<PAGE> 1
--------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------------------------
FORM 8-K/A
Amendment No. 1
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported): June 23, 2000
Mpower Communications Corp.
(Exact name of Registrant as specified in its charter)
Nevada 0-24059 88-0360042
(State of (Commission (I.R.S. Employer
incorporation) File Number) Identification No.)
175 Sully's Trail, Pittsford, NY 14534
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (716) 218-6550
MGC Communications, Inc.: 171 Sully's Trail, Suite 202, Pittsford, NY 14534
(Former name and former address)
This Amendment No. 1 to the Current Report of Mpower Communications Corp.
(the "Company") on Form 8-K dated June 28, 2000 (the "report") relates to the
Company's completion of the acquisition of 100% of the common stock of Primary
Network Holdings, Inc. ("Primary Network"). The purpose of this Amendment is to
amend Item 7(A) to provide the financial statements of Primary Network and Item
7(B) to provide the required pro forma financial information relating to the
business combination between the Company and Primary Network on June 23, 2000
which were impracticable to provide at the time the Company filed this report.
The financial statements of CDM On-Line, Inc., the predecessor to Primary
Network, as of May 31, 1999, December 31, 1998 and December 31, 1997 are
included in this report.
<PAGE> 2
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS.
-------------------------------------------
(a) FINANCIAL STATEMENTS OF BUSINESSES ACQUIRED.
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 26,712,416 $ 4,828,306
Investments............................................... 5,076,212 --
Accounts receivable, less allowance for doubtful accounts
of $630,920 at September 30, 1999 and $959,169 at March
31, 2000................................................ 963,512 2,545,798
Due from affiliates....................................... 1,052,505 --
Inventory................................................. 105,886 220,577
Other current assets...................................... 923,385 2,058,240
------------ ------------
Total current assets........................................ 34,833,916 9,652,921
Restricted cash............................................. 1,000,000 2,000,000
Property and equipment, net................................. 8,900,931 32,636,059
Refundable capital lease deposit with affiliate............. 707,660 707,660
Debt issuance costs, net of accumulated amortization of
$160,582 at September 30, 1999 and $401,457 at March 31,
2000...................................................... 3,211,658 2,984,988
Intangible assets, net...................................... 13,110,252 17,038,036
------------ ------------
$ 61,764,417 $ 65,019,664
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable.......................................... $ 2,322,537 $ 5,134,293
Accrued expenses.......................................... 3,130,130 2,851,502
Unearned revenues......................................... 1,069,696 1,307,104
Current maturities of capital lease obligations........... 1,137,019 11,205,758
Note payable.............................................. 16,614 477,742
Due to affiliates......................................... 158,376 --
------------ ------------
Total current liabilities................................... 7,834,372 20,976,399
Capital lease obligations, less current maturities........ 1,280,252 7,427,490
Convertible note payable.................................. 1,000,000 1,750,000
Senior subordinated discount note......................... 48,837,310 52,586,101
Stockholders' equity (deficit):
Preferred stock, $.001 par value, 20,000,000 shares
authorized
Series A preferred stock, 2,306,765 shares issued and
outstanding............................................ 494,375 494,375
Series B preferred stock, 1,500,000 shares designated,
850,000 shares issued and outstanding at March 31,
2000................................................... -- 170,000
Deferred stock compensation............................... -- (141,668)
Common stock, $.001 par value, 80,000,000 shares
authorized, 63,600,815 shares issued.................... 63,601 63,601
Additional paid-in capital................................ 14,496,596.. 14,496,596
Accumulated deficit....................................... (12,242,089) (32,803,230)
------------ ------------
2,812,483 (17,720,326)
------------ ------------
$ 61,764,417 $ 65,019,664
============ ============
</TABLE>
See notes to unaudited consolidated financial statements.
1
<PAGE> 3
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
----------------------------- -----------------------------
MARCH 31, MARCH 31, MARCH 31, MARCH 31,
1999 2000 1999 2000
(PREDECESSOR) (SUCCESSOR) (PREDECESSOR) (SUCCESSOR)
------------- ------------ ------------- ------------
<S> <C> <C> <C> <C>
Revenues:
Access revenues.............. $1,141,754 $ 3,140,338 $2,026,771 $ 5,771,959
Communication revenues....... -- 1,710,966 -- 2,854,131
Retail revenues.............. 298,054 286,211 518,800 528,388
Other revenues............... 129,298 236,137 333,165 472,687
---------- ------------ ---------- ------------
1,569,106 5,373,652 2,878,736 9,627,165
Costs and expenses:
Costs of access revenues..... 351,779 1,320,008 688,995 2,395,394
Cost of communication
revenues.................. -- 1,937,654 -- 3,102,857
Cost of retail revenues...... 179,293 148,438 326,219 245,734
Costs of other revenues...... 89,567 147,936 253,493 354,988
Operations and customer
support................... 207,727 3,203,729 400,759 4,799,453
Sales and marketing.......... 199,310 2,193,308 436,337 3,535,889
General and administrative... 552,020 3,022,429 972,741 5,415,148
Retail store expenses........ 305,934 103,839 604,242 293,700
Depreciation and
amortization.............. 52,649 3,449,800 144,841 6,263,609
---------- ------------ ---------- ------------
1,938,279 15,527,141 3,827,627 26,406,772
---------- ------------ ---------- ------------
Loss from operations........... (369,173) (10,153,489) (948,891) (16,779,607)
Other income (expense):
Interest
expense -- affiliates..... -- (72,438) (18,909) (151,395)
Interest expense............. (1,219) (2,131,327) (1,641) (4,147,157)
Other, net................... 8,184 174,987 (19,268) 517,018
---------- ------------ ---------- ------------
Loss from continuing
operations................... (362,208) (12,182,267) (988,709) (20,561,141)
Income (loss) from operations
of discontinued Web
development division......... (44,512) -- 12,595 --
---------- ------------ ---------- ------------
Loss before income taxes....... (406,720) (12,182,267) (976,114) (20,561,141)
Provision for income taxes..... -- -- -- --
---------- ------------ ---------- ------------
Net loss....................... $ (406,720) $(12,182,267) $ (976,114) $(20,561,141)
========== ============ ========== ============
</TABLE>
See notes to unaudited consolidated financial statements
2
<PAGE> 4
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
-----------------------------
MARCH 31, MARCH 31,
1999 2000
(PREDECESSOR) (SUCCESSOR)
------------- ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss.................................................... $ (976,114) $(20,561,141)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 144,841 6,263,609
Amortization of debt issuance costs....................... -- 240,875
Allowance for doubtful accounts........................... 201,427 332,630
Accretion of discount on senior subordinated Debt......... -- 3,748,791
Amortization of discount on investment.................... -- (48,788)
Stock based compensation expense.......................... 436,772 28,332
Changes in operating assets and liabilities:.............. -- --
Accounts receivable.................................... (382,063) (1,762,628)
Due from affiliates.................................... (1,870,826) 1,052,505
Inventory.............................................. 37,821 (114,691)
Other current assets................................... 128,104 262,370
Accounts payable....................................... 510,309 2,655,489
Accrued expenses....................................... 211,366 (320,826)
Unearned revenues...................................... 70,006 16,821
----------- ------------
Net cash used in operating activities....................... (1,488,357) (8,206,652)
INVESTING ACTIVITIES
Increase in restricted cash................................. -- (1,000,000)
Sale of held to maturity security........................... -- 5,125,000
Purchases of property and equipment,
net of capital lease obligations.......................... (110,677) (10,213,120)
Acquisition of Information Services Technologies, Inc. ..... -- (591,006)
Acquisition of Business Product Systems Internet, Inc. ..... -- (700,112)
Acquisition of UNI Networking, Inc. ........................ -- (345,301)
Acquisition of GlobalVision Systems, Inc., net of cash
acquired.................................................. -- (3,102,445)
Acquisition of Digital Internet Access Inc., net of cash
acquired.................................................. -- (1,417,771)
Acquisition of Harvest Telecom, Inc. ....................... -- (50,000)
Business acquisition costs.................................. (454,783) --
----------- ------------
Net cash used in investing activities....................... (565,460) (12,294,755)
</TABLE>
3
<PAGE> 5
<TABLE>
<CAPTION>
SIX MONTHS ENDED
-----------------------------
MARCH 31, MARCH 31,
1999 2000
(PREDECESSOR) (SUCCESSOR)
------------- ------------
<S> <C> <C>
FINANCING ACTIVITIES
Principal payments of obligations under capital leases...... -- (1,222,826)
Principal payments under notes payable...................... -- (1,501)
Purchase of common stock held in treasury................... (73,086) --
Due to affiliates........................................... (153,270) (158,376)
Proceeds from issuance of common stock...................... 2,535,487 --
----------- ------------
Net cash provided by (used in) financing activities......... 2,309,131 (1,382,703)
----------- ------------
Net increase (decrease) in cash and cash equivalents........ 255,314 (21,884,110)
Cash and cash equivalents at beginning of period............ 689 26,712,416
----------- ------------
Cash and cash equivalents at end of period.................. $ 256,003 $ 4,828,306
=========== ============
Noncash investing and financing transactions:
Capital leases entered into................................. $ -- $ 17,438,803
=========== ============
</TABLE>
See notes to unaudited consolidated financial statements.
4
<PAGE> 6
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2000
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
NATURE OF BUSINESS
Primary Network Holdings, Inc. (the Company) is headquartered in St. Louis,
Missouri and provides full-service access to the Internet for corporate and
residential users primarily in Missouri, Kansas, and Oklahoma. The Company also
is a reseller of basic local telecommunications services, dedicated non-switched
local exchange telecommunications services, and intrastate interexchange
telecommunications services in Missouri. The basic local service is classified
as competitive by the State of Missouri Public Service Commission (PSC) and is
provided in portions of Missouri that are currently served primarily by
Southwestern Bell Telephone Company (SWBT). Furthermore, the Company also serves
as an authorized agent of Southwestern Bell Mobile Systems and operates cellular
and other wireless communication products retail stores in the St. Louis
metropolitan area. Billings are due upon receipt.
BASIS OF PRESENTATION
The unaudited consolidated financial statements of Primary Network
Holdings, Inc., the successor company, and CDM On-Line, Inc., the predecessor
company, have been prepared in accordance with generally accepted accounting
principles for interim financial information (refer to footnotes 1 and 2 in the
September 30, 1999 audited financial statements of the Company for further
explanation of the organization and basis of presentation and initial formation
and capitalization of the Company). Accordingly, these interim financial
statements do not include all of the information and notes required by generally
accepted accounting principles for complete financial statements, and,
therefore, should be read in conjunction with the Company's audited financial
statements for the four months ended September 30, 1999, contained in this
Prospectus. In the opinion of management, all adjustments (consisting only of
normal recurring items) considered necessary for a fair presentation have been
included. The results of operations for the three and six months ended March 31,
2000 are not necessarily indicative of the results that may be expected for the
year ended September 30, 2000.
2. INVENTORY
Inventory consists of cellular and other wireless communication products
and accessories and is stated at the lower of cost (specific identification
basis) or market.
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following at September 30, 1999 and
March 31, 2000:
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- -----------
<S> <C> <C>
Computer equipment................................... $ 4,465,458 $21,120,968
Software............................................. 478,574 890,576
Furniture, fixtures, and office equipment............ 680,884 971,060
Capitalized collocation costs........................ 150,236 7,992,275
</TABLE>
5
<PAGE> 7
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- -----------
<S> <C> <C>
Land, building, and leasehold improvements........... 285,552 535,447
Vehicles............................................. 71,348 71,348
----------- -----------
6,132,052 31,581,674
Less accumulated depreciation and amortization....... (1,881,830) (4,323,645)
----------- -----------
4,250,222 27,258,029
Construction in progress............................. 4,650,709 5,378,030
----------- -----------
$ 8,900,931 $32,636,059
=========== ===========
</TABLE>
4. OTHER ASSETS
Other assets consist of the following at September 30, 1999 and March 31,
2000:
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- ----------
<S> <C> <C>
Prepaid maintenance agreements............................ $ -- $1,484,806
Other non-current assets.................................. 923,385 573,434
-------- ----------
$923,385 $2,058,240
======== ==========
</TABLE>
5. INTANGIBLE ASSETS
Intangible assets consist of the following at September 30, 1999 and March
31, 2000:
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- -----------
<S> <C> <C>
Acquired customer list............................... $ 2,771,783 $ 5,460,083
Goodwill............................................. 11,631,661 16,213,676
----------- -----------
14,403,444 21,673,759
Less accumulated amortization........................ (1,293,192) (4,635,723)
----------- -----------
$13,110,252 $17,038,036
=========== ===========
</TABLE>
6. ACCRUED LIABILITIES
Accrued liabilities consist of the following at September 30, 1999 and
March 31, 2000:
<TABLE>
<CAPTION>
SEPTEMBER 30, MARCH 31,
1999 2000
------------- ----------
<S> <C> <C>
Accrual for equipment acquired............................ $1,836,572 $ --
Accrued payroll and related expenses...................... 366,933 661,704
Acquisition related holdback accrual...................... 130,000 621,675
Deferred gain on sale leaseback........................... -- 468,037
Other accrued liabilities................................. 796,625 1,100,086
---------- ----------
$3,130,130 $2,851,502
========== ==========
</TABLE>
6
<PAGE> 8
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. SEGMENT INFORMATION
The Company has three reportable segments, Internet, Retail, and
Communications, which are separate operating units that offer different products
and services and are managed accordingly. Performance of each segment is
evaluated by management based on income (loss) before income taxes. The
corporate and eliminations segment includes corporate assets, principally
consisting of cash and cash equivalents, investments and debt issuance costs,
corporate activities and the elimination of intersegment transactions. In
addition, as a result of the initial formation and capitalization of the Company
as of June 1, 1999, the Company adjusted its segment reporting structure whereby
interest expense is no longer allocated to its three reportable segments.
The Internet segment provides full service access to the Internet for
corporate and residential customers including dial-up and dedicated services and
activities related to setup and installation, selling equipment, and software.
The Retail segment sells cellular and other wireless communication products,
including phones, pagers, and related accessories. The Communications segment,
which was established June 1, 1999, provides facilities-based and resold basic
local telecommunications service, including dedicated/non-switched local
exchange services, and intrastate interexchange services.
The following segment information is as of March 31 or for the three months
and six months then ended:
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31, 1999
(PREDECESSOR)
------------------------------------
INTERNET RETAIL TOTAL
---------- -------- ----------
<S> <C> <C> <C>
Revenues from external customers........................ $1,271,052 $298,054 $1,569,106
Intersegment revenues................................... -- -- --
Depreciation and amortization........................... 48,929 3,720 52,649
Interest expense........................................ 988 231 1,219
Stock based compensation................................ 390,615 -- 390,615
Loss from continuing operations......................... (171,084) (191,124) (362,208)
Income from discontinued operation -- Web Development... (44,512) -- (44,512)
Loss before income taxes................................ (215,596) (191,124) (406,720)
Segment assets.......................................... 3,211,201 486,666 3,697,866
Capital expenditures, net of capital lease
obligations........................................... 15,240 4,552 19,792
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31, 2000 (SUCCESSOR)
--------------------------------------------------------------------
CORPORATE
AND
INTERNET RETAIL COMMUNICATIONS ELIMINATIONS TOTAL
---------- -------- -------------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Revenues from external
customers.................... $3,376,475 $286,211 $1,710,966 -- $ 5,373,652
Intersegment revenues.......... 415 30,847 291,650 (322,912) --
Depreciation and
amortization................. 1,442,521 9,158 1,936,122 61,999 3,449,800
Interest expense............... -- -- -- 2,203,765 2,203,765
Loss before income taxes....... (1,427,120) 24,771 (4,709,975) (6,069,943) (12,182,267)
Segment assets................. 18,330,068 463,406 34,760,916 11,465,274 65,019,664
Capital expenditures, net of
capital lease obligations.... 238,556 547 2,862,114 493,813 3,595,030
</TABLE>
7
<PAGE> 9
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED MARCH 31, 1999
(PREDECESSOR)
------------------------------------
INTERNET RETAIL TOTAL
---------- -------- ----------
<S> <C> <C> <C>
Revenues from external customers........................ $2,359,936 $518,800 $2,878,736
Intersegment revenues................................... -- -- --
Depreciation and amortization........................... 137,396 7,445 144,841
Interest expense........................................ 17,061 3,489 20,550
Stock based compensation................................ 436,772 -- 436,772
Loss from continuing operations......................... (566,114) (422,595) (988,709)
Income from discontinued operation -- Web Development... 12,595 -- 12,595
Loss before income taxes................................ (553,519) (422,595) (976,114)
Segment assets.......................................... 3,211,201 486,665 3,697,866
Capital expenditures, net of capital lease
obligations........................................... 101,875 8,802 110,677
</TABLE>
<TABLE>
<CAPTION>
SIX MONTHS ENDED MARCH 31, 2000 (SUCCESSOR)
--------------------------------------------------------------------
CORPORATE
AND
INTERNET RETAIL COMMUNICATIONS ELIMINATIONS TOTAL
---------- -------- -------------- ------------ ------------
<S> <C> <C> <C> <C> <C>
Revenues from external
customers.................... $6,244,646 $528,388 $2,854,131 -- $ 9,627,165
Intersegment revenues.......... 1,180 75,496 535,768 (612,444) --
Depreciation and
amortization................. 3,308,659 18,105 2,826,331 110,514 6,263,609
Interest expense............... -- -- -- 4,298,552 4,298,552
Loss before income taxes....... (3,325,208) (27,543) (7,407,792) (9,800,598) (20,561,141)
Segment assets................. 18,330,068 463,406 34,760,916 11,465,274 65,019,664
Capital expenditures, net of
capital lease obligations.... 278,495 1,083 7,393,116 1,140,426 8,813,120
</TABLE>
8. ACQUISITIONS
In the six month period ended March 31, 2000, the Company made the
following acquisitions:
On October 1, 1999, the Company purchased substantially all of the assets
of Information Systems Technologies, Inc. for approximately $591,000, net of
liabilities assumed.
On October 6, 1999, the Company purchased substantially all of the assets
of Business Products Systems Internet, Inc. for approximately $700,000, net of
liabilities assumed.
On October 13, 1999, the Company purchased substantially all of the assets
of UNI Networking Inc. for approximately $345,000, net of liabilities assumed.
On October 20, 1999, the Company purchased all of the outstanding common
stock of GlobalVision Systems, Inc. for approximately $3,102,000, net of cash
acquired and liabilities assumed.
On November 1, 1999, the Company purchased all of the outstanding common
stock of Harvest Telecom, Inc. for approximately $50,000.
On November 10, 1999, the Company purchased all of the outstanding common
stock of Digital Internet Access, Inc. for approximately $1,418,000, net of cash
acquired and liabilities assumed.
The above acquisitions were accounted for under the purchase method of
accounting, and accordingly, the purchase prices were allocated to assets
acquired and liabilities assumed based upon their estimated fair values at the
dates of acquisition. The customer lists were valued at $200 per
8
<PAGE> 10
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
subscriber acquired, which represents the estimated fair value of such
subscribers based upon recent transactions in the ISP industry. Included in the
purchase prices listed above are legal and acquisition costs of approximately
$32,600. For those businesses acquired, the results of operations are included
in the Company's consolidated statement of operations from the dates of
acquisition.
The combined historical results for the acquisitions listed above were not
deemed to be material and thus, pro forma financial information was not
presented for the periods disclosed.
9. SECONDMENT AGREEMENT
On November 23, 1999, the Company entered into a Secondment Agreement with
an investor to obtain certain services to be provided by an employee of the
investor. Under the terms of the agreement, the Company is required to pay
$17,500 per month for the services, including out-of-pocket expenses.
Furthermore, the seconded employee was issued 680,000 shares of Series B
preferred stock which vests in eight equal quarterly installments over a
two-year period and warrants with an exercise price of $1.52 per share to
purchase an additional 520,000 shares of Series B preferred stock which vest in
three equal annual installments. Furthermore, the investor was issued 170,000
shares of Series B preferred stock and was granted warrants with an exercise
price of $1.52 to purchase an additional 130,000 shares of Series B preferred
stock, both with the same vesting terms as the seconded employee described
above. All of the above issuances and grants vest immediately upon the
occurrence of certain events described in the agreement, including a change in
control. The Company will recognize the compensation expense related to these
transactions ratably over the vesting period. Finally, the investor is entitled
to receive a fee, payable immediately, in the event the Company consummates
certain transactions outlined in the agreement prior to June 1, 2000, including
a change in control, obtaining senior debt from a financial institution, or
issuing additional subordinated debt or equity securities.
10. LEASE TRANSACTIONS
On February 23, 2000, the Company entered into an equipment capital lease
to finance its continued build out of collocations. Under the terms of the
lease, the Company is required to make thirty-six equal monthly payments of
approximately $122,000 and has the guaranteed option to purchase the equipment
at 10% of original purchase price or approximately $3,700,000. The assets under
the capital lease are recorded at the lower of the present value of the minimum
lease payments or the fair value of the equipment. The lease is secured by the
equipment financed.
