<PAGE>
[LOGO]
2,400,000 Shares
Common Stock
Of the 2,400,000 shares of Common Stock, par value $0.01 per share (the
"Common Stock"), offered hereby, 1,521,360 shares are being offered by the
Company and 878,640 by certain stockholders of the Company (the "Selling
Stockholders"). See "Underwriting." The Company will not receive any of the
proceeds from the sale of shares by the Selling Stockholders. See "Principal
and Selling Stockholders."
The Common Stock is traded on the Nasdaq National Market under the symbol
"ELNK." On June 17, 1998, the last reported sales price of the Common Stock on
the Nasdaq National Market was $60 5/16 per share. See "Price Range of Common
Stock."
FOR INFORMATION CONCERNING CERTAIN RISK FACTORS WHICH SHOULD BE CONSIDERED BY
PROSPECTIVE INVESTORS, SEE "RISK FACTORS" COMMENCING ON PAGE 4.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
PROCEEDS TO
PRICE TO UNDERWRITING PROCEEDS TO SELLING
PUBLIC DISCOUNT(1) COMPANY(2) STOCKHOLDERS
<S> <C> <C> <C> <C>
Per Share $60.00 $3.00 $57.00 $57.00
Total(3) $144,000,000 $7,200,000 $86,717,520 $50,082,480
</TABLE>
(1) The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended. See "Underwriting."
(2) Before deducting expenses payable by the Company, estimated at $700,000.
(3) The Company has granted the Underwriters a 30-day option to purchase up
to an additional 360,000 shares of Common Stock solely to cover
over-allotments. If all such shares are purchased, the total Price to
Public, Underwriting Discount and Proceeds to Company will be
$165,600,000, $8,280,000 and $107,237,520, respectively. See
"Underwriting."
The shares of Common Stock are offered by the Underwriters, subject to prior
sale, when, as and if delivered to and accepted by them, and subject to the
approval of certain legal matters by counsel and certain other conditions. The
Underwriters reserve the right to withdraw, cancel or modify such offer and to
reject orders in whole or in part. Delivery of the shares of Common Stock
offered hereby to the Underwriters is expected to be made in New York, New
York on or about June 23, 1998.
DEUTSCHE BANK SECURITIES
INVEMED ASSOCIATES, INC.
THE ROBINSON-HUMPHREY COMPANY
The date of this Prospectus is June 18, 1998.
<PAGE>
EarthLink Network, Inc. is one of the world's largest Internet service
providers. Through a full range of innovative access and hosting services,
EarthLink makes the Internet relevant and productive to hundreds of thousands of
individuals and businesses every day.
[GRAPHICAL PRESENTATION
DIVIDED INTO FOUR SQUARES SURROUNDING THE EARTHLINK LOGO]
SERVICES:
Standard
Email
6MB Web Space for a Personal Web Site
Personal Start Page
Premium
Business Web Site Hosting
National ISDN
National Frame Relay
800 Service
MEMBER EXPERIENCE
Superior member and technical support
Ease of access and use
Member newsletter
EarthLink Web site
NETWORK
Reliable nationwide access through over 1,400 dial-up numbers
Network redundancy provided by UUNET, PSINet and Sprint
AWARDS
PC MAGAZINE'S EDITORS' CHOICE AWARD FOR BEST ISP
SEPTEMBER 1997
MOBILE COMPUTING'S FIRST CLASS AWARD FOR BEST ISP
FEBRUARY 1998
"EarthLink Network-Registered Trademark-," "EarthLink Network TotalAccess-TM-,"
"EarthLink Network TotalAccess Gold-TM-," "bLink-TM-,"
"The Arena-TM-," "Personal Start Page-TM-," "StarterSite-TM-," "the Mall-TM-,"
and the EarthLink logo are trademarks of the Company. This Prospectus includes
trademarks of other companies.
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT
STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK, INCLUDING
BY ENTERING STABILIZING BIDS, IMPOSING PENALTY BIDS OR OTHERWISE. SUCH
ACTIVITIES, IF COMMENCED, MAY BE DISCONTINUED AT ANY TIME. FOR A DISCUSSION OF
THESE ACTIVITIES, SEE "UNDERWRITING."
IN CONNECTION WITH THIS OFFERING, CERTAIN UNDERWRITERS (AND SELLING GROUP
MEMBERS, IF ANY) MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE COMMON
STOCK ON THE NASDAQ NATIONAL MARKET IN ACCORDANCE WITH RULE 103 OF REGULATION M.
SEE "UNDERWRITING."
2
<PAGE>
PROSPECTUS SUMMARY
THE FOLLOWING SUMMARY SHOULD BE READ IN CONJUNCTION WITH, AND IS QUALIFIED
IN ITS ENTIRETY BY, THE MORE DETAILED INFORMATION AND FINANCIAL STATEMENTS AND
NOTES THERETO APPEARING ELSEWHERE IN THIS PROSPECTUS.
THE TERMS "COMPANY" AND "EARTHLINK" REFER COLLECTIVELY TO EARTHLINK NETWORK,
INC. AND ITS WHOLLY-OWNED OPERATING SUBSIDIARY, EARTHLINK OPERATIONS, INC.
("EARTHLINK OPERATIONS"), UNLESS THE CONTEXT OTHERWISE REQUIRES. UNLESS
OTHERWISE INDICATED, ALL INFORMATION IN THIS PROSPECTUS ASSUMES THAT THE
UNDERWRITERS HAVE NOT EXERCISED THE OVER-ALLOTMENT OPTION.
THE COMPANY
EarthLink 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 has developed its member base, which was approximately 680,000 at June
5, 1998, through a combination of innovative and cost-conscious direct and
affinity marketing programs, the Sprint Transaction, which generated
approximately 130,000 new members, and a focused effort to retain current
members that has resulted in EarthLink having what management believes to be a
high retention rate for its industry. EarthLink's recently established strategic
alliance with Sprint Corporation provided EarthLink with approximately 130,000
new members and a 5-year commitment from Sprint to continue to generate at least
150,000 new members annually through Sprint's channels. In addition, EarthLink
is now co-branded with Sprint as its exclusive consumer Internet access provider
and will have access to Sprint's marketing and distribution channels. For a
detailed description of the Sprint Transaction, see "Strategic Alliance with
Sprint."
The Company's principal executive offices are located at 3100 New York
Drive, Pasadena, California 91107, and its telephone number is (626) 296-2400.
THE OFFERING
<TABLE>
<S> <C>
Common Stock Offered............................................ 2,400,000 shares (including 1,521,360 shares by the Company and
878,640 by the Selling Stockholders)
Common Stock Outstanding after this Offering.................... 13,744,678 shares (1)
Use of Proceeds................................................. General corporate purposes. See "Use of Proceeds."
Nasdaq National Market Symbol................................... ELNK
</TABLE>
- ----------------------------------
(1) Based on shares of Common Stock outstanding as of May 31, 1998. Excludes (i)
2,667,521 shares of Common Stock subject to outstanding options and
warrants, (ii) 97,286 shares of Common Stock available for future grant of
options under the Company's employee and director stock option plans, (iii)
4.1 million shares of Common Stock issuable upon conversion of the Series A
Convertible Preferred Stock and (iv) approximately 245,018 shares of Common
Stock which Sprint is entitled to purchase upon the closing of the Offering
pursuant to certain preemptive rights under the terms of the Sprint
Transaction. See "Capitalization," "Strategic Alliance with Sprint,"
"Management--1995 Stock Option Plan and Other Option and Warrant Issuances,"
"Management--Directors Stock Option Plan and Other Director Option
Issuances," "Description of Capital Stock" and Notes 8 and 9 of Notes to
Financial Statements.
SUMMARY HISTORICAL FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
----------------------------------------------- --------------------
PRO FORMA (2)
1995 1996 1997 1997 1997 1998
--------- --------- --------- -------------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Total revenues................................... $ 3,028 $ 32,503 $ 79,174 $ 93,663 $ 15,718 $ 29,240
Loss from operations............................. (6,018) (30,258) (28,454) (151,509) (8,037) (5,940)
Net loss......................................... (6,120) (31,149) (29,916) (152,971) (8,379) (6,404)
Dividends on convertible preferred stock......... (9,355)
Net loss attributable to common stockholders..... (162,326)
Basic and diluted net loss per share (1)......... $ (1.59) $ (5.13) $ (2.99) $ (16.23) $ (0.92) $ (0.56)
Weighted average shares outstanding (1).......... 3,837 6,069 10,001 10,001 9,094 11,373
<CAPTION>
PRO FORMA (2)
1998
--------------
<S> <C>
STATEMENT OF OPERATIONS DATA:
Total revenues................................... $ 35,499
Loss from operations............................. (29,279)
Net loss......................................... (29,743)
Dividends on convertible preferred stock......... (2,006)
Net loss attributable to common stockholders..... (31,749)
Basic and diluted net loss per share (1)......... $ (2.79)
Weighted average shares outstanding (1).......... 11,373
</TABLE>
<TABLE>
<CAPTION>
MARCH 31, 1998
--------------------------------------------
ACTUAL PRO FORMA (2) AS ADJUSTED (3)
--------- --------------- ----------------
<S> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents......................................................... $ 16,715 $ 40,465 $ 126,483
Total assets...................................................................... 52,092 195,560 281,578
Total liabilities................................................................. 45,618 54,086 54,086
Accumulated deficit............................................................... (72,476) (72,476) (72,476)
Stockholders' equity.............................................................. 6,474 141,474 227,492
</TABLE>
- ----------------------------------
(1) See Note 1 of Notes to Financial Statements for an explanation of the
determination of the number of weighted average shares outstanding used in
the net loss per share computation.
(2) Pro forma financial data give effect to the Sprint Transaction. The
unaudited pro forma statement of operations data are based on the statements
of operations of the Company and the statements of revenues and direct
expenses of the Consumer Internet Access Services of Sprint Corporation as
if the transaction occurred on January 1, 1997. The unaudited pro forma
balance sheet data includes the assets acquired from Sprint and have been
prepared to reflect the acquisition by the Company of the Sprint Internet
Passport subscriber base as of March 31, 1998. See "Strategic Alliance with
Sprint" and "Pro Forma Financial Information."
(3) As adjusted to reflect the sale of 1,521,360 shares of Common Stock offered
by the Company hereby. See "Capitalization."
3
<PAGE>
RISK FACTORS
THIS PROSPECTUS (INCLUDING WITHOUT LIMITATION THE FOLLOWING RISK FACTORS)
CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE
SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT") AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT") REGARDING THE
COMPANY AND ITS BUSINESS, FINANCIAL CONDITION, RESULTS OF OPERATIONS AND
PROSPECTS. WORDS SUCH AS "EXPECTS," "ANTICIPATES," "INTENDS," "PLANS,"
"BELIEVES," "SEEKS," "ESTIMATES" AND SIMILAR EXPRESSIONS OR VARIATIONS OF SUCH
WORDS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS, BUT ARE NOT THE
EXCLUSIVE MEANS OF IDENTIFYING FORWARD-LOOKING STATEMENTS IN THIS PROSPECTUS.
ADDITIONALLY, STATEMENTS CONCERNING FUTURE MATTERS SUCH AS THE DEVELOPMENT OF
NEW PRODUCTS, ENHANCEMENTS OR TECHNOLOGIES, POSSIBLE CHANGES IN LEGISLATION AND
OTHER STATEMENTS REGARDING MATTERS THAT ARE NOT HISTORICAL ARE FORWARD-LOOKING
STATEMENTS. SUCH STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES THAT COULD
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED. THESE RISKS AND
UNCERTAINTIES INCLUDE, BUT ARE NOT LIMITED TO, THOSE RISKS DISCUSSED BELOW AND
ELSEWHERE IN THIS PROSPECTUS. PROSPECTIVE INVESTORS IN THE SHARES OFFERED HEREBY
SHOULD CAREFULLY CONSIDER THE FOLLOWING RISK FACTORS IN ADDITION TO THE OTHER
INFORMATION CONTAINED IN THIS PROSPECTUS.
LIMITED OPERATING HISTORY; HISTORY OF LOSSES AND EXPECTATIONS OF FUTURE
LOSSES. The Company was founded in May 1994 and began offering its services in
July 1994. Accordingly, the Company has only a limited operating history upon
which an evaluation of its prospects can be made. Such prospects must be
considered in light of the substantial risks, expenses and difficulties
encountered in the relatively new and rapidly evolving Internet services
industry. The Company had net losses of approximately $66.1 million from
inception through 1997 and of approximately $6.4 million for the three months
ended March 31, 1998. As of March 31, 1998, the Company had an accumulated
deficit of approximately $72.5 million. These losses and the accumulated deficit
are exclusive of $1.3 million of 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.
The Company expects that it is likely to continue to incur net losses as it
expends substantial resources on sales, marketing and administration, builds its
network systems, develops new service offerings and improves its management
information systems. There can be no assurance that the Company will achieve or
sustain profitability or positive cash flow from its operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
COMPETITION. The Internet services market in which the Company operates is
extremely competitive, and the Company expects competition in this market to
intensify in the future. The Company's current and prospective competitors
include many large companies that have substantially greater market presence and
financial, technical, marketing and other resources than the Company. The
Company competes (or in the future expects to compete) directly or indirectly
with the following categories of companies: (i) local ISPs, (ii) national and
regional ISPs, such as MindSpring Enterprises, Inc., (iii) established online
services such as America Online, Prodigy and the Microsoft Network; (iv)
nonprofit or educational ISPs; (v) national telecommunications companies, such
as AT&T Corp., GTE Corporation and MCI Communications Corporation; (vi) Regional
Bell Operating Companies ("RBOCs"); (vii) competitive local exchange carriers;
and (viii) cable operators, such as At Home Corporation and Time Warner, Inc.
The consolidation of existing ISPs with or into larger entities, or entry of
new entities into the Internet services market, would likely result in greater
competition for the Company. The ability of competitors to bundle services and
products with Internet connectivity services could place the Company at a
significant competitive disadvantage. In addition, competitors in the
telecommunications industry may be able to provide members with lower
communications costs for their Internet access services, reducing the overall
cost of Internet access and significantly increasing pricing pressures on the
Company. There can be no assurance that the Company will be able to offset the
adverse effect on revenues of any necessary price reductions resulting from
competitive pressures by generating higher revenue from enhanced
4
<PAGE>
services or additional members, by reducing costs or otherwise. As a result,
price reductions could have a material adverse effect on the Company.
The Company believes that its ability to compete successfully in the
Internet services market depends on a number of factors, including market
presence; the adequacy of its member and technical support services; the
capacity, reliability and security of its network infrastructure; the ease of
access to and navigation of the Internet provided by the Company's services; the
pricing policies of the Company, its competitors and its suppliers; the timing
of introductions of new services by the Company and its competitors; the
Company's ability to support existing and emerging industry standards; and
industry and general economic trends. There can be no assurance that the Company
will have the financial resources, technical expertise or marketing and support
capabilities to compete successfully. See "--Evolution of the Internet; Rapid
Technological Change," and "Business--Competition."
RISKS ASSOCIATED WITH MANAGEMENT OF POTENTIAL GROWTH. The Company's growth
has placed, and is expected to continue to place, a significant strain on its
managerial, operational, financial and information systems resources. To
accommodate its increasing size and manage growth, the Company must continue to
implement and improve its operational, financial and information systems, and
expand, train and manage its employee base. Additionally, expansion of the
Company's information and network systems would be required in the event of
significant future growth. There can be no assurance that the Company will be
able to effectively manage expansion of its operations, or that the Company's
facilities, systems, procedures or controls will be adequate to support the
Company's operations. The inability of the Company to manage future growth
effectively would have a material adverse effect on the Company.
Demand on the Company's network infrastructure, technical staff and
resources has grown rapidly with the Company's expanding member base. There can
be no assurance that the Company's infrastructure, technical staff and resources
will be adequate to accommodate or facilitate the Company's growth. In addition,
the Company's success depends largely on its ability to provide timely, accurate
and useful member and technical support. There can be no assurance that the
Company will be able to provide member or technical support on a timely basis,
or that any delays will not result in a loss of members or an inability to
attract new members. The Company believes that its ability to provide timely
access for members and adequate member and technical support largely will depend
on its ability to identify, attract, train, integrate and retain qualified
personnel. Failure to provide adequate member and technical support services
would adversely affect the Company's ability to maintain and increase its member
base, and could therefore have a material adverse effect on the Company. See
"--Dependence on Network Infrastructure and Third Party Network Providers,"
"--Dependence on Key Personnel," "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Overview" and
"Business--Employees."
SIGNIFICANT OWNERSHIP BY SPRINT; COMMERCIAL RELATIONSHIP WITH SPRINT. At
June 5, 1998, as a result of the Sprint Transaction (see "Strategic Alliance
with Sprint"), Sprint Corporation (together with its affiliates, "Sprint,"
unless the context otherwise requires) owned 1.25 million shares of Common Stock
and approximately 4.1 million shares of Series A Convertible Preferred Stock.
Pursuant to certain preemptive rights to which Sprint is entitled under the
terms of the Sprint Transaction and assuming full exercise of Underwriters'
over-allotment option, Sprint may purchase an additional 245,018 shares of
Common Stock upon closing of the Offering. Upon consummation of the Offering and
assuming acceleration of certain dividend rights and that Sprint exercises
certain preemptive rights, Sprint will own approximately 27% of the Company's
capital stock on a fully diluted basis and approximately 9% of the Company's
voting stock. As a result of Sprint's significant ownership stake, as well as
the two members of the Company's Board of Directors which Sprint has designated,
and is entitled to designate under the terms of the Sprint Transaction, Sprint
is in a position to exercise considerable influence over the operations and
business strategy of the Company. There can be no assurance that the goals of
Sprint and those of the Company will remain aligned during the term of the
relationship. As a result, Sprint may
5
<PAGE>
be able to limit the Company's ability to act in its self interest, which could
have a material adverse effect on the Company.
In addition, under the terms of the Sprint Transaction, the Company is
prohibited, without the prior consent of Sprint, from entering into certain
commercial relationships with companies which are competitors of Sprint. Such
restrictions could reduce or eliminate potential opportunities for revenue
growth. Moreover, even in the absence of direct contractual restrictions on the
Company, third parties that perceive themselves to be competitors of Sprint may
choose not to engage in commercial relationships with the Company because of
Sprint's close relationship with the Company, which could adversely affect
potential opportunities for revenue growth.
The terms of the Sprint Transaction could substantially reduce the
likelihood of a third-party acquisition of the Company. Beginning 39 months
after the closing of the Sprint Transaction (subject to additional delay by the
Company under certain circumstances), Sprint has the right, for a subsequent 24
month period, to acquire the Company for fair private market value (including an
appropriate control premium), subject to arbitration in the event the parties do
not agree on such amount. The terms of the Sprint Transaction also limit the
Company's ability to solicit third party acquisition proposals and grant Sprint
the right, at any time, to make a superior offer in response to a third party
proposal to acquire the Company. These provisions may force EarthLink
stockholders to sell their shares at a time when they do not wish to do so. The
combination of these factors, the Company's significant commercial relationship
with Sprint more generally and Sprint's significant ownership stake in the
Company could substantially reduce the likelihood of a third party acquisition
of the Company. See "Description of Capital Stock-- Governance Agreement."
The Company faces certain operational risks relating to the Sprint
Transaction, including the failure to successfully transition the approximately
130,000 Sprint Internet Passport subscribers to the Company's Internet service
and to assimilate additional members expected to be generated by the Sprint
relationship. Any failure to successfully integrate Sprint subscribers into the
Company's member base could adversely affect the Company. Moreover, there can be
no assurance that the Company will be able to take full advantage of the
Company's role as Sprint's exclusive consumer Internet access provider and the
ability to use Sprint's brand and distribution network.
The Company and Sprint have also entered into a four year agreement
providing for access to Sprint's data network pursuant to which, after a six
month initial period, the Company will have a financial obligation to pay Sprint
a minimum of $1.34 million per month for such access. As a result of this
pricing structure, the Company bears substantial financial and business risks
associated with (i) ensuring that an adequate number of Company members utilize
the Sprint data network, and (ii) any inability to appropriately allocate and
reallocate its members to each of the Company's three network providers in such
a manner as to minimize network service costs and maximize network service
quality. In the event the Company is unable to optimize the network usage of its
members, the Company's per member network access costs could increase
significantly above existing levels, which could have a material adverse effect
on the Company.
For a variety of reasons, the Company may not achieve the anticipated
benefits of the Sprint Transaction. The Sprint Internet Passport subscribers and
any additional members Sprint generates may not be retained by the Company.
Despite Sprint's contractual commitment, it may not deliver the agreed upon
number of additional members. Even if Sprint does meet its commitments, there is
no assurance that such members will remain with the Company. Moreover, Sprint
may, in the event it is acquired, terminate the Company's rights (i) as Sprint's
exclusive consumer Internet access provider, (ii) to use Sprint's brand or
distribution network and (iii) under the credit facility provided by Sprint. In
addition, the joint marketing of the Company's services with Sprint products and
services may not attract new members as anticipated. See "Strategic Alliance
with Sprint."
6
<PAGE>
EVOLUTION OF THE INTERNET; RAPID TECHNOLOGICAL CHANGE. Widespread use of
the Internet is a relatively recent phenomenon, the long-term growth prospects
and eventual evolution of which are difficult to predict. The market for
Internet services is characterized by rapidly changing technology, evolving
industry standards, changes in member needs and frequent new service and product
introductions. The Company's future success will depend, in part, on its ability
to use leading technologies effectively, to continue to develop its technical
expertise, to enhance its existing services and to develop new services that
meet changing member needs on a timely and cost-effective basis and obtain
market acceptance. In particular, successful ISPs must provide subscribers with
the appropriate products, services and guidance to best take advantage of the
rapidly evolving Internet. In addition, any failure on the part of the Company
to respond in a timely and effective manner to new and evolving access
technologies including cable modems and satellite and other wireless
telecommunications technologies either internally or through arrangements with
third parties, could have a material adverse effect on the Company. Moreover,
EarthLink's future success is substantially dependent on continued growth in the
use of the Internet. There can be no assurance that Internet usage will continue
to grow as it has in the past or that extensive Internet content will continue
to be developed and continue to be accessible at no or nominal cost. If use of
the Internet does not continue to grow or evolves in a way which the Company
cannot address, the Company will be materially and adversely affected.
The Company expects that its members will increasingly use the Internet for
commercial transactions. Any network malfunction or security breach could cause
these transactions to be interrupted, not completed or completed with
compromised security. Alleviating problems caused by computer viruses or other
inappropriate uses or security breaches may cause interruptions, delays or
cessation in service to the Company's members, which could have a material
adverse effect on the Company. In addition, there can be no assurance that
members or others will not assert claims of liability against the Company as a
result of these events. See "--Potential Liability," "--Year 2000" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Year 2000."
FACTORS AFFECTING OPERATING RESULTS; 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, member usage, 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 by the Company and its
competitors; 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. Further, such intense competition may cause market rates for Internet
services to decrease, which could in turn force the Company to reduce its rates,
thereby likely causing revenue reductions. In addition, a significant portion of
the Company's expenses are fixed; therefore, the Company's operating margins are
particularly sensitive to fluctuations in revenues. Under its network services
agreement with UUNET Technologies, Inc. ("UUNET") (the "UUNET Agreement"), the
Company pays UUNET the greater of a fixed minimum fee, which cannot be lowered
regardless of usage, or an amount that varies based primarily on the network
usage of the Company's members during UUNET's peak hours. The UUNET Agreement
also provides for price adjustments if regulatory or legislative changes occur
which have a structural impact on the ISP services marketplace and materially
increase UUNET's costs. As a result of these provisions, the Company's fees to
UUNET will not decrease below a fixed minimum quarterly fee, but may increase
significantly above that level in the future. By contrast, the Company's members
generally pay a fixed monthly fee, which does not vary based on usage for the
Company's services, and the Company would not likely be able to increase such
fees in response to increased UUNET costs. Moreover, in connection with the
Sprint Transaction, EarthLink has agreed to use Sprint's data network, at a
minimum $1.34 million per month fee, regardless of whether the Company requires
such capacity to adequately service its members or derives any revenue in
connection with such
7
<PAGE>
expenditures. These factors could cause the Company's operating results in
future quarters to fall below the expectations of securities analysts and
investors, which would likely cause the market price of the Common Stock to be
materially and adversely affected. See "--Significant Ownership by Sprint;
Commercial Relationship with Sprint" and "Management's Discussion and Analysis
of Financial Condition and Results of Operations."
DEPENDENCE ON NETWORK INFRASTRUCTURE AND THIRD PARTY NETWORK PROVIDERS. The
future success of the Company's business will depend on the capacity,
reliability and security of the Company's network infrastructure. In the past,
capacity constraints have occurred, and may occur in the future, both at the
level of particular dial-up points of presence ("POPs") (affecting only members
attempting to use that particular POP) and in connection with system wide
services (such as email and news services, which can affect all members),
resulting in effects ranging from delays when trying to use a particular service
to general slow downs of all services offered by the Company on the Internet.
Poor network performance could cause members to terminate use of the Company's
services. In order to reduce the incidence of such problems in the future, as
well as to permit further expansion of the Company's member base, the Company
will be required to expand and improve this infrastructure as the number of
members and the amount and type of information its members communicate over the
Internet increases, and the means by which members connect to the Internet
evolve. Such expansion and improvement may require substantial financial,
operational and managerial resources, involving actions and investments by the
Company as well as obtaining third party equipment, services and technologies,
including POPs and telephone lines, modems, servers and other telecommunications
equipment and browsers and other software. There can be no assurance that the
Company will be able to expand or improve its network infrastructure to meet any
additional demand or changing member requirements on a timely basis or at a
commercially reasonable cost, if at all.
The Company's operations are further dependent on its ability to protect
this infrastructure against damage from fire, earthquake, power loss,
telecommunication failure, computer viruses, security breaches and similar
events. The Company does not currently maintain redundant or backup Internet
services or backbone facilities or other redundant computing or
telecommunications facilities. The occurrence of a natural disaster or another
unanticipated problem at the Company's headquarters and sole network hub in
Pasadena, California, at POPs through which members connect to the Internet, or
in the nation's telecommunication network in general could cause interruptions
in the services provided by the Company. The Company's network infrastructure is
also vulnerable to the failure of its third-party infrastructure providers to
ensure that such third-party provided infrastructure will correctly operate on
and beyond the year 2000. Accordingly, any failure of the Company to maintain,
expand or enhance its network infrastructure on a timely basis, or to adapt it
to an expanding member base, changing member requirements or evolving industry
standards, could have a material adverse effect on the Company.
As of March 31, 1998, approximately 94% of the POPs through which the
Company provided Internet access were owned and operated by UUNET and PSINet,
Inc. ("PSINet") to which the Company's members now have access on a
non-exclusive basis. In addition, the Company's members have exclusive access to
certain ports within 89 Sprint-owned POPs. The Company is thus dependent on
UUNET, PSINet and Sprint for crucial portions of its network infrastructure and
does not have direct control over network reliability and other quality service
concerns. The Company's agreements with PSINet, UUNET and Sprint providing this
access can be terminated starting in July 1998, March 1999 (subject to earlier
required reductions in usage at UUNET's option), and June 2002, respectively.
There can be no assurance that any such agreement will be renewed beyond such
dates or that such agreements, if renewed, will provide network access to the
Company and its members on acceptable terms. Moreover, both UUNET and PSINet
provide network access to entities other than the Company offering Internet or
online services, including, in the case of UUNET, America Online, Microsoft
Corporation ("Microsoft") and AT&T. Either UUNET or PSINet could choose to grant
such large providers preferential access to their networks, potentially limiting
the Company's members' ability to access the
8
<PAGE>
Internet through these POPs. In addition, even without such preferential
treatment, increased usage of UUNET's and PSINet's POPs by other ISPs and online
service providers' subscribers may negatively affect access and system
performance. In sum, the inability or unwillingness of one or all of UUNET,
PSINet and Sprint to provide reliable, high quality POP access to the Company on
commercially reasonable terms, or the Company's inability to secure alternative
POP arrangements, if necessary, would limit the Company's ability to provide
Internet access to its members, which would, in turn, have a material adverse
effect on the Company.
UNCERTAINTY OF MEMBER RETENTION. The sales, marketing and other costs to
the Company of acquiring new members are substantial relative to the monthly fee
derived from such members. Accordingly, the Company believes that its long-term
success largely depends on its ability to retain its existing members, while
continuing to attract new members. The Company continues to invest significant
resources in its infrastructure and member and technical support capabilities.
However, there can be no assurance that such investment will maintain or improve
member retention. The Company believes that intense competition from
competitors, some of which offer many free hours of services for new members,
has likely caused, and may continue to cause, some of the Company's members to
switch to competitors' services. In addition, a certain number of new Internet
users experience the Internet only as a novelty and do not become consistent
users of Internet services. These factors adversely affect the Company's member
retention rates. Any decline in member retention rates would have a material
adverse effect on the Company. Unless offset by other factors, significant
member loss could have a material adverse impact on the Company. See "--Risks
Associated with Management of Potential Growth," "--Dependence on Network
Infrastructure and Third Party Network Providers," "--Competition" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-- Overview."
DEPENDENCE ON TELECOMMUNICATIONS CARRIERS AND OTHER SUPPLIERS. The Company
relies on local telephone and other companies to provide data communications
capacity via local telecommunications lines, long distance lines and wireless
connections, all of which are subject to potential disruptions that may not be
remedied easily or on a timely basis. In addition, the Company is dependent on
certain third-party suppliers of hardware components, some of which are acquired
from limited sources. The Company also depends on third-party software vendors
to provide the Company with much of its Internet software, including its browser
software. The Company's suppliers and telecommunications carriers also sell or
lease services and products to the Company's competitors. There can be no
assurance that the Company's suppliers and telecommunications carriers will not
enter into exclusive arrangements with the Company's competitors or otherwise
stop selling or leasing their services or products to the Company, which events
could have a material adverse effect on the Company. Failure of any of Company's
suppliers to provide services, equipment or software in the quantities, at the
quality levels or at the times required by the Company, or an inability by the
Company to develop alternative sources of supply could materially adversely
affect the Company's ability to effectively support the growth of its member
base in a timely manner would increase its costs of expansion. See
"--Competition," "Business--Supplier Relationships" and "Business--Marketing."
DEPENDENCE ON KEY PERSONNEL. The Company is highly dependent on the
technical and managerial skills of its key employees, including technical,
sales, marketing, information systems, financial and executive personnel, and on
its ability to identify, hire and retain additional personnel. To accommodate
its current size and manage its anticipated growth, the Company must maintain
and expand its employee base. Competition for key personnel, particularly
persons having technical expertise, is intense, and there can be no assurance
that the Company will be able to retain existing personnel or to identify or
hire additional personnel. The need for such personnel is particularly important
given the strains on the Company's existing infrastructure and the need to
anticipate the demands of any future growth. In particular, the Company is
highly dependent on the continued services of its senior management team, which
currently is composed of a small number of individuals. Of the members of its
senior
9
<PAGE>
management team, only the Company's President and Chief Executive Officer,
Charles G. Betty, is a party to an employment agreement with the Company;
however, this agreement may not prevent Mr. Betty from terminating his
employment with the Company. The Company maintains key-man life insurance on the
lives of Messrs. Dayton, Betty and David Beckemeyer, the Company's Vice
President of Information Technology, but there can be no assurance that these
policies would be sufficient to compensate the Company for the loss of their
services. The inability of the Company to attract, hire or retain the necessary
technical, sales, marketing, information systems, financial and executive
personnel, or the loss of the services of any member of the Company's senior
management team, could have a material adverse effect on the Company. See
"--Risks Associated with Management of Potential Growth," "Business--Employees"
and "Business--Management."
GOVERNMENT REGULATION. The Company provides Internet services, in part,
through data transmissions over public telephone lines. These transmissions are
governed by regulatory policies establishing charges and terms for wireline
communications. The Company currently is not subject to direct regulation by the
Federal Communications Commission (the "FCC") or any other governmental agency,
other than regulations applicable to businesses generally. However, in the
future the Company could become subject to regulation by the FCC or another
regulatory agency as a provider of basic telecommunications services. The FCC
has considered the issue of whether ISPs should be subject to access charges,
Universal Service Fund support fees and regulation, and has determined that it
would not adopt such regulations. The FCC has announced that it will be issuing
a Notice of Proposed Rule Making ("NPRM") to explore proposals to create
incentives for companies to make the most efficient use of the telephone network
for Internet and other information services. While the FCC has announced that it
does not intend for this NPRM to consider the imposition of access charges or
regulations on ISPs, it could result in the creation of more competition for the
Company. In addition, the FCC could reopen and reconsider these issues at any
time.
On April 10, 1998, the FCC issued its report to Congress regarding the
Universal Service Fund support payments. One of the principal issues considered
in this report is whether Internet services should still be classified as
non-telecommunications services, so as to be exempt from regulation, access
charges and Universal Service Fund support payments. While the FCC determined
that it would continue the exemption, primarily as part of a continuing policy
to permit continued expansion of the Internet, it also indicated that Congress
directed the universal service support mechanism to be competitively neutral.
The FCC also noted the novel status of Internet telephony, and noted that it may
continue investigation of the regulatory status of Internet telephony. While
Internet services, including Internet telephony, remain unregulated and exempt
from access charges and Universal Service Fund support payments, the FCC could
change its policy at any time. In fact, the FCC has indicated that it will take
a case-by-case evaluation approach to determine whether individual Internet
telephony service offerings more closely resemble enhanced services, which
should remain exempt from regulation, or telecommunications services which are
subject to regulation.
The Telecommunications Act of 1996 (the "Telecommunications Act") contains
provisions that lift, or establish procedures for lifting, certain restrictions
relating to the RBOCs' ability to engage directly in the Internet access
business. The Telecommunications Act also makes it easier for national long
distance carriers, such as AT&T, to offer local telephone service. In addition,
the Telecommunications Act allows the RBOCs to provide electronic information
and database publishing. The Telecommunications Act, which permits ISPs to
operate outside of the regulations applied to carriers, also permits other
providers of Internet services, including voice and facsimile services, to
operate more easily. These entities could provide additional sources of
competition for the Company.
The Telecommunications Act, through the portion commonly known as the "1996
Communications Decency Act," imposed fines for certain uses of the Internet, and
the provision of access to indecent and obscene services. These provisions were
struck down as unconstitutional by the Supreme Court of the United States in
June of 1997. On March 12, 1998, the Senate Commerce Committee approved two
bills
10
<PAGE>
that attempt to reconstruct the unconstitutional provisions of the 1996
Communications Decency Act. While it is too early to determine the ultimate
course of these bills, and to evaluate the constitutionality of the proposals,
there is a possibility that these provisions, if enacted and upheld, could
impose liability on ISPs.
Due to the increasing use of the Internet, it is possible that additional
laws and regulations may be adopted with respect to the Internet, covering
issues such as Universal Service Fund support payments, content, user privacy,
pricing, libel, intellectual property protection and infringement and technology
export and other controls. Legislation has been introduced to define and protect
citizens from illegal Internet gambling. Other Internet-related legislation has
been introduced which may limit commerce and discourse on the Internet. The FCC
currently is considering (1) whether ISPs are information service providers or
telecommunications providers; (2) whether ISPs are legally required to
contribute to the Universal Service Fund; (3) how various companies in the
Internet/information/data/telephony service provider field should be classified;
and (4) whether ISPs should benefit from the Universal Service Fund. Changes in
the regulatory environment relating to the application of access charges and
Universal Service Fund support payments to Internet and Internet telephony
providers, regulation of Internet services, including Internet telephony, and
other regulatory changes that directly or indirectly affect costs imposed on
Internet or Internet telephony providers, telecommunications costs or increase
in the likelihood or scope of competition from RBOCs or others, could have a
material adverse impact on the Company.
FUTURE ADDITIONAL CAPITAL REQUIREMENTS. The Company has funded its
operations primarily through private and public sales of equity securities,
borrowings from third parties and capitalized leases. 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,
infrastructure improvements required by advancements in technology, the level of
resources required to implement the Company's marketing and sales programs, the
Company's acquisition and other strategic goals and plans, information systems
and research and development activities, the availability of hardware and
software provided by third-party vendors and other factors. The timing and
amount of such capital requirements cannot accurately be predicted. If capital
requirements vary materially from those currently planned, the Company may
require additional financing sooner than anticipated. The Company has no
commitments for any additional financing other than a $25 million (increasing to
$100 million over a three year period) line of credit from Sprint, and there can
be no assurance that any such commitments can be obtained on favorable terms, if
at all. Any additional equity financing may be dilutive to the Company's
stockholders, and debt financing, if available, may involve restrictive
covenants with respect to dividends, raising future capital and other financial
and operational matters, and may otherwise limit the Company's ability to raise
additional equity capital. If the Company is unable to obtain additional
financing as needed, the Company may be required to reduce the scope of its
operations or its anticipated expansion, which could have a material adverse
effect on the Company. See "--Risks Associated with Management of Potential
Growth," "--Dependence on Network Infrastructure and Third Party Network
Providers," "Use of Proceeds" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Liquidity and Capital Resources."
