<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1999
Commission File Number 333-59393
------------------------
RHYTHMS NETCONNECTIONS INC.
State of Incorporation: Delaware I.R.S. Employer ID #: 33-0747515
Address: 6933 South Revere Parkway Telephone #: (303) 476-4200
Englewood, Colorado 80112-3931
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days Yes X No
As of November 10, 1999, a total of 77,141,961 shares of the Registrant's Common
Stock, $0.001 par value, were issued and outstanding.
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<PAGE>
RHYTHMS NETCONNECTIONS INC.
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
The following are three-month third quarter and nine-month year-to-date, as
applicable, consolidated financial statements of the Registrant as of and
through September 30, 1999.
1
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31 SEPTEMBER 30
1998 1999
------------ -------------
(UNAUDITED)
<S> <C> <C>
ASSETS:
Current assets:
Cash and cash equivalents............................... $21,315,000 $ 273,694,000
Short-term investments.................................. 115,497,000 171,193,000
Restricted cash......................................... -- 35,028,000
Accounts, loans, interest, and other receivables, net... 2,376,000 9,243,000
Inventory............................................... 340,000 3,132,000
Prepaid expenses and other current assets............... 230,000 936,000
------------ -------------
Total current assets.................................. 139,758,000 493,226,000
Equipment and furniture, net.............................. 11,510,000 99,022,000
Collocation fees, net..................................... 13,804,000 50,406,000
Restricted cash........................................... -- 78,332,000
Deferred business acquisition costs, net.................. -- 19,988,000
Deferred debt issue costs, net............................ 6,304,000 16,385,000
Other assets.............................................. 350,000 712,000
------------ -------------
$171,726,000 $ 758,071,000
============ =============
LIABILITIES AND STOCKHOLDERS' EQUITY:
Current liabilities:
Current portion of long-term debt....................... $ 333,000 $ 333,000
Accounts payable........................................ 10,601,000 21,616,000
Interest payable........................................ 39,000 18,226,000
Accrued expenses and other current liabilities.......... 2,816,000 16,541,000
------------ -------------
Total current liabilities............................. 13,789,000 56,716,000
Long-term debt............................................ 472,000 194,000
13.50% senior discount notes due 2008, net 157,465,000 174,599,000
12.75% senior notes due 2009 -- 325,000,000
Other liabilities......................................... 180,000 145,000
------------ -------------
Total liabilities..................................... 171,906,000 556,654,000
------------ -------------
Mandatorily redeemable common stock warrants.............. 6,567,000 1,069,000
------------ -------------
Stockholders' equity:
Series A convertible preferred stock, $0.001 par value;
12,900,000 shares authorized in 1998, no shares
authorized in 1999; 12,855,094 shares issued and
outstanding in 1998, no shares issued and outstanding
in 1999................................................ 13,000 --
Series B convertible preferred stock, $0.001 par value;
4,044,943 shares authorized in 1998, no shares
authorized in 1999; 4,044,943 shares issued and
outstanding in 1998, no shares issued and outstanding
in 1999................................................ 4,000 --
Common stock, $0.001 par value; 80,049,892 shares
authorized in 1998, 250,000,000 shares authorized in
1999; 8,042,530 shares issued in 1998, 77,318,242
shares issued in 1999.................................. 8,000 77,000
Treasury stock, at cost; 438,115 shares in 1998 and
488,890 shares in 1999................................. (18,000) (28,000)
Additional paid-in capital.............................. 37,212,000 366,293,000
Warrants................................................ -- 10,397,000
Deferred compensation................................... (5,210,000) (9,102,000)
Accumulated deficit..................................... (38,756,000) (167,289,000)
------------ -------------
Total stockholders' equity (deficit).................. (6,747,000) 200,348,000
------------ -------------
$171,726,000 $ 758,071,000
============ =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
2
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
--------------------------- ----------------------------
SEPTEMBER 30 SEPTEMBER 30 SEPTEMBER 30 SEPTEMBER 30
1998 1999 1998 1999
------------ ------------ ------------ -------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C> <C> <C>
REVENUE:
Service and installation, net....... $ 166,000 $ 3,317,000 $ 248,000 $ 5,618,000
------------ ------------ ------------ -------------
OPERATING EXPENSES:
Network and service costs........... 1,404,000 21,800,000 2,072,000 39,971,000
Selling, marketing, general and
administrative.................... 7,059,000 28,653,000 14,040,000 64,771,000
Depreciation and amortization....... 472,000 3,977,000 507,000 6,121,000
Amortized deferred business
acquisition costs................. -- 1,550,000 -- 3,202,000
------------ ------------ ------------ -------------
Total operating expenses.......... 8,935,000 55,980,000 16,619,000 114,065,000
------------ ------------ ------------ -------------
LOSS FROM OPERATIONS.................. (8,769,000) (52,663,000) (16,371,000) (108,447,000)
------------ ------------ ------------ -------------
OTHER INCOME AND EXPENSE:
Interest income..................... 2,160,000 7,344,000 3,834,000 15,673,000
Interest expense (including
amortized debt discount and issue
costs)............................ (5,280,000) (16,500,000) (8,501,000) (35,871,000)
Other income........................ 8,000 41,000 8,000 112,000
------------ ------------ ------------ -------------
NET LOSS.............................. $(11,881,000) $(61,778,000) $(21,030,000) $(128,533,000)
============ ============ ============ =============
NET LOSS PER SHARE:
Basic............................... $ (3.47) $ (0.89) $ (7.89) $ (2.80)
============ ============ ============ =============
Diluted............................. $ (3.47) $ (0.89) $ (7.89) $ (2.80)
============ ============ ============ =============
SHARES USED IN COMPUTING NET LOSS PER
SHARE:
Basic............................... 3,421,097 69,646,044 2,659,426 45,893,691
============ ============ ============ =============
Diluted............................. 3,421,097 69,646,044 2,659,426 45,893,691
============ ============ ============ =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
NINE MONTHS ENDED
-----------------------------
SEPTEMBER 30 SEPTEMBER 30
1998 1999
------------- -------------
(UNAUDITED)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss.................................................. $(21,030,000) $(128,533,000)
Adjustments to reconcile net loss to net cash used for
operating activities:
Depreciation of equipment and furniture................. 470,000 4,976,000
Amortization of collocation fees........................ 37,000 1,144,000
Amortization of deferred business acquisition costs..... -- 3,202,000
Amortization of deferred debt issue costs and debt
discount............................................... 8,446,000 17,542,000
Amortization of deferred compensation................... 407,000 2,541,000
Amortization of gain on sale of equipment to leasing
company................................................ -- (110,000)
Changes in assets and liabilities:
Increase in accounts, loans, interest, and other
receivables, net..................................... (1,179,000) (6,867,000)
Increase in inventory................................. (285,000) (2,792,000)
Increase in prepaid expenses and other current
assets............................................... (65,000) (706,000)
Increase in other assets.............................. (207,000) (362,000)
Increase (decrease) in accounts payable............... 2,708,000 (957,000)
Increase in interest payable.......................... -- 18,187,000
Increase in accrued expenses and other current
liabilities.......................................... 1,330,000 13,725,000
Increase in other liabilities......................... 209,000 75,000
------------- -------------
Net cash used for operating activities.............. (9,159,000) (78,935,000)
------------- -------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of short-term investments..................... (133,703,000) (237,273,000)
Maturities of short-term investments.................... -- 181,577,000
Purchases of government securities as restricted cash... -- (113,360,000)
Purchases of equipment and furniture.................... (7,981,000) (104,271,000)
Payments of collocation fees............................ (8,450,000) (37,746,000)
------------- -------------
Net cash used for investing activities.............. (150,134,000) (311,073,000)
------------- -------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from leasing company for equipment............. 6,606,000 23,755,000
Proceeds from issuance of 13.50% senior discount notes
and warrants........................................... 150,365,000 --
Proceeds from issuance of 12.75% senior notes........... -- 325,000,000
Payments of debt issue costs............................ (6,403,000) (10,489,000)
Proceeds from borrowings on long-term debt.............. 432,000 --
Repayments of long-term debt............................ (139,000) (278,000)
Proceeds from issuance of common stock.................. 229,000 246,756,000
Proceeds from issuance of preferred stock and
warrants............................................... 18,292,000 75,000,000
Payments of equity issue costs.......................... (19,000) (17,347,000)
Purchases of treasury stock............................. -- (10,000)
------------- -------------
Net cash provided by financing activities........... 169,363,000 642,387,000
------------- -------------
Net increase in cash and cash equivalents................... 10,070,000 252,379,000
Cash and cash equivalents at beginning of period............ 10,166,000 21,315,000
------------- -------------
Cash and cash equivalents at end of period.................. $ 20,236,000 $ 273,694,000
============= =============
SUPPLEMENTAL SCHEDULE OF CASH FLOW INFORMATION:
Cash paid for interest.................................... $ 53,000 $ 42,000
============= =============
SUPPLEMENTAL SCHEDULE OF NON-CASH FINANCING ACTIVITIES:
Equipment purchases payable, to be financed through
operating leases....................................... $ 640,000 $ --
============= =============
Equipment and furniture purchases payable............... $ -- $ 11,972,000
============= =============
Intangible business acquisition costs arising from
issuance of preferred stock and warrants............... $ 6,567,000 $ 23,190,000
============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES A SERIES B SERIES C
CONVERTIBLE CONVERTIBLE CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK
$0.001 PAR VALUE $0.001 PAR VALUE $0.001 PAR VALUE
--------------------- ------------------- -------------------
# SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT
----------- -------- ---------- ------- ---------- -------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998............ 12,855,094 $ 13,000 4,044,943 $4,000 -- $ --
Issuance of common stock in initial
public offering in April 1999
(unaudited)........................... -- -- -- -- -- --
Issuance of common stock in secondary
offering in September 1999
(unaudited)........................... -- -- -- -- -- --
Issuance of common stock upon exercise
of options for cash ($0.04 to $16.00
per share) (unaudited)................ -- -- -- -- -- --
Issuance of common stock upon cashless
exercise of warrants ($1.85 per share)
in May and June 1999 (unaudited)...... -- -- -- -- -- --
Issuance of common stock upon cashless
exercise of warrants ($0.004 per
share) in August 1999 (unaudited)..... -- -- -- -- -- --
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited)...... -- -- -- -- 8,395,655 8,000
Issuance of Series D preferred stock and
warrants for cash ($8.04 per share) in
April 1999 (unaudited)................ -- -- -- -- -- --
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited)...................... -- -- -- -- -- --
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited)...................... (12,855,094) (13,000) (4,044,943) (4,000) (8,395,655) (8,000)
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited)............ -- -- -- -- -- --
Costs arising from public offerings in
April and September 1999
(unaudited)........................... -- -- -- -- -- --
Purchase of treasury stock for cash
($0.04 to $16.00 per share)
(unaudited)........................... -- -- -- -- -- --
Issuance of warrants to leasing
companies in March, April and July
1999 (unaudited)...................... -- -- -- -- -- --
Issuance of warrants to business partner
in April 1999 (unaudited)............. -- -- -- -- -- --
Deferred compensation from grants of
options to purchase common stock
(unaudited)........................... -- -- -- -- -- --
Amortization of deferred compensation
(unaudited)........................... -- -- -- -- -- --
Reversal of deferred compensation from
cancellation of grants to purchase
common stock (unaudited).............. -- -- -- -- -- --
Net loss through September 30, 1999
(unaudited)........................... -- -- -- -- -- --
----------- -------- ---------- ------- ---------- -------
Balance at September 30, 1999
(unaudited)........................... -- $ -- -- $ -- -- $ --
=========== ======== ========== ======= ========== =======
<CAPTION>
SERIES D
CONVERTIBLE
PREFERRED STOCK COMMON STOCK TREASURY STOCK
$0.001 PAR VALUE $0.001 PAR VALUE AT COST
------------------ ------------------- ------------------
# SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT
-------- -------- ---------- ------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1998............ -- $ -- 8,042,530 $8,000 438,115 $(18,000)
Issuance of common stock in initial
public offering in April 1999
(unaudited)........................... -- -- 10,781,250 11,000 -- --
Issuance of common stock in secondary
offering in September 1999
(unaudited)........................... -- -- 594,279 -- -- --
Issuance of common stock upon exercise
of options for cash ($0.04 to $16.00
per share) (unaudited)................ -- -- 2,610,158 3,000 -- --
Issuance of common stock upon cashless
exercise of warrants ($1.85 per share)
in May and June 1999 (unaudited)...... -- -- 252,112 -- -- --
Issuance of common stock upon cashless
exercise of warrants ($0.004 per
share) in August 1999 (unaudited)..... -- -- 3,961,862 4,000 -- --
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited)...... -- -- -- -- -- --
Issuance of Series D preferred stock and
warrants for cash ($8.04 per share) in
April 1999 (unaudited)................ 441,176 -- -- -- -- --
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited)...................... -- -- -- -- -- --
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited)...................... (441,176) -- 51,076,051 51,000 -- --
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited)............ -- -- -- -- -- --
Costs arising from public offerings in
April and September 1999
(unaudited)........................... -- -- -- -- -- --
Purchase of treasury stock for cash
($0.04 to $16.00 per share)
(unaudited)........................... -- -- -- -- 50,775 (10,000)
Issuance of warrants to leasing
companies in March, April and July
1999 (unaudited)...................... -- -- -- -- -- --
Issuance of warrants to business partner
in April 1999 (unaudited)............. -- -- -- -- -- --
Deferred compensation from grants of
options to purchase common stock
(unaudited)........................... -- -- -- -- -- --
Amortization of deferred compensation
(unaudited)........................... -- -- -- -- -- --
Reversal of deferred compensation from
cancellation of grants to purchase
common stock (unaudited).............. -- -- -- -- -- --
Net loss through September 30, 1999
(unaudited)........................... -- -- -- -- -- --
-------- -------- ---------- ------- ------- --------
Balance at September 30, 1999
(unaudited)........................... -- $ -- 77,318,242 $77,000 488,890 $(28,000)
======== ======== ========== ======= ======= ========
<CAPTION>
TOTAL
ADDITIONAL STOCKHOLDERS'
PAID-IN DEFERRED ACCUMULATED EQUITY
CAPITAL WARRANTS COMPENSATION DEFICIT (DEFICIT)
------------ ----------- ------------ ------------- -------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1998............ $ 37,212,000 $ -- $(5,210,000) $ (38,756,000) $ (6,747,000)
Issuance of common stock in initial
public offering in April 1999
(unaudited)........................... 226,395,000 -- -- -- 226,406,000
Issuance of common stock in secondary
offering in September 1999
(unaudited)........................... 17,233,000 -- -- -- 17,233,000
Issuance of common stock upon exercise
of options for cash ($0.04 to $16.00
per share) (unaudited)................ 3,114,000 -- -- -- 3,117,000
Issuance of common stock upon cashless
exercise of warrants ($1.85 per share)
in May and June 1999 (unaudited)...... -- -- -- -- --
Issuance of common stock upon cashless
exercise of warrants ($0.004 per
share) in August 1999 (unaudited)..... 5,494,000 -- -- -- 5,498,000
Issuance of Series C preferred stock and
warrants for cash ($8.04 per share) in
March and April 1999 (unaudited)...... 60,368,000 7,124,000 -- -- 67,500,000
Issuance of Series D preferred stock and
warrants for cash ($8.04 per share) in
April 1999 (unaudited)................ 6,317,000 1,183,000 -- -- 7,500,000
Business relationship value arising from
issuance of Series C and Series D
preferred stock in March and April
1999 (unaudited)...................... 21,100,000 -- -- -- 21,100,000
Conversion of preferred stock to common
upon initial public offering in April
1999 (unaudited)...................... (26,000) -- -- -- --
Costs arising from issuances of Series C
and Series D preferred stock in March
and April 1999 (unaudited)............ (245,000) -- -- -- (245,000)
Costs arising from public offerings in
April and September 1999
(unaudited)........................... (17,102,000) -- -- -- (17,102,000)
Purchase of treasury stock for cash
($0.04 to $16.00 per share)
(unaudited)........................... -- -- -- -- (10,000)
Issuance of warrants to leasing
companies in March, April and July
1999 (unaudited)...................... -- 1,180,000 -- -- 1,180,000
Issuance of warrants to business partner
in April 1999 (unaudited)............. -- 910,000 -- -- 910,000
Deferred compensation from grants of
options to purchase common stock
(unaudited)........................... 7,009,000 -- (7,009,000) -- --
Amortization of deferred compensation
(unaudited)........................... -- -- 2,541,000 -- 2,541,000
Reversal of deferred compensation from
cancellation of grants to purchase
common stock (unaudited).............. (576,000) -- 576,000 -- --
Net loss through September 30, 1999
(unaudited)........................... -- -- -- (128,533,000) (128,533,000)
------------ ----------- ----------- ------------- -------------
Balance at September 30, 1999
(unaudited)........................... $366,293,000 $10,397,000 $(9,102,000) $(167,289,000) $ 200,348,000
============ =========== =========== ============= =============
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
RHYTHMS NETCONNECTIONS INC.
Notes to Consolidated Financial Statements (Unaudited)
NOTE 1--BASIS OF PRESENTATION:
THE COMPANY: Rhythms NetConnections Inc. ("Rhythms" or the "Company"), a
Delaware corporation, was organized under the name Accelerated Connections Inc.
in February 1997. The Company's name was changed to Rhythms NetConnections Inc.
in August 1997. The Company is in the business of providing high-speed data
communications services on an end-to-end basis to business customers and end
users. The Company began service trials in the San Diego, California, market in
December 1997 and began commercial operations in San Diego effective April 1,
1998.