On March 31, 2000, the Company entered into a sale leaseback agreement,
whereby the Company sold collocation equipment with a book value of
approximately $8,000,000 and subsequently entered into a capital lease for
approximately $9,400,000, including the financing of approximately $900,000 in
equipment maintenance agreements. The assets under the capital lease are
recorded at the lower of the present value of the minimum lease payments or the
fair value of the equipment. The gain resulting from this transaction of
approximately $500,000 is being amortized over the term of the lease. Under the
terms of the lease, the Company is required to make six monthly payments of
approximately $106,000 and then thirty monthly payments of approximately
$340,000. In addition to the equipment being financed under the lease, the
Company granted the lessor an additional security interest in substantially all
tangible and intangible assets of the Company. The lessor has provided a
contingent clause in the agreement for the release of the additional security
upon the Company obtaining unrestricted cash equity proceeds in the amount of
$50,000,000 or greater. The lease agreement also contains covenants requiring
the Company to maintain certain debt to total
9
<PAGE> 11
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
contributed capital ratios as well as requiring the Company to secure future
minimum commitments of either secured bridge debt or unrestricted equity by
various dates. The Company was in violation of its senior debt to contributed
capital ratio covenant at April 30, 2000. Accordingly, the entire amount
outstanding under this capital lease agreement has been classified as a current
liability in the March 31, 2000 balance sheet.
11. SIGNIFICANT UNCERTAINTY
In connection with the June 17, 1999 acquisition of Q-Networks Inc. (Qnet),
the Company issued a $1,000,000 convertible note payable to the seller. The note
was issued with an interest rate of 6 percent and is due in full no later than
June 2001. Furthermore, the note allowed the holder to convert the note into
shares of the Company in the event the Company completed an initial public
offering. On July 20, 2000, the Company received notice from the seller
declaring certain events of default on the part of the Company under the terms
of the note. The notice also demanded the Company take all actions necessary to
cure such events and that Qnet intends to seek indemnification from the Company
for all damages and expenses incurred as a result of such alleged breaches.
While the Company intends to vigorously defend its position, management and its
legal counsel are unable to estimate the probability of outcome or the potential
economic impact on the Company.
12. SUBSEQUENT EVENTS
LEASE COMMITMENT
On April 15, 2000 the Company entered into an agreement for the lease of a
new office building. The term of the agreement is five years with total annual
rent of approximately $1,200,000. In addition, through July 14, 2000, the
Company has committed $3,900,000 for leasehold improvements and certain
equipment purchases related to this property.
MERGER
On June 23, 2000, the Company was acquired by Mpower Communications Corp.
(A/K/A MGC Communications, Inc.).
In connection with the consummation of the merger, the following occurred:
(i) The Company's stockholders exchanged their shares in the Company for
1,350,000 shares of common stock of Mpower Communications Corp.
(Mpower). Each outstanding share of the Company's common stock and
preferred stock was converted into .02022 shares of Mpower common
stock.
(ii) All of the Company's stock options outstanding under the Company's
stock option plan shall continue to have, and be subject to, the same
terms and conditions as set forth in the Company's stock option plan
and the agreements pursuant to which such Company stock options were
issued, except that each Company stock option shall be exercisable
for .02022 shares of Mpower common stock and the price per share will
be adjusted accordingly.
(iii) The Company's 4,476,423 detachable non-callable warrants to the
Investors that entitle the holders to purchase common shares of the
Company at a price of $3.385 per share shall continue to be subject
to the same terms and conditions, except that each warrant shall be
exercisable for .02022 shares of Mpower common stock and the price
per share will be adjusted accordingly.
10
<PAGE> 12
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(iv) Mpower assumed approximately $80,000,000 of net liabilities of the
Company, a portion of were exchanged for additional high-yield bonds
to be issued under Mpower's recent high-yield financing indenture.
The holders of exchanged debt also received 50,000 shares of Mpower
common stock.
(v) Mpower became the sole stockholder of the Company.
NOTE PAYABLE
On April 27, 2000 the Company issued a $10,000,000 senior promissory note
(senior note) to Mpower due the earliest of April 17, 2001, upon a change of
control of the Company other than the merger discussed above, or upon the event
of default, as defined. Interest accrues at 15 percent per annum until the
maturity date. After the maturity date, interest accrues at 18 percent per annum
until the senior note is paid in full. At any time prior to maturity of the
senior note, the unpaid principal amount of the senior note together with any
accrued but unpaid interest may be prepaid in whole or in part as long as the
Company has provided at least 15 business days notice to Mpower.
Due to the issuance of this senior note, the Company was in violation of a
covenant included in the Note and Purchase Agreement dated June 1, 1999 related
primarily to limitations of indebtedness. The holders of Notes waived their
right to call the debt as well as this covenant violation as of April 27, 2000.
11
<PAGE> 13
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1999
------------- ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................ $ 26,712,416 $ 15,644,224
Investments.............................................. 5,076,212 --
Accounts receivable, less allowance for doubtful accounts
of $630,920 at September 30, 1999 and $1,014,009 at
December 31, 1999..................................... 963,512 2,238,733
Due from affiliates...................................... 1,052,505 995,807
Inventory................................................ 105,886 129,610
Other current assets..................................... 923,385 1,603,446
------------ ------------
Total current assets............................. 34,833,916 20,611,820
Restricted cash............................................ 1,000,000 1,000,000
Property and equipment, net................................ 8,900,931 20,361,875
Refundable capital lease deposit with affiliate............ 707,660 707,660
Debt issuance costs, net of accumulated amortization of
$160,582 at September 30, 1999 and $281,020 at December
31, 1999................................................. 3,211,658 3,091,221
Intangible assets, net..................................... 13,110,252 18,628,241
------------ ------------
$ 61,764,417 $ 64,400,817
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable......................................... $ 2,322,537 $ 4,112,501
Accrued expenses......................................... 3,130,130 8,243,755
Unearned revenues........................................ 1,069,696 1,171,315
Current maturities of capital lease obligations.......... 1,137,019 1,626,112
Note payable............................................. 16,614 462,928
Due to affiliates........................................ 158,376 --
------------ ------------
Total current liabilities........................ 7,834,372 15,616,611
Capital lease obligations, less current maturities....... 1,280,252 1,906,408
Convertible note payable................................. 1,000,000 1,750,000
Senior subordinated discount note........................ 48,837,310 50,687,106
Stockholders' equity (deficit):
Preferred Stock, $.001 par value, 20,000,000 shares
authorized Series A preferred stock, 2,306,765 shares
issued and outstanding................................ 494,375 494,375
Series B preferred stock, 1,500,000 shares designated,
850,000 shares issued and outstanding................. -- 170,000
Deferred stock compensation.............................. -- (162,917)
Common stock, $.001 par value, 80,000,000 shares
authorized, 63,600,815 shares issued.................. 63,601 63,601
Additional paid-in capital............................... 14,496,596 14,496,596
Accumulated deficit...................................... (12,242,089) (20,620,963)
------------ ------------
2,812,483 (5,559,308)
------------ ------------
$ 61,764,417 $ 64,400,817
============ ============
</TABLE>
See notes to unaudited consolidated financial statements.
12
<PAGE> 14
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
--------------------------------------
DECEMBER 31, DECEMBER 31,
1998 1999
(PREDECESSOR) (SUCCESSOR)
----------------- -----------------
<S> <C> <C>
Revenues:
Access revenues..................................... $ 885,017 $ 2,631,621
Communication revenues.............................. -- 1,143,165
Retail revenues..................................... 220,746 242,177
Other revenues...................................... 203,866 236,550
---------- -----------
1,309,629 4,253,513
Costs and expenses:
Costs of access revenues............................ 337,216 1,075,386
Cost of communication revenues...................... -- 1,165,203
Cost of retail revenues............................. 146,925 97,296
Costs of other revenues............................. 163,925 207,052
Operations and customer support..................... 193,032 1,595,724
Sales and marketing................................. 237,028 1,342,581
General and administrative.......................... 420,720 2,392,719
Retail store expenses............................... 298,308 189,861
Depreciation and amortization....................... 92,192 2,813,809
---------- -----------
1,889,346 10,879,631
---------- -----------
Loss from operations.................................. (579,717) (6,626,118)
Other income (expense):
Interest expense -- affiliates...................... (18,909) --
Interest expense.................................... (422) (2,094,787)
Other, net.......................................... (27,453) 342,031
---------- -----------
Loss from continuing operations....................... (626,501) (8,378,874)
Income from operations of discontinued Web development
division............................................ 57,106 --
---------- -----------
Loss before income taxes.............................. (569,395) (8,378,874)
Provision for income taxes............................ -- --
---------- -----------
Net loss.............................................. $ (569,395) $(8,378,874)
========== ===========
</TABLE>
See notes to unaudited consolidated financial statements.
13
<PAGE> 15
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-----------------------------
DECEMBER 31, DECEMBER 31,
1998 1999
(PREDECESSOR) (SUCCESSOR)
------------- ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss.................................................... $(569,395) $ (8,378,874)
Adjustments to reconcile net loss to net cash used in
operating activities: -- --
Depreciation and amortization............................. 92,192 2,813,809
Amortization of debt issuance costs....................... -- 120,438
Allowance for doubtful accounts........................... 14,692 387,471
Accretion of discount on senior subordinated debt......... -- 1,849,796
Amortization of discount on investment.................... -- (48,788)
Stock based compensation expense.......................... 46,157 7,083
Changes in operating assets and liabilities:
Accounts receivable.................................... 75,189 (1,510,404)
Due from affiliates.................................... (203,164) 56,698
Inventory.............................................. 14,041 (23,724)
Other current assets................................... (38,226) (668,631)
Accounts payable....................................... 66,531 1,635,906
Accrued expenses....................................... 102,697 (86,704)
Unearned revenues...................................... 42,205 (118,969)
--------- ------------
Net cash used in operating activities....................... (357,081) (3,964,893)
INVESTING ACTIVITIES
Sale of held to maturity security........................... -- 5,125,000
Advances to affiliates...................................... (152,172) --
Purchases of property and equipment, net of accrued
expenses.................................................. (90,885) (5,218,090)
Acquisition of Information Services Technologies, Inc. ..... -- (591,006)
Acquisition of Business Product Systems Internet, Inc. ..... -- (700,112)
Acquisition of UNI Networking, Inc. ........................ -- (345,301)
Acquisition of Global Vision Systems, Inc., net of cash
acquired.................................................. -- (3,102,445)
Acquisition of Digital Internet Access Inc., net of cash
acquired.................................................. -- (1,417,771)
Acquisition of Harvest Communications, Inc. ................ -- (50,000)
--------- ------------
Net cash used in investing activities....................... (243,057) (6,299,725)
FINANCING ACTIVITIES
Principal payments of obligations under capital lease....... -- (645,198)
Net proceeds under line of credit........................... 20,000 --
Purchase of common stock held in treasury................... (33,255) --
Due to affiliates........................................... 634,226 (158,376)
Proceeds from issuance of common stock...................... 279,058 --
--------- ------------
Net cash provided by (used in) financing activities......... 900,029 (803,574)
--------- ------------
Net increase (decrease) in cash and cash equivalents........ 299,891 (11,068,192)
Cash and cash equivalents at beginning of period............ 689 26,712,416
--------- ------------
Cash and cash equivalents at end of period.................. $ 300,580 $ 15,644,224
========= ============
</TABLE>
14
<PAGE> 16
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999
1. NATURE OF BUSINESS AND BASIS OF PRESENTATION
NATURE OF BUSINESS
Primary Network Holdings, Inc. (the Company) is headquartered in St. Louis,
Missouri, and provides full-service access to the Internet for corporate and
residential users primarily in Missouri and Kansas. The Company also is a
reseller of basic local telecommunications services, dedicated non-switched
local exchange telecommunications services, and intrastate interexchange
telecommunications services in Missouri. The basic local service is classified
as competitive by the State of Missouri Public Service Commission (PSC) and is
provided in portions of Missouri that are currently served primarily by
Southwestern Bell Telephone Company (SWBT). Furthermore, the Company also serves
as an authorized agent of Southwestern Bell Mobile Systems and operates cellular
and other wireless communication products retail stores in the St. Louis
metropolitan area. Billings are due upon receipt.
BASIS OF PRESENTATION
The unaudited consolidated financial statements of Primary Network
Holdings, Inc., the successor company, and CDM On-Line, Inc., the predecessor
company, have been prepared in accordance with generally accepted accounting
principles for interim financial information (refer to footnotes 1 and 2 in the
September 30, 1999 audited financial statements of the Company for further
explanation of the organization and basis of presentation and initial formation
and capitalization of the Company). Accordingly, these interim financial
statements do not include all of the information and notes required by generally
accepted accounting principles for complete financial statements, and,
therefore, should be read in conjunction with the Company's audited financial
statements for the four months ended September 30, 1999, contained in this
Prospectus. In the opinion of management, all adjustments (consisting only of
normal recurring items) considered necessary for a fair presentation have been
included. The results of operations for the three months ended December 31, 1999
are not necessarily indicative of the results that may be expected for the year
ended September 30, 2000.
2. INVENTORY
Inventory consists of cellular and other wireless communication products
and accessories and is stated at the lower of cost (specific identification
basis) or market.
15
<PAGE> 17
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following at September 30, 1999 and
December 31, 1999:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1999
------------- ------------
<S> <C> <C>
Computer equipment................................... $ 4,465,458 $ 6,441,308
Software............................................. 478,574 698,167
Furniture, fixtures, and office equipment............ 680,884 793,849
Capitalized collocation costs........................ 150,236 4,342,291
Land, building, and leasehold improvements........... 285,552 480,219
Vehicles............................................. 71,348 71,348
----------- -----------
6,132,052 12,827,182
Less accumulated depreciation and amortization....... (1,881,830) (2,459,256)
----------- -----------
4,250,222 10,367,926
Construction in progress............................. 4,650,709 9,993,949
----------- -----------
$ 8,900,931 $20,361,875
=========== ===========
</TABLE>
4. INTANGIBLE ASSETS
Intangible assets consist of the following at September 30, 1999 and
December 31, 1999:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1999
------------- ------------
<S> <C> <C>
Acquired customer list............................... $ 2,771,783 $ 5,460,083
Goodwill............................................. 11,631,661 16,733,735
----------- -----------
14,403,444 22,193,818
Less accumulated amortization........................ (1,293,192) (3,565,577)
----------- -----------
$13,110,252 $18,628,241
=========== ===========
</TABLE>
5. ACCRUED LIABILITIES
Accrued liabilities consist of the following at September 30, 1999 and
December 31, 1999:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1999
------------- ------------
<S> <C> <C>
Accrual for equipment acquired....................... $1,836,572 $6,369,305
Accrued payroll and related expenses................. 366,933 550,076
Acquisition related holdback accrual................. 130,000 751,355
Other accrued liabilities............................ 796,625 573,019
---------- ----------
$3,130,130 $8,243,755
========== ==========
</TABLE>
16
<PAGE> 18
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. SEGMENT INFORMATION
The Company has three reportable segments, Internet, Retail, and
Communications, which are separate operating units that offer different products
and services and are managed accordingly. Performance of each segment is
evaluated by management based on income (loss) before income taxes. The
corporate and eliminations segment includes corporate assets, principally
consisting of cash and cash equivalents, investments and debt issuance costs,
corporate activities and the elimination of intersegment transactions. In
addition, as a result of the initial formation and capitalization of the Company
as of June 1, 1999, the Company adjusted its segment reporting structure whereby
interest expense is no longer allocated to its three reportable segments.
The Internet segment provides full service access to the Internet for
corporate and residential customers including dial-up and dedicated services and
activities related to setup and installation, selling equipment, and software.
The Retail segment sells cellular and other wireless communication products,
including phones, pagers, and related accessories. The Communications segment,
which was established June 1, 1999, provides facilities-based and resold basic
local telecommunications service, including dedicated/non-switched local
exchange services, and intrastate interexchange services.
The following segment information is as of December 31 or for the three
months then ended:
<TABLE>
<CAPTION>
1998 (PREDECESSOR)
-------------------------------------
INTERNET RETAIL TOTAL
---------- --------- ----------
<S> <C> <C> <C>
Revenues from external customers................... $1,088,883 $ 220,746 $1,309,629
Intersegment revenues.............................. -- -- --
Depreciation and amortization...................... 88,467 3,725 92,192
Interest expense................................... 16,073 3,258 19,331
Loss from continuing operations.................... (395,028) (231,473) (626,501)
Income from discontinued operation -- Web
Development...................................... 57,106 -- 57,106
Loss before income taxes........................... (337,922) (231,473) (569,395)
Segment assets..................................... 1,123,687 540,241 1,663,928
Capital expenditures, net of accrued expenses...... 86,635 4,250 90,885
</TABLE>
<TABLE>
<CAPTION>
1999 (SUCCESSOR)
--------------------------------------------------------------------
CORPORATE
AND
INTERNET RETAIL COMMUNICATIONS ELIMINATIONS TOTAL
----------- -------- -------------- ------------ -----------
<S> <C> <C> <C> <C> <C>
Revenues from external
customers................. $ 2,868,171 $242,177 $ 1,143,165 -- $ 4,253,513
Intersegment Revenues....... 765 44,649 244,118 (289,532) --
Depreciation and
amortization.............. 1,866,138 8,947 890,209 48,515 2,813,809
Interest expense............ -- -- -- 2,094,787 2,094,787
Loss before income taxes.... (1,898,088) (52,314) (2,697,817) (3,730,655) (8,378,874)
Segment assets.............. 20,192,172 360,552 22,502,260 21,345,833 64,400,817
Capital expenditures, net of
accrued expenses.......... 39,939 536 4,531,002 646,613 5,218,090
</TABLE>
17
<PAGE> 19
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
7. ACQUISITIONS
In the three month period ended December 31, 1999, the Company made the
following acquisitions:
On October 1, 1999, the Company purchased substantially all of the assets
of Information Systems Technologies, Inc. for approximately $591,000, net of
liabilities assumed.
On October 6, 1999, the Company purchased substantially all of the assets
of Business Products Systems Internet, Inc. for approximately $700,000, net of
liabilities assumed.
On October 13, 1999, the Company purchased substantially all of the assets
of UNI Networking Inc. for approximately $345,000, net of liabilities assumed.
On October 20, 1999, the Company purchased all of the outstanding common
stock of GlobalVision Systems, Inc. for approximately $3,102,000, net of cash
acquired and liabilities assumed.
On November 1, 1999, the Company purchased all of the outstanding common
stock of Harvest Telecom, Inc. for approximately $50,000.
On November 10, 1999, the Company purchased all of the outstanding common
stock of Digital Internet Access, Inc. for approximately $1,418,000, net of cash
acquired and liabilities assumed.
The above acquisitions were accounted for under the purchase method of
accounting, and accordingly, the purchase prices were allocated to assets
acquired and liabilities assumed based upon their estimated fair values at the
dates of acquisition. The customer lists were valued at $200 per subscriber
acquired, which represents the estimated fair value of such subscribers based
upon recent transactions in the ISP industry. Included in the purchase prices
listed above are legal and acquisition costs of approximately $32,600. For those
businesses acquired, the results of operations are included in the Company's
consolidated statement of operations from the dates of acquisition.
The combined historical results for the acquisitions listed above were not
deemed to be material and thus, pro-forma financial information was not
presented for the periods disclosed.
8. SECONDMENT AGREEMENT
On November 23, 1999, the Company entered into a Secondment Agreement with
an investor to obtain certain services to be provided by an employee of the
investor. Under the terms of the agreement, the Company is required to pay
$17,500 per month for the services, including out-of-pocket expenses.
Furthermore, the seconded employee was issued 680,000 shares of Series B
preferred stock which vests in eight equal quarterly installments over a
two-year period and warrants with an exercise price of $1.52 per share to
purchase an additional 520,000 shares of Series B preferred stock which vest in
three equal annual installments. Furthermore, the investor was issued 170,000
shares of Series B preferred stock and was granted warrants with an exercise
price of $1.52 to purchase an additional 130,000 shares of Series B preferred
stock, both with the same vesting terms as the seconded employee described
above. All of the above issuances and grants vest immediately upon the
occurrence of certain events described in the agreement, including a change in
control. The Company will recognize the compensation expense related to these
transactions ratably over the vesting period. Finally, the investor is entitled
to receive a fee, payable immediately, in the event the Company consummates
certain transactions outlined in the agreement prior to June 1, 2000, including
a change in control, obtaining senior debt from a financial institution, or
issuing additional subordinated debt or equity securities.
18
<PAGE> 20
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. SUBSEQUENT EVENTS
LEASE TRANSACTIONS
On February 23, 2000, the Company entered into an equipment capital lease
to finance its continued build out of collocations. Under the terms of the
lease, the Company is required to make thirty-six equal monthly payments of
approximately $122,000 and has the guaranteed option to purchase the equipment
at 10% of original purchase price or approximately $3,700,000. The assets under
the capital lease are recorded at the lower of the present value of the minimum
lease payments or the fair value of the equipment. The lease is secured by the
equipment financed.