INTEGRATION OF POTENTIAL ACQUISITIONS AND STRATEGIC ALLIANCES. As part of
its business strategy, the Company may make acquisitions of, significant
investments in, or enter into strategic alliances with, other companies or their
services or technologies. Any such future transactions would be accompanied by
the risks commonly encountered in making acquisitions of companies or their
services and technologies. Such risks include, among other things, the
difficulty associated with assimilating the operations and personnel of the
acquired companies, the potential disruption of the Company's ongoing business,
the inability of management to maximize the financial and strategic position of
the Company through the successful integration of acquired members, network
facilities, technology, rights and other assets,
11
<PAGE>
additional expenses associated with the amortization of acquired intangible
assets, the inability to maintain uniform standards, controls, procedures and
policies and the impairment of relationships with employees and members as a
result of the integration of new management personnel. There can be no assurance
that the Company will be successful in overcoming these or other risks
associated with any such acquisitions or relationships. See "--Significant
Ownership by Sprint; Commercial Relationship with Sprint," "Use of Proceeds" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Quarterly Results."
POTENTIAL LIABILITY. The potential imposition of liability upon the Company
for information carried on and disseminated through its network, including the
transmission of computer viruses and other similarly disruptive programs, could
require the Company to implement additional measures to reduce its exposure to
such liability. The implementation of such measures could require the
expenditure of substantial resources or the discontinuation of certain product
and service offerings. Any costs that are incurred as a result of such
expenditure, contesting any related claims or the imposition of related
liability could have a material adverse effect on the Company.
Due to the increasing use of the Internet, it is possible that additional
laws and regulations may be adopted with respect to the Internet covering issues
such as content, user privacy, pricing, libel, intellectual property protection
and infringement and technology export and other controls. In particular,
Congress has previously proposed to impose and may again seek to impose
liability on entities which "knowingly" permit a telecommunications facility
under their control to transmit obscene materials to minors. Changes in the
regulatory environment relating to the Internet services industry, including
regulatory changes that directly or indirectly affect telecommunication costs or
increase the likelihood or scope of competition, could have a material adverse
effect on the Company. See "--Government Regulation."
PROPRIETARY RIGHTS; INFRINGEMENT CLAIMS. The Company believes that its
success is dependent in part on its technology and other proprietary rights and
information (collectively, its "Proprietary Property") and its continuing right
to use such Proprietary Property. The Company relies on a combination of
copyright, trademark, patent and trade secret laws and contractual restrictions
to establish and protect its Proprietary Property. It is the Company's policy to
require employees, consultants and, when possible, suppliers to execute
confidentiality agreements upon the commencement of their relationships with the
Company. There can be no assurance that the steps taken by the Company will be
adequate to prevent misappropriation of its Proprietary Property or that the
Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's Proprietary Property.
The Company has obtained authorization, typically in the form of a license,
to distribute third-party software incorporated in the EarthLink Network
TotalAccess software product for Microsoft Windows 3.1 and Windows 95 and Apple
Macintosh platforms. Most of these licenses have one-year terms and
automatically renew for additional one-year terms in the absence of notice of
termination from the other party, but are generally terminable earlier upon the
occurrence of certain events (and, with respect to Microsoft, is terminable by
Microsoft or the Company at will). Applications licensed by the Company include
Web browsers from Netscape and Microsoft and MacTCP software from Apple
Computer, Inc. There can be no assurance that the Company will be able to
maintain its existing licenses or successfully obtain necessary license renewals
in the future. The failure to maintain or renew its licenses in the future could
have a material adverse effect on the Company.
There can be no assurance that third parties will not assert that the
Company's services and products infringe their proprietary rights. From time to
time, the Company has received communications from third parties alleging that
certain of the names or marks for the Company's services infringe the trademarks
of such parties. To date, no such claims have had an adverse effect on the
Company's ability to market and sell its services. However, there can be no
assurance that those claims will not have an
12
<PAGE>
adverse effect in the future or that other parties will not assert infringement
claims against the Company in the future with respect to current or future
services. Such claims could result in substantial costs and diversion of
resources, even if ultimately decided in favor of the Company, and could have a
material adverse effect on the Company, particularly if judgments on such claims
are adverse to the Company. In the event a claim is asserted alleging that the
Company has infringed the proprietary technology or information of a third
party, the Company may be required to seek licenses to continue to use such
intellectual property. There can be no assurance, however, that such licenses
would be offered or obtained on commercially reasonable terms, if at all, or
that the terms of any offered licenses would be acceptable to the Company. The
failure to obtain the necessary licenses or other rights could have a material
adverse effect on the Company. See "Business--Proprietary Rights."
CONTROL BY DIRECTORS, EXECUTIVE OFFICERS, FIVE PERCENT STOCKHOLDERS AND
AFFILIATED ENTITIES. Based on stock ownership as of June 1, 1998, the Company's
executive officers, directors and holders of more than 5% of the outstanding
Common Stock (and their affiliates) will beneficially own an aggregate of
approximately 51.5% of the Company's outstanding shares of Common Stock after
this Offering (approximately 50.3% if the Underwriters' over-allotment option is
exercised in full). However, assuming the acceleration of certain dividend
rights relating to its shares of the Company's Series A Convertible Preferred
Stock and that Sprint exercises certain preemptive rights, Sprint will own
approximately 9% of the Company's voting stock and approximately 27% of its
capital stock on a fully diluted basis. As a result, assuming the acceleration
of such Sprint dividend rights and the exercise of such Sprint preemptive
rights, the Company's executive officers, directors and holders of more than 5%
of the outstanding Common Stock (and their affiliates) will own an aggregate of
approximately 63.7% of the Company's outstanding Common Stock offer this
Offering (approximately 62.5% if the Underwriters' over-allotment option is
exercised in full). See "Principal and Selling Stockholders."
YEAR 2000. Many existing computer programs use only two digits to identify
a year. These programs were designed and developed without considering the
impact of the upcoming change in the century. If not corrected, many computer
software applications could fail or create erroneous results by, at or beyond
the year 2000 (the "Year 2000 Phenomenon"). The Company utilizes software,
computer technology and other services provided by third-party vendors that may
not be Year 2000 Phenomenon ready. The Company is also indirectly dependent on
the institutions involved in processing the Company's members' credit card
payments for the Company's services. The Company is currently assessing the Year
2000 Phenomenon readiness of its third-party supplied software, computer
technology and other services. Based upon the results of this assessment, the
Company will develop and implement, if necessary, a remediation plan with
respect to third-party software, computer technology and services which may fail
to be Year 2000 Phenomenon ready. The Company has assessed its proprietary
software and systems and has determined them to be Year 2000 Phenomenon ready.
Management anticipates that the Company's systems, including components thereof
provided by third-party vendors, will be Year 2000 Phenomenon ready by 2000. At
this time, the expenses associated with this assessment and potential
remediation plan cannot presently be determined. The failure of the software and
computing systems of the Company and its third-party vendors to be Year 2000
Phenomenon ready could have material adverse effect on the Company. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
SHARES ELIGIBLE FOR FUTURE SALE. Sales of a substantial number of shares of
the Common Stock in the public market following this Offering could adversely
affect the market price of the Common Stock. The number of shares of Common
Stock available for sale in the public market is limited by restrictions under
the Securities Act and lock-up agreements under which the Company, the executive
officers and directors of the Company, Sprint and the Selling Stockholders have
agreed not to sell or otherwise dispose of any of such shares of Common Stock,
any such options or warrants to acquire shares of Common Stock or any such
securities convertible into shares of Common Stock (or any shares of Common
Stock issuable upon exercise of such securities) for a period of ninety (90)
days after the date
13
<PAGE>
of this Prospectus without the prior written consent of Deutsche Bank Securities
Inc. However, Deutsche Bank Securities Inc. may, in its sole discretion and at
any time without notice, release all or any portion of the securities subject to
such lock-up agreements. Further, the holders of substantially all of the shares
of unregistered Common Stock outstanding prior to this Offering as well as
holders of certain warrants and convertible debt are parties to registration
rights agreements. The exercise of these registration rights and subsequent sale
of a substantial number of shares of the Common Stock in the public market could
adversely affect the market price of the Common Stock. See "Description of
Capital Stock--Registration Rights," "Shares Eligible for Future Sale" and
"Underwriting."
EFFECT OF CERTAIN CHARTER, BYLAW AND SPRINT AGREEMENT PROVISIONS. The
Company's Certificate of Incorporation, Bylaws and the terms of the Sprint
Transaction contain certain provisions that may, individually or in the
aggregate, discourage proposals or bids to acquire the Company, potentially
limiting the price that investors might be willing to pay for shares of the
Common Stock. Certain of such provisions allow the Company to issue Preferred
Stock, the rights and preferences of which may be specified by the Board of
Directors at any time prior to issuance, without further stockholder approval,
potentially delaying, deferring or preventing a change in control of the
Company. The Company is also subject to Section 203 of the Delaware General
Corporation Law which could delay, defer or prevent a business combination with
an "interested stockholder." See "Significant Ownership by Sprint; Commercial
Relationship with Sprint," "Strategic Alliance with Sprint" and "Description of
Capital Stock-- Governance Agreement."
POTENTIAL VOLATILITY OF STOCK PRICE. There can be no assurance that the
market price of the Common Stock will not decline below the Offering price. The
stock markets have experienced price and volume fluctuations that have
particularly affected the stocks of Internet and other technology companies,
resulting in changes in the market prices of the stocks of many companies that
may not have been directly related to the operating performance of those
companies. Such broad market fluctuations may adversely affect the market price
of the Common Stock following this Offering. In addition, factors such as
variations in the Company's financial results, comments by securities analysts,
announcements of technological innovations or new products by the Company or its
competitors, changing government regulations, developments concerning the
Company's proprietary rights or litigation may have a material adverse effect on
the market price of the Common Stock.
IMMEDIATE AND SUBSTANTIAL DILUTION. Investors purchasing shares of Common
Stock in this Offering will incur immediate and substantial dilution in net
tangible book value of the Common Stock of $53.99 per share. To the extent that
currently outstanding options and warrants are exercised or converted, there
will be further dilution. See "Dilution."
NO SPECIFIC USE OF PROCEEDS. The Company has not designated any specific
use for the net proceeds from the sale of the Common Stock offered hereby and
accordingly, management will have significant flexibility in applying the net
proceeds of this Offering. The Company expects to use the net proceeds for
general corporate purposes, including the funding of anticipated operating
losses and capital expenditures. The Company may, when the opportunity arises,
use an unspecified portion of the net proceeds to acquire or invest in
businesses, products and technologies. From time to time, in the ordinary course
of business, the Company expects to evaluate potential acquisitions of such
businesses, products or technologies. The failure of management to apply such
funds effectively could have a material adverse effect on the Company's
business, prospects, financial condition and results of operations. See "Use of
Proceeds."
14
<PAGE>
USE OF PROCEEDS
The net proceeds to the Company from the sale of the shares of Common Stock
offered hereby are estimated to be approximately $86.0 million ($106.5 million
if the Underwriters' over-allotment option is exercised in full) after deducting
estimated underwriting discount and Offering expenses payable by the Company.
The Company will not receive any portion of the proceeds from the sale of shares
of Common Stock by the Selling Stockholders.
As of the date of this Prospectus, the Company has not designated any
specific use for the net proceeds from the sale of the Common Stock offered
hereby. The Company expects to use the net proceeds for general corporate
purposes, including working capital to fund anticipated operating losses,
capital expenditures and increased marketing, sales, and member service to
sustain member growth. The Company may, when the opportunity arises, use an
unspecified portion of the net proceeds to acquire or invest in complementary
businesses, additional subscriber bases, products and technologies. However, as
of the date of this Prospectus, the Company has no understandings, commitments
or agreements with respect to any material acquisition or investment. Pending
such uses, the Company intends to invest the net proceeds of this Offering in
government securities or short-term, investment grade, interest-bearing
securities.
PRICE RANGE OF COMMON STOCK
The Common Stock has been traded on the Nasdaq National Market under the
symbol "ELNK" since the Company's initial public offering on January 22, 1997.
Prior to that time, there was no public market for the Common Stock. The
following table sets forth for the periods indicated the high and low closing
sales price as reported by the Nasdaq National Market.
<TABLE>
<CAPTION>
HIGH LOW
--------- --------
<S> <C> <C>
1997
First Quarter (from January 22, 1997)........................................ $20 1/4 $10 1/8
Second Quarter............................................................... 13 1/2 8 5/8
Third Quarter................................................................ 19 1/2 10 1/4
Fourth Quarter............................................................... 23 3/4 16
1998
First Quarter................................................................ $56 7/16 $24 1/2
Second Quarter (through June 17, 1998)....................................... 74 3/4 50
</TABLE>
On June 17, 1998, the last reported sale price of Common Stock on the Nasdaq
National Market was $60 5/16 per share. As of June 16, 1998 there were
approximately 179 holders of record of the Common Stock.
DIVIDEND POLICY
The Company has not paid any dividends since its inception and does not
intend to pay any dividends on its Common Stock in the foreseeable future. The
payment of future cash dividends on its Common Stock, if any, will be at the
sole discretion of the Board of Directors.
15
<PAGE>
CAPITALIZATION
The following table sets forth, as of March 31, 1998, (i) the capitalization
of the Company, (ii) the pro forma capitalization of the Company giving effect
to the Sprint Transaction, and (iii) the pro forma capitalization of the Company
as adjusted to reflect the sale of the shares of Common Stock being offered by
the Company in this Offering, after deduction of estimated offering expenses and
underwriting discounts.
<TABLE>
<CAPTION>
MARCH 31, 1998
------------------------------------
PRO AS
ACTUAL FORMA ADJUSTED
---------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Long-term debt............................................................. $ 8,257 $ 8,257 $ 8,257
---------- ----------- -----------
Stockholders' equity:
Preferred stock, $0.01 par value, 25,000,000 shares authorized actual,
pro forma and as adjusted: none outstanding actual, 4,102,941 shares
Series A Convertible outstanding pro forma and as adjusted (1)......... -- 41 41
Common stock, $0.01 par value, 50,000,000 shares authorized: 11,997,884
shares outstanding actual and pro forma, 13,519,244 shares outstanding
as adjusted (2)........................................................ 120 120 135
Additional paid-in capital............................................... 77,677 212,636 298,639
Warrants to purchase common stock........................................ 1,153 1,153 1,153
Accumulated deficit...................................................... (72,476) (72,476) (72,476)
---------- ----------- -----------
Total stockholders' equity........................................... 6,474 141,474 227,492
---------- ----------- -----------
Total capitalization............................................... $ 14,731 $ 149,731 $ 235,749
---------- ----------- -----------
---------- ----------- -----------
</TABLE>
- ------------------------------
(1) Convertible into up to 4,102,941 shares of Common Stock, assuming
acceleration of certain dividend rights.
(2) Excludes the following securities outstanding or reserved for future grant
as of March 31, 1998: (i) 1,444,716 shares of Common Stock subject to
options outstanding under the Company's 1995 Stock Option Plan at a weighted
average exercise price of $16.53 per share, (ii) 1,164,866 shares of Common
Stock subject to outstanding warrants and non-employee plan stock options at
a weighted average exercise price of $5.91 per share and (iii) 191,773 and
62,500 shares of Common Stock reserved for future grant of options under the
Company's 1995 Stock Option Plan and Directors Stock Option Plan,
respectively. The number of shares reserved for future issuance under the
1995 Stock Option Plan includes an increase of 1 million shares approved by
the Company's Board of Directors in May 1998, subject to stockholder
approval. See "Management-- 1995 Stock Option Plan and Other Option and
Warrant Issuances," "Management--Directors Stock Option Plan and Other
Director Option Issuances," "Description of Capital Stock" and Notes 8 and 9
of Notes to Financial Statements.
16
<PAGE>
DILUTION
The pro forma net tangible book value of the Common Stock as of March 31,
1998 was $19.9 million, or approximately $1.24 per share. Pro forma net tangible
book value per share represents the amount of the Company's pro forma total
tangible assets less total liabilities (giving effect to the Sprint
Transaction), divided by the pro forma number of shares of Common Stock
outstanding (assuming conversion into Common Stock of the Series A Convertible
Preferred Stock held by Sprint on a one-to-one basis). After giving effect to
the sale of the 1,521,360 shares of Common Stock offered by the Company hereby
and after deducting estimated underwriting discount and Offering expenses
payable by the Company, the pro forma net tangible book value of the Company as
of March 31, 1998 would have been $105.9 million, or approximately $6.01 per
share. This represents an immediate increase in the net tangible book value of
$4.77 per share to existing stockholders and an immediate dilution of $53.99 per
share to new investors purchasing shares of Common Stock in this Offering.
Dilution per share represents the difference between the amount per share paid
by purchasers of shares of Common Stock in the Offering made hereby and the net
tangible book value per share of Common Stock immediately after completion of
this Offering. The following table illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Offering price per share.............................................. $ 60.00
Pro forma net tangible book per share value as of March 31, 1998.... $ 1.24
Increase per share attributable to the Offering..................... 4.77
---------
Pro forma net tangible book value after the Offering.................. 6.01
---------
Dilution per share to new investors................................... $ 53.99
---------
---------
</TABLE>
The foregoing table excludes all options and warrants that will remain
outstanding upon consummation of the Offering. See Notes 8 and 9 of Notes to
Financial Statements. The exercise of outstanding options and warrants having an
exercise price less than the Offering price would increase the dilutive effect
to new investors illustrated by the foregoing table. The foregoing table also
excludes 245,018 shares of Common Stock which Sprint is entitled to purchase
upon closing of the Offering. See "Strategic Alliance with Sprint."
17
<PAGE>
STRATEGIC ALLIANCE WITH SPRINT
On February 10, 1998, EarthLink Operations (formerly EarthLink Network,
Inc.), Sprint and an entity created by EarthLink Operations, Dolphin, Inc.
(referred to herein as "Newco" and, together with EarthLink Operations, as the
"Company" or "EarthLink"), entered into various agreements to establish a
strategic relationship between the Company and Sprint in the area of consumer
Internet access and related services on terms and conditions summarized below
(collectively, the "Sprint Transaction"). Following consummation of the Sprint
Transaction, the former EarthLink Network, Inc. changed its name to EarthLink
Operations, Inc., and Newco changed its name to EarthLink Network, Inc.
On June 5, 1998, Sprint consummated a tender offer for 1.25 million shares
of EarthLink Operations Common Stock at a price per share of $45 net in cash to
each seller (the "Offer"). Immediately following the closing of the Offer,
Sprint received approximately 4.1 million shares of Newco Series A Convertible
Preferred Stock, par value $0.01 per share, in exchange for (i) transfer to the
Company of Sprint's approximately 130,000 Sprint Internet Passport subscribers,
(ii) aggregate cash consideration of approximately $24 million and (iii) the
exclusive right to use certain ports within Sprint's high-speed data network for
four years. EarthLink and Sprint also entered into a Marketing and Distribution
Agreement which includes a commitment by Sprint to deliver a minimum of 150,000
new subscribers per year for five years through its own channels, EarthLink's
right to be Sprint's exclusive provider of consumer Internet access services for
at least ten years and the right to use Sprint's brand and distribution network
for at least ten years. Sprint has also provided EarthLink with a credit
facility of up to $25 million (increasing to $100 million over three years) in
the form of convertible senior debt. Following consummation of the Sprint
Transaction and this Offering, Sprint will own Common Stock and Series A
Convertible Preferred Stock constituting approximately 27% of the Company's
capital stock on a fully diluted basis (assuming acceleration of certain
dividend rights and the exercise by Sprint of certain preemptive rights) and
approximately 9% of the Company's voting stock.
In connection with the Sprint Transaction, a wholly-owned subsidiary of
Newco was merged with and into the former EarthLink Network, Inc. (the
"Merger"), pursuant to which (i) the former EarthLink became a wholly-owned
subsidiary of Newco and (ii) each outstanding share of former EarthLink common
stock was converted into one share of common stock of Newco, par value $0.01 per
share. EarthLink Operations, the corporation surviving the Merger, is now a
wholly-owned subsidiary of Newco.
Also in connection with the Sprint Transaction, the Company and Sprint have
entered into a governance agreement (the "Governance Agreement") which
establishes certain terms and conditions concerning the corporate governance of
the Company in the future, the acquisition and disposition of equity securities
of the Company by Sprint (including certain preemptive rights in favor of
Sprint), the rights of Sprint to make offers to purchase all outstanding shares
of Common Stock of the Company and the rights of the Board of Directors of the
Company to receive and entertain offers to effect certain business combinations.
The Company and certain of its stockholders have entered into an agreement with
Sprint which obligates such stockholders, under certain terms and conditions, to
take action in support of the Company's obligations to Sprint under the
Governance Agreement. In connection with the Sprint Transaction, Sprint is
entitled to appoint two individuals to the Company's Board so long as Sprint's
fully diluted ownership interest in the Company is in excess of 20% and one
Board seat so long as Sprint's fully diluted ownership interest is in excess of
10%. Sprint has designated William T. Esrey, Chairman and Chief Executive
Officer of Sprint, and Patti S. Manuel, President of the Long Distance Division
of Sprint, to fill the EarthLink Board seats to which Sprint is entitled. See
"Risk Factors-- Significant Ownership by Sprint; Commercial Relationship with
Sprint" and "Description of Capital Stock."
Generally, if Sprint, by virtue of an acquisition, merger or other
transaction, including a transaction by which Sprint or its brand is acquired,
becomes engaged in a Restricted Services Business, EarthLink may terminate the
Marketing and Distribution Agreement if Sprint has not, within 180 days of such
transaction, transferred the Restricted Services Business to EarthLink or
terminated or divested itself of the Restricted Services Business. Upon such
termination Sprint must pay EarthLink a termination fee as
18
<PAGE>
follows: $60 million decreased pro rata over the initial five years of the
agreement, provided, that if such termination occurs prior to the end of the
second year, no such decrease will occur; plus, a fee to compensate EarthLink
for the lost benefit of Sprint's commitment to provide 150,000 new members per
year during the first five years of the agreement. "Restricted Services
Business" is defined as a set of services and products which are substantially
similar to EarthLink's standard dial-up Internet access service offering.
Upon consummation of the Offering, assuming full exercise of the
Underwriters' over-allotment option and pursuant to certain preemptive rights to
which Sprint is entitled under the Sprint Transaction, Sprint may purchase an
additional approximately 245,018 shares of Common Stock.
19
<PAGE>
SELECTED HISTORICAL FINANCIAL INFORMATION
The following selected historical financial information has been derived
from historical financial statements of the Company and should be read in
conjunction with such historical financial statements and the notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Prospectus. The selected historical
financial information for the period from inception on May 26, 1994 through
December 31, 1994 and the three years ended December 31, 1997 are derived from
the financial statements of the Company, which were audited by Price Waterhouse
LLP. The selected historical financial information for the three months ended
March 31, 1997 and 1998 have been derived from the Company's unaudited financial
statements. In the opinion of management, the unaudited financial statements
include all adjustments (consisting only of normal recurring adjustments)
necessary for a fair presentation of the results for the periods presented.
The pro forma statement of operations data give effect to the Sprint
Transaction as if it had occurred on January 1, 1997, and the pro forma balance
sheet data give effect to the Sprint Transaction as if it had occurred at March
31, 1998. The pro forma financial information does not purport to represent what
the Company's results of operations would have been if the Sprint Transaction
had in fact occurred on such dates, nor does it purport to indicate the future
financial position or results of future operations of the Company. The pro forma
adjustments are based on currently available information and certain assumptions
that management believes to be reasonable.
The selected historical and pro forma financial and operating data set forth
below should be read in conjunction with "Use of Proceeds," "Management's
Discussion and Analysis of Financial Condition and Results of Operations," the
Company's financial statements and notes thereto, and other financial and
operating data included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
THREE
MONTHS
INCEPTION ENDED
(MAY 26, 1994) YEAR ENDED DECEMBER 31, MARCH 31,
THROUGH ----------------------------------------------- ---------
DECEMBER 31, PRO FORMA (3)
1994 1995 1996 1997 1997 1997
----------------- --------- --------- --------- -------------- ---------
<S> <C> <C> <C> <C> <C> <C>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
STATEMENT OF OPERATIONS DATA:
Revenues:
Recurring revenues.......................... $ 53 $ 2,422 $ 26,879 $ 72,943 $ 72,943 $ 14,086
Other revenues.............................. 58 606 5,624 6,231 6,231 1,632
Incremental revenues........................ -- -- -- -- -- --
SIP net operating revenues.................. -- -- -- -- 14,489 --
------- --------- --------- --------- -------------- ---------
Total revenues............................ 111 3,028 32,503 79,174 93,663 15,718
------- --------- --------- --------- -------------- ---------
Operating costs and expenses:
Cost of recurring revenues.................. 4 1,055 18,462 37,974 37,974 7,955
Cost of other revenues...................... 12 349 2,699 3,401 3,401 915
Sprint Internet Passport ("SIP") cost of
services.................................. -- -- -- -- 51,313 --
Sales and marketing......................... 37 3,711 15,258 21,020 21,020 4,961
General and administrative.................. 168 2,062 10,534 14,333 84,061 3,502
Operations and member support............... 38 1,869 15,808 30,900 30,900 6,422
SIP selling, general and administrative..... -- -- -- -- 13,099 --
SIP other................................... -- -- -- -- 3,404 --
------- --------- --------- --------- -------------- ---------
Total operating costs and expenses........ 259 9,046 62,761 107,628 245,172 23,755
------- --------- --------- --------- -------------- ---------
Loss from operations.......................... (148) (6,018) (30,258) (28,454) (151,509) (8,037)
Interest expense.............................. -- (136) (1,041) (2,099) (2,099) (507)
Interest income............................... -- 34 150 637 637 165
------- --------- --------- --------- -------------- ---------
Net loss.................................. $ (148) $ (6,120) $ (31,149) $ (29,916) (152,971) $ (8,379)
------- --------- --------- --------- ---------
------- --------- --------- --------- ---------
Deductions for dividends on convertible
preferred stock............................. 9,355
--------------
Net loss attributable to common stockholders.. $ (162,326)
--------------
--------------
Basic and diluted net loss per share (1)...... $ (0.10) $ (1.59) $ (5.13) $ (2.99) $ (16.23) $ (0.92)
------- --------- --------- --------- -------------- ---------
------- --------- --------- --------- -------------- ---------
Weighted average shares outstanding (1)....... 1,550 3,837 6,069 10,001 10,001 9,094
------- --------- --------- --------- -------------- ---------
------- --------- --------- --------- -------------- ---------
<CAPTION>
PRO FORMA (3)
1998 1998
--------- --------------
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Recurring revenues.......................... $ 27,270 $ 27,270
Other revenues.............................. 1,578 1,578
Incremental revenues........................ 392 392
SIP net operating revenues.................. -- 6,259
--------- --------------
Total revenues............................ 29,240 35,499
--------- --------------
Operating costs and expenses:
Cost of recurring revenues.................. 14,506 14,506
Cost of other revenues...................... 705 705
Sprint Internet Passport ("SIP") cost of
services.................................. -- 9,813
Sales and marketing......................... 5,916 5,916
General and administrative.................. 4,513 21,945
Operations and member support............... 9,540 9,540
SIP selling, general and administrative..... -- 2,155
SIP other................................... -- 198
--------- --------------
Total operating costs and expenses........ 35,180 64,778
--------- --------------
Loss from operations.......................... (5,940) (29,279)
Interest expense.............................. (687) (687)
Interest income............................... 223 223
--------- --------------
Net loss.................................. $ (6,404) (29,743)
---------
---------
Deductions for dividends on convertible
preferred stock............................. 2,006
--------------
Net loss attributable to common stockholders.. $ (31,749)
--------------
--------------
Basic and diluted net loss per share (1)...... $ (0.56) $ (2.79)
--------- --------------
--------- --------------
Weighted average shares outstanding (1)....... 11,373 11,373
--------- --------------
--------- --------------
</TABLE>
20
<PAGE>
<TABLE>
<CAPTION>
THREE
MONTHS
INCEPTION ENDED
(MAY 26, 1994) YEAR ENDED DECEMBER 31, MARCH 31,
THROUGH ----------------------------------------------- ---------
DECEMBER 31, PRO FORMA (3)
1994 1995 1996 1997 1997 1997
----------------- --------- --------- --------- -------------- ---------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
Other operating data:
EBITDA (2).................................. $ (141) $ (5,713) $ (26,105) $ (19,077) $ (6,157)
Cash flows from:
Operating activities...................... (146) (3,643) (16,222) (21,290) (12,101)
Investing activities...................... (97) (4,266) (18,361) (16,095) (4,786)
Financing activities...................... 243 8,199 38,286 49,842 26,043
<CAPTION>
PRO FORMA (3)
1998 1998
--------- --------------
<S> <C> <C>
Other operating data:
EBITDA (2).................................. $ (2,951)
Cash flows from:
Operating activities...................... 3,648
Investing activities...................... (6,943)
Financing activities...................... 3,560
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------
1994 1995 1996 1997
--------- --------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents........................................................ $ -- $ 290 $ 3,993 $ 16,450
Total assets..................................................................... 186 4,874 27,119 46,887
Long-term debt................................................................... -- 355 6,088 8,218
Total liabilities................................................................ 89 4,584 34,367 40,812
Accumulated deficit.............................................................. (148) (5,007) (36,156) (66,072)
Stockholders' equity (deficit)................................................... 97 290 (21,261) 6,075
<CAPTION>
MARCH 31, 1998
-------------------------
ACTUAL PRO FORMA (3)
--------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents........................................................ $ 16,715 $ 40,465
Total assets..................................................................... 52,092 195,560
Long-term debt................................................................... 8,257 8,257
Total liabilities................................................................ 45,618 54,086
Accumulated deficit.............................................................. (72,476) (72,476)
Stockholders' equity (deficit)................................................... 6,474 141,474
</TABLE>
- ----------------------------------
(1) See Note 1 of Notes to Financial Statements for an explanation of the
determination of the number of weighted average shares outstanding in the
net loss per share computation.
(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, as an alternative to, or more meaningful than measures of
performance determined in accordance with generally accepted accounting
principles.
(3) Pro forma financial data give effect to the Sprint Transaction. The
unaudited pro forma statement of operations data are based on the statements
of operations of the Company and the statements of revenues and direct
expenses of the Consumer Internet Access Services of Sprint Corporation as
if the Sprint Transaction had occurred on January 1, 1997. The unaudited pro
forma balance sheet data are based on the balance sheet of the Company and
include the assets acquired from Sprint and have been prepared to reflect
the acquisition by the Company of the SIP subscriber base as of March 31,
1998. See "Strategic Alliance with Sprint" and "Pro Forma Financial
Information."
21
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
SAFE HARBOR STATEMENT
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL
STATEMENTS AND RELATED NOTES INCLUDED ELSEWHERE IN THIS PROSPECTUS. THE RESULTS
DISCUSSED HEREIN ARE NOT NECESSARILY INDICATIVE OF THE RESULTS TO BE EXPECTED IN
ANY FUTURE PERIODS. THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS BASED ON
CURRENT EXPECTATIONS WHICH INVOLVE RISKS AND UNCERTAINTIES. ACTUAL RESULTS AND
THE TIMING OF CERTAIN EVENTS MAY DIFFER SIGNIFICANTLY FROM THOSE PROJECTED IN
SUCH FORWARD-LOOKING STATEMENTS DUE TO A NUMBER OF FACTORS, INCLUDING THOSE SET
FORTH HEREIN, IN THE SECTION ENTITLED "RISK FACTORS" AND ELSEWHERE IN THIS
PROSPECTUS.
OVERVIEW
EarthLink is a leading 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. 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, PSINet
and Sprint for local access to their respective nationwide systems of POPs. Cost
of other revenues principally includes expenses related to the registration of
new members, 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. Net
losses were approximately $6.3 million from inception through 1995, $31.1
million for 1996 and $29.9 million for 1997. As of March 31, 1998, the Company
had an accumulated deficit of approximately $72.5 million (exclusive of $1.3
million of 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). The Company
has noted a trend of continuing improvement in net loss and earnings before
interest, taxes, depreciation and amortization ("EBITDA") since the beginning of
1996. EBITDA losses were $5.7 million, $26.1 million and $19.1 million,
respectively, for the three years ended December 31, 1995, 1996 and 1997, and
$6.2 million and $3.0 million, respectively, for the quarters ended March 31,
1997 and 1998. 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
22
<PAGE>
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 achieve or sustain profitability or positive
cash flow from its operations.
On June 5, 1998, the Company and Sprint entered into a long-term strategic
alliance. In connection with this alliance, Sprint consummated a tender offer
for 1.25 million shares of Common Stock at $45 per share (the "Offer").
Immediately following the closing of the Offer, Sprint received approximately
4.1 million shares of Newco Series A Convertible Preferred Stock, par value
$0.01 per share, in exchange for (i) transfer to the Company of Sprint's
approximately 130,000 Sprint Internet Passport subscribers, (ii) aggregate cash
consideration of approximately $24 million and, (iii) the exclusive right to use
certain ports within Sprint's high-speed data network for four years. EarthLink
and Sprint also entered into a Marketing and Distribution Agreement including a
commitment by Sprint to deliver a minimum of 150,000 new subscribers per year
for five years through its own channels, the right to be Sprint's exclusive
provider of consumer Internet access services for at least ten years, and the
right to use Sprint's brand and distribution network for at least ten years.
Sprint has also provided EarthLink with a credit facility of up to $100 million
in the form of convertible senior debt. Following consummation of the Sprint
Transaction and this Offering, Sprint will own Common Stock and convertible
preferred stock constituting approximately 27% of the Company's capital stock on
a fully diluted basis (assuming acceleration of certain dividend rights and the
exercise by Sprint of certain preemptive rights).
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 MARCH
YEAR ENDED DECEMBER 31, 31,
----------------------------------- ------------------------
1995 1996 1997 1997 1998
--------- ----- ----- ----- -----
<S> <C> <C> <C> <C> <C>
Revenues:
Recurring revenues............................................ 80% 83% 92% 90% 93%
Other revenues................................................ 20 17 8 10 6
Incremental revenues.......................................... -- -- -- -- 1
--- --- --- --- ---
Total revenues.............................................. 100 100 100 100 100
--- --- --- --- ---
Operating costs and expenses:
Cost of recurring revenues.................................... 35 57 48 50 50
Cost of other revenues........................................ 11 8 4 6 2
Sales and marketing........................................... 123 47 27 32 20
General and administrative.................................... 68 32 18 22 15
Operations and member support................................. 62 49 39 41 33
--- --- --- --- ---
Total operating costs and expenses.......................... 299 193 136 151 120
--- --- --- --- ---
Loss from operations.......................................... (199) (93) (36) (51) (20)
Interest expense.............................................. (4) (3) (3) (3) (3)
Interest income............................................... 1 -- 1 1 1
--- --- --- --- ---
Net loss................................................ (202)% (96)% (38)% (53)% (22)%
--- --- --- --- ---
--- --- --- --- ---
EBITDA.......................................................... (189)% (80)% (24)% (39)% (10)%
</TABLE>
23
<PAGE>
THREE MONTHS ENDED MARCH 31, 1998 AND 1997
RECURRING REVENUES
The Company experienced substantial growth in revenues for the quarter ended
March 31, 1998 as compared to the corresponding period of 1997. Recurring
revenues increased 94% from $14.1 million in the quarter ended March 31, 1997 to
$27.3 million in the quarter ended March 31, 1998 due to a significant increase
in the Company's member base.
OTHER REVENUES
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
--------------------------------------------------
PERCENT PERCENT
OF OTHER OF OTHER
1997 REVENUES 1998 REVENUES
--------- ------------- --------- -------------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C>
Dial-up set up fees.............................. $ 1,130 69% $ 828 52%
Other set up fees and other revenues............. 502 31 750 48
--------- --- --------- ---
Total other revenues............................. $ 1,632 100% $ 1,578 100%
--------- --- --------- ---
--------- --- --------- ---
</TABLE>
Other revenues decreased 3% for the quarter ended March 31, 1998 as compared
to the corresponding period of 1997 primarily as a result of the Company waiving
set up fees for dial-up members acquired through certain affinity marketing
partnerships due to market pressures. This resulted in a decrease in dial-up set
up fees collected in the quarter ended March 31, 1998 as compared to the
corresponding period of 1997. The Company expects this trend to continue for
dial-up set up revenue. The decline in the dial-up set up fees was offset by
increases in other set up fees and other revenues as a result of increased sales
of premium services.
COST OF RECURRING REVENUES
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
--------------------------------------------------
PERCENT OF PERCENT OF
RECURRING RECURRING
1997 REVENUES 1998 REVENUES
--------- ------------- --------- -------------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C>
Recurring revenues........................... $ 14,086 100% $ 27,270 100%
Cost of recurring revenues................... 7,955 56 14,506 53
</TABLE>
Cost of recurring revenues increased 82% during the quarter ended March 31,
1998 as compared to the corresponding period of 1997, primarily due to the
increase in the Company's member base. Cost of recurring revenues was 53% of
recurring revenues for the quarter ended March 31, 1998 as compared to 56% for
the corresponding period of 1997. The decrease in the cost of recurring revenues
as a percentage of recurring revenue was primarily due to the Company's ability
to manage and reduce communications costs per member more effectively and to
exploit economies of scale to reduce per member costs as the total member base
expanded.