The Company's ultimate success depends upon, among other factors, rapidly
expanding the geographic coverage of its network services; entering into
interconnection agreements with incumbent local exchange carriers, some of which
are competitors or potential competitors of the Company; deploying network
infrastructure; attracting and retaining customers; accurately assessing
potential markets; continuing to develop and integrate its operational support
system and other back office systems; obtaining any required governmental
authorizations; responding to competitive developments; continuing to attract,
retain, and motivate qualified personnel; and continuing to upgrade its
technologies and commercialize its network services incorporating such
technologies. There can be no assurance that the Company will be successful in
addressing these matters and failure to do so could have a material adverse
effect on the Company's business, prospects, operating results, and financial
condition. As the Company continues the development of its business, it will use
currently available funds and seek additional sources of financing. If
unsuccessful in obtaining additional financing, the Company will continue
expansion of its operations on a reduced scale based on its existing capital
resources.
INTERIM RESULTS (UNAUDITED): The accompanying consolidated financial
statements (unaudited), which include the transactions and balances of Rhythms
NetConnections Inc. and its wholly owned subsidiaries Rhythms Links Inc.
(formerly ACI Corp.) and ACI Corp.-Virginia, have been prepared in accordance
with generally accepted accounting principles for interim financial information
and, therefore, do not include all the information and footnotes required by
generally accepted accounting principles for complete financial statements. In
the opinion of management, these statements have been prepared on the same basis
as the audited financial statements and include all adjustments, consisting only
of normal recurring accruals, that are necessary for the fair statement of
results for the unaudited interim periods. The data disclosed in these notes to
consolidated financial statements is also unaudited. 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 the disclosure of contingent assets and
liabilities at the financial statement date, as well as the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates. The operating results for the interim period are not
necessarily indicative of the results to be expected for a full fiscal year or
for any future periods. All material intercompany transactions and balances have
been eliminated.
NOTE 2--NET LOSS PER SHARE:
Basic earnings per share is calculated by dividing the income or loss
available to common stockholders by the weighted average number of common shares
outstanding for the period, without consideration for common stock equivalents.
Diluted EPS is computed by dividing the income or loss available to common
stockholders by the weighted average number of common shares outstanding for the
period in addition to the weighted average number of common stock equivalents
outstanding for the period. Shares subject to repurchase by the Company are
considered Common Stock equivalents for purposes of this calculation. Shares
issuable upon conversion of preferred stock and upon the exercise of outstanding
stock options and
6
<PAGE>
RHYTHMS NETCONNECTIONS INC.
Notes to Consolidated Financial Statements (Unaudited) (Continued)
NOTE 2--NET LOSS PER SHARE: (CONTINUED)
warrants, and shares subject to repurchase by the Company totaling 50,125,301
and 13,261,271 at September 30, 1998 and 1999, respectively, have been excluded
from the computation since their effect would be antidilutive.
NOTE 3--STOCKHOLDERS' EQUITY:
On July 30, 1999, the Company entered into a 36-month lease line that
provides for $26,000,000 in equipment on an operating lease basis. In connection
with this lease agreement, the Company issued 10,000 warrants to purchase common
stock at a price of $50.00 per share, exercisable immediately. During the third
quarter of 1999, the Company additionally agreed to terms on a 36-month lease
line that provides for $30,000,000 in equipment on an operating lease basis.
Effective August 17, 1999, the Company completed a secondary public offering
of its common stock in a transaction that allowed certain holders of warrants
issued in connection with the 13.5 percent Senior Discount Notes to exercise
those warrants and sell the resulting Common Stock at $29.00 per share. A total
of 3,961,862 shares were issued in the transaction; the Company received no
proceeds from the sale of these shares. In connection with the secondary
offering, the underwriters of the offering were allowed to purchase 594,279
shares of Common Stock from the Company for $29.00 per share. The sale of these
shares was completed on September 14, 1999 and the Company received proceeds of
$16,415,000, net of underwriting discount.
During the third quarter of 1999, the Company granted options to employees
to purchase a total 1,103,750 shares of Common Stock pursuant to its Stock
Option/Stock Issuance Plan. During this same time, employees exercised
previously granted options to purchase a total of 53,325 shares of Common Stock
for total proceeds to the Company of $47,000.
NOTE 4--SUBSEQUENT EVENTS:
On October 29, 1999, the Company completed a strategic investment in OCI
Communications, Inc. ("OCI"), a provider of telecommunications services in
Canada. In exchange for a $5,300,000 cash investment, the Company received
warrants to purchase 763,680 shares of Class B Non-voting stock in OCI. These
warrants are in the process of being registered and are expected to convert into
Class B Non-voting shares before December 31, 1999. As part of this investment
Rhythms received various rights, including the ability to appoint a
representative to OCI's Board of Directors, among others. As part of this
strategic relationship, the Company intends to create a joint venture with OCI
to offer DSL-based services in selected Canadian markets.
7
<PAGE>
RHYTHMS NETCONNECTIONS INC.
PART I
FINANCIAL INFORMATION (CONTINUED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
We have based the following discussion and analysis on the consolidated
financial statements of our company and this should be read in conjunction with
our financial statements and the related footnotes presented previously. Certain
statements we have set forth below constitute forward-looking statements.
Forward-looking statements are based on our current expectations and projections
about future events. They involve known and unknown risks, uncertainties, and
other factors that may cause our actual results, performance or achievements, or
industry results, to be materially different from any future results anticipated
or implied by the forward-looking statements. Given these uncertainties, we
caution investors and prospective investors not to place undue reliance on any
forward-looking statements. Factors discussed in the "Risk Factors" and
"Business" sections contained in the Company's Registration Statement on
Form S-3 as filed with the Securities and Exchange Commission on November 8,
1999 could, among other things, cause or contribute to differences from the
forward-looking statements. We disclaim any obligation to publicly update or
revise information contained in any forward-looking statement, whether as a
result of new information, future events, or otherwise. In light of these risks,
uncertainties, and assumptions, the forward-looking events discussed in this
Form 10-Q might not occur.
RESULTS OF OPERATIONS:
We are a leading service provider of high-speed local access networking
solutions using DSL technology to businesses. We began offering commercial
services in our first market in April 1998 and as of September 30, 1999 offer
service in a total of 27 markets. We intend to continue our network rollout into
an additional ten markets in 1999 and a further 33 markets by the end of year
2000.
Since our inception in February 1997, our primary activities have consisted
of:
- obtaining required governmental authorizations;
- negotiating and executing interconnection agreements with incumbent
carriers;
- entering into strategic alliances;
- identifying collocation space and locations for our connection points,
metro service centers, and business offices;
- acquiring and deploying equipment and facilities;
- launching service trials;
- hiring management and other personnel;
- raising capital; and
- developing and integrating our operations support systems and other back
office systems.
During the first nine-months of 1999, we continued the development of our
business operations as follows:
- entered one new market during the first quarter, nine new markets during
the second quarter and ten new markets in the third quarter;
- added 155 central office locations during the first quarter, 153 during
the second quarter and 347 during the third quarter for a total of
855 central offices at September 30, 1999;
- added service to 735 DSL lines during the first quarter, 2,105 during the
second quarter and 3,450 during the third quarter for a total of 6,700 DSL
lines at September 30, 1999; and
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- increased headcount by 170 employees during the first quarter, 225 during
the second quarter and 300 during the third quarter for a total of
approximately 880 employees at September 30, 1999.
We have incurred operating losses, net losses and negative operating cash
flow for each month since our formation. As of September 30, 1999, we had an
accumulated deficit of approximately $167.3 million. We expect to substantially
increase our expenditures and operating expenses as we continue our rapid
expansion of our infrastructure and network services. We expect to incur
substantial operating losses, net losses, and negative cash flow during the
network build-out and the initial penetration of each new market we enter. We
expect to continue these losses for at least the next several years.
THREE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THREE MONTHS ENDED
SEPTEMBER 30, 1998
For the three months ended September 30, 1999, we recorded revenues of
$3.3 million and network and service costs of $21.8 million. This compares to
revenues of $166,000 and network and service costs of $1.4 million during the
same period in the prior year. The substantial increases in both revenues and
costs in 1999 is a result of our continued rapid expansion. Each new market we
enter provides us with an additional revenue opportunity, but also higher costs
until we have an established customer base in the market. As of September 30,
1999 we operated in 27 markets, compared to six markets at September 30, 1998.
Our revenues are derived primarily from DSL service and installation charges,
net of discounts given to customers upon service establishment. Network service
costs include customer installation costs, line and backbone expenses, equipment
operating leases, and repair and support costs.
Our selling, marketing, general, and administrative expenses for the third
quarter of 1999 were $28.7 million, which compares to $7.1 million in the prior
year. This increase between years reflects our continuing increases in staffing
levels, legal fees, and marketing efforts coinciding with the development and
launch of new markets.
We recorded depreciation and amortization of $4.0 million during the third
quarter of 1999, a significant increase over the $472,000 recorded during the
third quarter of 1998. This increase reflects the rapid expansion of our network
and includes amortization of collocation fees and depreciation on operating
equipment as we turn up service in each new location.
During the first and second quarters of 1999, we entered into strategic
arrangements with Microsoft Corporation and Qwest Communications Corporation. In
addition to their investments in our company totaling $45.0 million, the
strategic arrangements provide for certain other business relationships.
Combined, these business relationships are valued at $21.1 million and we have
capitalized these costs as deferred assets. We are amortizing these assets over
three- and five-year periods. Accordingly, during the third quarter of 1999 we
recorded $1.6 million in amortized deferred business acquisition costs that have
no corresponding amortization in the prior year.
During the third quarter of 1999 we recorded interest income of
$7.3 million. During the third quarter in 1998 we recorded interest income of
$2.2 million. The increase between years primarily resulted from a substantial
increase in invested cash balances. As of September 30, 1999, we had cash and
investments totaling $558.2 million, compared to cash and investments of
$153.9 million at September 30, 1998. The increase during 1999 resulted from a
variety of financing activities, including:
- issuing Series C and Series D preferred stock and warrants totaling
$75.0 million in March and April 1999;
- issuing common stock upon our initial public offering in April 1999 for
cash proceeds of $210.1 million;
- issuing 12.75 percent senior debt in April 1999 for cash proceeds of
$314.5 million;
- executing equipment lease lines totaling $44.0 million in March and
April 1999;
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- executing equipment lease lines totaling $56 million in July and
September; and
- issuing common stock upon our secondary public offering in August 1999 for
cash proceeds of $16.4 million.
While we recorded increased interest income on the invested cash balances,
we also recorded higher interest expense during 1999 as compared to 1998. For
the quarter ended September 30, 1999 we had interest expense of $16.5 million
which compared to $5.3 million for the same period in the prior year. This
increase primarily resulted from the senior debt we issued in April 1999.
We continue to be in a net operating loss tax position through
September 30, 1999; consequently, we have not recorded a provision for income
taxes for periods through September 30, 1999.
NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO NINE MONTHS ENDED
SEPTEMBER 30, 1998
We recorded $5.6 million in revenues for the nine months ended
September 30, 1999 compared to $248,000 in revenues for the nine months ended
September 30, 1998. Our network and service costs for the nine-month periods
were $40.0 million in 1999 compared to $2.1 million in 1998. The increases in
both revenues and costs resulted from the continued expansion of our operations,
as more fully detailed above.
During the first nine months of 1999, our selling, marketing, general, and
administrative expenses were $64.8 million, which compares to $14.0 million
during the first nine months of 1998. This increase resulted primarily from
additional salary, overhead, marketing, and legal expenses associated with our
continuing expansion, as more fully detailed above.
Depreciation and amortization for the nine-month periods was $6.1 million in
1999 and $507,000 in 1998. As we continue our expansion into additional markets
and central offices, as discussed above, we employ additional equipment and
collocation sites that we begin depreciating when we place them in service.
The increase in amortized deferred business acquisition costs between years
from zero for the nine months ended September 30, 1998 to $3.2 million for the
nine months ended September 30, 1999 is a result of the Microsoft and Qwest
business relationships as discussed above.
Interest income was $15.7 million and interest expense was $35.9 million for
the nine months ended September 30, 1999. This compares to interest income of
$3.8 million and interest expense of $8.5 million for the same nine-month period
in 1998. The increases in 1999 resulted from our financing activities that are
described above. The primary financing activities included our initial public
offering of common stock and our issuance of senior debt in April 1999. We
invested the proceeds from these financings, which provided increased interest
income. Interest and issue cost amortization on the debt, however, contributed
to a large increase in interest expense for 1999.
LIQUIDITY AND CAPITAL RESOURCES:
The development and expansion of our business requires significant capital
expenditures. These capital expenditures primarily include build-out costs such
as the procurement, design, and construction of our connection points and one or
two metro service center locations in each market, as well as other costs that
support our network design.
The number of targeted central offices in each market varies, as does the
average capital cost to build our connection points in each market. Capital
expenditures, including payments for collocation fees, were $142.0 million
during the first nine months of 1999. We sold approximately $23.8 million of
these purchases to a leasing company and are currently leasing the equipment
back on an operating-lease basis. We expect our capital expenditures to be
higher in future periods, arising primarily from payments of collocation fees
and the purchase of infrastructure equipment necessary for the development and
expansion of our network.
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Our capital requirements may vary based upon the timing and success of our
rollout and as a result of regulatory, technological, and competitive
developments or if:
- demand for our services or our anticipated cash flow from operations is
less or more than expected;
- our development plans or projections change or prove to be inaccurate;
- we engage in any acquisitions; and
- we accelerate deployment of our network services or otherwise alter the
schedule or targets of our rollout plan.
Since our primary activities have focused on building our network and
building a customer base, we have operated at a loss since inception. We intend
to continue to expand our operations at a rapid pace and expect to continue to
operate at a loss for the foreseeable future. The nature of expenses
contributing to our future losses will include network and service costs in
existing and new markets; legal, marketing, and selling expenses as we enter
each new market; payroll-related expenses as we continue to add employees;
general overhead to support the operational increases; and interest expense
arising from financing our expenditures.
We have not paid any dividends to our shareholders and will not pay
dividends for the foreseeable future. Our senior notes contain covenants that
restrict our ability to make certain payments, including dividend payments.
Through September 30, 1999, we have financed our operations and market
build-outs primarily through:
- issuing 12.75 percent senior notes in April 1999 for $314.5 million in net
proceeds;
- issuing common stock in April 1999 in our initial public offering for
$210.1 million in net proceeds; issuing common stock in August 1999
resulting in $16.4 million in net proceeds to the company
- issuing 13.50 percent senior discount notes in May 1998 for
$144.0 million in net proceeds;
- private placements of equity totaling $105.8 million; and
- executing equipment lease lines totaling $124.5 million.
As of September 30, 1999, we had $558.2 million in cash and investments and
we had an accumulated deficit of $167.3 million.
For the nine months ended September 30, 1998 and September 30, 1999, we used
cash of $9.2 million and $78.9 million, respectively in our operating
activities. This cash was used for a variety of operating purposes including
salaries, consulting and legal expenses, network operations, marketing, and
overhead expenses. For the nine months ended September 30, 1998 and
September 30, 1999, we used net cash of $150.1 million and $311.1 million,
respectively, for investing activities. We used this cash primarily for
purchases of short-term investments and equipment and payments of collocation
fees. Net cash provided by financing activities for the nine months ended
September 30, 1998 and September 30, 1999 was $169.3 million and
$642.4 million, respectively. These funds were generated primarily from the
issuances of equity and senior debt as described above.
We expect our operating losses and capital expenditures to increase
substantially in the near-term, primarily due to our network expansion. We
believe that our existing cash and investment balances as of September 30, 1999,
together with the anticipated future revenue generated from operations, will be
sufficient to fund our operating losses, capital expenditures, lease payments,
and interest payments through approximately October 2000. We expect that
additional financing will be required in the future. We may attempt to raise
financing through some combination of commercial bank borrowings, leasing,
vendor financings, or the private or public sale of equity or debt securities.
Future equity or debt financings may
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not be available to us at all, or, if available, may not be on favorable terms.
If we are unable to obtain financing in the future, we will continue the
expansion of our operations on a reduced scale based on our existing capital
resources.
IMPACT OF THE YEAR 2000 ISSUE:
Many computer programs have been written using two digits rather than four
to define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year 1900
rather than the year 2000. This, in turn, could result in major system failures
or miscalculations, and is generally referred to as the "Year 2000 issue." We
have formulated and, to a large extent, effected a plan to address our Year 2000
issues. Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year 2000
compliance testing for all of our internal systems and believe that they are
Year 2000 compliant. Because we are a young company, we believe we have been
able to build our business systems with the Year 2000 issue in mind in a more
effective manner than many older companies. Therefore, there have been few Year
2000 changes required to our existing systems and applications. We have
substantially completed a compliance check of our external customers and
providers, except for the incumbent carriers. Based on responses from these
third parties, other than the incumbent carriers, we believe that they will not
experience Year 2000 problems that would materially and adversely affect our
business. We have not been able to conduct a compliance check of incumbent
carriers nor assess the incumbent carriers' Year 2000 compliance. To the extent
that one or more incumbent carriers or other third parties experience Year 2000
problems, our network and services could be adversely affected. Furthermore, the
purchasing patterns of our customers may be affected by Year 2000 issues as
companies expend significant resources to correct their current systems for Year
2000 compliance. These expenditures may result in reduced funds available for
our services. Any of these developments could have a material and adverse effect
on our business, prospects, operating results and ability to repay our debt,
including the notes. We have not fully determined the risks associated with the
reasonably worst-case scenario and have not formulated a contingency plan to
address Year 2000 issues. We do not expect to have a specific contingency plan
in place in the future.
RISKS AND UNCERTAINTIES:
In addition to the other risks stated in this document, you should consider
the following risks and uncertainties in evaluating our company.
WE CANNOT PREDICT OUR SUCCESS BECAUSE WE HAVE A SHORT OPERATING HISTORY
We formed our company in February 1997, and we have a short operating
history for you to review in evaluating our business. We have limited historical
financial and operating data upon which you can evaluate our business and
prospects. We entered into our first interconnection agreement with an incumbent
carrier in July 1997 and began to offer commercial services in our first market
in April 1998. We have limited commercial operations and have recognized limited
revenues since our inception. In addition, our senior management team and our
other employees have worked together at our company for only a short period of
time.
