<PAGE>
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON FEBRUARY 16, 1999
REGISTRATION NO. 333-
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
RHYTHMS NETCONNECTIONS INC.
(Exact Name of Registrant as Specified in its Charter)
<TABLE>
<S> <C> <C>
DELAWARE 4813 33-0747515
(State or Other Jurisdiction (Primary Standard Industrial (I.R.S. Employer
of Classification Code Number) Identification
Incorporation or Organization) Number)
</TABLE>
6933 SOUTH REVERE PARKWAY
ENGLEWOOD, COLORADO 80112
(303) 476-4200
(Address, Including Zip Code, and Telephone Number, Including
Area Code, of Registrant's Principal Executive Offices)
--------------------------
CATHERINE HAPKA
PRESIDENT AND CHIEF EXECUTIVE OFFICER
RHYTHMS NETCONNECTIONS INC.
6933 SOUTH REVERE PARKWAY
ENGLEWOOD, COLORADO 80112
(303) 476-4200
(Name, Address, Including Zip Code, and Telephone Number, Including Area Code,
of Agent for Service)
--------------------------
COPIES TO:
JOHN A. DENNISTON, ESQ. MALCOLM I. ROSS, ESQ.
MARTIN C. NICHOLS, ESQ. MICHAEL S. NOVINS, ESQ.
BROBECK, PHLEGER & HARRISON LLP BAKER & MCKENZIE
550 WEST "C" STREET, SUITE 1200 805 THIRD AVENUE
SAN DIEGO, CALIFORNIA 92101 NEW YORK, NEW YORK 10022
(619) 234-1966 (212) 751-5700
--------------------------
APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: AS SOON AS
PRACTICABLE AFTER THE EFFECTIVE DATE OF THIS REGISTRATION STATEMENT.
--------------------------
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. / /
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. / / _________
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. / / _________
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. / /
--------------------------
CALCULATION OF REGISTRATION FEE
<TABLE>
<CAPTION>
PROPOSED MAXIMUM
TITLE OF EACH CLASS OF AGGREGATE AMOUNT OF
SECURITIES TO BE REGISTERED OFFERING PRICE(1) REGISTRATION FEE
<S> <C> <C>
Common stock...................................................................... $165,000,000 $45,870
</TABLE>
(1) Estimated solely for the purpose of calculating the registration fee in
accordance with Rule 457(o) under the Securities Act of 1933.
--------------------------
THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF
THE SECURITIES ACT OF 1933 OR UNTIL THE REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SUCH SECTION 8(a),
MAY DETERMINE.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
SUBJECT TO COMPLETION
PRELIMINARY PROSPECTUS DATED FEBRUARY 16, 1999
The information in this prospectus is not complete and may be changed. We may
not sell these securities until the registration statement filed with the
Securities and Exchange Commission is
effective. This prospectus is not an offer to sell these securities and it is
not soliciting an offer to buy these securities in any state where the offer or
sale is not permitted.
<PAGE>
P_R_O_S_P_E_C_T_U_S
______ SHARES
[LOGO]
RHYTHMS NETCONNECTIONS INC.
COMMON STOCK
--------------
This is Rhythms' initial public offering of common stock.
We expect the public offering price to be between $ and $ per share.
Currently, no public market exists for the shares. After pricing of the
offering, we expect that the common stock will trade on The Nasdaq National
Market under the symbol "RTHM".
INVESTING IN THE COMMON STOCK INVOLVES RISKS WHICH ARE DESCRIBED IN THE
"RISK FACTORS" SECTION BEGINNING ON PAGE 8 OF THIS PROSPECTUS.
-----------------
<TABLE>
<CAPTION>
PER SHARE TOTAL
--------------- -----------
<S> <C> <C>
Public Offering Price........................................ $ $
Underwriting Discount........................................ $ $
Proceeds, before expenses, to Rhythms........................ $ $
</TABLE>
The underwriters may also purchase up to an additional shares at
the public offering price, less the underwriting discount, within 30 days from
the date of this prospectus to cover over-allotments.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if this
prospectus is truthful or complete. Any representation to the contrary is a
criminal offense.
The shares of common stock will be ready for delivery in New York, New York
on or about , 1999.
------------------
MERRILL LYNCH & CO. SALOMON SMITH BARNEY
HAMBRECHT & QUIST THOMAS WEISEL PARTNERS LLC
-------------
The date of this prospectus is , 1999
<PAGE>
[MAP OF UNITED STATES SHOWING RHYTHMS NATIONAL COVERAGE]
Our goal is to provide service in 50 metropolitan areas which contain
approximately 60% of U.S. LANs.*
*In addition to the 33 metropolitan areas indicated above, our plan is to
launch service in an additional 17 metropolitan areas in 2000.
[MAP OF UNITED STATES SHOWING RHYTHMS NETWORK ARCHITECTURE]
We use market data and industry forecasts throughout this prospectus, which
we have obtained from internal surveys, market research, publicly available
information and industry publications. Industry publications generally state
that the information they provide has been obtained from sources believed to be
reliable, but that the accuracy and completeness of such information is not
guaranteed. Similarly, we believe that the surveys and market research we or
others have performed is reliable, but we have not independently verified this
information. Neither we nor any of the underwriters represents that any such
information is accurate.
We own applications for federal registration and claim rights in the
following trademarks: ACI-TM-; ACCELERATED CONNECTIONS-TM-; APPLINET-TM-; DSL
... CAN YOU HANDLE THE SPEED?-TM-; HOME.RHYTHMS-TM-; LOOP.RHYTHMS-TM-;
NET.RHYTHMS-TM-; NETRHYTHMS-TM-; RHYTHM WORKS-TM-; RHYTHMS-TM-; RHYTHMS
COGNITIVE NETWORK-TM-; RHYTHMS NETCONNECTIONS-TM-; RHYTHMS PBXPRESS-TM-; RHYTHMS
TOOLBAR-TM-; RING.RHYTHMS-TM-; WORK.RHYTHMS-TM- and [LOGO].
This prospectus also refers to trade names and trademarks of other
companies.
2
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
---------
<S> <C>
Summary.................................................................................................... 4
Risk Factors............................................................................................... 8
Use of Proceeds............................................................................................ 22
Dividend Policy............................................................................................ 22
Capitalization............................................................................................. 23
Dilution................................................................................................... 24
Selected Consolidated Financial Data....................................................................... 25
Management's Discussion and Analysis of Financial Condition and Results of Operations...................... 26
Description of Certain Indebtedness........................................................................ 32
Business................................................................................................... 33
Management................................................................................................. 51
Certain Relationships and Related Transactions............................................................. 58
Principal Stockholders..................................................................................... 61
Description of Capital Stock............................................................................... 63
Shares Eligible for Future Sale............................................................................ 67
Underwriting............................................................................................... 68
Legal Matters.............................................................................................. 70
Experts.................................................................................................... 70
Where You Can Find More Information........................................................................ 70
Glossary of Terms.......................................................................................... A-1
Index to Financial Statements.............................................................................. F-1
</TABLE>
WE HAVE NOT AUTHORIZED ANY DEALER, SALESPERSON OR OTHER PERSON TO GIVE ANY
INFORMATION OR TO MAKE ANY REPRESENTATIONS OTHER THAN THOSE CONTAINED IN THIS
PROSPECTUS. IF THEY GIVE YOU SUCH INFORMATION OR MAKE SUCH REPRESENTATIONS, YOU
MUST NOT RELY UPON THEM AS HAVING BEEN AUTHORIZED BY US OR THE UNDERWRITERS.
THIS PROSPECTUS IS NOT AN OFFER TO SELL, OR THE SOLICITATION OF AN OFFER TO BUY,
ANY SECURITIES OTHER THAN THESE REGISTERED SECURITIES. IT IS ALSO NOT AN OFFER
TO, OR SOLICITATION OF, ANY PERSON IN ANY JURISDICTION IN WHICH SUCH OFFER OR
SOLICITATION WOULD BE UNLAWFUL. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY
OFFER OR SALE SHALL, UNDER ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT WE
HAVE HAD NO CHANGE IN OUR BUSINESS SINCE THE DATE OF THIS PROSPECTUS OR THAT THE
INFORMATION CONTAINED IN THIS PROSPECTUS IS CORRECT AS OF ANYTIME AFTER THE DATE
OF THIS PROSPECTUS.
UNTIL , 1999, ALL DEALERS SELLING OR BUYING OUR COMMON STOCK MAY
BE REQUIRED TO DELIVER A PROSPECTUS EVEN IF THEY ARE NOT PARTICIPATING IN THIS
OFFERING. THIS DELIVERY REQUIREMENT IS IN ADDITION TO THE OBLIGATION OF DEALERS
TO DELIVER A PROSPECTUS WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR
UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.
3
<PAGE>
SUMMARY
THIS SUMMARY HIGHLIGHTS CERTAIN SIGNIFICANT ASPECTS OF OUR BUSINESS AND THIS
OFFERING, BUT YOU SHOULD READ THE ENTIRE PROSPECTUS, INCLUDING THE FINANCIAL
DATA AND RELATED NOTES, BEFORE MAKING AN INVESTMENT DECISION. WE USE THE TERMS
"WE," "OUR" AND "US" TO REFER TO RHYTHMS NETCONNECTIONS INC. AND ITS
SUBSIDIARIES, AS A COMBINED ENTITY, EXCEPT WHERE WE INDICATE OTHERWISE. ALL
COMMON STOCK NUMBERS IN THIS PROSPECTUS REFLECT A FOR ONE STOCK SPLIT
EFFECTED IN 1999. WE HAVE PROVIDED A GLOSSARY OF TERMS FOR YOUR
CONVENIENCE BEGINNING ON PAGE A-1. YOU SHOULD CAREFULLY CONSIDER THE INFORMATION
SET FORTH UNDER "RISK FACTORS." IN ADDITION, CERTAIN STATEMENTS INCLUDE
FORWARD-LOOKING INFORMATION WHICH INVOLVES RISKS AND UNCERTAINTIES. PLEASE SEE
"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS--FORWARD-LOOKING STATEMENTS."
THE COMPANY
We are a leading service provider of high-speed local access networking
solutions using digital subscriber line ("DSL") technology to businesses. We
have designed our network to give our customers a high-speed "always on" local
connection to the Internet and to private local and wide area networks. We offer
a variety of DSL technologies that deliver data transfer rates ranging from 128
Kilobits per second (Kbps) to 7.1 Megabits per second (Mbps). For customers that
subscribe at the 7.1 Mbps rate, our network provides transfer speeds faster than
frame relay and T-1 circuits, and is approximately 125 times the speed of the
fastest dial-up modem and over 55 times the speed of integrated services digital
network ("ISDN") lines. Through our packet-based network, multiple users on a
single connection are able to simultaneously access the Internet and private
networks. Beyond high-speed access, we also offer a growing suite of features
and applications that we can individually configure to each user's needs. We
believe our network solutions will increase remote office and worker
productivity and reduce the complexity of communications for businesses.
Since our inception in February 1997, we have made substantial progress in
implementing a scalable nationwide network. We began offering commercial
services in San Diego in April 1998, and have subsequently begun service in nine
additional markets: San Francisco, San Jose, Oakland/East Bay, Chicago, Los
Angeles, Orange County, Boston, Sacramento and New York. We intend to continue
our network rollout into an additional 23 markets in 1999 and a further 17
markets by the end of 2000. Upon completion of this network expansion, we
anticipate providing services in 50 of the nation's largest metropolitan areas,
which we believe contain 60% of the nation's local area networks. We have signed
interconnection agreements with Ameritech, Bell Atlantic, Bell South, GTE,
Pacific Bell and U S WEST, and we are currently pursuing interconnection
arrangements with two other incumbent local exchange carriers ("ILECs"). As of
January 31, 1999, we provide service or have installed equipment in nearly 200
ILEC central offices. We have obtained competitive local exchange carrier
("CLEC") authority or have been permitted to operate as a CLEC carrier in 21
states.
In January 1999, we entered into a letter of intent with MCI WorldCom, Inc.
The letter contemplates that MCI WorldCom's investment fund will invest $30
million in us in connection with a broader strategic agreement. The letter also
contemplates that we will be MCI WorldCom's preferred provider of business DSL
lines in certain circumstances, and that MCI WorldCom will contract to sell at
least 100,000 of our DSL lines over a period of five years. In turn, MCI
WorldCom will be our preferred provider of network services in certain
circumstances. MCI WorldCom will also work with us to develop voice and data
applications over a single DSL connection.
We also market our services through our direct sales force and through our
partnerships with recognized leaders in the networking industry, including Cisco
Systems, Inc. and a contemplated arrangement with Verio Inc. Under our strategic
partnership with Cisco, Cisco agreed to jointly market and sell our networking
solutions to its customer base and will engage in joint development projects
4
<PAGE>
with us. As of January 31, 1999, we had over 650 lines in service, and we are
currently under contract to supply over 9,000 additional DSL lines to our
business and service provider customers, including Cisco, Silicon Graphics,
Inc., QUALCOMM Incorporated, Wind River Systems, Broadcom Corporation and
Bechtel Corporation.
Our senior management team has extensive experience in developing
next-generation networking businesses. Our President and Chief Executive
Officer, Catherine Hapka, was previously the founder, President and Chief
Operating Officer of !NTERPRISE Networking Services, U S WEST's data networking
business. Scott Chandler, our Chief Financial Officer, was previously President
and Chief Executive Officer of C-COR Electronics, Inc., a manufacturer of
broadband telecommunications equipment. James Greenberg, our Chief Network
Officer, directed the design, planning, operation and construction of Sprint
Corporation's data networks. Frank Tolve, our Chief Sales Officer, previously
served as Vice President, Sales Operations of Bay Networks. Our sponsors, which
include Kleiner Perkins Caufield & Byers, Enterprise Partners, Brentwood Venture
Capital, the Sprout Group and a subsidiary of Enron Corporation, have to date
invested approximately $30.3 million. In addition, our letter of intent with MCI
WorldCom contemplates a $30 million investment from MCI WorldCom's investment
fund.
MARKET OPPORTUNITY
We believe that a substantial market opportunity exists as a result of the
convergence of six factors:
- the growing demand for high-speed access to the Internet and corporate
networks;
- the inherent limitations of dial-up modems as a connection to data
networks;
- the need for large companies to improve the productivity of their remote
offices and workers;
- the need for small and medium businesses to have an integrated
communication solution for their networking requirements;
- the increasing adoption of DSL and widespread use of packet-based
networks; and
- the 1996 Telecommunications Act.
These factors create a dual market opportunity: new carriers can create
efficient high-speed data, voice and video networks using existing
infrastructure, and business customers can better address their local and wide
area networking needs through a single carrier.
THE RHYTHMS SOLUTIONS
We believe our network solutions effectively address many of the unmet
communication needs of today's businesses by offering an appealing combination
of quality, performance, price and service. Our network consists of:
- HIGH-SPEED, "ALWAYS ON" LOCAL CONNECTIONS. Using DSL technology over
standard telephone lines, our network is capable of delivering data at
speeds ranging from 128 Kbps to 7.1 Mbps.
- METROPOLITAN AND WIDE AREA OVERLAY NETWORK. We have designed our network
architecture so that we can effectively and efficiently manage data
traffic within and among metropolitan areas in which we offer our
services. We manage the network and monitor service levels on a nationwide
basis from our Network Operations Center in Denver.
- PRODUCTIVITY-ENHANCING FEATURES AND APPLICATIONS. We offer a growing suite
of network-enabled features and applications to extend the functionality
of corporate communications and networking resources for remote offices
and workers. We also offer high performance Internet
5
<PAGE>
access solutions to remote offices and workers as well as small and medium
businesses in conjunction with our Internet Service Provider customers.
- SERVICE FLEXIBILITY. We have designed our network so that, over a single
DSL connection, we are able to customize the features and applications for
each individual user and local area network user.
- TURNKEY SOLUTION. We offer turnkey network solutions for our customers by
providing each customer with a single point of contact for all of our
services, including network implementation, maintenance and billing.
BUSINESS STRATEGY
Our goal is to become the leading national service provider of high
performance networking solutions for remote offices and workers. We intend to
implement the following strategies in an effort to achieve our goal:
- exploit our early market entrance by deploying our network rapidly and
building strong relationships with businesses and service provider
customers;
- focus on businesses that demand high performance networking solutions;
- use our network as a platform for productivity-enhancing features and
applications that we and third parties develop;
- continue to establish strong distribution channels to reach large, medium
and small businesses; and
- provide superior service and customer care.
------------------------
Our principal executive office is located at 6933 South Revere Parkway,
Englewood, Colorado 80112, and our telephone number is (303) 476-4200 or (800)
RHYTHMS.
6
<PAGE>
THE OFFERING
<TABLE>
<S> <C>
Common stock offered......................... shares
Common stock to be outstanding after this
offering................................... shares(1)
Use of proceeds.............................. We will use the net proceeds to fund the
continuing deployment of network services in
our existing markets, as well as our planned
rollout in additional markets. We also expect
to use these proceeds for expenses associated
with the continued development of our sales
and marketing activities, to fund operating
losses, to pay our debt obligations and for
general corporate purposes.
Dividend policy.............................. We currently intend to retain any future
earnings to fund the development of our
business. Therefore, we do not currently
anticipate paying cash dividends.
Proposed Nasdaq National Market symbol....... RTHM
</TABLE>
- ------------------------
(1) Gives effect to the conversion of our preferred stock into 33,800,074 shares
of common stock on the completion of this offering. If the underwriters
exercise their over-allotment option in full, the number of outstanding
shares would increase by shares.
