<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 000-20799
EARTHLINK NETWORK, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 58-2389244
(STATE OF INCORPORATION) (I.R.S. EMPLOYER IDENTIFICATION NUMBER)
3100 NEW YORK DRIVE, PASADENA, CALIFORNIA 91107
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(626) 296-2400
(REGISTRANT'S TELEPHONE, INCLUDING AREA CODE)
--------------------
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$.01 par value
--------------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
--- ---
There were 28,521,321 shares of Common Stock outstanding as of September
30, 1998.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
EARTHLINK NETWORK, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
PART I
<TABLE>
<CAPTION>
<S> <C> <C>
Item 1. Financial Statements and Supplementary Data....................... 1
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations......................................... 6
Item 3. Quantitative and Qualitative Disclosures About Market Risk ....... 12
Item 4. Submission of Matters to a Vote of Security Holders................12
PART II
Item 6. Exhibits and Reports on Form 8-K...................................13
</TABLE>
<PAGE>
PART I
ITEM 1. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
EARTHLINK NETWORK, INC.
CONDENSED CONSOLIDATED BALANCE SHEET
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31, 1997 SEPTEMBER 30, 1998
----------------- ------------------
(AUDITED) (UNAUDITED)
(in thousands)
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 16,450 $ 134,397
Restricted short-term investment 1,250 1,250
Accounts receivable, net 2,520 4,596
Prepaid expenses 1,109 3,755
Other assets 753 644
--------- ---------
Total current assets 22,082 144,642
Other long-term assets 449 564
Property and equipment, net 23,398 30,405
Intangibles, net (Note 4) 958 97,731
--------- ---------
$ 46,887 $ 273,342
--------- ---------
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 6,472 $ 11,918
Accrued payroll and related expenses 2,316 6,881
Other accounts payable and accrued liabilities 3,717 13,017
Current portion of capital lease obligations 7,112 7,985
Notes payable 9,387 80
Deferred revenue 3,590 7,318
--------- ---------
Total current liabilities 32,594 47,199
Long-term portion of capital lease obligations 8,218 7,288
--------- ---------
Total liabilities 40,812 54,487
--------- ---------
Stockholders' equity:
Preferred stock 41
Common stock 225 285
Additional paid-in capital 70,829 324,855
Warrants to purchase common stock 1,093 1,324
Accumulated deficit (66,072) (107,650)
--------- ---------
Total stockholders' equity 6,075 218,855
--------- ---------
$ 46,887 $ 273,342
--------- ---------
--------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements
1
<PAGE>
EARTHLINK NETWORK, INC
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------ ----------------------
1997 1998 1997 1998
--------- ---------- --------- ---------
(UNAUDITED)
(in thousands, except per share data)
<S> <C> <C> <C> <C>
Revenues:
Recurring revenues $ 19,450 $ 46,877 $ 51,869 $ 109,957
Other revenues 1,559 1,699 4,558 4,897
Incremental revenues - 1,248 - 2,786
--------- ---------- --------- ----------
Total revenues 21,009 49,824 56,427 117,640
Operating costs and expenses:
Cost of recurring revenues 9,304 21,174 25,828 53,163
Cost of other revenues 352 394 1,326 730
Sales and marketing 6,670 9,975 18,904 25,348
General and administrative 3,511 5,843 10,462 15,344
Operations and member support 7,970 15,078 22,183 36,248
Amortization and transaction costs (Note 4) - 17,754 - 24,962
--------- ---------- --------- ----------
Total operating costs and expenses 27,807 70,218 78,703 155,795
--------- ---------- --------- ----------
Loss from operations (6,798) (20,394) (22,276) (38,155)
Interest income 116 1,919 416 2,568
Interest expense (516) (353) (1,467) (1,661)
--------- ---------- --------- ----------
Net loss (7,198) (18,828) (23,327) (37,248)
Deductions for dividends on convertible
preferred stock (Note 5) (3,276) (4,330)
--------- ---------- --------- ----------
Net loss attributable to common
stockholders $ (7,198) $ (22,104) $ (23,327) $ (41,578)
--------- ---------- --------- ----------
--------- ---------- --------- ----------
Basic and diluted net loss per share
(Note 3) $ (0.36) $ (0.78) $ (1.22) $ (1.64)
--------- ---------- --------- ----------
--------- ---------- --------- ----------
Weighted average shares 19,864 28,458 19,186 25,292
--------- ---------- --------- ----------
--------- ---------- --------- ----------
</TABLE>
The accompanying notes are an integral part of these financial statements
2
<PAGE>
EARTHLINK NETWORK, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------- ---------------------------
1997 1998 1997 1998
--------- --------- --------- ---------
(UNAUDITED)
(in thousands)
<S> <C> <C> <C> <C>
Net cash (used in) provided by
operating activities $ (4,048) $ 2,462 $ (20,252) $ 14,398
--------- --------- --------- ---------
Cash flows from investing activities:
Purchases of property and equipment (2,522) (4,381) (11,490) (15,911)
Purchases of intangible assets (48) - (1,404) (9)
Transaction costs (449) (8,861)
Net cash acquired from acquisition 23,750
Purchase of restricted short-term
investment (200) - (200) -
Liquidation of restricted short-term
investment - - 38 -
--------- --------- --------- ---------
Net cash used in investing
activities (2,770) (4,830) (13,056) (1,031)
--------- --------- --------- ---------
Cash flows from financing activities:
Proceeds from issuance of notes
payable 981 - 2,252 200
Repayment of notes payable - (120) (2,225) (4,507)
Proceeds from capital lease
obligations 2,512 576 7,837 6,212
Principal payments under capital
lease obligations (1,274) (2,380) (3,354) (6,269)
Proceeds from issuance of common
stock, net 15,436 - 41,718 105,329
Proceeds from stock options and
warrants exercised 87 976 176 3,615
--------- --------- --------- ---------
Net cash provided by (used in)
financing activities 17,742 (948) 46,404 104,580
--------- --------- --------- ---------
Net increase (decrease) in cash and
cash equivalents 10,924 (3,316) 13,096 117,947
Cash and cash equivalents, beginning
of period 6,165 137,713 3,993 16,450
--------- --------- --------- ---------
Cash and cash equivalents, end
of period $ 17,089 $ 134,397 $ 17,089 $ 134,397
--------- --------- --------- ---------
--------- --------- --------- ---------
Acquisition, net of cash acquired
(Note 4):
Issuance of convertible preferred stock $ 135,000
Transaction costs 9,914
Intangible assets (121,164)
---------
Net cash acquired from acquisition $ 23,750
---------
---------
</TABLE>
The accompanying notes are an integral part of these financial statements
3
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The condensed consolidated financial statements of EarthLink Network,
Inc., which include the accounts of its wholly owned subsidiary, EarthLink
Operations Inc., (collectively, "EarthLink" or the "Company") for the three
month and nine month periods ended September 30, 1998 and the related
footnote information are unaudited and have been prepared on a basis
substantially consistent with the Company's audited financial statements as
of December 31, 1997 contained in the Company's Annual Report on Form 10-K,
as amended, as filed with the Securities and Exchange Commission (the "Annual
Report"). All significant intercompany transactions have been eliminated.
These financial statements should be read in conjunction with the audited
financial statements and the related notes thereto contained in the Company's
Annual Report. In the opinion of management, the accompanying unaudited
financial statements contain all adjustments (consisting of normal recurring
adjustments) which management considers necessary to present fairly the
financial position of the Company at September 30, 1998 and the results of
operations and of cash flows for the three month and nine month periods ended
September 30, 1997 and 1998. The results of operations for the three month
and nine month periods ended September 30, 1998 are not necessarily
indicative of the results for the entire year ending December 31, 1998.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements.
Actual results may differ from those estimates.
2. RECLASSIFICATIONS
Certain amounts in prior period financial statements have been
reclassified to conform to the current period presentation.