BECAUSE OUR MARKET IS NEW AND EVOLVING, WE CANNOT PREDICT ITS FUTURE GROWTH OR
ULTIMATE SIZE, AND WE MAY BE UNABLE TO COMPETE EFFECTIVELY
The market for packet-based high-speed digital communication services using
telephone lines is in the early stages of development. Since this market is new
and evolving and because our current and future competitors are likely to
introduce competing services, we cannot accurately predict the rate at which
this market will grow, if at all, or whether new or increased competition will
result in market saturation. Various providers of high-speed digital
communication services are testing products from various suppliers
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for various applications, and suppliers have not broadly adopted an industry
standard. Certain critical issues concerning commercial use of DSL for Internet
and local area network access, including security, reliability, ease and cost of
access and quality of service, remain unresolved and may impact the growth of
these services. If the markets for our services fail to develop, grow more
slowly than anticipated or become saturated with competitors, these events could
materially and adversely affect our business, prospects, operating results, and
financial condition.
Our success will depend on the development of this new and rapidly evolving
market and our ability to compete effectively in this market. To address these
risks, we must, among other things:
- rapidly expand the geographic coverage of our network services;
- raise additional capital;
- enter into interconnection agreements and working arrangements with
additional incumbent carriers, substantially all of which we expect to be
our competitors;
- deploy an effective network infrastructure;
- attract and retain customers;
- successfully develop relationships and activities with our partners and
distributors, including MCI WorldCom, Microsoft, Qwest and Cisco;
- continue to attract, retain and motivate qualified personnel;
- accurately assess potential markets and effectively respond to competitive
developments;
- continue to develop and integrate our operational support system and other
back office systems;
- obtain any required governmental authorizations;
- comply with evolving governmental regulatory requirements;
- increase awareness of our services;
- continue to upgrade our technologies; and
- effectively manage our expanding operations.
We may not be successful in addressing these and other risks, and our
failure to address risks would materially and adversely affect our business,
prospects, operating results, and financial condition.
WE CANNOT PREDICT OUR SUCCESS BECAUSE OUR BUSINESS MODEL IS UNPROVEN
We have not validated our business model and strategy in the market. We
believe that the combination of our unproven business model and the highly
competitive and fast changing market in which we compete makes it impossible to
predict the extent to which our network service will achieve market acceptance
and our overall success. To be successful, we must develop and market network
services that are widely accepted by businesses at profitable prices. We may
never be able to deploy our network as planned, achieve significant market
acceptance, favorable operating results or profitability or generate sufficient
cash flow to repay our debt. Of the approximately 6,700 lines that are in
service, we installed approximately 65% to only five customers. None of our
large business customers has rolled out our services broadly to its employees,
and we cannot be certain when or if these rollouts will occur. We will not
receive significant revenue from our large customers unless these rollouts
occur. Any continued or ongoing failure for any reason of large business
customers to roll out our services, failure to validate our business model in
the market, including failure to build out our network, achieve widespread
market acceptance or sustain desired pricing would materially and adversely
affect our business, prospects, operating results, and financial condition.
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WE EXPECT OUR LOSSES TO CONTINUE
We have incurred losses and experienced negative operating cash flow for
each month since our formation. As of September 30, 1999, we had an accumulated
deficit of approximately $167.3 million. We intend to rapidly and substantially
increase our expenditures and operating expenses in an effort to expand our
network services. We expect to have annual interest and amortization expense
relating to our 1998 senior discount notes and 1999 senior notes of
approximately $52.2 million in 1999 and increasing to $81.0 million in 2003. In
addition, we may incur more debt in the future. Furthermore, as a result of
recent business relationships arising from preferred stock and warrant issuances
and of previous stock option grants, we anticipate that there will be
significant charges to earnings in future periods. We estimate that these
charges will total approximately $6.2 million per year over each of the next
several years. As a result of these factors, we expect to incur substantial
operating and net losses and negative operating cash flow for the foreseeable
future. We will need to obtain additional financing to pay our expenses and to
make payments on our debt. We cannot give you any assurance about whether or
when we will have sufficient revenues to satisfy our funding requirements or pay
our debt service obligations.
OUR OPERATING RESULTS IN ONE OR MORE FUTURE PERIODS ARE LIKELY TO FLUCTUATE
SIGNIFICANTLY AND MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF SECURITIES
ANALYSTS OR INVESTORS
Our annual and quarterly operating results are likely to fluctuate
significantly in the future due to numerous factors, many of which are outside
of our control. These factors include:
- the rate of customer acquisition and turnover;
- the prices our customers are willing to pay;
- the amount and timing of expenditures relating to the expansion of our
services and infrastructure;
- the timing and availability of incumbent carrier central office
collocation facilities and transport facilities;
- the success of our relationships with our partners and distributors,
including MCI WorldCom, Microsoft, Qwest and Cisco;
- our ability to deploy our network on a timely basis;
- introduction of new services or technologies by our competitors;
- price competition;
- the ability of our equipment and service suppliers to meet our needs;
- regulatory developments, including interpretations of the 1996
Telecommunications Act;
- technical difficulties or network downtime;
- the success of our strategic alliances; and
- the condition of the telecommunication and network service industries and
general economic conditions.
Because of these factors, our operating results in one or more future
periods could fail to meet or exceed the expectations of securities analysts or
investors. In that event, any trading price of our common stock would likely
decline.
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IF SALES FORECASTED FOR A PARTICULAR PERIOD ARE NOT REALIZED IN THAT PERIOD DUE
TO THE LENGTHY SALES CYCLE OF OUR SERVICES, OUR OPERATING RESULTS FOR THAT
PERIOD WILL BE HARMED
The sales cycle of our network services can be very lengthy, particularly
for large businesses. The sales cycle for large businesses typically involves:
- a significant technical evaluation;
- an initial trial rollout to a relatively small number of end users;
- a commitment of capital and other resources by the customer;
- delays associated with the customer's internal procedures to approve large
capital expenditures;
- time required to engineer the deployment of our services;
- coordination of the activation of multiple access lines with incumbent
carriers; and
- testing and acceptance of our services.
For these and other reasons, our sales cycle for large businesses lasts at
least six months. During this lengthy sales cycle, we will incur significant
expenses in advance of the receipt of revenues. If sales that we forecast for a
particular period do not occur because of our lengthy sales cycle, this event
could materially and adversely affect our business, prospects, operating
results, and financial condition during that period.
WE DEPEND ON INCUMBENT CARRIERS FOR COLLOCATION AND TRANSMISSION FACILITIES
We must use copper telephone lines controlled by the incumbent carriers to
provide DSL connections to customers. We also depend on the incumbent carriers
for collocation and for a substantial portion of the transmission facilities we
use to connect our equipment in incumbent carrier central offices to our Metro
Service Centers. In addition, we depend on the incumbent carriers to test and
maintain the quality of the copper lines that we use. We have not established a
history of obtaining access to collocation and transmission facilities from
incumbent carriers in large volumes. In many cases, we may be unable to obtain
access to collocation and transmission facilities from the incumbent carriers,
or to gain access at acceptable rates, terms and conditions, including
timeliness. We have experienced, and expect to experience in the future, lengthy
periods between our request for and the actual provision of the collocation
space and telephone lines. An inability to obtain adequate and timely access to
collocation space or transmission facilities on acceptable terms and conditions
from incumbent carriers could have a material and adverse effect on our
business, prospects, operating results, and financial condition.
Because we compete with incumbent carriers in our markets, they may be
reluctant to cooperate with us. The incumbent carriers may experience, or claim
to experience, a shortage of collocation space or transmission capacity. If this
occurs, we may not have alternate means of connecting our DSL equipment with the
copper lines or connecting our equipment in central offices to Metro Service
Centers. We have experienced rejections of some of our collocation applications
on the grounds that no space is available. We may receive additional rejections
in the future. The number of other competitive local exchange carriers that
request collocation space will also affect the availability of collocation space
and transmission capacity. If we are unable to obtain physical collocation space
or transmission capacity from our targeted incumbent carriers, we may face
delays, additional costs or an inability to provide services in certain
locations. In many cases where our application for physical collocation is
rejected, we expect to have the option of adjacent location -- where we install
our equipment in a building that is very close to the incumbent carrier central
office -- or virtual collocation -- where the incumbent carrier manages and
operates our equipment. While we have used adjacent and virtual collocation in
our network, those alternatives reduce our control over our equipment, and
therefore may reduce the level of quality and service we provide to our
customers. We are currently in an arbitration proceeding with SBC
Communications Inc. concerning the availability of DSL-enabled copper lines, as
well as other operational
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issues. Delays in obtaining access to collocation space and telephone lines or
the rejection of our applications for collocation could result in delays in, and
increased expenses associated with, the rollout of our services, which in turn
could have a material and adverse effect on our business, prospects, operating
results, and financial condition.
WE ARE UNABLE TO CONTROL THE TERMS AND CONDITIONS UNDER WHICH WE GAIN ACCESS TO
INCUMBENT CARRIER COLLOCATION AND TRANSMISSION FACILITIES
We cannot control the terms under which we collocate our equipment, connect
to copper lines or gain the use of an incumbent carrier's transmission
facilities. State tariffs, state public utility commissions, the Federal
Communications Commission and interconnection agreements with the incumbent
carriers determine the price, terms and conditions under which collocation space
is made available, and they make these administrative determinations in ongoing
hearings. Interconnection agreements and state public utility commissions also
determine the terms and conditions of access to copper lines and other
components of an incumbent carrier's network. We may be unable to negotiate or
enter into interconnection agreements on acceptable terms or at all. In
addition, we cannot be sure that incumbent carriers will abide by their
obligations under those agreements. Delays in obtaining interconnection
agreements would delay our entry into certain markets. In addition, disputes may
arise between us and the incumbent carriers with respect to interconnection
agreements, and we may be unable to resolve disputes in our favor. If we are
unable to enter into, or experience a delay in obtaining, interconnection
agreements, this inability or delay could adversely affect our business,
prospects, operating results, and financial condition. Further, the
interconnection agreements are generally short term, and we may be unable to
renew the interconnection agreements on acceptable terms or at all. The state
commissions, the Federal Communications Commission and the courts oversee, in
varying degrees, interconnection arrangements as well as the terms and
conditions under which we gain access to incumbent carrier copper lines and
transmission facilities. These government entities may modify the terms or
prices of our interconnection agreements and our access to incumbent carrier
copper lines and transmission facilities in ways that would be adverse to our
business. The Federal Communications Commission and state regulatory commissions
establish the rates for DSL-capable copper lines as well as other rates, terms
and conditions of our dealings with the incumbent carriers in ongoing public
hearings. Participation in these hearings will involve significant management
time and expense. Incumbent carriers may from time to time propose new rates,
and the outcomes of hearings and rulings could have a material and adverse
effect on our business, prospects, operating results, and financial condition.
WE DEPEND ON THIRD PARTIES, PARTICULARLY MCI WORLDCOM, MICROSOFT, QWEST AND
CISCO, FOR THE MARKETING AND SALES OF OUR NETWORK SERVICES
We will rely significantly on indirect sales channels for the marketing and
sales of our network services. We will seek to establish relationships with
numerous service providers, including Internet Service Providers, interexchange
carriers, other competitive carriers and value-added resellers, to gain access
to customers. Our agreements to date with service providers are non-exclusive,
and we anticipate that future agreements will also be on a non-exclusive basis,
allowing service providers to resell services offered by our competitors. These
agreements are generally short term, and can be cancelled by the service
provider without significant financial consequence. We cannot control how these
service providers perform and cannot be certain that their performance will be
satisfactory to us or our customers. Many of these companies also compete with
us. If the number of customers we obtain through indirect sales channels is
significantly lower than our forecast for any reason, or if the service
providers with which we have contracted are unsuccessful in competing in their
own intensely competitive markets, these events would have a material and
adverse effect on our business, prospects, operating results, and financial
condition.
We expect to rely particularly on the sales and marketing efforts of our
strategic partners, including MCI WorldCom, Microsoft, Qwest and Cisco. While
our agreements with MCI WorldCom and Qwest call
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for them to sell an aggregate of 200,000 DSL lines, the agreements also enable
MCI WorldCom and Qwest to terminate their respective agreements under certain
circumstances and to receive offsets and credits under other circumstances.
Therefore, MCI WorldCom and Qwest might sell significantly fewer than 200,000
DSL lines, or we might receive significantly lower revenues than we otherwise
would.
THE MARKET IN WHICH WE OPERATE IS HIGHLY COMPETITIVE, AND WE MAY NOT BE ABLE
TO COMPETE EFFECTIVELY, ESPECIALLY AGAINST ESTABLISHED INDUSTRY COMPETITORS WITH
SIGNIFICANTLY GREATER FINANCIAL RESOURCES
We will face competition from many competitors with significantly greater
financial resources, well-established brand names and large, existing installed
customer bases. We expect the level of competition to intensify in the future.
We expect significant competition from incumbent carriers, traditional and new
long distance carriers, cable modem service providers, Internet Service
Providers, wireless and satellite data service providers and other competitive
carriers. Incumbent carriers have existing metropolitan area networks and
circuit-switched local access networks. In addition, most incumbent carriers are
establishing their own Internet Service Provider businesses and are in some
stage of market trials and retail sales of DSL-based access services. Some
incumbent carriers have announced that they intend to aggressively market these
services to their residential customers at attractive prices. We believe that
incumbent carriers have the potential to quickly overcome many of the issues
that have delayed widespread deployment of DSL services in the past. In
addition, we may experience substantial customer turnover in the future. Many
providers of telecommunications and networking services experience high rates of
customer turnover.
Many of the leading traditional long distance carriers, including AT&T
Corporation, MCI WorldCom and Sprint, are expanding their capabilities to
support high-speed, end-to-end networking services. The newer long distance
carriers, including Williams, Level 3 Communications, Inc. and Qwest, are
building and managing high bandwidth, nationwide packet networks and partnering
with Internet Service Providers to offer services directly to the public. Cable
modem service providers, like @Home Networks, are offering or preparing to offer
high-speed Internet access over hybrid fiber networks to consumers, and @Work
has positioned itself to do the same for businesses. Several new companies are
emerging as wireless, including satellite-based, data service providers.
Internet Service Providers, including some with significant and even nationwide
presences, provide Internet access to residential and business customers,
generally over the incumbent carriers' circuit switched networks, although some
have begun offering DSL-based access. Certain competitive carriers, including
Covad Communications Group, Inc. and NorthPoint Communications, Inc., have begun
offering DSL-based access services, and, like us, have attracted strategic
equity investors, marketing allies and product development partners. Others are
likely to do the same in the future. In addition, regional Internet Service
Providers and competitive carriers, including HarvardNet, Inc., Network Access
Solutions Corp. and DSL.net, Inc. have begun offering DSL-based access services
that compete with the services we offer. As a result of increasing competition
for our services, we are experiencing substantial price competition,
particularly with respect to sales generated through our indirect sales
channels.
Many of these competitors are offering, or may soon offer, technologies and
services that will directly compete with some or all of our service offerings.
Some of the technologies used by these competitors for local access connections
include integrated services digital network (ISDN), DSL, wireless data and cable
modems. Some of the competitive factors in our markets include transmission
speed, reliability of service, breadth of service availability, price
performance, network security, ease of access and use, content bundling,
customer support, brand recognition, operating experience, capital availability
and exclusive contracts. We believe that we compare unfavorably with many of our
competitors with regard to, among other things, brand recognition, existing
relationships with end users, available pricing discounts, central office
access, capital availability and exclusive contracts. Substantially all of our
competitors and potential competitors have substantially greater resources than
us. We may not be able to compete effectively in our target markets. Our failure
to compete effectively would have a material and adverse effect on our business,
prospects, operating results, and financial condition.
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OUR NETWORK SERVICES MAY NOT ACHIEVE SIGNIFICANT MARKET ACCEPTANCE BECAUSE OUR
PRICES ARE OFTEN HIGHER THAN THOSE CHARGED FOR COMPETING SERVICES
Our prices are in some cases higher than those that our competitors charge
for some of their services. Prices for digital communications services have
fallen historically, and we expect prices in the industry in general, and for
the services we offer now and plan to offer in the future, to continue to fall.
We may be required to reduce prices periodically to respond to competition and
to generate increased sales volume. Our prices may not permit our network
services to gain a desirable level of commercial acceptance, and we may be
unable to sustain any current or future pricing levels. Due to these factors, we
cannot accurately forecast our revenues or the rate at which we will add new
customers.
WE WILL NEED SIGNIFICANT ADDITIONAL FUNDS, WHICH WE MAY NOT BE ABLE TO OBTAIN
The expansion and development of our business will require significant
additional capital. We intend to seek substantial additional financing in the
future to fund the growth of our operations, including funding the significant
capital expenditures and working capital requirements necessary for us to
provide service in our targeted markets. We believe that our current capital
resources will be sufficient to fund our aggregate capital expenditures and
working capital requirements, including operating losses, through approximately
June 2001. We will not have completed our network rollout by this date and will
need additional capital, whether or not our estimate on how long current capital
resources will last is accurate. In addition, our actual funding requirements
may differ materially if our assumptions underlying this estimate turn out to be
incorrect. Therefore, you should consider our estimate in light of the following
facts:
- we have no meaningful history of operations or revenues;
- our estimated funding requirements do not reflect any contingency amounts
and may increase, perhaps substantially, if we are unable to generate
revenues in the amount and within the time frame we expect or if we have
unexpected cost increases; and
- we face many challenges and risks, including those discussed elsewhere in
this document.