7
<PAGE>
RISK FACTORS
YOU SHOULD CAREFULLY CONSIDER THE RISKS AND UNCERTAINTIES DESCRIBED BELOW
AND THE OTHER INFORMATION IN THIS PROSPECTUS BEFORE DECIDING TO INVEST IN US.
YOU MAY LOSE ALL OR PART OF YOUR INVESTMENT. THE RISKS AND UNCERTAINTIES
DESCRIBED BELOW ARE NOT THE ONLY ONES FACING OUR COMPANY.
THIS PROSPECTUS ALSO CONTAINS "FORWARD-LOOKING" STATEMENTS THAT INVOLVE
RISKS AND UNCERTAINTIES. PLEASE SEE "MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS--FORWARD-LOOKING STATEMENTS."
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 ILEC in
July 1997 and began to offer commercial services in San Diego 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 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 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 ILECs, 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 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;
8
<PAGE>
- 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 make 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 9,800 lines that we have committed to
deliver to date, we committed approximately 8,700 to only two 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.
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, 1998, we had an accumulated
deficit of approximately $23.5 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 senior discount notes of approximately $23.6 million in 1999 and
increasing to $41.5 million in 2003. In addition, we intend to seek additional
debt financing in the future. 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 ILEC central office collocation facilities
and transport facilities;
9
<PAGE>
- the success of our relationships with our partners and distributors,
including MCI WorldCom 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, the trading price of our common stock would likely
decline.
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 ILECs; 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.
WE DEPEND ON ILECS FOR COLLOCATION AND TRANSMISSION FACILITIES
We must use copper telephone lines controlled by the ILECs to provide DSL
connections to customers. We also depend on the ILECs for collocation and for a
substantial portion of the transmission facilities we use to connect our
equipment in ILEC central offices to our Metro Service Centers. In addition, we
depend on the ILECs 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 ILECs in large volumes. In many cases, we may be
unable to obtain access to collocation and transmission facilities from the
ILECs, or to gain access at acceptable rates, terms and conditions, including
timeliness. An inability to obtain adequate and timely access to collocation
space or
10
<PAGE>
transmission facilities on acceptable terms and conditions from ILECs could have
a material and adverse effect on our business, prospects, operating results and
financial condition.
Because we compete with ILECs in our markets, they may be reluctant to
cooperate with us. The ILECs 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 ILECs, 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 ILEC central office -- or virtual collocation -- where the
ILEC 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 issues.
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. 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
ILEC 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 ILEC's transmission facilities. State
tariffs, state public utility commissions and interconnection agreements with
the ILECs 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 ILEC'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 ILECs 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
ILECs 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 ILEC copper lines and
transmission facilities. These government entities may modify the terms or
prices of our interconnection agreements and our access to ILEC copper lines and
transmission facilities in ways that would be adverse to our business. State
regulatory commissions establish the price rates for DSL-capable copper lines as
well as other rates, terms and conditions of our dealings with the ILECs in
ongoing public hearings. Participation in these hearings will involve
significant management time and expense. ILECs may from time to time propose new
rates, and the outcomes of hearings and
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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 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 MCI
WorldCom and Cisco. We have a contract with Cisco and have entered into a letter
of intent with MCI WorldCom. While we anticipate our agreement with MCI WorldCom
will call for it to sell 100,000 DSL lines, we also anticipate that the
agreement will enable MCI WorldCom to terminate the agreement under certain
circumstances and to receive offsets and credits under other circumstances.
Therefore, MCI WorldCom might sell significantly fewer than 100,000 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 ILECs, traditional and new long distance
carriers, cable modem service providers, Internet Service Providers, wireless
and satellite data service providers and other competitive carriers. ILECs have
existing metropolitan area networks and circuit-switched local access networks.
In addition, most ILECs 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 ILECs have announced that they intend to aggressively
market these services to their residential customers at attractive prices. We
believe that ILECs have the potential to quickly overcome many of the issues
that have delayed widespread deployment of DSL services in the past.
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 Companies Inc., Qwest Communications International,
Inc. and Level 3 Communications, Inc., 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 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
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presences, provide Internet access to residential and business customers,
generally over the ILECs' 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.
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 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. See "Business--Competition."
Our financial performance depends on attracting and retaining customers and
reducing levels of customer turnover, which can result from a variety of
sources, including employee turnover within our customers' businesses. Many
providers of telecommunications and networking services experience high rates of
customer turnover. We may experience substantial customer turnover in the
future.
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, including the proceeds of this offering and the proposed $30 million
investment in us by MCI WorldCom's investment fund, will be sufficient to fund
our aggregate capital expenditures and working capital requirements, including
operating losses, until June 2000. 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 requirement 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;
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- 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 in "Risk
Factors."
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 indenture that governs
our senior discount notes restricts 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
are 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 level, without achieving
a favorable result. The FCC 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 ILECs will work aggressively to modify or restrict the operation
of many provisions of the 1996 Telecommunications Act. We expect ILECs will
pursue litigation in courts, institute administrative proceedings with the FCC
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 ILECs and
against the interest of competitive carriers such as us. If the ILECs 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. For more details about our regulatory
situation, please see "Business--Government Regulation."
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
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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, 1998, we had approximately $153.0 million of
outstanding debt, and our debt made up 91% of our capitalization. Please see
"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
"Risk Factors;"
- 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.
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 project with Cisco and our proposed joint development project with
MCI WorldCom 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.
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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 ILECs. 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 ILECs 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 ILECs 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, 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. Please see "Business--Employees" and "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
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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, except for our IDSL service, the DSL modem and DSL multiplexing
equipment used 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 ILEC,
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 ILECs 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, ILECs 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 unable to
provide service on selected lines. The procedures to resolve interference issues
between CLECs and ILECs are still being developed, and these procedures may not
be effective. We may be unable to successfully negotiate interference resolution
procedures with ILECs. Moreover, ILECs 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, ILECs 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
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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 FCC 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 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.
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WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE COVENANTS
IN OUR EXISTING DEBT SECURITIES
The indenture for our senior discount notes imposes 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 pay 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
will beneficially own % of the common stock after completion of this
offering, or % if the over-allotment option is exercised in full.
Accordingly, these stockholders will be 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. See "Principal Stockholders" for information about
the ownership of common stock by our executive officers, directors and principal
stockholders.
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 new company, we believe we have been able
to build our business 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 ILECs. Based on responses from these third
parties, other than the ILECs, 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 ILECs nor assess the ILECs' Year
2000 compliance. To the extent that one or more ILECs 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
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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 the
worst-case Year 2000 scenario.
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 this offering and 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. Please see "Use of Proceeds."
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 price at which our common stock will trade will depend upon many
factors, including our historical and anticipated quarterly and annual operating
results, variations between our actual results and analyst and investor
expectations, announcements by us or others and developments affecting our
business, investor perceptions of our company and comparable public companies,
changes in our industry and general market and economic conditions. Some of
these factors are beyond our control. You should be aware that the stock market
has from time to time experienced extreme price and volume fluctuations.
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.
THERE HAS BEEN NO PRIOR MARKET FOR THE COMMON STOCK
Before this offering, there has not been a public market for the common
stock. We will apply to the Nasdaq National Market System to list our common
stock, but we do not know whether active trading in the common stock will
develop and continue after the offering. We will determine the initial public
offering price for the common stock through negotiations with the underwriters.
You may not be able to resell your shares at or above the initial public
offering price. For a description of the factors that will be taken into account
to determine the offering price, please see "Underwriting."
20
<PAGE>
ANTI-TAKEOVER PROVISIONS COULD NEGATIVELY IMPACT OUR STOCKHOLDERS
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. We intend to adopt a stockholder rights plan
prior to the completion of this offering. 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. See
"Description of Capital Stock--Possible Anti-Takeover Matters."
In addition, the indenture governing our senior discount notes requires us
to offer to repurchase all senior discount notes for 101% of their principal
amount or accreted value, plus any accrued interest due, within 30 days after a
change of control. See "Description of Certain Indebtedness." 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 common stock in the public market following
this offering, 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 will be
limited by lock-up agreements under which the holders of substantially all of
our outstanding shares of common stock and options and warrants to purchase
common stock will agree not to sell or otherwise dispose of any of their shares
for a period of 180 days after the date of this prospectus without the prior
written consent of Merrill Lynch and Salomon Smith Barney. However, Merrill
Lynch and Salomon Smith Barney may, in their sole discretion and at any time
without notice, release all or any portion of the securities subject to lock-up
agreements. 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. See "Description of Capital Stock--Registration Rights" and
"Shares Eligible for Future Sale."
YOU WILL INCUR IMMEDIATE AND SUBSTANTIAL DILUTION OF $___ PER SHARE
The initial public offering price is substantially higher than the net
tangible book value per share of the outstanding common stock immediately after
this offering. Accordingly, if you purchase common stock in this offering, you
will incur immediate and substantial dilution of $___ in the net tangible book
value per share of the common stock from the price you pay for the common stock
in this offering.
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<PAGE>
MANAGEMENT HAS BROAD DISCRETION TO USE THE PROCEEDS FROM THIS OFFERING
Our management will have broad discretion over the use of proceeds we raise
in this offering, and you must rely on the judgment of management in the
application of the proceeds. Please see "Use of Proceeds" for more information
related to our financing plan.
USE OF PROCEEDS
We will use the aggregate net proceeds of this offering, which we estimate
at approximately $ million after deducting the underwriters' discount and
other estimated offering expenses, to fund the expenditures incurred in the
continuing deployment of network services in our existing markets, as well as
our planned rollout in additional markets. Additionally, we plan to use the net
proceeds from this offering for expenses associated with the continued
development of our sales and marketing activities, to fund operating losses, to
pay our debt obligations and for general corporate purposes. Pending use of such
net proceeds, we intend to invest the net proceeds in short-term, investment
grade securities to the extent permitted by the terms of the covenants governing
our existing debt and any statistical asset tests imposed by the Investment
Company Act of 1940.
The actual amounts we spend will vary significantly depending upon a number
of factors, including future revenue growth, if any, capital expenditures, the
amount of cash generated by our operations and other factors, many of which are
beyond our control. Additionally, we may modify the number, selection and timing
of our entry with respect to any or all of our targeted markets. Accordingly,
our management will retain broad discretion in the allocation of the net
proceeds. Please see "Risk Factors--We will need significant additional funds,
which we may not be able to obtain" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
DIVIDEND POLICY
We have never declared or paid dividends on our capital stock, and we do not
anticipate paying any cash dividends in the foreseeable future. Payments of any
future dividends will be at the discretion of our Board of Directors after
taking into account various factors, such as our financial condition, operating
results, current and anticipated cash needs and plans for expansion.
22
<PAGE>
CAPITALIZATION
The following unaudited table sets forth our capitalization as of September
30, 1998 on an actual basis and on an adjusted basis to give effect to this
offering, including conversion of the existing Series A and Series B preferred
stock into common stock which will occur automatically upon the completion of
this offering. Please read this table in conjunction with our consolidated
financial statements, the related notes to the financial statements and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this prospectus.
<TABLE>
<CAPTION>
AS OF
SEPTEMBER 30, 1998
----------------------
ACTUAL AS ADJUSTED
--------- -----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Cash, cash equivalents and short-term investments............................................ $ 153,939 $
--------- -----------
--------- -----------
Debt:
Bank note (1).............................................................................. $ 861 $ 861
13 1/2% Senior Discount Notes due 2008..................................................... 152,115 152,115
--------- -----------
Total debt............................................................................... 152,976 152,976
--------- -----------
Mandatorily redeemable Common Stock Warrants................................................. 6,567 6,567
--------- -----------
Stockholders' equity:
Series A Convertible preferred stock, $0.001 par value; 12,900,000 shares authorized actual
and as adjusted; 12,855,094 shares issued and outstanding actual and no shares issued and
outstanding as adjusted.................................................................. 13 --
Series B Convertible preferred stock, $0.001 par value; 4,044,943 shares authorized actual
and as adjusted; 4,044,943 shares issued and outstanding actual and no shares issued and
outstanding as adjusted.................................................................. 4 --
Common stock, $0.001 par value; 66,708,243 shares authorized actual and shares as
adjusted; 6,645,608 shares issued actual and shares issued as adjusted........... 7
Treasury stock at cost; 365,096 shares....................................................... (19) (19)
Additional paid-in capital................................................................... 34,547
Deferred compensation........................................................................ (2,875) (2,875)
Accumulated deficit.......................................................................... (23,452) (23,452)
--------- -----------
Total stockholders' equity............................................................... 8,225
--------- -----------
Total capitalization................................................................... $ 167,768 $
--------- -----------
--------- -----------
</TABLE>
- ------------------------------
(1) Consists of a $1.0 million note payable to Silicon Valley Bank which is
being amortized over a 36-month period that ends in April 2001.
23
<PAGE>
DILUTION
Our net tangible book value at September 30, 1998 was $0.21 per share. Net
tangible book value per share represents the amount of our total tangible assets
less total liabilities, divided by the number of shares of common stock
outstanding after giving effect to the conversion of all outstanding shares of
preferred stock into 33,800,074 shares of common stock upon the completion of
this offering. Please see "Capitalization." After giving effect to the sale of
the shares of common stock in this offering, assuming a public offering
price of $ per share, the mid-point of the range set forth on the front
cover, less estimated underwriting discounts and commissions and other expenses
of this offering, our pro forma net tangible book value as of September 30, 1998
would have been $ per share. This represents an immediate increase in net
tangible book value per share of $ to existing stockholders and immediate
dilution in net tangible book value of $ per share to new investors in this
offering. The following table illustrates the per share dilution:
<TABLE>
<S> <C> <C>
Assumed public offering price per share................. $
Net tangible book value per share at September 30,
1998................................................ $ 0.21
Increase per share attributable to new investors......
---------
Pro forma net tangible book value per share after this
offering..............................................
---------
Dilution per share to new investors (1)................. $
---------
---------
</TABLE>
- ------------------------
(1) If the underwriters' over-allotment option is exercised in full, dilution
per share to new investors would be $ .
The following table summarizes the number of shares of common stock
purchased from us, assuming conversion of all outstanding shares of preferred
stock into common stock, the total consideration paid and the average price per
share paid by the existing stockholders and by new investors in this offering,
before deduction of estimated underwriting discounts and commissions and other
expenses of this offering. The calculations in this table with respect to the
shares to be purchased by new investors in this offering reflect an assumed
initial public offering price of $ per share, the mid-point of the range set
forth on the front cover.
<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
------------------------- --------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
-------------- -------- ----------- -------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders....................................... % $ % $
New investors............................................... $
-------------- --- ----------- ---
Total................................................... (1) 100% $ 100%
-------------- --- ----------- ---
-------------- --- ----------- ---
</TABLE>
- ------------------------
(1) Excludes as of , 1999:
- shares of common stock issuable upon exercise of outstanding options
with a weighted average exercise price of $ per share,
- shares of common stock reserved for issuance and
- shares of common stock issuable upon the exercise of outstanding
warrants with a weighted average exercise price of $ .
To the extent these options and warrants are exercised, there will be
further dilution to the new investors.
24
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following statement of operations data for the periods from our
inception on February 27, 1997 to December 31, 1997 (audited), February 27, 1997
to September 30, 1997 (unaudited) and for the nine months ended September 30,
1998 (unaudited), and the balance sheet data as of December 31, 1997 (audited)
and the actual data as of September 30, 1998 (unaudited), have been derived from
our consolidated financial statements and the related notes to the financial
statements. The following selected consolidated financial data should be read in
conjunction with our consolidated financial statements and the related notes to
the financial statements and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included elsewhere in this prospectus.
<TABLE>
<CAPTION>
FEBRUARY 27, 1997 FEBRUARY 27, 1997
(INCEPTION) TO (INCEPTION) TO NINE MONTHS ENDED
DECEMBER 31, 1997 SEPTEMBER 30, 1997 SEPTEMBER 30, 1998
------------------- ------------------- ------------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue.............................................. $ -- $ -- $ 248
Operating expenses:
Network and service costs.......................... -- -- 2,072
Selling, general and administrative................ 2,534 938 14,040
Depreciation and amortization...................... 1 -- 507
------- ------ --------
Total operating expenses......................... 2,535 938 16,619
------- ------ --------
Loss from operations................................. (2,535) (938) (16,371)
Interest and other income (expense), net............. 113 55 (4,659)
------- ------ --------
Net loss............................................. $ (2,422) $ (883) $ (21,030)
------- ------ --------
------- ------ --------
Net loss per share (basic and diluted)............... $ (1.34) $ (0.49) $ (9.49)
------- ------ --------
------- ------ --------
OTHER FINANCIAL DATA:
EBITDA (1)........................................... $ (2,342) $ (836) $ (15,449)
Adjusted EBITDA (2).................................. (2,342) (836) (15,039)
Net cash used for operating activities............... (1,560) (679) (9,159)
Net cash used for investing activities............... (1,345) (257) (150,134)
Net cash provided by financing activities............ 13,071 6,140 169,363
</TABLE>
<TABLE>
<CAPTION>
AS OF SEPTEMBER 30, 1998
AS OF --------------------------
DECEMBER 31, 1997 ACTUAL AS ADJUSTED (3)
------------------- --------- ---------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments................. $ 10,166 $ 153,939 $
Equipment and furniture, net...................................... 1,621 3,166 3,166
Total assets...................................................... 12,241 173,982
Total debt........................................................ 568 152,976 152,976
Mandatorily redeemable common stock warrants...................... -- 6,567 6,567
Total stockholders' equity........................................ 10,346 8,225
</TABLE>
- ------------------------------
(1) EBITDA consists of the net loss excluding net interest, depreciation and
amortization of capital assets and deferred compensation expense. EBITDA is
presented to enhance an understanding of our operating results and is not
intended to represent cash flow or results of operations in accordance with
generally accepted accounting principles for the period indicated and may be
calculated differently than EBITDA for other companies.