24
<PAGE>
COST OF OTHER REVENUES
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
------------------------------------------------------
PERCENT PERCENT
OF OTHER OF OTHER
1997 REVENUES 1998 REVENUES
--------- --------------- --------- ---------------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C>
Royalties............................................ $ 346 21% $ 14 1%
Bounties............................................. 436 27 590 37
Other................................................ 133 8 101 7
-- --
--------- ---------
Total cost of other revenues......................... $ 915 56% $ 705 45%
-- --
-- --
--------- ---------
--------- ---------
</TABLE>
Cost of other revenues decreased $210,000 or 23% during the quarter ended
March 31, 1998 as compared to the corresponding period of 1997. The decrease was
primarily due to a reduction in royalty expense occasioned by the renewal of
various contracts for licensed software under more favorable terms.
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 19% from $5.0 million during the quarter ended March 31 1997
to $5.9 million in the quarter ended March 31, 1998. The increase was primarily
due to increased emphasis on marketing the Company's services,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
29%, from $3.5 million in the quarter ended March 31, 1997 to $4.5 million in
the same period of 1998, due to increases in payroll, rent, depreciation
expenses and credit card fees. The rise in payroll costs was primarily due to
growth in headcount. The numbers of general and administrative employees as of
March 31, 1997 and 1998 were 102 and 110, respectively. In October 1997, the
Company occupied an additional 45,000 square feet of its existing 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 from $350,000 to $619,000 was primarily 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 register and
maintain member accounts. Operations and member support expenses increased $3.1
million or 49% from $6.4 million in the quarter ended March 31, 1997 to $9.5
million in the quarter ended March 31, 1998, reflecting management's focus on
retaining existing members by providing superior services and devoting
significant resources to expanding technical support and network operations
capabilities. The number of employees engaged in operations and member support
activities was 474 and 712 at March 31, 1997 and 1998, respectively. The Company
also continued to make significant investments in improving its customer
services
25
<PAGE>
functions by investing in training programs, hardware and software. The Company
intends to continue to invest in this area in the future.
INCOME TAXES
No provision for federal or state income taxes has been recorded as the
Company incurred net operating losses through March 31, 1998. At December 31,
1997, the Company had net operating loss carryforwards for federal income tax
purposes of approximately $61.0 million, which begin to expire in 2011. The
Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"),
includes provisions that limit the net operating loss carryforwards for use in a
given year if significant ownership changes have occurred. The Company's initial
public offering resulted in an ownership change limiting the Company's ability
to utilize net operating loss carryforwards to offset future income, if any. The
Company expects that its strategic alliance with Sprint will result in further
limitations. The Company has provided a full valuation allowance on the deferred
tax asset because of the uncertainty regarding whether such carryforwards will
ever be used. Prior to July 1995, the Company was taxed as an S Corporation
under the Internal Revenue Code. As a result, losses for tax purposes totaling
approximately $2.8 million flowed directly to stockholders during the period and
are not included in the amount of net operating loss carryforwards.
INTEREST EXPENSE
Interest expense increased from $507,000 in the quarter ended March 31, 1997
to $687,000 in the quarter ended March 31, 1998. The increase in interest
expense was primarily due to increased borrowings and capital lease obligations
which were incurred to finance the Company's network infrastructure and capital
improvements.
INTEREST INCOME
The increase in interest income from $165,000 in the quarter ended March 31,
1997 to $223,000 in the quarter ended March 31, 1998 was primarily due to an
increase in average cash balances available for investment.
1997 COMPARED TO 1996
RECURRING REVENUES
Recurring revenues are recognized over the period for which the services are
provided. Recurring revenues increased $46.1 million or 171% from $26.9 million
in 1996 to $72.9 million in 1997 due to the significant increase in the
Company's member base during 1997.
OTHER REVENUES
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------
PERCENT PERCENT
OF OTHER OF OTHER
1996 REVENUES 1997 REVENUES
--------- ------------- --------- -------------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C>
Dial-up set up fees.............................. $ 4,563 81% $ 3,478 56%
Other set up fees and revenues................... 1,061 19 2,753 44
--------- --- --------- ---
Total other revenues............................. $ 5,624 100% $ 6,231 100%
--------- --- --------- ---
--------- --- --------- ---
</TABLE>
Other revenues increased $607,000 or 11% from 1996 to 1997. Due to
competitive pricing and other pressures, the Company waived set up fees for
dial-up members acquired through certain affinity
26
<PAGE>
marketing partnerships. This caused a decrease in dial-up set up fees earned
during 1997. This trend is expected to continue for dial-up set up fees. During
1997, the Company began to aggressively promote its Web hosting and nationwide
high speed access services and in the fourth quarter began to capitalize on
incremental revenue activities. The decline in dial-up set up fees was offset by
increases in the other set up fees and revenues attributable to the Company's
Web hosting, high speed access services and related products.
COST OF RECURRING REVENUES
Cost of recurring revenues increased from $18.5 million in 1996 to $38.0
million in 1997 due to the increase in the Company's member base, but decreased
from 69% of recurring revenues in 1996 to 52% of recurring revenues in 1997. The
decrease from 1996 to 1997 was primarily due to the Company's ability to
effectively manage communications costs and economies of scale to reduce per
member costs as the total member base expanded. Until October 1996, the Company
paid UUNET a fixed monthly fee per member plus a variable amount based on member
usage in excess of a threshold number of hours per month. The Company's network
services agreement with UUNET was amended as of October 1996 to change the cost
basis from per member costs to peak port hours. In June 1997, UUNET agreed to
waive monthly revenue minimums, excess hours fees and peak service user targets
during the six months ended December 31, 1997. In return, EarthLink agreed not
to invoke its early termination right prior to September 1998. If usage becomes
more concentrated during peak times, the fees paid by the Company to UUNET will
increase, thereby adversely affecting the Company's operating margins. Under the
Company's agreement with PSINet, the Company pays PSINet a fixed monthly fee for
each member accessing the Company's services through a PSINet POP. As the
Company continues to expand, the Company anticipates that it may build and use
additional Company-owned POPs in those geographical areas where there is a
sufficient concentration of members to support the cost of such investment.
COST OF OTHER REVENUES
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------------------------------------
PERCENT PERCENT
OF OTHER OF OTHER
1996 REVENUES 1997 REVENUES
--------- --------------- --------- ---------------
(IN THOUSANDS, EXCEPT PERCENTAGES)
<S> <C> <C> <C> <C>
Royalties........................................ $ 1,907 34% $ 930 15%
Bounties......................................... 465 8 1,744 28
Other............................................ 327 6 727 12
-- --
--------- ---------
Total cost of other revenues..................... $ 2,699 48% $ 3,401 55%
-- --
-- --
--------- ---------
--------- ---------
</TABLE>
Cost of other revenues increased $702,000 or 26% from $2.7 million in 1996
to $3.4 million in 1997. The increase was due to growth in affinity marketing
partnerships and payment of the related bounties. The growth in bounties was
partially offset by a decrease in royalty expense due to the renewal of various
contracts under more favorable terms. The increase in the total cost of other
revenues as a percentage of other revenues was attributable to the decrease in
other revenues, specifically, dial-up set up fees.
SALES AND MARKETING
Sales and marketing expenses increased $5.8 million or 38% from $15.3
million in 1996 to $21.0 million 1997. The increase was primarily due to the
emphasis on marketing the Company's services, expanding sales and marketing
efforts nationwide, 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.
27
<PAGE>
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased $3.8 million or 36% from $10.5
million in 1996 to $14.3 million in 1997 due to increases in bad debt, payroll,
rent, depreciation expenses and credit card fees. Bad debt expense was $2.5
million or 7.7% of total revenues in 1996 due to difficulties in billing and in
disconnecting late-paying members on a timely basis. Bad debt expense was $3.5
million or 4.4% of total revenues in 1997. The increase in bad debt was due to
management's review and elimination of accounts with questionable payment
history and the compression of the Company's collection cycle. The rise in
payroll costs was primarily due to growth in headcount. Personnel engaged in
general and administrative activities increased from 92 to 110 during 1997. The
rise 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 primarily due to the increase in the Company's member base.
OPERATIONS AND MEMBER SUPPORT
Operations and member support expenses increased $15.1 million or 96% from
$15.8 million in 1996 to $30.9 million in 1997 reflecting management's efforts
to retain existing members by devoting significant resources to expanding
technical support and network operations capabilities. Employees engaged in
operations and member support activities increased from 401 to 565 during 1997.
During 1997, the Company created a new call center and invested in training
programs and hardware and software to solve member problems.
INTEREST EXPENSE
The increase in interest expense from $1.0 million in 1996 to $2.1 million
in 1997 was primarily due to increased borrowings and capital lease obligations
incurred by the Company to finance the expansion of the Company's network
infrastructure and capital equipment acquisitions.
INTEREST INCOME
The increase in interest income from $150,000 in 1996 to $637,000 in 1997
was primarily due to the increase in average cash balances available for
investment.
1996 COMPARED TO 1995
REVENUES
Recurring revenues increased $24.5 million or more than 1,000% from $2.4
million in 1995 to $26.9 million in 1996 as a result of an increase in the
number of EarthLink members. The increase in revenues was partially offset by
credits given to members under the Company's member referral program. Under this
program, the Company waived, and continues to waive, one month of standard
service fees in consideration for each new member referred by an existing
member. This waived service fee resulted in a reduction of revenues. The
increase in other revenues from $606,000 in 1995 to $5.6 million in 1996 was
primarily due to the increase in the number of new members during the latter
period and one-time set up fees collected from those new members.
COST OF REVENUES
Cost of recurring revenues increased from 44% of recurring revenues or $1.1
million in 1995 to 69% of recurring revenues or $18.5 million in 1996 due the
Company's expansion to nationwide service through its relationship with UUNET.
The Company paid UUNET a fixed monthly fee per member plus a variable amount
based on customer usage in excess of a threshold number of hours per month. The
Company's agreement with UUNET was amended as of October 1996 so that the key
variable component is peak usage rather than hourly usage.
28
<PAGE>
SALES AND MARKETING
Sales and marketing expense increased from $3.7 million in 1995 to $15.3
million in 1996. EarthLink's principal strategy during 1995 and 1996 was to
rapidly expand its customer base and increase its market share of the
under-penetrated market for Internet access services. To realize this strategy,
the Company aggressively invested in sales and marketing. This strategy required
substantial initial cash outlays which outpaced the resultant growth in
revenues. In the latter part of 1996, EarthLink's marketing efforts emphasized
the variety of services available to business members, including business Web
sites, high-speed ISDN communications capability, high-speed frame relay
connections and Internet access through corporate Intranets.
GENERAL AND ADMINISTRATIVE
Since inception, general and administrative expenses have increased as a
result of increased employee headcount, rent, depreciation and credit card fees.
During 1996, the Company hired a number of senior management personnel, moved
into a new headquarters building and engaged professional consultants to assist
in the development of an administrative infrastructure to accommodate
anticipated increases in the number of members and employees, which resulted in
a significant increase in general and administrative expenses as compared to
1995. General and administrative expenses for 1996 included bad debt expense of
$2.5 million which resulted from difficulties in billing and in disconnecting
late-paying members on a timely basis. In addition, in September 1996, the
Company issued 37,500 shares of Common Stock as consideration for the
termination of a consulting agreement. The value of the stock, $413,000, was
included in general and administrative expenses for the year ended December 31,
1996.
OPERATIONS AND MEMBER SUPPORT
Operations and member support expenses increased from $1.9 million in 1995
to $15.8 million in 1996. This trend reflected the costs associated with
building a member service organization to support the Company's member base and
anticipated member growth. Employees engaged in operations and member support
activities increased from 112 to 444 during 1996.
INTEREST EXPENSE
The increase in interest expense from $136,000 in 1995 to $1.0 million in
the 1996 was primarily due to increased borrowings and capital lease obligations
incurred by the Company to finance the expansion of the Company's network
infrastructure and capital equipment acquisitions.
INTEREST INCOME
The increase in interest income from $34,000 in 1995 to $150,000 in 1996 was
primarily due to the increase in average cash balances available for investment.
QUARTERLY RESULTS
Revenues and operating expenses have increased in each of the nine quarters
ended March 31, 1998, primarily due to increases in the Company's member base
and associated costs. Loss from operations as a percent of revenue over this
period has declined reflecting the Company's increasing economies of scale.
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, member
usage, new member acquisition, member retention, capital expenditures and other
costs relating to the expansion of operations, including upgrading the Company's
systems and
29
<PAGE>
infrastructure; the timing and market acceptance of new and upgraded service
introductions by the Company and its competitors; 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
significant portion of the Company's expenses are fixed; therefore, the
Company's operating margins are particularly sensitive to fluctuations in
revenues. See "Risk Factors--Factors Affecting Operating Results; Potential
Fluctuations in Quarterly Results."
The following table sets forth certain unaudited quarterly financial data
for the nine quarters ended March 31, 1998. This unaudited information has been
prepared on the same basis as the audited financial statements contained herein
and, in the opinion of the Company's management, includes all adjustments
(consisting of normal recurring adjustments) necessary to present fairly the
information set forth therein when read in conjunction with the financial
statements and notes thereto. The operating results for any quarter are not
necessarily indicative of results for any future period.
<TABLE>
<CAPTION>
1996 1997
------------------------------------------------ ----------------------------------------------
MAR. 31 JUN. 30 SEPT. 30 DEC. 31 MAR. 31 JUN. 30 SEPT. 30 DEC. 31
----------- --------- ----------- ----------- --------- --------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Recurring revenues................ $ 2,628 $ 5,014 $ 8,272 $ 10,965 $ 14,086 $ 17,479 $ 19,044 $ 22,334
Other revenues.................... 790 1,714 1,744 1,376 1,632 1,367 1,559 1,673
Incremental revenues (1).......... -- -- -- -- -- -- -- --
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Total revenues.................. 3,418 6,728 10,016 12,341 15,718 18,846 20,603 24,007
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Cost of revenues.................. 1,698 3,865 6,173 6,726 7,955 9,187 9,543 11,289
Cost of other revenues............ 569 758 693 679 915 804 741 941
Sales and marketing............... 2,209 3,263 4,395 5,391 4,961 5,056 5,636 5,367
General and administrative........ 1,632 2,423 3,783 2,696 3,502 3,449 3,511 3,871
Operations and member support..... 2,098 3,094 4,749 5,867 6,422 7,791 7,970 8,717
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Total operating costs and
expenses........................ 8,206 13,403 19,793 21,359 23,755 26,287 27,401 30,185
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Loss from operations.............. (4,788) (6,675) (9,777) (9,018) (8,037) (7,441) (6,798) (6,178)
Interest expense.................. (100) (161) (422) (358) (507) (444) (516) (632)
Interest income................... 19 1 94 36 165 135 116 221
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Net loss........................ $ (4,869) $ (6,835) $ (10,105) $ (9,340) $ (8,379) $ (7,750) $ (7,198) $ (6,589)
----------- --------- ----------- ----------- --------- --------- ----------- -----------
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Basic and diluted net loss per
share (2)..................... $ (0.96) $ (1.21) $ (1.65) $ (1.26) $ (0.92) $ (0.80) $ (0.72) $ (0.59)
----------- --------- ----------- ----------- --------- --------- ----------- -----------
----------- --------- ----------- ----------- --------- --------- ----------- -----------
Weighted average shares
outstanding (2)................. 5,097 5,652 6,139 7,386 9,094 9,738 9,932 11,241
----------- --------- ----------- ----------- --------- --------- ----------- -----------
----------- --------- ----------- ----------- --------- --------- ----------- -----------
EBITDA (3)........................ $ (4,338) $ (5,916) $ (8,213) $ (7,638) $ (6,157) $ (5,263) $ (4,285) $ (3,372)
<CAPTION>
1998
---------
MAR. 31
---------
<S> <C>
STATEMENT OF OPERATIONS DATA:
Recurring revenues................ $ 27,270
Other revenues.................... 1,578
Incremental revenues (1).......... 392
---------
Total revenues.................. 29,240
---------
Cost of revenues.................. 14,506
Cost of other revenues............ 705
Sales and marketing............... 5,916
General and administrative........ 4,513
Operations and member support..... 9,540
---------
Total operating costs and
expenses........................ 35,180
---------
Loss from operations.............. (5,940)
Interest expense.................. (687)
Interest income................... 223
---------
Net loss........................ $ (6,404)
---------
---------
Basic and diluted net loss per
share (2)..................... $ (0.56)
---------
---------
Weighted average shares
outstanding (2)................. 11,373
---------
---------
EBITDA (3)........................ $ (2,951)
</TABLE>
- ------------------------------
(1) Beginning in the first quarter of 1998, the Company began reporting
incremental revenues.
(2) SFAS No. 128, Earnings per Share ("EPS"), and Staff Accounting Bulletin No.
98 require companies, such as EarthLink, that incorporated the SAB 83
concept of "cheap stock" in determining pre-initial public offering EPS data
to restate EPS data to conform to SFAS 128. Basic EPS now represents the
weighted average number of shares divided into net income during a given
period. Potential common stock items, options, warrants or convertible
instruments are not included in the calculation of EPS due to their
anti-dilutive effect.
(3) 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, as an alternative to, or more meaningful than measures of
performance determined in accordance with generally accepted accounting
principles.
30
<PAGE>
<TABLE>
<CAPTION>
1996 1997
-------------------------------------------------- ---------------------------------------
MAR. 31 JUN. 30 SEPT. 30 DEC. 31 MAR. 31 JUN. 30 SEPT. 30
----------- ----------- ----------- ----------- ----------- ----------- -------------
AS A PERCENTAGE OF TOTAL REVENUES
<S> <C> <C> <C> <C> <C> <C> <C>
Recurring revenues................. 77% 75% 83% 89% 90% 93% 92%
Other revenues..................... 23 25 17 11 10 7 8
Incremental revenues............... -- -- -- -- -- -- --
--- --- --- --- --- --- ---
Total revenues................... 100 100 100 100 100 100 100
--- --- --- --- --- --- ---
Cost of revenues................... 50 57 62 55 50 49 46
Cost of other revenues............. 17 11 7 6 6 4 4
Sales and marketing................ 65 48 44 44 32 27 27
General and administrative......... 48 36 38 22 22 18 17
Operations and member support...... 61 46 47 48 41 41 39
--- --- --- --- --- --- ---
Total operating costs and
expenses......................... 241 198 198 175 151 139 133
--- --- --- --- --- --- ---
Loss from operations............... (140) (99) (98) (73) (51) (39) (33)
Interest expense................... (3) (2) (4) (3) (3) (2) (3)
Interest income.................... 1 -- 1 -- 1 1 1
--- --- --- --- --- --- ---
Net loss......................... (142)% (101)% (101)% (76)% (53)% (40)% (35)%
--- --- --- --- --- --- ---
--- --- --- --- --- --- ---
EBITDA (3)......................... (127)% (88)% (82)% (62)% (39)% (28)% (21)%
<CAPTION>
1998
-----------
DEC. 31 MAR. 31
----------- -----------
<S> <C> <C>
Recurring revenues................. 93% 93%
Other revenues..................... 7 6
Incremental revenues............... -- 1
--- ---
Total revenues................... 100 100
--- ---
Cost of revenues................... 48 50
Cost of other revenues............. 4 2
Sales and marketing................ 22 20
General and administrative......... 16 15
Operations and member support...... 36 33
--- ---
Total operating costs and
expenses......................... 126 120
--- ---
Loss from operations............... (26) (20)
Interest expense................... (3) (3)
Interest income.................... 1 1
--- ---
Net loss......................... (28)% (22)%
--- ---
--- ---
EBITDA (3)......................... (14)% (10)%
</TABLE>
- ------------------------------
(3) 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, as an alternative to, or more meaningful than measures of
performance determined in accordance with generally accepted accounting
principles.
LIQUIDITY AND CAPITAL RESOURCES
Cash used in operating activities was $3.6 million, $16.2 million and $21.3
million during the years ended December 31, 1995, 1996 and 1997, respectively.
Cash provided by operating activities was $3.6 million during the quarter ended
March 31, 1998, primarily as a result of the increase in accounts payable and
accrued liabilities of $7.2 million relating to network service costs.
Cash used in investing activities has consisted primarily of capital
equipment purchases for expansion. Capital expenditures amounted to
approximately $2.8 million, $18.8 million and $14.5 million, respectively, for
1995, 1996 and 1997. Capital expenditures amounted to approximately $4.8 million
and $5.7 million for the quarter ended March 31, 1997 and 1998, respectively.
During 1997, the Company purchased the rights to subscribers and related assets
of Internet in a Mall, Inc., a Tarzana, California based ISP, at a cost of
approximately $1.4 million. During the quarter ended March 31, 1998, the Company
incurred approximately $1.3 million in specific incremental acquisition costs
directly attributable to the Sprint Transaction.
Cash provided by financing activities was approximately $8.2 million, $38.3
million and $49.8 million during 1995, 1996 and 1997, respectively. Cash
provided by financing activities was approximately $26.0 million and $3.6
million during the quarter ended March 31, 1997 and 1998, respectively. The
Company raised $6.3 million, $8.7 million and $15.4 million in private sales of
its equity securities during 1995, 1996 and 1997, respectively. In the first
quarter of 1997, the Company sold 2,284,750 shares of Common Stock in its
initial public offering. Net proceeds from the offering were approximately $26.2
million. During 1995, 1996 and 1997, respectively, the Company financed the
acquisition of data processing and office equipment amounting to approximately
$556,000, $11.3 million and $10.5 million, respectively, by entering into a
number of agreements for the sale and leaseback of equipment. Lease proceeds for
the quarter ended March 31, 1998 were $2.5 million. 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 at cost. 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.
31
<PAGE>
In connection with an amendment of its agreement with UUNET in October 1996,
the Company issued a $5.0 million, one-year convertible promissory note to
UUNET. This note, along with accrued interest, was converted into 391,515 shares
of Common Stock at $12.88 per share on March 31, 1998 per the terms of the note.
As of March 31, 1998, the Company had cash and cash equivalents of
approximately $16.7 million. The Company believes that available cash will be
sufficient to meet the Company's operating expenses and capital requirements for
at least the next 12 months. In addition, as a result of the Sprint Transaction,
EarthLink will obtain approximately $24 million in cash and have available a $25
million credit facility in the form of convertible debt financing, increasing to
$100 million over a three-year period, at an interest rate of 6% per annum. See
"Strategic Alliance with Sprint." 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. The timing and
amount of such capital requirements cannot accurately be predicted. If capital
requirements vary materially from those currently planned, the Company may
require additional financing sooner than anticipated. The Company has no
commitments for any additional financing other than the $25 million (which
increases to $100 million over three years) line of credit from Sprint, and
there can be no assurance that any such commitments can be obtained on favorable
terms, if at all. Any additional equity financing may be dilutive to the
Company's stockholders, and debt financing, if available, may involve
restrictive covenants with respect to dividends, raising future capital and
other financial and operational matters and may otherwise limit the Company's
ability to raise additional equity capital. If the Company is unable to obtain
additional financing as needed, the Company may be required to reduce the scope
of its operations or its anticipated expansion, which could have a material
adverse effect on the Company. See "Risk Factors--Future Additional Capital
Requirements."
YEAR 2000
Many existing computer programs use only two digits to identify a year.
These programs were designed and developed without considering the impact of the
upcoming change in the century. If not corrected, many computer software
applications could fail or create erroneous results by, at or beyond the year
2000 (the "Year 2000 Phenomenon"). The Company utilizes software, computer
technology and other services provided by third-party vendors that may not be
Year 2000 Phenomenon ready. The Company is also indirectly dependent on the
institutions involved in processing the Company's members' credit card payments
for the Company's services. The Company is currently assessing the Year 2000
Phenomenon readiness of its third-party supplied software, computer technology
and other services. Based upon the results of this assessment, the Company will
develop and implement, if necessary, a remediation plan with respect to
third-party software, computer technology and services which may fail to be Year
2000 Phenomenon ready. The Company has assessed its proprietary software and
systems and has determined them to be Year 2000 Phenomenon ready. Management
anticipates that the Company's systems, including components thereof provided by
third-party vendors, will be Year 2000 Phenomenon ready by 2000. At this time,
the expenses associated with this assessment and potential remediation plan
cannot presently be determined. The failure of the software and computing
systems of the Company and its third-party vendors to be Year 2000 Phenomenon
ready could have material adverse effect on the Company. See "Risk Factors--Year
2000."
32
<PAGE>
PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma condensed combined financial statements
give effect to the acquisition by the Company of the Sprint Internet Passport
business ("SIP") of Sprint in a transaction accounted for as a purchase. The
unaudited pro forma balance sheet is based on the balance sheet of the Company
included elsewhere in this Prospectus and the assets acquired and liabilities
assumed from SIP and Sprint and has been prepared to reflect the acquisition by
the Company of SIP as of March 31, 1998. The unaudited statements of operations
are based on the statements of operations of the Company and the statements of
revenues and direct expenses of SIP appearing elsewhere in this Prospectus, and
combine the results of operations of the Company and of SIP for the year ended
December 31, 1997 and the quarter ended March 31, 1998 as if the acquisition
occurred on January 1, 1997. These unaudited pro forma financial statements
should be read in conjunction with the historical statement of revenues and
direct expenses and notes thereto of SIP and the historical financial statements
and notes thereto of the Company, both included elsewhere in this Prospectus.
The historical statement of revenues and direct expenses of SIP are not
necessarily indicative of the financial condition or results of operations of
such operations on a prospective basis because of the omission of various
operating expenses from such presentation and the change in the nature and scope
of such business as it will be operated by the Company.
The purchase price paid by the Company consisted of approximately 4.1
million shares of Series A Convertible Preferred Stock, which has been valued at
$135,000,000. In exchange for the Series A Convertible Preferred Stock, the
Company obtained SIP's customer base of approximately 130,000 members, cash of
$23,750,000 and access to Sprint's high-speed data network. Sprint has further
provided the Company access to $25 million (increasing to $100 million over a
three year period) in convertible debt financing, and has entered into a
Marketing and Distribution Agreement with the Company. The Company acquired no
other assets of SIP or Sprint. Accordingly, the purchase price was allocated to
the cash and intangible assets acquired. The excess of the purchase price over
the fair value of the assets acquired was allocated to goodwill. The final
allocation may differ from that used in the unaudited pro forma condensed
combined financial statements. The acquisition was accounted for using the
purchase method.
Sprint began offering Internet access in the fourth quarter of 1996 and
reported this operation within its Emerging Businesses Segment (the "Group").
Sprint maintained the financial information relative to the Internet subscribers
in the financial statements for the Group. Sprint maintained revenue and direct
operating expense information separately within the Group. Direct operating
expenses include cost of services and products, selling, general and
administrative expense, and depreciation expense. Sprint, however, did not
separately maintain and account for other costs and expenses to operate this
business. The Company is unable to determine or estimate these costs on a
historical and pro forma basis. In addition, Sprint did not separately maintain
and account for all assets used in the individual business. Such assets,
primarily network related, are recorded in the other businesses of Sprint and
used by the other divisions of Sprint in addition to the Group.
33
<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA CONDENSED COMBINED BALANCE SHEET
(UNAUDITED)
<TABLE>
<CAPTION>
MARCH 31, 1998
-----------------------------------------
ASSETS
ACQUIRED AND
EARTHLINK LIABILITIES PRO FORMA
NETWORK, INC. ASSUMED COMBINED
------------- ------------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash and cash equivalents....................................... $ 16,715 $ 23,750(a) $ 40,465
Restricted short-term investment................................ 1,250 1,250
Accounts receivable, net........................................ 2,923 2,923
Prepaid expenses................................................ 1,904 1,904
Deferred transaction costs...................................... 1,270 1,270
Other assets.................................................... 427 427
------------- ------------- -----------
Total current assets.......................................... 24,489 23,750 48,239
Other long-term assets.......................................... 563 563
Property and equipment, net..................................... 26,465 26,465
Intangibles, net................................................ 575 119,718(b) 120,293
------------- ------------- -----------
$ 52,092 $ 143,468 $ 195,560
------------- ------------- -----------
------------- ------------- -----------
Trade accounts payable.......................................... $ 10,128 $ 10,128
Accrued payroll and related expenses............................ 2,698 2,698
Other accounts payable and accrued liabilities.................. 6,873 $ 8,468(c) 15,341
Current portion of capital lease obligations.................... 7,692 7,692
Notes payable................................................... 5,585 5,585
Deferred revenue................................................ 4,385 4,385
------------- ------------- -----------
Total current liabilities..................................... 37,361 8,468 45,829
Long-term debt.................................................. 8,257 8,257
------------- ------------- -----------
Total liabilities......................................... 45,618 8,468 54,086
------------- ------------- -----------
Stockholders' equity
Preferred stock............................................... 41(d) 41
Common stock.................................................. 120 120
Additional paid-in capital.................................... 77,677 134,959(d) 212,636
Warrants to purchase common stock............................. 1,153 1,153
Accumulated deficit........................................... (72,476) (72,476)
------------- ------------- -----------
Total stockholders' equity................................ 6,474 135,000 141,474
------------- ------------- -----------
$ 52,092 $ 143,468 $ 195,560
------------- ------------- -----------
------------- ------------- -----------
</TABLE>
34
<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA CONDENSED COMBINED BALANCE SHEET
(UNAUDITED)
NOTES TO PRO FORMA CONDENSED COMBINED BALANCE SHEET
Pro forma adjustments are as follows:
a. This adjustment reflects the cash acquired of $23,750,000.
b. This adjustment reflects the fair value of the intangible assets acquired,
consisting of a customer base valued at $65,000,000, intangible assets
related to Sprint's provision of customers and the co-branding feature of
the Marketing and Distribution Agreement valued at $20,000,000 and the
excess of consideration over the fair value of assets acquired totalling
$34,718,000.
c. Represents incremental acquisition costs directly attributable to the
transactions, consisting of primarily investment banking, legal and
accounting professional fees.
d. These adjustments reflect the issuance of approximately 4.1 million shares
of Convertible Preferred Stock in connection with the transactions
contemplated by the Investment Agreement at estimated fair value. The Series
A Convertible Preferred Stock will pay dividends for the first five years in
the form of increases in its Liquidation Value ("Liquidation Accretion
Dividends"), 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.
35
<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA COMBINED STATEMENT OF OPERATIONS
FOR THE YEAR ENDED DECEMBER 31, 1997
(UNAUDITED)
<TABLE>
<CAPTION>
SPRINT
EARTHLINK INTERNET
NETWORK, INC. PASSPORT PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
------------- ---------- ------------ ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Revenues:
Recurring revenues.................................... $ 72,943 $ 72,943
Other revenues........................................ 6,231 6,231
Net operating revenues................................ $ 14,489 14,489
------------- ---------- ------------ ------------
Total revenues...................................... 79,174 14,489 93,663
------------- ---------- ------------ ------------
Operating costs and expenses:
Cost of recurring revenues............................ 37,974 37,974
Cost of other revenues................................ 3,401 3,401
Cost of services...................................... 51,313 51,313
Sales and marketing................................... 21,020 21,020
General and administrative............................ 14,333 69,728(a) 84,061
Operations and member support......................... 30,900 30,900
Selling, general and administrative................... 13,099 13,099
Depreciation.......................................... 6,070 (6,070)(b) --
Other................................................. 3,404 3,404
------------- ---------- ------------ ------------
Total operating costs and expenses.................. 107,628 73,886 63,658 245,172
------------- ---------- ------------ ------------
Loss from operations.................................. (28,454) (59,397) (63,658) (151,509)
Interest expense...................................... (2,099) (2,099)
Interest income....................................... 637 637
------------- ---------- ------------ ------------
Net loss.......................................... (29,916) (59,397) (63,658) (152,971)
Deductions for dividends on convertible preferred
stock................................................. 9,355(c) 9,355
------------- ---------- ------------ ------------
Net loss attributable to common stockholders........ $ (29,916) $ (59,397) $ (73,013) $ (162,326)
------------- ---------- ------------ ------------
------------- ---------- ------------ ------------
Basic and diluted net loss per share.................. $ (2.99) $ (16.23)
------------- ------------
------------- ------------
Weighted average shares outstanding................... 10,001 10,001(d)
------------- ------------
------------- ------------
</TABLE>
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<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA COMBINED STATEMENT OF OPERATIONS (CONTINUED)
FOR THE YEAR ENDED DECEMBER 31, 1997
(UNAUDITED)
NOTES TO PRO FORMA COMBINED STATEMENT OF OPERATIONS
Pro Forma adjustments are as follows:
a. This entry reflects the amortization of intangible assets as follows:
customer base amortized over 18 months, the Marketing and Distribution
Agreement amortized over five and ten years, which are the life of the
portion of the contract related to Sprint's provision of customers and the
overall contract life relative to the co-branding feature, respectively, and
the excess of purchase price over net assets acquired amortized over 18
months. Additional costs to provide service to the acquired members are not
considered to be material.
b. The Company acquired no depreciable assets of SIP. This adjustment
eliminates the depreciation expense recorded by SIP.
c. This adjustment reflects the Liquidation Dividends based upon a 3%
Liquidation Value accretion dividend ($3,736,000), the accretion of a
dividend related to the beneficial conversion feature in accordance with
EITF Topic No. D-60 based upon the rate at which the preferred stock becomes
convertible ($5,619,000).
d. Pro forma share data are based on the number of shares of the Company's
Common Stock and common equivalent shares that would have been outstanding
had SIP been acquired on January 1, 1997, but excludes any shares purchased
by Sprint in the Offer. As of December 31, 1997, EarthLink had reserved
1,688,611 shares for issuance upon the exercise of outstanding employee
stock options, 391,515 shares for issuance pursuant to the Convertible Note
issued to UUNET Technologies, Inc. and 887,647 shares reserved for issuance
upon exercise of outstanding warrants. These common stock equivalents and
4.1 million shares of the Series A Convertible Preferred Stock have been
excluded from the calculation as their effect is antidilutive. The pro forma
per share data also reflects the exchange on a one-for-one basis of common
stock between the former EarthLink and the new EarthLink upon consummation
of the Merger.
37
<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA COMBINED STATEMENT OF OPERATIONS
FOR THE THREE MONTHS ENDED MARCH 31, 1998
(UNAUDITED)
<TABLE>
<CAPTION>
SPRINT
EARTHLINK INTERNET
NETWORK, INC. PASSPORT PRO FORMA PRO FORMA
HISTORICAL HISTORICAL ADJUSTMENTS COMBINED
------------- ----------- ------------ -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Revenues:
Recurring revenues....................................... $ 27,270 $ 27,270
Other revenues........................................... 1,578 1,578
Incremental revenues..................................... 392 392
Net operating revenues................................... $ 6,259 6,259
------------- ----------- ------------ -----------
Total revenues......................................... 29,240 6,259 35,499
------------- ----------- ------------ -----------
Operating costs and expenses:
Cost of recurring revenues............................... 14,506 14,506
Cost of other revenues................................... 705 705
Cost of services......................................... 9,813 9,813
Sales and marketing...................................... 5,916 5,916
General and administrative............................... 4,513 17,432(a) 21,945
Operations and member support............................ 9,540 9,540
Selling, general and administrative...................... 2,155 2,155
Depreciation............................................. 2,146 (2,146)(b) --
Other.................................................... 198 198
------------- ----------- ------------ -----------
Total operating costs and expenses..................... 35,180 14,312 15,286 64,778
------------- ----------- ------------ -----------
Loss from operations..................................... (5,940) (8,053) (15,286) (29,279)
Interest expense......................................... (687) (687)
Interest income.......................................... 223 223
------------- ----------- ------------ -----------
Net loss............................................. (6,404) (8,053) (15,286) (29,743)
Deductions for dividends on convertible preferred stock.... 2,006(c) 2,006
------------- ----------- ------------ -----------
Net loss attributable to common stockholders........... $ (6,404) $ (8,053) $ (17,292) $ (31,749)
------------- ----------- ------------ -----------
------------- ----------- ------------ -----------
Basic and diluted net loss per share..................... $ (0.56) $ (2.79)
------------- -----------
------------- -----------
Weighted average shares outstanding...................... 11,373 11,373(d)
------------- -----------
------------- -----------
</TABLE>
38
<PAGE>
EARTHLINK NETWORK, INC.
PRO FORMA COMBINED STATEMENT OF OPERATIONS (CONTINUED)
FOR THE THREE MONTHS ENDED MARCH 31, 1998
(UNAUDITED)
NOTES TO PRO FORMA COMBINED STATEMENT OF OPERATIONS
Pro Forma adjustments are as follows:
(a) This entry reflects the amortization of intangible assets as follows:
customer base amortized over 18 months, the Marketing Agreement amortized
over five and ten years, which are the life of the portion of the contract
related to Sprint's provision of customers and the overall contract life
relative to the co-branding feature, respectively, and the excess of
purchase price over net assets acquired amortized over 18 months. Additional
costs to provide service to the acquired members are not considered to be
material.
(b) The Company acquired no depreciable assets of SIP. This adjustment
eliminates the depreciation expense recorded by SIP.
(c) This adjustment reflects the Liquidation Dividends based upon a 3%
Liquidation Value accretion dividend ($951,000) and the accretion of a
dividend related to the beneficial conversion feature in accordance with
EITF Topic No. D-60 based upon the rate at which the preferred stock becomes
convertible ($1,055,000).
(d) Pro forma per share data are based on the number of shares of the Company's
Common Stock and common equivalent shares that would have been outstanding
had SIP been acquired on January 1, 1997, but excludes any shares to be
purchased by Sprint in the Offer. As of March 31, 1998, EarthLink had
reserved for issuance 1,913,716 shares upon the exercise of outstanding
employee stock options, and 695,866 shares reserved for issuance upon
exercise of outstanding warrants. These common stock equivalents and 4.1
million shares of the Series A Convertible Preferred Stock have been
excluded from the calculation as their effect is antidilutive. The pro forma
per share data also reflects the exchange on a one for one basis of common
stock between former EarthLink and new EarthLink upon consummation of the
Merger.