3. NET LOSS PER SHARE
The Company has adopted Statement of Financial Accounting Standards
(SFAS) No. 128, "Earnings per Share" ("EPS"). SFAS No. 128 requires a dual
presentation of basic and diluted EPS. Basic EPS represents the weighted
average number of shares outstanding divided into net income attributable to
common stockholders during a reported period. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock. However, the
Company has not included potential common stock in the calculation of EPS as
such inclusion would have an anti-dilutive effect.
4. INTANGIBLE ASSETS AND AMORTIZATION COSTS
In June 1998 the Company consummated its strategic alliance with Sprint
Corporation ("the Sprint Transaction") in the area of consumer Internet
access and related services. The value of intangible assets acquired in the
Sprint Transaction, aggregating $121.2 million, as of September 30, 1998, is
being amortized on a straight-line basis over their estimated useful lives.
During the quarter ended September 30, 1998 the Company incurred amortization
expense of $17.8 million on these assets.
4
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
5. DEDUCTIONS FOR DIVIDENDS ON CONVERTIBLE PREFERRED STOCK
The Series A Convertible Preferred Stock issued in conjunction with the
Sprint Transaction will pay liquidation dividends for the first five years in
the form of increases in its Liquidation Value, as defined, at a rate of 3%
of the Liquidation Value. Thereafter, the Series A Convertible Preferred
Stock will pay a cash dividend of 3% for 15 years increasing from 8% to 12%
in years 21 through 23. Dividends on the Convertible Preferred Stock are
reflected as an increase to net loss attributable to common stockholders. The
adjustment of $3.3 million recorded during the quarter ended September 30,
1998 represents a liquidation dividend of $1.8 million based on a 3% dividend
and the accretion of a $1.5 million dividend related to the beneficial
conversion feature of the Convertible Preferred Stock in accordance with EITF
Topic No. D-60 based upon the rate at which the preferred stock becomes
convertible.
6. AMENDMENT TO LEASE
Effective July 1998, the Company amended the lease for its Data Center
facility. Under the amended lease the Company increased the space it occupies
from 55,000 to 110,000 square feet of the existing facility and received an
improvement allowance of $1.2 million from the lessor. Rent commitments for
the 110,000 square feet of space are as follows:
<TABLE>
<CAPTION>
Annual
Term Commitment
-------------- ------------
<S> <C>
1998 (October 1, 1998 - December 31, 1998) $ 276,000
1999 1,270,000
2000 1,765,000
2001 1,765,000
2002 1,881,000
2003 1,897,000
Thereafter 6,263,000
------------
$ 15,117,000
------------
------------
</TABLE>
Under the amended lease the Company will deliver an irrevocable letter of
credit of $1 million to the lessor and cancel its current letter of credit of
$800,000.
7. RECENT ACCOUNTING PRONOUNCEMENTS
The Company is subject to the provisions of Statement of Financial
Accounting Standards No. 130 ("SFAS 130"), "Reporting Comprehensive Income"
and Statement of Financial Accounting Standards No. 131 ("SFAS 131"),
"Disclosures about Segments of an Enterprise and Related Information". The
statements have not had an impact on the Company's financial statements as
the Company does not have any "comprehensive income" type earnings (losses)
and its financial statements reflect how the "key operating decision maker"
views the business. The Company will continue to review these statements over
time to determine if any additional disclosures are necessary based on
evolving circumstances.
5
<PAGE>
This Report contains certain forward-looking statements with respect to
the Company's operations, industry, financial condition and liquidity. These
statements, which are typically introduced by phrases such as "the Company
believes", "anticipates", "estimates" or "expects" certain conditions to
exist, reflect management's best current assessment of a number of risks and
uncertainties. The Company's actual results could differ materially from the
results anticipated in these forward-looking financial statements as a result
of certain factors described in this report. See "Safe Harbor Statement."
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE ACCOMPANYING
UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES
THERETO AND THE AUDITED FINANCIAL STATEMENTS AND THE NOTES THERETO CONTAINED
IN THE ANNUAL REPORT.
OVERVIEW
EarthLink Network, Inc. (together with its wholly-owned operating
subsidiary, "EarthLink" or the "Company") is a leading Internet service
provider ("ISP") that provides reliable, nationwide Internet access and
related value-added services to its individual and business members, helping
them to derive meaningful benefits from the extensive resources of the
Internet. The Company has experienced rapid member growth and has become one
of the world's largest ISPs by enhancing its members' Internet experience
through simple, rapid and reliable access to the Internet, high quality
service and member support and enhanced services.
EarthLink provides its members with a core set of features through its
standard Internet service, which provides unlimited access to the Internet
and several related value-added services for a flat monthly fee of $19.95. In
addition, the Company offers a variety of premium services to both its
individual and business members. Recurring revenues, which are generally paid
for in advance with credit cards, consist of monthly fees charged to members
for Internet access and other ongoing services including Business Web Site
Hosting, National ISDN, LAN ISDN, and Frame Relay Connections and, in certain
areas, cable modem access. Access fees are recognized ratably over the period
services are provided. Other revenues generally represent one-time,
non-refundable set up fees and are recorded as earned. Incremental revenues
are derived from leveraging the Company's member base, including online
advertising, commissions from electronic commerce, and sales of certain
products.
Cost of recurring revenues principally includes telecommunications costs
and depreciation expense on equipment used in network operations for ongoing
member services. Included in telecommunications costs are fees paid to UUNET
Technologies, Inc. ("UUNET"), PSINet, Inc. ("PSINet") and Sprint Corporation
("Sprint") for local dial-up access to their respective nationwide systems of
points of presence ("POPs"). Cost of other revenues principally includes
expenses, such as bounties paid to third parties for generating new members
for the Company and licensing fees for software.
The Company has experienced net losses since it commenced operations. As
of September 30, 1998, the Company had an accumulated deficit of $107.7
million (exclusive of $1.3 million in losses incurred from inception through
June 19, 1995 which have been reclassified from accumulated deficit to common
stock as a result of the Company's conversion from S Corporation to C
Corporation status and inclusive of $4.3 million representing dividends on
Series A Convertible Preferred Stock). The Company has noted a trend of
continuing improvement in net loss and earnings before interest, taxes,
depreciation and amortization ("EBITDA"). EBITDA for the three months ended
September 30, 1998 was a positive $900,000.
6
<PAGE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
---------------------------------------- -----------------------------------------
PERCENT PERCENT PERCENT PERCENT
OF TOTAL OF TOTAL OF TOTAL OF TOTAL
1997 REVENUES 1998 REVENUES 1997 REVENUES 1998 REVENUES
-------- -------- ----- -------- -------- -------- -------- --------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
EBITDA $ (4,285) (20%) $ 900 2% $(15,705) (28%) $ (4,759) (4%)
One-Time Sprint Transaction costs 1,397 1%
-------- -------- ----- -------- -------- -------- -------- --------
EBITDA before Sprint Transaction
Costs $ (4,285) (20%) $ 900 2% $(15,705) (28%) $ (3,362) (3%)
-------- -------- ----- -------- -------- -------- -------- --------
-------- -------- ----- -------- -------- -------- -------- --------
</TABLE>
The improvement in EBITDA was primarily due to significant member growth and
the Company's ability to take advantage of economies of scale to control
costs and expenses. EBITDA is not determined in accordance with generally
accepted accounting principles, is not indicative of cash used by operating
activities and should not be considered in isolation from, an alternative to,
or more meaningful than measures of performance determined in accordance with
generally accepted accounting principles. The Company expects that it will
continue to incur net losses as it continues to expend substantial resources
on sales and marketing to rapidly increase its member base. There can be no
assurance that the Company will sustain profitability or positive cash flow
from its operating activities.