We may be unable to obtain any future equity or debt financing on acceptable
terms or at all. Recently the financial markets have experienced extreme price
fluctuations. A market downturn or general market uncertainty may adversely
affect our ability to secure additional financing. The indentures that govern
the 1998 senior discount notes and the 1999 senior notes restrict our ability to
obtain additional debt financing. Any future borrowing instruments, such as
credit facilities and lease agreements, are likely to contain similar or more
restrictive covenants and could require us to pledge assets as security for the
borrowings. If we are unable to obtain additional capital or are required to
obtain it on terms less satisfactory than what we desire, we will need to delay
deployment of our network services or take other actions that could adversely
affect our business, prospects, operating results, and financial condition. If
we are unable to generate sufficient cash flow or obtain funds necessary to meet
required payments of our debt, then we will be in default on our debt
instruments. To date, our cash flow from operations has been insufficient to
cover our expenses and capital needs. Please see "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Liquidity and Capital
Resources."
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN CURRENT OR
FUTURE LAWS OR REGULATIONS COULD RESTRICT THE WAY WE OPERATE OUR BUSINESS
A significant portion of the services that we offer through our subsidiaries
is subject to regulation at the federal, state and/or local levels. Future
federal or state regulations and legislation may be less favorable to us than
current regulation and legislation and therefore have an adverse impact on our
business, prospects, operating results, and financial condition. In addition, we
may expend significant financial and managerial resources to participate in
rule-setting proceedings at either the federal or state
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level, without achieving a favorable result. The Federal Communications
Commission prescribes rules applicable to interstate communications, including
rules implementing the 1996 Telecommunications Act, a responsibility it shares
with the state regulatory commissions. In particular, we believe that incumbent
carriers will work aggressively to modify or restrict the operation of many
provisions of the 1996 Telecommunications Act. We expect incumbent carriers will
pursue litigation in courts, institute administrative proceedings with the
Federal Communications Commission and other regulatory agencies and lobby the
United States Congress, all in an effort to affect laws and regulations in a
manner favorable to the incumbent carriers and against the interest of
competitive carriers such as us. If the incumbent carriers succeed in any of
their efforts, if these laws and regulations change or if the administrative
implementation of laws develops in an adverse manner, these events could have a
material and adverse effect on our business, prospects, operating results, and
financial condition.
OUR FAILURE TO MANAGE GROWTH COULD ADVERSELY AFFECT US
We have rapidly and significantly expanded our operations. We anticipate
further significant expansion of our operations in an effort to achieve our
network rollout and deployment objectives. Our expansion to date has strained
our management, financial controls, operations systems, personnel and other
resources. Any future rapid expansion would increase these strains. If our
marketing strategy is successful, we may experience difficulties responding to
customer demand for services and technical support in a timely manner and in
accordance with their expectations. As a result, rapid growth of our business
would make it difficult to implement successfully our strategy to provide
superior customer service. To manage any growth of our operations, we must:
- improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
- hire, train and manage additional qualified personnel;
- expand and upgrade our core technologies; and
- effectively manage multiple relationships with our customers, suppliers
and other third parties.
We may not be able to install management information and control systems in
an efficient and timely manner, and our current or planned personnel, systems,
procedures and controls may not be adequate to support our future operations.
Failure to manage our future growth effectively could adversely affect the
expansion of our customer base and service offerings. Any failure to
successfully address these issues could materially and adversely affect our
business, prospects, operating results, and financial condition.
OUR SUBSTANTIAL DEBT CREATES FINANCIAL AND OPERATING RISK
We are highly leveraged, and we intend to seek additional debt funding in
the future. As of September 30, 1999, we and approximately $500.1 million of
outstanding debt and our debt made up 71.3% of our capitalization. We are not
generating any meaningful revenue to fund our operations or to repay our debt.
Our substantial leverage poses the risks that:
- we may be unable to repay our debt due to one or more events discussed in
this document;
- we may be unable to obtain additional financing;
- we must dedicate a substantial portion of our cash flow from operations to
servicing our debt once our debt requires us to make cash interest
payments, and any remaining cash flow may not be adequate to fund our
planned operations; and
- we may be more vulnerable during economic downturns, less able to
withstand competitive pressures and less flexible in responding to
changing business and economic conditions.
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THE TELECOMMUNICATIONS INDUSTRY IS UNDERGOING RAPID TECHNOLOGICAL CHANGE, AND
NEW TECHNOLOGIES MAY BE SUPERIOR TO THE TECHNOLOGY WE USE
The telecommunications industry is subject to rapid and significant
technological changes, such as continuing developments in DSL technology and
alternative technologies for providing high-speed data communications. We cannot
predict the effect of technological changes on our business. We will rely in
part on third parties, including certain of our competitors and potential
competitors, for the development of and access to communications and networking
technology. We expect that new products and technologies applicable to our
market will emerge. New products and technologies may be superior and/or render
obsolete the products and technologies that we currently use. Our future success
will depend, in part, on our ability to anticipate and adapt to technological
changes and evolving industry standards. We may be unable to obtain access to
new technology on acceptable terms or at all, and we may be unable to adapt to
new technologies and offer services in a competitive manner. Our joint
development projects with Cisco and MCI WorldCom and our strategic arrangement
with Microsoft may not produce useful technologies or services for us. Further,
new technologies and products may not be compatible with our technologies and
business plan. We believe that the telecommunications industry must set
standards to allow for the compatibility of various products and technologies.
However, the industry may not set standards on a timely basis or at all. In
addition, many of the products and technologies that we intend to use in our
network services are relatively new and unproven and may be unreliable.
WE MAY BE UNABLE TO EFFECTIVELY EXPAND OUR NETWORK SERVICES AND PROVIDE HIGH
PERFORMANCE TO A SUBSTANTIAL NUMBER OF END USERS
Due to the limited deployment of our network services, we cannot guarantee
that our network will be able to connect and manage a substantial number of end
users at high transmission speeds. We may be unable to scale our network to
service a substantial number of end users while achieving high performance.
Further, our network may be unable to achieve and maintain competitive digital
transmission speeds. While digital transmission speeds of up to 7.1 Mbps are
possible on certain portions of our network, that speed is not available over a
majority of our network. Actual transmission speeds on our network will depend
on a variety of factors and many of these factors are beyond our control,
including the type of DSL technology deployed, the distance an end user is
located from a central office, the quality of the telephone lines, the presence
of interfering transmissions on nearby lines and other factors. As a result, we
may not be able to achieve and maintain digital transmission speeds that are
attractive in the market.
OUR SERVICES MAY SUFFER BECAUSE THE TELEPHONE LINES WE REQUIRE MAY BE
UNAVAILABLE OR IN POOR CONDITION
Our ability to provide DSL-based services to potential customers depends on
the quality, physical condition, availability and maintenance of telephone lines
within the control of the incumbent carriers. We believe that the current
condition of telephone lines in many cases will be inadequate to permit us to
fully implement our network services. In addition, the incumbent carriers may
not maintain the telephone lines in a condition that will allow us to implement
our network effectively. The telephone lines may not be of sufficient quality or
the incumbent carriers may claim they are not of sufficient quality to allow us
to fully implement or operate our network services. Further, some customers use
technologies other than copper lines to provide telephone services, and DSL
might not be available to these customers.
OUR SUCCESS DEPENDS ON OUR RETENTION OF CERTAIN KEY PERSONNEL AND ON THE
PERFORMANCE OF THOSE PERSONNEL
Our success depends on the performance of our officers and key employees,
especially our Chief Executive Officer. Members of our senior management team
have worked together for only a short period of time. We do not have "key
person" life insurance policies on any of our employees nor do we have
employment agreements for fixed terms with any of our employees. Any of our
employees, including any member of our senior management team, may terminate his
or her employment with us at any time. Given our early stage of development, we
depend on our ability to retain and motivate high quality personnel,
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especially our management. Our future success also depends on our continuing
ability to identify, hire, train and retain highly qualified technical, sales,
marketing and customer service personnel. Moreover, the industry in which we
compete has a high level of employee mobility and aggressive recruiting of
skilled personnel. We may be unable to continue to employ our key personnel or
to attract and retain qualified personnel in the future. We face intense
competition for qualified personnel, particularly in software development,
network engineering and product management.
WE DEPEND ON THIRD PARTIES FOR EQUIPMENT, INSTALLATION AND PROVISION OF FIELD
SERVICE
We currently plan to purchase all of our equipment from many vendors and
outsource the majority of the installation and field service of our networks to
third parties. Our reliance on third party vendors involves a number of risks,
including the absence of guaranteed capacity and reduced control over delivery
schedules, quality assurance, production yields and costs. If any of our
suppliers reduces or interrupts its supply, or if any significant installer or
field service provider interrupts its service to us, this reduction or
interruption could disrupt our business. Although multiple manufacturers
currently produce or are developing equipment that will meet our current and
anticipated requirements, our suppliers may be unable to manufacture and deliver
the amount of equipment we order, or the available supply may be insufficient to
meet our demand. Currently, almost all of the DSL modem and DSL multiplexing
equipment we use for a single connection over a copper line must come from the
same vendor since there are no existing interoperability standards for the
equipment used in our higher speed services. If our suppliers or licensors enter
into competition with us, or if our competitors enter into exclusive or
restrictive arrangements with the suppliers or licensors, then these events may
materially and adversely affect the availability and pricing of the equipment we
purchase and the technology we license.
A SYSTEM FAILURE OR BREACH OF NETWORK SECURITY COULD CAUSE DELAYS OR
INTERRUPTIONS OF SERVICE TO OUR CUSTOMERS
Our operations depend on our ability to avoid damages from fires,
earthquakes, floods, power losses, excessive sustained or peak user demand,
telecommunications failures, network software flaws, transmission cable cuts and
similar events. A natural disaster or other unanticipated problem at our owned
or leased facilities could interrupt our services. Additionally, if an incumbent
carrier, competitive carrier or other service provider fails to provide the
communications capacity we require, as a result of a natural disaster,
operational disruption or any other reason, then this failure could interrupt
our services.
Despite the implementation of security measures, our network may be
vulnerable to unauthorized access, computer viruses and other disruptive
problems. Corporate networks and Internet Service Providers have in the past
experienced, and may in the future experience, interruptions in service as a
result of accidental or intentional actions of Internet users, current and
former employees and others. Unauthorized access could also potentially
jeopardize the security of confidential information stored in the computer
systems of our customers, which might cause us to be liable to our customers,
and also might deter potential customers. Eliminating computer viruses and
alleviating other security problems may require interruptions, delays or
cessation of service to our customers and our customers' end users.
INTERFERENCE OR CLAIMS OF INTERFERENCE COULD DELAY OUR ROLLOUT OR HARM OUR
SERVICES
All transport technologies deployed on copper telephone lines have the
potential to interfere with, or to be interfered with by, other transport
technologies on the copper telephone lines. We believe that our DSL
technologies, like other transport technologies, do not interfere with existing
voice services. We believe that a workable plan that takes into account all
technologies could be implemented in a scalable way across all incumbent
carriers using existing plant engineering principles. There are several
initiatives underway to establish national standards and principles for the
deployment of DSL technologies. We believe that our technologies can be deployed
consistently with these evolving standards. Nevertheless, incumbent carriers may
claim that the potential for interference permits them to restrict or delay our
deployment of DSL services. Interference could degrade the performance of our
services or make us
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unable to provide service on selected lines. The procedures to resolve
interference issues between competitive carriers and incumbent carriers are
still being developed, and these procedures may not be effective. We may be
unable to successfully negotiate interference resolution procedures with
incumbent carriers. Moreover, incumbent carriers may make claims regarding
interference or unilaterally take action to resolve interference issues to the
detriment of our services. State or federal regulators could also institute
responsive actions. Interference, or claims of interference, if widespread,
would adversely affect our speed of deployment, reputation, brand image, service
quality and customer satisfaction and retention.
WE DEPEND ON THIRD PARTIES FOR FIBER OPTIC TRANSPORT FACILITIES
We depend on the availability of fiber optic transmission facilities from
third parties to connect our equipment within and between metropolitan areas.
These third party fiber optic carriers include long distance carriers, incumbent
carriers and other competitive carriers. Many of these entities are, or may
become, our competitors. This approach includes a number of risks. For instance,
we may be unable to negotiate and renew favorable supply agreements. Further, we
depend on the timeliness of these companies to process our orders for customers
who seek to use our services. We have in the past experienced supply problems
with certain of our fiber optic suppliers, and they may not be able to meet our
needs on a timely basis in the future. Moreover, the fiber optic transport
providers whose networks we lease may be unable to obtain or maintain permits
and rights-of-way necessary to develop and operate existing and future networks.
UNCERTAIN FEDERAL AND STATE TAX AND OTHER SURCHARGES ON OUR SERVICES MAY
INCREASE OUR PAYMENT OBLIGATIONS
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate and intrastate services. The division of our
services between interstate and intrastate services is a matter of
interpretation, and in the future the Federal Communications Commission or
relevant state commission authorities may contest this division. A change in the
characterization of the jurisdiction of our services could cause our payment
obligations to increase. In addition, pursuant to periodic revisions by state
and federal regulators of the applicable surcharges, we may be subject to
increases in the surcharges and fees currently paid.
OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS
We rely on a combination of licenses, confidentiality agreements and other
contracts to establish and protect our technology and other intellectual
property rights. We have applied for trademarks and servicemarks on certain
terms and symbols that we believe are important for our business. We currently
have no patents or patent applications pending. The steps we have taken may be
inadequate to protect our technology or other intellectual property. Moreover,
our competitors may independently develop technologies that are substantially
equivalent or superior to ours. Third parties may assert infringement claims
against us and, in the event of an unfavorable ruling on any claim, we may be
unable to obtain a license or similar agreement to use technology we rely upon
to conduct our business. We also rely on unpatented trade secrets and know-how
to maintain our competitive positions, which we seek to protect, in part, by
confidentiality agreements with employees, consultants and others. However,
these agreements may be breached or terminated, and we may not have adequate
remedies for any breach. In addition, our competitors may otherwise learn or
discover our trade secrets. Our management personnel were previously employees
of other telecommunications companies. In many cases, these individuals are
conducting activities for us in areas similar to those in which they were
involved prior to joining us. As a result, we or our employees could be subject
to allegations of violation of trade secrets and other similar claims.
RISKS ASSOCIATED WITH POTENTIAL GENERAL ECONOMIC DOWNTURN
In the last few years the general health of the economy, particularly the
economy of California where we have conducted a significant portion of our
operations to date, has been relatively strong and growing, a
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consequence of which has been increasing capital spending by individuals and
growing companies to keep pace with rapid technological advances. To the extent
the general economic health of the United States or of California declines from
recent historically high levels, or to the extent individuals or companies fear
a decline is imminent, these individuals and companies may reduce expenditures
such as those for our services. Any decline or concern about an imminent decline
could delay decisions among certain of our customers to roll out our services or
could delay decisions by prospective customers to make initial evaluations of
our services. Any delays would have a material and adverse effect on our
business, prospects, operating results, and financial condition.
WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE COVENANTS
IN OUR EXISTING DEBT SECURITIES
The indentures governing our 1998 senior discount notes and 1999 senior
notes impose significant restrictions on how we can conduct our business. For
example, the restrictions prohibit or limit our ability to incur additional
debt, make dividend payments and engage in certain business activities. The
restrictions may materially and adversely affect our ability to finance future
operations or capital needs or conduct additional business activities. Any
future senior debt that we may incur will likely impose additional restrictions
on us. If we fail to comply with any existing or future restrictions, we could
default under the terms of the applicable debt and be unable to meet our debt
obligations. If we default, the holders of the applicable debt could demand that
we repay the debt, including interest, immediately. We may be unable to make the
required payments or raise sufficient funds from alternative sources to make the
payments. Even if additional financing is available in the event that we
default, it may not be on acceptable terms.
OUR PRINCIPAL STOCKHOLDERS AND MANAGEMENT OWN A SIGNIFICANT PERCENTAGE OF OUR
COMPANY AND WILL BE ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR COMPANY
Our executive officers and directors and principal stockholders together
beneficially own 75.4% of the total voting power of our company. Accordingly,
these stockholders are able to determine the composition of our Board of
Directors, will retain the voting power to approve all matters requiring
stockholder approval and will continue to have significant influence over our
affairs. This concentration of ownership could have the effect of delaying or
preventing a change in our control or otherwise discouraging a potential
acquirer from attempting to obtain control of us, which in turn could have a
material and adverse effect on the market price of the common stock or prevent
our stockholders from realizing a premium over the market prices for their
shares of common stock.
OUR FAILURE AND THE FAILURE OF THIRD PARTIES TO BE YEAR 2000 COMPLIANT COULD
NEGATIVELY IMPACT OUR BUSINESS
Many computer programs have been written using two digits rather than four
to define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year 1900
rather than the year 2000. This, in turn, could result in major system failures
or miscalculations, and is generally referred to as the "Year 2000 issue." We
have formulated and, to a large extent, effected a plan to address our Year 2000
issues.
Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year 2000
compliance testing for all of our internal systems and believe that they are
Year 2000 compliant. Because we are a young company, we believe we have been
able to build our business systems with the Year 2000 issue in mind. Therefore,
there have been few Year 2000 changes required to our existing systems and
applications. We have substantially completed a compliance check of our external
customers and providers, except for the incumbent carriers. Based on responses
from these third parties, other than the incumbent carriers, we have no
information or data to suggest that they will experience Year 2000 problems that
would materially and adversely affect our business. We have not been able to
conduct a compliance check of incumbent carriers nor assess the incumbent
carriers' Year 2000 compliance. To the extent that one or more incumbent
carriers or other third parties experience Year 2000 problems, our network and
services could be adversely affected. Furthermore, the purchasing patterns of
our customers may be affected by Year 2000 issues as companies
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expend significant resources to correct their current systems for Year 2000
compliance. These expenditures may result in reduced funds available for our
services. Any of these developments could have a material and adverse effect on
our business, prospects, operating results, and financial condition. We have not
fully determined the risks associated with the reasonably worst-case scenario
and have not formulated a contingency plan to address Year 2000 issues. We do
not expect to have a specific contingency plan in place in the future.