39
<PAGE>
BUSINESS
OVERVIEW
EarthLink is a leading 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 has developed its member base,
which was approximately 680,000 at June 5, 1998, through a combination of
innovative and cost-conscious direct and affinity marketing programs, the Sprint
Transaction, which generated approximately 130,000 new members, and a focused
effort to retain current members that has resulted in EarthLink having what
management believes to be a high retention rate for its industry. EarthLink's
recently announced strategic alliance with Sprint provided EarthLink with
approximately 130,000 new members, and a 5-year commitment from Sprint to
generate at least 150,000 new members annually through Sprint's channels. In
addition, EarthLink is now co-branded with Sprint as its exclusive consumer
Internet access provider. Furthermore, the Company has exclusive access to
certain dial-up modem ports in Sprint's network. Moreover, EarthLink will have
access to Sprint's marketing and distribution channels and the right to use
Sprint's widely recognized brand.
EarthLink has aggressively expanded its member base from approximately
420,000 members at December 31, 1997 to approximately 680,000 members at June 5,
1998 (including the approximately 130,000 members gained through the Sprint
Transaction). Throughout this period of substantial growth, the Company has
maintained highly reliable service by actively developing and managing a
nationwide telecommunications network of leased, high-speed, dedicated data
lines and over 1,400 POPs by leveraging third party network service providers.
Substantially all of the Company's members have access to the Internet through a
local telephone call. In addition to traditional dial access, EarthLink offers
connectivity via cable, ISDN, frame relay and other high-speed access
technologies. Moreover, EarthLink proactively manages the allocation of members
across the ports of its third-party networks and its own facilities in
California in order to reduce network costs and ensure high-quality service.
Furthermore, the Company has made substantial investments in its data center,
accounting and billing systems and member care systems to allow for significant
growth beyond its current member base. EarthLink's high-quality service offering
has been recognized by several independent sources, including PC MAGAZINE,
which, in September 1997, honored EarthLink with its Editor's Choice award as
the best Internet service provider.
EarthLink Network TotalAccess software, which the Company distributes free
of charge, allows members to register for and access the Company's Internet
service through an automated, multimedia user interface. EarthLink's standard
$19.95 per month dial-up Internet service provides members with unlimited access
to the Internet, email, a Web browser, six megabytes of space for the creation
of a personal web site, the ability to create a Personal Start Page, a
subscription to BLINK (EarthLink's member newsletter), toll-free 24-hour
technical support and access to newsgroups. Premium services available include
high bandwidth connections such as frame relay or ISDN and TotalAccess Gold,
which provides members with an additional email box, priority technical support
and quarterly software offerings for an additional $9.95 per month. EarthLink's
offerings to small businesses include Web hosting and direct connection of LANs
to the Internet through either ISDN or frame relay. Additionally, the Company is
developing the following emerging network access services for future release:
ADSL, fiber to the curb and satellite/wireless.
40
<PAGE>
EarthLink's marketing efforts to acquire new members include print and
broadcast advertisements, affinity marketing programs and a membership referral
program. EarthLink has over 400 affinity marketing partners including
relationships with prominent retailers, print publishers, and software and
hardware companies. Leading affinity marketing partners include Cendant
Software, CompUSA, Novus Service's Discover Card, Gateway, MacMillan Digital
Publishing USA, SAM's Club, Sony Entertainment and Warner Bros. In the future,
EarthLink believes its marketing efforts will be supplemented significantly by
Sprint's marketing of EarthLink's services to Sprint's approximately 16 million
customers.
SPRINT TRANSACTION
On June 5, 1998, EarthLink and Sprint entered into a strategic alliance, in
which the Company acquired Sprint's approximately 130,000 Sprint Internet
Passport Subscribers and became Sprint's exclusive consumer Internet access
service provider. Additionally, the Company entered a 10-year marketing
agreement with Sprint accompanied by a commitment for Sprint to deliver a
minimum of 150,000 new members per year for 5 years through its own distribution
channels. The Company believes that new members generated by the Sprint
relationship will be obtained at significantly less cost than what it would cost
the Company to add these members through its own efforts. Under the terms of the
Sprint Transaction, the Company also obtained the right to use Sprint's brand
and distribution network, approximately $24 million in cash, a $25 million
credit facility (increasing to $100 million over a three year period) in the
form of convertible debt and a four year agreement to use certain ports within
Sprint's high-speed data network. In addition, Sprint purchased 1.25 million
shares of Common Stock at $45 per share in a tender offer and received 4.1
million shares of EarthLink Series A Convertible Preferred Stock. See "Strategic
Alliance With Sprint," "Management--Executive Officers and Directors" and
"Description of Capital Stock."
INDUSTRY BACKGROUND
GROWTH OF THE INTERNET
The Internet is an increasingly significant global medium for
communications, information and online commerce. IDC estimates that the number
of Internet users was 81 million in 1997 and will reach 177 million by 2000. In
addition, IDC projects that ISP revenues in the United States will grow from
$4.6 billion in 1997 to $18.3 billion in 2000, implying a compound annual growth
rate of 58.5% per year. Continued growth in Internet usage is expected to be
fueled by several factors, including the large and growing installed base of
personal computers in the workplace and home, advances in the performance and
speed of personal computers and modems, improvements in network infrastructure,
easier and cheaper access to the Internet, and increased general awareness of
the Internet.
CHALLENGES OF INTERNET ACCESS
Due to the rapid growth of content on the Internet and its unindexed nature,
potential Internet users, particularly non-technical users, may perceive the
Internet to be difficult and intimidating to use. Such users generally place a
premium on products and services that are easy to use. For experienced users,
the Internet is increasingly viewed as a mission critical telecommunications
service. Experienced users are generally focused on network quality,
reliability, customer service quality and cost. The Company believes the
requirements of both inexperienced and experienced users create a significant
market opportunity for vendors that can serve both user groups.
41
<PAGE>
EARTHLINK'S STRATEGY
EarthLink's objectives are to be the leading nationwide ISP and to provide
its members with a high-quality Internet experience. Key elements of EarthLink's
strategy include:
RAPIDLY EXPAND ITS MEMBER BASE. EarthLink believes that a key to its
success in the competitive ISP market is to rapidly expand its member base,
thereby amortizing its fixed assets over a larger revenue base and enhancing its
ability to enter into favorable arrangements with network service providers,
affinity marketing partners and providers of content. The Company plans to
accelerate its efforts and financial commitments to attract new members, while
continuing to provide high-quality service to ensure member retention.
Historically, the Company has capitalized on its reputation for high quality and
obtained a significant portion of its new members as a result of referrals from
existing members. The Company also plans to continue to place advertisements in
major computer magazines, to expand its affinity marketing program, to maintain
a presence at national, regional and local trade shows, and to continue to offer
economic incentives to members who refer new members. The Company believes that
its access to Sprint's high-speed data network will further enhance its ability
to add new members.
PROVIDE AN EASY TO USE SOLUTION AND SUPERIOR MEMBER SUPPORT. Due to the
unindexed nature of the Internet and its associated complexity, users may
encounter numerous difficulties. Therefore, the Company focuses significant
resources on retaining members by providing them with reliable and easy to use
Internet access combined with on-demand member support. To that end, EarthLink
will continue to devote significant resources to expanding its 24-hour, 7 days
per week customer and technical support, enhancing its network operations
capability, and refining and maintaining its Web site. In addition, the Company
strives to minimize call times and to maintain member support representatives
sufficient to effectively meet its members' needs. At March 31, 1998, the
Company had 712 member and technical support employees. The EarthLink Network
TotalAccess software, which includes front-end software and documentation for
both Windows and Macintosh users, is designed to make it easy for members to
register and configure their system for Internet access. The Company believes
that the combination of its EarthLink Network TotalAccess software, and its
reliable network infrastructure significantly enhances the Internet experience
for a wide variety of users. Moreover, the Company constantly works to develop
new services, content and features to enhance that user experience.
CAPITALIZE ON SPRINT RELATIONSHIP. The Company intends to maximize the
opportunities presented by the Sprint Transaction to attract new members
nationwide and to further enhance the Company's position as a leading ISP. The
Company believes that the substantial increase in members and other financial
and operational resources resulting from the Sprint Transaction will enable the
Company to achieve its strategic objectives on a cost-effective and accelerated
basis while providing the Company with opportunities to further increase its
member base. The Company believes that new members generated by the Sprint
relationship will be obtained at significantly less cost than what it would cost
the Company to add these members through its own efforts. The Company intends to
take advantage of Sprint's recognized brand image, extensive distribution
channels and existing approximately 16 million long-distance and local telephone
customers. The EarthLink brand will be jointly marketed with Sprint's
widely-recognized brand in connection with consumer Internet services. In
addition, EarthLink expects to benefit from having exclusive access to certain
dial-up modem ports in Sprint's high-speed data network.
LEVERAGE THIRD PARTY SERVICE PROVIDERS. In order to maintain its focus on
member needs, the Company leverages the infrastructure of others by leasing POP
capacity from UUNET, PSINet and Sprint. In addition to lowering required capital
expenditures, the Company believes that this approach gives it flexibility to
rapidly expand its service coverage. Moreover, access to multiple networks
provides members with increased service quality resulting from redundant network
access. The Company will
42
<PAGE>
continue to pursue this strategy so that it can devote its principal resources
to its sales and marketing efforts and to improving its members' Internet
experience.
DERIVE INCREMENTAL REVENUES. The Company is focused on leveraging its
growing member base and user traffic to increase revenues from sources other
than access-related sources such as advertising and electronic commerce. The
principal component of this 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 space on its various online properties like
the Personal Start Page and its bi-monthly print newsletter, BLINK, and is
developing other potential new sources of incremental revenue like the EarthLink
Mall, branded start pages and EarthLink Internet Rooms.
ENHANCE MARKETING AND DISTRIBUTION. Historically, the Company's member base
has been concentrated in selected major metropolitan areas, particularly in the
western United States. The Company plans to expand its targeted marketing
programs and distribution efforts in underpenetrated geographic markets in order
to increase its nationwide presence and brand recognition. In order to achieve
these objectives, the Company plans to employ a wide-ranging marketing and
distribution program, including expanded affinity partners, print publication,
radio, billboards and direct mail. EarthLink closely monitors the results of its
marketing techniques as part of an ongoing effort to increase the
cost-effectiveness of its marketing efforts.
MANAGE A RELIABLE AND SCALABLE NETWORK INFRASTRUCTURE. Throughout its
history, the Company has experienced rapid member growth and intends for such
growth to continue. To effectively add new members and continue to offer high
quality service, the Company has made significant capital investments, including
expansion of its data center, accounting, and billing systems and customer care
systems. EarthLink believes that its current infrastructure will be adequate to
manage a significant increase in its member base.
EARTHLINK'S SERVICES
EarthLink provides a wide variety of competitively priced Internet services
to its individual and business members. The Company enables these services
through use of its EarthLink Network TotalAccess software package. This software
incorporates a telephone dialer and email functionality with several leading
third-party Internet access tools, including the latest browsers from Netscape
and Microsoft, thereby providing a functional, easy-to-use Internet access
solution for Windows 3.1, Windows 95 and Macintosh platforms. EarthLink Network
TotalAccess software automatically installs these and other software
applications on the member's computer. The simple point-and-click functionality
of EarthLink Network TotalAccess, combined with its easy-to-use multimedia
registration system, permits online credit card registration, allowing both
novice and experienced EarthLink members to quickly set up access to the
Internet.
43
<PAGE>
The Company's service offerings include:
<TABLE>
<S> <C>
STANDARD INTERNET SERVICES
EMAIL PUBLICATIONS
WEB BROWSER MEMBER AND TECHNICAL SUPPORT
6MB WEB SPACE FOR A PERSONAL WEB EARTHLINK WEB SITE
SITE NEWSGROUPS
PERSONAL START PAGE THE EARTHLINK ONLINE MALL
NATIONWIDE POPS
PREMIUM SERVICES
BUSINESS WEB SITE HOSTING DOMAIN OR VANITY NAME SERVICE
NATIONAL ISDN STAR EMAIL ADDRESSING
NATIONAL LAN ISDN INTERNATIONAL ROAMING SERVICE
NATIONAL FRAME RELAY 800 SERVICE
TOTALACCESS GOLD INTERNET ROOMS
ADDITIONAL MAILBOXES ADDITIONAL ADVERTISING SERVICES
EMERGING ACCESS SERVICES
CABLE FIBER TO THE CURB
ADSL SATELLITE/WIRELESS ACCESS
</TABLE>
EARTHLINK'S STANDARD INTERNET SERVICES. EarthLink provides its members with a
core set of features through its standard Internet service, which allows
unlimited access to the Internet and the World Wide Web as well as other
features and services, subject to EarthLink's acceptable use policy and other
member agreements and policies, for a flat monthly fee of $19.95 and a one-time
set up fee (which is frequently waived). The following features are included in
EarthLink's standard Internet service:
EMAIL. Each member is provided a mailbox which enables members to exchange
an unlimited number of multimedia, text, graphics, audio and video messages
with other online and Internet users.
WEB BROWSER. EarthLink provides members with a free Web browser. Currently,
EarthLink offers its members Netscape Communicator or Microsoft Internet
Explorer. Members may also use any other browser of their choice.
6MB WEB SPACE FOR A PERSONAL WEB SITE. Each EarthLink member is provided
with six free megabytes of space on the Company's Web server to create the
member's own personal Web site. EarthLink also provides tutorials and tools
to help members develop their sites, enabling members to participate in the
Internet community by personally adding content to the World Wide Web.
PERSONAL START PAGE. The Company provides each member with a Personal Start
Page, an enhanced default start page for members that first appears when
they log on to the EarthLink Network. Members can customize their start
page. For example, a member may include content from CNN's online news
service. Members also have the option to view stock quotes, and weather
reports and are provided with a personal reminder system, as well as a place
to list their own personal Web links and links to EarthLink member and
technical support resources.
NATIONWIDE POPS. EarthLink members can access their accounts from
nationwide POPs from any of over 1,400 POPs. More than 400 of these POPs
allow 56 Kbps access.
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<PAGE>
PUBLICATIONS. EarthLink mails its bi-monthly printed newsletter, BLINK, to
each of its members. BLINK provides members with useful information, such as
tips on how to search for certain categories of information on the Internet,
information regarding new EarthLink service offerings, pointers to new
Internet sites and other items of interest. This publication is also
available online on the EarthLink home page. Additionally, the Company
provides its new members with an orientation booklet called "Getting the
Most Out of EarthLink," written by the Company's founder, Sky Dayton.
MEMBER AND TECHNICAL SUPPORT. The Company currently provides the following
member and technical support services: (i) toll-free, live telephone
assistance available seven days a week, 24 hours a day; (ii) email-based
assistance available seven days a week, 24 hours a day; (iii) help sites and
Internet guide files on the EarthLink Web site; and, (iv) automated "fax
back" and "fax on demand" assistance. Additionally, the Company provides
dedicated support for its business members through dedicated member care
support personnel who are specially trained for business products and
services such as Business Web Sites and local area network ("LAN") ISDN.
EARTHLINK WEB SITE. EarthLink has developed and maintains a Web site at
www.earthlink.net containing content and links to third-party content and
services. EarthLink's in-house staff actively seeks out interesting content
from across the World Wide Web and organizes it into areas of interest on
the EarthLink Web site under topics such as "Hollywood," "Sports," "Travel,"
"News," "Finance" and "Games." The Company's Web site provides a road map to
the abundance of information and services available on the Internet. The
site also contains Web pages dedicated to online member assistance including
technical support, account maintenance and service updates.
NEWSGROUPS. EarthLink provides a free link to Usenet, a collection of
Internet discussion groups called "newsgroups" and one of the most popular
areas of the Internet. Usenet creates and facilitates ongoing online
discussions of specific areas of interest. There are currently more than
25,000 of these newsgroups discussing different topics.
THE EARTHLINK ONLINE MALL. EarthLink's online shopping mall, the Mall,
provides users with a one-stop gateway to some of the top retailers on the
Web, using a familiar mall map interface. Retailers such as The Disney
Store, BarnesandNoble.com and 1-800-FLOWERS "lease" space in the Mall.
EARTHLINK'S PREMIUM SERVICES. In addition to its standard service, the Company
offers a variety of premium services, including the following:
BUSINESS WEB SITE HOSTING. The Company provides a Web hosting service for
business members. Monthly fees for business Web sites range from $89 to
$455, plus one-time set up fees of $179 to $479, depending on the size of
the site and whether the site is a shared or unique address. A wide variety
of options is available for an extra fee. Additional charges may apply for
excess site traffic. The Company also offers an introductory service for
small businesses, STARTERSITE, which is a ten megabyte, unique-domain Web
site priced at $19.95 per month, plus a one-time set up fee of $25.
NATIONAL ISDN. EarthLink offers nationwide high-speed ISDN access providing
significantly higher access speeds than conventional analog modems. The
monthly charge for ISDN is $34.95 for the first 100 channel hours and $0.99
thereafter, plus a one-time set up fee of $50.
NATIONAL LAN ISDN. EarthLink offers small to medium-sized businesses the
ability to connect their entire existing LAN to the Internet at ISDN speed
with LAN ISDN. This nationwide service uses dynamic IP addresses and costs
$99.95 per month for 160 channel hours and four email boxes. The set up fee
of $149 is waived for current EarthLink members, and additional channel
hours cost $0.85 per hour.
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<PAGE>
NATIONAL FRAME RELAY. Frame relay enables companies to connect their LANs
to the Internet via a direct, continuous connection at speeds ranging from
56 Kbps to 1.5 Mbps. Frame relay connections, available nationwide, range
from $335 to $2,350 per month depending on access speeds, data throughput
and other data transfer metrics. One-time set up fees range from $495 to
$1,995.
TOTALACCESS GOLD. EarthLink recently introduced an optional, value-added
package, TotalAccess Gold. TotalAccess Gold includes an additional email box,
priority technical support with a guaranteed 5-minute maximum wait time, and
a quarterly CD-ROM containing software tools and plugins. The package adds
$9.95 to the monthly price of a standard dialup or ISDN account.
ADDITIONAL MAILBOXES. The Company provides additional electronic mailboxes
for a per-mailbox fee of $4.95 per month and a $9.95 set up fee. The service
is intended for those members who require more than one mailbox for
colleagues, employees or family members.
DOMAIN OR VANITY NAME SERVICE. EarthLink provides unique or vanity domain
names for those members who prefer an individualized address or plan to
establish a business Web site. These vanity domain names allow consumers and
businesses to customize their email and Web site addresses. EarthLink
charges a one-time fee of $75 to set up domain name service and assist
members in establishing their unique domain names. Members then pay an
annual renewal fee to an Internet domain registration agency.
STAR EMAIL ADDRESSING. EarthLink members desiring an unlimited choice of
email addresses (for example "[email protected]" or "[email protected]")
can purchase star addressing. Within the star addressing scheme, all email
goes into a central mailbox, for easy processing to individual addresses at
the same domain. There is a one-time set up fee of $125, but no monthly fee
for maintaining the service.
INTERNATIONAL ROAMING SERVICE. EarthLink offers international roaming
services, so that members who travel outside the United States can access
their EarthLink accounts and the Internet. The fee for international roaming
is $0.15 per minute plus applicable fees, if any, charged by local and long
distance carriers.
800 SERVICE. EarthLink provides 800 number dial-up service for members who
do not have access to a local POP. EarthLink charges members $24.95 per
month for five hours of 800 number service plus a one-time set up fee of
$25.00. Additional hours are $4.95 per hour.
INTERNET ROOMS. The Internet Room is an easy to use communications tool
enabling members to use email, online chat and other advanced tools for
communication. The Internet Rooms provide members with a powerful and easy
way to establish Web sites without having to rely on complicated programming
languages such as HTML or FTP. There is an annual fee of $29.95 for each
Internet Room.
ADDITIONAL ADVERTISING SERVICES. EarthLink provides a variety of
advertising services including online banner advertisements and print
advertisements in BLINK. Additionally, as part of its strategy to generate
incremental revenue through advertising and to leverage its current
properties, the Company developed the premier partnership program. The
program consists of the following three options: the "Platinum Package," the
"Gold Package" and the "Silver Package." Each package includes advertising
in three separate areas: the Personal Start Page, the Mall and the member
newsletter, BLINK. EarthLink focuses the Premier Partnership Program on
advertisers having a natural affinity to and benefit for EarthLink's member
base.
The Silver Partner Package includes: TotalAccess; advertisements in BLINK
and 600,000 banner advertisement impressions distributed on any two of the
two following sites: Personal Start Page, EarthLink Homepage, PeopleLink,
Software Superstore and The Arena. The Gold Partner Package
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<PAGE>
includes all features of the Silver Partner Package plus advertisements in
Getting the Most Out of EarthLink, quarterly contest participation and a
banner ad in the Mall; and a second priority right of refusal with regard to
additional activities in the partner's category. Lastly, the Platinum
Partner Package includes all of the features of the Gold Partner Package,
but gives the partner a first right of refusal as to exclusivity, placement
and any additional Platinum opportunities available for partners with
qualifying products and for content.
EARTHLINK'S EMERGING ACCESS SERVICES. In response to feedback from its members,
EarthLink is developing the next generation of Internet access services targeted
at consumers and small businesses. These services offer access speeds several
times faster than ISDN connections utilizing a variety of emerging connectivity
technologies.
CABLE. EarthLink currently offers high-speed cable modem connections to the
Internet in selected service areas. The service utilizes a shared 27 Mbps
downstream (toward the user) channel, with differing lower speed return
path. This service is offered as either a two-way cable data modem or a
telephony return cable data modem service, depending on the particular cable
service provider. Consumer and small business-targeted service levels are
available ranging from 256 Kbps downstream/56 Kbps upstream, to 2 Mbps
downstream/1 Mbps upstream. EarthLink delivers this service as a co-branded
offering with its cable partners at prices ranging from $44.95 per month
(telephony return consumer service) to $150.00 per month (768 Kbps/384 Kbps
service).
ADSL. EarthLink has started technology trials utilizing Asymetric Digital
Subscriber Line ("ADSL") modems. ADSL modems provide continuous connection
speeds of from 384 Kbps/384 Kbps (downstream/upstream), to 1.5 Mbps/384
Kbps, with connectivity provided by the existing copper wire used for
delivery of voice telephone services. The ADSL technology is a continuous
connection service, with the potential of differentiated offerings similar
to cable modem based services. This service is in the pilot phase and has
not yet been priced.
FIBER TO THE CURB. EarthLink has started a technology trial utilizing fiber
to the curb technology, an emerging broadband-capable technology alternative
to both twisted pair copper lines and coaxial cable. The initial offerings
will be a symmetric services of 256 Kbps (upstream and downstream) and 512
Kbps, targeted at the residential consumer market. This service is in the
pilot phase and has not yet been priced.
SATELLITE/WIRELESS ACCESS. EarthLink is currently evaluating opportunities
to offer Internet access service delivery via both satellite and terrestrial
wireless technologies.
All prices quoted above are subject to change.
MEMBER AND TECHNICAL SUPPORT
The Company believes that reliable member and technical support is critical
to retaining existing and attracting new members. The Company currently provides
the following types of member and technical support: (i) toll-free, live
telephone assistance available seven days a week, 24 hours a day; (ii)
email-based assistance available seven days a week, 24 hours a day; (iii) help
sites and Internet guide files on the EarthLink Web site; (iv) automated "fax
back" and "fax on demand" assistance; and (v) printed reference material.
Additionally, the Company provides dedicated support for its business members.
EarthLink's call center currently handles an average of over 50,000 member
and technical support calls a week. The Company believes the center's technology
and systems are scaleable to accommodate call volume growth. The Company
actively evaluates its call center facilities so as to deliver more effective
and efficient services to its members.
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SALES AND MARKETING
EarthLink's sales and marketing efforts consist of the following programs:
ADVERTISING. The Company advertises its services in print, electronic and
broadcast media. Another component of EarthLink's advertising strategy involves
maintaining a presence at national trade shows such as Internet World and
MacWorld, as well as numerous local and regional trade shows. Additionally, the
Company markets through computer, Internet and related publications, and bundles
EarthLink Network TotalAccess software with certain of these publications.
AFFINITY MARKETING PROGRAM. EarthLink's affinity marketing partners
typically bundle EarthLink Network TotalAccess software with their own goods or
services to create a package that promotes EarthLink to potential members.
EarthLink's affinity marketing partners include, among numerous others:
CENDANT SOFTWARE. EarthLink Network TotalAccess software is bundled on
software titles from Cendant and its subsidiaries.
COMPUSA. EarthLink Network TotalAccess software is offered to CompUSA
customers through in-store displays.
DISCOVER CARD. EarthLink and NOVUS Services' Discover Card division will
offer the Discover Connection, an Internet access package, with exclusive
features and awards for Discover Cardmembers.
GATEWAY. EarthLink Network TotalAccess software will be distributed with
certain Gateway systems.
MACMILLAN DIGITAL PUBLISHING USA. EarthLink is the exclusive national
Internet access provider included in the Internet Starter Kit CD-Rom which
MacMillan publishes.
SAM'S CLUB. SAM's Club co-brands and co-offers the EarthLink Network
TotalAccess software through direct mail and catalog promotions to SAM's
Club members.
SONY ENTERTAINMENT. The EarthLink Network TotalAccess software is included
on enhanced Sony Music CDs.
WARNER BROS. The EarthLink Network TotalAccess software has been included
on CDs promoting bands on the Warner music roster and major motion pictures
such as "Batman and Robin" and "Contact."
SPRINT ALLIANCE. EarthLink's alliance with Sprint includes a marketing
agreement and distribution arrangement, which will provide EarthLink with access
to Sprint's branded marketing and distribution channels in the United States,
the right to use Sprint's brand for a minimum of ten years and a five-year
commitment from Sprint to deliver a minimum of 150,000 new members annually
through Sprint's channels. Additionally, Sprint will promote EarthLink as
Sprint's exclusive consumer Internet access provider. See "Strategic Alliance
with Sprint" and "Management--Executive Officers and Directors."
MEMBER REFERRAL PROGRAM. The Company believes that one of its most
important marketing tools is its existing members. In order to encourage members
to refer other users, the Company currently waives one month of standard access
service fees per referred member. A significant percentage of the Company's new
membership is currently generated by referrals.
OTHER MARKETING PROGRAMS
ELITE PROGRAM. EarthLink recently launched the EarthLink Internet
Technology for Education (ELITE) program, which is designed to provide a
cost-effective, flexible Internet access solution for
48
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colleges and universities. The Company has already won contracts with the
University of California, Los Angeles and two colleges in Georgia.
PARTNER PROGRAM. This program enables vendors, such as value-added
resellers, retailers and other companies that target vertical markets, to resell
EarthLink's dial-up Internet service along with high-end business services, such
as Web site hosting, ISDN, LAN ISDN and frame relay, to their customers. Through
this partnership, these companies can provide their customers with a full range
of turn-key, Internet business solutions.
TECHNICAL DEVELOPMENT AND SERVICE ENHANCEMENT
EarthLink places significant emphasis on expanding and refining its services
to enhance its members' Internet experience. EarthLink's technical staff is
engaged in a variety of technical development and service enhancement activities
and continuously reviews new third-party software products and technology for
potential incorporation into EarthLink's systems and services. A recent result
of these efforts is a redesigned and enhanced version of EarthLink Network
TotalAccess, version 2.0. The new version places a premium on ease of use, and
incorporates a variety of powerful features that reduce the number and types of
challenges faced by new members using the Internet for the first time. EarthLink
also regularly updates and expands the online services provided through the
EarthLink Web site, organizes Web content and develops online guides, help
screens and other user services and resources.
POPS AND NETWORK INFRASTRUCTURE
As of June 5, 1998, the Company had approximately 680,000 members (including
approximately 130,000 members acquired in connection with the Sprint
Transaction). The Company provides its members with Internet access primarily
through UUNET, PSINet and Sprint POPs. EarthLink's use of third parties to
provide Internet connectivity enables it to offer and increase port capacity
without the significant capital requirements necessary to build and maintain a
network. It also gives the Company flexibility necessary to adapt to changing
technology such as cable modems. Substantially all of the Company's members
access the EarthLink Network and the Internet through a local telephone call. Of
these, the Company currently owns 82 POP sites in California and currently
offers additional access through 871 UUNET POPs and 394 PSINet POPs, to which it
has access on a non-exclusive basis. The alliance with Sprint includes a network
service agreement which provides EarthLink members access to additional POPs
owned and operated by Sprint. The inability or unwillingness of these
third-party network providers to provide POP access to EarthLink's members on
commercially reasonable terms, or the Company's inability to secure alternative
POP arrangements, could have a material adverse effect on the Company. See "Risk
Factors--Dependence on Network Infrastructure and Third Party Network
Providers", "Risk Factors--Significant Ownership by Sprint; Commercial
Relationship with Sprint" and "Strategic Alliance with Sprint."
For members located in a geographic area not currently serviced by a local
POP, the EarthLink Network can be accessed by a toll-free number for which the
Company bills members on an hourly usage basis. The Company's POP sites are
connected to the Internet primarily through its network hub in Pasadena. The
Company's network hub is in turn connected directly to the Internet via
redundant high-speed fiber optic data lines obtained from various vendors. The
Company has invested in measures to minimize the effects of damage from fire,
earthquake, power loss, telecommunications failure, computer viruses, security
breaches and similar events or backup Internet services or backbone facilities
or other redundant computing or telecommunications facilities. The occurrence of
a natural disaster or another unanticipated problem at the Company's
headquarters and sole network hub, at POPs, or in the nation's
telecommunications network in general could cause interruptions in the services
provided by the Company. The Company, however, does not currently maintain
redundant network hub facilities.
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COMPETITION
The Internet services market in which the Company operates is extremely
competitive, and the Company expects competition in this market to intensify in
the future. The Company's current and prospective competitors include many large
companies that have substantially greater market presence and financial,
technical, marketing and other resources than the Company. The Company competes
(or in the future expects to compete) directly or indirectly with the following
categories of companies: (i) local ISPs, (ii) national and regional ISPs, such
as MindSpring Enterprises, Inc., (iii) established online services such as
America Online, Prodigy and the Microsoft Network; (iv) nonprofit or educational
ISPs; (v) national telecommunications companies, such as AT&T Corp., GTE
Corporation and MCI Communications Corporation; (vi) Regional Bell Operating
Companies ("RBOCs"); (vii) competitive local exchange carriers; and (viii) cable
operators, such as At Home Corporation and Time Warner, Inc.
The consolidation of existing ISPs with or into larger entities, or entry of
new entities into the Internet services market, would likely result in greater
competition for the Company. The ability of competitors to bundle services and
products with Internet connectivity services could place the Company at a
significant competitive disadvantage. In addition, competitors in the
telecommunications industry may be able to provide members with lower
communications costs for their Internet access services, reducing the overall
cost of Internet access and significantly increasing pricing pressures on the
Company. There can be no assurance that the Company will be able to offset the
adverse effect on revenues of any necessary price reductions resulting from
competitive pressures by generating higher revenue from enhanced services or
additional members, by reducing costs or otherwise. As a result, price
reductions could have a material adverse effect on the Company.
The Company believes that its ability to compete successfully in the
Internet services market depends on a number of factors, including market
presence; the adequacy of its member and technical support services; the
capacity, reliability and security of its network infrastructure; the ease of
access to and navigation of the Internet provided by the Company's services; the
pricing policies of the Company, its competitors and its suppliers; the timing
of introductions of new services by the Company and its competitors; the
Company's ability to support existing and emerging industry standards; and,
industry and general economic trends. There can be no assurance that the Company
will have the financial resources, technical expertise or marketing and support
capabilities to compete successfully. See "Risk Factors--Competition."
PROPRIETARY RIGHTS
GENERAL. EarthLink relies on a combination of copyright, trademark, patent
and trade secret laws and contractual restrictions to establish and protect its
technology and other proprietary rights and information (collectively its
"Proprietary Property"). It is EarthLink's policy to require employees and
consultants and, when possible, suppliers and distributors, to execute
confidentiality agreements upon the commencement of their relationships with the
Company. There can be no assurance that the steps taken by the Company will be
sufficient to prevent misappropriation of its Proprietary Property or that the
Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's Proprietary Property.
From time to time, the Company has received communications from third
parties alleging that certain of the names or trade marks for the Company's
services infringe the trademarks of such third parties. To date, no such claims
have had an adverse effect on the Company's ability to market and sell its
services. However, there can be no assurance that those claims would not have an
adverse effect in the future or that other parties will not assert infringement
claims against the Company in the future with respect to current or future
services.
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LICENSES. EarthLink has obtained authorization, typically in the form of a
license, to distribute third-party software incorporated in EarthLink Network
TotalAccess. Applications licensed for distribution by the Company include
Netscape Communicator (which license automatically renews each December for
additional one-year terms unless either party terminates the license on 120 days
notice), Microsoft Internet Explorer, which license expires in August 1998 and
thereafter automatically renews for additional one-year terms, although either
party may terminate the license at any time on 30 days notice), and MacTCP
software from Apple, (which license renews each December for additional one-year
terms unless either party terminates the license on twelve-month notice). The
only software in the EarthLink Network TotalAccess package that is developed by
the Company is the front-end and installation/registration program. The Company
currently intends to maintain or negotiate renewals of existing software
licenses and authorizations. The Company may want or need to license other
applications in the future. The inability to renew existing software licenses or
to license additional applications could have a material adverse effect on the
Company. See "Risk Factors--Proprietary Rights; Infringement Claims."
EMPLOYEES
As of March 31, 1998, the Company employed 1,004 people, including 182 sales
and marketing personnel, 712 operations and member and technical support
representatives and 110 administrative personnel. None of the Company's
employees are represented by a labor union, and the Company is not a party to
any collective bargaining agreement.
FACILITIES
EarthLink's corporate headquarters are located in an 85,500 square-foot
facility in Pasadena, California. In June 1997, the Company amended the lease
for its corporate headquarters facility. Under the amended lease, the lessor
will provide improvements costing up to $1.4 million and convert approximately
45,000 square feet of the existing facility to office space. Base rent is
currently $73,000 per month. Under the amended lease, the Company increased the
existing irrevocable letter of credit to the lessor from $200,000 to $450,000.
The Company has an option to extend this lease for an additional five years at
the then prevailing market rate following its September 30, 2007 expiration.
EarthLink's data center and its primary data hubs are housed in a 55,000 square
foot facility adjacent to its headquarters. EarthLink's lease for this space has
an initial ten-year term at $66,000 per month for the first 60 months and
$77,000 per month for the remaining 60 months. The Company has an option to
extend this lease for an additional ten years at the then prevailing market
rate. In addition to the Company's corporate headquarters and data center, the
Company also leases approximately 7,200 square feet of office space in Los
Angeles, which until recently housed a portion of the Company's data center
network hub. The lease for this space expires July 31, 1999 and currently
provides for rental payments of approximately $10,000 per month.
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MANAGEMENT
EXECUTIVE OFFICERS AND DIRECTORS
The following table sets forth certain information concerning the Company's
executive officers and directors:
<TABLE>
<CAPTION>
NAME AGE POSITION
- -------------------------------------------------- --- --------------------------------------------------------
<S> <C> <C>
Sky D. Dayton..................................... 26 Founder and Chairman of the Board of Directors
Charles G. Betty.................................. 41 President, Chief Executive Officer and Director
Dr. Richard D. Edmiston........................... 55 Vice President, Research and Development
Grayson L. Hoberg................................. 39 Vice President, Finance and Administration and Chief
Financial Officer
David R. Tommela.................................. 59 Vice President, Operations
Brinton O.C. Young................................ 46 Vice President, Strategic Planning
Sidney Azeez (1).................................. 65 Director
William T. Esrey.................................. 58 Director
Robert M. Kavner (1).............................. 54 Director
Linwood A. Lacy, Jr. (2).......................... 52 Director
Patti S. Manuel................................... 42 Director
Paul McNulty...................................... 36 Director
Kevin M. O'Donnell (2)............................ 47 Director
Reed E. Slatkin (1)(2)............................ 48 Director
</TABLE>
- ------------------------------
(1) Member of Audit Committee.
(2) Member of Compensation Committee.
SKY D. DAYTON, the founder of the Company, has served as Chairman of the
Board of Directors since the Company's inception in May 1994 and served as its
Chief Executive Officer from May 1994 until May 1996. From 1992 to 1993, he was
co-owner of a computer-based digital imaging firm, Dayton Walker Design. From
1991 to 1992, he served as Director of Marketing for new products at Executive
Software, a software company. From 1990 to 1994, Mr. Dayton co-owned Cafe Mocha,
a coffee house in Los Angeles, which he co-founded, and was a co-owner of Joe
Cafe, a coffee house in Studio City, California.
CHARLES G. BETTY has served as the President and as a director of the
Company since January 1996, and in May 1996 was named the Company's Chief
Executive Officer. From February 1994 to January 1996, Mr. Betty was a strategic
planning consultant, advising Reply Corp., Perot Systems Corporation and
Microdyne, Inc. From September 1989 to February 1994, Mr. Betty served as
President, Chief Executive Officer and a director of Digital Communications
Associates, Inc., a publicly traded network connectivity provider.