RESULTS OF OPERATIONS
The following table sets forth the percentage of total revenues
represented by certain items on the Company's statements of operations for
the periods indicated:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------- ---------------
1997 1998 1997 1998
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues:
Recurring revenues 93% 94% 92% 94%
Other revenues 7 3 8 4
Incremental revenues - 3 - 2
---- ---- ---- ----
Total revenues 100% 100% 100% 100%
Operating costs and expenses:
Cost of recurring revenues 44 42 46 45
Cost of other revenues 1 1 2 1
Sales and marketing 32 20 34 21
General and administrative 17 12 18 13
Operations and member support 38 30 39 31
Amortization and transaction costs (1) - 36 - 21
---- ---- ---- ----
132 141 139 132
---- ---- ---- ----
Loss from operations (32) (41) (39) (32)
Interest income 1 4 1 2
Interest expense (3) (1) (3) (1)
---- ---- ---- ----
Net loss (34%) (38%) (41%) (31%)
---- ---- ---- ----
---- ---- ---- ----
EBITDA (2) (20%) 2% (28%) (4%)
---- ---- ---- ----
---- ---- ---- ----
</TABLE>
- -------------------
(1) Represents $17.8 million and $23.6 million in amortization of intangible
assets acquired in the Sprint Transaction during the respective three and
nine month periods ended September 30, 1998, respectively, and a one-time
transaction cost of $1.4 million in June 1998 due the Company's strategic
alliance with Sprint.
(2) Represents earnings (loss) before depreciation and amortization, interest
income and expense and income tax expense. EBITDA is not determined in
accordance with generally accepted accounting principles, is not indicative
of cash used by operating activities and should not be considered in
isolation from an alternative to, or more meaningful than measures of
performance determined in accordance with generally accepted accounting
principles.
7
<PAGE>
RECURRING REVENUES
The Company experienced substantial growth in revenues for the three and
nine month periods ended September 30, 1998 as compared to the corresponding
periods of 1997. The increase in recurring revenues of 141% from $19.5
million in the quarter ended September 30, 1997 to $46.9 million in the
quarter ended September 30, 1998 was primarily due to an increase in the
Company's member base from 420,000 at December 31, 1997 to 815,000 at
September 30, 1998.
OTHER REVENUES
<TABLE>
<CAPTION>
THREE MONTHS NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
-------------------- INCREASE ------------------- INCREASE
1997 1998 (DECREASE) 1997 1998 (DECREASE)
------ ------ ---------- ------ ------ ----------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Dial-up set up fees $ 822 $ 771 $ (51) $2,736 $2,310 $ (426)
Non Dial-up set up fees 737 928 191 1,822 2,587 765
------ ------ ------ ------ ------ ------
Total other revenues $1,559 $1,699 $ 140 $4,558 $4,897 $ 339
------ ------ ------ ------ ------ ------
------ ------ ------ ------ ------ ------
</TABLE>
The decrease in dial up set up fees is primarily due to the Company's
willingness to waive set up fees for dial-up members acquired through certain
affinity marketing partnerships and other programs in response to market
pressures. The Company expects this trend to continue for dial-up set up
revenues. EarthLink has continued to expanded its sales of premium services
such as Business Web Site Hosting, National ISDN, LAN ISDN and Frame Relay
Connections and cable-modem connections. As such, one-time fees for the set
up of non-dial-up accounts has increased significantly.
INCREMENTAL REVENUES
In the first quarter of 1998 EarthLink began reporting incremental
revenues derived from programs such as advertising and electronic commerce
fees that leverage the Company's growing member base and user traffic. The
principal component of the Company's strategy is the Premier Partnership
Program through which the Company offers and sells promotional packages that
provide advertisers with access to the multiple points of contact EarthLink
has with its members. The Company also sells advertising and content space on
its various online properties such as the Personal Start Page and its
bi-monthly print newsletter, "bLink". Incremental revenues were $1.1 million
and $1.3 million during the three months ended June 30, 1998 and September
30, 1998, respectively.
COST OF RECURRING REVENUES
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------- -----------------------------------------------
PERCENT OF PERCENT OF PERCENT OF PERCENT OF
RECURRING RECURRING RECURRING RECURRING
1997 REVENUES 1998 REVENUES 1997 REVENUES 1998 REVENUES
------- ---------- ------- ---------- ------- ---------- -------- ----------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Recurring revenues $19,450 100% $46,877 100% $51,869 100% $109,957 100%
Cost of recurring revenues 9,304 48 21,174 45 25,828 50 53,163 48
</TABLE>
Cost of recurring revenues increased 128% and 106% during the three and
nine month periods ended September 30, 1998, respectively, as compared to the
corresponding periods of 1997, primarily due to the corresponding increase in
the Company's member base. The decrease in the cost of recurring revenues as
a percentage of recurring revenues was primarily due to the Company's ability
to more effectively manage and thereby reduce communications costs per member
to exploit economies of scale and to reduce per member costs as the total
member base expanded.
8
<PAGE>
COST OF OTHER REVENUES
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
----------------------------------------------- -----------------------------------------------
PERCENT OF PERCENT OF PERCENT OF PERCENT OF
OTHER OTHER OTHER OTHER
1997 REVENUES 1998 REVENUES 1997 REVENUES 1998 REVENUES
------- ---------- ------- ---------- ------- ---------- -------- ----------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Royalties $ 192 13% $ 61 4% $ 873 19% $ 108 2%
Other 160 10% 333 19% 453 10% 622 13%
------- ---------- ------- ---------- ------- ---------- -------- ----------
Total cost of other revenues $ 352 23% $ 394 23% $1,326 29% $ 730 15%
------- ---------- ------- ---------- ------- ---------- -------- ----------
------- ---------- ------- ---------- ------- ---------- -------- ----------
</TABLE>
Cost of other revenues increased 12% during the three months ended
September 30, 1998 as compared to the corresponding period of 1997. The
increase is primarily due to increases in the cost of ISDN equipment sold to
members and the cost to produce TotalAccess diskettes. These increases were
partially offset by a reduction in royalty expense occasioned by the renewal
of various contracts for licensed software under more favorable terms. Cost
of other revenues decreased 45% for the nine months ended September 30, 1998
as compared to the corresponding period of 1997. The decrease was primarily
due to a reduction in royalty expense. The increase in the other components
of cost of other revenues is primarily due to the increase in the rate of
member growth during the three and nine month periods ended September 30,
1998 as compared to the corresponding periods of 1997.
SALES AND MARKETING
Sales and marketing expenses consist primarily of advertising, sales
commissions, salaries and the cost of promotional material. Sales and
marketing expenses increased 50% from $6.7 million to $10.0 million during
the three month periods ended September 30, 1997 and 1998, respectively, and
34% from $18.9 million to $25.3 million during the nine months ended
September 30, 1997 and 1998, respectively. The increases were primarily due
to increased emphasis on marketing including expanding sales and marketing
efforts on a nationwide basis, increased sales commissions and increased
marketing personnel headcount. The Company does not defer sales, marketing or
other direct costs associated with the acquisition of members. These costs
are expensed as incurred.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of costs
associated with the accounting and human resources departments, professional
expenses, rent, bad debt and compensation. General and administrative
expenses increased 66% from $3.5 million to $5.8 million during the three
months ended September 30, 1997 and 1998, respectively and 46% from $10.5
million to $15.3 million during the nine months ended September 30, 1997 and
1998, respectively. The increase was primarily due to increases in payroll,
rent, depreciation expenses and credit card fees. The rise in payroll costs
was primarily due to growth in headcount. In October 1997, the Company
occupied an additional 45,000 square feet of its corporate headquarters
facility, and monthly rent increased from $46,000 to $73,000. The increase in
depreciation expense was due to the acquisition of office equipment and the
build-out of leasehold improvements. The increase in credit card processing
fees was due to the increase in the Company's member base.