IF WE ARE REQUIRED TO REGISTER AS AN INVESTMENT COMPANY, WE WOULD BECOME
SUBJECT TO SUBSTANTIAL REGULATION WHICH WOULD INTERFERE WITH OUR ABILITY TO
CONDUCT OUR BUSINESS ACCORDING TO OUR BUSINESS PLAN
As a result of our previous financings, we have substantial cash, cash
equivalents and short-term investments. We plan to continue investing the excess
proceeds of these financings in short-term instruments consistent with prudent
cash management and not primarily for the purpose of achieving investment
returns. Investment in securities primarily for the purpose of achieving
investment returns could result in our being treated as an "investment company"
under the Investment Company Act of 1940. The Investment Company Act requires
the registration of companies that are primarily in the business of investing,
reinvesting or trading securities or that fail to meet certain statistical tests
regarding their composition of assets and sources of income even though they
consider themselves not to be primarily engaged in investing, reinvesting or
trading securities.
We believe that we are primarily engaged in a business other than investing
in or trading securities and, therefore, are not an investment company within
the meaning of the Investment Company Act. If the Investment Company Act
required us to register as an investment company, we would become subject to
substantial regulation with respect to our capital structure, management,
operations, transactions with affiliated persons and other matters. Application
of the provisions of the Investment Company Act to us would materially and
adversely affect our business, prospects, operating results, and financial
condition.
WE EXPECT OUR STOCK PRICE TO BE VOLATILE
The trading price of our common stock has been and is likely to continue to
be highly volatile. Our stock price could fluctuate widely in response to many
factors, including the following:
- our historical and anticipated quarterly and annual operating results;
- announcements of new products or services by us or our competitors or new
competing technologies;
- the addition or loss of business or service provider customers;
- variations between our actual results and analyst and investor
expectations;
- investor perceptions of our company and comparable public companies;
- conditions or trends in the telecommunications industry, including
regulatory developments;
- announcements by us of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
- additions or departures of key personnel;
- future equity or debt offerings or our announcements of such offerings;
and
- general market and economic conditions.
In addition, in recent years the stock market in general, and the Nasdaq
National Market and the market for Internet and technology companies in
particular, have experienced extreme price and volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating
performance of these companies. These market and industry factors may materially
and adversely affect our stock price, regardless of our operating performance.
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WE HAVE NOT PAID AND DO NOT INTEND TO PAY DIVIDENDS
We have not paid any dividends, and we do not intend to pay cash dividends
in the foreseeable future. Our current financing documents contain provisions
which restrict our ability to pay dividends.
ANTI-TAKEOVER PROVISIONS COULD NEGATIVELY IMPACT OUR STOCKHOLDERS
Our Board of Directors has adopted a stockholder rights plan. Our
stockholder rights plan would cause substantial dilution to any person or group
that attempts to acquire our company on terms not approved in advance by our
Board of Directors. In addition, some of the provisions that may be included in
our certificate of incorporation and bylaws may discourage, delay or prevent a
merger or acquisition at a premium price. These provisions include:
- authorizing the issuance of "blank check" preferred stock;
- providing for a classified Board of Directors with staggered, three-year
terms;
- eliminating the ability of stockholders to call a special meeting of
stockholders;
- limiting the removal of directors by the stockholders to removal for
cause; and
- requiring a super-majority stockholder vote to effect certain amendments.
In addition, certain provisions of the Delaware General Corporation Law and
our stockholder rights plan may deter someone from acquiring or merging with us,
including a transaction that results in stockholders receiving a premium over
the market price for the shares of common stock held by them. Section 203 of the
Delaware General Corporation Law also imposes certain restrictions on mergers
and other business combinations between us and any holder of more than 15% and
less than 85% of our common stock.
The indentures governing our 1998 senior discount notes and 1999 senior
notes require us to offer to repurchase all such notes for 101% of their
principal amount or accreted value, as the case may be, plus any accrued
interest and liquidated damages, within 30 days after a change of control. We
might not have sufficient funds available at the time of any change of control
to make any required payment, as well as any payment that may be required
pursuant to any other outstanding indebtedness at the time, including our
indebtedness to equipment financing lenders. These covenants may also deter
third parties from entering into a change of control transaction with us.
Furthermore, following the occurrence of certain change-of-control events, we
must offer to repurchase for cash all of the outstanding warrants issued in
connection with the senior discount notes.
THE PRICE OF OUR COMMON STOCK MAY DECLINE DUE TO SHARES ELIGIBLE FOR FUTURE SALE
Sales of substantial amounts of our common stock in the public market, or
the appearance that a large number of shares is available for sale, could
adversely affect the market price for the common stock. The number of shares of
common stock available for sale in the public market was previously limited by
lock-up agreements that were entered into in connection with our initial public
offering in April 1999 and our secondary offering in August 1999. Under such
lock-up agreements in connection with our initial public offering, the holders
of approximately 78.4% of our outstanding shares of common stock agreed not to
sell or otherwise dispose of any of their shares until October 4, 1999. Under
the lock-up agreements in connection with our secondary public offering, the
holders of approximately 76.1% of our outstanding shares of common stock agreed
not to sell or otherwise dispose of any of their shares until November 9, 1999.
In addition to the adverse effect a price decline could have on holders of
common stock, that decline would likely impede our ability to raise capital
through the issuance of additional shares of common stock or other equity
securities.
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RHYTHMS NETCONNECTIONS INC.
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
There were no material changes in our legal proceedings during the quarter
ended September 30, 1999.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) None.
(b) None.
(c) During the quarter ended September 30, 1999, we issued the following
unregistered securities:
(1) In July 1999, we issued a warrant to GATX Capital Corporation to
purchase up to 10,000 shares of the Registrant's common stock at an
exercise price of $50.00 per share in connection with an equipment
lease financing. This warrant is exercisable immediately and expires
on July 30, 2004.
(d) On April 12, 1999, we completed the sale of 10,781,250 shares of common
stock priced at $21.00 per share for an aggregate offering price of
$226.4 million in an initial public offering led by an underwriting group
consisting of Merrill Lynch & Co., Salomon Smith Barney, Hambrecht & Quist, and
Thomas Weisel Partners LLC. The proceeds of the offering to us, net of
underwriting fees and estimated offering expenses were approximately
$210.1 million. The Registration Statement on Form S-1 filed by us with the SEC
in connection with the offering (File No. 333-72409), as amended, was declared
effective by the Commission on April 6, 1999.
Since the completion of the offering, the net offering proceeds have been
applied to the following uses in the following approximate amounts:
- $90.0 million to fund payments of collocation fees and purchases of
equipment and furniture in our continuing development of network services
in our existing markets and our planned rollout into additional markets;
- $60.0 million for operating activities including salaries, consulting and
legal expenses, network operations and overhead expenses; and
- the remainder of the proceeds are invested in short-term securities to be
used for future working capital and network build-out needs.
All of the payments indicated above were direct or indirect payments to
entities or persons other than our directors, officers or their associates,
greater than 10% owners of any of our equity securities or our affiliates.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
No defaults upon senior securities occurred during the quarter ended
September 30, 1999.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended September 30, 1999.
ITEM 5. OTHER INFORMATION
Not applicable.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits:
27.1 Financial Data Schedule
10.1 Master Lease Agreement, dated July 30, 1999, by and between the
Registrant and GATX Capital Corporation
(b) Reports on Form 8-K:
There have been no reports on Form 8-K filed during the quarter ended
September 30, 1999.
27
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RHYTHMS NETCONNECTIONS INC.
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
/s/ SCOTT C. CHANDLER
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Scott C. Chandler
CHIEF FINANCIAL OFFICER AND EXECUTIVE VICE PRESIDENT
November 15, 1999
28
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Exhibit 10.1
[LOGO] GATX CAPITAL CORPORATION
MASTER LEASE AGREEMENT
NO. 1903
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This Master Lease Agreement ("Lease Agreement") is made as of the 30TH day of
JULY ,1999, between GATX CAPITAL CORPORATION of Four Embarcadero Center, Suite
2200, San Francisco, CA 94111 (the "Lessor") and RHYTHMS NETCONNECTIONS INC
having its principal offices at 6933 SOUTH REVERE PARKWAY, SUITE 100, ENGLEWOOD,
CO 80112 (the "Lessee").
TERMS AND CONDITIONS
1. DEFINITIONS.
"Lease Order" shall refer to that document wherein Lessor agrees to
lease to Lessee and Lessee agrees to lease from Lessor certain Equipment. Each
Lease Order shall be signed and submitted by Lessee to Lessor and, when so
submitted, shall constitute a firm irrevocable offer by Lessee to lease the
Equipment identified on the Lease Order subject to the terms of the Lease Order
and this Lease Agreement which, if accepted by Lessor by signing and returning
to Lessee one copy of the same within thirty (30) days of the date of the Lease
Order shall be deemed a duly executed and in force Lease Order.
"Initial Term" shall mean the period beginning on the Commencement Date
and continuing for the number of months set forth in each Lease Order.
"Equipment" shall mean the equipment identified in a duly executed and in
force Lease Order and all related replacements, parts, additions, software,
accessories, alterations and repairs incorporated therein or affixed thereto,
together with any items included on the related Lease Order including, but not
limited to, training, maintenance, license agreements, etc.
"Software" shall mean a computer program in any data, program
description, media or supporting documentation provided by a licensor as part of
the transaction.
"Delivery and Acceptance Date" shall mean the date that the Equipment
listed on the related Lease Order is accepted at Lessee's premises, such date
being specified in the related Delivery and Acceptance Receipt. Unless expressly
agreed otherwise by the parties or Lessee notifies Lessor in writing that the
Equipment has been rejected, the Equipment must be accepted within seven (7)
days after the delivery date, and if not accepted by such time the Delivery and
Acceptance Date shall be deemed to be seven (7) days after the delivery date.
"Commencement Date" means, as to the Equipment designated on any Lease
Order, where the Delivery and Acceptance Date for such Equipment falls on the
first day of the month, that date, or, in any other case, the first day of the
month or calendar quarter if so provided in the Lease Order, following the
Delivery and Acceptance Date, unless otherwise agreed by the parties.
"Progress Payment Rider" shall refer to that document wherein the seller
of the Equipment requires payment prior to the commencement of a Lease Order and
Lessee agrees to make payments prior to the commencement of a Lease Order.
2. NET LEASE.
THIS LEASE AGREEMENT TOGETHER WITH EACH LEASE ORDER CONSTITUTES A NET
LEASE AND LESSEE'S AGREEMENT TO PAY RENT AND ANY OTHER OBLIGATIONS HEREUNDER AND
UNDER ANY APPLICABLE LEASE ORDERS SHALL BE ABSOLUTE AND UNCONDITIONAL AND SHALL
NOT BE SUBJECT TO ANY ABATEMENT, REDUCTION, SET-OFF, DEFENSE, COUNTERCLAIM,
INTERRUPTION, DEFERMENT OR RECOUPMENT FOR ANY REASON WHATSOEVER. Lessor and
Lessee will enter into one or more Lease Orders pursuant to this Lease
Agreement. Subject to the terms and conditions of this Lease Agreement and a
duly executed and in force Lease Order, Lessor agrees to lease to Lessee and
Lessee agrees to lease from Lessor the Equipment described in each Lease Order.
This Lease Agreement is a master lease and each Lease Order is subject to the
terms of this Lease Agreement. Each Lease Order shall be treated as a separate
lease with respect to the Equipment covered by such Lease Order. In the event of
any conflict between the language of this Lease Agreement and any Lease Order
entered into pursuant hereto, the language of the Lease Order shall prevail with
respect to that Lease Order and the Equipment covered thereby. NO EQUIPMENT
SHALL BE DEEMED LEASED HEREUNDER UNLESS IT IS THE SUBJECT OF A DULY EXECUTED AND
IN FORCE LEASE ORDER.
3. TERM.
The term of this Lease Agreement shall commence on the date set forth
above and shall continue in effect for the Initial Term of any Lease Order and
any extended term as provided herein.
The term of each lease as to any items of Equipment designated on any
Lease Order shall commence on the Delivery and Acceptance Date for such
Equipment, and shall continue for the Initial Term and any extended term
provided herein.
(CONTINUED ON THE FOLLOWING 3 PAGES)
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IN WITNESS WHEREOF, the parties have executed this Lease Agreement effective as
of the date first above written.
LESSOR: GATX CAPITAL CORPORATION LESSEE: RHYTHMS NETCONNECTIONS INC.
SIGNATURE: SIGNATURE: /X/
----------------------- -------------------------
BY: BY:
------------------------------ --------------------------------
(PRINT NAME) (PRINT NAME)
TITLE: TITLE:
--------------------------- -----------------------------
DATE: DATE:
---------------------------- ------------------------------
<PAGE>
4. RENTAL. Rental shall begin to accrue on the Delivery and Acceptance Date and
Lessee shall pay to Lessor, as rental for the Equipment during the Initial Term,
the rent set forth in the respective Lease Order, which shall be due and payable
in advance on the first day of each calendar month or quarter as specified in
the Lease Order during such Initial Term plus any extended term (each date being
hereinafter called a "Rent Payment Date"), unless modified by a Progress Payment
Rider. If the Delivery and Acceptance Date of any Equipment shall be other than
the first day of the month, Lessee shall make an initial payment based on the
Delivery and Acceptance Date in an amount equal to the fraction of the rent as
specified in the related Lease Order for each day from the Delivery and
Acceptance Date to (but not including) the Commencement Date. Rent shall be paid
to Lessor at the address set forth above or at such other place as Lessor shall
designate in writing, or if to an Assignee of Lessor, at such place as such
Assignee shall designate in writing, and shall be paid free and clear of all
claims, demands or setoffs against Lessor or such Assignee. Whenever any payment
by Lessee (of rent or otherwise) is past due hereunder for more than seven (7)
days, Lessee shall pay to Lessor, as additional rent, interest on such amount
until and including the date of payment, at the lesser of 1.5% per month or the
maximum allowable rate of interest permitted by law.
5. TAXES. Lessee covenants to promptly report, file, pay and indemnify and hold
Lessor harmless with respect to any and all Taxes, as hereinafter defined. The
term "Taxes" as used herein shall mean all taxes (including sales, use, excise,
personal property, ad valorem, stamp, documentary and other taxes), and all
other governmental fees, charges and assessments (general or special) due,
assessed or levied by any foreign, federal, state, county or local government or
taxing authority, and any penalties, fines or interest thereon, which are
imposed against, upon or relating to the Equipment or the use, registration,
rental, shipment, transportation, delivery, ownership or operation thereof, and
on or relating to the lease thereof including the rentals or receipts due under
this Lease Agreement, but shall not include any taxes solely based upon or
measured by the income of Lessor. Lessee will, upon request by Lessor, submit to
Lessor written evidence of Lessee's payment of all Taxes due hereunder. Any tax
returns filed by Lessee shall show Lessor as the owner of the Equipment.
6. INSTALLATION, USE, MAINTENANCE AND INSPECTION OF EQUIPMENT.
(a) Lessee shall pay all installation, transportation, rigging, unpacking
and repacking, drayage, handling and insurance charges on the Equipment upon
delivery to Lessee and upon redelivery to Lessor upon the expiration or earlier
termination of the Initial Term or any extension thereof, to such destination as
is specified by Lessor within the continental United States of America ("Return
Location"). Lessee shall furnish appropriate installation facilities for the
Equipment. Lessee represents and warrants that: (i) it has selected all
Equipment based on its own judgment and expressly disclaims any reliance upon
statements made by Lessor; and (ii) as of the Delivery and Acceptance Date, as
between Lessee and Lessor, Lessee shall have unconditionally accepted such
Equipment. Lessee shall execute and deliver to Lessor a Delivery and Acceptance
Receipt which shall be conclusive evidence that, without limitation, Lessee
finds the Equipment complete, in good working order and condition and
satisfactory for its requirements.
(b) Lessee shall comply with all laws, regulations and orders of any
governmental branch or agency which relates to the installation, use, possession
or operation of the Equipment, and shall use the Equipment in the regular course
of its business only, within its normal capacity, without abuse.
(c) Lessee, at its own expense, shall maintain the Equipment in good
operating condition, repair and appearance, and protect the same from
deterioration other than normal wear and tear, and shall enter into, and keep in
force a maintenance agreement with the manufacturer of the Equipment. Lessee
shall cause the manufacturer to keep the Equipment in good and efficient working
order, less normal wear and tear in full compliance and in accordance with the
provisions of such maintenance agreement and shall furnish evidence of such
agreement to Lessor upon request. During Lessee's normal business hours, Lessee
shall provide the manufacturer's field engineering representatives with access
to the equipment to install engineering changes necessary to keep the Equipment
at currently announced engineering change levels. Upon deinstallation of any
Equipment, Lessee shall provide Lessor evidence from the manufacturer stating
the Equipment is at currently announced engineering change levels and is
qualified for the manufacturer's maintenance agreement. The Equipment shall be
returned in the same operating order, repair, condition and appearance as on the
Delivery and Acceptance Date, reasonable wear and tear excepted.
(d) During Lessee's normal business hours, upon prior written notice to
Lessee and subject to Lessee's reasonable security procedures, Lessee shall
permit Lessor or its designee to inspect the Equipment, Lessee's equipment log
and maintenance records.
(e) Prior to delivery of any Equipment, the obligations of Lessor may be
suspended to the extent that Lessor is hindered or prevented from complying
therewith because of labor disturbances, acts of God, fire, storms, accidents,
failure of the manufacturer to deliver any Equipment, governmental regulations
or any cause whatsoever not within the control of Lessor.