(2) Total operating expenses for the nine months ended September 30, 1998
include $410,000 of operating lease expense to GATX Capital Corporation. No
amounts were incurred to GATX in 1997. Adjusted EBITDA reflects EBITDA
excluding the operating lease expense to GATX.
(3) Adjusts the actual information to give effect to this offering.
25
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
We are a leading service provider of high-speed local access networking
solutions using DSL technology to businesses. We began offering commercial
services in San Diego in April 1998, and have subsequently begun service in nine
additional markets: San Francisco, San Jose, Oakland/East Bay, Chicago, Los
Angeles, Orange County, Boston, Sacramento and New York. We intend to continue
our network rollout into an additional 23 markets in 1999 and a further 17
markets by the end of 2000.
Since our inception in February 1997, our primary activities have consisted
of:
- obtaining required governmental authorizations;
- negotiating and executing interconnection agreements with ILECs;
- 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 system and other back
office systems.
We have incurred operating losses, net losses and negative operating cash
flow for each month since our formation. As of September 30, 1998, we had an
accumulated deficit of $23.5 million. We currently intend to substantially
increase our operating expenses and capital expenditures in an effort to rapidly
expand our infrastructure and network services. We expect to incur substantial
operating losses, net losses and negative cash flow during the network build-out
and initial penetration of each new market we enter. These losses are expected
to continue for at least the next several years.
In January 1999, we entered into a letter of intent with MCI WorldCom. The
letter contemplates that MCI WorldCom's investment fund will invest $30 million
in us in connection with a broader strategic agreement. The letter also
contemplates that we will be MCI WorldCom's preferred provider of business DSL
lines in certain circumstances, and that MCI WorldCom will contract to sell at
least 100,000 of our DSL lines over a period of five years. In turn, MCI
WorldCom will be our preferred provider of network services in certain
circumstances.
FACTORS AFFECTING OPERATIONS
REVENUE
The following factors affect our revenue:
- SERVICE OFFERING. We derive a majority of our operating revenue from DSL
access and wide area network services. For both local access and wide area
network connections, we bill our customers for monthly recurring charges
based on the data transfer speeds selected by the customer. We offer flat
rate plans for our services. In addition to monthly service fees, we bill
users for nonrecurring service activation and installation charges. We
also charge both monthly and nonrecurring charges to each customer for the
high-speed connection between our Metro Service Center and the customer's
router. To encourage potential customers to adopt our
26
<PAGE>
services, we sometimes offer reduced prices for an initial period of time.
We expect that, as a result of competitive forces, our prices will decline
over time.
- PENETRATION OF TARGET MARKETS. We base our target market assessment on the
number of local area networks in each market, which we believe is the best
indication of data intensive business density and potential customers for
our services. According to a leading data communications industry source,
the total number of business local area networks in the United States is
approximately 1.5 million, with an average of 40 users per local area
network. We believe that our initial ten markets contain 23% of all local
area networks in the United States. Our goal is to cover 60% of the local
area networks in the United States, which we believe is achievable by
building out a total of 50 markets. Initially, DSL is expected to reach
over 70% of the businesses and residences served from the central offices.
Within each metropolitan area, we expect to collocate in the appropriate
number of central offices to cover 75% of the total market opportunity.
- TURNOVER. To date, our customer turnover has been minimal. We expect this
to increase in the future as competition intensifies.
NETWORK AND SERVICE COSTS
Our network and service costs are generally comprised of the following:
- EQUIPMENT INSTALLATION CHARGES. In each market, we will require a number
of field service technicians to install customer premise equipment at end
user locations. We currently outsource most of this function.
- MONTHLY RECURRING AND NONRECURRING LINE AND SERVICE CHARGES. We pay ILECs
a one-time installation and activation fee and a monthly service fee for
each copper line.
- METROPOLITAN AREA NETWORK TRANSPORT CHARGES. We incur charges for
transport between our Connection Points and our Metro Service Centers.
Currently, these charges are typically for DS-3 services from a CLEC or
ILEC. These charges also include customer connections to our network.
- NETWORK FACILITIES OPERATING EXPENSES. We incur various recurring costs at
our network locations. These costs include facility rent and utility
costs.
- WIDE AREA NETWORK CONNECTION CHARGES. We pay long distance carriers a
one-time installation and activation fee and a monthly service fee for
wide area network connections over a frame relay or Asynchronous Transfer
Mode network. We are currently leasing these services from long distance
carriers.
- COST OF CUSTOMER PREMISE EQUIPMENT. As part of our DSL product offering,
we provide the customer premise equipment and expense the cost of the
customer premise equipment for each customer line.
- EQUIPMENT OPERATING LEASE EXPENSES. We currently take advantage of
short-term operating leases to finance the acquisition of substantially
all of our network equipment, including DSL multiplexers, Asynchronous
Transfer Mode switches and routers. We may decide to purchase and to
capitalize some or all of this equipment in the future.
- LINE REPAIR AND SUPPORT COSTS. Similar to other telecommunications
providers, we estimate that a small percentage of our lines may require
repair or support. These costs will consist of field dispatch labor and a
portion of our Network Operations Center costs.
27
<PAGE>
SELLING, GENERAL AND ADMINISTRATIVE COSTS
Our selling, general and administrative expenses include customer service
and technical support, information systems, billing and collections, general
management and overhead, and administrative functions. Headcount in functional
areas, such as customer service, engineering and operations, will
increase as we expand our network, and if our number of customers increases.
- SALES AND MARKETING COSTS. Our sales and marketing efforts focus on
attracting and retaining service providers, including national and
regional Internet Service Providers, national and regional systems and
network integrators, value-added resellers, CLECs and long distance
carriers, as well as large business customers.
- GENERAL AND ADMINISTRATIVE COSTS. As we expand our network, we expect the
number of employees located in specific markets to grow. Certain
functions, such as customer service, network operations, finance, billing
and site planning, are likely to remain centralized in order to achieve
economies of scale.
DEPRECIATION AND AMORTIZATION
Depreciation expense arising from our network equipment will be minimal
since leased equipment expenses will reflect most of the cost and financing of
this equipment. Collocation fees are capitalized and amortized over an estimated
useful life of ten years.
RESULTS OF OPERATIONS
REVENUE
We did not offer commercial services in 1997 and, as a result, did not
record any revenue in 1997. During the nine months ended September 30, 1998, we
continued the development of our business operations, commencing service in the
San Diego market in April, the San Francisco, the Oakland/East Bay and San Jose
markets in July, and the Los Angeles and Orange County markets in September. We
recorded revenue of $248,000 during this period, which was primarily from DSL
service and installation charges, net of discounts given to customers.
NETWORK AND SERVICE COSTS
Since we did not offer commercial services in 1997, we did not record any
network or service costs in 1997. For the nine months ended September 30, 1998,
we recorded network and service costs of $2.1 million. We expect network and
service costs to increase significantly in future periods as we expand our
network into additional markets.
SELLING, GENERAL AND ADMINISTRATIVE
From inception through December 31, 1997 selling, general and administrative
expenses were $2.5 million and consisted primarily of salaries and legal and
consulting fees incurred to establish a management team and develop our
business. For the nine months ended September 30, 1998, we recorded selling,
general and administrative expenses of $14.0 million. This increase is
attributable to a continued increase in staffing levels, increased marketing
efforts coinciding with the launch of commercial services and increased legal
fees associated with the development of additional markets. We expect selling,
general and administrative expenses to continue to increase significantly as we
expand our business.
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<PAGE>
DEPRECIATION AND AMORTIZATION
Depreciation from network equipment is minimal since substantially all of
this equipment is currently leased. Depreciation and amortization was negligible
for the period from inception through December 31, 1997 and was $507,000 for the
nine months ended September 30, 1998. The increase was due to the commencement
of our operations in 1998. We expect depreciation and amortization to increase
significantly in future periods as we increase capital expenditures to expand
our network.
OTHER INCOME AND EXPENSE
Other income and expense consists primarily of interest income from our cash
and short-term investments and interest expense associated with our debt. From
inception through December 31, 1997 net interest income was $113,000, which was
primarily attributable to the interest income earned from the proceeds raised in
our Series A preferred stock financing. For the nine months ended September 30,
1998, we recorded net interest expense of $4.7 million, consisting of interest
income of $3.8 million generated from invested cash balances, offset by $8.5
million in interest expense. The increase in the interest expense is
substantially due to the accretion of interest on the senior discount notes that
were issued in May 1998.
INCOME TAXES
We generated net operating loss ("NOL") carryforwards of $2.1 million from
inception to December 31, 1997. We expect significant consolidated losses for
the foreseeable future which will generate additional NOL carryforwards.
However, our ability to use NOLs may be subject to annual limitations. In
addition, income taxes may be payable during this time due to operating income
in certain tax jurisdictions. In the future, if we achieve operating profits and
the NOLs have been exhausted or have expired, we may experience significant tax
expense. We recognized no provision for taxes because we operated at a loss
throughout 1997 and for the nine months ended September 30, 1998.
LIQUIDITY AND CAPITAL RESOURCES
The development and expansion of our business requires significant capital
expenditures. The principal capital expenditures incurred during the build-out
phase of any market involve the procurement, design and construction of our
Connection Points, one or two Metro Service Centers and other elements of our
network design.
The number of targeted central offices in a market varies, as does the
average capital cost to build our Connection Points in a given market. Capital
expenditures, including payments for collocation fees, were $16.4 million for
the first nine months of 1998. We expect our capital expenditures to be
substantially higher in future periods, arising primarily from payment of
collocation fees and the purchase of infrastructure equipment necessary for the
development and expansion of our network.
Through September 30, 1998, we financed our operations primarily through
private placements of equity totaling $30.5 million, of which we received $30.3
million from our venture capital and institutional sponsors, the use of
operating equipment leases totaling $26.5 million, borrowings under a note
payable from Silicon Valley Bank of $1.0 million, and $144.0 million in net
proceeds raised from the issuance of the senior discount notes. As of September
30, 1998, we had an accumulated deficit of $23.5 million and cash, cash
equivalents and short-term investments of $153.9 million.
During the first nine months of 1998, the net cash used in our operating
activities was $9.2 million. This cash was used for a variety of operating
purposes, including salaries, consulting and legal expenses, network operations
and overhead expense. Our net cash used for investing activities for the first
nine months of 1998 was $150.1 million and was used primarily for purchases of
short-term investments and
29
<PAGE>
equipment and payments of collocation fees. Net cash provided by financing
activities for the nine months ended September 30, 1998 was $169.4 million and
primarily came from the issuance of the senior discount notes and from the
issuance of preferred stock.
We believe that the net proceeds from this offering, together with the
contemplated MCI WorldCom fund investment of $30 million, our existing cash and
short-term investments, existing and anticipated equipment lease financings and
future revenue generated from operations, will be sufficient to fund our
operating losses, capital expenditures, lease payments and working capital
requirements through June 2000. We expect our operating losses and capital
expenditures to increase substantially primarily due to our network expansion.
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 financing or the private or public sale of equity or
debt securities. We have received a financing proposal from GATX Capital
Corporation for up to $30 million of additional lease financing, of which $24
million is allocated for equipment and $6 million is allocated for collocation
fees. This proposal also contains a provision for another $20 million of
available financing, for a total of $50 million, that would be available upon
the occurrence of certain events.
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; or
- we accelerate deployment of our network services or otherwise alter the
schedule or targets of our rollout plan.
Equity or debt financing may not be available to us on favorable terms or at
all. See "Risk Factors--We will need significant additional funds, which we may
not be able to obtain."
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 would not properly recognize a year that begins
with "20" instead of "19." 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 our internal
business systems 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 ILECs. Based on responses from these third parties
other than ILECs, we believe that they will not experience Year 2000 problems
that would materially adversely affect our business. We have not been able to
conduct a compliance check of ILECs nor assess the ILECs' Year 2000 compliance.
To the extent that one or more ILECs 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.
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Any of these developments could have a material and adverse effect on our
business, prospects, operating results and financial condition.
We have not 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.
FINANCIAL INFORMATION
The preceding discussion and analysis is based on our consolidated financial
statements and the related notes and should be read in conjunction with the
consolidated financial statements and the related notes included in this
prospectus.
FORWARD-LOOKING STATEMENTS
This prospectus includes forward-looking statements. These forward-looking
statements address, among other things:
- our network rollout plans and strategies;
- development and management of our business;
- our ability to attract, retain and motivate qualified personnel;
- success of our strategic alliances;
- our ability to attract and retain customers;
- the extent of acceptance of our services;
- the market opportunity and trends in the markets for our services;
- our ability to upgrade our technologies;
- prices of telecommunication services;
- the nature of regulatory requirements that apply to us;
- our ability to obtain any required governmental authorizations;
- our future capital expenditures and needs;
- our ability to obtain financing on commercially reasonable terms;
- our ability to implement a Year 2000 readiness program;
- our ability to compete; and
- the extent and nature of competition.
These statements may be found in this section, in the front inside cover of
this prospectus, in the sections of this prospectus entitled "Summary," "Risk
Factors," "Use of Proceeds" and "Business" and in this prospectus generally.
We have based these forward-looking statements on our current expectations
and projections about future events. However, our actual results could differ
materially from those anticipated in these forward-looking statements as a
result of risks facing us, including risks stated in "Risk Factors," or faulty
assumptions on our part. For example, assumptions that could cause actual
results to vary materially from future results include, but are not limited to:
- our ability to successfully market our services to current and new
customers;
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- our ability to generate customer demand for our services in our target
markets;
- the development of our target market and market opportunities;
- market pricing for our services and for competing services;
- the extent of increasing competition;
- our ability to acquire funds to expand our network;
- the ability of our equipment and service suppliers to meet our needs;
- trends in regulatory, legislative and judicial developments;
- our ability to manage growth of our operations; and
- our ability to access regions and enter into suitable interconnection
agreements with ILECs.
We undertake no obligation to publicly update or revise any forward-looking
statements, 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 prospectus might not occur.
DESCRIPTION OF CERTAIN INDEBTEDNESS
In November 1997 and May 1998, we entered into 36-month lease lines for an
aggregate $26.5 million in lease financing with Sun Financial Group, Inc., now
GATX Capital Corporation, pursuant to which we lease office equipment,
telecommunications equipment, network equipment and furniture on an operating
lease basis. In connection with this leasing arrangement, we issued to GATX a
warrant to purchase 478,650 shares of common stock at a price of $2.225 per
share. This warrant is immediately exercisable. During February 1999, we
received a financing proposal from GATX for up to $30 million in additional
lease financing, of which $24 million is allocated for equipment and $6 million
is allocated for collocation fees. This new proposal also contains a provision
for another $20 million of available financing, for a total of $50 million, that
would be available upon the occurrence of certain events.
We also have outstanding senior discount notes, which we issued in May 1998.
These 13 1/2% notes were issued at a discount and raised net proceeds of
approximately $144.0 million. These notes are senior unsecured obligations that
mature with a principal amount of $290 million on May 15, 2008. The discount
amount is being accreted to interest expense for the first five years of the
notes; cash interest on these notes will not accrue prior to May 15, 2003, but
will do so after that date and will be payable semi-annually each year,
commencing November 15, 2003. These notes are redeemable at our option, in whole
or in part, at any time after May 15, 2003 and, prior to May 15, 2001, out of
the proceeds of certain equity offerings, at predetermined redemption prices
together with accrued and unpaid interest through the date of redemption. We
will not use the proceeds of this offering to redeem any of these notes. Upon a
change of control, each holder of these notes may require us to repurchase the
notes at 101% of the principal amount thereof, plus accrued and unpaid interest
to the date of purchase. These notes contain certain restrictive covenants,
including limitations on future indebtedness, restricted payments, transactions
with affiliates, liens, sale of stock of subsidiaries, dividends, mergers and
transfers of assets.
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BUSINESS
THE COMPANY
We are a leading service provider of high-speed local access networking
solutions using DSL technology to businesses. We have designed our network to
give our customers a high-speed "always on" local connection to the Internet and
to private local and wide area networks. We offer a variety of DSL technologies
that deliver data transfer rates ranging from 128 Kbps to 7.1 Mbps. For
customers that subscribe at the 7.1 Mbps rate, our network provides transfer
speeds faster than frame relay and T-1 circuits, and is approximately 125 times
the speed of the fastest dial-up modem and over 55 times the speed of ISDN
lines. Through our packet-based network, multiple users on a single connection
are able to simultaneously access the Internet and private networks. Beyond
high-speed access, we also offer a growing suite of features and applications
that we can individually configure to each user's needs. We believe our network
solutions will increase remote office and worker productivity and reduce the
complexity of communications for businesses.
Since our inception in February 1997, we have made substantial progress in
implementing a scalable nationwide network. We began offering commercial
services in San Diego in April 1998, and have subsequently begun service in nine
additional markets: San Francisco, San Jose, Oakland/East Bay, Chicago, Los
Angeles, Orange County, Boston, Sacramento and New York. We intend to continue
our network rollout into an additional 23 markets in 1999 and a further 17
markets by the end of 2000. Upon completion of this network expansion, we
anticipate providing services in 50 of the nation's largest metropolitan areas,
which we believe contain 60% of the nation's local area networks. We have signed
interconnection agreements with Ameritech, Bell Atlantic, Bell South, GTE,
Pacific Bell and U S WEST, and we are currently pursuing interconnection
arrangements with two other ILECs. As of January 31, 1999, we provide service or
have installed equipment in nearly 200 ILEC central offices. We have obtained
CLEC authority or have been permitted to operate as a CLEC carrier in 21 states.