OPERATIONS AND MEMBER SUPPORT
Operations and member support expenses consist primarily of costs
associated with technical support and member service, as well as costs to
maintain member accounts. Operations and member support expenses increased
89% from $8.0 million to $15.1 million during the three month periods ended
September 30, 1997 and 1998, respectively, and 64% from $22.2 million to
$36.3 million during the nine months ended September 30, 1997 and 1998,
respectively. The increases reflect management's focus on retaining existing
members by providing superior services and devoting significant resources to
expanding technical support staff and network operations capabilities. The
number of employees engaged in operations and member support activities was
518
9
<PAGE>
and 893 at September 30, 1997 and 1998, respectively. The Company also
continues to improve member service functions by investing in training
programs, hardware and software.
INTEREST EXPENSE
Interest expense decreased from $516,000 to $353,000 during the three
months ended September 30, 1998, as compared to the corresponding period of
1997. This was primarily due to the aging of capital lease obligations. As
capital lease obligations have aged a greater portion of lease payments has
been attributed to principal payments rather than interest expense. Interest
expense increased from $1.5 million to $1.7 million during the nine months
ended September 30, 1998 as compared to the corresponding periods of 1997.
INTEREST INCOME
Interest income increased from $116,000 to $416,000 and from $1.9
million to $2.6 million during the three and nine months ended September 30,
1997 and 1998, respectively. The increases were primarily due to an increase
in average cash balances available for investment.
POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS
The Company's operating results may fluctuate significantly in the
future as a result of a variety of factors, many of which are beyond the
Company's control. These factors include the rates of, and costs associated
with, new member acquisition, member retention, capital expenditures and
other costs relating to the expansion of operations, including upgrading the
Company's systems and infrastructure, the timing and market acceptance of new
and upgraded service introductions, changes in the pricing policies of the
Company and its competitors, changes in operating expenses (including
telecommunications costs), the introduction of alternative technologies, the
effect of potential acquisitions, increased competition in the Company's
markets and other general economic factors. In addition, a portion of the
Company's expenses are fixed; therefore, the Company's operating margins are
particularly sensitive to fluctuations in revenues.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operating activities was $2.5 million and $14.3 million
during the three and nine month periods ended September 30, 1998,
respectively. The increase during the nine month period ended September 30,
1998 was primarily due to an increase in accrued liabilities of $13.8 million.
Cash used in investing activities was $4.8 million and $1.0 million for
the three and nine month periods ended September 30, 1998, respectively. Net
cash acquired in the Sprint Transaction of $23.8 million was partially offset
by Sprint Transaction costs of $449,000 and $9.9 million for the three and
nine month periods ended September 30, 1998, respectively. Capital equipment
purchases were $4.4 million and $15.9 million for the three and nine month
periods ended September 30, 1998, respectively.
10
<PAGE>
Cash used in and provided by financing activities was approximately
$948,000 and $104.6 million during the three and nine month periods ended
September 30, 1998, respectively. In June 1998 the Company completed a follow
on public offering of 4.8 million shares of its Common Stock at $30 per
share. The offering consisted of 3.0 million shares and an underwriter's
overallotment of 720,000 shares offered by the Company and 1.8 million shares
offered by certain stockholders. The Company did not receive any proceeds
from the sale of shares by selling stockholders. Net proceeds to the Company
were approximately $105 million. Proceeds from capital lease transactions for
the three and nine month periods ended September 30, 1998 were $576,000 and
$6.3 million, respectively. The sale leaseback transactions are recorded at
cost, which approximates the fair market value of the property and,
therefore, no gains or losses are recorded. The property continues to be
depreciated by the Company. A financing obligation representing the proceeds
is recorded and reduced based upon payments under the lease agreement.
As of September 30, 1998, the Company had cash and cash equivalents of
approximately $134.4 million. The Company believes that available cash will
be sufficient to meet the Company's operating expenses and capital
requirements for the next 12 months. EarthLink has available a $25 million
credit facility from Sprint in the form of convertible senior debt,
increasing to $100 million over a three-year period, at an interest rate of
6% per annum. The Company's capital requirements depend on numerous factors,
including the rate of market acceptance of the Company's services, the
Company's ability to maintain and expand its member base, the rate of
expansion of the Company's network infrastructure, the level of resources
required to expand the Company's marketing and sales programs, information
systems and research and development activities, the availability of hardware
and software provided by third-party vendors and other factors.
YEAR 2000
Many existing computer programs and systems use only two digits to
identify a year. These programs and systems were designed and developed
without considering the impact of the upcoming change in the century. If not
corrected, many computer programs and systems may fail or create erroneous
results by, at or beyond the Year 2000.
The Company recently completed an extensive audit of all hardware and
software which is critical to both Internet and business operations. The
results of the audit are being analyzed to formulate a comprehensive Year
2000 test plan. Preliminary indications are that, since EarthLink is a
relatively new company (founded in 1994), most hardware and software systems
and software will not be impacted by the Year 2000 Phenomenon. Subsequent
testing will indicate what modifications or replacements will be necessary
for EarthLink to be internally Year 2000 ready. Current versions of
EarthLink's TotalAccess software, which end-user members use to access their
Internet accounts, have already been tested and are believed to be Year 2000
ready. EarthLink's primary concern, at this point, is with its third party
communications providers of digital trunks and dial-up ports (AT&T, PSINet,
UUNet, Sprint, etc.). These vendors are performing their own assessments of
their Year 2000 readiness. The Company expects that these third party vendors
will be Year 2000 ready. However, any failure by third party vendors to
resolve any Year 2000 issues on a timely basis or in a manner that is
compatible with the Company's systems could have a material adverse effect on
the Company. Preliminary indications are, however, that the Company's
third-party providers are, or will be, Year 2000 compliant.
There are no significant historical costs associated with EarthLink's
Year 2000 compliance efforts and it is not anticipated that there will be
significant replacement or modification costs required. At this point, the
most likely worst-case scenario is that one or more of EarthLink's service
providers will experience some problems resulting in the loss of dial-up
service to one or more point's of presence ("POP") for a period of time. A
contingency POP management plan should lessen the impact of this risk. At
this time, other than what is mentioned above, it is not anticipated that
EarthLink will require a significant Year 2000 Contingency Plan.
11
<PAGE>
"SAFE HARBOR" STATEMENT
The Management's Discussion and Analysis and other portions of this
Report include "forward looking" statements within the meaning of the federal
securities laws that are subject to future events, risks and uncertainties
that could cause actual results to differ materially from those expressed or
implied. Important factors that ether individually or in the aggregate could
cause actual results to differ materially from those expressed include,
without limitation, (1) that the Company will not retain or grow its member
base, (2) that the Company will fail to be competitive with existing and new
competitors, (3) that the Sprint alliance will not be as beneficial to the
Company as management anticipates, (4) that the Company will not be able to
sustain its current growth, (5) that the Company will not adequately respond
to technological developments impacting the Internet, (6) that needed
financing will not be available to the Company if and as needed, (7) that a
significant change in the growth rate of the overall U.S. economy will occur,
such that consumer and corporate spending are materially impacted, (8) that a
significant reversal in the trend toward increased usage of the Internet will
occur, and (9) that the Company or its vendors and suppliers may fail to
timely achieve Year 2000 readiness such that there is a material adverse
impact on the business, operations or financial results of the Company, (10)
that a drastic negative change in the market conditions may occur, or (11)
that some other unforeseen difficulties may occur. This list is intended to
identify only certain of the principal factors that could cause actual
results to differ materially from those describe in the forward-looking
statements included herein.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Earthlink held its 1998 annual meeting of Stockholders (the "Annual
Meeting") on August 28, 1998 for the purposes of electing directors for the
ensuing year and for amending its 1995 Stock Option Plan to increase the
number of shares authorized for grant thereunder from 3.7 million to 5.7
million. The following individuals were re-elected to the Company's Board of
Directors:
Sky Dayton Kevin O'Donnell
Charles G. Betty Reed Slatkin
Linwood A. Lacy, Jr. Sidney Azeez
Robert M. Kavner Paul McNulty
Each nominee received 22,420,360 votes for his election and 26,722
shares abstained from voting. There were no votes against the election of any
of the nominees. With respect to the amendment of the Company's Stock Option
Plan, 16,877,732 shares voted for the proposal, 570,088 voted against the
proposal and there were 22,508 abstentions. Both proposals passed.