7. RELOCATION. Lessee shall not move or permit to be moved any Equipment from
the location set forth in the applicable Lease Order without the prior written
consent of Lessor, which shall not be unreasonably withheld; provided, however,
in no event shall any Equipment be moved to a location outside the United States
of America. Risk of loss and all costs and expenses incurred in connection with
any movement of Equipment shall be the responsibility of Lessee.
8. ALTERATIONS AND MODIFICATIONS. Lessee shall not make modifications,
alterations or additions to Equipment (other than normal operating accessories
or controls) without the prior written consent of Lessor, which consent shall
not be unreasonably withheld. Notwithstanding the foregoing, Lessee shall be
entitled to acquire and install, at Lessee's expense, such additional features
or options ("Modifications") which (i) will not impair the originally intended
function or use of the Equipment in which the Modifications are installed, (ii)
will not require removal of any part of the Equipment, (iii) will not interfere
with Lessee's ability to obtain and maintain the maintenance contract required
by Paragraph 6(c), and (iv) the addition of which will not have an adverse
impact upon the value of the underlying Equipment or Lessor's rights therein.
Such Modifications shall be of the type which are readily installed and removed
without damage to the Equipment so as to restore the Equipment to the condition
in which it existed prior to the installation of such Modifications provided,
however, that if Lessor so agrees in writing, Lessee shall not be required to
remove such Modifications. Any Modifications not so removed shall become the
property of Lessor. All Modifications must qualify for the manufacturer's
maintenance agreement and be maintained in accordance with Paragraph 6(c)
hereof. Lessee hereby grants to Lessor the right and opportunity to first submit
or match the last proposal for the lease, financing or supply of any
Modification.
9. SOFTWARE. Lessee and Lessor acknowledge that the Equipment may contain or
include a description of certain Software in which Lessor and Lessee may have no
ownership or other proprietary rights. Where required by the Software owner,
manufacturer or distributor, Lessee shall enter into a license or other
agreement for the use of such Software. Any Software agreement shall be separate
and distinct from this Master Lease and any Lease Order, and Lessor and Assignee
shall not have any obligations thereunder, but shall have the right to require
Lessee to terminate Lessee's use of the Software if an Event of Default shall
occur and shall be continuing hereunder. In the event rent specified in a Lease
Order includes an amount attributable to the financing by Lessor of Lessee's fee
for use of Software, Lessee agrees that such amount shall be deemed rent and
subject to all the provisions of this Lease Agreement. Upon termination of this
Lease Agreement for reasons other than default, Lessee hereby assigns to Lessor,
to the extent assignable, any and all rights and obligations relating to
software and applicable software licenses.
10. OWNERSHIP, SECURITY INTEREST. It is expressly understood that the Equipment
is, and shall at all times remain, personal property of Lessor. Lessee shall
have no right, title or interest in the Equipment except as expressly provided
herein. If requested by Lessor, Lessee will obtain, prior to delivery of any
Equipment, a certificate satisfactory to Lessor from all parties with a real
property interest in the premises where the Equipment shall be located, waiving
any claim with respect to the Equipment. If Lessor supplies Lessee with labels,
plates or other markings stating that the Equipment is owned by Lessor, Lessee
shall attach same in a prominent place on the Equipment. Lessee agrees to
execute Uniform Commercial Code financing statements and any and all additional
instruments requested by Lessor to perfect the interest of Lessor, its
successors or assigns in this Master Lease, any Lease Order, the payments due
hereunder or the Equipment. Lessee authorizes Lessor to file a copy of the
Master Lease or any Lease Order or invoice as a financing statement. Lessee
agrees to reimburse Lessor for all recording and filing fees.
11. ASSIGNMENT OR SUBLETTING BY LESSEE. LESSEE SHALL NOT ASSIGN, TRANSFER,
PLEDGE OR OTHERWISE DISPOSE OF THIS LEASE AGREEMENT, ANY LEASE ORDER OR ANY OF
ITS RIGHTS THEREUNDER NOR SUBLEASE OR LEND ANY OF THE EQUIPMENT TO ANY OTHER
PERSON WITHOUT THE PRIOR WRITTEN CONSENT OF LESSOR. ANY PURPORTED ASSIGNMENT,
TRANSFER, PLEDGE, OR OTHER DISPOSITION OF THIS LEASE AGREEMENT, ANY LEASE ORDER
OR ANY OF LESSEE'S RIGHTS THEREUNDER, OR ANY PURPORTED SUBLEASE OR LENDING OF
THE EQUIPMENT, WITHOUT LESSOR'S PRIOR WRITTEN CONSENT, AT LESSOR'S OPTION, SHALL
BE VOID AND OF NO EFFECT. FOR THE PURPOSES OF THIS PARAGRAPH 11, ANY PURPORTED
SALE OR OTHER TRANSFER OF A CONTROLLING OWNERSHIP INTEREST OF LESSEE (WHETHER IN
ONE TRANSACTION OR SERIES OF RELATED TRANSACTIONS) SHALL BE DEEMED AN ASSIGNMENT
OF THE LESSEE'S RIGHTS HEREUNDER REQUIRING THE PRIOR WRITTEN CONSENT OF THE
LESSOR. As to any permitted assignment or sublease, the following conditions
shall apply:
(a) Lessee shall remain fully liable for all payments due under each Lease
Order and remain the primary obligor for all remaining obligations under this
Lease Agreement and any Lease Orders hereunder.
(b) Lessee shall give Lessor at least thirty (30) days written notice of
the location of the Equipment and the identity of the assignee or sublessee
prior to the installation at assignee's or sublessee's premises. Lessee shall be
responsible for obtaining any and all financing statements and other
documentation reasonably requested by Lessor.
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(c) Any sublessee's interest in any permitted sublease hereunder shall be
subordinate to the interests of Lessor or any Assignee of Lessor.
12. DISCLAIMER OF WARRANTIES.
(A) LESSEE ACKNOWLEDGES THAT LESSOR IS NOT THE MANUFACTURER OF THE
EQUIPMENT, NOR THE AGENT OF THE MANUFACTURER AND THAT LESSOR HAS MADE NO
REPRESENTATIONS, WARRANTIES OR COVENANTS OF ANY KIND, EXPRESS OR IMPLIED, AS TO
ANY MATTER WHATEVER, INCLUDING BUT NOT LIMITED TO: THE DESIGN, CONDITION OR
PERFORMANCE OF THE EQUIPMENT, ITS MERCHANTABILITY OR FITNESS FOR A PARTICULAR
PURPOSE OR THE QUALITY OF THE MATERIAL OR WORKMANSHIP OF THE EQUIPMENT. FURTHER,
LESSOR MAKES NO WARRANTIES WITH RESPECT TO THE CONFORMITY OF THE EQUIPMENT TO
THE PROVISIONS AND SPECIFICATIONS OF ANY LAW, RULE, REGULATION, CONTRACT OR
PURCHASE ORDER, OR WITH RESPECT TO PATENT, TRADEMARK OR COPYRIGHT INFRINGEMENT
MATTERS OR "YEAR 2000" COMPLIANCE. LESSOR EXPRESSLY DISCLAIMS ANY AND ALL
EXPRESS OR IMPLIED WARRANTIES. AS TO LESSOR, LESSEE LEASES THE EQUIPMENT "AS IS,
WHERE IS".
(B) LESSEE AGREES THAT LESSOR SHALL NOT BE LIABLE TO THE LESSEE FOR ANY
CLAIM, LOSS OR DAMAGE, INCIDENTAL, SPECIAL, CONSEQUENTIAL OR OTHERWISE,
INCLUDING WITHOUT LIMITATION, LOSS OF PROFIT, LOSS OF BUSINESS, OR OTHER
FINANCIAL LOSS, WHICH MAY BE CAUSED, DIRECTLY OR INDIRECTLY, BY THE EQUIPMENT,
THE INADEQUACY OF THE EQUIPMENT FOR ANY PURPOSE OR ANY USE THEREOF, BY ANY
DEFICIENCY OR DEFECT THEREIN, OR BY ANY INCIDENT WHATSOEVER IN CONNECTION
THEREWITH, ARISING IN STRICT LIABILITY, NEGLIGENCE, CONTRACT, TORT OR OTHERWISE,
OR IN ANY WAY RELATING TO OR ARISING OUT OF THE EQUIPMENT, THIS LEASE AGREEMENT
OR ANY LEASE ORDER. THE LESSEE AGREES THAT IT WILL, IRRESPECTIVE OF ANY SUCH
CLAIM, LOSS, DAMAGE OR EXPENSE, CONTINUE TO PAY SUCH MONTHLY RENTAL CHARGES AND
OTHER SUMS AS MAY COME DUE UNDER ANY LEASE ORDER HEREUNDER.
13. ASSIGNMENT OF MANUFACTURER'S WARRANTIES. Lessor hereby assigns to Lessee, to
the extent assignable, all manufacturer's warranties, service agreements and
patent indemnities with respect to the Equipment, if any, for the purpose of
making appropriate claims against the manufacturer, provided that the Lessor
shall retain at all times the right to be protected by these warranties,
agreements and indemnities as the owner of the Equipment. The Lessee's sole
remedy for the breach of any such warranty, indemnification or service agreement
shall be against the manufacturer, and not against Lessor or any Assignee of
Lessor, nor shall any such breach have any effect whatsoever on the rights and
obligations of either party with respect to this Lease Agreement. Lessor will,
upon request by Lessee and at Lessee's sole expense, cooperate with Lessee in
the enforcement of any benefit provided in any such warranties, service
agreements and patent indemnities.
14. INDEMNIFICATION. Lessee agrees that it will defend, indemnify and hold
Lessor harmless against any and all claims, demands, liabilities, obligations,
losses, damages, injuries, penalties, actions, costs and expenses, including
reasonable attorney's fees, of whatever kind and nature arising out of or in
connection with the possession, use, condition (including, but not limited to,
latent and other defects, whether or not discoverable by Lessor or Lessee),
operation, ownership by Lessor, selection, delivery, leasing or return of any
item of Equipment leased hereunder, regardless of where, how and by whom
operated, or any failure on the part of Lessee to accept the Equipment or
otherwise to perform or comply with the provisions of this Lease Agreement or
any Lease Order, except for Lessor's gross negligence or willful misconduct. The
indemnities and assumptions of liabilities and obligations herein provided for
shall continue in full force and effect notwithstanding the expiration or
termination of the Initial Term, any renewal or extension thereof, or of any
Lease Order or this Lease Agreement.
15. ASSIGNMENT BY LESSOR. LESSOR MAY ASSIGN OR TRANSFER THIS MASTER LEASE OR ANY
LEASE ORDER HEREUNDER OR LESSOR'S INTEREST IN THE EQUIPMENT OR GRANT A SECURITY
INTEREST THEREIN TO ONE OR MORE ASSIGNEES WITHOUT NOTICE TO LESSEE. Any Assignee
of Lessor shall have all of the rights but none of the obligations of Lessor
hereunder unless expressly agreed in writing, and Lessee agrees that it will not
assert against any Assignee any defense or counterclaim that Lessee may have
against Lessor. Lessee shall have no greater obligations to any Assignee than it
had to Lessor at the time of assignment, and such assignment shall not limit or
otherwise restrict the rights afforded Lessee hereunder. Lessee hereby (i)
consents to such assignments and/or grants, (ii) agrees to promptly execute and
deliver UCC financing statements, an Acknowledgment and Consent of Assignment
and such further acknowledgments, agreements, certificates and other instruments
as may be reasonably requested by Lessor or Assignee to effect such assignments
and/or grants. Lessee acknowledges that any assignment or transfer by Lessor
made in accordance with the provisions of this paragraph shall not materially
change Lessee's duties or obligations under this Lease nor materially increase
the burdens or risks imposed on Lessee. In the event of an assignment, all
references herein to Lessor shall be deemed to include Assignee. Notwithstanding
any such assignment: (i)Lessor shall not be relieved of any of its obligations
hereunder; and (ii) the rights of Lessee to quiet enjoyment and possession of
the Equipment shall not be impaired so long as Lessee is not in default under
this Lease.
16. QUIET POSSESSION AND ENJOYMENT. Lessor covenants that so long as Lessee is
not in default hereunder, neither Lessor nor any Assignee will disturb Lessee's
quiet possession and enjoyment of the Equipment, subject to and in accordance
with the provisions of this Lease Agreement and the applicable Lease Order.
17. DAMAGE, DESTRUCTION OR LOSS.
(a) Upon delivery of the Equipment to Lessee until the Equipment is
redelivered to Lessor, Lessee shall bear the entire risk of loss, damage, or
destruction with respect to the Equipment resulting from any cause whatsoever.
(b) If any Equipment becomes damaged beyond repair, lost, stolen,
destroyed or permanently rendered unfit, or in the event of any condemnation or
taking by any governmental authority (any such occurrence being hereinafter
referred to as an "Event of Loss"), then Lessee shall promptly notify Lessor and
shall do either of the following within thirty (30) days after the occurrence of
an Event of Loss:
(i) At its expense, promptly replace the affected Equipment with like
or better replacement equipment of identical make, model, configuration,
capacity and condition, in good repair, free and clear of all liens, in which
case any such replacement equipment shall become the property of Lessor and for
all purposes of this Master Lease shall be deemed to be the Equipment which it
replaced; or
(ii) Terminate the Lease Order with respect to the affected Equipment
and pay to Lessor on the next payment date, an amount equal to the present value
of the remaining rental payments discounted by five percent (5%), plus the fair
market value in continued use of the Equipment.
18. INSURANCE. Lessee shall, at its expense, insure the Equipment against all
risks and in such amounts as Lessor shall reasonably require (but not less than
the full replacement value) with carriers reasonably acceptable to Lessor, shall
maintain a loss payable endorsement in favor of Lessor and its assigns affording
to Lessor and its assigns such additional protection as Lessor and its assigns
shall reasonably require, and Lessee shall maintain liability insurance
reasonably satisfactory to Lessor and its assigns. All such insurance policies
shall name Lessee, Lessor and its assigns as additional insureds and shall name
Lessor and its assigns as loss payee(s), and shall provide that insurance
coverage shall not be canceled or altered without at least thirty (30) days
prior written notice to Lessor and Assignee, and that no breach of warranty by
Lessor shall invalidate such insurance with respect to any additional insured.
Lessee shall promptly furnish appropriate evidence of such insurance to Lessor
and any Assignee.
19. REPRESENTATIONS AND WARRANTIES OF LESSEE. Lessee represents and warrants to
Lessor and any Assignees on the date hereof and on the date of each Lease Order
that: (i) the execution and performance of this Lease Agreement and all Lease
Orders are duly authorized and this Lease Agreement and the Lease Orders
constitute legal, valid and binding obligations of Lessee enforceable in
accordance with their terms; (ii) the performance under the Lease Agreement and
all Lease Orders by Lessee will not result in any breach, default or violation
of Lessee's articles of incorporation or by-laws, if applicable, or partnership
agreement, if applicable, or any agreement to which Lessee is a party; (iii)
Lessee is in good standing duly organized, and validly existing in its
jurisdiction of incorporation or organization and in any jurisdiction(s) in
which any of the Equipment is to be located; (iv) there are no actions, suits or
proceedings pending or threatened, before any court, agency, or arbitrator which
will, if determined adversely to Lessee, materially adversely affect its ability
to perform its obligations under this Lease Agreement or any Lease Order; and
(v) any and all information with respect to Lessee heretofore furnished to
Lessor was, when furnished, true and complete.
20. FINANCIAL STATEMENTS, ETC.. During the term of this Lease Agreement, Lessee
shall furnish to Lessor and any Assignee Lessee's audited balance sheet, income
statement and statement of cash flows for its most recent fiscal year, within
ninety days and quarterly statements within forty-five days, all prepared in
accordance with generally accepted accounting principles consistently applied,
and, from time to time, such other information concerning the Equipment as
Lessor or any Assignee may reasonably request.
21. DEFAULT. The occurrence of any of the following events shall constitute an
"Event of Default" hereunder and under each Lease Order entered into pursuant
hereto:
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(a) Lessee shall fail to pay any installment of rent or other charge due
under this Lease Agreement or any Lease Order thereunder within ten (10) days
after the same is due and payable;
(b) Lessee attempts to move, sell, assign, transfer, encumber, dispose of,
sublet or lend any of the Equipment without the prior written consent of Lessor;
(c) Except for defaults covered by Paragraph (a) above, Lessee shall fail
to perform or observe any covenant, condition or agreement to be performed or
observed by it hereunder or under any Lease Order and such failure continues
unremedied for fifteen (15) days after notice thereof to Lessee by Lessor;
(d) Any representation or warranty made by Lessee in this Lease Agreement,
any Lease Order, or in any document or certificate made or furnished to Lessor
in connection herewith or pursuant hereto shall prove to be false at any time in
any material respect;
(e) Lessee ceases doing business as a going concern; makes an assignment
for the benefit of creditors; admits in writing its inability to pay its debts
as they become due; files a voluntary petition in bankruptcy; is adjudicated to
be bankrupt or insolvent; files a petition seeking for itself any
reorganization, arrangement, composition, readjustment, liquidation, dissolution
or similar arrangement under any present or future statute, law or regulation or
files an answer admitting the material allegations of a petition filed against
it in any such proceeding; consents to or acquiesces in the appointment of a
trustee, receiver or liquidator of it or of all or any substantial part of its
assets or properties, or if it or its shareholders shall take any action to
effect a dissolution or liquidation and, in the case of any such proceeding not
being instituted by Lessee, such proceeding is not dismissed or vacated within
thirty (30) days.
