liabilities of its TIE Repair division to Aztec East, Inc. for $1,700. In
addition, TIE received deferred payments over a six month period totaling $134.
On August 29, 1996, the Company sold the stock of its TIE/telecommunications
Canada Limited subsidiary to 3280993 Canada Inc. for $6,536. In connection with
the Canadian sale, TIE retained the right to receive the proceeds of a
liquidated pension plan of $535 which was received during 1997.
The discontinued operations recorded revenues for the period January 1, 1996
through the sale dates of $16,999, and net income during the same period of
$782. Interest costs allocated to net assets held for sale for the period
January 1, 1996 through the sale date was $692. A loss of $1,721 on the
disposition of these operations was recorded as an adjustment of the original
purchase price allocation during 1996.
12. Related Party Transactions
TIE agreed to pay Security Properties Real Estate Services Inc. ("Security
Properties"), which is a subsidiary of SP Investments Inc. (owned by the
majority stockholders of TIE Acquisition Co.), a management fee aggregating
$240 annually beginning December 1, 1995 and amended to $300 annually beginning
January 1, 1997. TIE also agreed to reimburse Security Properties for all
reasonable expenses it incurs in connection with services to TIE. TIE recorded
expense of $20 for the period from November 1, 1995 through December 31, 1995,
$220 for the year ended December 31, 1996, $300 for the year ended December 31,
1997 and $83 for the seven months ended July 31, 1998 related to the management
agreement.
13. Supplemental Cash Flow Information
Supplemental cash flow information for the period from November 1, 1995
through December 31, 1995, for the years ended December 31, 1996 and 1997, and
for the seven months ended July 31, 1998.
<TABLE>
<CAPTION>
Period from
November 1, 1995
through Year Ended Year Ended Seven Months
December 31, December 31, December 31, Ended July 31,
1995 1996 1997 1998
---------------- ------------ ------------ --------------
(dollars in thousands, except share related data)
<S> <C> <C> <C> <C>
Supplemental cash flow
information:
Cash paid during the
period for:
Interest.............. $ 24 $1,810 $ 923 $ --
Income taxes.......... $272 $1,672 $ 194 $ --
Reorganization
expenses............. $-- $ -- $ -- $1,251
Supplemental noncash
investing and financing
activities:
Capital asset and lease
obligation additions.. $-- $ 145 $4,484 $ --
</TABLE>
TIE-22
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
14. Commitments And Contingencies
Purchase commitments
TIE has entered into several long term contracts to purchase long distance
services and equipment. A summary of those commitments is as follows:
<TABLE>
<CAPTION>
Vendor Minimum Commitment Penalties
------ ------------------ ---------
<S> <C> <C>
MCI.................. $6,000 of long Difference between actual usage
distance services and annual minimum.
annually
Phoenix.............. $1,000 of long 25% of difference between
distance services monthly minimum and actual
monthly usage.
Northern Telecom..... $8,000 in equipment Termination of agreement or $30
purchases penalty plus the difference in
discount rates.
</TABLE>
During 1997 and 1998, TIE's resales of Phoenix long distance service were
below the required monthly minimum of the contract. TIE accrued penalties of
$179 and $736 at December 31, 1997 and July 31, 1998, respectively, for the
differences.
TIE had purchased $2,824 of long distance services under the MCI contract and
has recorded a liability of $676 for estimated penalties based on usage during
the first seven months of 1998.
TIE had purchased $5 million of equipment leases under the Northern Telecom
agreement through the seven months ended July 31, 1998.
The long-term contracts for MCI, Phoenix, and Northern Telecom expire on
December 31, 2000, December 31, 1999 and December 31, 2000, respectively. The
MCI commitment increases to $9,000 and $12,000 in January 1999 and January
2000, respectively, and the minimum commitment for Northern Telecom is adjusted
annually every October 1.