12
<PAGE>
PART II
ITEM 6. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Exhibits. The following exhibits are filed as part of this report:
<TABLE>
<CAPTION>
Exhibit No. Description
----------- -----------
<S> <C>
10.1 Third Amendment to the lease agreement between WHMNY Real Estate
Limited Partnership, a Delaware limited partnership
("Landlord"), and Earthlink Network, Inc., ("Tenant").
27 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K.
Form 8-K filed August 14, 1998 describing the Company's recently completed
strategic alliance with Sprint Corporation and related transactions.
13
<PAGE>
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, thereunto duly authorized.
EARTHLINK NETWORK, INC.
Date: November 16, 1998 /s/ Charles G. Betty
---------------------------- -----------------------------------------
Charles G. Betty, President, Chief
Executive Officer and Director
Date: November 16, 1998 /s/ Grayson L. Hoberg
---------------------------- -----------------------------------------
Grayson L. Hoberg, Senior Vice
President - Finance and Administration
and Chief Financial Officer
Date: November 16, 1998 /s/ Richard A. Quiroga
---------------------------- -----------------------------------------
Richard A. Quiroga, Vice President,
Corporate Controller
14
<PAGE>
THIRD AMENDMENT TO LEASE
THIS THIRD AMENDMENT TO LEASE ("Third Amendment") is made and entered
into as of August 11, 1998, by and between WHMNY REAL ESTATE LIMITED
PARTNERSHIP, a Delaware limited partnership ("Landlord"), and EARTHLINK
NETWORK, INC., a Delaware corporation ("Tenant").
RECITALS
A. ORIGINAL LEASE. Pursuant to that certain Office Lease dated
September 26, 1996 (the "Original Lease"), Landlord's predecessor in
interest, The Mutual Life Insurance Company of New York ("MONY"), leased to
Tenant certain premises in Suite 100 consisting of the first floor (the
"Original Premises") of the building located at 2947 Bradley Street,
Pasadena, California, 91107 (the "Building").
B. FIRST AMENDMENT. The Original Lease was amended by that certain
First Amendment to Lease (the "First Amendment") dated February 1997, and by
the following letter agreements, each by and between MONY and Tenant: that
certain letter agreement dated October 8, 1996 (regarding the letter of
credit); that certain letter agreement dated October 10, 1996 (regarding
submetering of utilities); that certain letter agreement dated November 18,
1996 (regarding modification to parabolic light fixtures); and that certain
letter agreement dated February 24, 1997 (regarding payment for submeters)
(collectively, the "Letter Agreements").
C. SECOND AMENDMENT. The Original Lease was further amended to
confirm the size of the Original Premises by that certain Second Amendment
to Lease (the "Second Amendment") dated February 1997, by and between MONY
and Tenant.
D. EXISTING LEASE. The Original Lease, as amended by the First
Amendment, the Letter Agreements, and the Second Amendment, is referred to
herein as the "Existing Lease."
E. LEASE. The Existing Lease, as amended by this Third Amendment, is
referred to herein as the Lease.
F. PURPOSE. Landlord and Tenant desire to further amend the Existing
Lease as set forth herein.
AGREEMENT
NOW, THEREFORE, for good and valuable consideration, the receipt and
adequacy of which are hereby mutually acknowledged, Landlord and Tenant
hereby agree as follows:
1. PREMISES. The description of the Premises set forth in the
Existing Lease is hereby amended by adding the following:
Landlord hereby leases to Tenant and Tenant hereby leases
from Landlord the lobby area on the first floor and the
entire second floor of the Building (the "First Additional
Premises"), as shown on the floor plan attached hereto as
Exhibit "A." Unless otherwise expressly provided to the
contrary herein, on and after the First Additional Premises
Commencement Date (defined below) the term "Premises" as
used in this Lease shall consist of the Existing Premises
(the entire first floor) and the First Additional Premises
(the first floor lobby and the entire second floor), for a
total of approximately 110,497 rentable square feet, and
shall be commonly referred to as Suite 100. Except as
otherwise provided in this Third Amendment, the First
Additional Premises shall be leased by Tenant on the same
terms and conditions as are applicable from time to time to
the Existing Premises.
<PAGE>
2. TERM. The description of the term set forth in the Existing Lease
is hereby amended by adding the following:
The term of this Lease with respect to the First Additional
Premises shall commence on October 1, 1998 (the "First
Additional Premises Commencement Date"), shall run
concurrently with the remaining term of the Existing Lease,
and shall terminate on February 13, 2007. Notwithstanding
the foregoing to the contrary, upon the full execution of
this Third Amendment by Landlord and Tenant, and until the
First Additional Premises Commencement Date, Tenant shall
have the right to occupy the First Additional Premises,
subject to all of the provisions of this Lease excepting
only those requiring the payment of Rent respecting the
First Additional Premises.
3. MONTHLY RENTAL. Section IVA of the Original Lease, Exhibit D
attached to the Original Lease, and paragraph 3c of the Second Amendment are
hereby amended by adding the following:
Tenant agrees to pay to Landlord, as Monthly Rental for the
Existing Premises and the First Additional Premises, the
amounts set forth below per month for the time periods set
forth below payable on the first day of each calendar month
without offset or deduction during the term of this Lease.
<TABLE>
<CAPTION>
EFFECTIVE DATES MONTHLY RENTAL
--------------- --------------
<S> <C>
10/01/1998-09/30/1999 $ 92,071.00
10/01/1999-01/31/2002 $147,081.00
02/01/2002-02/28/2002 $153,294.00
03/01/2002-12/31/2003 $158,046.00
01/01/2004-01/31/2007 $167,307.00
02/01/2007-02/13/2007 $ 72,499.70
</TABLE>
4. COMMON OPERATING COSTS. Section IQ of the Original Lease, and
paragraph 3b of the Second Amendment are hereby amended by adding the
following:
On and after the First Additional Premises Commencement
Date, Tenant's Proportionate Share of Common Operating Costs
shall be 100%.
5. PARKING. As of the First Additional Premises Commencement Date,
Tenant shall have the exclusive use of the entire Building, including its
parking lot, and Tenant shall have no obligation to pay rent for the use of
the spaces in such lot.
6. SECURITY DEPOSIT. Section IL of the Original Lease, and Section
XXXV.D of the Addendum attached to the Original Lease, are hereby amended by
adding the following:
On or before the First Additional Premises Commencement
Date, Tenant shall deliver a new Letter of Credit from no more
than two (2) banks in the aggregate amount of $1,000,000.00 as
security for Tenant's full and faithful performance of its
obligations and payments due under this Lease (the "New
Letter of Credit"). Once the New Letter of Credit is
delivered to Landlord, the existing Letter of Credit in
effect at the time of execution of this Third Amendment (the
"Existing Letter of Credit") shall be cancelled and shall be of
no further force or effect. Upon execution of this Third Amendment
by Landlord and Tenant, Landlord shall deliver the Existing Letter
of Credit to the bank that issued same, to be held in trust by such
bank
2
<PAGE>
pending the issuance of the New Letter of Credit and the subsequent
cancellation of the Existing Letter of Credit. All terms of
Section XXXV.D of the Addendum to the Original Lease respecting
the Existing Letter of Credit shall apply to the New Letter of
Credit, with the following exceptions: the Anniversary Dates
shall be measured from the First Additional Premises Commencement
Date, and the aggregate amount of the New Letter of Credit shall
be reduced by $120,000.00 yearly on the Anniversary Dates, as set
forth below:
<TABLE>
<CAPTION>
AMOUNT OF RENEWED
ANNIVERSARY DATES NEW LETTER OF CREDIT
----------------- --------------------
<S> <C>
10/01/1998 $1,000,000.00
10/01/1999 $ 880,000.00
10/01/2000 $ 760,000.00
10/01/2001 $ 640,000.00
10/01/2002 $ 520,000.00
10/01/2003 $ 400,000.00
10/01/2004 $ 280,000.00
10/01/2005 $ 160,000.00
10/01/2006-02/13/2007 $ 40,000.00
</TABLE>
7. TENANT IMPROVEMENT ALLOWANCE. Landlord shall provide Tenant with a
Tenant Improvement Allowance in the amount of $1,231,900.00 (the "Tenant
Improvement Allowance") to be applied towards the cost of the work to be
performed within the Premises by Tenant (the "Tenant Improvements"), in
accordance with the Work Letter attached hereto as Exhibit "B." Landlord and
Tenant acknowledge and agree that on or before March 31, 2000, the entire
Tenant Improvement Allowance must be used for the Tenant Improvement Costs
(as defined in the Work Letter), and any unused amount after such date shall
be retained by Landlord.