On March 31, 2000, the Company entered into a sale leaseback agreement,
whereby the Company sold collocation equipment with a book value of
approximately $8,000,000 and subsequently entered into a capital lease for
approximately $9,400,000, including the financing of approximately $900,000 in
equipment maintenance agreements. The assets under the capital lease are
recorded at the lower of the present value of the minimum lease payments or the
fair value of the equipment. The gain resulting from this transaction of
approximately $500,000 is being amortized over the term of the lease. Under the
terms of the lease, the Company is required to make six monthly payments of
approximately $106,000 and then thirty monthly payments of approximately
$340,000.
In addition to the equipment being financed under the lease, the Company
granted the lessor an additional security interest in substantially all tangible
and intangible assets of the Company. The lessor has provided a contingent
clause in the agreement for the release of the additional security upon the
Company obtaining unrestricted cash equity proceeds in the amount of $50,000,000
or greater. The lease agreement also contains covenants requiring the Company to
maintain certain debt to total contributed capital ratios as well as requiring
the Company to secure future minimum commitments of either secured bridge debt
or unrestricted by various dates.
LEASE COMMITMENT
On April 15, 2000 the Company entered into an agreement for the lease of a
new office building. The term of the agreement is five years with total annual
rent of approximately $1,200,000. In addition, the Company has committed
$3,900,000 for leasehold improvements and certain equipment purchases related to
this property.
PENDING TRANSACTION
On April 17, 2000, the Company signed an agreement and plan of merger
(merger agreement) with Mpower Communications Corp. (A/K/A MGC Communications,
Inc.).
In connection with the consummation of the merger agreement, the following
will occur:
(i) The Company's stockholders will exchange their shares in the Company
for 1,350,000 shares of common stock of Mpower Communications Corp.
(Mpower). Each outstanding share of the Company's common stock and
preferred stock will be converted into .02022 shares of Mpower common
stock.
(ii) All of the Company's stock options outstanding under the Company's
stock option plan shall continue to have, and be subject to, the same
terms and conditions as set forth in the Company's stock option plan
and the agreements pursuant to which such Company stock options were
issued, except that each Company stock option shall be exercisable
for .02022 shares of Mpower common stock and the price per share will
be adjusted accordingly.
19
<PAGE> 21
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
(iii) The Company's 4,476,423 detachable non-callable warrants to the
Investors that entitle the holders to purchase common shares of the
Company at a price of $3.385 per share shall continue to be subject
to the same terms and conditions, except that each warrant shall be
exercisable for .02022 shares of Mpower common stock and the price
per share will be adjusted accordingly.
(iv) Mpower will assume approximately $80,000,000 of net liabilities of
the Company, a portion of which will be swapped for additional
high-yield bonds to be issued under Mpower's recent high-yield
financing indenture. The holders of the swapped debt will also
receive 50,000 shares of Mpower common stock.
(v) Mpower will become the sole stockholder of the Company.
NOTE PAYABLE
On April 27, 2000 the Company issued a $10,000,000 senior promissory note
(senior note) to Mpower due the earliest of April 17, 2001, upon a change of
control of the Company other than the pending transaction discussed above, or
upon the event of default, as defined. Interest accrues at 15 percent per annum
until the maturity date. After the maturity date, interest accrues at 18 percent
per annum until the senior note is paid in full. At any time prior to maturity
of the senior note, the unpaid principal amount of the senior note together with
any accrued but unpaid interest may be prepaid in whole or in part as long as
the Company has provided at least 15 business days notice to Mpower.
Due to the issuance of this senior note, the Company was in violation of a
covenant included in the Note and Purchase Agreement dated June 1, 1999 related
primarily to limitations of indebtedness. The holders of Notes waived their
right to call the debt as well as this covenant violation as of April 27, 2000.
20
<PAGE> 22
CONSOLIDATED FINANCIAL STATEMENTS
PRIMARY NETWORK HOLDINGS, INC.
FOR THE PERIOD JUNE 1, 1999 TO SEPTEMBER 30, 1999
WITH REPORT OF INDEPENDENT AUDITORS
21
<PAGE> 23
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE PERIOD JUNE 1, 1999 TO SEPTEMBER 30, 1999
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors.............................. 23
Consolidated Financial Statements
Consolidated Balance Sheet.................................. 24
Consolidated Statement of Operations........................ 25
Consolidated Statement of Stockholders' Equity.............. 26
Consolidated Statement of Cash Flows........................ 27
Notes to Consolidated Financial Statements.................. 28
</TABLE>
22
<PAGE> 24
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Primary Network Holdings, Inc.
We have audited the accompanying consolidated balance sheet of Primary
Network Holdings, Inc. as of September 30, 1999 and the related consolidated
statements of operations, stockholders' equity, and cash flows for the period
June 1, 1999 to September 30, 1999. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Primary Network Holdings, Inc. at September 30, 1999 and the consolidated
results of its operations and its cash flows for the period June 1, 1999 to
September 30, 1999, in conformity with accounting principles generally accepted
in the United States.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As more fully
described in Note 1, the Company has incurred significant operating losses and
negative cash flows from operations. These conditions raise substantial doubt
about the Company's ability to continue as a going concern. Management's plans
in regard to these matters are also described in Note 1. The September 30, 1999
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.
ERNST & YOUNG LLP
February 11, 2000, except for
Note 16, as to which the date is April 27, 2000
St. Louis, Missouri
23
<PAGE> 25
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED BALANCE SHEET
SEPTEMBER 30, 1999
<TABLE>
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 26,712,416
Investments............................................... 5,076,212
Accounts receivable, less allowance for doubtful accounts
of $630,920............................................ 963,512
Due from affiliates....................................... 1,052,505
Inventory................................................. 105,886
Prepaid expenses and other current assets................. 923,385
------------
Total current assets.............................. 34,833,916
Restricted cash............................................. 1,000,000
Property and equipment, net................................. 8,900,931
Refundable capital lease deposit with affiliate............. 707,660
Debt issuance costs, net of accumulated amortization of
$160,582.................................................. 3,211,658
Intangible assets, net...................................... 13,110,252
------------
$ 61,764,417
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 2,322,537
Accrued expenses.......................................... 3,130,130
Unearned revenues......................................... 1,069,696
Current maturities of capital lease obligations........... 1,137,019
Note payable.............................................. 16,614
Due to affiliates......................................... 158,376
------------
Total current liabilities......................... 7,834,372
Capital lease obligations, less current maturities.......... 1,280,252
Convertible note payable.................................... 1,000,000
Senior subordinated discount notes.......................... 48,837,310
Stockholders' equity:
Preferred stock, $.001 par value, 20,000,000 shares
authorized Series A, 2,306,765 shares issued and
outstanding............................................ 494,375
Common stock, $.001 par value, 80,000,000 shares
authorized, 63,600,815 shares issued and outstanding... 63,601
Additional paid-in capital................................ 14,496,596
Accumulated deficit....................................... (12,242,089)
------------
2,812,483
------------
$ 61,764,417
============
</TABLE>
See accompanying notes.
24
<PAGE> 26
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENT OF OPERATIONS
FOR THE PERIOD JUNE 1, 1999 TO SEPTEMBER 30, 1999
<TABLE>
<S> <C>
Revenues:
Access revenues........................................... $ 2,712,058
Communications revenues................................... 850,367
Retail revenues........................................... 350,715
Other revenues............................................ 168,997
-----------
4,082,137
Costs and expenses:
Costs of access revenues.................................. 947,293
Costs of communications revenues.......................... 903,846
Costs of retail revenues.................................. 141,734
Costs of other revenues................................... 109,700
Operations and customer support........................... 1,595,725
Sales and marketing....................................... 1,342,581
General and administrative................................ 2,046,290
Retail store expenses..................................... 275,554
Depreciation and amortization............................. 1,766,901
Impairment charge......................................... 254,132
-----------
9,383,756
-----------
Loss from operations........................................ (5,301,619)
Other income (expense):
Interest expense -- affiliates............................ (118,507)
Interest expense.......................................... (2,582,804)
Interest income -- affiliates............................. 30,301
Other income, net......................................... 663,926
-----------
(2,007,084)
-----------
Loss before income taxes.................................... (7,308,703)
Provision for income taxes.................................. --
-----------
Net loss.................................................... $(7,308,703)
===========
</TABLE>
See accompanying notes.
25
<PAGE> 27
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES A PREFERRED
STOCK COMMON STOCK ADDITIONAL
-------------------- -------------------- PAID-IN ACCUMULATED
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT
--------- -------- ---------- ------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
Balance at June 1, 1999... -- $ -- -- $ -- $ -- $ --
Issuance of stock in
connection with the
acquisition of CDM
Online, Inc.......... -- -- 24,632,359 24,632 6,655,497 (4,933,386)
Issuance of stock in
connection with the
acquisition of
BroadSpan
Communications,
Inc.................. -- -- 7,085,664 7,086 1,511,480 --
Issuance of stock in
initial
capitalization (See
Note 2).............. 2,306,765 494,375 31,882,792 31,883 6,329,619 --
Net loss................ -- -- -- -- -- (7,308,703)
--------- -------- ---------- ------- ----------- ------------
Balance at September 30,
1999.................... 2,306,765 $494,375 63,600,815 $63,601 $14,496,596 $(12,242,089)
========= ======== ========== ======= =========== ============
</TABLE>
See accompanying notes.
26
<PAGE> 28
PRIMARY NETWORK HOLDINGS, INC.
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE PERIOD JUNE 1, 1999 TO SEPTEMBER 30, 1999
<TABLE>
<S> <C>
OPERATING ACTIVITIES
Net loss.................................................... $ (7,308,703)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 1,766,901
Amortization of debt issue costs.......................... 160,582
Allowance for doubtful accounts........................... 305,692
Accretion of discount on senior subordinated debt......... 2,392,255
Amortization of discount on investment.................... (76,667)
Impairment charge......................................... 254,132
Gain on disposal of fixed assets.......................... (75,000)
Changes in operating assets and liabilities:
Accounts receivable.................................... (178,375)
Due from affiliates.................................... (1,126,900)
Inventory.............................................. (9,560)
Prepaid expenses and other current assets.............. (532,987)
Accounts payable....................................... (209,308)
Accrued expenses....................................... 825,371
Due to affiliates...................................... (348,488)
Unearned revenues...................................... 105,706
------------
Net cash used in operating activities....................... (4,055,349)
INVESTING ACTIVITIES
Increase in restricted cash................................. (1,000,000)
Purchase of held-to-maturity security....................... (4,999,545)
Cash acquired in acquisition of CDM On-Line, Inc............ 73,938
Cash acquired in acquisition of BroadSpan Communications,
Inc....................................................... 109,762
Acquisition of InLink Communications Company................ (4,738,848)
Acquisition of Q-Networks Inc., net of cash acquired........ (3,980,795)
Acquisition of CySource, Inc................................ (593,502)
Additional costs incurred in acquisitions made by
predecessor in prior periods.............................. (34,726)
Purchase of property and equipment, net of accounts
payable................................................... (3,772,056)
------------
Net cash used in investing activities....................... (18,935,772)
FINANCING ACTIVITIES
Payments of equity and debt issuance costs.................. (3,071,307)
Principal payments of obligations under capital leases...... (222,350)
Proceeds from issuance of senior subordinated discount
notes..................................................... 46,445,055
Proceeds from issuance of common stock...................... 6,554,945
Principal payments under note payable....................... (2,806)
------------
Net cash provided by financing activities................... 49,703,537
------------
Net increase in cash and cash equivalents................... 26,712,416
Cash and cash equivalents at June 1, 1999................... --
------------
Cash and cash equivalents at September 30, 1999............. $ 26,712,416
============
Noncash investing and financing transactions:
Note payable issued to seller in acquisition of Q-Networks
Inc.................................................... $ 1,000,000
============
Capital leases entered into............................... $ 119,311
============
</TABLE>
See accompanying notes.
27
<PAGE> 29
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 1999
1. ORGANIZATION AND BASIS OF PRESENTATION
Primary Network Holdings, Inc., a Delaware corporation (PNH or the
Company), was incorporated on March 3, 1999 for the purpose of combining two
affiliated entities, CDM On-Line, Inc., d/b/a/ Primary Network Internet, Inc.
(PNI), an Internet service provider (ISP), and BroadSpan Communications, Inc.,
d/b/a/ Primary Network Communication, Inc. (PNC), a competitive local exchange
carrier (CLEC). In an April 1999 joint stockholders meeting, the stockholders of
PNI and PNC voted to approve an Agreement & Plan of Reorganization, pursuant to
which the respective stockholders of each company would exchange their current
ownership interests for shares of common stock in the Company effective the
close of business on May 31, 1999 (the Exchange) (see Note 3). Subsequent to the
Exchange, PNI and PNC continued as wholly owned subsidiaries of the Company.
The Company was in the development stage for the period from March 3, 1999
(date of inception) to June 1, 1999. Accordingly, the Company had no assets,
liabilities, or financial activity prior to June 1, 1999.
Pursuant to the requirements of the Securities and Exchange Commission's
Staff Accounting Bulletin No. 97, which was issued and became effective July 31,
1996, although the Company is the legal acquiror of both entities, PNI has been
designated as the acquirer of PNC and the predecessor of PNH for financial
reporting purposes. This designation was the result of the PNI stockholders
receiving the largest ownership interests in the combined corporation subsequent
to the Exchange. In addition, because PNI was treated as the acquirer in the
Exchange for financial accounting purposes, the Company's financial position on
June 1, 1999 reflected the historical cost basis of PNI. Furthermore, the
acquisition of PNC was accounted for as a purchase transaction, and accordingly,
purchase accounting adjustments, including the recognition of goodwill, were
recorded based on the fair value of the Company's common stock issued in the
Exchange at that date.
The accompanying consolidated financial statements of the Company for the
period June 1, 1999 to September 30, 1999 have been prepared on a going-concern
basis which contemplates the realization of assets and the settlement of
liabilities and commitments in the normal course of business. The Company
incurred a net loss of $7,308,703 and had negative cash flows from operations of
$4,055,349 for the period June 1, 1999 to September 30, 1999. Additionally, the
Company continues to incur substantial capital expenditures as it relates to the
collocation build-out for its Digital Subscriber Line (DSL) service, which is
necessary for the Company to be able to offer its future core services, and has
continued to incur operating losses through the first four months of fiscal
2000. These two factors have resulted in a significant decrease in the Company's
cash position subsequent to year-end. These conditions raise substantial doubt
about the Company's ability to continue as a going concern. Furthermore, the
online services, Internet, and telecommunications markets are highly
competitive. The Company believes that existing competitors, Internet-based
services, other ISPs, Internet directory services, incumbent local exchange
carriers, other CLECs, and other telecommunications companies are likely to
enhance their service offerings, resulting in greater competition for the
Company. The competitive conditions could have the following effects: require
additional pricing programs, increase spending on marketing, limit the Company's
ability to expand its subscriber base, and result in increased attrition in the
existing subscriber base. The Company's viability as a going concern is
dependent upon management's operational and financing plans to address these
conditions which include, but are not limited to, obtaining additional equity
and debt financing, continuing investments in its infrastructure to increase its
efficiency and capacity to serve
28
<PAGE> 30
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
existing and additional customers, and employing marketing and sales strategies
to increase its customer base. Although there can be no assurance that growth in
the Company's revenues or subscriber base will continue or that the Company will
be able to achieve or sustain profitability or positive cash flow, the Company
believes that these steps are appropriate and will enable the Company to
effectively reorganize its operations. Under current circumstances, the
Company's ability to continue as a going concern depends upon the successful
implementation of its plan. If the Company is unsuccessful in its efforts, it
may be necessary to undertake such other actions as may be appropriate to
preserve asset values. The accompanying consolidated financial statements do not
include any adjustments to reflect the possible future effects on the
recoverability and classification of assets or the amounts and classification of
liabilities that may result from the outcome of this uncertainty.
2. INITIAL FORMATION AND CAPITALIZATION
As described in Note 1, effective the close of business on May 31, 1999,
the Company legally acquired PNI through the execution of an Agreement & Plan of
Reorganization, whereby all common stockholders of PNI exchanged each of their
shares for 16.67 shares of common stock in the Company. This transaction
resulted in the issuance of 24,632,359 common shares of the Company and occurred
simultaneously with the acquisition of PNC discussed below and, as mentioned
previously, resulted in PNI being designated as the accounting acquirer of PNC
and PNI being deemed to be the predecessor of PNH. Accordingly, the Company's
acquisition of PNI was accounted for using the carryover basis of PNI's assets,
liabilities, and retained earnings. As a result, no goodwill was recorded in
this acquisition. The net carrying value of PNI's assets as of the acquisition
date was $1,746,743.
Also in connection with the Agreement & Plan of Reorganization, the Company
legally acquired PNC, whereby all common stockholders of PNC exchanged each of
their shares for 13.227 shares of common stock in the Company. This transaction
resulted in the issuance of 7,085,664 common shares of the Company and was
accounted for under the purchase method of accounting, based on the fair value
of the Company's common stock issued in the Exchange at the acquisition date of
$1,518,566, plus net liabilities assumed of $1,702,547 and acquisition costs of
$100,420. The purchase price allocation resulted in the Company recording total
goodwill associated with this transaction of $3,321,533.
The acquisitions of PNI and PNC have been structured as tax-free exchanges
of stock; therefore, the difference between the recognized fair value of the
acquired assets, including intangible assets, and their historical tax bases is
not deductible for income tax purposes.
On June 1, 1999, the Company entered into a Purchase Agreement with a
syndicate of investors (Investors) to obtain additional financing. Under this
agreement, the Company received cash proceeds of $53,000,000 and issued the
following debt and equity securities to the Investors: senior subordinated
discount notes with a face value of $84,473,948, 30,564,640 shares of common
stock, and detachable non-callable warrants to purchase 4,476,423 shares of
common stock. The Company determined the fair value of the common stock based
upon an independent valuation as of June 1, 1999. Accordingly, the Company
allocated the proceeds received among the debt, common stock, and warrants based
on their respective fair values at the time of issuance. The value attributable
to the common stock of approximately $6,550,000 was recorded as a debt discount
to be charged to interest expense over the life of the notes. The fair value of
the warrants was deemed insignificant on the date of grant, and thus only a
nominal amount was recorded as additional paid-in capital. This nominal
29
<PAGE> 31
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
value was also recorded as a debt discount to be charged to interest expense
over the life of the notes. The balance of the proceeds of approximately
$46,445,000 was allocated to the notes.
Offering costs incurred in connection with the Purchase Agreement of
approximately $3,500,000, including legal costs, accounting fees, and financial
advisor fees, were recorded as debt issuance costs or as a reduction to
additional paid-in capital, based on the proportional allocation of proceeds
described above. Included in these offering costs were amounts equaling the fair
value at the transaction date of 2,306,765 shares of the Company's Series A
preferred stock and 1,318,152 shares of the Company's common stock which were
granted to certain investors who also acted as financial advisors and exclusive
placement agents in this transaction.
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
The Company, which is headquartered in St. Louis, Missouri, provides
full-service access to the Internet for corporate and residential users
primarily in Missouri and Kansas. The Company also is a reseller of basic local
telecommunications services, dedicated non-switched local exchange
telecommunications services, and intrastate interexchange telecommunications
services in Missouri. The basic local service is classified as competitive by
the State of Missouri Public Service Commission (PSC) and is provided in
portions of Missouri that are currently served primarily by Southwestern Bell
Telephone Company (SWBT). Furthermore, the Company also serves as an authorized
agent of Southwestern Bell Mobile Systems and operates cellular and other
wireless communication products retail stores in the St. Louis metropolitan
area.
CONSOLIDATION
The consolidated financial statements of the Company include the accounts
of all of its wholly owned subsidiaries. All significant intercompany
transactions and balances have been eliminated.
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect reported amounts in the financial statements and
accompanying notes. Actual results could differ from those estimates.
ACCOUNTING PERIOD
Effective June 1, 1999, the Company changed its fiscal year-end from
December 31, which was used by its predecessor, to September 30.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid financial instruments with a
maturity of three months or less at the time of purchase to be cash equivalents.
INVESTMENTS
Debt securities are classified as held-to-maturity when the Company has the
positive intent and ability to hold the securities to maturity. Held-to-maturity
securities are stated at amortized cost, adjusted for amortization of premiums
and discounts to maturity. Such amortization and the interest on securities are
included in other income.
30
<PAGE> 32
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
PROPERTY AND EQUIPMENT
Property and equipment, including leasehold improvements, are stated at
cost. Costs related to software developed for internal use are capitalized in
accordance with AcSEC Statement of Position 98-1, Accounting for the Costs of
Computer Software Developed For or Obtained For Internal Use. Depreciation is
calculated using the straight-line method over the estimated useful lives
ranging from 18 months to 15 years. Leasehold improvements are amortized over
the lesser of the related lease term or the useful life of the assets.