In January 1999, we entered into a letter of intent with MCI WorldCom. The
letter contemplates that MCI WorldCom's investment fund will invest $30 million
in us in connection with a broader strategic agreement. The letter also
contemplates that we will be MCI WorldCom's preferred provider of business DSL
lines in certain circumstances, and that MCI WorldCom will contract to sell at
least 100,000 of our DSL lines over a period of five years. In turn, MCI
WorldCom will be our preferred provider of network services in certain
circumstances. MCI WorldCom will also work with us to develop voice and data
applications over a single DSL connection.
We also market our services through our direct sales force and through our
partnerships with recognized leaders in the networking industry, including Cisco
and a contemplated arrangement with Verio. Under our strategic partnership with
Cisco, Cisco agreed to jointly market and sell our networking solutions to its
customer base and will engage in joint development projects with us. As of
January 31, 1999, we had over 650 lines in service, and we are currently under
contract to supply over 9,000 additional DSL lines to our business and service
provider customers, including Cisco, Silicon Graphics, Inc., QUALCOMM
Incorporated, Wind River Systems, Broadcom Corporation and Bechtel Corporation.
Our senior management team has extensive experience in developing
next-generation networking businesses. Our President and Chief Executive
Officer, Catherine Hapka, was previously the founder, President and Chief
Operating Officer of !NTERPRISE Networking Services, U S WEST's data networking
business. Scott Chandler, our Chief Financial Officer, was previously President
and Chief Executive Officer of C-COR Electronics, Inc., a manufacturer of
broadband telecommunications equipment. James Greenberg, our Chief Network
Officer, directed the design, planning, operation and construction of Sprint
Corporation's data networks. Frank Tolve, our Chief Sales Officer, previously
served as Vice President, Sales Operations of Bay Networks. Our sponsors, which
include Kleiner Perkins Caufield & Byers, Enterprise Partners, Brentwood Venture
Capital, the Sprout Group and a
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subsidiary of Enron Corporation, have to date invested approximately $30.3
million. In addition, our letter of intent with MCI WorldCom contemplates a $30
million investment from MCI WorldCom's investment fund.
MARKET OPPORTUNITY
We believe that a substantial market opportunity exists as a result of the
convergence of six factors:
- the growing demand for high-speed access to the Internet and corporate
networks;
- the inherent limitations of dial-up modems as a connection to data
networks;
- the need for large companies to improve the productivity of their remote
offices and workers;
- the need for small and medium businesses to have an integrated
communication solution for their networking requirements;
- the increasing adoption of DSL and widespread use of packet-based
networks; and
- the 1996 Telecommunications Act.
GROWING DEMAND FOR HIGH-SPEED ACCESS TO THE INTERNET AND CORPORATE NETWORKS
The value of goods and services sold through the Internet will grow from
$2.6 billion in 1996 to $400 billion in 2002, according to analyst projections.
Today, business spending for connecting remote workers, branch offices and
corporate headquarters to each other and to customers, suppliers and partners --
either through the Internet or private networks -- is large and growing.
Industry analysts estimate that the U.S. market for remote Internet and local
area network access will grow from $5.9 billion in 1997 to $11.7 billion by
2002. Industry sources estimate that spending in the United States on
distributed networking and network services and applications will grow from
$54.2 billion in 1998 to $173 billion in 2002. Much of that growth is expected
to result from increased demand for e-mail, Web hosting services, e-commerce,
collaboration and real-time video services and applications. Industry sources
expect spending on distributed networking and network services and applications
to encompass 57% of a company's total annual information technology spending by
2002.
LIMITATIONS OF DIAL-UP MODEMS AND ISDN
Because only five percent of buildings in the United States are currently
connected to high-speed fiber rings -- typically large buildings in downtown
areas of cities or clusters of buildings in regional campus parks -- the vast
majority of workers who access data networks do so through slow dial-up modems
connected to the traditional circuit switched public telephone system. These
traditional dial-up modems are creating a bottleneck in data communications
because the data-carrying capacity of the fastest commercially available dial-up
modem is only 56 Kbps. The capacity of another alternative, an ISDN line, is
only 128 Kbps. While ISDN technology provides improved capacity relative to
dial-up modems, the cost of an ISDN solution is often prohibitive.
NEEDS OF LARGE BUSINESSES FOR REMOTE OFFICE AND WORKER PRODUCTIVITY
Many large companies are supporting increasing numbers of remote offices and
workers. These companies face the challenge of finding a cost effective way to
make their remote workers as productive as those who have access to all of the
high performance communications and networking resources available to workers
located at corporate headquarters. A high-speed network solution that
encompasses access to the corporate local area network, the corporate telephone
system, the Internet, the corporate video conferencing system, customers,
suppliers and partners would substantially increase remote office and worker
productivity. At present, large businesses are incurring significant capital
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expenditures to purchase equipment to support dial-up modems and ISDN
connections, and paying for high cost technical support personnel only to
implement networking solutions that fail to optimize worker productivity.
NEEDS OF SMALL AND MEDIUM BUSINESSES FOR INTEGRATED COMMUNICATION SOLUTIONS
A significant number of small and medium businesses have no practical
alternative to dial-up modems or ISDN for their workers to access the Internet
and remote local area networks. As a result, these workers suffer productivity
limitations associated with slow transmission speeds. In addition, these
businesses need to contend with the cost and complexity of retaining multiple
vendors for their communication needs: ILECs for local voice traffic; long
distance carriers for long distance voice traffic; Internet Service Providers
for Internet access; and equipment integrators for on-premises voice and network
systems. We believe that these businesses can benefit from working with a single
service provider that offers integrated communication solutions, using a single
connection.
EMERGENCE OF DSL AND PACKET-BASED TECHNOLOGIES
DSL technology dramatically increases the data, voice and video carrying
capacity of standard copper telephone lines. Because DSL technology uses
existing copper telephone lines, a broad network deployment can be implemented
rapidly, and requires a lower initial fixed investment than some existing
alternative technologies, such as fiber, cable modems and satellite
communications systems. A significant portion of the build-out of a DSL-based
network is directly related to the demand of paying subscribers, resulting in a
success-based deployment of capital.
Packet-based networks often are more efficient than traditional
point-to-point networks, and allow end users to connect to any location that can
be assigned an Internet Protocol address. Traditional point-to-point networks,
including the traditional telephone network and private line networks, are less
efficient because they require a dedicated connection between two locations.
Packet-based networks allow multiple users to share connections between
locations.
1996 TELECOMMUNICATIONS ACT
The 1996 Telecommunications Act allows competitive carriers to leverage the
existing ILEC infrastructure, as opposed to building a competing infrastructure
at significant cost. The 1996 Telecommunications Act requires all ILECs to allow
competitive carriers to collocate their equipment along with ILEC equipment in
ILEC central offices, which enables competitive carriers to access end users
through existing telephone line connections. The 1996 Telecommunications Act
creates an incentive for ILECs that were formerly part of the Bell system to
cooperate with competitive carriers: these ILECs cannot provide long distance
service until regulators determine that there is competition in the ILEC's local
market.
MARKET IMPACT OF CONVERGENCE
We believe the convergence of these factors has had several fundamental
effects on the communications market. New carriers can:
- leverage the existing network infrastructure by obtaining local network
access connections, and offer efficient high-speed data, voice and video
networks;
- provide large businesses with productivity enhancing remote office and
worker networking solutions;
- offer small and medium businesses integrated voice and data solutions that
reduce the complexity of using multiple vendors for communication
services; and
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- build new networks that can provide efficient high-speed access over a
single connection to any Internet Protocol address on the Internet and/or
corporate network, along with features and applications that can be
configured to meet each user's needs.
THE RHYTHMS SOLUTIONS
We believe our network solutions effectively address many of the unmet
communications needs of today's businesses by offering an appealing combination
of quality, performance, price and service. Our network consists of:
- HIGH-SPEED, "ALWAYS ON" LOCAL CONNECTIONS. Our network delivers
high-speed, "always on" local access. Using DSL technology over standard
copper telephone lines, our network is capable of delivering data transfer
rates at speeds ranging from 128 Kbps to 7.1 Mbps. For customers that
subscribe at the 7.1 Mbps rate, the transfer rate is faster than frame
relay and T-1 circuits, and is approximately 125 times the rate of the
fastest dial-up modem and over 55 times the rate of an ISDN line.
Moreover, unlike dial-up modems and ISDN lines, the DSL solution is
"always-on" -- it does not require users to dial-up to connect to the
Internet or their local area network for each use.
- METROPOLITAN AND WIDE AREA OVERLAY NETWORK. We have designed our network
so that we can effectively and efficiently manage data traffic within and
among the metropolitan areas in which we offer our services. We use
transport services provided by other carriers for local access to users,
metropolitan area network connections and for long distance backbone
capacity. This overlay network is designed to route and switch traffic
within each metropolitan area, keeping local traffic local and sending
only long distance traffic over the wide area network, thereby increasing
overall network capacity and reliability and minimizing our backbone
costs. We manage the network and monitor service levels on a nationwide
basis from our Network Operations Center in Denver.
- PRODUCTIVITY ENHANCING FEATURES AND APPLICATIONS. We offer a growing
suite of network-enabled features and applications that extend the
functionality of corporate communications and networking resources to
remote offices and workers. We also offer remote offices and workers, as
well as small and medium businesses high performance Internet access
solutions in conjunction with our service provider customers.
- SERVICE FLEXIBILITY. We have designed our network so that we are able,
over a single DSL connection, to individually configure each network
user's features and applications.
- TURNKEY SOLUTION. We offer turnkey network solutions for our customers by
providing each customer with a single point of contact for a complete
package of services, including network implementation, maintenance,
billing and the DSL modem. For large customers, we provide complete
project management, including design, implementation and results
reporting. In some cases, we also seamlessly link our network operations
systems to existing customer information systems to ensure maximum service
efficiency.
BUSINESS STRATEGY
Our goal is to become the leading national service provider of high
performance networking solutions for remote offices and workers. We intend to
implement the following strategies to achieve our goal:
EXPLOIT EARLY MOVER ADVANTAGE
We intend to exploit our early market entrance to deploy our network and
establish strong relationships with business and service provider customers. As
of January 31, 1999, we provide service
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or had installed our network equipment in nearly 200 central offices.
Installation on this scale requires significant time and resources; therefore,
we believe our progress to date provides us a significant time-to-market
advantage over would-be competitors. We have gained significant build-out
experience, which we believe will streamline our further expansion. We plan to
construct our network rapidly so that we are an early mover in our other target
markets. We intend to exploit our early mover advantage to gain significant
market share in our target markets.
FOCUS ON PERFORMANCE-DRIVEN BUSINESS CUSTOMERS
We believe that the underserved segment of the business networking market
that demands high performance is currently relying on dial-up modems or ISDN for
network access. Many large businesses have remote offices and workers that are
not able to take advantage of the full array of communications and networking
resources available to workers at the main office. In addition to offering these
businesses high-speed access to the Internet and corporate networks, we intend
to offer them network-enabled features and applications that increase worker
productivity. Further, we believe that small and medium businesses are looking
for an integrated service provider to reduce their reliance on multiple vendors.
Accordingly, we intend to offer multiple networking services, including voice
and data services over a single DSL connection, to meet the needs of small and
medium businesses.
EXPAND NETWORK-ENABLED FEATURES AND APPLICATIONS
We seek to have our network become a platform that facilitates the delivery
of productivity-enhancing features and applications to businesses and their
employees. By collaborating with industry leaders such as MCI WorldCom and
Cisco, we intend to jointly develop features and applications that will meet the
needs of our customers. For example, as part of our anticipated strategic
agreement with MCI WorldCom, we have agreed to jointly develop voice and data
applications over a single DSL connection. In addition, we believe that the
proliferation of high-speed local access networks, such as our own, will
encourage third parties to create more bandwidth-intensive features and
applications. One of our objectives in providing these enhanced features and
applications is to strengthen customer loyalty and increase revenue per network
user.
ESTABLISH STRONG DISTRIBUTION CHANNELS
We intend to build strong distribution channels. For large businesses, we
are building a direct sales force and are entering into strategic joint
marketing alliances. We have executed a letter of intent to enter into a
strategic alliance with MCI WorldCom in which we will become its preferred
provider of business DSL connections for large, medium and small businesses. We
have also entered into a strategic alliance with Cisco, in which we will jointly
market and sell our networking solutions to large businesses. For small and
medium businesses, we will distribute our services through our service provider
customers. Over time, we will seek to develop additional strategic alliances,
focusing on partners that can both add value to our network and give us a
meaningful distribution channel.
PROVIDE SUPERIOR CUSTOMER SERVICE
As part of our strategy to obtain and retain business and service provider
customers, we intend to provide superior service and customer care. We will
guarantee high-quality service by providing carrier-class networking solutions
and superior customer service. Our carrier-class networking solutions include
end-to-end proactive network monitoring and management through our Network
Operations Center, 24 hours a day, seven days a week. We also offer multiple
security features and a network that we can scale to meet demand. Our customer
service includes a personal and Web-based single point of contact, a complete
packaged solution including the DSL modem, installation, activation and network
management, and specific customer service objectives against which we measure
our performance. Our
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objective in providing outstanding customer service is to provide a high level
of customer satisfaction, achieve customer loyalty and accelerate the adoption
rate of our service.
STRATEGIC PARTNERSHIPS
MCI WORLDCOM
In January 1999, we entered into a letter of intent with MCI WorldCom. The
letter contemplates, among other things:
- MCI WORLDCOM INVESTMENT. MCI WorldCom's investment fund will invest $30
million in us, in return for 3,731,410 shares of our Series C preferred
stock and warrants to purchase 600,000 shares of our common stock at $8.04
per share. As a holder of Series C preferred stock, the fund will have the
right to elect one of our directors.
- PROVIDING DSL TO MCI WORLDCOM. We will be MCI WorldCom's preferred
provider of business DSL access services in areas where we deploy our
network, except for services to certain subsidiaries and in locations where
MCI WorldCom deploys its own DSL equipment. We will have a right of first
refusal to match offers made to MCI WorldCom by other providers of DSL
services.
MCI WorldCom will agree to resell a minimum of 100,000 business quality DSL
lines. MCI WorldCom will have 60 months to place orders for these lines,
starting on the date when we have 1,250 collocations in commercial service
in at least 32 metropolitan statistical areas. As part of our agreement, we
must provide specified service levels and have available capacity.
- OBTAINING NETWORK SERVICES FROM MCI WORLDCOM. MCI WorldCom will be our
preferred provider of network services, including metropolitan area
network services, long-haul backbone services and Internet Protocol
backbone services. MCI WorldCom will have a right of first refusal to
provide all of these services to us.
- COLLABORATION. We will jointly develop voice and data applications over a
single DSL connection. We will also form a working group with MCI WorldCom
to develop and implement the systems and procedures necessary to jointly
deploy DSL service nationwide. We will agree to collaborate with MCI
WorldCom in selecting technologies and vendors to support our network
deployments.
CISCO SYSTEMS
In October 1998, we entered into a strategic partnership with Cisco, in
which Cisco agreed to work jointly with us to sell our services to its customers
including providing compensation to its sales representatives for selling our
services. In addition, Cisco has committed to a joint marketing program with us
to increase our market recognition among businesses. We are also under contract
with Cisco to manage and upgrade its remote access program for 8,500 teleworkers
nationwide.
OTHER PARTNERS
In October 1998, we entered into a letter of intent contemplating a joint
marketing agreement with Verio to jointly fund an advertising and market
awareness program in the Chicago metropolitan area. In the future we intend to
pursue additional joint marketing relationships to strengthen our distribution
capabilities and enable us to penetrate our target markets more rapidly.
RHYTHMS NETWORK SERVICES, FEATURES AND APPLICATIONS
We offer our customers solutions that address many of their high performance
networking needs. Our local connection services use a variety of DSL
technologies to deliver high-speed, "always on" local access. We also aggregate
traffic within metropolitan areas and route or switch the traffic to our service
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provider customers, or to a corporate local area network within the same
metropolitan area or another metropolitan area using our inter-network
connections. In addition to local connections and metropolitan and wide area
inter-network connections, we offer a growing suite of network-enabled features
and applications.
LOCAL CONNECTIONS
Our local connection services connect individual users or multiple users on
a local area network to our metropolitan or national network or to the Internet
using DSL technology over traditional telephone lines. Using DSL technology over
copper lines, our network is capable of data transfer rates ranging from 128
Kbps to 7.1 Mbps. Unlike dial-up modems and ISDN lines, the DSL solution is
"always on" -- it does not require users to dial-up to connect to the Internet
or their local area network for each use.
We place DSL equipment both at the customer premises -- a residence or
business -- and in the central office that services that specific customer
premises. There are typically many ILEC central offices in each metropolitan
area. We connect the DSL equipment in each central office to one of our Metro
Service Centers so that we can route or switch network traffic to either a local
destination, a national destination where we provide service or the Internet.