Operating leases
TIE leases office and warehouse space under noncancellable operating leases
expiring at various dates through 2003, and leases certain equipment under
operating lease agreements expiring in 1998. At July 31, 1998, the future
minimum lease payments under operating leases are as follows:
<TABLE>
<S> <C>
5 months ending December 31, 1998.................................... $1,067
Year ending December 31,
1999............................................................... 1,740
2000............................................................... 696
2001............................................................... 480
2002............................................................... 182
2003............................................................... 37
------
Total minimum rentals............................................ $4,202
======
</TABLE>
TIE-23
<PAGE>
TIE/COMMUNICATIONS, INC.
(a wholly-owned subsidiary of TIE Acquisition Co. and a Debtor-in-Possession)
NOTES TO FINANCIAL STATEMENTS--(Continued)
Rent expense charged to operations for the period from November 1, 1995
through December 31, 1995, the years ended December 31, 1996 and 1997 and for
the seven months ended July 31, 1998 was $627, $3,591, $2,931 and $1,654,
respectively. In the ordinary course of business, leases expire and are
replaced or renewed, therefore, the rent expense in future periods may exceed
the minimum annual rentals noted above.
Litigation
TIE is party to various lawsuits, proceedings and other matters arising from
the conduct of its business. It is management's opinion that the final
resolution of these matters will not have a material effect upon the business,
financial condition or results of operations of TIE.
15. Subsequent Events
As discussed in Note 1, TIE entered into an asset purchase agreement with
Convergent Communications Services, Inc. (Convergent Communications) for the
acquisition of substantially all of the operating assets and the assumption of
certain liabilities for a cash payment of approximately $40 million. The sale
was consummated on August 1, 1998 and the proceeds were used to pay off TIE's
advance from Convergent Communications. The remainder of the proceeds were
placed into a trust until the plan of reorganization is approved by the
Bankruptcy Court. The following unaudited condensed pro forma balance sheet
reflects the sale of operating assets, the pay-off of the advance from
Convergent Communications, receipt of sale proceeds and the assumption of
certain liabilities by Convergent Communications subsequent to the closing.
<TABLE>
<CAPTION>
Historical July 31, Pro Forma Pro Forma July
1998 Adjustments 31, 1998
------------------- ----------- --------------
Unaudited
<S> <C> <C> <C>
Assets
Cash..................... $ 650 $ 23,942 (a) $ 24,592
Deferred tax assets...... 6,892 (6,892)(b) --
Other current assets..... 15,504 (15,504)(c) --
Noncurrent assets........ 24,678 (24,678)(c) --
-------- -------- --------
Total assets......... $ 47,724 $(23,132) $ 24,592
======== ======== ========
Liabilities and
stockholder's deficit
Notes payable............ $ 17,378 $ -- $ 17,378
Other current
liabilities............. 54,940 (26,151)(d) 28,789
Noncurrent liabilities... 1,495 (1,495)(d) --
-------- -------- --------
Total liabilities.... 73,813 (27,646) 46,167
Stockholder's equity
(deficit)............... (26,089) 4,514 (e) (21,575)
-------- -------- --------
Total liabilities and
stockholder's equity
(deficit)........... $ 47,724 $(23,132) $ 24,592
======== ======== ========
</TABLE>
- --------
(a) Represents the receipt of sales proceeds net of the advance from Convergent
Communications.
(b) Represents utilization of the deferred tax asset.
(c) Represents assets purchased by Convergent Communications.
(d) Represents the assumption of certain liabilities by Convergent
Communications and payoff of the advance from Convergent Communications.
(e) Represents gain on sale of assets net of income taxes.
TIE-24
<PAGE>
UNDERWRITING
Convergent Communications, the selling shareholders and the underwriters
named below have entered into an underwriting agreement with respect to the
shares being offered. Subject to certain conditions, each underwriter has
severally agreed to purchase the number of shares indicated in the following
table. Goldman, Sachs & Co., J.P. Morgan Securities Inc., Warburg Dillon Read
LLC, and William Blair & Company, L.L.C. are the representatives for the
underwriters.