Capitalized collocation costs represent application fees, equipment costs,
and leasehold improvement costs related to the leasing of collocation space at
SWBT. These costs are necessary for the delivery of certain communication
services, primarily DSL service, to the Company's customers. The Company
depreciates these costs using a straight-line method over a three-year period
beginning on the date the service becomes available. At September 30, 1999, the
Company has incurred $4,650,709 of collocation costs which are under
construction and classified in construction in progress.
Equipment under capital leases is amortized over its related lease terms or
its estimated productive useful lives, depending on the criteria met in
determining a lease's qualification as a capital lease. Costs of repair and
maintenance are charged to expense as incurred.
INVENTORY
Inventory consists of cellular and other wireless communication products
and accessories and is stated at the lower of cost (specific identification
basis) or market.
CUSTOMER LISTS
The cost of customer lists acquired is being amortized over three years
using the straight-line method.
GOODWILL
Goodwill, which represents the cost in excess of the fair market value of
identifiable net assets acquired, is being amortized using the straight-line
method over three years.
IMPAIRMENT OF LONG-LIVED ASSETS
Periodically, management determines whether any property or equipment or
any other assets have been impaired based on the criteria established in
Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the
Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of. Based
on these criteria, customer lists and goodwill associated with assets acquired
in a business combination are included in impairment evaluations when events or
circumstances exist that indicate the carrying amount of those assets may not be
recoverable. During the four-month period ended September 30, 1999, the Company
recorded a $254,000 noncash charge to earnings related to the impairment
associated with the acquisition of the customer list and goodwill of CySource,
Inc. (see Note 4).
STOCK COMPENSATION
The Financial Accounting Standards Board's SFAS No. 123, Accounting for
Stock-Based Compensation, establishes the use of the fair value-based method of
accounting for stock-based
31
<PAGE> 33
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
employee compensation arrangements, under which compensation cost is determined
using the fair value of stock-based compensation determined as of the grant date
and is recognized over the periods in which the related services are rendered.
SFAS No. 123 also permits companies to elect to continue using the intrinsic
value accounting method specified in Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, (APB 25) and related interpretations
to account for stock-based compensation. The Company has elected to retain the
intrinsic value-based method and will disclose in its financial statements the
pro forma effect of using the fair value-based method to account for its
stock-based compensation.
REVENUE RECOGNITION
Access revenues: Internet customers are billed in advance for the periods
for which Internet services are provided. Internet access service plans range
from one month to one year. The Company defers recognition of revenue on these
advance billings and amortizes the amounts to revenue on a straight-line basis
as the services are provided.
Communications revenues services: Revenues from communications services are
recognized when customers use the services. Revenues billed in advance are
deferred and are recognized in the period in which the related services are
provided.
Retail revenues: These revenues consist primarily of retail product sales
of cellular and other wireless products, such as phones, pagers, and related
accessories. Such sales are recorded upon customer purchase. The Company also
generates revenues from activation commissions from cellular carriers for each
new cellular phone subscription sold by the Company. Revenue from such
commissions is recorded upon customer subscription. New subscription activation
commissions are fully refundable if the subscriber cancels service within a
certain minimum period of continuous active service (generally 180 days).
Customers generally sign a service agreement that requires a customer deposit
which is forfeited in case of early cancellation. At September 30, 1999, the
Company's allowance for accounts receivable includes an amount for estimated
cancellation losses, net of deposit forfeitures.
The Company generally receives monthly residual income from the cellular
service providers based on a percentage of actual phone usage by subscribers.
Revenue from residual income is recorded as the cellular service is provided.
Revenue from prepaid pager service is deferred and recognized over the period
service is provided, usually annually. Revenue from monthly installment pager
service contracts is recorded as earned.
Other revenues: Other revenues consist of setup and installation fees and
selling equipment and software. These revenues are recognized in the period in
which the service has been provided.
COSTS OF REVENUES
Costs of access revenues primarily consist of telecommunications expenses
inherent in the network infrastructure, including fees paid for the lease of the
Company's backbone. Costs of communications revenues include local and long
distance services purchased from SWBT and Qwest Communications Corporation
(Qwest), respectively. Costs of retail revenues consist of the costs of cellular
and other wireless communication products and accessories purchased for resale.
Costs of other revenues primarily consist of the costs of equipment and software
purchased for resale.
32
<PAGE> 34
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ADVERTISING COSTS
All advertising and promotion costs are expensed as incurred and totaled
$508,000 for the period June 1, 1999 to September 30, 1999.
INCOME TAXES
The provision for income taxes is computed using the liability method.
Deferred income taxes are provided to reflect the tax effects of temporary
differences between the book and tax basis of assets and liabilities. The
primary difference between the reported loss and taxable loss results from
financial statement accruals and reserves. The Company reported book and tax
losses for the period June 1, 1999 to September 30, 1999 and, therefore, has not
recorded income tax expense for the period then ended. Valuation allowances are
established, when appropriate, to reduce any deferred tax assets to the amount
that will more likely than not be realized.
For tax years prior to June 1, 1999, PNI was taxed under the provisions of
Subchapter S of the Internal Revenue Code (the Code). Under the Subchapter S
provisions of the Code, the stockholders of PNI included the Company's income or
loss in their personal income tax returns. Effective June 1, 1999, pursuant to
the Exchange, PNI's status as an S Corporation under the Code terminated, and it
became subject to state and federal corporate income taxes. Accordingly, the
Company established deferred tax assets and liabilities for PNI effective June
1, 1999. This calculation resulted in a net deferred tax asset position which
was fully reserved for by a valuation allowance.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash and cash equivalents,
investments, accounts receivable, accounts payable, and senior subordinated
discount notes. The cash and cash equivalents and investments are held by a
high-credit-quality financial institution. For accounts receivable, the Company
performs ongoing credit evaluations of the financial condition of its customers
and does not require collateral. The Company maintains reserves for credit
losses, and such losses have been within management's expectations. The
concentration of credit risk is mitigated by the large customer base. The net
carrying amount of all of these financial instruments, excluding the senior
subordinated discount notes, approximates their fair value at September 30,
1999. The fair value of the senior subordinated discount notes approximates the
liquidation value (see Note 9).
SOURCES OF SUPPLIES/SIGNIFICANT SUPPLIERS
The Company relies on local telephone companies and other companies to
provide data communications for its Internet access services. Furthermore, the
Company relies on SWBT and Qwest to provide the services that the Company
resells to its customers. Although management believes alternative
telecommunication facilities and providers could be found in a timely manner,
any disruption of these services could have an adverse effect on operating
results.
Although the Company attempts to maintain numerous vendors for required
products, its modems, terminal servers, and high-performance routers, which are
important components of its network, are each currently acquired from a limited
number of sources. In addition, some of the Company's suppliers have limited
resources and production capacity. If the suppliers are unable to meet the
Company's needs as its network infrastructure grows, then delays and increased
costs in the
33
<PAGE> 35
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
expansion of the Company's network infrastructure could result, having an
adverse effect on operating results.
4. ACQUISITIONS
In the period June 1, 1999 to September 30, 1999, the Company completed the
three acquisitions described below:
On June 17, 1999, the Company acquired all outstanding stock of Q-Networks
Inc. (Qnet), an ISP located in Kansas City, Missouri, from the sole stockholder
for $5,630,000, including the assumption of liabilities of approximately
$649,000. The purchase price was funded with $3,981,000 cash and $1,000,000 of
financing in the form of a convertible note payable issued to the seller. The
note was issued with an interest rate of 6 percent and is due in full or
convertible no later than June 2001. This note allows the seller to convert the
note into shares of the Company at the initial public offering price should the
Company complete an initial public offering any time prior to June 2001. The
Company may make prepayments at any time during the note term; however, should
the note be prepaid in full, the seller continues to have an option to acquire
up to $1,000,000 of the Company's stock in an initial public offering should it
occur at any time prior to June 2001. Interest under the convertible note is due
quarterly. In connection with the issuance of the convertible note, the Company
was required to place $1,000,000 in escrow at the time of acquisition. The funds
in escrow cannot be accessed by the Company without the consent of the seller
and thus are reflected as restricted cash in the accompanying consolidated
balance sheet at September 30, 1999. Approximately $1,056,000 and $4,264,000
were allocated to the acquired customer list and goodwill, respectively, as a
result of this transaction.
On June 22, 1999, the Company entered into an asset purchase agreement to
acquire the Internet access customer base of CySource, Inc. (CySource) for
approximately $602,000, including the assumption of liabilities of approximately
$8,000. The acquisition was funded with cash, and as of September 30, 1999, the
Company had made all required payments to the former stockholders of CySource.
Approximately $362,000 and $240,000 were allocated to the acquired customer list
and goodwill, respectively, as a result of this transaction.
As of September 30, 1999, the Company reviewed the carrying value of the
customer list as well as the goodwill associated with the CySource acquisition
and determined the following conditions:
i) The customer database used to determine the acquisition price was
corrupted, resulting in the actual number of customers receiving
Internet access from CySource at the date of acquisition being
significantly less than was expected.
ii) Subsequent to the acquisition date, the Company experienced
significant difficulties in merging the former CySource customers into
the Company's operations, which resulted in lost subscribers well in
excess of the Company's traditional customer attrition or churn rate.
iii) Additionally, as the Company continued to review the customer service
and reputation of CySource, the Company identified that the expected
internal growth rate resulting from the acquisition of the CySource
customer base was significantly impacted in a negative manner.
The foregoing factors have resulted in a material and permanent reduction
in both the forecasted cash flows for the operation and the results for the
four-month period ended September 30, 1999. Accordingly, the Company recorded a
$254,000 charge to earnings to reflect the impairment of the customer list and
goodwill associated with this acquisition. This charge was recorded ratably
among
34
<PAGE> 36
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
these assets, and the remaining $298,000 will be amortized over the estimated
remaining useful life of the customer list and goodwill.
On August 5, 1999, the Company entered into an asset purchase agreement to
acquire substantially all of the assets of InLink Communications Company
(Inlink), an ISP located in St. Louis, Missouri, for approximately $5,217,000,
including the assumption of liabilities of approximately $478,000. The
acquisition was funded with cash, and as of September 30, 1999, the Company had
made all required payments to the former stockholders of Inlink except for
$85,000 which is included in accounts payable at September 30, 1999.
Approximately $1,301,000 and $3,678,000 were allocated to the acquired customer
base and goodwill, respectively, as a result of this transaction.
The above acquisitions were accounted for under the purchase method of
accounting, and accordingly, the purchase prices were allocated to assets
acquired and liabilities assumed based upon their estimated fair values at the
dates of acquisition. The customer lists were valued at $200 per subscriber
acquired, which represents the estimated fair value of such subscribers based
upon recent transactions in the ISP industry. Included in the purchase prices
listed above are legal and acquisition costs of approximately $224,000. For
those businesses acquired, the results of operations are included in the
Company's consolidated statement of operations from the dates of acquisition.
The unaudited pro forma combined historical results of the Company and PNI,
its predecessor, as if PNC, Qnet, Cysoure and Inlink had been acquired by the
predecessor at the beginning of the respective periods, are included in the
table below. The pro forma combined historical results for KC One Internet
Services, Inc., Web World Services, Inc., and LidaNet, Inc. were not deemed
material and are not included in the table below.
<TABLE>
<CAPTION>
NINE MONTHS
YEAR ENDED ENDED
DECEMBER 31, 1998 SEPTEMBER 30, 1999
----------------- ------------------
<S> <C> <C>
Total revenues............................... $ 9,350,099 $ 9,532,064
Net loss..................................... (7,447,087) (12,613,676)
</TABLE>
The pro forma results above include amortization of intangibles and are not
necessarily indicative of what actually would have occurred if the acquisitions
had been completed as of the beginning of each of the periods presented, nor are
they necessarily indicative of future consolidated results.
5. INVESTMENTS
At September 30, 1999, the Company held one U.S. government agency security
that is classified as held-to-maturity and is due in less than one year. This
investment's amortized cost, unrealized loss, and estimated fair value at
September 30, 1999 are $5,076,212, $1,437, and $5,074,775, respectively.
35
<PAGE> 37
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. PROPERTY AND EQUIPMENT
Property and equipment consist of the following at September 30, 1999:
<TABLE>
<S> <C>
Computer equipment......................................... $ 4,465,458
Software................................................... 478,574
Furniture, fixtures, and office equipment.................. 680,884
Capitalized collocation costs.............................. 150,236
Land, building, and leasehold improvements................. 285,552
Vehicles................................................... 71,348
-----------
6,132,052
Less accumulated depreciation and amortization............. (1,881,830)
-----------
4,250,222
Construction in progress................................... 4,650,709
===========
$ 8,900,931
===========
</TABLE>
7. INTANGIBLE ASSETS
Intangible assets consist of the following at September 30, 1999:
<TABLE>
<S> <C>
Acquired customer list..................................... $ 2,771,783
Goodwill................................................... 11,631,661
-----------
14,403,444
Less accumulated amortization.............................. (1,293,192)
-----------
$13,110,252
===========
</TABLE>
8. ACCRUED LIABILITIES
Accrued liabilities consist of the following at September 30, 1999:
<TABLE>
<S> <C>
Accrual for equipment acquired.............................. $1,836,572
Accrued payroll and related expenses........................ 366,933
Other accrued liabilities................................... 926,625
----------
$3,130,130
==========
</TABLE>
9. RELATED PARTY TRANSACTIONS
Affiliates include officers, employees, and other corporations and
partnerships that are substantially or partially owned by officers and
stockholders of the Company. The significant affiliates include CBC Distribution
and Marketing, Inc., CDM Fantasy Sports, Inc., and CDM Properties Management,
L.L.C.
36
<PAGE> 38
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As of September 30, 1999, amounts due from affiliates consist of the
following:
<TABLE>
<S> <C>
Advances to affiliates...................................... $1,020,090
Accounts receivable -- trade affiliates..................... 32,415
----------
$1,052,505
==========
</TABLE>
The advances to affiliates are unsecured, due on demand, and bear interest
at 12 percent per annum, which is payable upon repayment of the advances.
As of September 30, 1999, the amount due to affiliates was $158,375 and
consisted primarily of borrowings from affiliates. Such advances are unsecured,
due on demand, and bear interest at 12 percent per annum, which is payable upon
demand.
Revenues derived from affiliates for the period June 1, 1999 to September
30, 1999 were approximately $162,000. Expenses and costs incurred to affiliates
related to purchasing advertising, insurance, and other services for the period
June 1, 1999 to September 30, 1999 were approximately $872,000.
The Company leases office space under noncancelable operating leases from
an affiliate. The leases expire in August 2008, contain an option to renew for a
five-year term, and provide for additional rent related to the Company's share
of certain taxes and operating expenses. Rent expense associated with these
leases was approximately $57,000 for the period June 1, 1999 to September 30,
1999.
The Company leases certain computer equipment under capital leases with an
affiliate. These lease agreements required the Company to make a refundable
deposit equal to approximately 25 percent of the fair market value of the
equipment at the lease inception date, or $707,660. The assets under capital
leases are recorded at the lower of the present value of the minimum lease
payments or the fair value of the asset. The related computer equipment had a
cost and accumulated amortization of $2,565,764 and $566,902, respectively, at
September 30, 1999. Amortization of leased equipment is included in depreciation
and amortization.
37
<PAGE> 39
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Future minimum lease payments under capital leases and noncancelable
operating leases with the affiliate at September 30, 1999 are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
---------- ----------
<S> <C> <C>
2000................................................... $1,259,470 $ 170,764
2001................................................... 1,054,596 172,423
2002................................................... 260,356 181,663
2003................................................... -- 181,663
2004................................................... -- 183,710
Thereafter............................................. -- 748,610
---------- ----------
Total minimum lease payments........................... 2,574,422 $1,638,833
==========
Less amount representing interest...................... (378,302)
----------
Present value of minimum lease payments (including
current portion of $998,188)......................... $2,196,120
==========
</TABLE>
10. SENIOR SUBORDINATED DISCOUNT NOTES
The senior subordinated discount notes (the Notes), issued in connection
with the Purchase Agreement described in Note 2, mature on June 1, 2006 and were
issued at a substantial discount from their principal amount on the closing
date. Accordingly, the Notes will accrete semiannually at a rate of 12 percent
from $53,000,000 on June 1, 1999 to $84,473,948 (the Principal Amount) at June
1, 2003. Subsequently, interest will accrue on the Principal Amount at a rate of
12 percent. This interest will be due and payable on a semiannual basis
commencing on December 1, 2003 and thereafter on June 1 and December 1 of each
year until maturity. On June 1, 2006, all principal and accrued but unpaid
interest on the Notes will be due and payable. The discounted value (see Note 2)
and the liquidation value of the Notes at September 30, 1999 are $48,837,310 and
$55,100,000, respectively.
At any time prior to maturity of the Notes, the accreted value, together
with any accrued but unpaid interest, may be redeemed or prepaid in whole or in
part as long as the Company is not in default on any senior indebtedness, as
defined in the agreement. In the event of a change in control, as defined in the
agreement, the Company must offer to repay these notes for an amount equal to
101 percent of the accreted value plus any accrued but unpaid interest.
If either (a) the Notes are redeemed in whole within 9 months of closing or
(b) the Notes are redeemed in whole within 15 months of the closing date through
a qualified public offering, as defined in the agreement, the Company may
repurchase the number of shares of common stock representing one-seventh of the
total common shares issued to the investors at June 1, 1999 for $0.01.
In the event of default, as defined in the note agreement, holders of at
least a 25 percent interest in the principal amount of Notes outstanding may
declare the entire accreted value plus any accrued but unpaid interest
immediately due and payable by written notice to the Company. In addition,
holders of a 50 percent interest may (1) waive the Company's compliance with its
covenants and obligations under the Note and Purchase Agreement, (2) waive a
breach or default by the Company, or (3) rescind an acceleration of the Notes
subject to certain restrictions defined in the agreements.
38
<PAGE> 40
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
For the period June 1, 1999 to September 30, 1999, the Company was in violation
of certain covenants included in the Note and Purchase Agreement related
primarily to transactions with affiliates. The holders of Notes waived their
right to call the debt as well as these violations as of September 30, 1999.
11. EMPLOYEE BENEFIT PLAN
The Company sponsors a defined contribution 401(k) profit sharing plan
covering substantially all eligible employees. Under this plan, the Company
matches 100 percent of the first 6 percent of compensation that employees
contribute into the plan. Additional contributions may be made to the plan at
the discretion of Company management. The Company made contributions of $22,110
to the plan for the period June 1, 1999 to September 30, 1999.
12. COMMITMENTS, CONTINGENCIES, AND UNCERTAINTIES
LEASE COMMITMENTS
The Company leases vehicles and office and retail space under noncancelable
operating lease agreements with unaffiliated vendors. The leases for office and
retail space generally include renewal options and require the Company to pay a
portion of the expenses for common areas, including maintenance, real estate
taxes, and other expenses. Rent expense under these operating leases for the
period June 1, 1999 to September 30, 1999 was approximately $130,000.
The Company leases certain computer equipment under capital leases with
unaffiliated vendors. The assets under capital leases are recorded at the lower
of the present value of the minimum lease payments or the fair value of the
asset. The related computer equipment had a cost and accumulated amortization of
$611,817 and $383,489, respectively, at September 30, 1999. Amortization of
leased equipment is included in depreciation and amortization.
Future minimum lease payments under capital leases and noncancelable
operating leases with unaffiliated vendors with initial or remaining lease terms
in excess of one year are as follows at September 30, 1999:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
-------- ----------
<S> <C> <C>
2000..................................................... $146,499 $ 411,848
2001..................................................... 53,963 303,287
2002..................................................... 41,502 199,627
2003..................................................... -- 121,548
2004..................................................... -- 50,701
-------- ----------
Total minimum lease payments............................. 241,964 $1,087,011
==========
Less amount representing interest........................ (20,813)
--------
Present value of minimum lease payments (including
current portion of $138,831)........................... $221,151
========
</TABLE>
39
<PAGE> 41
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
BACKBONE AGREEMENT
The Company has agreements with its principal ISP which require payment of
minimum monthly Internet access and other charges totaling $33,520. These
agreements automatically renew unless the ISP or Company terminates them, as
described in the agreements. The Company has additional agreements with two
other ISPs related to the acquisition of Inlink (see Note 4). These agreements
require the Company to make minimum monthly payments of $6,800 and $1,300,
respectively, for a specified period ending in January 2001. The total minimum
purchase requirements under these agreements for the years ending September 30,
2000, 2001, and 2002, are $95,100, $81,600, and $20,200, respectively. Under all
agreements, additional monthly charges are incurred for the use of capacity
above the amounts contracted in the agreements. Expenses incurred under all
backbone agreements were $154,645 for the period June 1, 1999 to September 30,
1999.