22. REMEDIES. Upon the occurrence of any Event of Default and at any time
thereafter, Lessor may, with or without terminating this Lease Agreement, do any
one or more of the following:
(a) Proceed by appropriate court action to enforce performance by Lessee
of the applicable terms of this Lease Agreement or any Lease Order;
(b) Declare immediately payable all sums due and to become due hereunder
for the full term of any and all Lease Orders under this Master Lease;
(c) If the Lease Order provides for a Stipulated Loss Value or other fixed
value of the Equipment, recover (i) any then accrued and unpaid rent plus
interest thereon at the late payment rate, (ii) the Stipulated Loss Value or
other fixed value, at Lessor's option, of the Equipment as of the rent payment
date immediately preceding Lessee's date of default, and (iii) all commercially
reasonable costs and expenses incurred by Lessor in any repossession, recovery,
storage, repair, sale, release or other disposition of the Equipment, including
reasonable attorney's fees and costs incurred in connection therewith or
otherwise resulting from Lessee's default;
(d) If the Lease Order does not provide for a Stipulated Loss Value or
other fixed value for the Equipment, recover from Lessee damages, not as a
penalty, but herein liquidated for all purposes and in an amount equal to the
sum of (i) any then accrued and unpaid Rent plus interest thereon at the Late
Payment Rate, (ii) the present value of all remaining Rent contracted to be paid
over the unexpired portion of the Initial Term or any extended term, discounted
at an interest rate of five percent (5%) per annum plus prepayment penalty fees,
(iii) all commercially reasonable costs and expenses incurred by Lessor in any
repossession, recovery, storage, or repair, sale, re-lease or other disposition
of the Equipment, including reasonable attorney's fees and costs incurred in
connection therewith or otherwise resulting from Lessee's default and (iv) the
fair market residual value in continued use at the time of default of the
Equipment determined by Lessor;
(e) Re-lease or sell any or all of the Equipment at a public or private
sale, with the privilege of becoming the purchaser or Lessee thereof, on such
terms and notice as Lessor shall deem reasonable, and thereafter Lessor shall
apply the proceeds derived therefrom as follows, Lessee remaining liable for any
deficiency: First, to reimburse Lessor for all costs and expenses incurred by
Lessor in any repossession, recovery, storage, repair, sale, re-lease or other
disposition of the Equipment, including reasonable attorney's fees, commissions
and broker's fees and costs incurred in connection therewith or otherwise
resulting from Lessee's default; second, to pay Lessor any amounts owing
hereunder, third, to reimburse Lessee for any amount paid hereunder as a result
of Lessee's default; and fourth, any surplus remaining thereafter to Lessor;
(f) Take immediate possession of any or all of such Equipment wherever
situated, and for such purpose, enter upon any premises (by summary proceedings
or otherwise) where the Equipment is located without prejudice to any other
remedy or claim referred to herein; and
(g) Exercise any other right or remedy which may be available to it under
the Uniform Commercial Code or any other applicable law.
A termination hereunder shall occur only upon notice by Lessor and only as
to such Equipment as Lessor specifically elects to terminate and this Master
Lease and all Lease Orders hereunder shall continue in full force and effect as
to the remaining Equipment, if any. No remedy referred to in this Paragraph 22
is intended to be exclusive, but each shall be cumulative and in addition to any
other remedy referred to above or otherwise available to Lessor at law or in
equity. No express or implied waiver by Lessor of any default shall constitute a
waiver of any other default by Lessee or a waiver of any of Lessor's rights.
23. LOSS OF ANTICIPATED TAX BENEFITS. Lessee acknowledges that unless otherwise
agreed to in writing by Lessor, Lessor intends to claim all available tax
benefits of ownership with respect to the Equipment (the "Tax Benefits"),
including, but not limited to, cost recovery deductions as provided in Section
168 of the Internal Revenue Code of 1986, as amended (the "Code"), with respect
to each item of Equipment for each of Lessor's taxable years during the Initial
Term and any extended or renewal term. Notwithstanding anything herein to the
contrary, if Lessor shall not be entitled to, or shall be subject to recapture
of the Tax Benefits as a result of any act, omission or misrepresentation of
Lessee, Lessee shall pay to Lessor upon demand an amount sufficient to reimburse
Lessor for such loss, together with any related interest and penalties, based on
the highest marginal corporate income tax rate prevailing at the time of such
loss, regardless of whether Lessor or any member of a consolidated group of
which Lessor is also a member is then subject to any increase in tax as a result
of such loss of Tax Benefits.
24. TERMINATION. Each Lease Order, with respect to all but not less than all of
the Equipment covered thereby, may be terminated by either party at the end of
the Initial Term or any renewal or extended term thereof provided written notice
of termination of a Lease Order is given between one hundred eighty days and
ninety days prior to the termination of the Lease Order. If proper notice of
termination is not given, or if the Equipment is not returned to Lessor as
notified, the term of the Lease Order shall be extended on the same terms and
conditions for six months. Thereafter, the Lease Order as so extended may be
terminated by either party at the end of any calendar month by giving the other
party ninety days prior written notice.
25. GENERAL.
(a) This Lease Agreement and any Lease Order hereunder shall be governed
in all respects by the laws of the State of Florida. Lessor and Lessee agree
that any dispute between them arising under this Lease Agreement or any Lease
Order shall be resolved in the state or federal courts in the State of Florida
having within its jurisdiction the City of Tampa, Florida. Lessee hereby
knowingly and irrevocably waives any objections to an action in such courts in
the State of Florida on the grounds of lack of personal jurisdiction or improper
venue and agrees that effective service of process may be made upon Lessee by
mail under the notice provisions of subparagraph 25(c) hereof. NO RIGHTS OR
REMEDIES REFERRED TO IN ARTICLE 2A OF THE UNIFORM COMMERCIAL CODE SHALL BE
INCORPORATED INTO THIS LEASE AGREEMENT UNLESS EXPRESSLY GRANTED IN THIS LEASE
AGREEMENT OR A LEASE ORDER HEREUNDER.
(b) This Lease Agreement and all Lease Orders constitute the entire
agreement between Lessee and Lessor with respect to the Equipment covered
thereby and supersede any prior or contemporaneous agreements or understandings
relating thereto. No covenant, condition or other term or provision hereof or of
any Lease Order may be waived, changed, amended or modified except by a written
agreement signed by both Lessor and Lessee.
(c) All notices, consents or requests desired or required to be given
hereunder shall be in writing and shall be mailed, via certified mail, return
receipt requested, to the address of the other party set forth on the first page
hereof or to such other address as such party shall have designated by a proper
notice.
(d) This Lease Agreement shall be binding upon and inure to the benefit of
the parties hereto and their respective permitted successors and assigns.
(e) Paragraph headings are for convenience of reference only and shall not
be construed as part of this Lease Agreement. (f) It is expressly
understood that all of the Equipment shall be and remain personal property
of the Lessor notwithstanding the
manner in which the same may be attached or affixed to realty, and Lessee shall
do all acts and execute all documents necessary to insure that the Equipment
remains personal property.
(g) All agreements, representations and warranties contained in this Lease
Agreement, any Lease Order, and in any document delivered pursuant hereto or in
connection herewith shall be for the benefit of Lessor and any Assignee and
shall survive the execution and delivery, and the expiration or other
termination, of this Lease Agreement and any Lease Order.
(h) Time is of the essence of this Lease Agreement and each Lease Order.
(i) Lessee shall, upon request of Lessor, perform all such other acts and
execute and deliver to Lessor all such other documents which Lessor deems
reasonably necessary to implement the provisions of this Lease Agreement or any
Lease Order.
(j) Each Lease Agreement may be executed in one or more counterparts, each
of which shall be deemed an original, but there shall be only one executed
original of each Lease Order which shall be marked "Original" (the "Original")
and all other counterparts shall be marked "Duplicate". To the extent, if any,
that a Lease Order constitutes chattel paper (as such term is defined in the
Uniform Commercial Code) no security interest in the Lease Order may be created
through the transfer or possession of any counterpart other than the Original of
the Lease Order accompanied by an Original or certified copy of the Lease
Agreement.
4 of 4
<PAGE>
FIRST ADDENDUM TO MASTER LEASE AGREEMENT
DATED AS OF JULY 30, 1999
BETWEEN
GATX CAPITAL CORPORATION
AND
RHYTHMS NETCONNECTIONS INC.
Dated as of July 30, 1999
This First Addendum amends the Master Lease Agreement, dated as of July
30, 1999 (the "Lease"), between GATX Capital Corporation and Rhythms
NetConnections Inc. All capitalized terms used but not defined herein shall have
the respective meanings given thereto in the Lease.
1. FINANCING.
(a) COMMITMENT. Subject to the satisfaction of the conditions set
forth in paragraph 2 below and on the basis set forth in this paragraph, Lessor
has agreed to provide up to $26,000,000 of lease financing to Lessee. The
funding of each Lease Order is subject to the satisfaction of the conditions set
forth in paragraph 3 below. Lessor's commitment to finance Equipment under this
Addendum, shall terminate on the date (the "Commitment Termination Date") that
is the same day of the month in the fifteenth month following the date hereof.
(b) TERM AND LEASE RATE FACTOR. The Initial Term of each Lease Order
financed under this Addendum shall be 36 months and the rental for the initial
Lease Order under this Addendum during the six-month period following the
funding of such initial Lease Order and for each subsequent Lease Order funded
during such six-month period shall be payable in accordance with Section 4 of
the Lease in an amount on each Rent Payment Date equal to the amount funded
under the applicable Lease Order multiplied by 3.0% (the "Lease Rate Factor").
The Lease Rate Factor for all Lease Orders funded following such six-month
period will be determined by calculating a new Lease Rate Factor using as the
implicit interest rate for such Lease Rate Factor the U.S. Treasury note rate
for notes having a 36 month term as quoted in THE WALL STREET JOURNAL on the
date of preparation of the first such Lease Order funded during such subsequent
period; provided, however, that no such adjustment shall be made unless and
until such U.S. Treasury rate shall have increased by more than 25 basis points
above the rate in effect on the date hereof.
(c) END OF TERM OPTIONS. Provided that the Lease has not been
terminated and that no Event of Default or event which, with notice or lapse of
time or both, would become an Event of Default shall have occurred and be
continuing, not more than 180 days and not less than 120 days prior to the
expiration of the Initial Term of each Lease Order funded under this Addendum,
by written notice to Lessor, Lessee shall irrevocably elect either the option
under clause
(i) or a combination of the options under clauses (i), (ii) and (iii) within the
parameters set forth therein:
(i) Lessee may elect to purchase Equipment (excluding Soft
Cost Equipment, as defined in Paragraph 1(d)) having an original total cost
(determined with reference to the Equipment Addendum to the applicable Lease
Order) equal to at least 70% of the aggregate total cost of the Equipment under
such Lease Order for a purchase price equal to the "Fair Market Value" (as
defined below) thereof as of the end of the Initial Term of such Schedule, but
such amount shall not be less than fifteen percent (15%) of the aggregate total
amount originally funded with respect to the Equipment being purchased, nor more
than twenty-five percent (25%) of the aggregate total amount originally funded
with respect to the Equipment being purchased, under such Lease Order, plus any
applicable sales or other transfer tax.
(ii) Lessee may elect to return either (i) one hundred percent
(100%) of the Equipment (other than Soft Cost Equipment, as defined in Paragraph
1(d)), or (ii) Equipment (other than Soft Cost Equipment, as defined in
Paragraph 1(d)) having an original total cost (determined with reference to the
Equipment Addendum to the applicable Lease Order) equal to not more than thirty
percent (30%) of the aggregate total cost of the Equipment subject to such Lease
Order, in each case in the condition required by the Lease.
(iii) Lessee may elect to renew the Lease with respect to any
Equipment not purchased or returned at the end of Initial Term of the applicable
Lease Order, for not less than twelve (12) months or the remainder of an item of
Equipment's remaining useful life if shorter, for a rent equal to the "Fair
Rental Value" (as defined below) of such item for such additional period, which
rent shall be paid monthly in advance.
At the end of the renewal term, Lessee shall elect one of the options set forth
in clauses (i), (ii) or (iii) of this paragraph (c).
"Fair Market Value" shall mean the estimated amount, as of a certain date, at
which the Equipment subject to the Lease may reasonably be valued in the
marketplace by a buyer who could choose not to buy and a seller who could choose
not to sell. In the event that the parties cannot agree on a Fair Market Value
amount, an independent appraiser (mutually acceptable to Lessor and Lessee) with
knowledge of the Equipment, appropriate certification and experience utilizing
Fair Market Value as defined shall be retained to render an opinion.
"Fair Rental Value" shall mean the estimated amount, as of a certain date, at
which the Equipment subject to the Lease may reasonably be valued in the
marketplace by a lessee who could choose not to lease and a lessor who could
choose not to lease. In the event that the parties cannot agree on a Fair Rental
Value amount, an independent appraiser (mutually acceptable to Lessor and
Lessee) with knowledge of the Equipment, appropriate certification and
experience utilizing Fair Rental Value as defined shall be retained to render an
opinion.
(d) PAYMENTS FOR SOFT COSTS. With respect to any Equipment which is
deemed by Lessor to be soft cost equipment, including without limitation
software, software development costs, tooling, tenant improvements, custom-built
equipment, cabling, installation or freight costs (collectively, and excluding
collocation space costs, "Soft Cost Equipment"), at the time of the final
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<PAGE>
Rent Payment Date under each Lease Order, Lessee shall make a payment (in
addition to any payment under Paragraph 1(c)(i) or under Paragraph 1(c)(ii)
hereof) equal to fifteen percent (15%) of the total cost of the Soft Cost
Equipment subject to such Lease Order, plus any applicable sales or other
transfer tax.
2. CONDITIONS TO EXECUTION OF THIS ADDENDUM. On or prior to the date of
execution of this Addendum by Lessor and the funding of the first Lease Order
under this Addendum, Lessor shall have received in form and substance
satisfactory to Lessor:
(a) A legal opinion of Lessee's legal counsel in form and substance
reasonably satisfactory to Lessor covering the matters set forth in Exhibit A
hereto.
(b) Copies, certified by the Secretary or Assistant Secretary or
Chief Financial Officer of Lessee, of: (A) the Certificate/Articles of
Incorporation and By-Laws of Lessee (as amended to the date of the Lease); and
(B) the resolutions adopted by Lessee's board of directors authorizing the
execution and delivery of the Lease and this Addendum, the Lease Orders and the
other documents referred to herein and the performance by Lessee of its
obligations hereunder and thereunder.
(c) A good standing certificate (including franchise tax status)
with respect to Lessee from Lessee's state of incorporation, the state where
Lessee's chief executive office is located and each state where Equipment is
expected to be located, each dated a date reasonably close to the date of
acceptance of the Lease by Lessor.
(d) Evidence of the insurance coverage required by Section 18 of the
Lease, if not previously provided to Lessor.
(e) All other documents as Lessor shall have reasonably requested.
3. CONDITIONS TO THE FUNDING OF EACH LEASE ORDER. Prior to the funding
of each Lease Order, Lessee shall have satisfied all of the following
conditions:
(a) Lessor shall have received:
(i) A Landlord's Waiver and Consent of each landlord of
premises on which Equipment will be located, substantially in the form of
Exhibit B hereto.
(ii) To the extent Lessor, in its commercially reasonable
business judgment, deems it necessary, a release or other arrangement with any
other lessor or lender to the Lessee to insure that there will be no impairment
of Lessor's interest in the Equipment subject to the Lease Order.
(iii) Copies of invoices, purchase orders and canceled checks
relating to all Equipment being placed under the Lease pursuant to the Lease
Order and/or a Purchase Order and Invoice Assignment from Lessee to Lessor
substantially in the form of Exhibit C hereto.
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<PAGE>
(b) Lessee shall have filed or recorded, to the satisfaction of
Lessor, all instruments and documents, including, but not limited to,
precautionary Financing Statements on Form UCC-1 and releases and termination
statements on Form UCC-2, then deemed necessary by Lessor to preserve and
protect its rights hereunder, under the Uniform Commercial Code (including the
termination of any after-acquired property clause of third parties that might if
in force apply to any Equipment).
(c) Lessor shall have received all other documents and Lessee shall
have performed all other acts as Lessor shall have reasonably requested to
consummate the transaction contemplated by the Lease Order.
(d) Except with the prior consent of Lessor, not to be unreasonably
withheld or delayed, the cost of Soft Cost Equipment which is financed under the
Lease Order shall not exceed fifteen percent (15%) of the total amount of such
Lease Order. Lessee will use its diligent efforts to obtain from the vendor of
any software financed under the Lease a consent to transfer the right to use
such software to a third party without further payment if an Event of Default
under the Lease exists.
(e) On the date of funding of the Lease Order no Event of Default or
event, which with the passage of time or the giving of notice or both would
constitute an Event of Default, shall exist.
(f) Except with the prior written consent of Lessor which shall not
be unreasonably withheld, all of the Equipment subject to the Lease Order shall
consist of routers and ATM switches, DSLAMs, IP concentrators and servers and
related networking and information technology hardware and Soft Cost Equipment.
(g) The amount to be funded under the Lease Order shall not be less
than $4,000,000, as determined by reference to the Equipment Addendum to such
Lease Order.
Lessor may, in its sole discretion, terminate its commitment herein to fund
Lease Orders under the Lease if there is any material adverse change to the
general affairs, management, results of operations, condition (financial or
otherwise) or prospects of Lessee, whether or not arising from transactions in
the ordinary course of business.
4. FINANCIAL COVENANTS
(a) CERTAIN DEFINITIONS. The following capitalized terms shall have
the following respective meanings for purposes of this Lease:
"CONSOLIDATED OPERATING CASH FLOW" shall have the meaning given to
such term in the Indenture.
"INDENTURE" shall mean the Indenture, dated as of May 5, 1998,
between Lessee and State Street Bank and Trust Company of
California, N.A., as trustee.