8. EXPANSION OPTIONS. Sections XXXV.A(1) and XXXV.A(2) of the Addendum
to the Original Lease are hereby deleted in their entirety and Landlord and
Tenant acknowledge that Tenant has no right to further expand in the Building.
9. BROKERS. Neither Landlord nor Tenant has dealt with any broker or
agent in connection with the negotiation or execution of this Third
Amendment, other than Insignia/ESG and Ramsey-Shilling Commercial Real Estate
Services, Inc. ("RSCO"). Landlord shall pay Insignia/ESG a commission in the
amount of three percent (3%) for months 1 through 60, and one and one-half
percent (1-1/2%) for months 61 through 101, in accordance with a separate
listing agreement, and shall pay RSCO a commission in the amount of four
percent (4%) for months 1 through 60, and two percent (2%) for months 61
through 101, in accordance with a separate commission agreement originally by
and between MONY and RSCO, and assumed by Landlord. Tenant and Landlord shall
each indemnify the other against all costs, expenses, attorney fees, and
other liability for commissions or other compensation claimed by any broker
or agent claiming the same by, through, or under the indemnifying party.
10. FULL FORCE AND EFFECT. Except as expressly amended by this Third
Amendment, the Existing Lease shall remain in full force and effect for the
entire remaining term and any extensions thereof.
3
<PAGE>
IN WITNESS WHEREOF, the parties hereto have executed this Third
Amendment effective as of the date first written above.
LANDLORD: WHMNY REAL ESTATE LIMITED
PARTNERSHIP, a Delaware limited partnership
By: WHMNY GEN-PAR, INC., a Delaware
corporation, General Partner
By:
------------------------------------
Name: Nancy M. Haag
Title: Assistant Vice President
TENANT: EARTHLINK NETWORKS, INC.
a Delaware corporation
By:
-------------------------------------
Name:
---------------------------------
Title:
---------------------------------
By:
-------------------------------------
Name:
---------------------------------
Title:
---------------------------------
4
<PAGE>
EXHIBIT "A"
DESCRIPTION OF FIRST ADDITIONAL PREMISES
[DIAGRAM OF 2ND FLOOR]
[LOGO] INSIGNIA 2ND FLOOR
COMMERICIAL GROUP, INC.
FOR LEASING INFORMATION 2947 BRADLEY STREET, PASADENA, CA
CALL CONAN COTRELL AT (310)235-3037
<PAGE>
EXHIBIT "B"
WORK LETTER
(TENANT IMPROVEMENT ALLOWANCE)
This Work Letter is attached to and made a part of that certain Third
Amendment to Lease dated as of August 11, 1998 ("Third Amendment") by and
between Landlord and Tenant for the First Additional Premises consisting of
the lobby area on the first floor and the second floor of the Building
located at 2947 Bradley Street, Pasadena, California, 91107.
1. APPLICATION OF EXHIBIT. Capitalized terms used and not otherwise
defined herein shall have the same definitions as set forth in the Existing
Lease. The provisions of this Work Letter shall apply to the planning and
completion of leasehold improvements to be constructed by Tenant (the "Tenant
Improvements") for the build-out of the First Additional Premises, as more
fully set forth herein.
2. LANDLORD AND TENANT PRE-CONSTRUCTION OBLIGATIONS.
(a) PRELIMINARY PLANS. Tenant shall cause Wirt Design Group ("Tenant's
Architect") to prepare preliminary space plans for the Tenant Improvements
(the "Preliminary Plans"), which shall include, without limitation, sketches
and/or drawings showing locations of doors, partitioning, electrical
fixtures, outlets and switches, plumbing fixtures, floor loads and other
requirements, and a list of all specialized installations and improvements
and upgrade specifications determined by Tenant as required for its use of
the First Additional Premises. It is contemplated that the Tenant
Improvements will be completed in several phases as such space is needed by
Tenant, and that separate Preliminary Plans and Working Drawings will be
prepared for each phase of such work. The Preliminary Plans and Working
Drawings shall be reviewed by Landlord's Architect and the cost thereof shall
be paid by Landlord and included within the Tenant Improvement Allowance;
provided that the total sum for such review that will be deducted from the
Tenant Improvement Allowance shall in no event exceed $900.00, determined as
follows: $400.00 for architectural review, and $500.00 for mechanical,
electrical, plumbing and structural review. Landlord and Landlord's
Architect shall be entitled, in all respects, to rely upon all information
supplied by Tenant regarding the Tenant Improvements. The costs associated
with Tenant's Architect's preparation of the Preliminary Plans shall be borne
by Tenant and paid as set forth in Sections 5 and 6 of this Work Letter.
(b) APPROVAL OF PRELIMINARY PLANS. Tenant or Tenant's Architect shall
submit the Preliminary Plans to Landlord for Landlord's review and approval,
which approval shall not be unreasonably withheld, delayed or conditioned.
Landlord shall notify Tenant within five (5) business days after delivery
thereof if the Preliminary Plans are approved. If Landlord withholds
approval, Landlord shall so notify Tenant and specify the reasons for
withholding such approval. If the Preliminary Plans are not approved, then
within five (5) days after receipt of such notice, Tenant's Architect shall
make all necessary revisions to the Preliminary Plans and submit two (2)
copies thereof to Landlord for its final review and approval, which approval
shall not be unreasonably withheld, delayed or conditioned, and shall be
given within five (5) business days thereafter. If no response is given by
Landlord within the five (5) business day period, approval shall be deemed.
(c) WORKING DRAWINGS. Within thirty (30) days following the
Preliminary Plans Approval Date, Tenant's Architect shall prepare working
drawings (the "Working Drawings") for the Tenant Improvements based upon the
approved Preliminary Plans. The Working Drawings shall include
architectural, necessary mechanical and electrical construction drawings for
the Tenant Improvements based on the Preliminary Plans. Notwithstanding the
Preliminary Plans, in all cases the Working Drawings (i) shall be subject to
Landlord's final approval, which approval shall not be unreasonably withheld,
delayed, or conditioned, (ii) shall not be in conflict with building codes
for the City of Pasadena ("City") or County of Los Angeles ("County") or with
insurance requirements for a fire resistive building, and (iii) shall be in a
form satisfactory to appropriate governmental
B-1
<PAGE>
authorities responsible for issuing permits and licenses required for
construction. The costs associated with preparation of the Working Drawings
shall be borne by Tenant and paid as set forth in Sections 5 and 6 of this
Work Letter.
(d) APPROVAL OF WORKING DRAWINGS. Tenant or Tenant's Architect shall
submit the Working Drawings to Landlord for its review and approval, which
shall not be unreasonably withheld. Landlord shall notify Tenant within five
(5) business days after delivery thereof if the Working Drawings are
approved. If Landlord withholds approval, Landlord shall so notify Tenant
and specify the reasons for withholding such approval. If the Working
Drawings are not approved, within five (5) days after receipt of Landlord's
notice, Tenant's Architect shall make all necessary revisions to the Working
Drawings and submit two (2) copies thereof to Landlord for its final review
and approval, which approval shall not be unreasonably withheld, delayed or
conditioned and shall be given within five (5) days thereafter. If no
response is given by Landlord within the five (5) day period, approval shall
be deemed. Concurrently with the above review and approval process, Tenant
may submit all plans and specifications to City and other applicable
governmental agencies in an attempt to expedite City approval and issuance of
all necessary permits and licenses to construct the Tenant Improvements as
shown on the Working Drawings. Any changes which are required by City or
other governmental agencies shall be immediately submitted to Landlord for
Landlord's review and reasonable approval, and to Tenant for Tenant's review
and approval.