LOCAL SERVICES
In August 1998, the Company's wholly owned subsidiary, PNC, entered into an
Interconnection Agreement with SWBT. The agreement establishes the terms and
conditions by which the Company and SWBT interconnect their local networks and
by which the Company gains access to unbundled elements of SWBT's network
pursuant to the Telecommunications Act of 1996. This access allows the Company
to compete effectively with SWBT in reselling local telephone service. SWBT has
appealed the PSC orders which established the agreement. While the Company has
negotiated an amendment to its Agreement with SWBT precluding an interruption of
service in the event of an adverse court ruling, the appeal leaves various
aspects of the Agreement uncertain as to duration. Furthermore, there is the
possibility that the current rates charged to the Company by SWBT could change
significantly. The Company's management and its legal counsel are unable to
estimate the probability of outcome or the potential economic impact on the
Company.
LONG DISTANCE SERVICES
The Company has a $5 million three-year supply agreement, which has been
amended subsequent to September 30, 1999 to have an effective date of February
1, 2000, with Qwest. The agreement provides for a cancellation charge to be
assessed in the event of early termination by the Company and a deficiency
charge to be assessed if the Company does not meet the minimum purchase levels
each year of the agreement. Expenses incurred with its long distance service
provider were $154,099 for the period June 1, 1999 to September 30, 1999. The
minimum purchase requirements under this agreement for the years ending
September 30, 2000, 2001, 2002, and 2003, are $830,000, $1,416,000, $2,002,000,
and $752,000, respectively.
BILLING SERVICES
The Company has a three-year agreement, effective August 7, 1998, with its
service processor that requires minimum annual purchases by the Company for
billing services. The agreement provides for a cancellation charge to be
assessed in the event of early termination by the Company and a deficiency
charge to be assessed if the Company does not meet the minimum purchase levels
each year of the agreement. Expenses incurred under this agreement were $61,642
for the period June 1, 1999 to September 30, 1999. The minimum purchase
requirements under this agreement for the years ending September 30, 2000 and
2001, are $360,000 and $300,000, respectively.
40
<PAGE> 42
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
GUARANTEES
Letters of credit issued as prerequisites for entering agreements with the
Company's significant suppliers of $117,000 were outstanding at September 30,
1999.
13. INCOME TAXES
The difference between the effective income tax rate and the U.S. federal
income tax rate is explained as follows for the period June 1, 1999 to September
30, 1999:
<TABLE>
<S> <C>
Tax at U.S. statutory tax rate............................. $(2,558,000)
State income taxes, net of federal benefit................. (228,000)
Interest on senior subordinated discount notes............. 205,000
Intangibles................................................ 333,000
Other...................................................... 9,000
Valuation allowance........................................ 2,239,000
-----------
Provision for income taxes................................. $ --
===========
</TABLE>
The components of the deferred tax asset are as follows as of September 30,
1999:
<TABLE>
<S> <C>
Vacation accruals.......................................... $ 41,000
Organizational costs....................................... 54,000
Allowance for doubtful accounts............................ 239,000
Reserve for inventory obsolescence......................... 9,000
Intangibles................................................ 237,000
Capital leases............................................. 72,000
Interest on senior subordinated discount notes............. 707,000
Property and equipment..................................... 18,000
Net operating loss carryforward............................ 2,255,000
-----------
3,632,000
Valuation allowance........................................ (3,632,000)
-----------
Total deferred taxes....................................... $ --
===========
</TABLE>
The Company's net operating loss carryforwards were approximately
$5,914,000 at September 30, 1999 and expire on various dates through 2019. The
Company has recorded a valuation allowance for the entire deferred tax asset
balance as of September 30, 1999 due to the uncertainty of its realization.
14. STOCKHOLDER EQUITY
SERIES A PREFERRED STOCK
Pursuant to the Purchase Agreement discussed in Note 2, one investor, who
also acted as a financial advisor and exclusive placement agent in the
transaction, received 2,306,765 shares of
41
<PAGE> 43
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Series A preferred stock. These preferred shares have no liquidation preference
and are not entitled to vote on matters submitted for stockholder approval.
Each preferred stockholder has the right at any time to convert any or all
shares into an equal number of common shares subject to the following:
(i) The total number of shares held by a Series A stockholder, aggregated
with any common shares held by an affiliate of such holder, and after
giving effect to the proposed conversion, shall be less than 5 percent
of the total shares of common stock outstanding immediately after such
conversion.
(ii) Upon the occurrence of a change in federal law that permits a
registered bank holding company to acquire in excess of 5 percent of
the voting shares of the Company, a Series A stockholder may convert
its shares to common stock to the maximum extent permitted by
then-current federal law.
(iii) In the event the Company (a) subdivides its outstanding shares of
common stock into a larger number of shares or (b) combines its
outstanding shares of common stock into a smaller number of shares,
then the number of shares of common stock into which the Series A
preferred stockholder are convertible shall also be adjusted
proportionally.
WARRANTS
Also in connection with the Purchase Agreement discussed in Note 2, the
Company issued 4,476,423 detachable non-callable warrants to the Investors. The
warrants entitle the holders to purchase common shares of the Company at a price
of $3.385 per share. The warrants may be exercised by a cash payment or a
cashless exercise following either (i) the occurrence of a qualified public
offering or (ii) upon delivery of the subordinated notes for cancellation in an
accreted principal amount, along with any interest, equal to the exercise price.
The warrants are also subject to certain anti-dilution adjustments, as defined
in the Purchase Agreement, for any changes in the Company's outstanding shares
during the period the warrants are outstanding. The warrants expire on June 1,
2006 and can be exercised at any time.
STOCK OPTION PLAN
In July 1999, the Company established a stock option plan under which both
qualified and nonqualified options to purchase up to 3,468,820 shares of common
stock are available to be granted to employees, directors, and consultants. At
September 30, 1999, 753,579 shares are available for grant under the plan. The
plan is administered by the Board of Directors. No option can be for a term of
more that ten years from the date of grant. The option price and the vesting
provisions are determined by the Board of Directors at the date of grant.
42
<PAGE> 44
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Stock option activity under the plan during the period June 1, 1999 to
September 30, 1999 is as follows:
<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF AVERAGE
OPTIONS EXERCISE PRICE
--------- ----------------
<S> <C> <C>
Outstanding at June 1, 1999........................... -- $ --
Granted............................................... 2,715,241 1.52
Exercised, forfeited, and expired..................... -- --
--------- -----
Outstanding at September 30, 1999..................... 2,715,241 $1.52
========= =====
Exercisable at September 30, 1999..................... 366,295 $1.52
========= =====
</TABLE>
Pro forma information regarding results of operations is required by SFAS
No. 123 as if the Company had accounted for its stock-based awards under the
fair value method of SFAS No. 123. The fair value of the Company's stock-based
awards to employees has been estimated using the minimum value option pricing
model which does not consider stock price volatility.
Because the Company does not have actively traded equity securities,
volatility is not considered in determining the fair value of the stock-based
awards.
For the period June 1, 1999 to September 30, 1999, the fair value of the
Company's stock-based awards was estimated using the following weighted average
assumptions:
<TABLE>
<S> <C>
Expected life of options in years........................... 3
Risk-free interest rate..................................... 5.5 percent
Expected dividend yield..................................... 0.0 percent
</TABLE>
The weighted average remaining contractual life of the stock options
outstanding at September 30, 1999 is approximately ten years. The per share
weighted average fair value of stock options granted during the period June 1,
1999 to September 30, 1999 was zero. Accordingly, for pro forma purposes, the
estimated fair value of the Company's stock-based awards which is to be
amortized over the options' vesting period would have resulted in no change in
the Company's reported net loss for the period June 1, 1999 to September 30,
1999.
The effect of applying SFAS No. 123 to pro forma net income (loss) as
stated above is not necessarily representative of the effects on reported net
income (loss) for future periods due to, among other things, the vesting period
of the stock options and the fair value of additional stock options granted in
future years.
SHARES RESERVED FOR FUTURE ISSUANCE
Common stock shares reserved for future issuance as of September 30, 1999
are as follows:
<TABLE>
<S> <C>
Warrants.................................................... 4,476,423
Convertible Series A preferred stock........................ 2,306,765
Stock options............................................... 3,468,820
----------
10,252,008
==========
</TABLE>
43
<PAGE> 45
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. SEGMENT INFORMATION
The Company has three reportable segments, Internet, Retail, and
Communications, which are separate operating units that offer different products
and services and are managed accordingly. Performance of each segment is
evaluated by management based on income (loss) before income taxes. Transactions
between segments are reported at fair value and the accounting policies of the
segments are the same as those in Note 1. The corporate and eliminations segment
includes corporate assets, principally consisting of cash and cash equivalents,
investments and debt issuance costs, corporate activities and the elimination of
intersegment transactions. In addition, as a result of the transactions
described in Notes 1 and 2, the Company adjusted its segment reporting structure
whereby interest expense is no longer allocated to its three reportable
segments.
The Internet segment provides full service access to the Internet for
corporate and residential customers including dial-up and dedicated services and
activities related to set up and installation, selling equipment and software.
The Retail segment sells cellular and other wireless communication products,
including phones, pagers, and related accessories. The Communications segment
provides facilities-based and resold basic local telecommunications service,
including dedicated/non-switched local exchange services, and intrastate
interexchange services.
The following segment information is as of September 30, 1999 or for the
four months then ended:
<TABLE>
<CAPTION>
CORPORATE
AND
INTERNET RETAIL COMMUNICATIONS ELIMINATIONS TOTAL
----------- -------- -------------- ------------ -----------
<S> <C> <C> <C> <C> <C>
Revenues from external
customers................... $ 2,881,055 $350,715 $ 850,367 $ -- $ 4,082,137
Intersegment revenues......... 4,554 73,792 86,434 (164,780) --
Depreciation and
amortization................ 1,145,516 9,848 593,897 17,640 1,766,901
Impairment charge (Note 4).... 254,132 -- -- -- 254,132
Interest expense.............. -- -- -- 2,701,311 2,701,311
Loss before income taxes...... (1,081,229) (77,424) (2,198,581) (3,951,469) (7,308,703)
Segment assets................ 14,466,339 234,800 10,075,595 36,987,683 61,764,417
Capital expenditures, net of
accounts payable............ 431,129 -- 3,092,593 248,334 3,772,056
</TABLE>
16. SUBSEQUENT EVENTS
ACQUISITIONS
Subsequent to year-end, the Company made the following acquisitions:
On October 1, 1999, the Company purchased substantially all of the assets
of Information Systems Technologies, Inc. for approximately $591,000, net of
liabilities assumed.
On October 6, 1999, the Company purchased substantially all of the assets
of Business Products Systems Internet, Inc. for approximately $700,000, net of
liabilities assumed.
On October 13, 1999, the Company purchased substantially all of the assets
of UNI Networking Inc. for approximately $345,000, net of liabilities assumed.
On October 20, 1999, the Company purchased all of the outstanding common
stock of GlobalVision Systems, Inc. for approximately $3,102,000, net of cash
acquired and liabilities assumed.
44
<PAGE> 46
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On November 1, 1999, the Company purchased all of the outstanding common
stock of Harvest Telecom, Inc. for approximately $50,000.
On November 10, 1999, the Company purchased all of the outstanding common
stock of Digital Internet Access, Inc. for approximately $1,418,000, net of cash
acquired and liabilities assumed.
SECONDMENT AGREEMENT
On November 23, 1999, the Company entered into a Secondment Agreement with
an investor to obtain certain services to be provided by an employee of the
investor. Under the terms of the agreement, the Company is required to pay
$17,500 per month for the services, including out-of-pocket expenses.
Furthermore, the seconded employee was issued 680,000 shares of Series B
preferred stock which vests in eight equal quarterly installments over a
two-year period and warrants with an exercise price of $1.52 per share to
purchase an additional 520,000 shares of Series B preferred stock which vest in
three equal annual installments. Furthermore, the investor was issued 170,000
shares of Series B preferred stock and was granted warrants with an exercise
price of $1.52 to purchase an additional 130,000 shares of Series B preferred
stock, both with the same vesting terms as the seconded employee described
above. All of the above issuances and grants vest immediately upon the
occurrence of certain events described in the agreement, including a change in
control. The Company will recognize the applicable compensation expense related
to these transactions ratably over the vesting period. Finally, the investor is
entitled to receive a fee, payable immediately, in the event the Company
consummates certain transactions outlined in the agreement prior to June 1,
2000, including a change in control, obtaining senior debt from a financial
institution, or issuing additional subordinated debt or equity securities.
LEASE TRANSACTIONS
On February 23, 2000, the Company entered into an equipment capital lease
to finance its continued build out of collocations. Under the terms of the
lease, the Company is required to make thirty-six equal monthly payments of
approximately $122,000 and has the guaranteed option to purchase the equipment
at 10% of original purchase price or approximately $3,700,000. The assets under
the capital lease are recorded at the lower of the present value of the minimum
lease payments or the fair value of the equipment. The lease is secured by the
equipment financed.
On March 31, 2000, the Company entered into a sale leaseback agreement,
whereby the Company sold collocation equipment with a book value of
approximately $8,000,000 and subsequently entered into a capital lease for
approximately $9,400,000, including the financing of approximately $900,000 in
equipment maintenance agreements. The assets under the capital lease are
recorded at the lower of the present value of the minimum lease payments or the
fair value of the equipment. The gain resulting from this transaction of
approximately $500,000 is being amortized over the term of the lease. Under the
terms of the lease, the Company is required to make six monthly payments of
approximately $106,000 and then thirty monthly payments of approximately
$340,000. In addition to the equipment being financed under the lease, the
Company granted the lessor an additional security interest in substantially all
tangible and intangible assets of the Company. The lessor has provided a
contingent clause in the agreement for the release of the additional security
upon the Company obtaining unrestricted cash equity proceeds in the amount of
$50,000,000 or greater. The lease agreement also contains covenants requiring
the Company to maintain certain debt to total contributed capital ratios as well
as requiring the Company to secure future minimum commitments of either secured
bridge debt or unrestricted equity by various dates.
45
<PAGE> 47
PRIMARY NETWORK HOLDINGS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
LEASE COMMITMENT
On April 15, 2000 the Company entered into an agreement for the lease of a
new office building. The term of the agreement is five years with total annual
rent of approximately $1,200,000. In addition, the Company has committed
$3,900,000 for leasehold improvements and certain equipment purchases related to
this property.
PENDING TRANSACTION
On April 17, 2000, the Company signed an agreement and plan of merger
(merger agreement) with Mpower Communications Corp. (A/K/A MGC Communications,
Inc.).
In connection with the consummation of the merger agreement, the following
will occur:
(i) The Company's stockholders will exchange their shares in the Company
for 1,350,000 shares of common stock of Mpower Communications Corp.
(Mpower). Each outstanding share of the Company's common stock and
preferred stock will be converted into .02022 shares of Mpower
common stock.
(ii) All of the Company's stock options outstanding under the Company's
stock option plan shall continue to have, and be subject to, the
same terms and conditions as set forth in the Company's stock option
plan and the agreements pursuant to which such Company stock options
were issued, except that each Company stock option shall be
exercisable for .02022 shares of Mpower common stock and the price
per share will be adjusted accordingly.
(iii) The Company's 4,476,423 detachable non-callable warrants to the
Investors that entitle the holders to purchase common shares of the
Company at a price of $3.385 per share shall continue to be subject
to the same terms and conditions, except that each warrant shall be
exercisable for .02022 shares of Mpower common stock and the price
per share will be adjusted accordingly.
(iv) Mpower will assume approximately $80,000,000 of net liabilities of
the Company, a portion of which will be swapped for additional
high-yield bonds to be issued under Mpower's recent high-yield
financing indenture. The holders of the swapped debt will also
receive 50,000 shares of Mpower common stock.
(v) Mpower will become the sole stockholder of the Company.
NOTE PAYABLE
On April 27, 2000 the Company issued a $10,000,000 senior promissory note
(senior note) to Mpower due the earliest of April 17, 2001, upon a change of
control of the Company other than the pending transaction discussed above, or
upon the event of default, as defined. Interest accrues at 15 percent per annum
until the maturity date. After the maturity date, interest accrues at 18 percent
per annum until the senior note is paid in full. At any time prior to maturity
of the senior note, the unpaid principal amount of the senior note together with
any accrued but unpaid interest may be prepaid in whole or in part as long as
the Company has provided at least 15 business days notice to Mpower.
Due to the issuance of this senior note, the Company was in violation of a
covenant included in the Note and Purchase Agreement (See Note 10) related
primarily to limitations of indebtedness. The holders of Notes waived their
right to call the debt as well as this violation as of April 27, 2000.
46
<PAGE> 48
FINANCIAL STATEMENTS
CDM ON-LINE, INC.
FOR THE PERIOD JANUARY 1, 1999 TO MAY 31, 1999
WITH REPORT OF INDEPENDENT AUDITORS
47
<PAGE> 49
CDM ON-LINE, INC.
FINANCIAL STATEMENTS
FOR THE PERIOD JANUARY 1, 1999 TO MAY 31, 1999
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors.............................. 49
Financial Statements
Balance Sheet............................................... 50
Statement of Operations..................................... 51
Statement of Stockholders' Equity........................... 52
Statement of Cash Flows..................................... 53
Notes to Financial Statements............................... 54
</TABLE>
48
<PAGE> 50
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
CDM On-Line, Inc.
We have audited the accompanying balance sheet of CDM On-Line, Inc. as of
May 31, 1999 and the related statements of operations, stockholders' equity, and
cash flows for the period January 1, 1999 to May 31, 1999. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of CDM On-Line, Inc. at May 31,
1999 and the results of its operations and its cash flows for the period January
1, 1999 to May 31, 1999, in conformity with accounting principles generally
accepted in the United States.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note 1, the
Company has incurred significant operating losses and has an accumulated
deficit. These conditions raise substantial doubt about the Company's ability to
continue as a going concern. Management's plans in regard to these matters are
also described in Note 1. The May 31, 1999 financial statements do not include
any adjustments that might result from the outcome of this uncertainty.
ERNST & YOUNG LLP
November 19, 1999
St. Louis, Missouri
49
<PAGE> 51
CDM ON-LINE, INC.
BALANCE SHEET
MAY 31, 1999
<TABLE>
<S> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 73,938
Accounts receivable, less allowance for doubtful accounts
of $126,845............................................ 558,980
Due from affiliates....................................... 1,624,811
Inventory, less reserve for obsolescence of $23,450....... 96,326
Other current assets...................................... 24,105
-----------
Total current assets........................................ 2,378,160
Property and equipment, net................................. 1,397,284
Refundable capital lease deposit with affiliate............. 295,739
Intangible assets, net...................................... 369,847
-----------
$ 4,441,030
===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 845,452
Accrued expenses.......................................... 336,555
Unearned revenues......................................... 471,443
Current maturities of capital lease obligations........... 388,473
Due to affiliates......................................... 160,018
-----------
Total current liabilities................................... 2,201,941
Capital lease obligations, less current maturities.......... 492,346
Stockholders' equity:
Common stock, $.15 par value; 2,000,000 shares
authorized............................................. 224,519
Additional paid-in capital................................ 6,680,887
Accumulated deficit....................................... (4,933,386)
-----------
1,972,020
Treasury stock at cost.................................... (225,277)
-----------
1,746,743
-----------
$ 4,441,030
===========
</TABLE>
See accompanying notes.
50
<PAGE> 52
CDM ON-LINE, INC.
STATEMENT OF OPERATIONS
FOR THE PERIOD JANUARY 1, 1999 TO MAY 31, 1999
<TABLE>
<S> <C>
Revenues:
Access revenues........................................... $2,070,368
Retail revenues........................................... 518,124
Other revenues............................................ 244,792
----------
2,833,284
Costs and expenses:
Costs of access revenues.................................. 614,441
Costs of retail revenues.................................. 299,287
Costs of other revenues................................... 160,967
Operations and customer support........................... 387,078
Sales and marketing....................................... 377,952
General and administrative................................ 978,661
Retail store expenses..................................... 518,571
Depreciation and amortization............................. 168,923
----------
3,505,880
----------
Loss from operations........................................ (672,596)
Other income (expense):
Interest expense -- affiliates............................ (18,009)
Interest expense.......................................... (1,149)
Interest income -- affiliates............................. 8,671
Other income, net......................................... 1,177
----------
Loss from continuing operations............................. (681,906)
Loss from disposal of discontinued Web development division
(Note 12)................................................. (81,785)
----------
Net loss.................................................... $ (763,691)
==========
</TABLE>
See accompanying notes.