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<PAGE>
(b) CONSOLIDATED OPERATING CASH FLOW. Lessee shall not permit its
Consolidated Operating Cash Flow for the fiscal quarter ending on the date set
forth below to be less than the amount set forth opposite such date below:
<TABLE>
<S> <C>
September 30, 1999 - 40,000,000
December 31, 1999 - 72,000,000
March 31, 2000 - 91,250,000
June 30, 2000 - 93,850,000
September 30, 2000 - 99,750,000
December 31, 2000 - 103,480,000
March 31, 2001 - 114,600,000
June 30, 2001 - 121,600,000
September 30, 2001 - 119,250,000
December 31, 2001 - 112,250,000
March 31, 2002 - 107,250,000
June 30, 2002 - 103,250,000
September 30, 2002 - 99,300,000
</TABLE>
A breach of a financial covenant under this paragraph 4 shall constitute an
"Event of Default" under Section 21 of the Lease.
5. REPORTING. Lessee shall furnish to Lender:
(a) FINANCIAL STATEMENTS. So long as Lessee is not subject to the
reporting requirements of Section 12 or Section 15 of the Securities and
Exchange Act of 1934, as amended, promptly as they are available, unaudited
quarterly and audited annual financial statements of Lessee and such other
financial information as Lender may reasonably request from time to time. From
and after such time as Lessee becomes a publicly reporting company, promptly as
they are available and in any event: (i) at the time of filing of Lessee's Form
10-K with the Securities and Exchange Commission after the end of each fiscal
year of Lessee, the financial statements of Lessee filed with such Form 10-K;
and (ii) at the time of filing of Lessee's Form 10-Q with the Securities and
Exchange Commission after the end of each of the first three fiscal quarters of
Lessee, the financial statements of Lessee filed with such Form 10-Q.
(b) COMPLIANCE STATEMENTS. Within thirty (30) days of the end of
each fiscal quarter of Lessee, a certificate of Lessee's Chief Financial Officer
or other senior officer stating that he or she has reviewed the provisions of
the Lease, this Addendum and any other addendum to the Lease then in effect, and
that Lessee is not in default in the observance or performance of any of the
provisions hereof, or if Lessee shall be so in default, specifying all such
defaults and events of which he or she may have knowledge, and setting forth the
calculation of compliance or noncompliance with each of the financial covenants
set forth in paragraph 4 above.
[caad 234]I -5-
<PAGE>
(c) MANAGEMENT REPORTS. Within twenty (20) days of the end of each
month, a management report setting forth by month and year-to-date, (i) new
markets entered and total markets entered, (ii) new central office locations and
total central office locations, and (iii) new lines and total lines.
6. ASSIGNMENT. Section 15 of the Lease shall be deemed amended to add
the following sentence:
"Notwithstanding the foregoing, Lessor shall in all circumstances
retain at least a 20% interest in the Lease, the Lease Orders
thereto and the Equipment. Lessee shall, at the reasonable request
of Lessor, cooperate in the conveyance of Lessor's interest in the
Lease, Lease Orders thereto, related instruments and documents and
the Equipment from Lessor to one or more third parties
("Participants"), or the use thereof as security for financing
obtained from Participants (such conveyance or financing, the
"Syndication"). Without limiting the generality of the foregoing,
Lessee shall execute and deliver such other documents, instruments,
notices, opinions, certificates and acknowledgements as may
reasonably be requested by Lessor or any Participant; PROVIDED,
HOWEVER, that Lessee shall not be required to take or consent to any
action that adversely affects any of its rights as set forth herein.
7. NON-UTILIZATION FEE. Lessee agrees that by execution of the Lease it
has agreed to lease Equipment from Lessor having an aggregate cost of not less
than $15,600,000 hereunder (the "Minimum Funding Amount"). If Lessee fails at
any time to meet the Minimum Funding Amount because (a) it has not requested
funding of Equipment under the Lease in the amount of the Minimum Funding
Amount, or (b) it has failed to satisfy any condition to any funding of Eligible
Equipment, then Lessee shall pay to Lessor upon Lessor's request therefor a
non-utilization fee of 1.25% of the difference between the maximum amount of
financing available hereunder on the date of such request and the aggregate
amount of Lease Orders then outstanding hereunder; provided, however, that
Lessee shall not pay a non-utilization fee upon more than one occasion during
the term of this Addendum. Lessee shall pay such non-utilization fee to Lessor,
as liquidated damages and not as a penalty, within ten business days of
receiving Lessor's request for payment thereof.
8. GOVERNING LAW. The first two sentences of Section 25(a) are amended
to read in their entirety as follows:
This Lease Agreement and any Lease Order hereunder shall be governed
in all respects by the laws of the State of California. Lessor and
Lessee agree that any dispute between them arising under this Lease
or any Lease Order shall be resolved in the state or federal courts
in the State of California located in the City and County of San
Francisco.
9. SURVIVAL OF TAX INDEMNITY. Section 23 shall be amended by adding at
the end thereof:
The provisions of this Section 23 shall survive the termination or
cancellation of this Lease.
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<PAGE>
10. MISCELLANEOUS. The following Sections of the Lease are amended as
follows:
SECTION 1: The eleventh line is amended by replacing "seven (7) days"
with "fourteen (14) days" after "accepted within" and "seven (7) days" with
"fourteen (14) days" after "shall be deemed to be".
SECTION 4: The second line is amended by deleting "or quarter" after
"each calendar month".
SECTION 6(c): The second line is amended by inserting "or certified
maintenance provider" after "and keep in force a maintenance agreement with the
manufacturer" and "or certified maintenance provider" after "Lessee shall cause
the manufacturer". The third sentence is deleted in its entirety.
SECTION 7: The first sentence is amended by replacing "not move or
permit to be moved any Equipment from the location set forth in the applicable
Lease Order without the prior written consent of Lessor, which shall not be
unreasonably withheld," with "be permitted to relocate the Equipment within the
State set forth in the applicable Lease Order without the prior written consent
of the Lessor provided Lessee provides Lessor with a quarterly report detailing
any and all relocations of the Equipment".
SECTION 8: The first sentence is amended by replacing "shall not" with
"may" and "which consent shall not be unreasonably withheld" with "provided
Lessee provides Lessor with a quarterly report detailing any and all
modifications, alterations or additions to the Equipment". The second sentence
is amended by deleting "(ii) will not require the removal of any part of the
Equipment" after "use of the Equipment in which the Modifications are
installed," The fourth line is amended by deleting the word "contract" after
"(iii) will not interfere with Lessee's ability to obtain and maintain the
maintenance". The eighth line is amended by changing the word "agreement" to
"requirements" after "All Modifications must qualify for the manufacturer's
maintenance".
SECTION 11: The third line is amended by adding "WHICH SHALL NOT BE
UNREASONABLY WITHHELD" after "THE PRIOR WRITTEN CONSENT OF LESSOR". The sixth
line is amended by inserting "DEFINED AS GREATER THAN 50%" after "CONTROLLING
OWNERSHIP INTEREST OF LESSEE". The seventh line is amended by inserting the
sentence "SUCH CONSENT SHALL NOT BE UNREASONABLY WITHHELD BY LESSOR (i.e. if the
purported assignee has a better credit rating than the Lessee)."
SECTION 14: The fifth line is amended by deleting "gross" after "except
for Lessor's" and deleting "willful" after "negligence or".
SECTION 17(b)(ii): The second line is amended by inserting "end of
term" after "plus the".
SECTION 21(b): The first line is amended by inserting "Equipment out of
the State" after "Lessee attempts to move".
SECTION 23: The fourth line is amended by inserting "material" after
"as a result of any" and "," after "or shall be subject to the recapture of".
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<PAGE>
SECTION 24: The fourth line is amended by changing "six" to "three"
after "on the same terms and conditions for".
IN WITNESS WHEREOF, Lessor and Lessee have executed this First Addendum
as of July 30, 1999.
LESSOR: LESSEE:
GATX CAPITAL CORPORATION RHYTHMS NETCONNECTIONS INC.
By: By:
-------------------------- -----------------------------
Name: Name:
------------------------ ---------------------------
Title: Title:
----------------------- --------------------------
-8-
<PAGE>
EXHIBIT A
MATTERS TO BE COVERED IN LEGAL OPINION
(a) Lessee is a corporation duly organized, validly existing and in
good standing under the laws of the State of Delaware and is duly qualified to
do business and in good standing in the State of California.
(b) Lessee has and had the requisite corporate power and authority to
execute, deliver and perform the Lease, the First Addendum and the Lease Orders
and to issue the Warrant. All action on the part of Lessee, its directors and
its shareholders necessary for the authorization, execution, delivery and
performance of the Lease, the First Addendum, the Lease Orders and the Warrant,
has been taken. The Transaction Documents have been duly executed and delivered
by an authorized officer of Lessee.
(c) The execution, delivery and performance of the Transaction
Documents (i) do not conflict with or violate any provision of Lessee's Restated
Certificate of Incorporation or Bylaws or of applicable law, (ii) do not
conflict with or constitute a default under any provision of any material
judgment, writ, decree, order or material agreement, indenture, or instrument to
which Lessee is a party or by which it is bound, and (iii) will not cause the
imposition of any Lien upon the assets or properties of Lessee.
(d) The Transaction Documents constitute legal, valid and binding
obligations of Lessee, enforceable in accordance with their respective terms. To
our knowledge, no filing need be made with any governmental authority with
respect to the Transaction Documents.
(e) The shares of Common Stock issuable upon exercise of the Warrant
have been duly authorized and reserved for issuance upon such exercise, and when
issued in accordance with the terms of the Warrant, will be duly authorized,
validly issued, fully paid and non-assessable.
<PAGE>
EXHIBIT B
LANDLORD WAIVER
<PAGE>
RECORDING REQUESTED BY
AND WHEN RECORDED RETURN TO:
GATX CAPITAL CORPORATION
Four Embarcadero Center, Suite 2200
San Francisco, CA 94111
Attn: Contract Administration
- --------------------------------------------------------------------------------
LANDLORD'S WAIVER AND CONSENT
THIS LANDLORD'S WAIVER AND CONSENT (this "Waiver"), dated as of
____________________, 199__ _________, is executed by and between
______________________________, _______________________________ ("Landlord") and
GATX CAPITAL CORPORATION ("Lessor").
RECITALS
Landlord and RHYTHMS NETCONNECTIONS, INC. ("Tenant") are parties to a
_____________________ [Lease Agreement], dated as of _________________________,
19___ (together with any other agreement between Landlord and Tenant relating to
the Premises, as defined below, all as amended from time to time, to be referred
to herein collectively as the "Lease"), pursuant to which Landlord has leased to
Tenant that certain real property commonly known as
_______________________________________________________________________________,
and more particularly described in ATTACHMENT 1 hereto (the "Premises").
Tenant and Lessor intend to or have entered into a Master Lease Agreement, dated
as of July__, 1999, as amended (the "Credit Agreement") pursuant to which Lessor
has agreed or will agree to lease to Tenant from time to time certain equipment
(the "Equipment") which will be located on the Premises.
AGREEMENT
NOW, THEREFORE, in consideration of the above recitals and for other
good and valuable consideration, the receipt and adequacy of which are hereby
acknowledged, Landlord and Lessor hereby agree as follows:
1. WAIVER AND CONSENT. Landlord hereby consents to the location of the
Equipment on the Premises and does irrevocably waive, disclaim and relinquish
and assign to Lessor any and all rights to impose, receive, assert or enforce
any lien, encumbrance, charge, security interest, ownership interest, claim or
demand of any kind against or involving the Equipment, whether arising by common
law, statute or consensually (under the Lease or otherwise) and whether now in
existence or hereafter created, including, but not limited to, those for rent or
other right of payment. This waiver, disclaimer, relinquishment and assignment
shall survive the termination of the Lease. Landlord further agrees that (a)
neither the Equipment nor any item thereof shall become part of, or otherwise be
or become a fixture attached to, the Premises, notwithstanding the manner of the
Equipment's annexation, the Equipment's adaptability to the uses and purposes
for which the Premises are used, and the intentions of the party making the
annexation; (b) the Equipment (or any item thereof) may be repossessed by
Lessor; (c) in connection with such repossession or otherwise, Lessor, and any
of its agents and employees, may enter upon the Premises for the purposes of (i)
guarding and maintaining the Equipment (or any item thereof), (ii) showing the
Equipment (or any item thereof) to prospective lenders, buyers, lessees and
sublessees, as applicable, and any of their respective agents and employees,
(iii) preparing, disassembling, dismantling, loading and/or removing the
Equipment (or any item thereof), and (iv) general inspections of the Equipment
pursuant to the Credit Agreement; and (d) the right of Lessor to enter the
Premises and the other rights granted to Lessor in this Waiver shall not
terminate until thirty (30) days after Lessor receives written notice from
Landlord of the termination of the Lease. If Lessor should exercise its rights
hereunder (and the failure to exercise such rights shall not be construed as a
waiver thereof), Landlord agrees upon receiving prior written notice, to provide
ingress and egress to effect such
<PAGE>
exercise as well as provide reasonably adequate space contiguous to the location
of the Equipment to permit the exercise of such rights. Landlord further agrees
that Lessor has no obligation to exercise any right granted to Lessor in this
Waiver and that Lessor may elect to remove only a portion or none of the
Equipment from the Premises.
2. COSTS. Lessor agrees to indemnify and hold the Landlord harmless
from any out-of-pocket costs incurred by Landlord for any physical damage to the
Premises caused by Lessor solely from the exercise of its rights under clause
(b) or (c) of Paragraph 1 above.
3. LEASE DEFAULTS. Landlord further agrees to provide Lessor written
notice of any default or event of default under the Lease (each a "Default
Notice") simultaneously with the giving of notice of the same to Tenant or, if
no such notice is required under the Lease, at least thirty (30) days prior to
the date Landlord would be entitled to terminate the Lease. Each such notice
shall be sent to the address of Lessor set forth below the signature of Lessor
on the last page hereof or such other address as Lessor may from time to time
provide to Landlord, and shall be deemed delivered (i) in the case of notice by
letter, five (5) business days after deposited in the United States mail
registered and return receipt requested, (ii) in the case of notice by overnight
courier, two (2) business days after delivery to such courier and (iii) in the
case of notice given by telex or telecommunication, when given or sent with
electronic confirmation of receipt. During any time period when Tenant is in
default under the Lease, Lessor shall have the option, but not the obligation,
to cure any such default. Landlord shall accept such cure if it occurs within
thirty (30) days after Lessor has received the relevant Default Notice as fully
as if Tenant had fully performed its obligation under the Lease. Upon curing any
such default, Lessor shall be subrogated to the rights of Landlord against
Tenant and, as between Landlord and Tenant, such cured defaults shall no longer
exist.
4. LANDLORD'S REPRESENTATIONS AND WARRANTIES. Landlord hereby warrants
and represents to Lessor that (a) Landlord is the lessor under the Lease; (b)
there are no other agreements between the parties affecting or relating to the
Premises; (c) Landlord has all requisite power and authority to execute and
deliver this Waiver and no consents from any third party are required to do so;
(d) Landlord is the sole owner of the landlord's interest under the Lease and
has not conveyed, transferred or assigned any part of that interest to any other
person or entity; (e) no event of default (nor any event which with the passage
of time would constitute an event of default) has occurred under the Lease; (f)
there exists no litigation affecting title to the Premises or any adverse claim
with respect to the Premises of which Landlord has received notice; (g) there is
no condemnation proceeding pending with respect to any part of the Premises, nor
any threat thereof, of which the Landlord has received notice; (h) the Lease is
in full force and effect; and (i) the Premises are not subject to any mortgage
or other security interest in favor of any person which has not executed an
attornment agreement acceptable to Lessor with respect to this Waiver.
5. MISCELLANEOUS. This Waiver and all rights hereby granted to Lessor
hereunder shall remain in effect so long as there are any obligations owing by
Tenant under the Credit Agreement or any present or future agreement between
Tenant and Lessor which involves the Equipment. All the terms and provisions of
this Waiver shall be binding on and inure to the benefit of the respective
successors and assigns of Landlord and Lessor, and Landlord covenants and agrees
that any assignment, mortgage or other transfer of all or any part of its
interest as the owner and/or landlord of the Premises shall provide and shall be
subject and subordinate to all the terms and provisions hereof. Landlord shall
provide each of Tenant and Lessor a duly executed copy of the agreement
evidencing such subordination. Such agreement shall be in form and substance
reasonably satisfactory to Lessor. The rights and benefits of this Waiver may be
assigned or transferred by Lessor or to third parties who may become the lessor,
directly or indirectly, to Tenant. Lessor shall provide subsequent written
notice to Landlord and Tenant of the assignment or transfer. Headings in this
Waiver are for convenience of reference only and are not part of the substance
hereof. This Waiver shall be governed by and construed in accordance with the
laws of the State of California.
-2-
<PAGE>
IN WITNESS WHEREOF, Landlord and Lessor have executed this Waiver as of
the date and year first written above.
_______________________________________
By:
Name________________________________
Title_______________________________
Address:
_______________________________________
_______________________________________
_______________________________________
Attention:
GATX CAPITAL CORPORATION
By:____________________________________
Name
Title_______________________________
Address:
GATX Capital Corporation
Four Embarcadero Center
Suite 2200
San Francisco, CA 94111
Attention: Contract Administrator
-3-
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEPTEMBER
30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL
STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 273,694
<SECURITIES> 171,193
<RECEIVABLES> 3,152
<ALLOWANCES> 367
<INVENTORY> 3,132
<CURRENT-ASSETS> 493,226
<PP&E> 104,344
<DEPRECIATION> 5,322
<TOTAL-ASSETS> 758,071
<CURRENT-LIABILITIES> 56,716
<BONDS> 499,599
0
0
<COMMON> 77
<OTHER-SE> 200,271
<TOTAL-LIABILITY-AND-EQUITY> 758,071
<SALES> 5,618
<TOTAL-REVENUES> 5,618
<CGS> 39,971
<TOTAL-COSTS> 39,971
<OTHER-EXPENSES> 74,094
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 35,871
<INCOME-PRETAX> (128,533)
<INCOME-TAX> 0
<INCOME-CONTINUING> (128,533)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (128,533)
<EPS-BASIC> (2.80)
<EPS-DILUTED> (2.80)
</TABLE>