DR. RICHARD D. EDMISTON has served as Vice President of Research and
Development of the Company since January 1997. From December 1992 to January
1997, Dr. Edmiston was Vice President of Network Planning and Architecture at
BBN Corporation, a leading Internet research and development organization, and
the founder of BBN Planet, a leading provider of Internet services to
businesses. From September 1990 to November 1992, Dr. Edmiston managed
distributed computer and information systems research at GTE Laboratories.
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GRAYSON L. HOBERG has served as Vice President, Finance and Administration
and Chief Financial Officer since December 1997. From September 1993 to December
1997, he served in various capacities for, and ultimately as, the Vice President
of Business Operations for TCI.NET, the Internet Division of TCI Cable. From
December 1991 to September 1993, he was Manager of Information Systems at Coors
Brewing Company. From January 1988 to December 1991, he was Consulting Manager
at Price Waterhouse LLP.
DAVID R. TOMMELA has served as Vice President, Operations of the Company
since December 1995. From 1973 to August 1995, he served in various capacities
for, and ultimately as the Chief Information Officer of, Southern California
Edison Company, an electric power utility.
BRINTON O.C. YOUNG has served as Vice President, Strategic Planning of the
Company since March 1996. From 1990 to 1996, Mr. Young was President of Young &
Associates, a consulting firm specializing in strategic planning for high growth
companies.
SIDNEY AZEEZ has been a director of the Company since June 1996. During the
past five years, Mr. Azeez has been a private investor. Mr. Azeez founded
Ultronic Systems Corp., which produced a stock and commodity quotation system.
He also founded American Cellular Network, Inc. and Universal Telecell, Inc.
("Unitel"), cellular telephone companies, PCS, Inc., a wireless communications
company, and several banks in Colorado and New Jersey. Mr. Azeez is a director
of Unitel and Thermal Tech Development, Inc.
WILLIAM T. ESREY has served as a director since June 1998. He has been
Chairman of the Board of Directors of Sprint Corporation since 1990, Chief
Executive Officer of Sprint since 1985 and a Director of Sprint since 1985. Mr.
Esrey is the Chairman of the Executive Committee of the Board of Directors of
Sprint. He is also a director of Duke Energy Corporation, The Equitable Life
Assurance Society of the United States, Everen Capital Corporation and General
Mills, Inc.
ROBERT M. KAVNER has been a director of the Company since June 1996. Since
September 1996, he has served as President and Chief Executive Officer of On
Command Corporation, a provider of on demand video for the hospitality industry.
From 1994 through August 1995, he was director of business advisory services for
Creative Artist Agency. From 1984 to 1994, Mr. Kavner held several senior
management positions at AT&T, including Senior Vice President and Chief
Financial Officer, Executive Vice President of the Communications Products
Group, Chief Executive Officer of the Multimedia Products and Services Group,
President of the Computer Division, Chairman of the UNIX Systems Laboratory,
Chairman of AT&T Capital Corporation, Chairman of AT&T Paradyne Corporation and
Chairman of AT&T Venture Capital Group. Mr. Kavner also served as a member of
AT&T's Executive Committee. Mr. Kavner serves as a director of Fleet Financial
Group, Ascent Entertainment, Inc. and Tandem Computers, Inc.
LINWOOD A. LACY, JR. has been a director of the Company since June 1998.
From October 1996 to October 1997, he served as President and Chief Executive
Officer of Micro Warehouse Incorporated. From 1989 to May 1996, he served as the
Co-Chairman and Chief Executive Officer of Ingram Micro, Inc., a microcomputer
products distributor and a then wholly-owned subsidiary of Ingram Industries
Inc. From December 1993 to June 1995, Mr. Lacy was also President of Ingram
Industries Inc. From June 1995 until April 1996, he was President and CEO of
Ingram Industries Inc., and from April 1996 to May 1996 served as its Vice
Chairman. Mr. Lacy serves as a director of Ingram Industries Inc., Entex
Information Services, Inc. and Micro Warehouse Incorporated.
PATTI S. MANUEL has been a director of the Company since June 1998. Ms.
Manuel has served as President and Chief Operating Officer--Long Distance
Division of Sprint Corporation since February 1998. She has also served as
President and Chief Operating Officer of Sprint L.P. since February 1998. Since
May 1997, she has served as President of Sprint Business, a division of Sprint
L.P. From 1994 to 1997, she was President of Sales and Marketing for Sprint
Business. She was named President of Marketing for Sprint Business in 1993.
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PAUL MCNULTY has been a Director of the Company since November 1996. Mr.
McNulty has been a Managing Director of Soros Fund Management LLC ("SFM"), a New
York-based investment firm, since January 1996, and was a Securities Analyst at
SFM from January 1993 until January 1996. Prior to joining SFM, Mr. McNulty was
employed as an Associate at MVP Ventures, a venture capital firm in Boston,
Massachusetts.
KEVIN M. O'DONNELL, a co-founder of the Company, has been a director of the
Company since its inception. Mr. O'Donnell is President of O'Donnell &
Associates, a venture capital firm specializing in emerging high technology
companies. In 1982, Mr. O'Donnell founded Government Technology Services, Inc.,
a reseller of computer equipment to the federal government, and from 1982 to
1990 served as its Chairman, Chief Executive Officer and President.
REED E. SLATKIN, a co-founder of the Company, has been a director of the
Company since its inception. Mr. Slatkin is a private investor and money manager
who has invested in public and private companies for the last 15 years. Mr.
Slatkin is a director of Havenwood Ventures, Inc.
Pursuant to the terms of the Company's Series A Convertible Preferred Stock
and the Governance Agreement, Sprint has the right to elect two individuals to
the Board of Directors of EarthLink Network, Inc., EarthLink Operations and any
significant subsidiaries of the Company for so long as Sprint and Sprint L.P.'s
equity interest in the Company does not decrease below 20% for three consecutive
months. Sprint may also designate one director to any strategic business
planning committee, finance committee and, subject to certain exceptions, all
other committees, if any exist. Sprint has designated Mr. Esrey and Ms. Manuel
as its initial two director representatives. See "Description of Capital Stock--
Preferred Stock" and "--Governance Agreement."
BOARD OF DIRECTORS AND COMMITTEES
Currently, all directors hold office until the next annual meeting of
stockholders and until their successors have been duly elected and qualified.
The Board of Directors maintains an Audit Committee and a Compensation
Committee. The Audit Committee consists of Messrs. Azeez, Kavner and Slatkin.
The Audit Committee is responsible for making recommendations to the Board
regarding the selection of independent auditors, reviews the results and scope
of audits and other services provided by the Company's independent auditors and
reviews and evaluates the Company's internal audit and control functions. The
Compensation Committee consists of Messrs. Lacy, O'Donnell and Slatkin. The
Compensation Committee is responsible for setting cash and long-term incentive
compensation for executive officers and other key employees of the Company. The
Compensation Committee also administers the Company's 1995 Stock Option Plan.
DIRECTOR COMPENSATION
Directors do not receive cash compensation for serving in that capacity, but
are reimbursed for the expenses they incur in attending meetings of the Board or
committees thereof. In addition, non-employee directors are eligible to receive
options to purchase Common Stock awarded under the Company's Directors Stock
Option Plan. See "--Directors Stock Option Plan."
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TECHNOLOGY ADVISORY COUNCIL
The Company has established a Technology Advisory Council, the purpose of
which is to help the Company predict and overcome long-range technology barriers
and to help the Company attract talented engineers and technology executives.
The Council is chaired by Mr. Dayton, and it is intended that the Council meet
at least quarterly. Presently, the Council consists of the following five
members in addition to Mr. Dayton:
STEWART ALSOP is a partner in New Enterprise Associates, a leading venture
capital firm. In addition Mr. Alsop writes a column, Alsop's Fables, for Forbes
Magazine. He is also executive producer of Agenda, the annual conference for
senior executives in the computer industry. Previously, Mr. Alsop was the
executive vice president of Infoworld Publishing Company and the former
editor-in-chief of Infoworld. He also founded "PC Letter" and started the Agenda
and Demo conferences.
DAVID FARBER is an Alfred Fitler Moore Professor of Telecommunications
Systems holding appointments in the Computer and Information Science and
Electrical Engineering Departments at the University of Pennsylvania and is the
Director of the Center for Communications and Information Science and Policy.
Mr. Farber is a member of the boards of trustees of the Internet Society and the
Electronic Frontier Foundation.
DR. PHILIP M. NECHES is recently retired as Group Technical Officer,
Multimedia Products Group, of Lucent Technologies, Inc. He has served as Senior
Vice President and Chief Scientist of NCR Corp. and was Group Technical Officer
for NCR Corp. after its acquisition by AT&T in 1991. Dr. Neches co-founded
Teradata Corporation, a company engaged in commercial parallel computing and
large-scale relational database management systems, and served as its Vice
President and Chief Scientist.
DR. ARNO PENZIAS, a 1978 Nobel Prize recipient, is Chief Scientist at Lucent
Technologies, Inc. Previously he was head of research at Bell Laboratories.
CHRISTINE VARNEY, former Federal Trade Commissioner and White House Cabinet
Secretary, specializes in Internet law at the firm of Hogan & Hartson. Ms.
Varney was a key participant in formulating the Clinton administration's
Internet strategies.
Except for Mr. Dayton, members Alsop, Farber, Neches and Penzias received
warrants to purchase 7,500 shares of Common Stock which vest in equal quarterly
increments over two years and have an exercise price of $11.00 per share except
Mr. Alsop's warrants have an exercise price of $10.50 per share. Ms. Varney
received warrants to purchase 7,500 shares of Common Stock which vest in equal
quarterly increments over two years and have an exercise price of $17.75 per
share.
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EXECUTIVE COMPENSATION
The following table presents certain information relating to compensation
awarded to, earned by or paid to the Company's Chief Executive Officer and each
of the four most highly compensated executive officers other than the Chief
Executive Officer during fiscal 1997 each of whom was serving at the end of
fiscal 1997 and Mr. Grayson L. Hoberg who commenced employment with the Company
on December 5, 1997. Such executive officers are hereinafter referred to as the
"Named Executive Officers."
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM COMPENSATION
ANNUAL COMPENSATION -----------------------
---------------------- SECURITIES ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS UNDERLYING OPTIONS (#) COMPENSATION
- -------------------------------------- --------- ----------- --------- ----------------------- --------------
<S> <C> <C> <C> <C> <C>
SKY D. DAYTON ........................ 1997 $ 180,000 $ 45,411 -- --
Chairman of the Board of Directors 1996 153,036 70,006 -- --
(1) 1995 97,726 16,573 250,000 --
CHARLES G. BETTY ..................... 1997 240,000 60,621 -- $ 10,578(2)
President and Chief Executive Officer 1996 220,550 77,635 250,000 24,000(2)
GRAYSON L. HOBERG .................... 1997 8,654 -- 100,000 --
Vice President, Finance and
Administration and Chief Financial
Officer (3)
DAVID R. TOMMELA ..................... 1997 132,000 26,723 -- 1,218(4)
Vice President, Operations 1996 130,392 34,439 12,500 --
1995 8,862 -- 37,500 --
RICHARD D. EDMISTON .................. 1997 185,000 33,398(5) 27,500 1,423(6)
Vice President, Research and
Development
BRINTON O.C. YOUNG ................... 1997 140,000 29,754 -- --
Vice President, Strategic Planning 1996 73,681 18,409 112,500 --
</TABLE>
- ------------------------
(1) Mr. Dayton served as the Company's President until January 15, 1996, when
Mr. Betty's employment commenced. Mr. Dayton served as the Company's Chief
Executive Officer until May 7, 1996, when Mr. Betty was appointed to that
position.
(2) Consists of reimbursement in 1997 of $8,363 in travel expenses pursuant to
Mr. Betty's employment agreement and $2,215 in matching contributions to
Mr. Betty's account under the Company's 401(k) Plan, and reimbursement in
1996 of $24,000 of such reimburseable expenses pursuant to Mr. Betty's
employment agreement.
(3) Mr. Hoberg's employment with the Company commenced on December 5, 1997.
(4) Consists of matching contributions made to Mr. Tommela's account under the
Company's 401(k) Plan.
(5) Includes a signing bonus of $15,000 paid to Dr. Edmiston pursuant to his
employment agreement with the Company.
(6) Consists of matching contributions made to Dr. Edmiston's account under the
Company's 401(k) Plan.
56
<PAGE>
STOCK OPTION INFORMATION
The following table sets forth certain information regarding options granted
in fiscal 1997 to the Named Executive Officers.
OPTION GRANTS IN FISCAL 1997
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
---------------------------------------------------------- POTENTIAL REALIZABLE VALUE
NUMBER OF PERCENTAGE OF AT ASSUMED ANNUAL RATES OF
SECURITIES TOTAL OPTIONS STOCK PRICE APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE THE OPTION TERM(3)
OPTIONS EMPLOYEES IN PRICE PER EXPIRATION ----------------------------
NAME GRANTED (#) FISCAL YEAR(1) SHARE(2) DATE 5% 10%
- -------------------------- ------------ ----------------- ------------- ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Sky D. Dayton............. -- -- -- -- -- --
Charles G. Betty.......... -- -- -- -- -- --
Grayson L. Hoberg......... 50,000(4) 12.6% $ 16.00 11/07/07 $ 1,297,207 $ 2,539,443
50,000(5) 12.6 19.88 12/05/07 1,103,452 2,345,693
David R. Tommela.......... -- -- -- -- -- --
Richard D. Edmiston....... 27,500(6) 7.0 13.00 01/23/07 795,961 1,479,194
Brinton O.C. Young........ -- -- -- -- -- --
</TABLE>
- ------------------------
(1) The total number of options granted to employees of the Company in fiscal
1997 was 395,625.
(2) The exercise price per share of options granted represented the fair market
value of the underlying shares of Common Stock on the dates the respective
options were granted.
(3) Amounts represent hypothetical gains that could be achieved for the
respective options if exercised at the end of the option term. These gains
are based on assumed rates of stock price appreciation of 5% and 10%
compounded annually from the date the respective options were granted to
their expiration date based upon the closing price of the Common Stock on
December 31, 1997, $25.75 per share. These assumptions are not intended to
forecast future appreciation of the Company's stock price. The potential
realizable value computation does not take into account federal or state
income tax consequences of option exercises or sales of appreciated stock.
(4) Vest in equal increments of 5% per quarter over the five-year period
beginning on the date of grant, November 7, 1997.
(5) Vest in equal increments of 5% per quarter over the five-year period
beginning on the date of grant, December 5, 1997.
(6) Vest in equal increments of 5% per quarter over the five-year period
beginning on the date of grant, January 23, 1997.
The following table sets forth certain information regarding stock options
held at December 31, 1997 by the Named Executive Officers. None of these options
has been exercised.
OPTION VALUES AS OF DECEMBER 31, 1997
<TABLE>
<CAPTION>
NUMBER OF
SECURITIES UNDERLYING VALUE OF UNEXERCISED
UNEXERCISED OPTIONS IN-THE-MONEY OPTIONS (1)
---------------------------- -----------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---------------------------------------------------- ------------ -------------- ------------- --------------
<S> <C> <C> <C> <C>
Sky D. Dayton....................................... 125,000 125,000 $ 2,992,500 $ 2,992,500
Charles G. Betty.................................... 80,000 170,000 1,557,300 3,208,200
Grayson L. Hoberg................................... -- 100,000 -- 781,250
David R. Tommela.................................... 18,750 31,250 373,613 610,388
Richard D. Edmiston................................. 4,125 23,375 52,594 298,031
Brinton O.C. Young.................................. 33,750 78,750 539,663 1,259,213
</TABLE>
- ------------------------
(1) The value of unexercised "in-the-money" options represents the difference
between the exercise price of stock options and $25.75, the closing sales
price of the Common Stock for December 31, 1997 as reported on the Nasdaq
Stock Market.
57
<PAGE>
EMPLOYMENT CONTRACTS AND CHANGE IN CONTROL ARRANGEMENTS
CONVERTIBLE SECURITIES VESTING PLAN
In December 1997, the Board of Directors adopted its Convertible Securities
Vesting Plan (the "Vesting Plan"), pursuant to which the vesting of stock
options and warrants held by certain directors and employees will accelerate
upon a "change in control" of the Company. Generally, a change in control
includes the sale of all or substantially all of the Company's assets or the
acquisition by a person or "group" (as that term is defined in Section 13(d) of
the Securities Exchange Act of 1934, as amended, and the rules promulgated
thereunder) of 25% or more of the Company's outstanding voting securities. In
February 1998, the Company amended the Vesting Plan to specifically exclude the
Sprint Transaction as a change in control.
KEY EMPLOYEE COMPENSATION CONTINUATION PLAN
In January 1998, the Board of Directors adopted the Key Employee
Compensation Continuation Plan (the "Continuation Plan") whereby those employees
identified by the Board of Directors as "key" or critical to the Company are
entitled to a severance payment equal to 50% of their compensation (including
certain other benefits) for the twelve-month period ending upon their
termination. The Company adopted the Continuation Plan to attract the highest
quality individuals to become key members of the Company's leadership team and
to retain the high-quality individuals who are presently members of the
Company's leadership team.
EMPLOYMENT AGREEMENT
Effective April 1998, the Company amended and restated its employment
agreement with Mr. Charles G. Betty. Under this agreement, the Company continues
to employ Mr. Betty as its President and Chief Executive Officer at a salary of
not less than $300,000 per year, plus a $24,000 a year travel allowance for Mr.
Betty and his family, and such other benefits as are generally made available to
other senior executives of the Company. Mr. Betty is entitled, upon the
attainment of specified performance goals, to an annual bonus in the amount
equal to 50% of his base salary. In addition, the agreement provides that Mr.
Betty will receive a severance payment equal to 100% of his then current base
salary, will receive the full bonus to which he would have otherwise been
entitled during the year in which the termination occurs, and will continue to
receive health, medical, life and liability insurance coverage for one year (i)
if he is terminated by the Company other than for "cause" as defined in the
agreement, (ii) if the Company elects not to extend the term of the employment
agreement at the end of the first three-year term or any yearly extension or
(iii) if Mr. Betty terminates his employment because of a breach of the
employment agreement by the Company. In connection with the amended and restated
employment agreement, Mr. Betty was granted an option to purchase an additional
150,000 shares of Common Stock at an exercise price of $44.75 per share. In the
event of a "change in control," as defined in the agreement, the termination of
Mr. Betty by the Company other than for "cause" or if Mr. Betty terminates his
employment because of a breach of the agreement by the Company, all unvested
options held by Mr. Betty will vest immediately.
1995 STOCK OPTION PLAN AND OTHER OPTION AND WARRANT ISSUANCES
The EarthLink Network, Inc. 1995 Stock Option Plan (the "1995 Plan")
provides for the grant to employees of the Company of incentive stock options
within the meaning of Section 422 of the Internal Revenue Code of 1986, as
amended, and nonstatutory stock options to employees, officers, directors and
consultants of the Company. The 1995 Plan was approved by the Board of Directors
and the Company's stockholders in 1995. In May 1998, the Board of Directors
approved certain amendments to the 1995 Plan which, among other things,
increased the number of shares reserved under the plan by 1,000,000. Such
amendments are subject to stockholder approval. Including the shares added by
these
58
<PAGE>
amendments, the total number of shares of Common Stock available for issuance
under the 1995 Plan as of March 31, 1998 was 2,850,000. If any options granted
under the plan are forfeited or terminated for any reason without being
exercised in full, then the unpurchased shares subject to those options will be
available for additional grants under the 1995 Plan.
The 1995 Plan is administered by the Compensation Committee of the Board of
Directors, which determines the terms of the options granted, including the
exercise price, the number of shares subject to individual option awards and the
vesting period of such options. The exercise price under any nonstatutory
options generally must be at least 85% of the fair market value of the Common
Stock on the date of grant. The exercise price under ISOs cannot be lower than
100% of the fair market value of the Common Stock on the date of grant and, in
the case of ISOs granted to holders of more than 10% of the voting power of the
Company, not less than 110% of such fair market value. The term of an ISO cannot
exceed 10 years, and the term of an ISO granted to a holder of more than 10% of
the voting power of the Company cannot exceed five years. As of March 31, 1998,
options to purchase 1,444,716 shares of Common Stock were outstanding under the
1995 Plan at a weighted average exercise price of $16.53 per share and 1,116,773
shares were reserved for future option grants under the 1995 Plan. In addition,
as of that date, the Company had issued non-plan options and warrants to
purchase an aggregate of 1,164,866 shares of Common Stock at a weighted average
exercise price of $5.91 per share. If not terminated earlier, the 1995 Plan will
terminate in 2005.
DIRECTORS STOCK OPTION PLAN AND OTHER DIRECTOR OPTION ISSUANCES
Under the Amended and Restated EarthLink Network, Inc. Stock Option Plan for
Directors (the "Directors Plan"), the Company has reserved 62,500 shares of
Common Stock for issuance upon exercise of options which may be granted to
non-employee directors of the Company who do not beneficially own, or serve as
employees, directors or officers of any entity that beneficially owns, 5% or
more of the outstanding shares of the Company's capital stock. Under the
Directors Plan, grants of options to purchase 10,000 and 2,500 shares of Common
Stock are automatically made to each non-management director at the time such
person first becomes a member of the Board of Directors and at the beginning of
each fiscal year of the Company, respectively. As of March 31, 1998, no options
had been granted under the Directors Plan. If not terminated earlier, the
Directors Plan will terminate in 2006.
Prior to the adoption by the Board of Directors of the Directors Plan, the
Company issued to each of Messrs. Kavner and Lacy warrants to purchase 50,000
shares of Common Stock at an exercise price of $4.84 per share, the amount then
determined by the Board of Directors to constitute fair market value per share
of the Common Stock, in consideration of Messrs. Kavner's and Lacy's agreement
to serve on the Board of Directors. These warrants vest ratably each year over a
five-year period from January 12, 1996, the date of grant.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
In September 1995, Reed E. Slatkin, a member of the Company's Board of
Directors, acted as lessee, together with the Company, under a $500,000
equipment lease. In connection with this arrangement, the Company granted Mr.
Slatkin warrants to purchase 50,000 shares of Common Stock at $1.81 per share.
Mr. Slatkin subsequently transferred one-half of these warrants to Mr. Kevin M.
O'Donnell, another Company director, as consideration for his indemnification of
Mr. Slatkin for certain liabilities arising in connection with the lease.
In January 1996, Mr. Slatkin guaranteed the Company's obligations under a
$1.5 million lease for network equipment. As consideration for this guarantee,
the Company issued Mr. Slatkin warrants to purchase 100,000 shares of Common
Stock at an exercise price of $4.84 per share, the amount then determined by the
Board of Directors to constitute the fair market value per share of Common Stock
as of January 1996. Kevin M. O'Donnell, a member of the Company's Board of
Directors, subsequently
59
<PAGE>
agreed to indemnify Mr. Slatkin against certain liabilities arising out of this
lease. As consideration for this agreement, Mr. Slatkin transferred one-half of
these warrants to Mr. O'Donnell.
In June 1996, the Company issued $2,950,000 of its 10% Promissory Notes to
17 purchasers, including certain of its directors and 5% stockholders. In
connection with this financing, and as additional consideration for the
investment of these purchasers, the Company also issued warrants to purchase
98,340 shares of Common Stock having an exercise price of $11.00 per share. The
10% Promissory Notes were due on or before June 6, 1997 with interest payable
monthly until such date. The warrants are exercisable for five years commencing
on the date of issuance. The following directors and 5% stockholders
participated in this financing: Sidney Azeez, $200,000 note, 6,667 warrants;
Robert M. Kavner, $100,000 note, 3,334 warrants; Kevin M. O'Donnell, $225,000
note, 7,500 warrants; Reed E. Slatkin, $225,000 note, 7,500 warrants; and Storie
Partners, L.P., $300,000 note, 10,000 warrants. The holders of $725,000 of the
10% Promissory Notes, including Messrs. Slatkin and Abbott and Storie Partners,
L.P., converted their indebtedness into 55,767 shares of Common Stock upon
consummation of the Companys' initial public offering in January 1997. At that
time, the Company also repaid the remaining balance of the 10% Promissory Notes.
In September 1997, the Company sold 1,459,759 shares of its Common Stock at
a price of $10.75 per share to certain purchasers, including, among others,
certain directors and stockholders. The following directors and more than 5%
stockholders (including certain of their family members and affiliates)
participated in this financing: Reed E. Slatkin (55,810 shares); Sidney Azeez
(46,512 shares); Charles G. Betty (10,000 shares); Linwood A. Lacy, Jr. (23,256
shares); Richard D. Edmiston (10,000 shares); Brinton O.C. Young (10,000
shares); and, Quantum Industrial Partners LDC (465,117 shares).
Until October 1997, Linwood A. Lacy, Jr. also served as President and Chief
Executive Officer of Micro Warehouse Incorporated ("Micro Warehouse"), one of
the Company's affinity marketing partners. For the year ended December 31, 1997,
the Company paid Micro Warehouse approximately $35,200 in bounties for new
Company members generated by Micro Warehouse.
None of the members of the Compensation Committee of the Board is currently
or has been, at any time since the formation of the Company, an officer or
employee of the Company. No executive officer of the Company serves as a member
of the Board of Directors or compensation committee of any entity that has one
or more executive officers serving on the Company's Board or Compensation
Committee.
CERTAIN TRANSACTIONS
In addition to the transactions described under "Compensation Committee
Interlocks and Insider Participation," the following transactions are required
to be disclosed under the rules of the SEC:
John W. Sidgmore, who served on the Company's Board of Directors until June
5, 1998, also serves as a director and as President and Chief Executive Officer
of UUNET and as a director and Vice Chairman and Chief Operations Officer of
UUNET's corporate parent, WorldCom. UUNET is the Company's primary provider of
Internet dial-up POPs capacity. In connection with the Company's and UUNET's
execution of a new network services agreement in May 1996, the Company issued
warrants to UUNET to purchase 10,000 shares of Common Stock having an exercise
price of $20.00 per share. UUNET exercised these warrants in full in March 1998.
In connection with an amendment to the Company's network services agreement
with UUNET, the Company issued a $5.0 million convertible promissory note to
UUNET and filled a vacancy on the Board of Directors with Mr. Sidgmore as a
designee of UUNET. This note and accrued interest was converted into 391,515
shares of Common Stock in March 1998 in accordance with its terms. The Company
also granted UUNET certain registration rights identical to those presently held
by most of the Company's then existing stockholders. EarthLink paid UUNET
approximately $21.9 million in 1997 for network services and for interest under
the note.
60
<PAGE>
The Company's network services agreement with UUNET obligates the Company to
pay certain minimum amounts to UUNET regardless of usage. See "Risk
Factors--Dependence on Network Infrastructure and Third Party Network
Providers."
The Company believes that the foregoing transactions were on terms no less
favorable to the Company than could be obtained from unaffiliated parties. It is
the Company's current policy that all transactions by the Company with officers,
directors, more than 5% stockholders and their affiliates will be entered into
only if such transactions are approved by a majority of disinterested
independent directors and are on terms such directors believe are no less
favorable to the Company than could be obtained from unaffiliated parties.
SPRINT TRANSACTION
In addition to the transactions described under "Compensation Committee
Interlocks and Insider Participation" and "Certain Transactions," the Sprint
Transaction as described under "Strategic Alliance with Sprint" involves
transactions with entities which own greater than 5% of the Company's capital
stock and with whom Mr. Esrey and Ms. Manuel, each a director of the Company,
are affiliates. See "Strategic Alliance with Sprint" and "Description of Capital
Stock--Governance Agreement."
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<PAGE>
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth information concerning (i) those persons
known by management of the Company to own beneficially more than 5% of the
Company's outstanding Common Stock, (ii) the directors of the Company, (iii) the
Named Executive Officers, (iv) all directors and officers of the Company as a
group and (v) the selling stockholders. Except as otherwise indicated in the
footnotes below, such information is provided as of June 1, 1998, which is prior
to the consummation of the Sprint Transaction. The table reflects only Sprint's
direct ownership of 1,250,000 shares of Common Stock acquired by Sprint upon
consummation of the Sprint tender offer but does not reflect Sprint's beneficial
ownership of 4,102,941 shares of Common Stock into which Sprint's Series A
Convertible Preferred Stock would have been convertible on the date of purchase
by Sprint assuming acceleration of certain dividend rights. The table also does
not reflect the sale by various of the beneficial owners and other principal
stockholders to Sprint of shares in the Sprint tender offer, the purchase by any
of the beneficial owners of shares in the Offering or immediately thereafter or
Sprint's right to purchase an additional 245,018 shares of Common Stock
(assuming that the Underwriters have exercised the over-allotment option) which
Sprint is entitled to purchase upon the closing of the Offering pursuant to
certain preemptive rights under the terms of the Sprint Transaction.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES
OWNED BENEFICIALLY OWNED
PRIOR TO OFFERING (2) SHARES AFTER OFFERING
---------------------- BEING ------------------
NAME OF BENEFICIAL OWNERS (1) NUMBER PERCENT OFFERED NUMBER PERCENT
- ---------------------------------------------------------------------------- ------------- ------- ------- --------- -------
<S> <C> <C> <C> <C> <C>
Sky D. Dayton............................................................... 1,646,017(3) 13.5% 1,646,017 12.0%
Reed E. Slatkin............................................................. 1,237,047(4) 10.1 1,237,047 9.0
Kevin M. O'Donnell.......................................................... 1,134,652(5) 9.3 1,134,652 8.3
Sidney Azeez................................................................ 590,636(6) 4.8 590,636 4.3
John W. Sidgmore............................................................ 401,515(7) 3.3 401,515 -- --
Charles G. Betty............................................................ 209,549(8) 1.7 209,549 1.5
Linwood A. Lacy, Jr......................................................... 98,066(9) * 20,000 78,066 *
Robert M. Kavner............................................................ 44,009(10) * 44,009 *
Paul McNulty................................................................ 504(11) * 120 384 *
Brinton O.C. Young.......................................................... 70,000(12) * 70,000 *
Dr. Richard D. Edmiston..................................................... 13,750(13) * 2,000 11,750 *
Grayson L. Hoberg........................................................... 7,500(14) * 5,000 2,500 *
David R. Tommela............................................................ 4,375(15) * 4,375 *
William T. Esrey............................................................ 1,250,000(16) 10.2 1,250,000 9.1
Patti S. Manuel............................................................. 1,250,000(17) 10.2 1,250,000 9.1
Quantum Industrial Partners LDC............................................. 1,523,180(18) 12.5 336,200 1,186,980 8.6
Storie Partners, L.P........................................................ 587,849(19) 4.8 587,849 4.3
Sprint Corporation.......................................................... 1,250,000(20) 10.2 1,250,000 9.1
All directors and executive officers as a group (15 persons)................ 5,457,620(21) 42.3 428,635 5,028,985 34.9
OTHER SELLING STOCKHOLDERS (1)
- ----------------------------------------------------------------------------
David Farber................................................................ 5,625 * 5,625 -- --
William S. Heys (22)........................................................ 9,300 * 1,500 7,800 *
Robert E. Johnson (23)...................................................... 26,000 * 22,500 3,500 *
George Soros (24)........................................................... 1,811,780 14.8 63,680 1,411,900 10.3
Leland Thoburn (25)......................................................... 46,500 * 6,500 40,000 *
WorldCom, Inc. (26)......................................................... 401,515 3.3 401,515 -- --
Irwin Zalcberg.............................................................. 14,000 * 14,000 -- --
</TABLE>
- ------------------------------
* Represents beneficial ownership of less than 1% of the Company's Common
Stock.
(1) Except as otherwise indicated by footnote (i) the named person has sole
voting and investment power with respect to all shares of Common Stock
shown as beneficially owned, and (ii) the address of the named person is
that of the Company.
(2) Beneficial ownership is determined in accordance with the rules of the SEC,
based on factors including voting and investment power with respect to
shares, subject to applicable community property laws. Shares of Common
Stock subject to options or warrants exercisable within 60 days of June 1,
1998 are deemed outstanding for the purpose of computing the percentage
ownership of the person holding such options or warrants, but are not
deemed outstanding for computing the percentage ownership of any other
person.
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<PAGE>
(3) Includes options to purchase 12,500 shares of Common Stock.
(4) Includes (i) warrants to purchase 182,500 shares of Common Stock and (ii)
12,074 shares of Common Stock held in trust for Mr. Slatkin's minor
children.
(5) Includes (i) 7,538 shares of Common Stock by Mr. O'Donnell's son, and (ii)
warrants to purchase 182,500 shares of Common Stock. Mr. O'Donnell
disclaims beneficial ownership of the shares of Common Stock held by his
son and the shares of Common Stock issuable upon exercise of options held
by his son.
(6) Includes (i) 347,085 shares of Common Stock held by Mr. Azeez's family and
(ii) warrants to purchase 6,667 shares of Common Stock.
(7) Mr. Sidgmore is Vice Chairman and Chief Operations Officer and a director
of WorldCom, Inc. ("WorldCom"), and shares voting and investment power with
the other WorldCom directors. All of the 401,515 shares of Common Stock
owned by WorldCom are being sold in this Offering. Mr. Sidgmore resigned
his position as a director of the Company effective June 5, 1998.
(8) Includes (i) options to purchase 167,500 shares of Common Stock and (ii)
2,049 shares of Common Stock held by Mr. Betty's father-in-law and
mother-in-law of which Mr. Betty disclaims beneficial ownership.
(9) Includes options to purchase 40,000 shares of Common Stock.
(10) Includes warrants to purchase 3,334 shares of Common Stock and options to
purchase 20,000 shares of Common Stock.
(11) Includes warrants to purchase 50 shares of Common Stock.
(12) Includes options to purchase 50,000 shares of Common Stock.
(13) Includes options to purchase 3,750 shares of Common Stock.
(14) Represents options to purchase 7,500 shares of Common Stock.
(15) Represents options to purchase 4,375 shares of Common Stock.
(16) Includes 1,250,000 shares of stock beneficially owned by Sprint and which
Mr. Esrey may be deemed to beneficially own.
(17) Includes 1,250,000 shares of stock beneficially owned by Sprint and which
Ms. Manuel may be deemed to beneficially own.
(18) Includes warrants to purchase 66,700 shares of Common Stock. Quantum
Industrial Partners LDC ("Quantum Industrial") has vested investment
discretion with respect to its portfolio investments, including the Common
Stock, in Soros Fund Management LLC, a Delaware limited liability company
of which Mr. Soros serves as Chairman ("SFM"). Mr. Soros may be deemed to
be the beneficial owner of the Common Stock held by Quantum Industrial.
The shares shown exclude 214,545 shares of Common Stock and warrants to
purchase 23,600 shares of Common Stock held directly by Mr. Soros and
45,455 shares of Common Stock and warrants to purchase 5,000 shares of
Common Stock held by trusts established for the benefit of the children of
Mr. Soros. The shares shown also exclude shares of Common Stock and
warrants to purchase shares of Common Stock held by certain managing
directors and other employees of SFM, of which Mr. Soros disclaims
beneficial ownership. The business address of Quantum Industrial is: c/o
Curacao Corporation Company N.V., Kaya Flamboyan 9, Willemstad, Curacao,
Netherlands Antilles.
(19) The business address of Storie Partners , L.P. is: c/o Mr. Steve Ledger,
One Bush Street, Suite 1350, San Francisco, California 94104.
(20) Includes 1,250,000 shares of Common Stock acquired by Sprint after March
31, 1998 pursuant to the Offer but excludes 4,102,941 shares of Common
Stock into which Sprint's Series A Convertible Preferred Stock would have
been convertible on the date of purchase by Sprint assuming acceleration
of certain dividend rights. The Series A Convertible Preferred Stock is
not convertible until one year following the consummation of the Offer.
Sprint may also be deemed to be a member of a group with certain
stockholders in those two groups who are parties to the Stockholders'
Agreement covering a total of 5,394,996 shares included among the above
number of shares. Also excludes 245,018 shares of Common Stock (assuming
that the Underwriters have exercised the over-allotment option) which
Sprint is entitled to purchase pursuant to certain preemptive rights under
the terms of the Sprint Transaction. Sprint's address is 2330 Shawnee
Mission Parkway, Westwood, Kansas 66205. See "Strategic Alliance with
Sprint" and "Description of Capital Stock--Governance Agreement" and "--
Stockholders' Agreement; Irrevocable Proxies."
(21) Includes (i) options and warrants to purchase 680,676 shares of Common
Stock, (ii) 368,746 shares of Common Stock owned by family members or
affiliates of certain members of the group, and (iii) options and warrants
held by family members or affiliates of certain members of the group to
purchase 87 shares of Common Stock.
(22) Includes warrants to purchase 9,300 shares of Common Stock.
63
<PAGE>
(23) Includes warrants to purchase 6,000 shares of Common Stock.
(24) Includes 1,523,180 shares of Common Stock beneficially owned by Quantum
Industrial of which Mr. Soros may be deemed to be the beneficial owner.
The Shares Being Offered includes 52,480 shares held directly by Mr. Soros
and 11,200 shares held by the trusts established for the benefit of the
children of Mr. Soros, but excludes the 336,200 shares being sold by
Quantum Industrial. The Shares Beneficially Owned After Offering includes
the Shares Beneficially Owned After Offering of Quantum Industrial. See
Note 18 above.
(25) Includes warrants to purchase 46,500 shares of Common Stock.
(26) The address of the stockholder is 515 East Amite Street, Jackson,
Mississippi 39201-2702.