For our local connection services, the speed and effectiveness of the DSL
connection will vary based on a number of factors, including the distance of the
end user from the central office and the condition of the copper line that
connects the end user to the central office. However, the specific number of
potential users for higher speeds will vary by central office and by region and
will be affected by line quality. In the future, we intend to examine adding a
variety of high-speed local access technologies as they are developed, including
emerging wireless technologies. The chart below compares the performance and
range for our local connection services as of February 1999:
<TABLE>
<CAPTION>
SPEED TO SPEED FROM RANGE(1)
END USER END USER (FEET) TECHNOLOGY(2)
- ----------- ----------- ----------- -------------
<C> <S> <C> <C>
144 Kbps 144 Kbps Unlimited IDSL(3)
256 Kbps 256 Kbps 18,000 SDSL
384 Kbps 384 Kbps 15,000 RADSL
512 Kbps 512 Kbps 14,000 RADSL
768 Kbps 768 Kbps 12,000 RADSL
1 Mbps 1 Mbps 12,000 RADSL
1.5 Mbps 1.5 Mbps 8,000 SDSL
3 Mbps 1 Mbps 10,700 RADSL
5 Mbps 1 Mbps 9,000 RADSL
7.1 Mbps 1 Mbps 7,800 RADSL
</TABLE>
- ------------------------
(1) Estimated maximum distance from the central office to the end user.
(2) The technologies are described more fully in "--DSL Technologies" below.
(3) Speeds are 128 Kbps under certain circumstances.
METROPOLITAN AREA AND WIDE AREA INTER-NETWORK CONNECTIONS
For our business and service provider customers, we offer high-speed
connections both within and among metropolitan areas. In order to switch and
route traffic aggregated from each central office to its ultimate local or long
distance destination, we offer two interconnection services.
Our 1.544 Mbps service -- DS-1 -- is suitable for small business customers
or service providers. Our 45 Mbps service -- DS-3 -- is intended for large
business customers or service providers. The
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monthly service charge for both services is greater if traffic aggregated in one
metropolitan area is terminated in another metropolitan area, and varies based
on the speed of the local access connection.
Our wide area network currently operates between each of the metropolitan
areas in which we provide service, and is currently a frame relay network which
we lease from a long distance carrier. In the future, we expect to add
Asynchronous Transfer Mode capability.
NETWORK-ENABLED SERVICES, FEATURES AND APPLICATIONS
We intend to use our high-speed local access connection to provide multiple
network services, features and applications. Instead of just providing a
high-speed access connection, we intend to offer many network-enabled features
and applications, which we are able to configure to meet each user's needs. We
believe our strategy to provide additional network services, features and
applications for each user on our network allows us to address a larger market
opportunity than the market opportunity represented by connection services
alone. Our strategy is to benefit from additional recurring monthly revenue by
providing multiple network features and applications.
The features and applications that we currently offer are outlined below.
- CORPORATE TELEPHONE SYSTEM EXTENSION. This feature extends the
functionality of the corporate telephone system directly into a
teleworker's home or, in the future, a company's branch office. This
feature supports common corporate telephone functions such as four digit
dialing, conference calling and speed dialing. Benefits to our business
customers include increased worker productivity, reduced second line
expenses for voice service and the ability to aggregate and control long
distance charges.
- COMPUTER BACKUP. The computer backup feature allows end users to
automatically backup data to a secure remote site. Computer backup
leverages our "always on," high-speed local access connection and allows
the backup to be done at the times most convenient for the end user. We
believe this feature is more cost effective than substitutes such as tape
drives and disk cartridge drives, and has the additional protection of
being stored off site. This application is provided by a third party,
@Backup, Inc.
- CONTENT CACHING. We offer content caching for our customers' end users
who access the Internet. This network feature operates in the background,
serving user requests for Web pages locally rather than obtaining the
content from the actual server across the Internet. Caching enables our
customers to retrieve content faster than would otherwise be possible. Our
caching solution requires no configuration setup by our customer. If the
cache fails in any way, it will be automatically bypassed and user
requests will be sent directly to the Internet.
- SERVICE SELECTION. We have implemented a service selection feature within
our network that enables end users to access multiple destinations,
including the corporate local area network, the corporate telephone
system, the Internet, customers, suppliers and partners. Using this
feature, a connection to the Internet and the corporate local area network
can be established simultaneously by different users over the same DSL
access line. This feature alleviates the corporate network from servicing
Internet traffic to a teleworker.
- DYNAMIC HOST CONFIGURATION PROTOCOL FUNCTIONALITY. This feature relieves
network administrators from the burden of notifying each teleworker of
network configuration changes. Through the use of this protocol, once
teleworkers start up their computers, the customer's server automatically
downloads all of his or her network configuration parameters. If any
modifications to the configuration are necessary, they only need to be
modified once by the network administrator, and the network configuration
parameters will be automatically distributed to all of the organization's
teleworkers.
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- TURNKEY INTERNET. This application allows small and medium businesses or
large business branch offices the ability to host Internet and intranet
Web sites. This application includes network equipment on the customer
premises that provides router, Web server, e-mail, file server, firewall
and Web-page caching. This premises-based Internet solution is combined
with our "always on" high-speed network connection and Internet services
from an Internet Service Provider customer.
In the future, we plan to continue to expand our network features and
appplications by working closely with leading hardware, software and networking
companies. We expect to focus on many applications, including combining voice
and data communications, increasing our directory and security capabilities, and
providing businesses with the ability to access their important applications
from remote locations. We have agreed to jointly develop directory and
voice-over Internet Protocol applications with Cisco. In addition, as part of
our anticipated strategic agreement with MCI WorldCom, we expect to jointly
develop multiple applications using DSL technology including voice and data
applications over a single DSL connection.
Using these network-enabled features and applications, we can assemble a
broad solution to meet our business customer needs. For example, for a
teleworker, we might combine high-speed access to the corporate network and the
Internet with computer backup and corporate telephone extension. For a small
business, we might offer a turnkey Internet solution by combining high-speed
access to the Internet through our Internet Service Provider customer, with
customer premise equipment that supports Web server, e-mail, file server,
firewall, Web-page caching and network backup.
TURNKEY SOLUTION
We offer a full service solution for the configuration, provisioning, and
installation of the local access connection at the end user location, for which
the customer pays a one-time charge. That charge covers the cost of installing
the DSL line, any required inside wiring, the DSL modem, attaching the DSL modem
to either a single computer, local area network or enterprise server,
installation of a single network interface card if required, and installing the
TCP/IP software if required. For our large business customers, we provide
complete project management, including design, implementation and results
reporting. In some cases we seamlessly link our network operations systems to
existing customer information systems through Web-based interfaces.
CUSTOMERS, SALES AND MARKETING
We offer our services to large, medium and small businesses. As of January
31, 1999, we served more than 75 business and 20 service provider customers. For
these business and service provider customers we have over 650 lines in service
and are under contract to supply over 9,000 additional DSL lines. Selected
business customers include Cisco, Silicon Graphics, QUALCOMM and Bechtel. In
addition, our service provider customers include CTSNet, ConnectNet, Verio,
Epoch Networks, Inc. and Ingram Micro.
DIRECT SALES CHANNELS
We market our services to large businesses through a direct sales force. Our
target account profile is a large, information-intensive enterprise with
multiple locations and large numbers of distributed workers. Our sales force
seeks to deal directly with the Chief Information Officer and the
telecommunications manager responsible for remote access in the target account.
Sales teams are deployed in each of the metropolitan areas in which we offer our
services. As of January 31, 1999, we had 40 sales and technical personnel
supporting our direct sales efforts. We intend to increase the size of our sales
and technical support force to sell and support large businesses as we enter new
geographic markets.
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Our relationship with large business customers can involve multiple phases.
A customer typically initially agrees to a first phase commitment for a specific
number of connections at a negotiated price and one year contract term.
Typically, three to six months into the first phase implementation, the customer
agrees to successive phases of implementation that could include additional
connections and upgrades in services, features and applications. In general, we
have experienced a six to nine month sales cycle prior to receiving significant
order volume from a business customer. We currently have two large business
customers that have committed to multi-phase implementation programs: Cisco and
Silicon Graphics. Collectively, these two customers account for over 90% of our
commitments to purchase our connections. Please see "Risk Factors--We cannot
predict our success because our business model is unproven."
INDIRECT SALES CHANNELS
We also market our services to small and medium businesses through indirect
channels, including Internet Service Providers, interexchange carriers, CLECs,
value-added resellers, and integrators. We offer each service provider the
ability to select those services that it would like to bundle with its own
service offerings to offer a total solution to its customers. For example,
Internet Service Providers typically combine our high-speed connections with
their Internet access services and resell the combination to their existing and
new customers. We address these markets through sales and marketing personnel
dedicated to each of these indirect channels.
We supplement our sales effort to certain of these service providers by
offering marketing support services that may include training, proposal
development, lead generation, channel support materials, joint marketing funds,
Web promotion, joint participation in national and regional customer events and
press announcements. We also offer promotions and sales incentives from time to
time to our service providers. Additionally, we support our service providers by
acting as a network integrator by qualifying potential customers for service,
ordering connections, installing equipment on the customer premises, turning up
the service, monitoring the network, troubleshooting, making repairs and
invoicing the customer on a single bill.
Our agreements with our service provider customers vary widely. Generally,
our agreements have a one to three year term, and are based on negotiated prices
that decline with increasing levels of volume achievement. In many cases,
service providers have selected one or two, and perhaps three, DSL service
providers as preferred suppliers in each market. Our goal is to be selected as
the preferred supplier or one of the preferred suppliers in each metropolitan
area where we operate. When we are selected as a preferred supplier within a
given market, we may enter into joint marketing arrangements to promote our DSL
services. See "Risk Factors--We depend on third parties, particularly MCI
WorldCom and Cisco, for the marketing and sales of our network services."
CUSTOMER SERVICE
We offer our business and service provider customers a single point of
contact for implementation, maintenance and billing. Our Network Operations
Center provides both proactive and customer initiated maintenance services 24
hours a day, seven days a week. We also provide a broad range of customer
service and Network Operations Center services through our Web interface.
- IMPLEMENTATION. Working with a business or service provider customer, our
customer service technicians and sales engineers will develop an
implementation plan for each customer. The plan will include qualifying
the customer for our service offerings, placing orders for the connection
facilities, coordinating the delivery of the connection, installation and
turn up.
- MAINTENANCE. Our Network Operations Center in Denver provides network
surveillance through standard Simple Network Management Protocol tools for
all equipment in our network. Because we have complete end-to-end
visibility of our network, we are able to proactively detect and
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correct the majority of our customer's maintenance problems remotely. Our
goal is to proactively detect and repair 90% of our customer's maintenance
problems before our customer is aware of a problem. Customer initiated
maintenance and repair requests are managed and resolved primarily through
the Customer Service Center. We utilize a trouble ticket management system
to communicate customer maintenance problems from the customer service
center to the Network Operations Center engineers and the field services
engineers. Because our Network Operations Center is fully staffed 24 hours
a day, seven days a week, we believe our ability to provide superior
proactive maintenance is significantly enhanced.
- BILLING. Customer bills are currently issued on a monthly basis through an
internal billing system. Customer billing inquiries are managed by our
Customer Service Center. In the future, billing inquiries will also be
supported through our Web interface.
- CUSTOMER SUPPORT SYSTEMS. Our system architecture is designed to
facilitate rapid service responsiveness and reduce the cost of customer
support. We use an integrated set of standard, off-the-shelf systems to
support our business processes. We designed all business functions,
including sales, ordering, provisioning, maintenance and repair, billing,
accounting and decision support to use a single database, ensuring that
every function has accurate, up-to-date information. The use of
client-server tools and scalable Unix and Microsoft NT servers enables
automation within and between processes.
NETWORK ARCHITECTURE
NETWORK TECHNOLOGY
The key design features allowing us to be a business-class network are:
- CARRIER-CLASS NETWORK MANAGEMENT. Our network is designed to be
carrier-class throughout. For example, it has been designed with redundant
network electronics and transmission paths. We have the ability to
electronically view our entire network including the DSL modem located at
the end user's computer or located on our customer's local area network
from our Network Operations Center in Denver. We provide our business and
service provider customers with service level agreements that guarantee
specific levels of network performance. We have found that by offering
service level agreements, we are better able to convince businesses to
move their mission-critical applications onto our network.
- SCALABLE SYSTEMS. We use industry standard, off-the-shelf software to
support preordering, ordering, provisioning, billing, network monitoring
and trouble management. We have implemented these systems using a
distributed client-server systems architecture that operates using a
single, integrated database. This approach allows us to grow our customer
support and network management capabilities as customer demand increases
by giving our personnel faster, more accurate access to a fully integrated
business information system.
- NETWORK SECURITY. Non-dedicated access, such as dial-up modem or ISDN
lines, or dedicated access to the public Internet, represents security
risks for business networks. These security risks are mitigated through
the use of virtual private network technologies such as authentication,
tunneling, encryption, and through the use of permanent virtual circuits
that define a logical dedicated connection between the end user and the
corporate network. Our network enables businesses to fully employ these
virtual private network technologies by using their own equipment at the
edges of our network, or optionally purchasing virtual private networking
services from us.
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NETWORK COMPONENTS
Our network is an overlay network in that we lease existing transport
services from other service providers: local access copper lines from ILECs,
metropolitan fiber from ILECs or CLECs and long-distance backbone fiber from
long distance carriers. This overlay network is designed to switch and route
traffic within each metropolitan area, keeping local traffic local and only
sending non-local traffic over the wide area network, thereby increasing overall
network capacity and reliability and reducing costs. The primary components of
our network are customer endpoint devices, local transport, our Connection
Points, high-speed metropolitan area network, our Metro Service Centers, our
backbone and our Network Operations Center.
- CUSTOMER ENDPOINT DEVICES. We currently offer DSL and private line local
access connections in our network. For DSL access, we include the customer
endpoint device -- the DSL modem -- as part of our complete turnkey
service offering. We configure and install these modems with the end
user's computer, or local area network or enterprise router along with any
required on-site wiring needed to connect the modem to the telephone line
leased from the ILEC. Currently, except for our IDSL service, the DSL
modem and DSL multiplexing equipment used 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.
- LOCAL TRANSPORT. Our local transport connects customer end-point devices
to our network. For digital subscriber line access, the transport is a
DSL-capable copper loop leased by us from the ILEC under terms specified
in our interconnection agreements. In many cases, DSL-capable lines result
from modification of voice grade lines to carry digital signals, at times
involving an additional one-time or monthly charge relative to voice grade
lines. For private line access, the transport is leased copper or fiber
trunks provided by the ILEC or a CLEC.
- CONNECTION POINTS. Through our interconnection agreements with the ILECs,
we secure collocation space in central offices. In each of these
Connection Points, we connect the DSL-equipped copper loop to our DSL
multiplexing equipment. Each of our Connection Points is designed to offer
the same high reliability and availability standards as the ILEC's own
central office space. We expect to place our equipment in each of 30 to 90
central offices in any metropolitan area that we enter. As of January 31,
1999, we had Connection Points in nearly 200 central offices. Although we
expect that many Connection Points will be physically located within the
central office, we have placed and will continue to place our Connection
Points in locations immediately adjacent to central offices, when
collocation space within the central office is not available.
- HIGH-SPEED METROPOLITAN AREA NETWORK. In each of our targeted
metropolitan area markets, we operate a private metropolitan area network.
The network consists of high-speed Asynchronous Transfer Mode
communications circuits that we lease from CLECs or ILECs to connect our
Connection Points to the Metro Service Center. The metropolitan area
network operates at 45 Mbps -- DS-3 -- today, and can be upgraded to 150
Mbps -- OC-3 -- and 600 Mbps -- OC-12 -- in the future. We anticipate
leasing a substantial portion of this capacity from MCI WorldCom, as
described in "--Strategic Partnerships."
- METRO SERVICE CENTERS. The Metro Service Center is a physical point of
presence within a metropolitan area where local access traffic is
aggregated from the Connection Points over our high-speed metropolitan
area network. Although we generally expect to have one Metro Service
Center in each of our targeted metropolitan areas, in larger metropolitan
areas, we may have two. The Metro Service Center houses our Asynchronous
Transfer Mode switches and Internet Protocol routers. We also place
applications servers in our Metro Service Centers to support network
enabled feature and applications. We design our Metro Service Centers for
high
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availability including battery backup power, redundant equipment and
active network monitoring.
- BACKBONE. Our backbone interconnects our Metro Service Centers so that
communications traffic can be transported among different metropolitan
areas. Currently, we lease a frame relay backbone from a long distance
carrier. In the future, we expect to add Asynchronous Transfer Mode
capability.
- NETWORK OPERATIONS CENTER. Our entire network is managed from the Network
Operations Center located in Denver. From these centers, we provide
end-to-end network monitoring and management using advanced network
management tools 24 hours a day, seven days a week. This enhances our
ability to address performance or connection issues before they affect our
end user's experience. From the Network Operations Center, we monitor the
equipment and circuits in each Metro Service Center, each metropolitan
area network, each Connection Point, individual end user lines and modems.
Please see "Risk Factors--A system failure or breach of network security
could cause delays or interruptions of service to our customers."
We are pursuing a program of ongoing network development. Our engineering
efforts focus on the design and development of new technologies and services to
increase the speed, efficiency, reliability and security of our network and to
enable network features and applications developed by us or by third parties.
Please see "Risk Factors--We may be unable to effectively expand our network
services and provide high performance to a substantial number of end users."
DSL TECHNOLOGIES
We utilize various DSL equipment and technologies from different vendors.
The various DSL technologies allow us to offer a range of connection speeds.