<TABLE>
<CAPTION>
Underwriters Number of Shares
------------ ----------------
<S> <C>
Goldman, Sachs & Co...................................... 2,096,334
J.P. Morgan Securities Inc............................... 2,096,333
Warburg Dillon Read LLC.................................. 2,096,333
William Blair & Company, L.L.C........................... 331,000
Robert W. Baird & Co. Incorporated....................... 110,000
J.C. Bradford & Co. ..................................... 110,000
Deutsche Bank Securities Inc. ........................... 225,000
A.G. Edwards & Sons, Inc. ............................... 225,000
EVEREN Securities, Inc. ................................. 225,000
Janco Partners, Inc. .................................... 110,000
Kaufman Bros., L.P. ..................................... 110,000
Keystone Investment Advisors, LLC........................ 110,000
Merrill Lynch, Pierce, Fenner & Smith Incorporated....... 225,000
Shepherd Financial Group, LLC............................ 110,000
Wit Capital Corporation.................................. 110,000
Wm Smith Securities, Incorporated........................ 110,000
---------
Total.................................................. 8,400,000
=========
</TABLE>
----------------
If the underwriters sell more shares than the total number set forth in the
table above, the underwriters have an option to buy up to an additional
1,260,000 shares from Convergent Communications to cover such sales. They may
exercise that option for 30 days. If any shares are purchased pursuant to this
option, the underwriters will severally purchase shares in approximately the
same proportion as set forth in the table above.
The following tables show the per share and total underwriting discounts and
commissions to be paid to the underwriters by Convergent Communications and the
selling shareholders. Such amounts are shown assuming both no exercise and full
exercise of the underwriters' option to purchase additional shares.
<TABLE>
<CAPTION>
Paid by Convergent
Communications
-------------------------
No Exercise Full Exercise
----------- -------------
<S> <C> <C>
Per Share................................... $ 1.05 $ 1.05
Total....................................... $8,060,565 $9,383,565
<CAPTION>
Paid by the
Selling Shareholders
-------------------------
No Exercise Full Exercise
----------- -------------
<S> <C> <C>
Per Share................................... $ 1.05 $ 1.05
Total....................................... $ 759,435 $ 759,435
</TABLE>
U-1
<PAGE>
Pursuant to contractual commitments with most of the selling shareholders,
Convergent Communications has agreed to pay $676,494 of the $759,435 total
underwriting discounts and commissions to be paid by the selling shareholders,
as part of its offering expenses.
Shares sold by the underwriters to the public will initially be offered at
the initial public offering price set forth on the cover of this prospectus.
Any shares sold by the underwriters to securities dealers may be sold at a
discount of up to $0.63 per share from the initial public offering price. Any
such securities dealers may resell any shares purchased from the underwriters
to certain other brokers or dealers at a discount of up to $0.10 per share from
the initial public offering price. If all the shares are not sold at the
initial public offering price, the representatives may change the offering
price and the other selling terms.
Convergent Communications, its officers and directors and the selling
shareholders have agreed with the underwriters not to dispose of or hedge any
of their common stock or securities convertible into or exchangeable for shares
of common stock during the period from the date of this prospectus continuing
through the date 180 days after the closing date of this offering, except with
the prior written consent of the representatives. This agreement does not apply
to any existing employee benefit plans. See "Shares Eligible for Future Sale"
for a discussion of certain transfer restrictions.
Prior to the offering, there has been no public market for the shares. The
initial public offering price has been negotiated among Convergent
Communications and the representatives. Among the factors considered in
determining the initial public offering price of the shares, in addition to
prevailing market conditions, were Convergent Communications' historical
performance, estimates of the business potential and earnings prospects of
Convergent Communications, an assessment of its management and the
consideration of the above factors in relation to market valuation of companies
in related businesses.