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<PAGE>
DESCRIPTION OF CAPITAL STOCK
The authorized capital stock of the Company consists of (i) 50 million
shares of Common Stock, $0.01 par value per share, and (ii) 25 million shares of
Preferred Stock, $0.01 par value per share. As of June 5, 1998, and giving
effect to this Offering, there were 13,744,678 shares of Common Stock and
4,102,941 shares of Preferred Stock outstanding. The following summary is
qualified in its entirety by reference to the Company's Certificate of
Incorporation, which is filed as an exhibit to the Registration Statement of
which this Prospectus is a part.
COMMON STOCK
Under the Delaware General Corporation Law and the Company's Certificate of
Incorporation, holders of Common Stock are entitled to one vote per share on all
matters submitted to a vote of the stockholders, including the election of
directors. The Common Stock carries no preemptive rights and is not convertible,
redeemable or assessable. The holders of Common Stock are entitled to dividends
in such amounts and at such times as may be declared by the Board of Directors
out of funds legally available therefor. See "Dividend Policy." Upon the
liquidation, dissolution or winding up of the Company, the holders of Common
Stock are entitled to receive ratably the net assets of the Company available
after payment or provision for payment of all debts and other liabilities
subject to prior rights of holders of Preferred Stock then outstanding, if any.
All shares of Common Stock outstanding immediately following this Offering will
be fully paid and non-assessable.
PREFERRED STOCK
The Company's Certificate of Incorporation authorizes the issuance of 25
million shares of Preferred Stock, of which 10 million have been designated as
Series A Convertible Preferred Stock pursuant to a Certificate of Designation
(the "Series A Convertible Preferred") of which 4,102,941 were issued and
outstanding as of June 5, 1998. All issued and outstanding shares of Series A
Convertible Preferred are held by Sprint. The undesignated and unissued
Preferred Stock may be issued from time to time in one or more series, and the
Board of Directors, without further approval of the stockholders, is authorized
to fix the dividend rights and terms, conversion rights, voting rights,
redemption rights and terms, liquidation preferences, sinking funds and any
other rights, preferences, privileges and restrictions applicable to each such
series of Preferred Stock. The issuance of additional shares of Preferred Stock,
while providing flexibility in connection with possible acquisitions and other
corporate purposes, could, among other things, adversely affect the voting power
of the holders of Common Stock and, under certain circumstances, make it more
difficult for a third party to gain control of the Company, discourage bids for
the Common Stock at a premium, or otherwise adversely affect the market price of
the Common Stock. The issuance by the Company to Sprint of additional shares of
Series A Convertible Preferred may have similar effects.
The following is a summary of the terms of the Series A Preferred, and is
qualified in its entirety by reference to the Certificate of Designation, which
is filed as an exhibit to the Registration Statement of which this Prospectus is
a part.
GENERAL; DIVIDEND RIGHTS
Of the issued and outstanding shares of Series A Convertible Preferred, all
are owned by Sprint. In addition, the Certificate of Designation provides that
the Company may originally issue shares of Series A Preferred to Sprint only.
The holders of shares of Series A Preferred are entitled to receive dividends at
a rate per annum of 3% of the Liquidation Value of such shares (as defined
below), compounded quarterly. For a period of five years from the initial
issuance date of the Series A Convertible Preferred (the "Issuance Date"), such
dividends are payable "in kind" by way of an increase in the Liquidation Value
of the shares and thereafter are payable in cash. Moreover, upon an optional
redemption of the
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Series A Convertible Preferred by the Company or the consummation of certain
business combination transactions during such five year period, the holders of
the Series A Convertible Preferred are entitled to receive an accelerated "in
kind" dividend for the entire initial five year period (the "Acceleration
Dividend"). Beginning 20 years after the Issuance Date, holders of the Series A
Convertible Preferred are entitled to cumulative quarterly cash dividends of 8%
of the Liquidation Value per share, increasing annually to a maximum rate of
12%.
LIQUIDATION RIGHTS
The Certificate of Designation provides that the holders of Series A
Convertible Preferred will receive, prior to any payment or distribution in
respect of other shares of the Company's capital stock, an amount per share
equal to the average market value of the Common Stock measured over the thirty
day period ending on the Issuance Date (the "Average Stock Price"), plus all
accrued and unpaid dividends on such share, whether in cash or in kind (such
amount, the "Liquidation Value")
CONVERSION RIGHTS
Beginning on the first anniversary of the Issuance Date, each share of
Series A Convertible Preferred is convertible into such number of shares of
Common Stock as is determined by dividing the Liquidation Value by the
"Conversion Price" in effect at such time. For the five year period following
the Issuance Date, the Conversion Price is equal to the Average Stock Price
multiplied by 116.118%. Thereafter, the Conversion Price is increased annually
by 6%, accruable quarterly. The Conversion Price is also subject to adjustment
based on changes in capitalization of the Common Stock such as stock splits,
stock dividends and the like. Although conversion of the Series A Convertible
Preferred is at the holder's option, conversion is required in the event the
Company consummates certain business combination transactions.
OPTIONAL REDEMPTION BY THE COMPANY
Beginning on the third anniversary of the Issuance Date, the Company may
elect to redeem the outstanding shares of Series A Convertible Preferred at a
redemption price per share equal to the Liquidation Value of such share
(including the Acceleration Dividend described above), multiplied by a specified
percentage. The specified percentage is initially equal to 103%, and will be
reduced by 1% annually in each of the subsequent three years, and thereafter
will be equal to 100%.
VOTING RIGHTS
The holders of Series A Convertible Preferred do not possess general voting
rights together with holders of Common Stock. However, the Series A Convertible
Preferred holders are separately entitled to elect two of the Company's
directors (the "Investor Directors"). This right terminates as to one of the
Investor Directors if Sprint fails to maintain at least a 20% equity interest in
the Company (on a fully diluted basis, subject to adjustment) for any three
consecutive months, and will terminate as to both of the Investor Directors if
Sprint fails to maintain at least a 10% equity interest over the same period.
The Certificate of Designation also requires a separate vote of 66 2/3% of the
then-outstanding shares of Series A Convertible Preferred in certain limited
situations, including any liquidation, dissolution or winding up of the Company,
or the taking of certain actions by the Company which would adversely affect the
rights of the holders of the Series A Convertible Preferred as a class.
CERTAIN CHARTER AND BYLAW PROVISIONS
The Company is subject to the "business combination" statute of the Delaware
General Corporation Law. This statute prohibits a publicly-held Delaware
corporation from engaging in a "business combination" with an "interested
stockholder" for a period of three years after the date of the transaction
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in which the person became an interested stockholder, unless the business
combination is approved in a prescribed manner, such as the approval of a
majority of certain members of the Board of Directors. The term "business
combination" includes mergers and stock and asset sales. An "interested
stockholder" is a person who, together with affiliates and associates, owns (or
within three years, did own) 15% or more of the corporation's voting stock. The
effect of this statute could, among other things, make it more difficult for a
third party to gain control of the Company, discourage bids for the Common Stock
at a premium or otherwise adversely affect the market price of the Common Stock.
GOVERNANCE AGREEMENT
GENERAL
In connection with the Sprint Transaction, the Company and Sprint entered
into a Governance Agreement. The Governance Agreement establishes certain terms
and conditions concerning the corporate governance of the Company, the
acquisition and disposition of equity securities of the Company by Sprint,
Sprint L.P. and any of their respective affiliates (collectively, the
"Affiliated Equity Holders"), the rights of Sprint to make offers to purchase
all of the outstanding securities of the Company not owned by the Affiliated
Equity Holders and the rights of the Board of Directors of the Company to
receive and entertain offers to effect business combinations, all as more
particularly described in the Governance Agreement. The following summary of the
Governance Agreement is qualified in its entirety by reference to the actual
Governance Agreement, which is attached as an exhibit to the Registration
Statement of which this Prospectus is a part.
CORPORATE GOVERNANCE AND ELECTION OF DIRECTORS
The Governance Agreement establishes that the fundamental policies and
strategic direction of the Company, the Company and any significant subsidiary
of the Company will be determined by their respective Boards of Directors.
Consistent with the voting rights granted to the holders of the Series A
Convertible Preferred, the Governance Agreement provides for two individuals to
be designated by Sprint as "Investor Directors." Following conversion or
redemption of the Series A Convertible Preferred into Common Stock, the Company
and EarthLink Operations are obliged to elect the Investor Directors (as defined
in the Governance Agreement) to their respective Boards of Directors. In
addition, the Governance Agreement permits one Investor Director to participate
on any Strategic Business Planning Committee, Finance Committee or other
significant committee of the Board of Directors of the Company or any
significant subsidiary, to the extent those committees exist. If there is no
such committee, the Governance Agreement allows Sprint a reasonable opportunity
to review and discuss the Company's strategic and business plans and financing
plans with the management of the Company prior to the submission of any such
plan to the Board of Directors, and to receive advance copies of information and
materials to be provided to the Board of Directors with respect to such matters.
Notwithstanding the foregoing, no Investor Director is entitled to participate
on any committee of the Board of Directors of the Company which the Company or
any significant subsidiary created for the purpose of considering a Business
Combination (as defined in the Governance Agreement) or any matter related
thereto, or to participate in the Board's deliberations with respect to any of
the foregoing. Consistent with the voting rights granted to the holders of the
Series A Convertible Preferred, Sprint is entitled to designate two Investor
Directors for so long as it holds 20% or more of the Company's fully diluted
shares outstanding (subject to adjustment for certain dilutive events, the
"Higher Threshold"), and one Investor Director for so long as it holds 10% or
more of the Company's fully diluted shares outstanding (subject to adjustment
for certain dilutive events, the "Lower Threshold").
At such time as the Series A Convertible Preferred has been converted into
Common Stock, the Governance Agreement obligates the Company to use its best
efforts to solicit from its stockholders proxies in favor of Sprint's Investor
Director nominees. The Governance Agreement also obligates the Affiliated Equity
Holders to vote in favor of any other nominee or director selected by the Board
of the
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Company in accordance with the agreement. The voting obligations of Affiliated
Equity Holders under the Governance Agreement are supported by an irrevocable
proxy granted by Sprint and Sprint L.P. to the Company and EarthLink Operations.
See "--Solicitation of Offers" and "-- Stockholders' Agreement; Irrevocable
Proxies."
For so long as "Sprint's Percentage Interest" (a term that measures the
Affiliated Equity Holders' combined equity stake in the Company, including their
ownership of both Common Stock and Series A Convertible Preferred Stock,
expressed as a percentage of the Company's fully-diluted stock outstanding) is
greater than the Lower Threshold, the Company is prohibited by the Governance
Agreement and the Certificate of Designation from taking or authorizing certain
actions without the concurrence of all Investor Directors serving in such
capacity at that time. These actions include (i) the execution or performance of
certain corporate acts or transactions that would impose limitations on the
rights of, or deny certain benefits to, the Affiliated Equity Holders; (ii) the
issuance of any class or series of stock of the Company that provides for voting
rights in excess of one vote per share; (iii) certain events involving the
dissolution or liquidation of the Company or any subsidiary thereof, or the
commencement by or with respect to the Company or any subsidiary thereof of
certain bankruptcy or bankruptcy-related events or proceedings; (iv) the conduct
by the Company or any significant subsidiary of business substantially outside
its current general field of enterprise; or (v) the issuance by the Company of
equity securities in connection with joint ventures, strategic alliances,
acquisitions, mergers and other business combination transactions ("Transaction
Securities") representing (A) in any twelve-month period, in one or more
transactions, 50% or more of the number of shares of Common Stock outstanding
prior to giving effect to such issuances, or (B) in any one transaction, 35% or
more of the number of shares of Common Stock outstanding prior to giving effect
to such issuance.
EQUITY PURCHASES FROM THE COMPANY; SUBSCRIPTION RIGHTS
So long as Sprint's Percentage Interest is greater than 20%, subject to
adjustment for certain dilutive events and for the Company's incurrence of
indebtedness under the Convertible Debt Financing (the "Top-Up Threshold"), the
Affiliated Equity Holders have certain anti-dilution and subscription rights
pursuant to the Governance Agreement. In addition to their rights to subscribe
for stock of the Company directly from the Company, the Affiliated Equity
Holders may effect their anti-dilution rights by making purchases of equity
securities of the Company ("Equity Securities") at any time from any person
other than the Company as long as, after giving effect to such purchases,
Sprint's Percentage Interest is less than or equal to the "Pro Rata Share," a
formula that limits the maximum equity stake in the Company that the Affiliated
Equity Holders may have. The Pro Rata Share, which adjusts only upon the
incurrence of indebtedness by the Company under the Convertible Debt Financing,
has been established, as of the date of the Governance Agreement, at an amount
equal to 0.278.
Upon proposing to issue any new Equity Securities other than new Equity
Securities that are Transaction Securities ("New Securities"), if Sprint's
Percentage Interest is greater than the Top-Up Threshold, the Company must
provide Sprint written notice of its intent to effect such issuance at least
five business days prior to the date on which the meeting of the Company's Board
of Directors is to be held to authorize such issuance. For a period of ten
business days after Sprint's receipt of such notice, Sprint has the right to
purchase the Pro Rata Share of such issuance and, if it does so, the New
Securities offered pursuant to such notice shall be issued and sold to Sprint by
the Company at the same times and on the same terms and conditions as the New
Securities are issued and sold to third parties. If for any reason the issuance
of such New Securities to third parties is not consummated, Sprint's right to
purchase its Pro Rata Share of such issuance shall lapse.
As noted above, Sprint's general subscription rights do not apply to the
issuance of Transaction Securities. However, if the Company determines that
Sprint's Percentage Interest has decreased by five percent or more as a result
of issuances of Transaction Securities, the Company must notify Sprint of such
event. In addition, not later than the second anniversary of Sprint's receipt of
that notice (the
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"Window Period"), the Company is obligated to make written offers (each, a
"Primary Share Offer") to Sprint to purchase, in the aggregate, a number of
shares sufficient to enable Sprint to bring Sprint's Percentage Interest up to
the amount in effect prior to the issuances of Transaction Securities. The
number of shares the Company is obligated to offer pursuant to such provision is
defined in the Governance Agreement as the "Available Top-Up Shares" and the
aggregate number of Available Top-Up Shares resulting from all issuances of
Transaction Securities is defined as the "Aggregate Number of Top-Up Shares."
Sprint may accept a Primary Share Offer within five business days of its receipt
thereof, and the offer is to be made at a purchase price equal to an average
stock price for Common Stock for the ten trading days prior to the date of such
issuance, less the underwriting discount applied in the most recent underwritten
offering of Common Stock. If the Company determines that Sprint's Percentage
Interest has decreased by 0.10 or more solely as a result of the issuance of
Transaction Securities (after giving effect to any and all Primary Share
Offers), the Window Period shall be accelerated such that the Company shall be
obligated to make one or more Primary Share Offers with respect to not less than
the Aggregate Number of Top-Up Shares, as then calculated, at the earlier of (i)
the expiration of the Window Period, as determined above, or (ii) six months
after the date Sprint receives notice to that effect from the Company.
Notwithstanding anything else in the Governance Agreement to the contrary, in no
event is the Company obligated to make Sprint a Primary Share Offer that, after
giving effect to such transaction, would cause Sprint's Percentage Interest to
exceed the Pro Rata Share. In addition, with respect to a purchase of New
Securities pursuant to the exercise of anti-dilution rights discussed above,
Sprint may, at its option, purchase New Securities in the form of "Alternative
Securities" convertible into the applicable number of shares of Common Stock.
"Alternative Securities" are defined as shares of a new series of Preferred
Stock having terms that are structured and priced in the same manner as the
Series A Convertible Preferred Stock. Such terms are determined, if applicable,
by reference to the average stock price for a share of Common Stock for the 30
trading days prior to the date of issuance of such Alternative Securities.
Sprint's purchase of New Securities in the form of Alternative Securities are
limited (i) to not more than 75% of any issuance of New Securities from the
Closing to the second anniversary thereof, (ii) to not more than 66.67% of any
issuance of New Securities after the second anniversary of the Closing until the
third anniversary thereof and (iii) after the third anniversary, the Company is
not obligated to issue any New Securities in the form of Alternative Securities.
STANDSTILL PROVISIONS
The Governance Agreement sets forth certain "Standstill Provisions"
applicable to Affiliated Equity Holders. These Standstill Provisions are
summarized below. For additional information concerning the survival of the
Standstill Provisions following termination of the Governance Agreement. See
"--Solicitation of Offers and "--Termination; Survival."
Except for purchases of shares and related activities by Sprint otherwise
permitted under the Governance Agreement, the Affiliated Equity Holders may not,
directly or indirectly, (i) acquire, offer to acquire or agree to acquire any
Equity Securities, or any equity securities of any subsidiary of the Company, or
material assets of the Company or any subsidiary or division of the Company;
(ii) make or participate in any "solicitation" of proxies or otherwise seek to
influence any person with respect to the voting of any voting Equity Securities;
(iii) make any public announcement with respect to, or submit a proposal for, or
offer to effect any purchase of any significant portion of the assets of the
Company or any subsidiary or division of the Company, any tender or exchange
offer for any Equity Securities, or a merger, consolidation or other
extraordinary transaction involving the Company or any of its Equity Securities;
(iv) form, join or in any way participate in a "group" as defined in Rule
13d-5(b) under the Exchange Act; or (v) request the Company or any of its
representatives to amend or waive any provision of the foregoing.
In addition, the Affiliated Equity Holders may not, directly or indirectly,
sell, transfer or otherwise dispose of any Equity Securities except (i) pursuant
to a registered underwritten public offering in
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accordance with the Registration Rights Agreement, (ii) in accordance with
certain expectations under the Securities Act and (iii) to any direct or
indirect subsidiary of Sprint. In addition, notwithstanding the foregoing, none
of the Affiliated Equity Holders may sell, transfer or otherwise dispose of any
equity interest in any Equity Securities to any purchaser or group of purchasers
if, after giving effect to such sale, such purchaser or group of purchasers
would, to Sprint's knowledge, own, or have the right to acquire, 5% or more of
the Equity Securities then outstanding, except to any person that is not
obligated (or would not, by virtue of such purchase, reasonably be anticipated
to be obligated) to file a Schedule 13D with the SEC pursuant to each of
paragraphs (b) and (e) of Rule 13d-1 under the Exchange Act.
PURCHASES OF ADDITIONAL EQUITY SECURITIES; BUSINESS COMBINATIONS
Following the 39-month anniversary and prior to the 63-month anniversary of
the Closing of the Merger (the "Right to Offer Period"), Sprint shall have the
right to make a "Sprint Offer," by offering to purchase all (but not less than
all) of the outstanding Equity Securities that it does not already own at a
price per share equal to the per share price determined by dividing the "Fair
Private Market Value" by the total number of shares of Company Common Stock
outstanding on a fully-diluted basis. The "Fair Private Market Value" is defined
as the aggregate private market equity value (including control premium) that an
unrelated third party would pay if it were to acquire all of the Company's
outstanding Equity Securities (including Equity Securities held by the
Affiliated Equity Holders) in an arm's length transaction, assuming (i) that all
credible buyers are given an equal opportunity by the Company to make and
effectuate an "Acquisition Proposal" (as defined by the Governance Agreement)
with respect to the Company, (ii) the absence of any commercial relations
between the Company and EarthLink Operating Subsidiary, on the one hand, and
Sprint and its affiliates, on the other hand, and (iii) the absence of any
ownership stake in the Company by the Affiliated Equity Holders. The Fair
Private Market Value is to be determined as follows: the respective Boards of
the Company and Sprint shall negotiate the amount of the Fair Private Market
Value to be paid pursuant to the Sprint Offer; in the event the two parties are
unable to agree on this amount, within 30 days after submission of the Sprint
Offer to the Company's Board of Directors, the parties shall agree to be bound
to the valuation arrived at pursuant to the following formula: (i) two
appraisals shall be made by recognized investment banks, one selected by each of
Sprint and the Company (the "Initial Values"), (ii) if the lower of the Initial
Values is more than 10% less than the higher, a third independent valuation will
be made by an investment bank jointly selected by the Company and Sprint (the
"Independent Valuation"); otherwise, the Fair Private Market Value shall be the
average of the Initial Values; and (iii) if the Independent Valuation is greater
or less than the average of the Initial Values by more than 5%, the Fair Private
Market Value shall be deemed to equal the average of the two closest valuations.
If the Independent Valuation does not differ by such amount, it shall be the
Fair Private Market Value.
A Sprint Offer shall not be subject to any financing contingency, and shall
be reflected in a form of definitive agreement that Sprint is prepared to
execute. The conditions to consummation of the Sprint Offer and the
representations and warranties set forth therein shall be reasonable and
customary for transactions in which a similarly situated stockholder offers to
purchase all of the Equity Securities not held by such stockholder or its
affiliates.
The Board of Directors of the Company shall have a one-time right,
exercisable within 14 days after receipt of the Sprint Offer, to postpone the
making of that offer for nine months. Upon exercise of such right, Sprint is
obligated to withdraw the Sprint Offer for a period of nine months, provided
that (i) the Right to Offer Period shall be extended to the 72-month anniversary
of the closing of the Merger and (ii) the exercise by the Company of its
postponement right shall not limit Sprint's right to respond to a "Third-Party
Offer" as set forth below.
In addition, upon the determination of the amount of the Fair Private Market
Value, Sprint shall be obligated to commence and effectuate a Sprint Offer,
provided that Sprint shall, subject to certain limitations, have a one-time
right, exercisable within 14 days after receipt of the determination of Fair
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Private Market Value, to determine not to proceed to make such Sprint Offer. If
Sprint does not exercise this right, the Board of Directors of the Company
shall, unless an "Intervening Offer" (as defined below) is then outstanding, (i)
support the Sprint Offer by approving and recommending it to the Company's
stockholders and (ii) cause the Company to take all steps reasonable and
necessary to facilitate consummation of such Sprint Offer. However, at such time
as a "Third-Party Offer" shall constitute an Intervening Offer, Sprint shall be
released from its obligation to commence and effectuate the Sprint Offer, and
the Company shall be released from its obligation to support and facilitate
consummation of the Sprint Offer. If the Intervening Offer is undertaken in the
form of a tender offer, at the consummation of such tender offer, the offeror
shall have an option to purchase from all Affiliated Equity Holders, at the
tender offer price, in the aggregate, a "Specified Number of Equity Securities"
(a number of Equity Securities owned by Affiliated Equity Holders equal to the
proportion of Equity Securities held by unaffiliated equity holders and tendered
into or voted for a competing Business Combination), less the number of Equity
Securities that have already been tendered to such offeror. In addition, if the
Intervening Offer (or a related matter) must be approved by the stockholders of
the Company in order for such offer to be effectuated, the Affiliated Equity
Holders are obligated, subject to certain limited exceptions, to cast in favor
of the Intervening Offer (and such related matters) such number of votes as is
equal to the Specified Number of Equity Securities. Affiliated Equity Holders
are not entitled to exercise rights of appraisal with respect to any Business
Combination effected in connection with an Intervening Offer.
The Governance Agreement defines an "Intervening Offer" as an offer for
aggregate consideration reasonably determined in good faith by the Board of the
Company to be in excess of the aggregate consideration proposed to be paid by
Sprint in a Sprint Offer or a "Qualified Offer" by Sprint (as defined below), as
applicable. The conditions to consummation of an Intervening Offer and the
representations, warranties and covenants set forth in the Intervening Offer
shall be customary for a transaction of that type.
THIRD-PARTY OFFERS
The Company is obligated to provide Sprint with prompt written notice of its
receipt of a bona fide, written offer to effect a Business Combination from a
third party (an "Offer"). Upon receipt of such Offer, the Board is to determine
whether it intends to recommend that Offer to the stockholders (a "Recommended
Third-Party Offer") or that such offer is not in the best interests of the
Company's stockholders, in which event it intends not to recommend such offer to
the stockholders (a "Non-Recommended Third-Party Offer" and, together with a
Recommended Third-Party Offer, a "Third-Party Offer").
For a period of ten days following the giving of notice of receipt of an
Offer, the Company may not enter into a definitive agreement with respect to
that Offer. Sprint has an option to make a "Qualified Offer" with respect to
either (i) an Offer that is a Recommended Third-Party Offer or (ii) an Offer
that is a Non-Recommended Third-Party Offer if the Board of Sprint reasonably
determines that the conditions to the Non-Recommended Third-Party Offer are
reasonably likely to be satisfied and the Offer consummated. A "Qualified Offer"
is defined as an offer made by an Affiliated Equity Holder to acquire all of the
Equity Securities not already owned by the Affiliated Equity Holders at a price
per share in excess of the equivalent per share price set forth in a Third-Party
Offer or an Intervening Offer, as the case may be. A Qualified Offer shall be
reflected in a form of definitive agreement that the Affiliated Equity Holder is
prepared to execute, and the conditions to consummation of such offer and the
representations, warranties and covenants set forth in it shall be customary for
transactions in which a similarly situated stockholder offers to purchase all of
the Equity Securities not held by such stockholder and may not, in any event, be
more onerous in any material respect than those set forth in the Third-Party
Offer or the Intervening Offer, as the case may be.
The Company may not adopt any takeover defenses, enter into any agreement or
take any other action in connection with a Recommended Third-Party Offer that
would materially impair an Affiliated Equity Holder's ability to make and
consummate a Qualified Offer or materially increase such Affiliated
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Equity Holder's cost of consummating a Qualified Offer. Notwithstanding the
foregoing, the Company is permitted to enter into a definitive agreement with
respect to a Recommended Third-Party Offer that provides for a termination fee
not to exceed 3% of the consideration to be received per share of Common Stock
multiplied by the number of shares of Company Common Stock outstanding on a
fully diluted basis (less the number of shares beneficially owned by the
offering party), plus customary fees and expenses. Nevertheless, the definitive
agreement with respect to such Recommended Third-Party Offer must provide that
such fees and expenses shall not be payable if Sprint makes a Qualified Offer
within 72 hours of the first public announcement of such Recommended Third-Party
Offer.
If Sprint has the option to make a Qualified Offer and does so more than
five days prior to the date of a stockholders' meeting held to consider a
Third-Party Offer or an Intervening Offer, the Board of Directors shall, unless
an Intervening Offer is then outstanding, support the Qualified Offer by
approving and recommending it to the Company's stockholders and cause the
Company to take all steps reasonable and necessary to facilitate consummation of
the Qualified Offer. However, at such time as a Third-Party Offer made
subsequent to a Qualified Offer shall constitute an Intervening Offer, the
Company's obligations to support and facilitate a Qualified Offer shall
terminate and the Company shall be free to consider and act upon such
Intervening Offer. Sprint is nonetheless entitled, at any time prior to
consummation of the Intervening Offer, to make another Qualified Offer, and in
such event, the most recent Third-Party Offer shall cease to constitute an
Intervening Offer.
If a Recommended Third-Party Offer or an Intervening Offer is undertaken in
the form of a tender offer, at the consummation of such tender offer, the
offeror shall have an option to purchase from all Affiliated Equity Holders, at
the tender offer price, in the aggregate, a Specified Number of Equity
Securities, less the number of Equity Securities that have already been tendered
to such offeror. In addition, if a Recommended Third-Party Offer or an
Intervening Offer, as the case may be (or a related matter), must be approved by
the stockholders of the Company in order for such offer to be effectuated, the
Affiliated Equity Holders are obligated, subject to certain limited exceptions,
to cast in favor of such offer (and such related matter) such number of votes as
is equal to the Specified Number of Equity Securities. Affiliated Equity Holders
are not entitled to exercise rights of appraisal with respect to any Business
Combination effected in connection with a Recommended Third-Party Offer or
Intervening Offer.
The Governance Agreement defines "Business Combination" to mean a
transaction, undertaken in any form whatsoever, involving (i) the purchase or
acquisition of Equity Securities if the consummation of such transaction would
result in the purchaser beneficially owning 35% or more of the Equity Securities
outstanding, or (ii) a merger, consolidation, combination or other extraordinary
transaction with respect to the Company in which, upon consummation thereof, the
shareholders or owners of the other entity that is a party thereto, or the
controlling persons thereof, would acquire beneficial ownership of 50% or more
of the Equity Securities outstanding. The term Business Combination includes a
"Significant Sale," which means the sale of assets of the Company or any
subsidiary or the sale of capital stock of any subsidiary by the Company, in any
such case, for which the consideration proposed to be paid in such transaction
represents 35% or more of the market capitalization of the Company on the date
that the Company agrees to such sale.
SOLICITATION OF OFFERS
From the closing date of the Merger until the earlier of the 27-month
anniversary of such date or the termination of the Governance Agreement in
accordance with its terms, the Company may not, directly or indirectly, (i)
solicit or initiate, or encourage the submission of, any "Acquisition Proposal"
(as defined below), or (ii) participate in any discussions or negotiations
regarding, or take any action that may reasonably be expected to lead to any
Acquisition Proposal. However, to the extent required by the fiduciary
obligations of the Board of Directors, as determined in good faith by the Board
based on the advice of outside counsel, the Company may (A) furnish information
in response to any unsolicited
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requests therefor and discuss such information, (B) upon receipt by the Company
of an Acquisition Proposal, following delivery to Sprint of notice thereof,
participate in negotiations regarding such Acquisition Proposal and (C) enter
into an agreement respecting such Acquisition Proposal or any related agreements
or take any other action ancillary thereto.
After the 27-month anniversary of the closing date of the Merger and until
the earlier of the 39-month anniversary of such date or the termination of the
Governance Agreement in accordance with its terms, the Company may not, directly
or indirectly, take any of the actions identified in the prior paragraph except
through an investment banking firm formally engaged by the Company for such
purpose; provided, that 30 days prior to engaging an investment banking firm for
that purpose, the Company shall notify Sprint of its intention to effect such
engagement, and Sprint shall be permitted to prepare and make a Sprint Offer for
so long as such investment banking firm remains engaged by the Company for that
specific purpose. Subject to the terms and conditions of the Sprint Offer, and
unless an Intervening Offer is then outstanding, Sprint is entitled to pursue
any such Sprint Offer for so long as necessary to permit it to be consummated.
The Company is obligated to furnish Sprint with copies of all information
provided by the Company to such investment banking firm at the time such
information is provided to such firm, subject to Sprint entering into a
customary confidentiality agreement with respect to that information.
The Board of Directors of the Company is obligated to (i) promptly notify
Sprint in writing of (A) its receipt of an Acquisition Proposal, (B) any
inquiries or discussions that may reasonably be expected to lead to an
Acquisition Proposal, (C) the execution by the Company of a confidentiality
agreement with respect to an Acquisition Proposal or (D) the furnishing of any
confidential information in contemplation of an Acquisition Proposal, whether or
not pursuant to a confidentiality agreement; (ii) describe the terms and
conditions of any Acquisition Proposal in reasonable detail; (iii) provide to
Sprint copies of any definitive agreements with respect to any Acquisition
Proposal and any confidentiality agreements with respect thereto; and (iv)
subject to Sprint's obligation to hold such information in strict confidence,
make available to Sprint all information made available to the party making the
Acquisition Proposal at the same time it is provided to such party.
An "Acquisition Proposal" means any proposal for a tender or exchange offer,
a merger, consolidation, share exchange or other business combination, in which
the Company is a constituent party to such transaction, or a sale of securities
(other than Transaction Securities), recapitalization, liquidation, dissolution
or similar transaction involving the Company, or any proposal or offer to
acquire in any manner, directly or indirectly, a material equity interest in, or
a material amount of voting securities (with the acquisition of beneficial
ownership of 20% or more of the voting Equity Securities being deemed to be
material for this purpose) or assets of, the Company. In addition, a "Material
Sale," defined as any proposal involving the sale of assets of the Company or
any subsidiary or the sale of capital stock of any subsidiary, in any such case,
for which the consideration proposed to be paid in such transaction represents
20% or more of the market capitalization on the date that the Company receives
such proposal, is also deemed to constitute an Acquisition Proposal.
Subject to certain exceptions, the Company is obligated under the Governance
Agreement not to take any action or omit to take any action that would result in
(i) any Affiliated Equity Holder being deemed an "Acquiring Person" or similar
designation under any stockholders' rights plan, (ii) any Affiliated Equity
Holder being prejudiced under any applicable state takeover statute, including
Section 203 of the Delaware General Corporation Law, or (iii) otherwise causing
any takeover defense to materially impair or obstruct, or prevent (either
legally or financially) the exercise by any Affiliated Equity Holder of rights
granted under Article IV of the Governance Agreement.
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<PAGE>
STOCKHOLDERS' AGREEMENT; IRREVOCABLE PROXIES
In order to provide for enforcement of certain aspects of the Governance
Agreement, Sprint and the following principal stockholders of the Company have
entered into a Stockholders' Agreement: Sky Dayton, Chairman of the Board of
Directors of the Company--1,500,000 Shares; Quantum Industrial Partners
LDC--1,456,480 Shares; Reed Slatkin, a Director of the Company (through Reed
Slatkin & Associates)--1,042,473 Shares; Kevin M. O'Donnell, a Director of the
Company--944,614 Shares; Sidney Azeez, a Director of the Company--236,884
Shares; and George Soros--214,545 Shares. Further, in order to provide for
enforcement of the Stockholders' Agreement and certain other provisions of the
Governance Agreement requiring the Affiliated Equity Holders to vote their
voting Equity Securities in a certain manner, Sprint has provided an Irrevocable
Proxy to the Company.
TERMINATION; SURVIVAL
The Governance Agreement terminates at the earliest to occur of the
following: (i) the termination of the Investment Agreement in accordance with
its terms; (ii) such time as Sprint's Percentage Interest is greater than 90% or
less than the Lower Threshold; (iii) the expiration of the Right to Offer
Period; (iv) the first date on which any person or "group" as defined in Rule
13d-5(b) of the Exchange Act is determined (A) to beneficially own or control
more than 35% of the Equity Securities outstanding by virtue of the acquisition
of such securities pursuant to a Third-Party Offer, provided the rights granted
and process contemplated by Article IV of the Governance Agreement have been
observed and effected in accordance with the terms thereof or (B) to
beneficially own or control 50% or more of the voting Equity Securities
outstanding; (v) upon the termination of the Company's Marketing and
Distribution Agreement with Sprint in accordance with certain of its provisions;
or (vi) upon the exercise of registration rights (demand or incidental) by any
"Holder" of "Registrable Securities" under the Registration Rights Agreement
entered into in connection with the Sprint Transaction.
Notwithstanding the termination of the Governance Agreement, until the sixth
anniversary of the closing date of the Merger, and thereafter for as long as
Sprint's Percentage Interest is greater than the Lower Threshold, Sprint shall
still be subject to the Standstill Provisions described above, and shall still
have certain governance and anti-dilution rights under the Governance Agreement.
In such event, the Standstill Provisions and such other provisions (as well as
any definitional provisions with respect to the foregoing) shall remain in full
force and effect until such time as Sprint's Percentage Interest is lower than
the Lower Threshold; provided, however, that during any period in which the
Standstill Provisions survive, Sprint and its affiliates may directly approach
the Board of the Company in order to make an offer to effect a Business
Combination.
LIMITATION OF DIRECTORS' AND OFFICERS' LIABILITY; INDEMNIFICATION
The Company has included in its Certificate of Incorporation provisions that
limit the personal liability of its officers and directors for monetary damages
for breach of their fiduciary duty of directors, except for liability that
cannot be eliminated under the Delaware General Corporation Law. The Certificate
of Incorporation provides that, to the fullest extent provided by the Delaware
General Corporation Law, directors of the Company will not be personally liable
for monetary damages for breach of their fiduciary duty as directors. The
Delaware General Corporation Law does not permit a provision in a corporation's
certificate of incorporation that would eliminate such liability (i) for any
breach of their duty of loyalty to the corporation or its stockholders, (ii) for
acts or omissions not in good faith or that involve intentional misconduct or a
knowing violation of law, (iii) for any unlawful payment of a dividend or
unlawful stock repurchase or redemption, as provided in Section 174 of the
Delaware General Corporation Law, or (iv) for any transaction from which the
director derived an improper personal benefit.
While these provisions provide directors with protection from awards for
monetary damages for breaches of their duty of care, they do not eliminate such
duty. Accordingly, these provisions will have no
74
<PAGE>
effect on the availability of equitable remedies such as an injunction or
rescission based on a director's breach of his or her duty of care. The
provisions described above apply to an officer of a corporation only if he or
she is a director of such corporation and is acting in his or her capacity as
director, and do not apply to the officers of the corporation who are not
directors.
The Company's Bylaws provide that, to the fullest extent permitted by the
Delaware General Corporation Law, the Company may indemnify its directors,
officers and employees. The Bylaws further provide that the Company may
similarly indemnify its other employees and agents. In addition, the Company
anticipates that each director will enter into an indemnification agreement with
the Company pursuant to which the Company will indemnify such director to the
fullest extent permitted by the Delaware General Corporation Law. At present,
there is no pending litigation or proceeding involving a director or officer of
the Company in which indemnification is required or permitted, and the Company
is not aware of any threatened litigation or proceeding that may result in a
claim for such indemnification.