Actual speeds are a function of the distance from the end user or local area
network to the central office and the quality of the copper line. We describe
the basic features and the market positioning of our primary DSL technologies
below.
RATE ADAPTIVE DIGITAL SUBSCRIBER LINE (RADSL)
RADSL technology allows each end user or local area network to utilize the
full digital capability of the underlying telephone line. Speeds reach up to 7.1
Mbps downstream and up to 1.1 Mbps upstream if the end user or local area
network is within 15,000 feet, or approximately 2.8 miles, from the central
office. We use this technology for end users or local area networks needing very
high access speeds. Our target customers for RADSL connections consist of small
and medium businesses and branch offices of large businesses needing T-1 or
higher speeds. We believe that these businesses often find the cost of dedicated
private line or frame relay services to be prohibitive. Our RADSL connection
competes favorably on a price/performance basis relative to traditional
fractional T-1 and frame relay services. The service also provides the highest
speed of any DSL service for bandwidth intensive applications.
SYMMETRIC DIGITAL SUBSCRIBER LINE (SDSL)
Our SDSL technology allows end users and local area network to achieve up to
1.5 Mbps speeds both downstream and upstream. Depending on the quality of the
copper line, 1.5 Mbps can typically be achieved if the end user or local area
network is within 8,000 feet, or approximately 1.5 miles, from the central
office.
INTEGRATED DIGITAL SUBSCRIBER LINE (IDSL)
IDSL technology allows us to reach all end users or local area networks
within a central office serving area irrespective of the end user or local area
network distance from the central office. Our
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IDSL service operates at up to 144 Kbps in each direction. This service can use
existing ISDN equipment at the end user site, and is targeted at the ISDN
replacement market. For information intensive users, we believe that IDSL
compares favorably with ISDN on a price/performance basis when the monthly flat
rate IDSL charge is compared with the per minute ISDN charge. We also offer IDSL
to end users that have lines that do not consist of continuous copper, such as
digital line carrier equipped lines that are partially copper and partially
fiber.
COMPETITION
We will face competition from many competitors with significantly greater
financial resources, well-established brand names and large, existing installed
customer bases. Moreover, we expect the level of competition to intensify in the
future. We expect significant competition from:
- ILECS. ILECs, such as GTE and U S WEST, are leasing wide area connections
from long distance carriers, and have existing metropolitan area networks
and circuit switched local access networks. Most ILECs have announced
deployment of commercial DSL services in certain areas. In addition, most
ILECs are combining their DSL service with their own Internet Service
Provider businesses. We believe that ILECs have the potential to quickly
overcome many of the issues that have delayed widespread deployment of DSL
services in the past. If a Regional Bell Operating Company is authorized
to provide in-region long distance service in one or more states, by
fulfilling the market-opening provisions of the 1996 Telecommunications
Act, the Regional Bell Operating Company may be able to offer "one stop
shopping" that would be competitive with our offerings. The ILECs have an
established brand name in their service areas, possess sufficient capital
to deploy DSL services rapidly and are in a position to offer service from
central offices where we may be unable to secure collocation space.
- TRADITIONAL INTEREXCHANGE CARRIERS. Many of the leading traditional
interexchange carriers, such as AT&T, MCI WorldCom and Sprint, are
expanding their capabilities to support high-speed, end-to-end networking
services. Increasingly, their bundled services include high-speed local
access combined with metropolitan and wide area networks, and a full range
of Internet services and applications. We expect them to offer combined
data, voice and video services over these networks.
These carriers have deployed large scale networks, have large numbers of
existing business and residential customers and enjoy strong brand
recognition, and as a result represent significant competition. For
instance, they have extensive fiber networks in many metropolitan areas
that primarily provide high-speed data and voice communications to large
companies. They could deploy DSL services in combination with their current
fiber networks. They also have interconnection agreements with many of the
ILECs and have secured collocation spaces from which they could begin to
offer competitive DSL services.
- NEWER INTEREXCHANGE CARRIERS. The newer interexchange carriers, such as
Williams, Qwest Communications International and Level 3 Communications,
are building and managing high bandwidth, packet-based networks
nationwide. They are also building direct sales forces and partnering with
Internet Service Providers to offer services directly to business
customers. They could extend their existing networks to include fiber
metropolitan area networks and high-speed, off-net services using DSL,
either alone, or in partnership with others.
- CABLE MODEM SERVICE PROVIDERS. Cable modem service providers, like @Home
Networks and its cable partners, are offering or preparing to offer
high-speed Internet access over hybrid fiber coaxial cable networks to
consumers. @Work has positioned itself to do the same for businesses.
Where deployed, these networks provide local access services similar to
our services, and in some cases at higher speeds. They typically offer
these services at lower prices than our services, in part by sharing the
bandwidth available on their cable networks among multiple end users.
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- WIRELESS AND SATELLITE DATA SERVICE PROVIDERS. Several new companies are
emerging as wireless and satellite-based data service providers, over a
variety of frequency allocations. These include:
- WinStar Communications, Inc.,
- Teligent, Inc.,
- Teledesic LLC,
- Hughes Space Communications, and
- Iridium World Communications Ltd.
These companies use a variety of new and emerging technologies, such as
terrestrial wireless services, point-to-point and point-to-multipoint fixed
wireless services, satellite-based networking and high-speed wireless
digital communications.
- INTERNET SERVICE PROVIDERS. Internet Service Providers provide Internet
access to residential and business customers. These companies generally
provide such Internet access over the ILECs' circuit switched networks at
ISDN speeds or below. However, some Internet Service Providers, including
HarvardNet, Inc. in Massachusetts, have begun offering DSL-based access
using their own DSL services, or DSL services offered by the ILEC or other
DSL-based CLECs. Some Internet Service Providers have significant and even
nationwide marketing presences and combine these with strategic or
commercial alliances with DSL-based CLECs. Some Internet Service
Providers, such as Concentric Network Corporation, Mindspring Enterprises,
Inc., PSINet Inc. and Verio have significant and even nationwide
presences.
- CLECS. Certain CLECs, including Covad Communications Group, Inc. and
NorthPoint Communications, Inc., have begun offering DSL-based data
services. Other CLECs are likely to do so in the future. The 1996
Telecommunications Act specifically grants CLECs the right to negotiate
interconnection agreements with ILECs, including interconnection
agreements which may be identical in all respects to our agreements.
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.
Such technologies include ISDN, DSL, wireless data and cable modems. Please see
"Risk Factors--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." Some of the
competitive factors we face 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,
- ability to scale,
- capital availability and
- exclusive contracts.
INTERCONNECTION AGREEMENTS WITH ILECS
Interconnection agreements with ILECs are critical to our business. These
agreements cover a number of aspects of our relationships with ILECs, including:
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- the price we pay to lease and the access we have to the ILEC's copper
lines;
- the special conditioning the ILEC provides on certain of these lines to
enable the transmission of DSL signals;
- the price and terms for collocation of our equipment in the ILEC central
offices;
- the price we pay and the access we have to the ILEC's transport
facilities;
- the ability we have to access conduits and other rights of way the ILEC
has to construct its own network facilities;
- the operational support systems and interfaces that we can use to place
orders and report and monitor the ILEC's response to our requests;
- the dispute resolution process we use with the ILEC to resolve
disagreements on the terms of the interconnection contract; and
- the term of the interconnection agreement, its transferability to
successors, its liability limits and other general aspects of our
relationship with the ILEC.
We have signed interconnection agreements with six different major ILECs
covering 23 states and the District of Columbia. In many cases, ILECs do not
agree to the provisions in interconnection agreements that we request, and we
have not consistently prevailed in obtaining all of the provisions we desire. We
may be unable to continue to sign interconnection agreements with ILECs. If we
are unable to enter into, or experience delay in obtaining, interconnection
agreements, this inability or delay may materially and adversely affect our
business and financial prospects. The ILECs are also permitting CLECs to adopt
previously signed interconnection agreements.
Our interconnection agreements have a maximum term of three years, requiring
us to renegotiate the existing terms in the future. We may be unable to extend
our existing interconnection agreements or renegotiate new agreements on
favorable or any terms. In addition, our interconnection agreements are subject
to state commission, FCC and judicial oversight. These bodies may modify the
terms or prices of our interconnection agreements in ways that would adversely
affect our business and financial prospects.
GOVERNMENT REGULATION
A significant portion of the services that we offer, particularly through
our wholly owned subsidiaries, ACI Corp. and ACI Corp.--Virginia, may be 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 a material and adverse impact on our business
and financial prospects. In addition, we may expend significant financial and
managerial resources to participate in proceedings setting rules at either the
federal or state level, without achieving a favorable result.
FEDERAL LEGISLATION AND REGULATION
The 1996 Telecommunications Act, enacted on February 8, 1996, substantially
departs from prior legislation in the telecommunications industry by
establishing local exchange competition as a national policy. This act removes
state regulatory barriers to competition and preempts laws restricting
competition in the local exchange market.
The 1996 Telecommunications Act in some sections is self-executing, but in
addition, the FCC issues regulations that identify specific requirements upon
which we and our competitors rely in implementing the changes it prescribes. The
outcome of these various ongoing FCC rulemaking
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proceedings or judicial appeals of such proceedings could materially affect our
business and financial prospects.
The FCC prescribes rules applicable to interstate communications, including
rules implementing the 1996 Telecommunications Act, a responsibility it shares
with the state regulatory commissions. The 1996 Telecommunications Act, and the
FCC's initial rules interpreting such act, encouraged increased local
competition. A federal appeals court for the Eighth Circuit reviewed some of the
initial rules, and overruled some of its provisions, including some rules on
pricing and nondiscrimination. In January, 1999, the United States Supreme Court
reversed elements of the Eighth Circuit's ruling, finding that the FCC has broad
authority to interpret the 1996 Telecommunications Act and issue rules for its
implementation, specifically including authority over pricing methodology. The
Supreme Court upheld the FCC's orders to the ILECs to combine unbundled elements
for competitors, and to allow competitors to pick and choose among provisions in
existing interconnection agreements. The Supreme Court also found that the FCC's
interpretation of the rules for establishing unbundled elements was not
consistent with the 1996 Telecommunications Act, and required the FCC to
reconsider its delineation of unbundled elements. The FCC's replacement decision
on unbundled elements may adversely affect our business. In addition, some ILECs
may take the position that they have no obligation to provide unbundled
elements, including copper loops, until the FCC issues new rules, which could
adversely affect our business.
In November, 1998, the FCC ruled that DSL services provided as dedicated
access services in connection with interstate services such as Internet access
are interstate services subject to the FCC's jurisdiction. This decision is
currently subject to reconsideration and appeal.
In addition, in the spring of 1998, four of the Regional Bell Operating
Companies petitioned the FCC to be relieved of certain regulatory requirements
in connection with their own DSL services, including obligations to unbundle DSL
loops, but not the obligation to unbundle the loops we purchase for our DSL
services, and to resell DSL services. In October 1998, the FCC ruled that DSL
services are telecommunications services subject to the requirements of the 1996
Telecommunications Act to unbundle such services and offer them for resale. In
October 1998, the FCC also issued a Notice of Proposed Rulemaking indicating its
intention to clarify expanded rights of CLECs for collocation, access to copper
loops, and various other issues of consequence to CLECs deploying DSL services.
The FCC also indicated its intention to allow ILECs to create separate
affiliates for their DSL businesses that would have to operate as CLECs and
would be permitted to operate free of the resale and unbundling obligations of
the 1996 Telecommunications Act. These decisions are currently subject to
reconsideration and appeal. The final outcome of these decisions, originally
scheduled to be announced on January 28, 1999, has been postponed by the FCC
while it considers the impact of the Supreme Court's ruling on the 1996
Telecommunications Act. The final outcome of these petitions or other
proceedings interpreting the requirements of the 1996 Telecommunications Act may
adversely affect our business.
STATE REGULATION
Some of our services, particularly those of our subsidiaries, ACI Corp. and
ACI Corp.--Virginia, may be classified as intrastate services subject to state
regulation. All of the states where we operate, or will operate, require some
degree of state regulatory commission approval to provide certain intrastate
services. In most states, intrastate tariffs are also required for various
intrastate services, although we are not typically subject to price or rate of
return regulation for tariffed intrastate services. Actions by state public
utility commissions could cause us to incur substantial legal and administrative
expenses.
Under the 1996 Telecommunications Act, if we so request, ILECs have a
statutory duty to negotiate in good faith with us for agreements for
interconnection and access to unbundled network elements. These negotiations are
conducted on a region-wide basis, and individual agreements are then signed for
each of the states in the region for which we have made a request. We have
signed
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interconnection agreements with Ameritech, Bell Atlantic, Bell South, GTE,
Pacific Bell and U S WEST. We have signed agreements with Ameritech for Illinois
and Michigan and currently are negotiating interconnection agreements for Ohio
and Wisconsin. We have signed agreements with Bell Atlantic for the District of
Columbia, Maryland, Massachusetts, New Jersey, New York, Pennsylvania and
Virginia. We have signed agreements with Bell South for Alabama, Arkansas,
Florida, Georgia, Kentucky, Louisiana, North Carolina, South Carolina and
Tennessee. We have signed an agreement with GTE for California and are currently
completing agreements for Florida, Minnesota, North Carolina, Oregon, Texas,
Virginia and Washington. We have signed an agreement with Pacific Bell for
California. We have signed agreements with U S WEST for Arizona, Colorado,
Minnesota, Oregon, and Washington and are currently negotiating an agreement for
Utah. In addition, we are currently negotiating with SBC Communications Inc. for
Kansas and Missouri and with Sprint for several states. These interconnection
agreements may not be on terms that are entirely satisfactory to us.
During these negotiations, either the ILEC or we may submit disputes to the
state regulatory commissions for mediation and, after the expiration of the
statutory negotiation period set forth in the 1996 Telecommunications Act, we
may submit outstanding disputes to the states for arbitration. We are currently
arbitrating with SBC Communications Inc. in Texas the terms of our
interconnection agreement with Southwestern Bell for Texas. The outcome of this
arbitration may be unfavorable to us.
Under the 1996 Telecommunications Act, states have begun and, in a number of
cases, completed regulatory proceedings to determine the pricing of unbundled
network elements and services, and the results of these proceedings will
determine the price we pay for, and whether it is economically attractive for us
to use, these elements and services.
LOCAL GOVERNMENT REGULATION
Should we in the future decide to operate our own transport facilities over
public rights-of-way, we may be required to obtain various permits and
authorizations from municipalities in which we operate such facilities. Some
municipalities may seek to impose similar requirements on users of transmission
facilities, even though they do not own such facilities. If municipal
governments impose conditions on granting permits or other authorizations or if
they fail to act in granting such permits or other authorizations, our business
could be adversely affected.
EMPLOYEES
As of January 31, 1999, we had approximately 220 employees. We believe that
our future success will depend in part on our continued ability to attract, hire
and retain qualified personnel. Competition for such personnel is intense, and
we may be unable to identify, attract and retain such personnel in the future.
None of our employees are represented by a labor union or are the subject of a
collective bargaining agreement. We have never experienced a work stoppage and
believe that our employee relations are good.
PROPERTIES
Our headquarters are located in facilities consisting of approximately
80,000 square feet in Englewood, Colorado, which we occupy under leases that
expire in October 1999 and January 2004. These leases may be extended. We also
lease space for network equipment installations in a number of other locations.
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LEGAL PROCEEDINGS
We are not currently a party to any legal proceedings other than arbitration
between us and SBC Communications regarding the terms of interconnection with
Southwestern Bell in Texas. This arbitration, instituted December 11, 1998, is
pending before the Public Utility Commission of Texas. The dispute involves the
terms and conditions of issues related to xDSL-based services and loops in
connection with our interconnection agreement with Southwestern Bell. We are
seeking to compel Southwestern Bell to include in our interconnection agreement
language comparable to that in our other interconnection agreements, which gives
us the ability to obtain copper telephone lines on which we provide our chosen
variety of DSL technologies.
In addition, we are subject to state commission, FCC and court decisions as
they relate to the interpretation and implementation of the 1996
Telecommunications Act, the interpretation of CLEC interconnection agreements in
general and our interconnection agreements in particular. In some cases, we may
be deemed to be bound by the results of ongoing proceedings of these bodies. We
therefore may participate in proceedings before these regulatory agencies or
judicial bodies that affect, and allow us to advance, our business plans.
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth, as of February 16, 1999, the names, ages and
positions of our executive officers and directors. Their respective backgrounds
are described below.
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
- ----------------------------------------------------- --- -----------------------------------------------------
<S> <C> <C>
Catherine M. Hapka................................... 44 President, Chief Executive Officer and Director
Jeffrey Blumenfeld................................... 51 Vice President and General Counsel
Michael E. Calabrese................................. 33 Vice President, Sales Engineering
Scott C. Chandler.................................... 37 Chief Financial Officer
Eric H. Geis......................................... 52 Vice President of National Deployment
James A. Greenberg................................... 38 Chief Network Officer
David J. Shimp....................................... 53 Chief Marketing Officer
Frank J. Tolve, Jr................................... 53 Chief Sales Officer
Kevin R. Compton..................................... 40 Director
Keith B. Geeslin..................................... 45 Director
Ken L. Harrison...................................... 56 Director
William R. Stensrud.................................. 48 Director
John L. Walecka...................................... 39 Director
</TABLE>
All the officers identified above serve at the discretion of our Board of
Directors. There are no family relationships between any persons identified
above. The following are brief biographies of the persons identified above.