The common stock will be quoted on the Nasdaq National Market under the
symbol "CONV".
In connection with the offering, the underwriters may purchase and sell
shares of common stock in the open market. These transactions may include short
sales, stabilizing transactions and purchases to cover positions created by
short sales. Short sales involve the sale by the underwriters of a greater
number of shares than they are required to purchase in the offering.
Stabilizing transactions consist of certain bids or purchases made for the
purpose of preventing or retarding a decline in the market price of the common
stock while the offering is in progress.
The underwriters also may impose a penalty bid. This occurs when a particular
underwriter repays to the underwriters a portion of the underwriting discount
received by it because the representatives have purchased shares sold by or for
the account of such underwriter in stabilizing or short covering transactions.
These activities by the underwriters may stabilize, maintain or otherwise
affect the market price of the common stock. As a result, the price of the
common stock may be higher than the price that otherwise might exist in the
open market. If these activities are commenced, they may be discontinued by the
underwriters at any time. These transactions may be effected on the Nasdaq
National Market, in the over-the-counter market or otherwise.
The underwriters do not expect sales to discretionary accounts to exceed five
percent of the total number of shares offered.
Certain of the underwriters or their affiliates have in the past and may in
the future provide investment banking or other services for Convergent
Communications. In June 1999, Goldman Sachs Credit Partners L.P. ("GSCP"), an
affiliate of Goldman, Sachs & Co., provided a $10.0 million senior secured
credit facility to Convergent Communications. This facility is described in
greater detail in
U-2
<PAGE>
"Description of Indebtedness." In connection with this facility, Convergent
Communications issued a warrant to GSCP to acquire 375,000 shares of common
stock at an exercise price of $15.00 per share. In addition to the warrants,
GSCP received customary compensation in connection with this transaction. The
GSCP warrant has been deemed to be underwriter's compensation by the NASD.
Convergent Communications and the selling shareholders estimate that the
total expenses of the offering, excluding underwriting discounts and
commissions, will be approximately $1,136,911 and $34,800, respectively.
Convergent Communications and the selling shareholders have agreed to
indemnify the several underwriters against certain liabilities, including
liabilities under the Securities Act of 1933.
U-3
<PAGE>
[INSIDE BACK COVER ART AND TEXT]
[Pictures of people from companies that use our network and quotes about the
advantages they have obtained from the network. Title caption contains text
"What our Customers Say...". Under title caption is a caption reading "Motorola
Credit Union" (photograph of customer) next to caption is text that reads
"Convergent Communications stepped up to provide a technology path that will
help us better serve our members and help us stay competitive into the next
millennium." Dan Desmond, President". Under the caption "Emco" (photograph of
customer) next to caption text that reads "Convergent Communications provides
EMCO with around-the-clock monitoring that's crucial to our aggressive
business. With Convergent Communication' "24x7' monitoring, problems are
prevented before they become apparent to us and are quickly corrected when they
do." Ronald N. Langston, Vice President of Administration & Organizational
Management." Above the caption "Franklin Covey" (photograph of customer) next
to caption text that reads "We selected Convergent Communications because they
have the necessary data expertise and they deliver on their promises." Brad
Jones, Network Manager". Under caption "Yellow Cab" (photograph of three
customers) with text next to the caption that reads "Convergent Communications
sharpens our competitive edge... Our business is booming and that's in part due
to our technological advantages over other cab companies." Michael Brown,
Information Technological Director." Below the text is more text "(clockwise,
from left) Steve Fowler, President; Bruce Moomaw, Chief Financial Officer;
Michael Brown, Information Technology Director".]