REGISTRATION RIGHTS
The holders of substantially all of the shares of Common Stock outstanding
prior to the closing of the Company's initial public offering, (including shares
held by the Company's founder and Chairman of the Board and its President and
Chief Executive Officer), as well as certain holders of warrants and convertible
debt, are parties to registration rights agreements with the Company. Sprint
also has registration rights with respect to the Common Stock issuable upon
conversion of the Series A Convertible Preferred held by it. These agreements,
which relate to approximately 8,283,176 shares of Common Stock (assuming the
exercise or conversion of all warrants and Preferred Stock), provide incidental
or "piggyback" registration rights that allow such holders, under certain
circumstances, to include their shares of Common Stock in registration
statements initiated by the Company or other stockholders. These agreements also
permit demand registrations on Form S-3 registration statements provided that
the Company is eligible to register its capital stock on such form. All such
registration rights are subject to conditions and limitations, including the
right of the underwriters of an offering to limit the number of shares to be
included in a registration. See "Shares Eligible for Future Sale."
TRANSFER AGENT AND REGISTRAR
The Company's transfer agent and registrar is American Stock Transfer &
Trust Company.
75
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Sales of a substantial number of shares of Common Stock in the public market
following this Offering could adversely affect market prices prevailing from
time to time. Furthermore, sales of substantial amounts of Common Stock in the
public market after various resale restrictions lapse could adversely affect the
prevailing market price and the ability of the Company to raise equity capital
in the future.
Upon the completion of this Offering, 13,744,678 shares of Common Stock will
be outstanding (based on shares outstanding on June 1, 1998, and assuming no
exercise of options or warrants). Of these shares, the 2,400,000 shares of
Common Stock sold in this Offering, the 2,284,750 shares sold in the Company's
initial public offering in January 1997, the 259,639 shares issued upon exercise
of vested stock options under the Company's 1995 Stock Option Plan and
registered on a Form S-8 and 10,000 shares issued pursuant to a consulting
agreement and registered on a Form S-8 will be freely tradable without
restriction under the Securities Act, except that shares purchased by
"affiliates" of the Company, as that term is defined in Rule 144 under the
Securities Act, may generally be sold only in compliance with the limitations of
Rule 144. The remaining 8,790,289 shares were issued and sold by the Company in
private transactions exempt from the registration requirements of the Securities
Act and may be publicly sold only if registered under the Securities Act or sold
in accordance with an applicable exemption from registration, such as those
provided under Rules 144 and 701 under the Securities Act. Of such shares,
7,330,530 shares are immediately available for sale (subject, in certain cases,
to the volume and other limitations of Rule 144) and 1,459,759 additional shares
will become eligible for sale during 1998. However, in connection with this
Offering, the holders of 3,679,941 shares of Common Stock (including all of the
Company's directors and officers, Sprint and all Selling Stockholders) have
entered into lock-up agreements under which they have agreed not to offer, sell
or otherwise dispose of any such shares of Common Stock, any such options or
warrants to acquire shares of Common Stock or any such securities convertible
into shares of Common Stock (or any shares of Common Stock issuable upon
exercise or conversion of such securities) owned by them for a period of 90 days
after the date of this Prospectus. Deutsche Bank Securities Inc. may, in its
sole discretion and at any time without notice, release all or any portion of
the securities subject to such lock-up agreements. Deutsche Bank Securities Inc.
currently has no plans to release any portion of the securities subject to such
lock-up agreements. The Company has agreed that it will not, directly or
indirectly, without the prior written consent of Deutsche Bank Securities Inc.
contract to sell, sell any option or contract to purchase, purchase any
option or contract to sell, grant any option right or warrant to purchase, or
otherwise transfer or dispose of any shares of Common Stock, or any securities
convertible into or exchangeable for Common Stock, for a period of 90 days from
the date of this Prospectus, except that the Company may grant additional
options under its 1995 Plan or Directors Plan or issue shares of Common Stock
under outstanding options, warrants and convertible securities.
The holders of substantially all of the shares of Common Stock issued prior
to the Company's initial public offering, including shares held by the Company's
founder and Chairman, its President and Chief Executive Officer, Sprint and
certain holders of warrants, are parties to registration rights agreements with
the Company that provide incidental or "piggyback" registration rights that
allow such holders, under certain circumstances, to include shares of Common
Stock in registration statements initiated by the Company or other stockholders.
Such registration rights agreements also permit demand registrations on Form S-3
registration statements, provided the Company is eligible to register securities
on such form. The number of shares sold in the public market could increase if
such rights are exercised. See "Description of Capital Stock--Registration
Rights."
In general, under Rule 144 as currently in effect, a person (or persons
whose shares are aggregated) who has beneficially owned "restricted shares" (as
defined in Rule 144) for at least one year (including the holding period of any
prior owner, except an affiliate) is entitled to sell, within any three month
period, a number of shares that does not exceed the greater of (i) one percent
of the number of
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<PAGE>
shares of Common Stock then outstanding or (ii) the average weekly trading
volume of the Common Stock on the Nasdaq National Market during the four
calendar weeks preceding the required filing of a Form 144 with respect to such
sale. Sales under Rule 144 are also subject to certain manner of sale provisions
and notice requirements and to the availability of current public information
about the Company. Under Rule 144(k), a person who is not deemed to have been an
affiliate at any time during the 90 days preceding a sale, and who has
beneficially owned the shares proposed to be sold for at least two years
(including the holding period of any prior owner except an affiliate), is
entitled to sell such shares without complying with the manner of sale, public
information, volume and other limitation or notice provisions of Rule 144. In
general, under Rule 701 of the Securities Act as currently in effect, any
employee, consultant or advisor of the Company who purchases shares from the
Company in connection with a compensatory stock or option plan or other written
agreement is eligible to resell such shares 90 days after the effective date of
the Company's initial public offering (which was completed in January 1997) in
reliance on Rule 144, but without compliance with certain restrictions,
including the holding period, contained in Rule 144.
77
<PAGE>
UNDERWRITING
The underwriters named below (the "Underwriters") have severally agreed,
subject to the terms and conditions contained in the Underwriting Agreement (the
form of which is filed as an exhibit to the Registration Statement of which this
Prospectus is a part), to purchase from the Company and the Selling Stockholders
the respective number of shares of Common Stock indicated opposite their
respective names below. The Underwriters are committed to purchase all of the
shares, if they purchase any.
<TABLE>
<CAPTION>
NUMBER OF
UNDERWRITER SHARES
- --------------------------------------------------------------------------------- -----------
<S> <C>
Deutsche Bank Securities Inc..................................................... 972,000
Invemed Associates, Inc.......................................................... 864,000
The Robinson-Humphrey Company, LLC............................................... 324,000
Cruttenden Roth, Inc............................................................. 48,000
Everen Securities, Inc........................................................... 96,000
Furman Selz LLC.................................................................. 96,000
-----------
2,400,000
</TABLE>
The Underwriting Agreement provides that the obligations of the Underwriters
thereunder are subject to approval of certain legal matters by counsel and to
various other conditions.
Pursuant to the Underwriting Agreement, the Company has granted the
Underwriters an option, expiring at the close of business on the 30th day after
the date of this Prospectus, to purchase up to 360,000 additional shares of
Common Stock at the Offering price, less the underwriting discounts and
commissions as set forth on the cover page of this Prospectus. Such option may
be exercised only to cover over-allotments in the sale of the shares of Common
Stock. To the extent such option is exercised, each Underwriter will be
committed, subject to certain conditions, to purchase approximately the same
percentage of such additional shares of Common Stock as the number set forth
opposite such Underwriters name in the preceding table bears to the total number
of shares offered hereby. The Company will be obligated, pursuant to the option,
to sell such shares to the Underwriters.
The Company has been advised by the Underwriters that they propose to offer
the Common Stock to the public initially on the terms set forth on the cover
page of this Prospectus. The Underwriters may allow certain dealers (who may
include the Underwriters) a concession not in excess of $1.80 per share under
the Offering price. The Underwriters and such dealers may reallow a concession
not in excess of $.10 per share on sales to other dealers, and other selling
terms may be changed by the Underwriters. After the Offering, the public
offering price and concessions to dealers may be changed by the Underwriters.
The Common Stock is offered subject to receipt and acceptance by the
Underwriters and to certain conditions, including the right to reject orders in
whole or in part. The Underwriters do not intend to sell any of the Common Stock
offered hereby to accounts for which they exercise discretionary authority.
In connection with this Offering, the Company, the executive officers and
directors of the Company, Sprint and the Selling Stockholders have entered into
"lock-up" agreements under which they have agreed, subject to limited
exceptions, not to offer, issue, sell or otherwise dispose of any such shares of
Common Stock, any such options or warrants to acquire shares of Common Stock or
any such securities convertible into shares of Common Stock (or any shares of
Common Stock issuable upon exercise or conversion of such securities) owned by
them for a period of 90 days after the date of this Prospectus, without the
prior written consent of Deutsche Bank Securities Inc. See "Shares Eligible for
Future Sale." The Company has agreed in the Underwriting Agreement that it will
not, directly or indirectly, without the prior written consent of Deutsche Bank
Securities Inc., contract to sell, sell any
78
<PAGE>
option or contract to purchase, purchase any option or contract to sell, grant
any option, right or warrant to purchase, or otherwise transfer or dispose of
any shares of Common Stock, or any securities convertible into or exchangeable
for Common Stock, for a period of 90 days after the date of this Prospectus,
except with respect to the issuance of shares of Common Stock issued pursuant to
any employee benefit plans, qualified stock option plans of other employee
compensation plans which are discussed herein.
Pursuant to the Underwriting Agreement, the Company and the Selling
Stockholders have agreed to indemnify the Underwriters against certain
liabilities, including civil liabilities under the Securities Act, or to
contribute to payments which the Underwriters may be required to make with
respect thereto.
At the request of the Company, the Underwriters are reserving up to 245,018
shares (assuming the over-allotment option is exercised in full) for sale to
Sprint in order to permit Sprint to fully exercise its subscription rights
pursuant to the Governance Agreement. The number of shares available for sale to
the general public in the Offering will be reduced to the extent Sprint elects
to purchase such reserved shares. Shares purchased by Sprint will be at the
Offering price as set forth on the cover page of this Prospectus. Sprint has
notified the Company that it intends to fully exercise its subscription rights.
However, any reserved shares not purchased by Sprint will be offered by the
Underwriters to the general public in the Offering. See "Description of Capital
Stock--Governance Agreement--Equity Purchases From the Company; Subscription
Rights."
As of December 31, 1997, Invemed Associates, Inc. ("Invemed"), one of the
Underwriters, and certain officers and employees of Invemed, held 56,815 shares
of Common Stock. In addition, two minority shareholders and directors of
Invemed's corporate parent own an aggregate of 6,817 shares of Common Stock.
Such Common Stock was purchased in September 1996 for $5.50 per share. Invemed
has agreed, for a period of 90 days following the date of this Prospectus, that
it will not sell, transfer, assign, pledge or hypothecate such shares other than
to another Underwriter or an officer of another Underwriter.
Certain persons participating in this Offering may over-allot or effect
transactions which stabilize, maintain or otherwise affect the market price of
the Common Stock at levels above those which might otherwise prevail in the open
market, including by entering stabilizing bids, imposing penalty bids or
otherwise. A stabilizing bid means the placing of any bid or effecting of any
purchase for the purpose of pegging, fixing or maintaining the price of the
Common Stock. A penalty bid means an arrangement that permits the Underwriters
to reclaim a selling concession from an Underwriter when shares of Common Stock
sold by the Underwriter are purchased in stabilization transactions. Such
transactions may be effected on the Nasdaq National Market, in the
over-the-counter market, or otherwise. Such stabilizing, if commenced, may be
discontinued at any time.
The Underwriters and dealers may engage in passive market making
transactions in the Common Stock in accordance with Rule 103 of Regulation M
promulgated by the SEC. In general, a passive market maker may not bid for, or
purchase, the Common Stock at a price that exceeds the highest independent bid.
In addition, the net daily purchases made by any passive market maker generally
may not exceed 30% of its average daily trading volume in the Common Stock
during a specified two month prior period, or 200 shares, whichever is greater.
A passive market maker must identify passive market making bids as such on the
Nasdaq electronic interdealer reporting system. Passive market making may
stabilize or maintain the market price of the Common Stock above independent
market levels. Underwriters and dealers are not required to engage in passive
market making and may end passive market making activities at any time.
Each of the Underwriters has represented and warranted to, and agreed with
the Company and the Selling Stockholders that (a) it has not offered or sold
and, prior to the expiry of six months from the closing of the Offering, will
not offer or sell any shares of Common Stock to persons in the United
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<PAGE>
Kingdom except to persons whose ordinary activities involve them in acquiring,
holding, managing or disposing of investments (as principal or agent) for the
purposes of their businesses or otherwise in circumstances which have not
resulted and will not result in an offer to the public in the United Kingdom
within the meaning of the Public Offers of Securities Regulations 1995 (the
"Regulations"); (b) it has complied and will comply with all applicable
provisions of the Financial Services Act 1986 with respect to anything done by
it in relation to any shares of Common Stock in, from or otherwise involving the
United Kingdom; and (c) it has only issued or passed on and will only issue and
pass on to any person in the United Kingdom any document received by it in
connection with the issue of the shares of Common Stock if that person is of a
kind described in Article 11(3) of the Financial Services Act 1986 (Investment
Advertisements (Exemptional Offer 1996, as amended, or is a person to whom such
document may otherwise lawfully be issued or passed on.
No action has been taken in any jurisdiction by the Company, the Selling
Stockholders or the Underwriters that would permit a public offering of the
Common Stock offered hereby, other than in the United States in the context of
the Offering. No offer or sale of Common Stock may be made in any jurisdiction
except under circumstances that will result in compliance with the applicable
laws thereof. Persons to whom this Prospectus is delivered are required by the
Company, the Selling Stockholders the Underwriters to inform themselves about
and to observe any restrictions as to the offering of the Common Stock and the
distribution of this Prospectus.
LEGAL MATTERS
The validity of the issuance of the shares of Common Stock offered hereby
will be passed upon for the Company by Hunton & Williams, Atlanta, Georgia.
Certain legal matters in connection with the Offering will be passed upon for
the Underwriters by Wilson Sonsini Goodrich & Rosati, Professional Corporation,
Palo Alto, California.
EXPERTS
The financial statements of EarthLink Network, Inc. as of December 31, 1996
and 1997 and for each of the three years in the period ended December 31, 1997
and the statement of assets acquired and liabilities assumed of the Sprint
Internet Passport Business acquired by EarthLink Network, Inc. as of June 5,
1998 included in this Prospectus have been so included in reliance on the
reports of Price Waterhouse LLP, independent accountants, given on the authority
of said firm as experts in auditing and accounting.
The statement of revenues and direct expenses of Consumer Internet Access
Services of Sprint for the year ended December 31, 1997, appearing in this
Prospectus and in the Registration Statement have been audited by Ernst & Young
LLP, independent auditors, as set forth in their report thereon appearing
elsewhere herein, and are included in reliance upon such report given upon the
authority of such firm as experts in accounting and auditing.
ADDITIONAL INFORMATION
The Company is subject to the reporting requirements of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance
therewith, files reports, proxy statements and other information with the
Securities and Exchange Commission ("SEC"). Such reports, proxy statements and
other information may be inspected and copied at the public reference facilities
maintained by the SEC at 450 Fifth Street, N.W., Washington, D.C. 20549 and at
the SEC's regional offices located at the Northwestern Atrium Center, 500 West
Madison Street, Suite 1400, Chicago, IL 60661 and Seven World Trade Center, 13th
Floor, New York, NY 10048. Copies of such material can be obtained from the
Public Reference Section of the SEC upon payment of certain fees prescribed by
the SEC. The SEC maintains a
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<PAGE>
World Wide Web site that contains reports, proxy and information statements and
other information regarding registrants that file electronically with the SEC.
The address of that site is http://www.sec.gov. The Common Stock is quoted on
the Nasdaq National Market and reports, proxy statements and other information
concerning the Company also may be inspected at the offices of Nasdaq
Operations, 1735 K Street, N.W., Washington, D.C. 20006.
The Company has filed a Registration Statement on Form S-1 with the SEC
under the Securities Act in respect of the Common Stock offered hereby. This
Prospectus, which constitutes part of the Registration Statement, omits certain
information contained in the Registration Statement as permitted by the rules
and regulations of the SEC. For further information with respect to the Company
and the Common Stock offered hereby, reference is made to the Registration
Statement, including the exhibits thereto. Statements herein concerning the
contents of any contract or other document filed with the SEC as an exhibit to
the Registration Statement are not necessarily complete and are qualified in all
respects by such reference. Copies of the Registration Statement, including all
exhibits and schedules thereto, may be inspected without charge at the public
reference facilities maintained by the SEC, or obtained at prescribed rates from
the Public Reference Section of the SEC at the address set forth above.
81
<PAGE>
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
EARTHLINK NETWORK, INC. PAGE
---------
<S> <C>
Report of Independent Accountants.................................................... F-2
Balance Sheet as of December 31, 1996 and 1997 and March 31, 1998 (unaudited)........ F-3
Statement of Operations for the years ended December 31, 1995, 1996, 1997 and the
three months ended March 31, 1997 and 1998 (unaudited)............................. F-4
Statement of Stockholders' Equity (Deficit) for the years ended December 31, 1995,
1996 and 1997 and the three months ended March 31, 1998 (unaudited)................ F-5
Statement of Cash Flows for the years ended December 31, 1995, 1996 and 1997 and the
three months ended March 31, 1997 and 1998 (unaudited)............................. F-6
Notes to Financial Statements........................................................ F-7
CONSUMER INTERNET ACCESS SERVICES OF SPRINT CORPORATION
Report of Independent Auditors....................................................... F-20
Statements of Revenues and Direct Expenses........................................... F-21
Note to Statements of Revenues and Direct Expenses................................... F-22
EARTHLINK NETWORK, INC.
Report of Independent Accountants.................................................... F-23
Statement of Assets Acquired and Liabilities Assumed of the Sprint Internet Passport
Business as of June 5, 1998........................................................ F-24
Note to Statement of Assets Acquired and Liabilities Assumed......................... F-25
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of EarthLink Network, Inc.
In our opinion, the accompanying balance sheet and the related statements of
operations, of changes in stockholders' equity (deficit) and of cash flows
present fairly, in all material respects, the financial position of EarthLink
Network, Inc. at December 31, 1996 and 1997, and the results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles. 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 of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
PRICE WATERHOUSE LLP
Costa Mesa, California
June 5, 1998
F-2
<PAGE>
EARTHLINK NETWORK, INC.
BALANCE SHEET
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1997
--------- ---------
MARCH 31,
1998
-----------
(UNAUDITED)
(IN THOUSANDS)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.................................................. $ 3,993 $ 16,450 $ 16,715
Restricted short-term investment........................................... 1,087 1,250 1,250
Accounts receivable, net of allowance of $781,000, $165,000 and $165,000 at
December 31, 1996 and 1997 and March 31, 1998, respectively.............. 1,725 2,520 2,923
Prepaid expenses........................................................... 885 1,109 1,904
Deferred transaction costs................................................. -- -- 1,270
Other assets (Note 5)...................................................... 1,383 753 427
--------- --------- -----------
Total current assets..................................................... 9,073 22,082 24,489
Other long-term assets (Note 5).............................................. 329 449 563
Property and equipment, net (Notes 1 and 4).................................. 17,401 23,398 26,465
Intangibles, net (Notes 3, 6 and 9).......................................... 316 958 575
--------- --------- -----------
$ 27,119 $ 46,887 $ 52,092
--------- --------- -----------
--------- --------- -----------
LIABILITIES, MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED
STOCK AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Trade accounts payable..................................................... $ 11,207 $ 6,472 $ 10,128
Accrued payroll and related expenses....................................... 1,469 2,316 2,698
Other accounts payable and accrued liabilities............................. 2,061 3,717 6,873
Current portion of capital lease obligations (Note 11)..................... 3,582 7,112 7,692
Notes payable (Note 7)..................................................... 7,950 9,387 5,585
Deferred revenue........................................................... 2,010 3,590 4,385
--------- --------- -----------
Total current liabilities................................................ 28,279 32,594 37,361
Long-term debt (Note 11)..................................................... 6,088 8,218 8,257
--------- --------- -----------
Total liabilities........................................................ 34,367 40,812 45,618
Commitments and contingencies (Note 11)
Mandatorily redeemable convertible preferred stock (Note 8).................. 14,013 -- --
Stockholders' equity (deficit):
Preferred stock, $0.01 par value, 25,000,000 shares authorized, 2,727,273,
nil and nil shares outstanding as redeemable preferred stock at December
31, 1996 and 1997 and March 31, 1998, respectively (Note 8).............. -- -- --
Common stock, $0.01 par value, 50,000,000 shares authorized, 6,022,724,
11,250,372 and 11,997,884 shares issued and outstanding at December 31,
1996 and 1997 and March 31, 1998, respectively (Note 8).................. 60 112 120
Additional paid-in capital................................................. 14,236 70,942 77,677
Warrants to purchase common stock (Note 9)................................. 599 1,093 1,153
Accumulated deficit........................................................ (36,156) (66,072) (72,476)
--------- --------- -----------
Total stockholders' equity (deficit)..................................... (21,261) 6,075 6,474
--------- --------- -----------
$ 27,119 $ 46,887 $ 52,092
--------- --------- -----------
--------- --------- -----------
</TABLE>
The accompanying notes are an integral part of these financial statements
F-3
<PAGE>
EARTHLINK NETWORK, INC
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------------- --------------------
1995 1996 1997 1997 1998
--------- --------- --------- --------- ---------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
<CAPTION>
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
Revenues:
Recurring revenues....................... $ 2,422 $ 26,879 $ 72,943 $ 14,086 $ 27,270
Other revenues........................... 606 5,624 6,231 1,632 1,578
Incremental revenues..................... -- -- -- -- 392
--------- --------- --------- --------- ---------
Total revenues......................... 3,028 32,503 79,174 15,718 29,240
--------- --------- --------- --------- ---------
Operating costs and expenses:
Cost of recurring revenues............... 1,055 18,462 37,974 7,955 14,506
Cost of other revenues................... 349 2,699 3,401 915 705
Sales and marketing...................... 3,711 15,258 21,020 4,961 5,916
General and administrative............... 2,062 10,534 14,333 3,502 4,513
Operations and member support............ 1,869 15,808 30,900 6,422 9,540
--------- --------- --------- --------- ---------
Total operating costs and expenses..... 9,046 62,761 107,628 23,755 35,180
--------- --------- --------- --------- ---------
Loss from operations..................... (6,018) (30,258) (28,454) (8,037) (5,940)
Interest expense......................... (136) (1,041) (2,099) (507) (687)
Interest income.......................... 34 150 637 165 223
--------- --------- --------- --------- ---------
Net loss............................. $ (6,120) $ (31,149) $ (29,916) $ (8,379) $ (6,404)
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Basic and diluted net loss per share (Note
1)....................................... $ (1.59) $ (5.13) $ (2.99) $ (0.92) $ (0.56)
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Weighted average shares outstanding
(Note 1)................................. 3,837 6,069 10,001 9,094 11,373
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements
F-4
<PAGE>
EARTHLINK NETWORK, INC.
STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
TOTAL
COMMON STOCK ADDITIONAL SHAREHOLDERS'
---------------------- PAID-IN WARRANTS ACCUMULATED EQUITY
SHARES AMOUNT CAPITAL ISSUED DEFICIT (DEFICIT)
--------- ----------- ----------- ----------- ----------- ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1994......... 2,941 $ 29 $ 147 $ 69 $ (148) $ 97
Issuance of common stock............. 2,116 22 6,236 -- -- 6,258
Reclassification of S Corporation
accumulated deficit................ -- -- (1,261) -- 1,261 --
Warrants issued for lease guarantee
(Note 9)........................... -- -- -- 50 -- 50
Warrants issued for non-competition
agreement (Note 9)................. -- -- -- 5 -- 5
Net loss......................... -- -- -- -- (6,120) (6,120)
--------- ----- ----------- ----------- ----------- ------------
Balance at December 31, 1995......... 5,057 51 5,122 124 (5,007) 290
Issuance of common stock............. 923 9 8,651 -- -- 8,660
Issuance of common stock for
services........................... 43 -- 463 -- -- 463
Warrants issued in connection with
equipment leases and other
financings (Note 9)................ -- -- -- 475 -- 475
Net loss......................... -- -- -- -- (31,149) (31,149)
--------- ----- ----------- ----------- ----------- ------------
Balance at December 31, 1996......... 6,023 60 14,236 599 (36,156) (21,261)
Initial public offering, net of
expenses........................... 2,000 20 22,766 -- -- 22,786
Conversion of redeemable preferred
stock into common stock............ 1,364 13 14,000 -- -- 14,013
Conversion of debt to common stock... 56 -- 725 -- -- 725
Underwriters over-allotment.......... 285 3 3,437 -- -- 3,440
Issuance of common stock in
connection with private
placement.......................... 1,460 15 15,394 -- -- 15,409
Issuance of common stock pursuant to
exercise of stock options.......... 62 1 384 -- -- 385
Warrants issued in exchange for
services (Note 9).................. -- -- -- 494 -- 494
Net loss......................... -- -- -- -- (29,916) (29,916)
--------- ----- ----------- ----------- ----------- ------------
Balance at December 31, 1997......... 11,250 112 70,942 1,093 (66,072) 6,075
Unaudited:
Conversion of debt to common
stock............................ 392 4 4,996 -- -- 5,000
Issuance of common stock for
services......................... 10 -- 130 -- -- 130
Issuance of common stock pursuant
to exercise of stock options..... 345 4 1,609 -- -- 1,613
Warrants issued in exchange for
services (Note 9)................ -- -- -- 60 -- 60
Net loss....................... -- -- -- -- (6,404) (6,404)
--------- ----- ----------- ----------- ----------- ------------
Balance at March 31, 1998
(unaudited)........................ 11,997 $ 120 $ 77,677 $ 1,153 $ (72,476) $ 6,474
--------- ----- ----------- ----------- ----------- ------------
--------- ----- ----------- ----------- ----------- ------------
</TABLE>
The accompanying notes are an integral part of these financial statements
F-5
<PAGE>
EARTHLINK NETWORK, INC.
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------------- --------------------
<S> <C> <C> <C> <C> <C>
1995 1996 1997 1997 1998
--------- --------- --------- --------- ---------
(UNAUDITED)
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Cash flows from operating activities:
Net loss.............................................. $ (6,120) $ (31,149) $ (29,916) $ (8,379) $ (6,404)
Adjustments to reconcile net loss to net cash provided
by (used in) operating activities:
Depreciation and amortization....................... 305 4,153 9,377 1,880 2,989
Provision for doubtful accounts receivable.......... -- 781 (615) (615) --
Issuance of common stock in exchange for
professional services............................. -- 50 -- -- --
Issuance of common stock in exchange for termination
of consulting agreement........................... -- 413 -- -- --
Issuance of warrants in exchange for professional
services.......................................... -- -- 494 -- 60
Increase in accounts receivable..................... (191) (2,288) (180) 408 (403)
(Increase) decrease in prepaid expenses and other
assets............................................ (141) (2,353) 202 360 (583)
Increase (decrease) in accounts payable and accrued
liabilities....................................... 2,292 12,373 (2,232) (6,139) 7,194
Increase in deferred revenue........................ 212 1,798 1,580 384 795
--------- --------- --------- --------- ---------
Net cash (used in) provided by operating
activities...................................... (3,643) (16,222) (21,290) (12,101) 3,648
--------- --------- --------- --------- ---------
Cash flows from investing activities:
Purchases of property and equipment................... (2,766) (18,774) (14,528) (4,786) (5,664)
Purchase of restricted short-term investment.......... (1,500) (1,087) (200) -- --
Liquidation of restricted short-term investment....... -- 1,500 37 -- --
Purchase of member base............................... -- -- (1,404) -- --
Purchase of intangible assets......................... -- -- -- -- (9)
Deferred transaction costs............................ -- -- -- -- (1,270)
--------- --------- --------- --------- ---------
Net cash used in investing activities............. (4,266) (18,361) (16,095) (4,786) (6,943)
--------- --------- --------- --------- ---------
Cash flows from financing activities:
Proceeds from (payment of) line of credit............. 1,494 (1,494) 4,387 -- --
(Payment of) proceeds from notes payable.............. (67) 7,950 (2,225) (2,225) 1,198
Proceeds from capital lease obligations............... 556 11,348 10,544 2,783 2,513
Principal payments under capital lease obligations.... (42) (2,191) (4,884) (886) (1,894)
Proceeds from issuance of mandatorily redeemable
convertible preferred stock......................... -- 14,013 -- -- --
Proceeds from initial public offering................. -- -- 26,226 26,371 --
Proceeds from stock options and warrants exercised.... -- -- 385 -- 1,743
Proceeds from private placements of common stock...... 6,258 8,660 15,409 -- --
--------- --------- --------- --------- ---------
Net cash provided by financing activities......... 8,199 38,286 49,842 26,043 3,560
--------- --------- --------- --------- ---------
Net increase in cash and cash equivalents............... 290 3,703 12,457 9,156 265
Cash and cash equivalents, beginning of year............ -- 290 3,993 3,993 16,450
--------- --------- --------- --------- ---------
Cash and cash equivalents, end of period................ $ 290 $ 3,993 $ 16,450 $ 13,149 $ 16,715
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
</TABLE>
The accompanying notes are an integral part of these financial statements
F-6
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
EarthLink Network, Inc. ("EarthLink" or the "Company") was organized on May
26, 1994 as a California corporation and reincorporated in 1996 as a Delaware
corporation. The Company is an Internet service provider that was formed to help
members derive meaningful benefits from the extensive resources of the Internet.
The Company has experienced operating losses since inception as a result of
efforts to build its network infrastructure and internal staffing, develop its
systems, and expand into new markets. The Company expects that it will continue
to incur net losses as it continues to expend substantial resources on sales and
marketing as it attempts to rapidly increase its market share. There can be no
assurance that the Company will achieve or sustain profitability or positive
cash flow from its operations.
REVENUES
Recurring revenues consists of monthly fees charged to members for Internet
access and other ongoing services from monthly Internet service and are
recognized over the period services are provided. Other revenues generally
represent one-time non-refundable set up fees. Such revenues are recorded as
earned.
CASH AND CASH EQUIVALENTS
All highly liquid investments with an original maturity of three months or
less at the date of acquisition are classified as cash equivalents.
ACCOUNTS RECEIVABLE AND DEFERRED REVENUES
Commencing in 1995, the Company began to bill for Internet service generally
one month in advance. Accordingly, these non-cancelable advanced billings are
included in both accounts receivable and deferred revenue.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to concentrations
of credit risk consist principally of cash investments and trade receivables.
The Company's cash investment policies limit investments to short-term,
investment grade instruments. Concentrations of credit risk with respect to
trade receivables are limited due to the large number of members comprising the
Company's member base.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated using the
straight-line method over the estimated useful life of the assets, which is
generally three years for computers and computer related equipment and five
years for other non-computer furniture and equipment. Leasehold improvements are
amortized using the straight-line method over the shorter of their estimated
lives or the term of the lease, ranging from one to ten years.
F-7
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EQUIPMENT UNDER CAPITAL LEASE
The Company leases certain of its data communications and other equipment
under capital lease agreements. The assets and liabilities under capital lease
are recorded at the lesser of the present value of aggregate future minimum
lease payments, including estimated bargain purchase options, or the fair value
of the assets under lease. Assets under capital lease are amortized over the
lesser of their estimated useful lives of three to five years or the term of the
lease.
INTANGIBLES
Intangible assets consist primarily of deferred financing and professional
service costs, prepaid lease guarantee costs, goodwill, rights to client lists
and a covenant not to compete. The costs assigned to intangible assets are being
amortized on a straight-line basis over the estimated useful lives of the
assets, which range from one to three years. The Company regularly reviews the
recoverability of intangible assets based on estimated undiscounted future cash
flows from operating activities compared with the carrying values of the
intangibles.
ADVERTISING AND CUSTOMER ACQUISITION COSTS
Advertising and customer acquisition costs are included in sales and
marketing. Such costs are expensed as incurred. Advertising expenses were
$937,000, $3.2 million and $5.1 million, respectively, for the three years ended
December 31, 1997.
INCOME TAXES
Income taxes are accounted for under the liability method. Under this
method, deferred tax assets and liabilities are determined based on differences
between the financial reporting basis and tax basis of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse.
NET LOSS PER SHARE
The Company adopted Statement of Financial Accounting Standards (SFAS) No.
128, "Earnings per Share" ("EPS") and Staff Accounting Bulletin (SAB) No. 98.
SAB No. 98 states that companies, such as EarthLink, that completed an initial
public offering ("IPO") within the past 5 years and incorporated the SAB No. 83
concept of "cheap stock" in determining pre-IPO EPS data must restate all EPS
data to conform to SFAS No. 128. Accordingly, all EPS data have been restated to
conform to SFAS No. 128. SFAS No. 128 requires a dual presentation of basic and
diluted EPS. Basic EPS represents the weighted average number of shares divided
into net income 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 since inception as
such inclusion would have an anti-dilutive effect.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements
F-8
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
COMMON STOCK BASED COMPENSATION
The Company continues to account for its employee stock based compensation
in accordance with the provisions of APB 25 and provides pro forma disclosures
in the notes to the financial statements (Note 9), as if the measurement
provisions of SFAS No. 123 had been adopted.
RECLASSIFICATION
Certain amounts in the prior year financial statements have been
reclassified to conform to current year presentation.
UNAUDITED INTERIM INFORMATION
The information presented as of March 31, 1998, and for the three month
periods ended March 31, 1997 and 1998, has not been audited. In the opinion of
management, the unaudited interim financial statements included all adjustments,
consisting only of normal recurring adjustments, necessary to present fairly the
Company's financial position as of March 31, 1998, and the results of its
operations and its cash flows for the three months ended March 31, 1997 and
1998, and the stockholders' deficit for the three months ended March 31, 1998.
2. PURCHASE OF CERTAIN ASSETS FROM BECKEMEYER DEVELOPMENT TECHNOLOGIES
In order to recruit the principal shareholder of Beckemeyer Development
Technologies ("BDT") to serve as the Company's Vice President of Engineering, on
November 7, 1995, the Company agreed to purchase all fixtures, equipment, and
the client list of BDT for cash of $64,000. In addition to the above, the
principal shareholder was issued warrants to purchase 10,330 shares of the
Company's Common Stock at $4.84 per share as consideration for an agreement not
to compete for a two-year period. The value assigned to the warrants was $5,000
based upon an appraisal obtained by the Company. The warrants expire October 10,
2005. This purchase price was allocated to the assets acquired with the
remainder reflected as an intangible asset. At the time of purchase, BDT was not
material to the results of operations, financial position or customer base of
EarthLink.
3. PURCHASE OF CERTAIN ASSETS FROM INTERNET IN A MALL
In April 1997, the Company purchased the subscribers and related assets,
including accounts receivable related to the consumer dial-up Internet access
service of Internet in a Mall, a Tarzana, California based Internet access
provider. Under the terms of the agreement, as amended, the Company purchased
rights to approximately 28,000 subscriber accounts as of April 1997.
F-9
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
4. PROPERTY AND EQUIPMENT
Property and equipment consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------
1996 1997
--------- ----------
<S> <C> <C>
(IN THOUSANDS)
Data communications equipment......................................... $ 11,464 $ 17,056
Office and other equipment............................................ 6,686 12,196
Leasehold improvements................................................ 646 5,013
Construction in progress.............................................. 2,841 1,901
--------- ----------
21,637 36,166
Less accumulated depreciation and amortization........................ (4,236) (12,768)
--------- ----------
$ 17,401 $ 23,398
--------- ----------
--------- ----------
</TABLE>
Property under capital lease, primarily data communications equipment
included above, aggregated $11,904,000, and $22,448,000 at December 31, 1996 and
1997, respectively. Included in accumulated depreciation and amortization are
amounts related to property under capital lease of $2,896,000 and $8,528,000 at
December 31, 1996 and 1997, respectively. Depreciation expense charged to
operations was $305,000, $3,924,000 and $8,531,000 in 1995, 1996, and 1997,
respectively, and included $56,000, $2,840,000 and $5,632,000, respectively,
pertaining to property under capital lease.
5. OTHER ASSETS
Other assets consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1997
--------- ---------
<S> <C> <C>
(IN THOUSANDS)
Deposits................................................................. $ 409 $ 789
Deferred offering costs.................................................. 804 --
Inventory................................................................ 499 413
--------- ---------
$ 1,712 $ 1,202
--------- ---------
--------- ---------
</TABLE>
6. INTANGIBLE ASSETS
Intangible assets consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1996 1997
--------- ---------
<S> <C> <C>
(IN THOUSANDS)
Deferred financing costs.................................................. $ 347 $ 430
Rights to client lists.................................................... 10 1,414
Other..................................................................... 188 188
--------- ---------
545 2,032
Less accumulated amortization............................................. (229) (1,074)
--------- ---------
$ 316 $ 958
--------- ---------
--------- ---------
</TABLE>
F-10
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
7. NOTES PAYABLE
In June 1996, the Company issued to 17 investors, 10% Promissory Notes
aggregating $2,950,000. Certain of the investors were directors and stockholders
of the Company. As described in Note 9, the Company issued warrants valued at
$116,000 to the note holders. The fair value of the warrants was recorded as
deferred financing costs and amortized as interest expense over the life of the
notes. Upon consummation of the Company's initial public offering on January 22,
1997, the holders of $725,000 of the 10% Promissory Notes converted their
indebtedness into 55,767 shares of Common Stock. In January 1997, the Company
repaid the $2,225,000 balance remaining on the 10% Promissory Notes.