CATHERINE M. HAPKA has been our President, Chief Executive Officer and a
director since June 1997. Prior to joining us, Ms. Hapka served as President of
NETS, Inc., an electronic commerce software company, from March 1997 to May
1997. Prior to joining NETS, Inc., Ms. Hapka served as Executive Vice President,
Markets, for U S WEST Communications, Inc. from January 1995 to October 1996. In
this capacity, Ms. Hapka led business and consumer telecommunications units
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<PAGE>
responsible for the voice, data, wireless, video and long distance businesses.
From 1991 to 1994, Ms. Hapka served as President and Chief Operating Officer of
the !NTERPRISE Networking Services Unit of U S WEST. Prior to joining U S WEST,
Ms. Hapka held general management positions with General Electric and McKinsey &
Co., Inc.
JEFFREY BLUMENFELD has been our Vice President and General Counsel since
August 1997, and has been a partner in the Washington, D.C. law firm of
Blumenfeld & Cohen since 1984, which specializes in pro-competition advocacy for
technology-intensive companies. Since 1995, Mr. Blumenfeld has served as senior
trial counsel to the Antitrust Division of the U.S. Department of Justice in
several matters. Before starting Blumenfeld & Cohen in 1984, Mr. Blumenfeld held
positions with the U.S. Department of Justice from 1973 to 1984, most recently
as Chief of the U.S. V. AT&T staff of the Antitrust Division. Mr. Blumenfeld is
an adjunct professor of communications law at the Georgetown University Law
Center. Pursuant to his employment agreement, Mr. Blumenfeld has agreed to
expend approximately 24 hours a week in his capacity as one of our officers. For
more information on Mr. Blumenfeld's relationship with us, please see "Certain
Relationships and Related Transactions-- Legal Services."
MICHAEL E. CALABRESE has been our Vice President, Sales Engineering since
August 1998. Prior to joining us, Mr. Calabrese served in various positions at
Cisco Systems, Inc. from August 1995 to August 1998, most recently as Account
Manager of the Data Equipment Group. In that capacity, Mr. Calabrese maintained
primary responsibility for managing Cisco's major accounts. From January 1993 to
August 1995, Mr. Calabrese held management positions at Sprint Communications.
First, as Manager, Project Engineering, Mr. Calabrese led Sprint Communication's
new product rollouts. Subsequently, as Manager, Network Planner, Mr. Calabrese
was responsible for the design and build-out of Sprint Communications Data
Networks.
SCOTT C. CHANDLER has served as our Chief Financial Officer since April
1998. From August 1996 to April 1998, Mr. Chandler served as President and Chief
Executive Officer of C-COR Electronics, Inc., a manufacturer of broadband
telecommunications equipment. From June 1990 to August 1996, Mr. Chandler served
in various positions at U S WEST and its subsidiaries, most recently as Vice
President and General Manager of U S WEST Cable and Multimedia from September
1995 to August 1996. While at U S WEST, Mr. Chandler also served as Vice
President and General Manager of the U S WEST subsidiary, !NTERPRISE AMERICA,
from January 1994 to August 1995 and as Director of Vendor Relations and Channel
Support of !NTERPRISE Networking Services from January 1992 to December 1993.
ERIC H. GEIS has been our Vice President of National Deployment since
January 1, 1999. Prior to that, he served as our Vice President and General
Manager, Western Region beginning June 1997 and was a consultant to us from
April 1997 to June 1997. From November 1995 to December 1996, Mr. Geis served as
National Sales Director at GRC International, a producer and seller of wide area
data network design and optimization software applications. Between July 1990
and November 1995, Mr. Geis served as President and Chief Executive Officer of
Quintessential Solutions Inc., a provider of wide area network design, pricing
and optimization software applications for interexchange carriers, regional bell
operating companies, ILECs, Internet Service Providers and major corporate
accounts. Mr. Geis was also Founder, President and Chief Executive Officer of
TeleQuest, Inc., a telecommunications products company from May 1983 to December
1990.
JAMES A. GREENBERG has been our Chief Network Officer since July 1997. From
January 1990 to July 1997, Mr. Greenberg served in various positions at Sprint
Communications, most recently as Senior Director and interim Vice President of
the Data Operations and Engineering Group. In that capacity, Mr. Greenberg
directed the design, planning, operation and construction of Sprint's data
networks.
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<PAGE>
DAVID J. SHIMP has served as our Chief Marketing Officer since October 1998.
Prior to joining us, Mr. Shimp was a partner at LAI Ward Howell, Inc., a
professional services firm, where he implemented that firm's first systems group
and was a leader in the technology department during his tenure from January
1991 to October 1998. Previously, Mr. Shimp held management positions at
McKinsey & Co. and the Deerpath Group.
FRANK J. TOLVE, JR. has served as our Chief Sales Officer since December
1998. From November 1994 to September 1998, Mr. Tolve served as Vice President,
Sales Operations at Bay Networks. In that capacity, Mr. Tolve's responsibilities
included sales administration, channel strategy and worldwide
telesales/telemarketing. Mr. Tolve also served as Vice President, Sales
Operations for SynOptics Communications from November 1992 to November 1994.
KEVIN R. COMPTON has been a director since July 1997. Since 1990, Mr.
Compton has served as a general partner of Kleiner Perkins Caufield & Byers, a
venture capital investment firm ("KPCB"). Mr. Compton is a director of Citrix
Systems, Inc., Digital Generation Systems, Inc., Global Village Communication,
Inc. and Corsair Communications, Inc., and is also a director of several
privately held companies. Mr. Compton was elected a director as the nominee of
KPCB, pursuant to the terms of a voting agreement.
KEITH B. GEESLIN has been a director since July 1997. Since 1988, Mr.
Geeslin has served as a general partner of The Sprout Group, a venture capital
investment firm. Mr. Geeslin is a director of Actel Corp. and SDL, Inc., and is
also a director of several privately held companies, including Paradyne
Corporation, a DSL equipment manufacturer and supplier to us. Please see
"Certain Relationships and Related Transactions--Director Relationships." Mr.
Geeslin was elected a director as the nominee of The Sprout Group, pursuant to
the terms of a voting agreement.
KEN L. HARRISON has been a director since March 1998. Since 1975, Mr.
Harrison has held various management positions at Portland General Electric
Company, where he currently serves as its Chairman and Chief Executive Officer,
a position he has held since December 1988. In addition, Mr. Harrison currently
serves as Vice Chairman and is a director of Enron Corporation, a position he
has held since July 1997. Mr. Harrison has also served as Chairman of Enron
Communications Group, Inc. since September 1997, and as a director of Enron Oil
and Gas Corporation since October 1997. Mr. Harrison was elected a director as
the nominee of Enron, pursuant to the terms of a voting agreement.
WILLIAM R. STENSRUD has been a director since our inception in February 1997
and also served as our President and Chief Executive Officer from February 1997
to June 1997. Mr. Stensrud has been a general partner at the venture capital
investment firm of Enterprise Partners since January 1997. From June 1996
through December 1996, Mr. Stensrud served as President of Paradyne Corporation.
Previously, from February 1992 to March 1996, Mr. Stensrud served as President
and Chief Executive Officer of Primary Access Corporation. Mr. Stensrud is a
director of several privately held companies, including Paradyne Corporation.
Please see "Certain Relationships and Related Transactions--Director
Relationships." Mr. Stensrud was elected a director as the nominee of Enterprise
Partners, pursuant to the terms of a voting agreement.
JOHN L. WALECKA has been a director since July 1997. Since 1984, Mr. Walecka
has been at Brentwood Venture Capital, a venture capital investment firm, and
has been a general partner since 1990. Mr. Walecka is a director of Documentum,
Inc. and Xylan Corporation, and is also a director of several privately held
companies. Please see "Certain Relationships and Related Transactions--Director
Relationships." Mr. Walecka was elected a director as the nominee of Brentwood
Venture Capital, pursuant to the terms of a voting agreement.
Members of the Board of Directors currently hold office and serve until our
next annual meeting of stockholders or until their respective successors have
been elected. The Board of Directors is
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<PAGE>
currently comprised of six directors and, prior to the completion of this
offering, will be classified into three classes of directors serving staggered
three-year terms, with one class of directors to be elected at each annual
meeting of stockholders. The classification of directors has the effect of
making it more difficult to change the composition of the Board of Directors.
See "Description of Capital Stock-- Possible Anti-Takeover Matters."
All of our executive officers are appointed annually by and serve at the
discretion of the Board of Directors. All of our executive officers are at-will
employees.
COMMITTEES OF THE BOARD OF DIRECTORS
We have a standing compensation committee currently composed of Messrs.
Walecka, Harrison and Stensrud. The compensation committee reviews and acts on
matters relating to compensation levels and benefit plans for our executive
officers and key employees, including salary and stock options. The compensation
committee is also responsible for granting stock awards, stock options and stock
appreciation rights and other awards to be made under our existing incentive
compensation plans. We also have a standing audit committee composed of Messrs.
Compton and Geeslin. The audit committee assists in selecting our independent
auditors and in designating services to be performed by, and maintaining
effective communication with, those auditors.
DIRECTOR COMPENSATION
Directors do not receive compensation for services provided as a director or
for participation on any committee of the Board of Directors. All directors are
reimbursed for their out-of-pocket expenses in serving on the Board of Directors
or any committee thereof.
EXECUTIVE COMPENSATION
The following table sets forth certain information with respect to the
compensation awarded to, earned by or paid to our current Chief Executive
Officer and our four other most highly compensated executive officers (the
"Named Executive Officers") during 1998 and 1997.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION AWARDS
--------------------------
ANNUAL COMPENSATION SECURITIES
----------------------- UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION(S) YEAR SALARY BONUS OPTIONS(#) COMPENSATION
- -------------------------------------------------- ---- -------- ------------- -------------- ---------
<S> <C> <C> <C> <C> <C>
Catherine M. Hapka (1)............................ 1998 $339,583 $ 134,584 -- $--
President, Chief Executive Officer and Director 1997 163,654 50,000 2,920,754(2) --
365,094(3)
Michael E. Calabrese (4).......................... 1998 42,417 158,483(5) 300,000(2) --
Vice President, Sales Engineering 1997 -- -- -- --
James A. Greenberg (6)............................ 1998 145,000 31,538 40,000(2) --
Chief Network Officer 1997 63,205 16,615 456,368(2) 50,000 (7)
Gloria A. Farler (8).............................. 1998 137,500 29,906 20,000(2) --
Vice President, Marketing Support 1997 25,781 7,161 40,000(2)
Eric H. Geis (9).................................. 1998 136,000 29,580 -- --
Vice President of National Deployment 1997 96,519 18,417 110,000(2) --
</TABLE>
- ------------------------------
(1) Ms. Hapka has been employed by us since June 1997, and the amount listed
sets forth her compensation since such date.
(2) Represents the number of shares of common stock that may be purchased upon
the exercise of options.
(3) Represents a right to purchase 365,094 shares of Series A preferred stock,
which she purchased in 1998.
(4) Mr. Calabrese has been employed by us since August 1998, and the amount
listed sets forth his compensation since such date.
(5) Includes a cash payment of $150,000 to cover a signing bonus and relocation
expenses.
(6) Mr. Greenberg has been employed by us since July 1997, and the amount listed
sets forth his compensation since such date.
(7) Represents a flat fee relocation payment.
(8) Ms. Farler had been employed by us since October 1997; she resigned her
position in February 1999.
(9) Mr. Geis has been employed by us since April 1997, and the amount listed
sets forth his compensation since such date.
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<PAGE>
OPTION GRANTS IN 1998
The following table sets forth information with respect to stock options
granted to each of the Named Executive Officers during 1998 pursuant to our 1997
Stock Option/Stock Issuance Plan. We did not grant any stock appreciation rights
to the Named Executive Officers during 1998.
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE
INDIVIDUAL GRANTS (1) VALUE AT ASSUMED
------------------------------------------------------------ ANNUAL RATES OF
NUMBER OF % OF TOTAL STOCK
SECURITIES OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM (3)
OPTIONS EMPLOYEES PRICE PER --------------------
NAME GRANTED IN 1998 (2) SHARE EXPIRATION DATE 5% 10%
- ------------------------------------- ----------- --------------- ----------- ----------------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Catherine M. Hapka................... -- -- -- -- -- --
Michael E. Calabrese................. 300,000 10.7% $ 0.30 September 9, 2008 $ 56,601 $ 143,437
James A. Greenberg................... 40,000 1.4% 0.30 September 9, 2008 7,547 19,125
Gloria A. Farler (4)................. 20,000 0.7% 0.30 September 9, 2008 3,773 9,562
Eric H. Geis......................... -- -- -- -- -- --
</TABLE>
- ------------------------------
(1) Options granted are immediately exercisable for all the option shares, but
any shares purchased under such options will be subject to repurchase by us
at such shares' option exercise price until they vest. Please see "--1997
Stock Option/Stock Issuance Plan."
(2) We granted options to purchase 2,803,900 shares of common stock during 1998.
(3) Amount represents potential realizable value of option grants, assuming that
our common stock appreciates at the annual rate shown, compounded annually,
from the date of grant until expiration of the granted options. These
numbers are calculated based on Securities and Exchange Commission
requirements and do not reflect our projection or estimate of future stock
price growth. Actual gains, if any, on stock option exercises are dependent
on the future performance of our common stock.
(4) Ms. Farler resigned her position in February 1999.
FISCAL YEAR-END 1998 OPTION VALUES
The following table provides information with respect to each of the Named
Executive Officers, concerning the exercise of common and preferred stock
options during 1998 and unexercised options held by them at the end of 1998.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING IN-THE-
UNEXERCISED OPTIONS AT MONEY OPTIONS AT
SHARES DECEMBER 31, 1998 DECEMBER 31, 1998(1)
ACQUIRED ON VALUE -------------------------------- --------------------------
NAME EXERCISE(1)(2) REALIZED(3) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ----------------------------- -------------- ------------- ----------- ------------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Catherine M. Hapka........... 3,285,848(4) $ 73,019 -- -- -- --
Michael E. Calabrese......... -- -- 300,000 -- $1,440,000 --
James A. Greenberg........... 456,368(5) -- 40,000 -- 192,000 --
Gloria A. Farler (6)......... 36,000(7) -- 20,000 -- 96,000 --
Eric H. Geis................. 110,000(8) -- -- -- -- --
</TABLE>
- ------------------------------
(1) Amount based on the fair market value of our common stock on December 31,
1998 as determined by our Board of Directors, less the exercise price
payable for such shares.
(2) The shares of common stock were deposited in escrow with our corporate
secretary where they continue to vest in accordance with the applicable
vesting provisions. Please see "--1997 Stock Option/Stock Issuance Plan."
(3) Amount based on the fair market value, as determined by our Board of
Directors, of our common stock and Series A preferred stock on the exercise
date for such shares, less the exercise price paid for such shares.
(4) Ms. Hapka exercised all of these options in February 1998 for a net purchase
price of $146,038 for common stock and $292,075 for Series A preferred
stock. Ms. Hapka purchased the shares of Series A preferred stock at a $0.20
per share discount from market value, for an aggregate discount of $73,019.
(5) Mr. Greenberg exercised all of these options in January 1998 for a net
purchase price of $22,818.
(6) Ms. Farler resigned her position in February 1999.
(7) Ms. Farler exercised all of these options in March 1998 for a net purchase
price of $1,800.
(8) Mr. Geis exercised all of these options in January 1998 for a net purchase
price of $5,500.
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EMPLOYMENT AGREEMENTS AND CHANGE IN CONTROL ARRANGEMENTS
None of our employees are employed for a specified term, and each employee's
employment with us is subject to termination at any time by either party for any
reason, with or without cause.
Ms. Hapka's employment agreement provides for a salary of $350,000 per year,
subject to periodic increases by the Board of Directors at its discretion. In
addition, it provides for a bonus potential of 50% of her base salary for her
second year of employment, which ends in June 1999, payable upon achievement of
certain milestones to be proposed by Ms. Hapka and agreed to by the Board of
Directors. In connection with her employment in June 1997, Ms. Hapka was granted
an option to purchase 2,920,754 shares of common stock at an exercise price of
$0.05 per share under the 1997 Stock Option/Stock Issuance Plan. Ms. Hapka
exercised such options in February 1998, subject to our right of repurchase
which lapses in accordance with the vesting schedule of the options. Please see
"-- 1997 Stock Option/Stock Issuance Plan." In connection with her employment,
Ms. Hapka was also given the right to purchase up to 365,094 shares of Series A
preferred stock at $0.80 per share. In February 1998, Ms. Hapka purchased these
shares for an aggregate purchase price of $292,075. We do not hold a right to
repurchase these shares of Series A preferred stock. In the event Ms. Hapka's
employment is terminated involuntarily and without cause, Ms. Hapka will be
entitled to receive a lump sum payment in an amount equal to her then-current
annual salary.
Mr. Calabrese's employment agreement provides for an annual salary of
$130,000, subject to periodic increases by the Board of Directors at its
discretion. It provides for an annual bonus of up to 20% of his annual salary.
In addition, Mr. Calabrese received, as part of the acceptance of his
employment, a cash payment of $150,000, which also covered relocation expenses.
In the event Mr. Calabrese's employment is terminated involuntarily and without
cause during the first year of employment, which ends in August 1999, Mr.
Calabrese will be entitled to receive a payment equal to one year's base salary
payable in 12 monthly installments.
Mr. Greenberg's employment agreement provides for an annual salary of
$145,000, subject to periodic increases by the Board of Directors at its
discretion.