51
<PAGE> 53
CDM ON-LINE, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE PERIOD JANUARY 1, 1999 TO MAY 31, 1999
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL TREASURY STOCK
-------------------- PAID-IN ACCUMULATED ------------------
SHARES AMOUNT CAPITAL DEFICIT SHARES AMOUNT
--------- -------- ---------- ----------- ------ ---------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1998..................... 1,222,406 $183,361 $3,841,839 $(4,169,695) 5,393 $ (59,239)
Net loss................... -- -- -- (763,691) -- --
Contribution of services... -- -- 233,162 -- -- --
Sale of stock.............. 214,298 32,145 2,214,027 -- -- --
Sale of stock to employees
under employee stock
purchase plan............ 850 127 10,130 -- -- --
Stock awards to
employees................ 59,241 8,886 381,729 -- -- --
Common stock purchased for
treasury................. -- -- -- -- 13,756 (166,038)
--------- -------- ---------- ----------- ------ ---------
Balance at May 31, 1999.... 1,496,795 $224,519 $6,680,887 $(4,933,386) 19,149 $(225,277)
========= ======== ========== =========== ====== =========
</TABLE>
See accompanying notes.
52
<PAGE> 54
CDM ON-LINE, INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD JANUARY 1, 1999 TO MAY 31, 1999
<TABLE>
<S> <C>
OPERATING ACTIVITIES
Net loss.................................................... $ (763,691)
Adjustments to reconcile net loss to net cash provided by
operating activities:
Depreciation and amortization............................. 185,939
Stock-based compensation expense.......................... 390,615
Allowance for doubtful accounts........................... 37,760
Changes in operating assets and liabilities:
Accounts receivable.................................... (280,550)
Due from affiliates.................................... (53,896)
Inventory.............................................. 34,208
Other current assets................................... 17,013
Refundable capital lease deposit with affiliate........ (295,739)
Other assets........................................... 174,105
Accounts payable....................................... 472,888
Accrued expenses....................................... 151,513
Unearned revenues...................................... 80,895
-----------
Net cash provided by operating activities................... 151,060
INVESTING ACTIVITIES
Advances to affiliates...................................... (1,302,159)
Business acquisition costs.................................. (454,783)
Purchases of property and equipment......................... (147,559)
-----------
Net cash used in investing activities....................... (1,904,501)
FINANCING ACTIVITIES
Principal payments of obligations under capital leases...... (37,263)
Net payments under line of credit........................... (20,000)
Purchase of common stock held in treasury................... (166,038)
Due to affiliates........................................... (506,329)
Proceeds from issuance of common stock...................... 2,256,429
-----------
Net cash provided by financing activities................... 1,526,799
-----------
Net decrease in cash and cash equivalents................... (226,642)
Cash and cash equivalents at beginning of period............ 300,580
-----------
Cash and cash equivalents at end of period.................. $ 73,938
===========
SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid during period for:
Interest.................................................. $ 19,158
===========
Noncash investing and financing transaction:
Capital lease obligations incurred........................ $ 918,082
===========
</TABLE>
See accompanying notes.
53
<PAGE> 55
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS
MAY 31, 1999
1. ORGANIZATION/BASIS OF PRESENTATION
CDM On-Line, Inc. (the Company) is a local provider of Internet access and
other Internet-related services in St. Louis and Kansas City, Missouri. In
addition, the Company serves as an authorized agent of Southwestern Bell Mobile
Systems and operates cellular and other wireless communication products retail
stores in the St. Louis metropolitan area. The Company was organized on
September 23, 1994 (Inception) and began providing Internet services in July
1995. The Company commenced its retail operations in November 1996. The
Company's targeted markets include residential and business customers in
Missouri.
The financial statements of the Company for the period January 1, 1999 to
May 31, 1999 have been prepared on a going-concern basis, which contemplates the
realization of assets and the settlement of liabilities and commitments in the
normal course of business. The Company incurred a net loss of $763,691 for the
five-month period ended May 31, 1999 and as of May 31, 1999 had an accumulated
deficit of $4,933,386. Additionally, the Company continues to commit substantial
capital expenditures as it relates to improvements and upgrades to its
infrastructure, which are necessary for the Company to be able to offer its
future core services. These conditions raise substantial doubt about the
Company's ability to continue as a going concern. Furthermore, the online
services and Internet markets are highly competitive. The Company believes that
existing competitors, Internet-based services, Internet services providers
(ISPs), Internet directory services, and telecommunications companies are likely
to enhance their service offerings, resulting in greater competition for the
Company. The competitive conditions could have the following effects: require
additional pricing programs, increase spending on marketing, limit the Company's
ability to expand its subscriber base, and result in increased attrition in the
existing subscriber base. The Company's viability as a going concern is
dependent upon management's operational and financing plans to address these
conditions which include, but are not limited to, obtaining additional equity
and debt financing, continuing investments in its infrastructure to increase its
efficiency and capacity to serve additional customers, and employing marketing
strategies to increase its customer base. Although there can be no assurance
that growth in the Company's revenues or subscriber base will continue or that
the Company will be able to achieve or sustain profitability or positive cash
flow, the Company believes that these steps are appropriate and will enable the
Company to effectively reorganize its operations. Under current circumstances,
the Company's ability to continue as a going concern depends upon the successful
implementation of its plan. If the Company is unsuccessful in its efforts, it
may be necessary to undertake such other actions as may be appropriate to
preserve asset values. The financial statements do not include any adjustments
to reflect the possible future effects on the recoverability and classification
of assets or the amounts and classification of liabilities that may result from
the outcome of this uncertainty.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect reported amounts in the financial statements and
accompanying notes. Actual results could differ from those estimates.
54
<PAGE> 56
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid financial instruments with maturity
of three months or less at the time of purchase to be cash equivalents.
PROPERTY AND EQUIPMENT
Property and equipment, including leasehold improvements, are stated at
cost. Costs related to software developed for internal use are capitalized in
accordance with AcSEC Statement of Position 98-1, Accounting for the Costs of
Computer Software Developed For or Obtained For Internal Use. Depreciation is
calculated using the straight-line method over the estimated useful lives
ranging from 18 months to 15 years. Leasehold improvements are amortized over
the lesser of the related lease term or the useful life of the assets.
Equipment acquired under capital leases is amortized over its related lease
terms or its estimated productive useful lives, depending on the criteria met in
determining the lease's qualification as a capital lease. Costs of repairs and
maintenance are charged to expense as incurred.
INVENTORY
Inventory consists of cellular and other wireless communication products
and accessories and is stated at the lower of cost (specific identification
basis) or market.
CUSTOMER LISTS
The cost of customer lists acquired is being amortized over three years
using the straight-line method.
GOODWILL
Goodwill, which represents the cost in excess of the fair market value of
identifiable net assets acquired, is being amortized using the straight-line
method over three years.
IMPAIRMENT OF LONG-LIVED ASSETS
At each balance sheet date, management determines whether any property or
equipment or any other assets have been impaired based on the criteria
established in Statement of Financial Accounting Standards (SFAS) No. 121,
Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be
Disposed Of. The Company made no adjustments to the carrying values of its
assets during the period January 1, 1999 to May 31, 1999.
STOCK COMPENSATION
The Financial Accounting Standards Board's SFAS No. 123, Accounting for
Stock-Based Compensation, establishes the use of the fair value-based method of
accounting for stock-based employee compensation arrangements, under which
compensation cost is determined using the fair value of stock-based compensation
determined as of the grant date and is recognized over the periods in which the
related services are rendered. SFAS No. 123 also permits companies to elect to
continue using the intrinsic value accounting method specified in Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB
25), and related interpretations to account for stock-based compensation. The
Company has elected to retain the intrinsic value-based method and will
55
<PAGE> 57
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
disclose in its financial statements the pro forma effect of using the fair
value-based method to account for its stock-based compensation.
REVENUE RECOGNITION
Access revenues: Internet customers are billed in advance for the periods
for which Internet services are provided. Internet access service plans range
from one month to one year. The Company defers recognition of revenue on these
advance billings and amortizes the amounts to revenue on a straight-line basis
as the services are provided.
Retail revenues: These revenues consist primarily of retail product sales
of cellular and other wireless products, such as phones, pagers, and related
accessories. Such sales are recorded upon customer purchase. The Company also
generates revenues from activation commissions from cellular carriers for each
new cellular phone subscription sold by the Company. Revenue from such
commissions is recorded upon customer subscription. New subscription activation
commissions are fully refundable if the subscriber cancels service within a
certain minimum period of continuous active service (generally 180 days).
Customers generally sign a service agreement that requires a customer deposit,
which is forfeited in case of early cancellation. At May 31, 1999, the Company's
allowance for accounts receivable includes an amount for estimated cancellation
losses, net of deposit forfeitures.
The Company generally receives monthly residual income from the cellular
service providers based on a percentage of actual phone usage by subscribers.
Revenue from residual income is recorded as the cellular service is provided.
Revenue from prepaid pager service is deferred and recognized over the period
service is provided, usually annually. Revenue from monthly installment pager
service contracts is recorded as received.
Other revenues: Other revenues consist of setup and installation fees and
selling equipment and software.
COSTS OF REVENUES
Costs of access revenues primarily consist of telecommunications expenses
inherent in the network infrastructure, including fees paid for the lease of the
Company's backbone. Costs of retail revenues consist of the costs of cellular
and other wireless communication products and accessories purchased for resale.
Costs of other revenues primarily consist of the costs of equipment and software
purchased for resale.
ADVERTISING COSTS
All advertising and promotion costs are expensed as incurred and totaled
$77,567 for the period January 1, 1999 to May 31, 1999.
INCOME TAXES
The Company is treated as an S Corporation under the provisions of the
Internal Revenue Code, whereby the Company's income or loss is allocated to the
individual stockholders for federal income tax purposes. While the Company is
not subject to federal income taxes, it is subject to certain state and local
taxes, which were not significant for the period presented.
56
<PAGE> 58
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
If the Company had been subject to federal and certain state income taxes
for the period ended May 31, 1999, the Company would have been in a net deferred
tax asset position, which would have been fully offset by a valuation allowance.
Any tax benefit or provision for the period ended also would have been fully
offset by changes in the deferred tax asset valuation allowance. Therefore,
unaudited pro forma income tax information is not presented in accordance with
Statement of Financial Accounting Standards No. 109, "Accounting for Income
Taxes," as if the Company had been subject to federal and certain state income
taxes.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash and accounts receivable.
The cash is held by a high-credit-quality financial institution. For accounts
receivable, the Company performs ongoing credit evaluations of the financial
condition of its customers and does not require collateral. The Company
maintains reserves for credit losses, and such losses have been within
management's expectations. The concentration of credit risk is mitigated by the
large customer base. The net carrying amount of the receivables approximates
their fair value.
SOURCES OF SUPPLIES
The Company relies on local telephone companies and other companies to
provide data communications. Although management feels alternative
telecommunication facilities could be found in a timely manner, any disruption
of these services could have an adverse effect on operating results.
Although the Company attempts to maintain numerous vendors for required
products, its modems, terminal servers, and high-performance routers, which are
important components of its network, are each currently acquired from three
sources. In addition, some of the Company's suppliers have limited resources and
production capacity. If the suppliers are unable to meet the Company's needs as
its network infrastructure grows, then delays and increased costs in the
expansion of the Company's network infrastructure could result, having an
adverse effect on operating results.
3. BUSINESS COMBINATIONS
During the period January 1, 1999 to May 31, 1999, the Company acquired
certain assets from three Internet access service providers as described below:
On February 17, 1999, the Company purchased the customer list of KC One
Internet Services, Inc. for approximately $75,000. Approximately $37,000 was
allocated to the acquired customer list, and approximately $38,000 was allocated
to goodwill.
On March 31, 1999, the Company entered into an asset purchase agreement to
acquire the customer base and certain computer equipment of Web World Services,
Inc. for approximately $167,000, including approximately $19,000 for the payment
of a liability related to terminating a lease agreement. Approximately $65,000
was allocated to the acquired customer list, and approximately $89,000 was
allocated to goodwill.
On April 9, 1999, the Company entered into an asset purchase agreement to
acquire the customer base and certain networking equipment of Lidanet, Inc. for
approximately $213,000, including approximately $72,000 for the payment of
certain liabilities related to terminating certain lease agreements.
Approximately $103,000 was allocated to the acquired customer list, and
approximately $68,000 was allocated to goodwill.
57
<PAGE> 59
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The above acquisitions were accounted for under the purchase method, and
accordingly, the purchase prices were allocated to assets acquired and
liabilities assumed based upon their estimated fair values at the dates of
acquisition. The customer lists were valued at $200 per subscriber acquired,
which represents the estimated fair value of such subscribers based upon recent
transactions in the ISP industry. Included in the purchase prices listed above
are legal and acquisition costs of $30,000. For those businesses acquired, the
results of operations are included in the Company's statement of operations from
the dates of acquisition.
The combined historical results for KC One Internet Services, Inc., Web
World Services, Inc., and LidaNet, Inc. were not deemed to be material and thus
the unaudited proforma combined historical results are not presented.
4. PROPERTY AND EQUIPMENT
Property and equipment consist of the following at May 31, 1999:
<TABLE>
<S> <C>
Computer equipment.......................................... $1,801,319
Software.................................................... 170,512
Furniture, fixtures, and office equipment................... 33,864
Land, building, and leasehold improvements.................. 109,930
Vehicles.................................................... 44,913
----------
2,160,538
Less accumulated depreciation and amortization.............. (763,254)
----------
$1,397,284
==========
</TABLE>
5. RELATED PARTY TRANSACTIONS
Affiliates include officers, employees, and other corporations and
partnerships that are substantially or partially owned by officers and
stockholders of the Company. The significant affiliates include CBC Distribution
and Marketing, Inc., CDM Fantasy Sports, Inc., CDM Properties Management, L.L.C.
(CDM Properties), and BroadSpan Communications, Inc. (BroadSpan).
As of May 31, 1999, amounts due from affiliates consist of the following:
<TABLE>
<S> <C>
Advances to affiliates...................................... $1,454,331
Accounts receivable -- trade affiliates..................... 170,480
----------
$1,624,811
==========
</TABLE>
The advances to affiliates are unsecured, due on demand, and bear interest
at 12 percent per annum, which is payable upon repayment of the advances.
As of May 31, 1999, the advances due to affiliates was $160,018 and
consisted primarily of borrowings from affiliates. Such advances are unsecured,
due on demand, and bear interest at 12 percent.
Revenues derived from affiliates related to providing Internet access and
other services for the period January 1, 1999 to May 31, 1999 were approximately
$126,172. Expenses and costs incurred to affiliates related to purchasing
advertising and insurance for the period January 1, 1999 to May 31, 1999 were
approximately $23,332.
58
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CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The Company leases office space under noncancelable operating leases from
an affiliate. The leases expire in August 2008, contain an option to renew for a
five-year term, and provide for additional rent related to the Company's share
of certain taxes and operating expenses. Rent expense associated with these
leases was approximately $36,000 from January 1, 1999 to May 31, 1999, and such
amounts and the future minimum lease payment are included in the disclosure in
Note 10.
The Company leases certain network-related equipment on a month-to-month
basis from an affiliate. Rent expense for the equipment for the period January
1, 1999 to May 31, 1999 was approximately $29,000. Total future minimum lease
payments under these month-to-month leasing arrangements are expected to
approximate $35,000 and will be paid within one year.
An affiliate provides the Company the use of its programmers, certain
equipment, payroll services and the administration of the 401(k) defined
contribution plan. All labor and administrative costs provided by the affiliate
were expensed and were $233,162 during the five months ended May 31, 1999.
In May 1999, the Company sold its investment in Interchange Technologies,
Inc., which was an investment in a private company that provided educational
courses over the Internet, to CDM Properties for $160,000. This purchase price
represented the net book value of that investment on the date of sale, and
accordingly, no gain or loss occurred as a result of this transaction.
6. INTANGIBLE ASSETS
Intangible assets consisted of the following at May 31, 1999:
<TABLE>
<S> <C>
Acquired customer list...................................... $206,000
Goodwill.................................................... 195,083
--------
401,083
Less accumulated amortization............................... (31,236)
--------
$369,847
========
</TABLE>
7. ACCRUED LIABILITIES
Accrued liabilities consisted of the following at May 31, 1999:
<TABLE>
<S> <C>
Due to employee from treasury stock transaction............. $125,000
Other....................................................... 211,555
--------
$336,555
========
</TABLE>
8. EMPLOYEE BENEFIT PLAN
Employees of the Company are eligible to participate in a defined
contribution 401(k) profit sharing plan, sponsored by an affiliate, covering
substantially all eligible employees. The Company matches 100 percent of the
first 6 percent of compensation that employees contribute into the plan.
Additional contributions may be made to the plan at the discretion of Company
management. The Company made contributions of $20,310 to the plan for the period
January 1, 1999 to May 31, 1999.
59
<PAGE> 61
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
9. LINE OF CREDIT
The Company has a line of credit with a bank allowing borrowings of up to
$25,000. Interest is payable monthly at the bank's prime rate plus .5 percent
(9.00 percent at May 31, 1999). The principal balance and any unpaid accrued
interest are payable on November 20, 1999. The line is secured by accounts
receivable, inventory, and property and equipment and is personally guaranteed
by certain stockholders. No borrowings were outstanding against the line at May
31, 1999.
10. COMMITMENTS
LEASE COMMITMENTS
The Company leases vehicles and office and retail space under noncancelable
operating lease agreements. The leases for office and retail space generally
include renewal options and require the Company to pay a portion of the expenses
for common areas, including maintenance, real estate taxes, and other expenses.
Rent expense under all operating leases for the period January 1, 1999 to May
31, 1999 was $123,894.
The Company leases certain computer equipment under capital leases with an
affiliate. These lease agreements require the Company to make a refundable
deposit equal to approximately 25 percent of the fair market value of the
equipment at the lease inception date. The total amount deposited to this
affiliate under these leases was $295,739. The assets under capital leases are
recorded at the lower of the present value of the minimum lease payments or the
fair value of the asset. The related computer equipment had a cost and
accumulated amortization of $918,082 and $53,830, respectively, at May 31, 1999.
Amortization of leased equipment is included in depreciation and amortization.
Future minimum lease payments under capital leases and noncancelable
operating leases with initial or remaining lease terms in excess of one year
(including operating lease commitments to affiliates disclosed in Note 5) are as
follows at May 31, 1999:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
---------- ----------
<S> <C> <C>
2000................................................... $ 488,049 $ 349,451
2001................................................... 399,001 338,982
2002................................................... 147,694 316,531
2003................................................... -- 211,748
2004................................................... -- 198,590
Thereafter............................................. -- 433,971
---------- ----------
Total minimum lease payments........................... 1,034,744 $1,849,273
==========
Less amount representing interest...................... 153,925
----------
Present value of minimum lease payments (including
current portion of $388,473)......................... $ 880,819
==========
</TABLE>
BACKBONE AGREEMENT
At May 31, 1999, the Company has three agreements with its principal ISP
which require payment of minimum monthly Internet access and other charges
totaling $19,185 per month.
60
<PAGE> 62
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
Additional monthly charges are incurred for the use of capacity above the
amounts contracted in the agreements. The agreements automatically renew on a
month-to-month basis unless the ISP or Company terminates them, as described in
the agreements. Expenses incurred under these agreements were $120,405 for the
period January 1, 1999 to May 31, 1999.
11. STOCKHOLDER EQUITY
Restrictive Stock Agreement
Under the terms of the 1994 restrictive stock agreement, as subsequently
amended in November 1996, certain employees/stockholders are restricted in their
ability to sell common stock of the Company. Specifically, if a stockholder
desires to sell Company common stock, written consent of the sale must be
obtained from the Company. In the absence of written consent, the Company
possesses a "right of first refusal" under which the employees/stockholders must
first offer the stock for sale to the Company before it may be sold to another
party. The purchase price for common stock purchased under the right of first
refusal is based on book value. The Company also has the right to purchase
common stock from an employee under voluntary or involuntary termination, as
defined. The purchase price for a voluntary termination is the book value, while
for involuntary termination the purchase price is a formula price defined in the
agreement. If the Company decides not to exercise its right of first refusal or
right to purchase stock in the event of termination, each stockholder has the
right for a certain period of time to purchase such common stock at the same
price and terms as the Company's rights. The restrictive stock agreement also
obligates the Company to repurchase, at a formula price, all of the stock owned
by an employee/stockholder in the event of death.
Common Stock
In December 1997, the Board of Directors approved the implementation of an
employee stock purchase program whereby employees eligible for the 401(k)
defined contribution plan are also eligible to purchase Company stock through
payroll withholdings. Purchases of Company stock are made at the end of each
quarter at a price determined by a formula, essentially based on multiples of
sales and certain other factors. During the period January 1, 1999 to May 31,
1999, employees purchased 850 shares of stock through the stock purchase program
for $10,257. Employees may sell and the Company is obligated to buy common stock
purchased under the program at the formula price in the quarter in which the
common stock is sold. Repurchased shares are carried as treasury stock, at cost.
In December 1997, the Company granted an officer an option to purchase
10,000 shares of common stock at an exercise price of $15 per share. The option
vested immediately and expires five years from the grant date.