<PAGE>
[OUTSIDE BACK GATE ART AND TEXT]
[Continuation of gatefold. Above the caption "Accent Health" (photograph of
customer) text next to caption reads "Convergent Communications gives us
technological flexibility that allows us to concentrate on the needs of our
customers. Their voice and data technology management capabilities help us do
our job more efficiently." Jody Strain, Customer Service Manager". Under
caption "New Horizons" (photograph of customer) text next to caption reads "The
Convergent Communications professionals in Des Moines did an excellent job of
providing a turnkey communications solution for us, including all the training
we needed. It's a convenient alternative (to network ownership) we haven't seen
before." Frank Yamen, Partner". Under caption "Redd Engineering" (photograph of
customer) text next to caption reads "Convergent Communications gave us the
identify we were looking for. They were able to communicate our special
business strategy in a way that's easy to understand and that showcases the
excitement and uniqueness of what we do." J. Michael Redd, Chairman". Over
caption "Campbell Irvine & Rosenbaum, P.C." (photograph of three customers)
text next to caption reads "Convergent Communications made it a point to
understand our business so that they could provide us with the best solutions
for our needs." (clockwise from left) David C. Irvin, Brian Campbell, Allan S.
Rosenbaum".
<PAGE>
[INSIDE BACK GATE ART AND TEXT]
[Cover contains the following copy and photographs: Caption for the cover
with text "Convergent Communications...". Below the caption is a photograph of
our National Operations Center. Caption in the photograph with text "Convergent
Communications' National Operations Center in Englewood, Colorado." Next to the
photograph is text "Our network management and monitoring services support our
customers' increasing need for superior performance and reliability throughout
their networks. We can augment corporate Information Systems staff to make them
more effective or assume all of their functions through a comprehensive package
of "24x7," around-the-clock network coverage." Below the text is a photograph
depicting one of our employees monitoring at a computer. Below this photograph
is a photograph depicting a system user at a computer. Next to the bottom
photograph is text "Convergent Communications' Computer Telephony Integrated
Support System(TM) (CTISS) automates the critical business processes and
systems that support our diverse products and services. This Oracle-based
platform is driven by each customer's service records and is web enabled." In
the bottom corner of the page is the Convergent Communications(TM) logo.]
<PAGE>
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No dealer, salesperson or other person is authorized to give any information
or to represent anything not contained in this prospectus. You must not rely on
any unauthorized information or representations. This prospectus is an offer to
sell only the shares offered hereby, but only under circumstances and in
jurisdictions where it is lawful to do so. The information contained in this
prospectus is current only as of its date.
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TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
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<S> <C>
Prospectus Summary...................................................... 3
Risk Factors............................................................ 8
Use of Proceeds......................................................... 19
Corporate Information................................................... 19
Dividend Policy......................................................... 19
Dilution................................................................ 20
Capitalization.......................................................... 21
Selected Financial Data................................................. 22
Management's Discussion and Analysis of Financial Condition and Results
of Operations.......................................................... 24
Business................................................................ 38
Management.............................................................. 52
Principal Shareholders.................................................. 60
Certain Relationships and Related Transactions.......................... 62
Description of Capital Stock............................................ 63
Description of Indebtedness............................................. 68
Shares Eligible for Future Sale......................................... 72
Legal Matters........................................................... 73
Experts................................................................. 73
Available Information................................................... 74
Index to Financial Statements........................................... F-1
Index to TIE Financial Statements....................................... TIE-1
Underwriting............................................................ U-1
</TABLE>
Through and including August 13, 1999 (the 25th day after the date of this
prospectus), all dealers effecting transactions in these securities, whether or
not participating in this offering, may be required to deliver a prospectus.
This is in addition to a dealer's obligation to deliver a prospectus when
acting as an underwriter and with respect to an unsold allotment or
subscription.
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8,400,000 Shares
Convergent Communications, Inc.
Common Stock
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[LOGO OF CONVERGENT COMMUNICATIONS(TM) APPEARS HERE]
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Goldman, Sachs & Co.
J.P. Morgan & Co.
Warburg Dillon Read LLC
William Blair & Company
Representatives of the Underwriters
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