(e) SCHEDULE OF CRITICAL DATES. Set forth on Exhibit "B-1" attached
hereto below is a schedule of certain probable dates relating to Landlord's
and Tenant's respective obligations for the design and construction of the
Tenant Improvements. Such dates and the respective obligations of Landlord
and Tenant are more fully described elsewhere in this Work Letter. The
purpose of the schedule is to provide a reference for Landlord and Tenant so
as to make certain the Final Approval Date occurs for each particular phase
of the work as set forth herein. Following the Final Approval Date for each
phase Tenant shall commence construction of the Tenant Improvements for that
particular phase of the work as set forth in Section 4 below.
3. BUILDING PERMIT. After the Final Approval Date for each phase has
occurred, Tenant shall, if Tenant has not already done so, submit the Working
Drawings to the appropriate governmental body or bodies for final plan
checking and a building permit. Tenant, with Landlord's cooperation, shall
cause to be made any change in the Working Drawings necessary to obtain the
building permit; provided, however, after the Final Approval Date, no changes
shall be made to the Working Drawings without the prior written approval of
both Landlord and Tenant, and then only after agreement by Tenant to pay any
excess costs resulting from such changes. Tenant may direct Landlord to pay
such excess costs out of the Tenant Improvement Allowance to the extent
available.
4. CONSTRUCTION OF TENANT IMPROVEMENTS.
(a) CONSTRUCTION. After the Final Approval Date has occurred and a
building permit for the work has been issued, Tenant shall select a licensed
general contractor ("Contractor") subject to Landlord's approval, which
approval shall not be unreasonably withheld, delayed or conditioned and
Tenant shall notify Landlord of same upon its selection. Tenant shall enter
into a construction contract ("Construction Contract") with the Contractor,
who shall cause the construction of the Tenant Improvements to be carried out
in substantial conformance with the Working Drawings in a good and
workmanlike manner using first-class materials. The Contractor and Tenant's
Agents (defined in Section 5(c) below) shall abide by all reasonable rules
and regulations of Landlord (copies of which have been given to Tenant) with
respect to the construction of the Tenant Improvements. The costs associated
with the construction of the Tenant Improvements shall be borne by Tenant and
paid as set forth in Sections 5 and 6 of this Work Letter. Tenant shall see
that the construction complies with all applicable building, fire, health,
and sanitary codes and regulations, the satisfaction of which shall be
evidenced by a certificate of occupancy for the Premises.
(b) NOTICE OF COMPLETION. Within ten (10) business days after the
issuance of the permanent or temporary certificate of occupancy for the
Tenant Improvements, Tenant shall cause
B-2
<PAGE>
a Notice of Completion to be recorded in the office of the Recorder of the
County of Los Angeles in accordance with Section 3093 of the Civil Code of
the State of California or any successor statute, and shall furnish a copy
thereof to Landlord upon such recordation.
5. TENANT IMPROVEMENT ALLOWANCE.
(a) TENANT IMPROVEMENT ALLOWANCE. Landlord shall provide Tenant with
an allowance in the amount of $1,231,900.00 ("Tenant Improvement Allowance")
towards the cost of the design, purchase and construction of the Tenant
Improvements, including without limitation design, engineering and consulting
fees (collectively, the "Tenant Improvement Costs"). The Tenant Improvement
Allowance shall be used for payment of the following Tenant Improvement Costs:
(i) Preparation by Tenant's Architect of all necessary documents
in connection with the Tenant Improvements, including without limitation the
Preliminary Plans and the Working Drawings as provided in Section 2 of this
Work Letter, and all fees charged by City (including without limitation fees
for building permits and plan checks) in connection with construction of the
Tenant Improvements in the First Additional Premises;
(ii) Construction work for completion of the Tenant Improvements
as reflected in the Construction Contract including, without limitation,
testing and inspection costs, freight elevator charges, utility usage, and
trash removal costs;
(iii) All contractor's charges, general conditions, reasonable
performance bond premiums and construction fees;
(iv) The cost of any changes in the Base Building when such
changes are required by the Construction Drawings (including all direct
architectural and/or engineering fees and expenses incurred in connection
therewith);
(v) The cost of any changes to the Construction Drawings or
Tenant Improvements required by applicable Law;
(vi) Any other expenses incurred by Tenant in making the Premises
ready for its occupancy, including without limitation carpeting, wiring,
communication systems and furnishings; and
(b) DISBURSEMENT OF TENANT IMPROVEMENT ALLOWANCE AND EXCESS COSTS.
During the construction of the Tenant Improvements, Landlord shall make
monthly disbursements of the Tenant Improvement Allowance for Tenant
Improvement Costs for the benefit of Tenant and shall authorize the release
of monies for the benefit of Tenant as set forth below. Landlord and Tenant
acknowledge and agree that on or before March 31, 2000, the entire Tenant
Improvement Allowance must be disbursed for the payment of Tenant Improvement
Costs and any Tenant Improvement Allowance remaining on April 1, 2000 shall
be retained by Landlord.
(i) MONTHLY DISBURSEMENTS. On or before the tenth (10th) day of
each calendar month, as determined by Landlord, during the construction of
the Tenant Improvements, Tenant shall deliver to Landlord as appropriate:
(i) a request for payment of the "Contractor," as that term is defined in
Section 4 of this Work Letter, approved by Tenant, in a form reasonably
approved by Landlord, showing the schedule, by trade, of percentage of
completion of the Tenant Improvements in the Premises, detailing the portion
of the work completed and the portion not completed; (ii) invoices from all
of "Tenant's Agents" (as defined in Section 5(c) below), for labor rendered
and materials delivered to the Premises for the applicable payment period;
(iii) executed conditional mechanic's lien releases from all of Tenant's
Agents which shall comply with the appropriate provisions, as reasonably
determined by Landlord, of California Civil Code Section 3262(d); and
B-3
<PAGE>
(iv) all other information reasonably requested by Landlord. Tenant's
request for payment shall be deemed Tenant's acceptance and approval of the
work furnished and/or the materials supplied as set forth in Tenant's payment
request. Thereafter, Landlord shall deliver a check to Tenant made jointly
payable to Contractor and Tenant in payment of the amounts so requested by
Tenant, as set forth in this Section 5(b), above, less a ten percent (10%)
retention (the aggregate amount of such retentions to be known as the "Final
Retention"), provided that Landlord does not reasonably dispute any request
for payment based on non-compliance of any work with the approved Working
Drawings, or due to any substandard work or for any other reason. Landlord's
payment of such amounts shall not be deemed Landlord's approval or acceptance
of the work furnished or materials supplied as set forth in Tenant's payment
request.
(ii) FINAL RETENTION. Subject to the provisions of this Work
Letter, a check for the Final Retention payable jointly to Tenant and
Contractor shall be delivered by Landlord to Tenant following the completion
of construction of the Premises, provided that (i) Tenant delivers to
Landlord properly executed mechanics lien releases in compliance with both
California Civil Code Section 3262(d)(2) and either Section 3262(d)(3) or
Section 3262(d)(4), (ii) Landlord has reasonably determined that no
substandard work exists which adversely affects the mechanical, electrical,
plumbing, heating, ventilating and air conditioning, life-safety or other
systems of the Building, the curtain wall of the Building, the structure or
exterior appearance of the Building, or any other tenant's use of such other
tenant's leased premises in the Building, and (iii) Tenant's Architect
delivers to Landlord a certificate, in a form reasonably acceptable to
Landlord, certifying that the construction of the Tenant Improvements in the
Premises has been substantially completed.