In January 1998, the Board of Directors awarded 9,000 shares of common
stock to certain employees, of which 1,100 vested immediately. The remaining
7,900 shares of common stock were to vest after the completion of two years of
service ending December 1999, at which time the earned shares of common stock
would be issued. In January 1999, one employee was terminated by the Company,
and the related 500 shares were forfeited and canceled. Compensation cost was
measured at the date of the award based on the formula price, which the Company
believed approximated fair value, used in the restrictive stock agreement and
the employee stock purchase program. This cost was to be amortized to expense
over the applicable vesting period in which the award was earned. In connection
with the exchange of shares with Primary Network Holdings, Inc. (PNH) (Note 14),
all
61
<PAGE> 63
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
7,400 remaining shares became fully vested on March 31, 1999. Also in March
1999, the Company awarded 51,841 shares of common stock to certain employees,
all of which vested immediately. Compensation expense for these awards is
measured based on estimated fair value at the date of the award. For the period
January 1, 1999 to May 31, 1999, the Company recognized compensation expense of
$390,615, which includes $31,533 related to the amortization of the 7,400 shares
of common stock. Finally in March 1999, the Company issued 422,693 options to
employees at an exercise price of $15 per share. As the exercise price of the
options was above fair value at the grant date, no compensation expense was
recorded by the Company related to these options. Effective May 31, 1999, all of
these options, as well as the option to purchase 10,000 shares granted in
December 1997, were canceled. No other options were granted, forfeited, or
expired during 1999, and no options were outstanding at May 31, 1999.
Under SFAS No. 123, the Minimum Value method may be used by nonpublic
companies to value an option. This includes estimating the risk-free interest
rate, the expected dividend yield, and the life of the options. Based on this
option valuation model, the weighted average fair value of options granted and
the total pro forma compensation expense to be disclosed as prescribed under
SFAS No. 123 for the period January 1, 1999 to May 31, 1999 are immaterial.
During the period January 1, 1999 to May 31, 1999, the Company sold 214,298
shares of common stock for $2,246,172. These stockholders are subject to the
restrictive stock agreement disclosed above.
Contributions to Capital
During the five months ended May 31, 1999, an affiliate provided $233,162
of services to the Company at no cost. The Company recorded these transactions
as additional capital contributions.
12. DISCONTINUED OPERATIONS
On January 1, 1999, the Board of Directors approved a decision to
discontinue the Company's Web development division. On May 19, 1999, the Company
sold that line of business to an affiliate. Sales of the Web development
division for the period January 1, 1999 to May 19, 1999 were $172,414. The
Company sold all assets of the division, with the exception of accounts
receivable totaling $125,020 as of May 31, 1999, for an amount equaling their
net book value of approximately $7,000 as of the disposal date and a 3 percent
royalty of future Web development gross revenues of the affiliate for two years.
13. SEGMENT INFORMATION
The Company has two reportable segments, Internet and Retail, which are
separate operating units that offer different products and services and are
managed accordingly. Performance of each segment is evaluated by management
based on income (loss) from continuing operations. Transactions between segments
are reported at fair value and the accounting polices of the segments are the
same as those in Note 1.
The Internet segment provides full service access to the Internet for
corporate and residential customers including dial-up and dedicated services and
activities related to setup and installation, selling equipment, and software.
The Retail segment sells cellular and other wireless communication products,
including phones, pagers, and related accessories.
62
<PAGE> 64
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The following segment information is as of May 31, 1999 or for the five
months then ended:
<TABLE>
<CAPTION>
INTERNET RETAIL TOTAL
---------- --------- ----------
<S> <C> <C> <C>
Revenues from external customers........... $2,315,160 $ 518,124 $2,833,284
Depreciation and amortization.............. 168,923 17,016 185,939
Stock-based compensation expense........... 390,615 -- 390,615
Interest expense........................... 15,655 3,503 19,158
Loss from continuing operations............ (329,157) (352,749) (681,906)
Loss from disposal of discontinued Web
development division (Note 12)........... (81,785) -- (81,785)
Loss before income taxes................... (410,942) (352,749) (763,691)
Segment assets............................. 4,093,931 347,099 4,441,030
Capital expenditures....................... 145,672 1,887 147,559
</TABLE>
14. SUBSEQUENT EVENTS
Effective the close of business on May 31, 1999, the Company executed a
plan of reorganization whereby all common stockholders of the Company exchanged
each of their shares for 16.67 shares in PNH, a newly formed holding company.
This transaction terminated the restrictive stock agreement (see Note 11) as of
that date. In addition, all of the common stockholders of BroadSpan (see Note
5), a Competitive Local Exchange Carrier, exchanged each of their shares for
13.227 shares in PNH. This reorganization will allow PNH, of which the Company
and BroadSpan will be wholly owned subsidiaries, to cross-sell Internet access
and cellular services to its local and long distance telephone customers.
Additionally, on June 1, 1999, PNH raised a combination of debt and equity
proceeds approximating $53,000,000 from various investors. The proceeds are
expected to be used to acquire ISPs, develop and offer DSL technology, and grow
revenues through aggressive marketing.
On June 17, 1999, the Company purchased all outstanding common stock of Q
Networks, Inc. for approximately $5,000,000.
On June 21, 1999, the Company purchased the Internet dial-up customer base
and certain assets of CySource Inc. for approximately $650,000.
On August 6, 1999, the Company purchased substantially all of the assets of
Inlink Communications Company for approximately $4,700,000.
63
<PAGE> 65
FINANCIAL STATEMENTS
CDM ON-LINE, INC.
YEARS ENDED DECEMBER 31, 1997 AND 1998
WITH REPORT OF INDEPENDENT AUDITORS
64
<PAGE> 66
CDM ON-LINE, INC.
FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997 AND 1998
CONTENTS
<TABLE>
<S> <C>
Report of Independent Auditors.............................. 66
Financial Statements
Balance Sheets.............................................. 67
Statements of Operations.................................... 68
Statements of Stockholders' Deficit......................... 69
Statements of Cash Flows.................................... 70
Notes to Financial Statements............................... 71
</TABLE>
65
<PAGE> 67
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
CDM On-Line, Inc.
We have audited the accompanying balance sheets of CDM On-Line, Inc. as of
December 31, 1997 and 1998, and the related statements of operations,
stockholders' deficit, and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of CDM On-Line, Inc. at
December 31, 1997 and 1998, and the results of its operations and its cash flows
for the years then ended, in conformity with accounting principles generally
accepted in the United States.
ERNST & YOUNG LLP
March 22, 1999
St. Louis, Missouri
66
<PAGE> 68
CDM ON-LINE, INC.
BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------
1997 1998
----------- -----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 148,527 $ 300,580
Accounts receivable, less allowance for doubtful accounts
of $27,604 in 1997 and $89,085 in 1998................. 279,934 296,190
Due from affiliates....................................... 29,172 268,756
Inventory................................................. 109,335 130,534
Other current assets...................................... 3,442 41,118
----------- -----------
Total current assets........................................ 570,410 1,037,178
Property and equipment, net................................. 521,771 452,646
Other assets................................................ 171,380 174,105
----------- -----------
$ 1,263,561 $ 1,663,929
=========== ===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Line of credit............................................ $ -- $ 20,000
Accounts payable.......................................... 204,568 372,564
Accrued expenses.......................................... 166,815 185,042
Unearned revenues......................................... 213,938 390,548
Due to affiliates......................................... 1,461,998 899,509
----------- -----------
Total current liabilities................................... 2,047,319 1,867,663
Stockholders' deficit:
Common stock, $.15 par value, 2,000,000 shares authorized,
1,197,745 and 1,222,406 shares issued in 1997 and 1998,
respectively........................................... 179,662 183,361
Additional paid-in capital................................ 1,972,157 3,841,839
Accumulated deficit....................................... (2,935,577) (4,169,695)
----------- -----------
(783,758) (144,495)
Treasury stock at cost.................................... -- (59,239)
----------- -----------
(783,758) (203,734)
----------- -----------
$ 1,263,561 $ 1,663,929
=========== ===========
</TABLE>
See accompanying notes.
67
<PAGE> 69
CDM ON-LINE, INC.
STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1997 1998
----------- -----------
<S> <C> <C>
Revenues:
Access revenues........................................... $ 1,496,237 $ 3,216,463
Retail revenues........................................... 549,997 883,380
Other revenues............................................ 529,318 695,728
----------- -----------
2,575,552 4,795,571
Costs and expenses:
Costs of access revenues.................................. 701,439 1,184,433
Costs of retail revenues.................................. 371,235 529,992
Costs of other revenues................................... 245,273 482,580
Operations and customer support........................... 494,292 671,592
Sales and marketing....................................... 645,827 745,067
General and administrative................................ 661,481 1,189,052
Retail store expenses..................................... 773,634 1,013,136
Depreciation and amortization............................. 233,073 263,063
----------- -----------
4,126,254 6,078,915
----------- -----------
Loss from operations........................................ (1,550,702) (1,283,344)
Other income (expense):
Interest expense -- affiliates............................ (83,131) (189,175)
Interest expense.......................................... (675) (1,805)
Other income, net......................................... 44,331 4,314
----------- -----------
Loss from continuing operations............................. (1,590,177) (1,470,010)
Income from operations of discontinued Web development
division (Note 12)........................................ 147,374 235,892
----------- -----------
Net loss.................................................... $(1,442,803) $(1,234,118)
=========== ===========
</TABLE>
See accompanying notes.
68
<PAGE> 70
CDM ON-LINE, INC.
STATEMENTS OF STOCKHOLDERS' DEFICIT
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL TREASURY STOCK
--------------------- PAID-IN ACCUMULATED ------------------
SHARES AMOUNT CAPITAL DEFICIT SHARES AMOUNT
--------- -------- ---------- ----------- ------ --------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1996..... 1,197,745 $179,662 $ 916,063 $(1,492,774) -- $ --
Net loss....................... -- -- -- (1,442,803) -- --
Forgiveness of advances by
stockholders and contribution
of services.................. -- -- 1,056,094 -- -- --
--------- -------- ---------- ----------- ----- --------
Balance at December 31, 1997..... 1,197,745 179,662 1,972,157 (2,935,577) -- --
Net loss....................... -- -- -- (1,234,118) -- --
Forgiveness of advances by
stockholders and contribution
of services.................. -- -- 1,548,166 -- -- --
Sale of stock to employees..... 19,967 2,995 238,007 -- -- --
Sale of stock to employees
under employee stock purchase
arrangement.................. 3,594 539 37,517 -- -- --
Stock awards to employees...... 1,100 165 9,889 -- -- --
Amortization of vested stock... -- -- 36,103 -- -- --
Common stock purchased for
treasury..................... -- -- -- -- 5,393 (59,239)
--------- -------- ---------- ----------- ----- --------
Balance at December 31, 1998..... 1,222,406 $183,361 $3,841,839 $(4,169,695) 5,393 $(59,239)
========= ======== ========== =========== ===== ========
</TABLE>
See accompanying notes.
69
<PAGE> 71
CDM ON-LINE, INC.
STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------
1997 1998
----------- -----------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss.................................................... $(1,442,803) $(1,234,118)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization............................. 233,073 263,063
Stock-based compensation expense.......................... -- 46,157
Allowance for doubtful accounts........................... 1,274 61,481
Gain on disposal of equipment to affiliates............... (29,539) --
Changes in operating assets and liabilities:
Accounts receivable.................................... (57,782) (77,737)
Due from affiliates.................................... (23,958) (87,412)
Inventory.............................................. (91,605) (21,199)
Other current assets................................... 9,477 (37,676)
Other assets........................................... (7,095) (2,725)
Accounts payable....................................... 114,399 167,996
Accrued expenses....................................... 68,241 18,227
Unearned revenues...................................... 143,518 176,610
----------- -----------
Net cash used in operating activities....................... (1,082,800) (727,333)
INVESTING ACTIVITIES
Advances to affiliates...................................... -- (152,172)
Purchases of property and equipment......................... (340,899) (193,938)
Proceeds from disposal of equipment to affiliates........... 81,718 --
Investments in and advances to unconsolidated
subsidiaries.............................................. (60,000) --
----------- -----------
Net cash used in investing activities....................... (319,181) (346,110)
FINANCING ACTIVITIES
Bank overdraft.............................................. (4,437) --
Net proceeds under line of credit........................... -- 20,000
Purchase of common stock held in treasury................... -- (59,239)
Due to affiliates........................................... 1,554,945 985,677
Proceeds from issuance of common stock...................... -- 279,058
----------- -----------
Net cash provided by financing activities................... 1,550,508 1,225,496
----------- -----------
Net increase in cash and cash equivalents................... 148,527 152,053
Cash and cash equivalents at beginning of year.............. -- 148,527
----------- -----------
Cash and cash equivalents at end of year.................... $ 148,527 $ 300,580
=========== ===========
</TABLE>
See accompanying notes.
70
<PAGE> 72
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. ORGANIZATION
CDM On-Line, Inc. (the "Company") is a local provider of Internet access
and other Internet-related services in St. Louis and Kansas City, Missouri. In
addition, the Company serves as an authorized agent of Southwestern Bell Mobile
Systems and operates cellular and other wireless communication products retail
stores in the St. Louis metropolitan area. The Company was organized on
September 23, 1994 (Inception) and began providing Internet services in July
1995. The Company commenced its retail operations in November 1996. The
Company's targeted markets include residential and business customers in
Missouri.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The Company has incurred losses since its inception, has had negative cash
flows from operations in all periods, and has working capital and stockholders'
equity deficiencies. Management's operational and financing plans to address
these conditions include but are not limited to obtaining additional equity and
debt financing, continuing investments in its network infrastructure to increase
its network efficiency and capacity to serve additional subscribers, and
employing marketing strategies to increase its subscriber base. Subsequent to
December 31, 1998, the Company raised approximately $2,300,000 in cash from the
sale of common stock. Further, the Company's stockholders have agreed to provide
the Company with the necessary funds to meet all of its working capital needs
during 1999.
The online services and Internet markets are highly competitive. The
Company believes that existing competitors, Internet-based services, Internet
service providers, Internet directory services, and telecommunications companies
are likely to enhance their service offerings, resulting in greater competition
for the Company. The competitive conditions could have the following effects:
require additional pricing programs, increase spending on marketing, limit the
Company's ability to expand its subscriber base, and result in increased
attrition in the existing subscriber base. The accompanying financial statements
have been prepared on a basis which contemplates the realization of the assets
and satisfaction of liabilities in the normal course of business.
USE OF ESTIMATES
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect reported amounts in the financial statements and
accompanying notes. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid financial instruments with a
maturity of three months or less at the time of purchase to be cash equivalents.
PROPERTY AND EQUIPMENT
Property and equipment, including leasehold improvements, are stated at
cost. Depreciation is calculated using the straight-line method over the
estimated useful lives ranging from 18 months to 15 years. Leasehold
improvements are amortized over the lesser of the related lease term or the
useful life of the assets.
71
<PAGE> 73
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
INVENTORY
Inventory consists of cellular and other wireless communication products
and accessories and is stated at the lower of cost (specific identification
basis) or market.
IMPAIRMENT OF LONG-LIVED ASSETS
At each balance sheet date, management determines whether any property or
equipment or any other assets have been impaired based on the criteria
established in Statement of Financial Accounting Standards (SFAS) No. 121,
Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be
Disposed Of. The Company made no adjustments to the carrying values of its
assets during the years ended December 31, 1997 and 1998.
STOCK COMPENSATION
The Company accounts for its stock-based compensation plans and
arrangements using the intrinsic value method prescribed by Accounting
Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees.
SFAS No. 123, Accounting for Stock-Based Compensation, requires that
companies electing to continue using the intrinsic value method make pro forma
disclosures of net income as if the fair value-based method of accounting had
been applied. The pro forma effect of using the fair value-based method to
account for its stock-based compensation would have resulted in no difference to
the net loss reported by the Company in 1997 and 1998.
REVENUE RECOGNITION
Access revenues: Internet customers are billed in advance for the periods
for which Internet services are provided. The Company defers recognition of
revenue on these advance billings and amortizes the amounts to revenue on a
straight-line basis as the services are provided.
Retail revenues: These revenues consist primarily of retail product sales
of cellular and other wireless products, such as phones, pagers, and related
accessories. Such sales are recorded upon customer purchase. The Company also
generates revenues from activation commissions from cellular carriers for each
new cellular phone subscription sold by the Company. Revenue from such
commissions is recorded upon customer subscription. New subscription activation
commissions are fully refundable if the subscriber cancels service within a
certain minimum period of continuous active service (generally 180 days).
Customers generally sign a service agreement that requires a customer deposit
which is forfeited in case of early cancellation. At December 31, 1997 and 1998,
the Company's allowance for accounts receivable includes an amount for estimated
cancellation losses, net of deposit forfeitures.
The Company generally receives monthly residual income from the cellular
service providers based on a percentage of actual phone usage by subscribers.
Revenue from residual income is recorded as the cellular service is provided.
Revenue from prepaid pager service is deferred and recognized over the period
service is provided, usually annually. Revenue from monthly installment pager
service contracts is recorded as received.
Other revenues: Other revenues consist of setup and installation fees and
selling equipment and software.
72
<PAGE> 74
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
COSTS OF REVENUES
Costs of access revenues primarily consist of telecommunications expenses
inherent in the network infrastructure, including fees paid for the lease of the
Company's backbone. Costs of retail revenues consist of the costs of cellular
and other wireless communication products and accessories purchased for resale.
Costs of other revenues primarily consist of the costs of equipment and software
purchased for resale.
ADVERTISING COSTS
All advertising and promotion costs are expensed as incurred. During the
years ended December 31, 1997 and 1998, the Company incurred advertising costs
of approximately $330,900 and $200,300, respectively.
INCOME TAXES
The Company is treated as an S Corporation under the provisions of the
Internal Revenue Code, whereby the Company's income or loss is allocated to the
individual stockholders for federal income tax purposes. While the Company is
not subject to federal income taxes, it is subject to certain state and local
taxes, which were not significant for the periods presented.
If the Company had been subject to federal and certain state income taxes
for the two year period ended December 31, 1998, the Company would have been in
a net deferred tax asset position which would have been fully offset by a
valuation allowance. Any tax benefit or provision for those years also would
have been fully offset by changes in the deferred tax asset valuation allowance.
Therefore, unaudited pro-forma income tax information is not presented in
accordance with Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes," as if the Company had been subject to federal and certain
state income taxes.
FINANCIAL INSTRUMENTS AND CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of cash and accounts receivable.
The cash is held by a high-credit-quality financial institution. For accounts
receivable, the Company performs ongoing credit evaluations of the financial
condition of its customers and does not require collateral. The Company
maintains reserves for credit losses, and such losses have been within
management's expectations. The concentration of credit risk is mitigated by the
large customer base. The net carrying amount of the receivables approximates
their fair value.
73
<PAGE> 75
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
3. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1997 1998
--------- ----------
<S> <C> <C>
Computer equipment...................................... $ 732,455 $ 777,521
Software................................................ 22,004 49,721
Furniture, fixtures, and office equipment............... 21,166 26,213
Land, building, and leasehold improvements.............. 55,919 169,529
Vehicles................................................ 42,413 44,913
--------- ----------
873,957 1,067,897
Less accumulated depreciation and amortization.......... (352,186) (615,251)
--------- ----------
$ 521,771 $ 452,646
========= ==========
</TABLE>
4. OTHER ASSETS
Other assets consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1997 1998
-------- --------
<S> <C> <C>
Investment in Interchange Technologies, Inc............... $160,000 $160,000
Other non-current assets.................................. 11,380 14,105
-------- --------
$171,380 $174,105
======== ========
</TABLE>
5. ACCRUED EXPENSES
Accrued expenses consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1997 1998
-------- --------
<S> <C> <C>
Accrued payroll and related expenses...................... $124,849 $150,358
Other accrued expenses.................................... 41,966 34,684
-------- --------
$166,815 $185,042
======== ========
</TABLE>
6. RELATED PARTY TRANSACTIONS
Affiliates include officers, employees, and other corporations and
partnerships that are substantially or partially owned by officers and
stockholders of the Company. The significant affiliates include CBC Distribution
and Marketing, Inc., CDM Fantasy Sports, Inc., CDM Properties Management,
L.L.C., and Primary Communications, Inc.
74
<PAGE> 76
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
As of December 31, 1997 and 1998, amounts due from affiliates consist of
the following:
<TABLE>
<CAPTION>
DECEMBER 31
-------------------
1997 1998
------- --------
<S> <C> <C>
Advances to affiliates..................................... $ -- $152,172
Accounts receivable -- trade affiliates.................... 29,172 116,584
------- --------
$29,172 $268,756
======= ========
</TABLE>
The advances to affiliates are unsecured, are due on demand, and bear
interest at 12 percent per annum, which is payable upon repayment of the
advances.
As of December 31, 1997 and 1998, the due to affiliates was $1,461,998 and
$899,509, respectively, and consisted solely of borrowings from affiliates. Such
advances are unsecured, are due on demand, and bear interest in 1997 at rates
ranging from 5.63 percent to 6.07 percent and at 12 percent in 1998 as published
by the Internal Revenue Service.