The Company has a convertible note payable to UUNET Technologies, Inc.
("UUNET"). The $5 million Convertible Note was extended one year, and, as such,
the entire amount is due October 31, 1998, if not converted. The Convertible
Note will become due and payable immediately if the monthly amounts payable
under Company's Network Service Agreement with UUNET (the "UUNET Agreement") are
less than $1.5 million during any consecutive three months. The Convertible Note
bears interest at 10.25% and is convertible into a maximum of 391,515 shares of
Common Stock at a conversion price of $12.88 per share.
8. CAPITAL STOCK AND MANDATORILY REDEEMABLE EQUITY SECURITIES
COMMON STOCK
The Company issued 367,155 shares of Common Stock at $0.82 per share,
827,085 shares of Common Stock at $1.81 per share and 921,745 at $4.84 per share
on March 10, 1995, June 19, 1995 and October 31, 1995, respectively. As a result
of these placements, the Company raised, in the aggregate $6,258,000 during
1995. The Company issued 45,485 shares of Common Stock at $4.84 per share and
25,000 shares of Common Stock at $4.84 per share on January 18, 1996 and March
20, 1996, respectively. On May 6, 1996, the Company issued 852,460 shares of
Common Stock at $9.76 per share in a private placement. As a result of these
placements, EarthLink raised, in the aggregate, $8,660,000 during 1996. On
September 19, 1997, the Company closed a private placement of 1,459,759 shares
of its unregistered restricted Common Stock. Net proceeds from the offering were
approximately $15.4 million.
MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
On September 10, 1996, the Company issued 2,727,273 shares of its Series A
Redeemable Convertible Preferred Stock to investors including among others,
certain directors, stockholders and the Underwriter associated with the
Company's initial public offering and certain of its associates for $15,000,000.
Stock issuance costs of $987,000 have been charged to redeemable convertible
preferred stock. Each two shares of the Series A Redeemable Convertible
Preferred Stock was automatically converted into one share of Common Stock upon
consummation of the initial public offering of the Company's Common Stock on
January 22, 1997.
INITIAL PUBLIC OFFERING
On January 22, 1997 the Company commenced its initial public offering. The
offering consisted of 2,000,000 shares of Common Stock issued at $13 per share.
Net proceeds to the Company were approximately $22.8 million. Upon consummation
of the offering 2,727,273 shares of the Company's Series A Redeemable
Convertible Preferred Stock were converted to 1,363,624 shares of Common Stock.
In February 1997, the Underwriter exercised its over-allotment option and
purchased 284,750 shares at the initial public offering price of $13.00. Net
proceeds to the Company were approximately $3.4 million.
F-11
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
8. CAPITAL STOCK AND MANDATORILY REDEEMABLE EQUITY SECURITIES (CONTINUED)
COMMON STOCK ISSUANCES FOR OTHER THAN CASH
In May 1996, the Company issued 5,122 shares of Common Stock at $9.76 per
share, to a sub-contractor in lieu of cash for services provided to the Company.
In September 1996, the Company issued 37,500 shares of Common Stock at $11.00
per share as consideration for the termination of a consulting agreement.
9. STOCK OPTIONS AND WARRANTS
STOCK OPTIONS
1995 STOCK OPTION PLAN
In September 1995, the Company established the EarthLink Network 1995 Stock
Option Plan (the "1995 Plan"). The 1995 Plan provides for the grant of incentive
stock options to purchase up to 1,250,000 shares of common stock to employees of
the Company and non-qualified stock options to employees, officers, directors
and consultants of the Company. The 1995 Plan is administered by a committee
appointed by the Board which determines the terms of the options granted,
including the exercise price, the number of shares subject to option, and the
option vesting period. The exercise price of all options granted under the plan
must be at least 100% of the fair market value on the date of grant. Options
generally vest in equal quarterly increments over a five year period. As of
December 31, 1997, 87,432 shares remain available for issuance under the 1995
Plan.
DIRECTORS STOCK OPTION PLAN
In September 1995, the Company established the EarthLink Directors Stock
Option Plan (the "Directors Plan"). The Directors Plan, as amended and restated
in December 1996, provides for the grant of options to purchase an aggregate of
62,500 shares of Common Stock to directors who do not also serve as employees of
the Company and do not beneficially own, nor are employees, directors or
officers of any entity which owns 5% or more of the outstanding shares of the
Company's capital stock. Under the Directors Plan, grants of options to purchase
10,000 and 2,500 shares of Common Stock are automatically made to each
non-management director at such time as the person first becomes a member of the
Board of Directors and at the beginning of each fiscal year, respectively.
Options generally vest in equal quarterly increments over a five year period. As
of December 31, 1997, there were no outstanding options to purchase shares of
Common Stock under the Directors Plan.
NON-QUALIFIED OPTION GRANTS
In addition to the options granted under the plans described above, the
Company granted non-qualified stock options to certain employees, officers and
directors. Non-qualified options generally have a maximum term of ten years and
generally vest in equal quarterly increments over a five-year period.
VALUE OF OPTIONS GRANTED TO EMPLOYEES
For disclosure purposes the fair value of all stock options granted is
estimated using the Black-Scholes option-pricing model with the following
weighted average assumptions used for stock options granted in 1997: no annual
dividends, expected volatility of 69%, risk-free interest rate of 6.49%, and
expected life of 6.6 years. For 1995 and 1996, the fair value of each option
grant is estimated on the date of grant using the minimum value method with the
following assumptions used for grants during both periods: dividend yield of
0.0%, risk free interest rate of 5.83% and expected option term of 10 years.
F-12
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. STOCK OPTIONS AND WARRANTS (CONTINUED)
Had compensation cost been determined on the basis of fair value pursuant to
SFAS No. 123, net loss and net loss per share would have been increased as
follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1995 1996 1997
--------- --------- ---------
<S> <C> <C> <C>
(IN THOUSANDS)
Net loss:
As reported................................................................... $ 6,120 $ 31,149 $ 29,916
--------- --------- ---------
--------- --------- ---------
Pro forma..................................................................... $ 6,145 $ 31,477 $ 30,737
--------- --------- ---------
--------- --------- ---------
Basic and diluted net loss per share:
As reported................................................................... $ 1.59 $ 5.13 $ 2.99
--------- --------- ---------
--------- --------- ---------
Pro forma..................................................................... $ 1.60 $ 5.19 $ 3.07
--------- --------- ---------
--------- --------- ---------
</TABLE>
WARRANTS
The Company has issued to certain Board members, consultants, lessors,
creditors and others warrants to purchase shares of the Company's Common Stock.
In September 1995, certain stockholders guaranteed a $500,000 lease for
networking equipment. The Company issued warrants to purchase 50,000 shares of
Common Stock at $1.81 per share, valued at $25,000, based upon an appraisal
obtained by the Company, as consideration for this guarantee. These warrants
expire August 31, 2000.
In December 1995, certain stockholders provided the Company with a $250,000
Irrevocable Standby Letter of Credit as a performance guarantee for a real
estate lease. In conjunction with this transaction the Company issued warrants
to purchase 50,000 shares at $4.84 per share, valued at $25,000, based upon an
appraisal obtained by the Company. These warrants expire December 1, 2000.
In January 1996, certain stockholders guaranteed a $1,500,000 lease for
networking equipment. The Company issued warrants to purchase 100,000 shares of
Common Stock at $4.84 per share. The fair value of the warrants has been
reflected in intangible assets. These warrants expire January 11, 2001.
In January 1996, the Company issued warrants to purchase 100,000 shares of
Common Stock at $4.84 to Board members. The warrants vest quarterly over five
years. As these warrants were issued for service on the Board of Directors they
are accounted for under APB 25 and as such are included in the summary of
non-qualified options and are not included in the summary of warrant grants.
In January 1996, LINC Capital Partners, Inc. ("LINC") provided a $1,500,000
lease line for equipment. The Company issued warrants to LINC to purchase 50,000
shares of Common Stock at $4.84 per share. The fair value of the warrants has
been reflected as deferred financing costs. These warrants expire January 18,
2006.
F-13
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. STOCK OPTIONS AND WARRANTS (CONTINUED)
In February 1996, Boston Financial & Equity Corporation ("Boston Financial")
provided a $700,000 lease line for equipment. The Company issued warrants to
Boston Financial to purchase 5,000 shares of Common Stock at $9.76 per share.
The fair value of the warrants has been reflected as deferred financing costs.
These warrants expire February 15, 2006.
In May 1996, the Company issued warrants to purchase 45,477 shares of Common
Stock at $9.76 per share to various lessors in return for lease lines and other
services to the Company. The fair value of the warrants has been reflected as
deferred financing costs. The warrants expire on May 10, 2006.
In May 1996, in connection with the amendment and restatement of the UUNET
Agreement, the Company agreed to issue warrants to purchase 10,000 shares of
Common Stock at an exercise price of $20.00 per share. The fair value of the
warrants has been reflected as deferred financing costs.
In connection with the issuance of 10% Promissory Notes aggregating
$2,950,000, the Company issued to the lenders warrants to purchase an aggregate
of 98,340 shares of Common Stock at an exercise price of $11.00 per share, as
adjusted. The fair value of the warrants has been reflected as deferred
financing costs.
In connection with the execution of the PSINet, Inc. ("PSINet") agreement in
July 1996 (Note 11), the Company issued warrants to purchase 100,000 shares of
Common Stock at an exercise price of $20.00 per share. The fair value of the
warrants has been reflected as deferred financing costs.
In connection with the private placement of Series A Redeemable Convertible
Preferred Stock, described above, the Company granted to certain purchasers of
the Series A Redeemable Convertible Preferred Stock warrants to purchase 100,000
shares of Common Stock at $11.00 per share.
WARRANTS ISSUED FOR SERVICES
In May 1996, the Company entered into an agreement with NMC, a producer of
infomercials and commercials, pursuant to which NMC agreed to produce and
broadcast commercials for EarthLink's services in exchange for warrants. Upon
completion of the infomercial in April 1997, the Company issued warrants to NMC
to purchase 50,000 shares of Common Stock, having an exercise price of $9.76 per
share. In September 1997, the parties orally agreed to rescind the agreement.
The rescission agreement included the return of the 50,000 warrants and the
cancellation of any future obligations of either party. However, the rescission
agreement was never executed and thus may be considered non-operative. The fair
value of the warrants, $76,000, has been recorded as prepaid advertising and
will be expensed upon airing of the infomericals.
In January 1997 and October 1997, the Company issued warrants to purchase
6,000 and 25,000 shares, respectively, of the Company's Common Stock to certain
consultants. The respective exercise prices of the warrants were $13.00 and
$17.75. The fair value of the warrants is reflected as prepaid consulting fees
and amortized ratably over the life of the consulting agreement. Consulting
expense recorded with respect to warrants issued to consultants was $23,340
during 1997.
In September 1996, the Company issued warrants to purchase 7,500 shares of
the Company's Common Stock at $11.00 per share to each of the three members of
the Company's Technology Advisory Council. The warrants vest quarterly over two
years. The fair value of the warrants is reflected as
F-14
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. STOCK OPTIONS AND WARRANTS (CONTINUED)
deferred professional services expense and amortized ratably over the member's
two year term of service in the Technology Advisory Council.
In March 1997 and October 1997, the Company issued warrants to purchase
7,500 shares of the Company's Common Stock to each of two new members of the
Company's Technology Advisory Council. The warrants have an exercise price of
$10.50 per share and $17.75 per share, respectively, and vest quarterly over two
years. The fair value of the warrants is reflected as deferred professional
services expense and amortized ratably over the member's two year term of
service in the Technology Advisory Council.
Following is a summary of stock option and warrant activity during the three
years ended December 31, 1997:
<TABLE>
<CAPTION>
NUMBER OF SHARES OF COMMON STOCK
-------------------------------------- WEIGHTED
INCENTIVE AVERAGE
STOCK NON-QUALIFIED PRICE PER EXERCISE
OPTIONS STOCK OPTIONS WARRANTS SHARE PRICE
----------- -------------- --------- -------------- -----------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994................ -- -- 150,000 $ 1.81 $ 1.81
Granted..................................... 232,500 425,000 110,330 $ 0.60- 4.84 $ 3.04
Forfeited................................... -- (60,209) -- $ 0.60 $ 0.60
----------- -------------- --------- --------------
Balance at December 31, 1995................ 232,500 364,791 260,330 $ 1.81- 4.84 $ 3.00
Granted..................................... 806,250 175,000 531,317 $ 1.81-20.00 $ 9.14
Forfeited................................... (10,500) -- -- $ 9.76 $ 9.76
----------- -------------- --------- --------------
Balance at December 31, 1996................ 1,028,250 539,791 791,647 $ 1.81-11.00 $ 6.91
Granted..................................... 345,625 50,000 96,000 $ 1.81-20.00 $ 13.42
Forfeited................................... (211,307) -- -- $ 4.84-13.00 $ 9.02
Exercised................................... (48,957) (14,791) -- $ 0.60-13.00 $ 5.64
----------- -------------- --------- --------------
Balance at December 31, 1997................ 1,113,611 575,000 887,647 $ 1.81-20.00 $ 8.01
----------- -------------- --------- --------------
----------- -------------- --------- --------------
Exercisable at December 31, 1997............ 299,355 208,750 836,920 $ 1.81-20.00 $ 7.32
----------- -------------- --------- --------------
----------- -------------- --------- --------------
</TABLE>
The weighted average fair values of the options granted during the three
years ended December 31, 1997, were $0.69, $2.01 and $9.95, respectively. The
weighted average fair values of warrants granted during the three years ended
December 31, 1997, were $0.09, $1.71 and $6.98, respectively.
F-15
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
9. STOCK OPTIONS AND WARRANTS (CONTINUED)
Following is a summary of stock options and warrants outstanding as of
December 31, 1997:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
REMAINING AVERAGE AVERAGE
RANGE OF NUMBER CONTRACTUAL EXERCISE NUMBER EXERCISE
EXERCISE PRICES OUTSTANDING LIFE PRICE EXERCISABLE PRICE
- ------------------ ------------ --------------- ----------- ------------ -----------
<S> <C> <C> <C> <C> <C>
$ 1.81 - $ 1.81 500,000 7.32 $ 1.81 350,000 $ 1.81
$ 4.84 - $ 4.84 787,630 7.98 $ 4.84 409,380 $ 4.84
$ 9.76 - $11.00 879,378 8.17 $ 10.40 454,508 $ 10.48
$11.50 - $19.88 299,250 9.49 $ 15.21 21,137 $ 12.77
$20.00 - $20.00 110,000 8.54 $ 20.00 110,000 $ 20.00
------------ ------------
$ 1.81 - $20.00 2,576,258 8.12 $ 8.00 1,345,025 $ 7.32
------------ ------------
------------ ------------
</TABLE>
10. INCOME TAXES
The stockholders, upon incorporating the Company, elected to treat the
Company as an S Corporation under the Internal Revenue Code. On June 19, 1995,
this election was revoked as certain ineligible entities (i.e partnerships and
corporations) became stockholders. Losses of $1,261,000 incurred from inception
through June 19, 1995 have been reclassified from accumulated deficit to Common
Stock as a result of the change to C Corporation status. The Company is now
subject to income taxes on income earned after June 19, 1995. At December 31,
1996 and 1997, the Company had net operating loss carryforwards for federal
income tax purposes totaling approximately $33,751,000, and $61,004,000,
respectively, which begin to expire in 2011. The Internal Revenue Code of 1986,
as amended, includes provisions which may limit the net operating loss
carryforwards available for use in any given year if certain events occur,
including significant changes in ownership. Due to the Company's initial public
offering and other issuances of Common Stock and Common Stock equivalents,
utilization of the Company's net operating loss carryforwards to offset future
income may be limited.
Deferred tax assets include the following:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1997
---------- ----------
(IN THOUSANDS)
<S> <C> <C>
Net operating loss carryforwards..................................... $ 13,578 $ 24,584
Deferred financing costs............................................. 88 118
Depreciation......................................................... 50 323
Accrued liabilities.................................................. 103 201
---------- ----------
Gross deferred tax assets............................................ 13,819 25,226
Deferred tax asset valuation allowance............................... (13,819) (25,226)
---------- ----------
$ -- $ --
---------- ----------
---------- ----------
</TABLE>
The Company recorded a full valuation allowance for net deferred tax assets
due to the uncertainty of future taxable income.
F-16
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED)
PROFIT SHARING PLAN
Effective January 1997, the Company implemented a profit sharing plan
pursuant to Section 401(k) of the Internal Revenue Code, whereby participants
may contribute a percentage of compensation, but not in excess of the maximum
allowed under the Code. The Company makes a discretionary matching contribution
of 25% up to a maximum of 6% of the participant's total eligible compensation.
The Company's matching contributions vest over four years from the participant's
date of hire. Total contributions for 1997 were $84,000.
11. COMMITMENTS AND CONTINGENCIES
LEASES
The Company leases its facilities and certain equipment under non-cancelable
operating leases expiring in various years through 2008. Total rent expense in
1995, 1996 and 1997, respectively, for all operating leases amounted to
$145,000, $914,000 and $1.9 million, respectively. The Company also leases
equipment, primarily data communications equipment, under non-cancelable capital
leases. Most of the Company's capital leases include purchase options at the end
of the lease term.
In February 1997, EarthLink commenced occupation of a 55,000 square feet in
a facility located adjacent to its corporate headquarters to house the Company's
data center. In June 1997, the Company amended the lease for its corporate
headquarters facility. Under the amended lease, the Company will occupy an
additional 45,000 square feet of the existing facility and deliver an
irrevocable letter of credit in the amount of $450,000 to the Lessor.
During the three years ended December 31, 1997, the Company financed the
acquisition of data processing and office equipment amounting to approximately
$556,000, $11.3 million and $10.5 million, respectively, by entering into a
number of agreements for the sale and leaseback of equipment. The sale leaseback
transactions are recorded at cost, which approximates the fair market value of
the property and, therefore, no gains or losses have been recorded. The property
remains on the books and continues to be depreciated. A financing obligation
representing the proceeds is recorded and reduced based upon payments under the
lease agreement.
F-17
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Minimum lease commitments under non-cancelable leases at December 31, 1997
are as follows:
<TABLE>
<CAPTION>
CAPITAL OPERATING
YEAR ENDING DECEMBER 31, LEASES LEASES
- ---------------------------------------------------------------------- --------- -----------
(IN THOUSANDS)
<S> <C> <C>
1998.................................................................. $ 8,576 $ 1,898
1999.................................................................. 6,516 2,126
2000.................................................................. 3,258 1,994
2001.................................................................. 657 1,767
2002.................................................................. 91 1,897
Thereafter............................................................ 8 8,807
--------- -----------
Total minimum lease payments.......................................... 19,106 $ 18,489
-----------
-----------
Less amount representing interest..................................... (3,776)
---------
Present value of future lease payments................................ 15,330
Less current portion.................................................. 7,112
---------
$ 8,218
---------
---------
</TABLE>
GUARANTEED USAGE LEVELS
At December 31, 1997, the Company has committed to guaranteed usage levels
of data and voice communication with certain telecommunication vendors in the
aggregate amount of $3 million in 1998.
SIGNIFICANT AGREEMENTS
Access to the Internet for members outside of the Company's California
regional base is provided through points of presence ("POP") capacity leased
from UUNET and PSINet. EarthLink is, in effect, buying this capacity in bulk at
a discount, and providing access to EarthLink's member base at EarthLink's
normal rates. Payment to UUNET and PSINet is generally concurrent with
EarthLink's receipt of funds from members. At December 31, 1997, $2.0 million
and $2.1 million in amounts due to UUNET were recorded in accounts payable and
other accrued liabilities, respectively, and $540,000 and $4.4 million in
amounts due PSINet were recorded in other accrued liabilities and notes payable,
respectively.
Effective June 30, 1997 the Company's agreement with UUNET was amended.
UUNET agreed to waive monthly revenue minimums, excess hours fees, and peak
service user targets during the six months ended December 31, 1997. In return,
EarthLink agreed not to invoke its early termination right prior to September
1998. If the number of hours used by EarthLink members accessing the Internet
through UUNET increases beyond the amount provided for in the agreement or the
usage becomes more concentrated during peak times, the fees paid by the Company
to UUNET would increase, which would adversely affect the Company's operating
margins.
EarthLink has licensed Netscape Communicator software ("Netscape
Communicator") from Netscape Communications Corporation, and Microsoft Internet
Explorer software ("Internet Explorer") from Microsoft Corporation. These
licenses permit the Company to distribute Netscape Communicator and Internet
Explorer in the EarthLink Network TotalAccess software package. Management
believes that contract renewal for both of the browsers, under conditions
acceptable to EarthLink, is probable.
F-18
<PAGE>
EARTHLINK NETWORK, INC.
NOTES TO FINANCIAL STATEMENTS (CONTINUED)
11. COMMITMENTS AND CONTINGENCIES (CONTINUED)
Minimum commitments under non-cancelable network service agreements from
UUNET and PSINet are as follows:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31, IN MILLIONS
- ---------------------------------------------------------------------------------- -----------
<S> <C>
1998.............................................................................. $ 22.8
1999.............................................................................. 6.0
-----
Total......................................................................... $ 28.8
-----
-----
</TABLE>
12. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1995 1996 1997
--------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash paid for:
Interest....................................................... $ 60 $ 1,041 $ 1,965
--------- --------- ---------
--------- --------- ---------
Income Taxes................................................... $ 1 $ 1 $ 1
--------- --------- ---------
--------- --------- ---------
</TABLE>
13. SUBSEQUENT EVENTS
STRATEGIC ALLIANCE WITH SPRINT CORPORATION
On February 11, 1998, the Company announced a long-term strategic alliance
with Sprint Corporation. In connection with this alliance, Sprint has tendered
to purchase approximately 1.25 million shares of EarthLink's Common Stock at $45
per share. Upon closing of this tender offer, Sprint purchased approximately 4.1
million shares of convertible preferred stock from Dolphin, Inc., a new
corporation formed by EarthLink for the purpose of consummating the Sprint
transactions. In exchange for the convertible preferred stock, Sprint transfered
to Dolphin, Inc. its Sprint Internet Passport customer base of approximately
130,000 members, paid approximately $24 million in cash and provided access to
Sprint's data network. Sprint and EarthLink also entered into a marketing and
distribution arrangement and EarthLink obtained access to up to $100 million in
convertible debt financing. Upon stockholder approval by EarthLink and
concurrently with the closing of these transactions, a wholly-owned subsidiary
of Dolphin, Inc. merged with and into EarthLink, and each share of EarthLink
Common Stock outstanding converted into one share of Dolphin, Inc. common stock.
Sprint also secured two seats on Newco's board of directors. Dolphin, Inc.
changed its name to EarthLink Network, Inc. and all references in these
financial statements to EarthLink relate to the Company or its successor. The
number of shares authorized in the balance sheet reflect that of the successor
company.
CONVERSION OF NOTE PAYABLE (UNAUDITED)
On March 31, 1998, UUNET converted the $5 million Convertible Note and
related accrued interest into 391,515 shares of the Company's Common Stock at a
conversion price of $12.88 per share.
F-19
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Board of Directors
Sprint Corporation
We have audited the accompanying statement of revenues and direct expenses
of the Consumer Internet Access Services of Sprint Corporation (the "Company")
for the year ended December 31, 1997. This statement is the responsibility of
the Company's management. Our responsibility is to express an opinion on the
statement based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the revenues and direct expenses are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statement. An audit also
includes assessing the basis of accounting 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.
The accompanying statement of revenues and direct expenses was prepared for
inclusion in the Registration Statement on Form S-1 of EarthLink Network, Inc.
for purposes of complying with the rules and regulations of the Securities and
Exchange Commission in lieu of the full financial statements required by Rule
3-05 for the transaction between EarthLink Network, Inc. and Sprint Corporation.
The statement is not intended to be a complete presentation of the Consumer
Internet Access Services of Sprint Corporation revenues and expenses.
In our opinion, the statement of revenues and direct expenses referred to
above presents fairly, in all material respects, the revenues and direct
expenses described in the note to the statement of revenues and direct expenses
for the Consumer Internet Access Services of Sprint Corporation for the year
ended December 31, 1997, in conformity with generally accepted accounting
principles.
Ernst & Young LLP
Kansas City, Missouri
March 6, 1998
F-20
<PAGE>
CONSUMER INTERNET ACCESS SERVICES OF SPRINT CORPORATION
STATEMENTS OF REVENUES AND DIRECT EXPENSES
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31, 1997
------------------- THREE MONTHS ENDED
MARCH 31, 1998
---------------------
(UNAUDITED)
<S> <C> <C>
(IN THOUSANDS)
Net operating revenues................................................ $ 14,489 $ 6,259
Direct expenses:
Cost of services.................................................... 51,313 9,813
Selling, general and administrative................................. 13,099 2,155
Depreciation........................................................ 6,070 2,146
Other............................................................... 3,404 198
-------- --------
Total direct expenses................................................. 73,886 14,312
-------- --------
Direct expenses in excess of revenues................................. $ (59,397) $ (8,053)
-------- --------
-------- --------
</TABLE>
SEE ACCOMPANYING NOTE.
F-21
<PAGE>
CONSUMER INTERNET ACCESS SERVICES OF SPRINT CORPORATION
NOTE TO STATEMENTS OF REVENUES AND DIRECT EXPENSES
YEAR ENDED DECEMBER 31, 1997
(UNAUDITED WITH RESPECT TO THE THREE MONTHS ENDED MARCH 31, 1998)
SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
BASIS OF PRESENTATION
The statements of revenues and direct expenses represent the activities
related to the Consumer Internet Access Services of Sprint Corporation and have
been prepared in connection with the transaction between EarthLink Network, Inc.
and Sprint Corporation. The statements of revenues and direct expenses are not
intended to be a complete presentation of the revenues and expenses of the
Consumer Internet Access Services of Sprint Corporation because corporate
allocated expenses have not been included. Direct expenses are defined as those
costs which were incurred as a direct result of providing Consumer Internet
Access Services and which will no longer be incurred by Sprint Corporation
subsequent to consummation of the transaction with EarthLink Network, Inc.
Sprint Corporation began offering Internet access in the fourth quarter of
1996 and any revenues generated and direct operating expenses incurred from
inception through December 31, 1996, were nominal. Sprint Corporation reports
this operation within its "Emerging Businesses Segment" (the "Group") and
maintains the financial information relative to the Internet subscribers in the
Group. Revenues and direct operating expense information are separately
maintained for the Consumer Internet Access Services within the Group. Sprint
Corporation does not, however, separately maintain and account for other costs
and expenses to operate this business and is unable to determine or reasonably
estimate these costs on a historical basis. In addition, Sprint Corporation does
not separately maintain and account for all assets used in the consumer Internet
access services business. Such assets, primarily network related, are recorded
in the other businesses of Sprint Corporation and used by the other divisions of
Sprint Corporation, including the Group. Accordingly, financial statements for
1996 and full financial statements required by Rule 3-05 of Regulation S-X have
not been presented.
The statements of revenues and direct expenses are not indicative of the
financial condition or results of operations of this business going forward
because of the change in the business and the omission of various operating
expenses.
UNAUDITED FINANCIAL INFORMATION
The statement of revenues and direct expenses for the three months ended
March 31, 1998 is unaudited. Sprint Corporation believes that such information
includes all adjustments (consisting only of normal recurring adjustments)
necessary to present fairly the revenues and direct expenses related to the
Consumer Internet Access Services of Sprint Corporation.
REVENUE RECOGNITION
Operating revenues are recognized as services are rendered to customers and
are recorded net of an estimate for uncollectible accounts. The provision for
doubtful accounts for the year ended December 31, 1997 and the three months
ended March 31, 1998 was $723,000 and $471,000 (unaudited), respectively.
DEPRECIATION
The cost of property, plant and equipment is depreciated on a straight-line
basis over estimated economic useful lives.
USE OF ESTIMATES
The statements of revenues and direct expenses are prepared in accordance
with generally accepted accounting principles which requires management to make
estimates and assumptions that affect the amounts reported in the financial
statement. Actual results could differ from those estimates.
F-22
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of EarthLink Network, Inc.
We have audited the accompanying statement of assets acquired and liabilities
assumed of the Sprint Internet Passport Business acquired by EarthLink Network,
Inc. as of June 5, 1998. This statement of assets acquired and liabilities
assumed is the responsibility of the Company's management; our responsibility is
to express an opinion on the statement of assets acquired and liabilities
assumed based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the statement of assets acquired and liabilities assumed
is free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the statement of assets
acquired and liabilities assumed. An audit also includes, assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall presentation of the statement of assets acquired and
liabilities assumed. We believe that our audit provides a reasonable basis for
our opinion.
The accompanying statement of assets acquired and liabilities assumed was
prepared for inclusion in the Registration Statement on Form S-1 of EarthLink
Network, Inc. for purposes of complying with the rules and regulations of the
Securities and Exchange Commission in lieu of the full financial statements
required by Rule 3-05 of Regulation S-X for the transaction between EarthLink
Network, Inc. and Sprint Corporation.
In our opinion, the accompanying statement of assets acquired and liabilities
assumed presents fairly, in all material respects, the assets acquired and
liabilities assumed as described in the note to the statement of assets acquired
and liabilities assumed of the Sprint Internet Passport Business by EarthLink
Network, Inc. as of June 5, 1998, in conformity with generally accepted
accounting principles.
PRICE WATERHOUSE LLP
Costa Mesa, California
June 16, 1998
F-23
<PAGE>
EARTHLINK NETWORK, INC.
STATEMENT OF ASSETS ACQUIRED AND LIABILITIES ASSUMED
OF THE SPRINT INTERNET PASSPORT BUSINESS
<TABLE>
<CAPTION>
JUNE 5, 1998
--------------
(IN THOUSANDS)
<S> <C>
Current assets:
Cash............................................................................................. $ 23,750
--------------
Total current assets........................................................................... 23,750
Intangible assets.................................................................................. 119,718
--------------
143,468
--------------
Current liabilities:
Other accounts payable and accrued liabilities................................................... (8,468)
--------------
Total current liabilities...................................................................... (8,468)
--------------
Net assets acquired................................................................................ $ 135,000
--------------
--------------
</TABLE>
See accompany note to this financial statement.
F-24
<PAGE>
EARTHLINK NETWORK, INC.
NOTE TO STATEMENT OF ASSETS ACQUIRED AND LIABILITIES ASSUMED
OF THE SPRINT INTERNET PASSPORT BUSINESS
JUNE 5, 1998
SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES
BASIS OF PRESENTATION
The statement of assets acquired and liabilities assumed represents the
acquisition by EarthLink Network, Inc. (the "Company") of the Sprint Internet
Passport business ("SIP") of Sprint Corporation ("Sprint") in a transaction
accounted for as a purchase. The purchase price paid by the Company consisted of
approximately 4.1 million shares of Series A Convertible Preferred Stock, which
has been valued at $135,000,000. In exchange for the Series A Convertible
Preferred Stock, the Company obtained SIP's customer base, cash and access to
Sprint's high-speed data network. Sprint has further provided the Company access
to up to $100 million in convertible debt financing, and has entered into a
Marketing and Distribution Agreement with the Company.
Sprint Corporation began offering Internet access in the fourth quarter of
1996. Sprint reports this operation within its "Emerging Businesses Segment"
(the "Group") and maintains the financial information relative to the Internet
subscribers in the Group. Revenues and direct operating expense information are
separately maintained for the Sprint Internet Passport business within the
Group. Sprint Corporation does not, however, separately maintain and account for
other costs and expenses to operate this business and is unable to determine or
reasonably estimate these costs on a historical basis. In addition, Sprint
Corporation does not separately maintain and account for all assets used in the
Sprint Internet Passport business. Such assets, primarily network related, are
recorded in the other businesses of Sprint Corporation and used by the other
divisions of Sprint Corporation, including the Group. Accordingly, the Company
has included this statement of assets acquired and liabilities assumed in order
to comply with Rule 3-05 of Regulation S-X.
USE OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
The preparation of the statement of assets acquired and liabilities assumed
in conformity with generally accepted accounting principles requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the statement. Actual results could differ from those estimates.
PURCHASE PRICE ALLOCATION
The purchase price was allocated to the fair value of assets acquired,
consisting of cash and intangible assets related to a customer base, Sprint's
provision of additional customers and the co-branding feature of the Marketing
and Distribution Agreement and the excess of consideration over the fair value
of net assets acquired.
INTANGIBLE ASSETS
The intangible assets are amortized on a straight-line basis over the
estimated useful lives as follows: customer base amortized over 18 months, the
Marketing and Distribution Agreement amortized over 5 and 10 years, which are
the life of the portion of the contract related to Sprint's provision of
additional customers and the overall contract life relative to the co-branding
feature, respectively, and the excess of consideration over the fair value of
net assets acquired over 18 months. The Company regularly reviews the
recoverability of intangible assets based on estimated undiscounted future cash
flows from operating activities compared with the carrying values of the
intangible assets.
F-25
<PAGE>
EARTHLINK NETWORK, INC.
NOTE TO STATEMENT OF ASSETS ACQUIRED AND LIABILITIES ASSUMED
OF THE SPRINT INTERNET PASSPORT BUSINESS (CONTINUED)
JUNE 5, 1998
OTHER ACCOUNTS PAYABLE AND ACCRUED LIABILITIES
The liabilities consist of accrued expenses for incremental acquisition
costs directly attributable to the acquisition, primarily investment banking,
legal and accounting professional fees.
F-26
<PAGE>
Powerful Partnerships
[GRAPHICAL PRESENTATION OF SECTION, CONSISTING OF 2/3-PAGE, WITH MOCKUP OF
EARTHLINK SPRINT LOGOS]
EarthLink Sprint Partnership
EarthLink and Sprint have formed an important strategic alliance including:
- 130,000 Sprint Internet Passport members acquired by EarthLink
- 150,000 new members to be generated by Sprint annually
- Sprint's appointment of EarthLink as its exclusive consumer Internet
access provider
- Significant initial financial investment
EarthLink has access to Sprint's substantial resources, including:
Distribution and Marketing Opportunities:
- Access to channels such as The Sprint Store at Radio Shack-R-
- Participation in direct mail campaigns
- Access to 16 million Sprint customers
- Corporate sponsorship and event marketing, such as NFL, Rolling Stones',
the US Olympic Ski Team
- Use of Sprint brand in co-branded offerings
Affinity Marketing Partners
[GRAPHICAL PRESENTATION OF SECTION, CONSISTING OF 1/3-PAGE, WITH VERTICAL
LISTING OF PARTNER LOGOS; PENDING PARTNER APPROVAL]
- Cendant Software--The EarthLink Network TotalAccess Software is bundled on
software titles from Cendant and their subsidiaries
- CompUSA--The EarthLink Network TotalAccess Software reaches CompUSA
customers through in-store programs
- Discover Card--EarthLink and NOVUS Services' Discover Card offer the
Discover Connection, an Internet access package, with exclusive features
and awards to Discover Card members
- Gateway--The EarthLink Network TotalAccess Software will be distributed on
the hard drive of all Gateway systems
- MacMillan Publishing USA--EarthLink is the exclusive national Internet
access provider included on the Internet Starter Kit CD-ROM, which
Macmillan Publishing develops
- SAM's Club--SAM's Club co-brands and co-offers the EarthLink Network
TotalAccess Software through direct mail and catalog promotions to SAM'S
Club members
- Sony Entertainment--The EarthLink Network TotalAccess Software is included
on enhanced Sony Music CDs
- Warner Bros.--The EarthLink Network TotalAccess Software has been included
on CDs promoting bands on the Warner music roster and major motion
pictures such as "Batman and Robin" and "Contact"
<PAGE>
NO DEALER, SALESPERSON OR OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY
INFORMATION OR MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS
IN CONNECTION WITH THE OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR
MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS
HAVING BEEN AUTHORIZED BY THE COMPANY OR THE UNDERWRITERS. THIS PROSPECTUS
DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO
BUY, THE COMMON STOCK IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM,
IT IS UNLAWFUL TO MAKE SUCH AN OFFER OR SOLICITATION. NEITHER THE DELIVERY
OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY
CIRCUMSTANCES, CREATE AN IMPLICATION THAT THERE HAS NOT BEEN ANY CHANGE IN
THE FACTS SET FORTH IN THIS PROSPECTUS OR IN THE AFFAIRS OF THE COMPANY
SINCE THE DATE HEREOF.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
Prospectus Summary.................................................. 3
Risk Factors........................................................ 4
Use of Proceeds..................................................... 15
Price Range of Common Stock......................................... 15
Dividend Policy..................................................... 15
Capitalization...................................................... 16
Dilution............................................................ 17
Strategic Alliance with Sprint...................................... 18
Selected Historical Financial Information........................... 20
Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................... 22
Business............................................................ 40
Management.......................................................... 52
Principal and Selling Stockholders.................................. 62
Description of Capital Stock........................................ 65
Shares Eligible for Future Sale..................................... 76
Underwriting........................................................ 78
Legal Matters....................................................... 80
Experts............................................................. 80
Additional Information.............................................. 80
Index to Financial Statements....................................... F-1
</TABLE>
<PAGE>
[LOGO]
2,400,000 SHARES
COMMON STOCK
DEUTSCHE BANK SECURITIES
INVEMED ASSOCIATES, INC.
THE ROBINSON-HUMPHREY COMPANY
PROSPECTUS
JUNE 18, 1998