(c) TENANT'S AGENTS. All subcontractors, laborers, materialmen and
suppliers used by Tenant (such subcontractors, laborers, materialmen and
suppliers and the Contractor to be known collectively as "Tenant's Agents")
must be approved in writing by Landlord, which approval shall not be
unreasonably withheld, delayed or conditioned.
6. COSTS IN EXCESS OF TENANT IMPROVEMENT ALLOWANCE AT TENANT'S EXPENSE.
Tenant shall pay the excess of the Tenant Improvement Costs over the amount
of the Tenant Improvement Allowance available to defray such costs.
Concurrent with the final plan checking referred to in Section 3 of this Work
Letter, Tenant shall prepare and submit to Landlord a written estimate of the
amount of the remaining Tenant Improvement Costs and the amount of the Tenant
Improvement Allowance still available to defray such costs (after preparation
of the Preliminary Plans and Working Drawings). If such estimate exceeds the
Tenant Improvement Allowance then still available, Tenant shall pay for all
such excess costs ("Excess Costs"), in coordination with the monthly
disbursement schedule outlined in Section 5(b), by paying to Landlord twenty
(20) days prior to each disbursement by Landlord the amount(s) Landlord needs
to pay each such monthly and final disbursement pursuant to Section 5(b). In
the event the Tenant Improvement Costs are less than the Tenant Improvement
Allowance, the difference shall be retained by Landlord.
7. CHANGE ORDERS. Tenant may from time to time request and obtain change
orders during the course of construction provided that: (i) each such
request shall be reasonable, shall be in writing and signed by or on behalf
of Tenant, and shall not result in any structural change in the Building, as
reasonably determined by Landlord except as contemplated by the approved
Working Drawings, and (ii) all additional charges and costs, including
without limitation architectural and engineering costs, construction and
material costs, and processing costs of any governmental entity shall be paid
out of the Tenant Improvement Allowance, to the extent available, and
otherwise shall be the sole and exclusive obligation of Tenant, and shall be
paid by Tenant to Landlord within twenty (20) days after Landlord's request
therefor.
8. TENANT DELAYS. In no event shall the Commencement Date of the Third
Amendment with respect to the First Additional Premises be extended or
delayed.
9. TRADE FIXTURES AND EQUIPMENT. Tenant acknowledges and agrees that
Tenant is solely responsible for obtaining, delivering and installing in the
First Additional Premises all necessary and desired furniture, trade
fixtures, equipment and other similar items, and that Landlord shall have no
responsibility whatsoever with regard thereto. Tenant further acknowledges
and agrees that neither
B-4
<PAGE>
the Commencement Date of the Third Amendment nor the payment of Rent shall be
delayed for any period of time whatsoever due to any delay in the furnishing
of the First Additional Premises with such items.
10. FAILURE OF TENANT TO COMPLY. Any failure of Tenant to comply with any
of the provisions contained in this Work Letter shall be deemed a default
under the Third Amendment. In addition to the remedies provided to Landlord
in this Work Letter upon the occurrence of such a default by Tenant, Landlord
shall have all remedies available at law or equity against a defaulting
tenant pursuant to a written contract, including but not limited to those set
forth in the Third Amendment.
11. INSPECTION BY LANDLORD. Landlord shall have the right to inspect the
Tenant Improvements at all times; provided, however, that Landlord's failure
to inspect the Tenant Improvements shall in no event constitute a waiver of
any of Landlord's rights hereunder, nor shall Landlord's inspection of the
Tenant Improvements constitute Landlord's approval of the same. Should
Landlord reasonably disapprove any portion of the Tenant Improvements,
Landlord shall notify Tenant in writing of such disapproval and shall specify
the items disapproved. Any defects or deviations in, and/or disapproval by
Landlord of, the Tenant Improvements shall be rectified, if necessary, by
Tenant at no expense to Landlord; provided, however, that in the event
Landlord determines that a defect or deviation exists or disapproves of any
matter in connection with any portion of the Tenant Improvements and such
defect, deviation or matter might adversely affect the mechanical,
electrical, plumbing, heating, ventilating and air-conditioning or
life-safety systems of the Building, the structure or exterior appearance of
the Building or any other tenant's use of such other tenant's leased
premises, Landlord may, after first requesting Tenant to cure such default,
deviation and/or matter, take such action as Landlord reasonably deems
necessary, at Tenant's expense and without incurring any liability on
Landlord's part, to correct any such defect, deviation and/or matter,
including, without limitation, causing the cessation of performance of the
construction of the Tenant Improvements until such time as the defect,
deviation and/or matter is corrected to Landlord's reasonable satisfaction.
12. MISCELLANEOUS.
(a) TENANT'S REPRESENTATIVE. Tenant has designated Wirt Design Group
as its sole representative with respect to the matters set forth in this Work
Letter, who, until further notice to Landlord, shall have full authority and
responsibility to act on behalf of the Tenant as required in this Work Letter.
(b) LANDLORD'S REPRESENTATIVE. Landlord has designated Insignia/ESG as
its sole representative with respect to the matters set forth in this Work
Letter, who, until further notice to Tenant, shall have full authority and
responsibility to act on behalf of the Landlord as required in this Work
Letter.
(c) TIME OF THE ESSENCE. Unless otherwise indicated, all references
herein to a "NUMBER OF DAYS" shall mean and refer to calendar days. In all
instances where Tenant is required to approve or deliver an item, if no
written notice of approval is given or the item is not delivered within the
stated time period, then Tenant shall be deemed to have approved the same.
B-5
<PAGE>
EXHIBIT B-1
SCHEDULE OF DATES
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C> <C> <C>
<PERIOD-TYPE> 3-MOS 9-MOS 3-MOS 9-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1998 DEC-31-1997 DEC-31-1997
<PERIOD-START> JUL-01-1998 JAN-01-1998 JUL-01-1997 JAN-01-1997
<PERIOD-END> SEP-30-1998 SEP-30-1998 SEP-30-1997 SEP-30-1997
<CASH> 134,397 0 0 0
<SECURITIES> 0 0 0 0
<RECEIVABLES> 4,983 0 0 0
<ALLOWANCES> 387 0 0 0
<INVENTORY> 289 0 0 0
<CURRENT-ASSETS> 144,642 0 0 0
<PP&E> 52,076 0 0 0
<DEPRECIATION> 21,671 0 0 0
<TOTAL-ASSETS> 273,342 0 0 0
<CURRENT-LIABILITIES> 47,199 0 0 0
<BONDS> 0 0 0 0
0 0 0 0
41 0 0 0
<COMMON> 285 0 0 0
<OTHER-SE> 218,529 0 0 0
<TOTAL-LIABILITY-AND-EQUITY> 273,342 0 0 0
<SALES> 0 0 0 0
<TOTAL-REVENUES> 49,824 117,640 21,009 56,427
<CGS> 0 0 0 0
<TOTAL-COSTS> 21,568 53,893 9,656 27,154
<OTHER-EXPENSES> 48,650 101,902 18,151 51,549
<LOSS-PROVISION> 991 2,678 840 2,814
<INTEREST-EXPENSE> 353 1,661 516 1,467
<INCOME-PRETAX> (20,394) (38,155) (6,798) (22,276)
<INCOME-TAX> 0 0 0 0
<INCOME-CONTINUING> (20,394) (38,155) (6,798) (22,276)
<DISCONTINUED> 0 0 0 0
<EXTRAORDINARY> 0 0 0 0
<CHANGES> 0 0 0 0
<NET-INCOME> (22,104) (41,578) (7,198) (23,327)
<EPS-PRIMARY> (0.78) (1.64) (0.36) (1.22)
<EPS-DILUTED> (0.78) (1.64) (0.36) (1.22)
</TABLE>