Revenues derived from affiliates related to providing Internet access and
other services were approximately $217,000 and $378,000 in 1997 and 1998,
respectively. Expenses and costs incurred to affiliates related to purchasing
advertising and insurance were approximately $51,000 and $53,000 in 1997 and
1998, respectively.
The Company leases office space under noncancelable operating leases from
an affiliate. The leases expire in August 2008, contain an option to renew for a
five-year term, and provide for additional rent related to the Company's share
of certain taxes and operating expenses. Rent expense associated with these
leases was $37,000 and $76,000 in 1997 and 1998, respectively, and such amounts
are included in the total rent expense disclosed in Note 9.
Future minimum lease payments under the noncancelable operating leases with
the affiliate at December 31, 1998 are as follows:
<TABLE>
<S> <C>
1999........................................................ $ 91,845
2000........................................................ 91,847
2001........................................................ 94,379
2002........................................................ 97,189
2003........................................................ 97,189
Thereafter.................................................. 466,016
--------
$938,465
========
</TABLE>
The Company leases certain network-related equipment on a month-to-month
basis from an affiliate. Rent expense for the equipment was approximately
$157,000 in 1997 and $276,000 in 1998. Future minimum lease payments under the
month-to-month leasing arrangements are expected to be as follows: $279,656 in
1999, $214,310 in 2000, and $38,701 in 2001.
An affiliate provides the Company the use of its programmers, certain
equipment, payroll services and the administration of the 401(k) defined
contribution plan. All labor and administrative costs provided by the affiliate
were expensed and were $374,973 and $491,511 during the years ended December 31,
1997 and 1998, respectively.
75
<PAGE> 77
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
7. LINE OF CREDIT
The Company has a line of credit with a bank allowing borrowings of up to
$25,000. Interest is payable monthly at the bank's prime rate plus .5 percent
(8.25 percent at December 31, 1998). The principal balance and any unpaid
accrued interest are payable on November 20, 1999. The line is secured by
accounts receivable, inventory, and property and equipment and is personally
guaranteed by certain stockholders. Borrowings of $20,000 were outstanding
against the line at December 31, 1998.
8. EMPLOYEE BENEFIT PLAN
Employees of the Company are eligible to participate in a defined
contribution 401(k) profit sharing plan, sponsored by an affiliate, covering
substantially all eligible employees. The Company matches 100 percent of the
first 6 percent of compensation that employees contribute into the plan.
Additional contributions may be made to the plan at the discretion of Company
management. Company matching amounts of employee contributions for the years
ended December 31, 1997 and 1998, were $39,324 and $50,603, respectively.
9. COMMITMENTS
LEASE COMMITMENTS
The Company leases vehicles and office and retail space under noncancelable
operating lease agreements. The leases for office and retail space generally
include renewal options and require the Company to pay a portion of the expenses
for common areas, including maintenance, real estate taxes, and other expenses.
Rent expense under these operating leases for the years ended December 31, 1997
and 1998, was $140,556 and $216,719, respectively.
Future minimum lease payments under noncancelable operating leases with
initial or remaining lease terms in excess of one year (including lease
commitments to affiliates disclosed in Note 6) are as follows at December 31,
1998:
<TABLE>
<S> <C>
1999........................................................ $ 240,366
2000........................................................ 232,304
2001........................................................ 230,518
2002........................................................ 134,305
2003........................................................ 97,189
Thereafter.................................................. 466,016
----------
$1,400,698
==========
</TABLE>
BACKBONE AGREEMENT
The Company has agreements with its principal Internet service provider
(ISP) which require payment of minimum monthly Internet access and other charges
of $7,350 under one agreement through April 1999 and $6,300 under another
agreement through March 1999. Additional monthly charges are incurred for the
use of capacity above the amounts contracted in the agreements. The agreements
automatically renew unless the ISP or Company terminates them, as described in
the agreements. Expenses incurred under these agreements were $154,051 in 1997
and $218,689 in 1998.
76
<PAGE> 78
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
10. STOCKHOLDER EQUITY
RESTRICTIVE STOCK AGREEMENT
Under the terms of the 1994 restrictive stock agreement, as subsequently
amended in November 1996, certain employees/stockholders are restricted in their
ability to sell common stock of the Company. Specifically, if a stockholder
desires to sell Company common stock, written consent of the sale must be
obtained from the Company. In the absence of written consent, the Company
possesses a "right of first refusal" under which the employees/stockholders must
first offer the stock for sale to the Company before it may be sold to another
party. The purchase price for common stock purchased under the right of first
refusal is based on book value. The Company also has the right to purchase
common stock from an employee under voluntary or involuntary termination, as
defined. The purchase price for a voluntary termination is the book value, while
for involuntary termination the purchase price is the same formula paid as the
right of first refusal. If the Company decides not to exercise its right of
first refusal or right to purchase stock in the event of termination, each
stockholder has the right for a certain period of time to purchase such common
stock at the same price and terms as the Company's rights. The restrictive stock
agreement also obligates the Company to repurchase, at a formula price, all of
the stock owned by an employee/stockholder in the event of death.
COMMON STOCK
In December 1997, the Board of Directors approved the implementation of an
employee stock purchase program whereby employees eligible for the 401(k)
defined contribution plan are also eligible to purchase Company stock through
payroll withholdings. Purchases of Company stock are made at the end of each
quarter at a price determined by a formula, essentially based on multiples of
sales and certain other factors. In 1998, employees purchased 3,594 shares of
stock through the stock purchase program for $38,056. Employees may sell and the
Company is obligated to buy common stock purchased under the program at the
formula price in the quarter in which the common stock is sold. Repurchased
shares are carried as treasury stock, at cost.
In December 1997, the Company granted an officer an option to purchase
10,000 shares of common stock at an exercise price of $15 per share. The option
vested immediately and expires five years from the grant date.
In January 1998, the Board of Directors awarded 9,000 shares of common
stock to certain employees, of which 1,100 vested immediately. The remaining
7,900 shares of common stock vest after the completion of two years of service
in December 1999, at which time the earned shares of common stock will be
issued. Compensation cost is measured at the date of the award based on the
formula price, which approximates fair value, used in the restrictive stock
agreement and the employee stock purchase program, and such cost is amortized as
expense over the period in which the award is earned over the applicable vesting
period. In 1998, the Company recognized compensation expense of $46,157, which
includes $36,103 related to the amortization of 7,900 shares of common stock.
CONTRIBUTIONS TO CAPITAL
In 1997 and 1998, an affiliate distributed to its stockholders, as a
tax-free distribution of its previously taxed earnings as an S Corporation, a
portion of its amount due from the Company. The affiliate's stockholders, who
are also stockholders of the Company, simultaneously made capital contributions
to the Company for the amount distributed to them. The effect of these
transactions is
77
<PAGE> 79
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
to reduce the amount due to the affiliate and increase additional paid-in
capital by $681,121 in 1997 and $1,056,655 in 1998. In addition the affiliate
provided $374,973 and $491,511 of services to the Company at no cost in 1997 and
1998, respectively. The Company recorded these transactions as additional
capital contributions.
11. SEGMENT INFORMATION
The Company has two reportable segments, Internet and Retail, which are
separate operating units that offer different products and services and are
managed accordingly. Performance of each segment is evaluated by management
based on income (loss) from continuing operations. Transactions between segments
are reported at fair value and the accounting polices of the segments are the
same as those in Note 1.
The Internet segment provides full service access to the Internet for
corporate and residential customers including dial-up and dedicated services and
activities related to setup and installation, selling equipment, and software.
The Retail segment sells cellular and other wireless communication products,
including phones, pagers, and related accessories.
The following segment information is as of December 31, or for the year
then ended:
<TABLE>
<CAPTION>
1997
--------------------------------------
INTERNET RETAIL TOTAL
---------- --------- -----------
<S> <C> <C> <C>
Revenues from external customers.......... $2,025,555 $ 549,997 $ 2,575,552
Depreciation and amortization............. 221,879 11,194 233,073
Stock-based compensation.................. -- -- --
Interest expense.......................... 65,910 17,896 83,806
Loss from continuing operations........... (915,232) (674,945) (1,590,177)
Income from discontinued operations -- Web
development (Note 12)................... 147,374 -- 147,374
Net loss.................................. (767,858) (674,945) (1,442,803)
Segment assets............................ 906,145 357,416 1,263,561
Capital expenditures...................... 218,953 121,946 340,899
</TABLE>
<TABLE>
<CAPTION>
1998
--------------------------------------
INTERNET RETAIL TOTAL
---------- --------- -----------
<S> <C> <C> <C>
Revenues from external customers.......... $3,912,191 $ 883,380 $ 4,795,571
Depreciation and amortization............. 224,598 38,465 263,063
Stock-based compensation.................. 46,157 -- 46,157
Interest expense.......................... 155,799 35,181 190,980
Loss from continuing operations........... (611,808) (858,202) (1,470,010)
Income from discontinued operations -- Web
development (Note 12)................... 235,892 -- 235,892
Net loss.................................. (375,916) (858,202) (1,234,118)
Segment assets............................ 1,170,156 493,773 1,663,929
Capital expenditures...................... 34,033 159,905 193,938
</TABLE>
78
<PAGE> 80
CDM ON-LINE, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
12. SUBSEQUENT EVENTS
On January 1, 1999, the Board of Directors approved a decision to
discontinue the Company's Web development division. The results of the Web
development division have been reported separately as discontinued operations in
the statement of operations. Sales for the Web development division for the
years ended December 31, 1997 and 1998 were $477,311 and $651,350, respectively.
Management expects the disposal to occur in the second quarter of 1999 and that
the gain or loss on disposal of this division will not be material.
Since January 1, 1999 through March 22, 1999, the Company has granted
51,841 shares of common stock to certain employees and sold 214,298 shares of
common stock, raising proceeds of $2,246,172.
79
<PAGE> 81
(b) PRO FORMA FINANCIAL INFORMATION.
UNAUDITED SELECTED PRO FORMA CONDENSED
COMBINED FINANCIAL INFORMATION
The following unaudited pro forma condensed combined balance sheet reflects
the combination of the balance sheets of Mpower and Primary Network as of March
31, 2000 as adjusted for the merger as if the merger of Mpower and Primary
Network had been consummated on March 31, 2000. The unaudited pro forma
condensed combined statements of operations reflect the combination of the
statement of operations of Mpower and Primary Network for the three months
ending March 31, 2000 and the twelve months ending December 31, 1999 as adjusted
for the merger as if the merger had been consummated on January 1, 1999. The
unaudited pro forma condensed combined financial information has been prepared
using the purchase method of accounting. This pro forma information does not
give effect to any potential cost savings or other operating efficiencies that
could result from the merger. Also, this pro forma information does not give
effect to the extraordinary loss of $8.7 million on the exchange of debt assumed
from Primary Network.
The unaudited pro forma statements are based on currently available
information and certain assumptions that Mpower believes are reasonable under
the circumstances. The unaudited pro forma condensed combined financial
information does not purport to represent what the combined company's position
or results of operations would have been had the merger occurred on such date or
at the beginning of the earliest period presented or to project the combined
financial position or results of operations for any future date or period.
The unaudited pro forma statements should be read in conjunction with the
separate historical financial statements of Mpower and Primary Network and its
predecessors and the notes thereto, and with the accompanying notes to the pro
forma statements and sections entitled "Management's Discussion and Analysis of
Financial Conditions and Results of Operations" of each of Mpower and Primary
Network, all of which are contained elsewhere in this prospectus.
80
<PAGE> 82
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
TWELVE MONTHS ENDED DECEMBER 31, 1999
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
MPOWER PRIMARY NETWORK PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
----------- --------------- ----------- -----------
<S> <C> <C> <C> <C>
Operating revenues.................. $ 55,066 $ 11,169 $ -- $ 66,235
----------- -------- ---------- -----------
Operating expenses:
Cost of operating revenues.......... 50,012 5,722 -- 55,734
Selling, general and
administrative.................... 44,836 13,297 -- 58,133
Stock-based compensation expense.... 714 -- -- 714
Depreciation and amortization....... 18,921 4,750 11,738(1) 35,409
----------- -------- ---------- -----------
114,483 23,769 11,738 149,990
----------- -------- ---------- -----------
Loss from operations................ (59,417) (12,600) (11,738) (83,755)
Other income (expense):
Interest income (expense), net...... (10,576) (4,815) (1,059)(2) (16,450)
Other, net........................ 224 1,046 -- 1,270
----------- -------- ---------- -----------
Net loss from continuing
operations........................ (69,769) (16,369) (12,797) (98,935)
Discontinued operations............. -- (82) -- (82)
----------- -------- ---------- -----------
Net loss............................ (69,769) (16,451) 12,797 (99,017)
Value of preferred stock beneficial
conversion feature................ (72,500) -- -- (72,500)
Accretion of preferred to redemption
value............................. (6,133) -- -- (6,133)
Accrued preferred stock dividend.... (2,577) -- -- (2,577)
----------- -------- ---------- -----------
Net loss applicable to common
stockholders...................... $ (150,979) $(16,451) $ (12,797) $ (180,227)
=========== ======== ========== ===========
Basic and diluted weighted average
shares outstanding................ 19,775,410 n/a 1,349,838(3) 21,125,248
=========== ======== ========== ===========
Basic and diluted loss per share of
common stock...................... $ (7.63) n/a n/a $ (8.53)
=========== ======== ========== ===========
</TABLE>
NOTES TO THE 1999 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
(1) Reflects 12 months of amortization of intangibles recorded in connection
with acquisition of Primary Network and includes amortization of goodwill
($12.4 million) and amortization of customer base ($2.4 million) less the
amortization of intangibles in the historical statement of operations of
Primary Network. Amortization periods assumed for goodwill and customer base
were 10 years and 5 years, respectively.
(2) Reflects additional interest expense associated with the exchange of debt
assumed from Primary Network.
(3) Reflects the number of shares of Mpower stock issued in exchange for the
preferred and common stock of Primary Network.
81
<PAGE> 83
UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
AS OF MARCH 31, 2000
(IN THOUSANDS)
<TABLE>
<CAPTION>
PRIMARY
MPOWER NETWORK PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
---------- ---------- ----------- ----------
<S> <C> <C> <C> <C>
Current assets:
Cash and cash equivalents.................... $ 307,769 $ 4,828 $(10,000)(1) $ 302,597
Investments available-for-sale............... 465,628 -- -- 465,628
Restricted investments....................... 20,534 -- -- 20,534
Accounts receivable, net..................... 14,281 2,546 -- 16,827
Prepaid expenses and other current assets.... 2,553 2,279 -- 4,832
---------- -------- -------- ----------
Total current assets......................... 810,765 9,653 (10,000) 810,418
Property and equipment, net.................... 230,163 32,636 -- 262,799
Investments available-for-sale................. 122,448 -- -- 122,448
Other assets................................... 12,890 5,693 -- 18,583
Intangible assets.............................. -- 17,038 118,561(2) 135,599
---------- -------- -------- ----------
Total assets................................. $1,176,266 $ 65,020 $108,561 $1,349,847
========== ======== ======== ==========
Current liabilities:
Current maturities of long-term debt and
capital lease obligations................. $ 670 $ 11,684 $ -- $ 12,354
Accounts payable............................. 59,327 5,134 -- 64,461
Accrued expense and other.................... 23,671 4,159 9,400(3) 37,230
---------- -------- -------- ----------
Total current liabilities.................... 83,668 20,977 9,400 114,045
Senior Secured Notes, net...................... 157,412 52,586 6,403(4) 216,401
Senior Notes, net.............................. 243,233 -- -- 243,233
Other long-term debt and capital lease
obligations.................................. 3,859 9,177 -- 13,036
---------- -------- -------- ----------
Total liabilities............................ 488,172 82,740 15,803 586,715
---------- -------- -------- ----------
Redeemable preferred stock..................... 239,216 -- -- 239,216
Stockholders' equity:
Preferred stock, net of deferred stock
compensation.............................. -- 522 (522)(5) --
Common stock................................. 35 64 (63)(5) 36
Additional paid-in capital................... 596,240 14,497 60,539(5) 671,276
Accumulated deficit.......................... (139,505) (32,803) 32,803(6) (139,505)
Less: Treasury stock......................... (76) -- -- (76)
Notes receivable from stockholders for
issuance of common stock.................. (5,844) -- -- (5,844)
Accumulated other comprehensive loss......... (1,972) -- -- (1,972)
---------- -------- -------- ----------
Total stockholders' equity................ 448,878 (17,720) 92,758 523,916
---------- -------- -------- ----------
Total liabilities, redeemable preferred
stock and stockholders' equity.......... $1,176,266 $ 65,020 $108,561 $1,349,847
========== ======== ======== ==========
</TABLE>
82
<PAGE> 84
NOTES TO THE UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET
(1) Includes $10 million pre-closing cash advance from Mpower to Primary
Network.
(2) Reflects purchase accounting adjustments for the acquisition based on
Mpower's preliminary estimate of the assets and liabilities assumed. For
purchase accounting, Primary Network's assets have been recorded at their
estimated fair market value subject to adjustments based upon the results of
an independent appraisal. Purchase accounting adjustments were recorded to
reflect the estimated fair value of the acquired customer base of $12
million, to decrease the recorded value of intangible assets acquired by $17
million, to record the excess of purchase cost over fair value of net assets
acquired by $123.6 million, to record estimated restructuring costs of $6.1
million and to increase the long-term debt by $6.4 million. These
adjustments are required to record the assets and liabilities at their
estimated fair market values. The calculation of excess purchase cost over
fair value of net assets acquired is as follows:
<TABLE>
<CAPTION>
(AMOUNTS IN THOUSANDS)
<S> <C>
Common stock issued..................................... $ 70,367
Cash paid............................................... 10,000
Options and warrants issued............................. 5,171
Direct acquisition costs................................ 2,800
--------
Total purchase cost................................... 88,338
Less: Net book value of Primary Network................. (17,720)
Less: Adjustment in net assets to fair value............ (17,541)
--------
Excess of purchase cost over fair value of assets
acquired and liabilities assumed (goodwill)........... $123,599
========
</TABLE>
(3) Includes accruals for estimated restructuring, direct acquisition and
registration costs, including legal, accounting and filing fees.
(4) Reflects purchase accounting adjustment to adjust to fair value of debt.
(5) Reflects the value of the Mpower stock exchanged for the preferred and
common stock of Primary Network, less registration costs and the elimination
of the equity of Primary Network.
(6) Reflects elimination of accumulated deficit of Primary Network as part of
the purchase accounting computation.
83
<PAGE> 85
UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
THREE MONTHS ENDED MARCH 31, 2000
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
PRIMARY
MPOWER NETWORK PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
----------- --------------- ----------- -----------
<S> <C> <C> <C> <C>
Operating revenues....................... $ 25,458 $ 5,374 $ -- $ 30,832
----------- -------- ---------- -----------
Operating expenses:
Cost of operating revenues............. 23,231 3,554 -- 26,785
Selling, general and administrative.... 23,140 8,523 -- 31,663
Stock-based compensation expense....... 1,576 -- -- 1,576
Depreciation and amortization.......... 6,761 3,450 2,160(1) 12,371
----------- -------- ---------- -----------
54,708 15,527 2,160 72,395
----------- -------- ---------- -----------
Loss from operations..................... (29,250) (10,153) (2,160) (41,563)
Other income (expense):
Interest income (expense), net......... 3,906 (2,204) (265)(2) 1,437
Other, net............................. -- 175 -- 175
----------- -------- ---------- -----------
Net loss from continuing operations...... (25,344) (12,182) (2,425) (39,951)
Accretion of preferred to redemption
value.................................. (3,489) -- -- (3,489)
Accrued preferred stock dividend......... (3,007) -- -- (3,007)
----------- -------- ---------- -----------
Net loss applicable to common
stockholders........................... (31,840) (12,182) (2,425) (46,447)
=========== ======== ========== ===========
Basic and diluted weighted average shares
outstanding............................ 26,938,911 n/a 1,349,838(3) 28,288,749
=========== ======== ========== ===========
Basic and diluted loss per share of
common stock........................... $ (1.18) n/a n/a $ (1.64)
=========== ======== ========== ===========
</TABLE>
NOTES TO THE 2000 UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS
(1) Reflects three months of amortization of intangibles recorded in connection
with the acquisition of Primary Network and includes amortization of
goodwill ($3.1 million) and amortization of customer base ($0.6 million)
less the amortization of intangibles in the historical statement of
operations of Primary Network. Amortization periods assumed for goodwill and
customer base were 10 years and 5 years, respectively.
(2) Reflects additional interest expense associated with the exchange of debt
assumed from Primary Network.
(3) Reflects the number of shares of Mpower stock issued in exchange for the
preferred and common stock of Primary Network.
84
<PAGE> 86
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
MPOWER COMMUNICATIONS CORP.
Date: September 6, 2000 /s/ FRANK C. SZABO
----------------------------------------
Name: Frank C. Szabo
Title: Vice President and Comptroller
85