Mr. Geis' employment agreement provides for an annual salary of $136,000,
subject to periodic increases by the Board of Directors at its discretion. It
provides for an annual bonus of up to 25% of his base salary.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Our Board of Directors currently has a compensation committee that reviews
and approves the compensation and benefits to be provided to our executive
officers and other key employees. In addition, the compensation committee
administers the 1997 Stock Option/Stock Issuance Plan. The compensation
committee currently consists of Messrs. Harrison, Stensrud and Walecka.
1997 STOCK OPTION/STOCK ISSUANCE PLAN
As of January 31, 1999, we had reserved 9,727,942 shares of common stock for
issuance pursuant to our 1997 Stock Option/Stock Issuance Plan (the "1997 Stock
Plan"), which has been approved by our Board of Directors and stockholders. The
1997 Stock Plan provides for the granting to employees and officers of qualified
"incentive stock options" within the meaning of Section 422 of the Internal
Revenue Code of 1986, as amended (the "Code"), and for the granting to
employees, officers and directors and consultants of nonqualified stock options.
The 1997 Stock Plan also provides for the granting of restricted stock. As of
January 31, 1999, options to purchase an aggregate of 8,507,393 shares of common
stock had been granted, net of cancellations, and 1,220,549 shares of common
stock remained available for future grants. From January 1, 1998 through January
31, 1999, 4,695,190 options to purchase common stock were exercised, of which an
aggregate of 3,523,122 were exercised by the Named Executive Officers as a
group, an aggregate of 365,096 were exercised by our other executive
56
<PAGE>
officers as a group, and an aggregate of 806,972 were exercised by our
non-officer employees. To date, we have not granted any shares of restricted
stock under the 1997 Stock Plan.
The 1997 Stock Plan is administered by the compensation committee of our
Board of Directors. Options granted generally vest at a rate of 25% of the
shares at the end of the first year and 2.083% of the shares at the end of each
month thereafter and generally expire ten years from the date of grant. All
options granted are immediately exercisable, subject to a repurchase right at
the original purchase price that we hold that lapses in accordance with the
vesting schedule of the options. If an optionee exercises an option to purchase
shares in which such optionee has not acquired a vested interest in accordance
with the applicable vesting provisions, then the purchased shares are deposited
in escrow with our corporate secretary, where they continue to vest in
accordance with the applicable vesting provisions. We hold a right, exercisable
at any time during the sixty-day period following the date an optionee ceases
for any reason to remain in service, to repurchase at the exercise price for
such options all or, at our discretion and with the consent of the optionee, any
portion of such unvested shares.
If we merge with or into another corporation or sell all or substantially
all of our assets, all outstanding options shall be assumed or an equivalent
option substituted by the successor corporation. If a successor corporation
refuses to assume or substitute for the options, a portion of each outstanding
option shall be accelerated so that such portion becomes fully vested. Please
see "--Employment Agreements and Change in Control Arrangements."
The exercise price of incentive stock options granted under the 1997 Stock
Plan must be at least equal to the fair value of our common stock on the date of
grant. The exercise price of options to an optionee who owns more than 10% of
our outstanding voting securities must equal at least 110% of the fair value of
the common stock on the date of grant, and the option term shall not exceed ten
years measured from the option grant date.
LIMITATION ON LIABILITY AND INDEMNIFICATION MATTERS
Our certificate of incorporation limits the liability of directors to the
maximum extent permitted by Delaware law. In addition, our bylaws require us to
indemnify our directors and officers, and allow us to indemnify our other
employees and agents, to the fullest extent permitted by law. We have also
entered into agreements to indemnify our directors and certain executive
officers. We believe that these provisions and agreements are necessary to
attract and retain qualified directors and executive officers. At present, there
is no pending litigation or proceeding involving any director, officer, employee
or agent where indemnification will be required or permitted. We are not aware
of any threatened litigation or proceeding that might result in a claim for such
indemnification. Insofar as indemnification for liabilities arising under the
Securities Act may be permitted to directors, officers or persons controlling
our company pursuant to the foregoing provisions, we have been informed that, in
the opinion of the Securities and Exchange Commission, such indemnification is
against public policy as expressed in the Securities Act and is therefore
unenforceable.
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<PAGE>
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
SERIES A PURCHASE AGREEMENT
On July 3, 1997, we entered into a Series A preferred stock Purchase
Agreement with Enterprise Partners, Brentwood Venture Capital, Kleiner Perkins
Caufield & Byers, The Sprout Group and certain other investors (together, the
"Series A Purchasers"). In a series of three closings, the Series A Purchasers
purchased in the aggregate 12,280,000 shares of our Series A preferred stock for
an aggregate purchase price of $12.3 million. Also, pursuant to a Subsequent
Closing Purchase Agreement dated as of December 23, 1997, we sold an additional
210,000 shares of our Series A preferred stock to certain other investors (the
"Additional Series A Purchasers") for an aggregate purchase price of $210,000.
In connection with these sales, we entered into an Investors' Rights Agreement
and Addendum with the Series A Purchasers and the Additional Series A
Purchasers, which provided the Series A Purchasers and Additional Series A
Purchasers with certain demand and piggyback registration rights, and certain
rights of first offer in the event we propose to offer for sale certain of our
securities. The Investors' Rights Agreement and Addendum has been superseded by
the Amended and Restated Investors' Rights Agreement. Please see "--Investors'
Rights Agreement," "Description of Capital Stock--Registration Rights" and
"--Right of First Offer."
In connection with an employment agreement between us and Catherine Hapka,
we issued 365,094 shares of Series A preferred stock at a purchase price of
$0.80 per share to Ms. Hapka. Please see "Management--Employment Agreements and
Change in Control Arrangements."
SERIES B PURCHASE AGREEMENT
On March 12, 1998, we entered into a Series B preferred stock Purchase
Agreement with certain of the Series A Purchasers and Enron Communications
Group, Inc. (together, the "Series B Purchasers"). Under this agreement, the
Series B Purchasers acquired an aggregate of 4,044,943 shares of Series B
preferred stock for an aggregate purchase price of $18.0 million. In connection
with the Series B preferred stock Purchase Agreement, we entered into an Amended
and Restated Investors' Rights Agreement with the Series A Purchasers, the
Additional Series A Purchasers and the Series B Purchasers on March 12, 1998.
The Amended and Restated Investors' Rights Agreement replaced the Investors'
Rights Agreement and Addendum from the Series A preferred stock financing.
Please see "--Investors' Rights Agreement."
INVESTORS' RIGHTS AGREEMENT
Pursuant to the terms of the Amended and Restated Investors' Rights
Agreement, the holders of preferred stock acquired certain registration rights
with respect to our common stock. At any time after the earlier of (i) March 11,
2002 or (ii) six months after the effective date of the first registration
statement for a public offering of our securities we file under the Securities
Act:
- holders of 60% or more of the registrable securities, as defined in the
Amended and Restated Investors' Rights Agreement, may require us to
register for public sale no less than 20% of their shares then
outstanding; or
- Enron may require us to register for public sale no less than 20% of our
shares it then holds.
Our Board of Directors may defer any of the above demands for registration
for a period of 120 days. We are obligated to effect only:
- two such registrations pursuant to the request of holders of 60% or more
of the registrable securities; and
- one such registration pursuant to the request of Enron.
58
<PAGE>
In addition, if we propose to register securities under the Securities Act
after this offering, with certain exceptions, then any of the parties to the
Amended and Restated Investors' Rights Agreement has a right to request that we
register such holder's registrable securities, subject to quantity limitations
determined by underwriters if the offering involves an underwriting. All
registration expenses incurred in connection with the registrations described
above and all piggyback registrations will be borne by us. The participating
stockholders will pay for underwriting discounts and commissions incurred in
connection with any such registrations. We have agreed to indemnify the parties
to the agreement against certain liabilities in connection with any registration
effected pursuant to the Amended and Restated Investors' Rights Agreement,
including Securities Act liabilities.
OFFERING OF NOTES AND WARRANTS
On May 5, 1998, we closed a private placement of units consisting of
$290,000,000 aggregate principal amount at maturity of senior discount notes and
warrants to purchase 3,944,000 shares of our common stock. In October 1998, we
exchanged our senior discount notes for a like principal amount of 1998 Notes
that we registered under the Securities Act. Certain associates of Donaldson,
Lufkin & Jenrette Securities Corporation ("DLJSC"), an initial purchaser in the
May 1998 offering, own an aggregate of 3,000,000 shares of Series A preferred
stock and 449,438 shares of Series B preferred stock, which represent in the
aggregate approximately 15.5% of our outstanding equity.
Of these, Sprout Capital VII, L.P. beneficially owns 2,609,686 shares of
Series A preferred stock and 390,966 shares of Series B preferred stock, which
represent in the aggregate approximately 6.7% of our outstanding equity. All of
the shares owned by Sprout Capital VII, L.P. are subject to a voting trust and
are held by an independent third party as trustee. The trustee will vote such
shares in its sole and absolute discretion as advised by an independent adviser
who is not affiliated with Sprout Capital VII, L.P. and DLJSC and subject to the
Amended and Restated Voting Agreement dated March 12, 1998.
Also, pursuant to the Amended and Restated Voting Agreement, Sprout Capital
VII, L.P., The Sprout CEO Fund, L.P., DLJ Capital Corporation and DLJ First ESC
L.L.C., all of which are affiliates of DLJSC, collectively have the right to
designate one member of the Board of Directors. Their current designee is Keith
B. Geeslin. Mr. Geeslin is a Divisional Senior Vice President of DLJ Capital
Corporation, a wholly owned subsidiary of Donaldson, Lufkin & Jenrette, Inc.,
the parent of DLJSC. Mr. Geeslin is also one of several individuals who serve as
general partners of DLJ Associates VII, L.P., which is a general partner of
Sprout Capital VII, L.P. DLJ Capital Corporation is the managing general partner
of each of Sprout Capital VII, L.P. and The Sprout CEO Fund, L.P.
DIRECTOR RELATIONSHIPS
William R. Stensrud, a member of our Board of Directors, also served as our
President and Chief Executive Officer from February 1997 through June 1997. Mr.
Stensrud and Mr. Geeslin, also a member of our Board of Directors, each also
serve as directors for Paradyne Corporation, one of our vendors. Additionally,
from June 1996 through December 1996, Mr. Stensrud served as President of
Paradyne Corporation. John L. Walecka, a member of our Board of Directors, also
serves as a director for Xylan Corporation, an indirect vendor to us. For the
period ended December 31, 1997 and for the nine months ended September 30, 1998,
we made purchases totaling approximately $419,000 and $4,798,000, respectively,
from Paradyne Corporation. We do not purchase any products directly from Xylan
Corporation; rather, our purchase of Xylan Corporation products is sourced
through Paradyne Corporation. We believe that our transactions with Paradyne
Corporation and Xylan Corporation were completed at rates similar to those
available from alternative vendors.
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LEGAL SERVICES
Jeffrey Blumenfeld, our Vice President and General Counsel, also serves as a
partner of Blumenfeld & Cohen, a law firm which performs legal services for us.
In connection with Mr. Blumenfeld's employment with us, we issued to him options
to purchase 365,096 shares of common stock at an exercise price of $0.05 per
share, which were exercised in January 1998. In addition, Mr. Blumenfeld and
certain other partners of Blumenfeld & Cohen purchased an aggregate of 140,000
shares of Series A preferred stock at $1.00 per share. For the year ended
December 31, 1997 and for the nine months ended September 30, 1998, we incurred
expenses for legal fees to Blumenfeld & Cohen of approximately $92,000 and
$897,000, respectively.
Pursuant to the terms of a written employment agreement with Mr. Blumenfeld,
we have agreed to employ him as Vice President and General Counsel at an annual
salary of $110,000 for a minimum time commitment by Mr. Blumenfeld of 24 hours a
week. Under the terms of such agreement, Blumenfeld & Cohen has agreed to charge
us at a discount from its regular rates for legal services, including Mr.
Blumenfeld's time in excess of his minimum time commitment.
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<PAGE>
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information as of January 31, 1999
with respect to the beneficial ownership of our common stock and as adjusted to
reflect the sale of shares of common stock in this offering by:
- each person known by us to own beneficially more than five percent, in the
aggregate, of the outstanding shares of our common stock, assuming the
conversion of all preferred stock into common stock,
- our directors and our Named Executive Officers, and
- all executive officers and directors as a group.
Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of January
31, 1999 as described in the footnotes below. Percentage of ownership is
calculated pursuant to SEC Rule 13d-3(d)(1). Certain of the outstanding shares
of our capital stock are subject to a voting agreement. Unless otherwise
indicated, the address for each stockholder is c/o Rhythms NetConnections Inc.,
6933 South Revere Parkway, Englewood, Colorado 80112.
<TABLE>
<CAPTION>
PERCENTAGE
BENEFICIALLY OWNED
NUMBER OF ----------------------
BENEFICIALLY BEFORE AFTER
BENEFICIAL OWNER (1) OWNED SHARES (1) OFFERING OFFERING
- -------------------------------------------------------------------------- ---------------- ----------- ---------
<S> <C> <C> <C>
Brentwood Venture Capital (2)............................................. 6,898,876 17.1%
Enterprise Partners (3)................................................... 8,700,346 21.5%
Kleiner Perkins Caufield & Byers (4)...................................... 6,898,876 17.1%
The Sprout Group (5)...................................................... 6,898,876 17.1%
Enron Communications Group (6)............................................ 4,494,382 11.1%
Catherine M. Hapka........................................................ 3,850,942(7) 9.5%
Michael E. Calabrese...................................................... 300,000(8) *
Eric H. Geis.............................................................. 125,000(9) *
James A. Greenberg........................................................ 596,368(10) 1.5%
Gloria Farler (11)........................................................ 60,000(12) *
Kevin R. Compton (13)..................................................... -- --
Keith B. Geeslin (14)..................................................... -- --
Ken Harrison (15)......................................................... -- --
William R. Stensrud (16).................................................. -- --
John L. Walecka (17)...................................................... -- --
All directors and executive officers as a group (14 persons) (18)......... 6,349,072 15.2%
</TABLE>
- ------------------------------
* Represents beneficial ownership of less than one percent of the outstanding
shares of our common stock.
(1) Except as indicated by footnote, we understand that the persons named in
the table above have sole voting and investment power with respect to all
shares shown as beneficially owned by them, subject to community property
laws where applicable.
(2) Consists of shares beneficially owned by Brentwood Affiliates Fund, L.P.
and Brentwood Associates VII, L.P. (collectively, the "Brentwood
Entities"). The address for the Brentwood Entities is 3000 Sand Hill Road,
Building 1, Suite 260, Menlo Park, California 94025.
(3) Consists of shares beneficially owned by Enterprise Partners III
Associates, L.P., Enterprise Partners III, L.P. and Enterprise Partners IV,
L.P. (collectively, the "Enterprise Entities"). The address for each of the
Enterprise Entities is 7979 Ivanhoe, Suite 550, La Jolla, California 92037.
(4) Consists of shares beneficially owned by Kleiner Perkins Caufield & Byers
VIII, KPCB VIII Founders Fund and KPCB VIII Information Sciences Zaibatsu
Fund II (collectively, the "KPCB Entities"). The address for each of the
KPCB Entities is 2750 Sand Hill Road, Menlo Park, California 94025.
(5) Consists of shares beneficially owned by DLJ Capital Corporation, DLJ First
ESC L.L.C., Sprout Capital VII, L.P. and The Sprout CEO Fund, L.P.
(collectively, the "Sprout Entities"). The address for each of the Sprout
Entities is 3000 Sand Hill Road, Building 3, Suite 170, Menlo Park,
California 94025. Of these, Sprout Capital VII, L.P. beneficially owns
6,001,304 shares. All of the shares beneficially owned by Sprout Capital
VII, L.P. are subject to a voting trust agreement and are held and voted by
an independent third party, First Union Trust Company, National
Association, as voting trustee. Please see "Certain Relationships and
Related Transactions--Offering of Senior Discount Offering Notes and
Warrants."
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(6) These shares are subject to a voting trust agreement. See "Description of
Capital Stock--Board Representation Rights and Voting." The address for
Enron Communications Group, Inc. is 210 Southwest Morrison Street, Suite
400, Portland, Oregon 97204.
(7) Includes 200,000 shares issuable upon exercise of options exercisable
within 60 days of January 31, 1999. Also, consists of shares held by Ms.
Hapka's children, Christopher H. Safaya and Catherine A. Safaya, in the
amount of 4,444 shares each and shares held by Christopher H. Safaya 1999
Trust and Catherine A. Safaya 1999 Trust in the amount of 100,000 shares
each.
(8) Includes 150,000 shares issuable upon exercise of options exercisable
within 60 days of January 31, 1999.
(9) Includes 15,000 shares issuable upon exercise of options exercisable within
60 days of January 31, 1999.
(10) Includes 140,000 shares issuable upon exercise of options exercisable
within 60 days of January 31, 1999.
(11) Ms. Farler resigned in February 1999.
(12) Includes 20,000 shares issuable upon exercise of options exercisable
within 60 days of January 31, 1999.
(13) Excludes shares held by the KPCB Entities. Mr. Compton, as a General
Partner of KPCB, may be deemed to have voting and investment power over
the shares held by the KPCB Entities. Mr. Compton disclaims beneficial
interest in such shares, except to the extent of his interest in the KPCB
Entities.
(14) Excludes shares held by the Sprout Entities. Mr. Geeslin, as a General
Partner of The Sprout Group, may be deemed to have voting and investment
power over the shares held by the Sprout Entities. Mr. Geeslin disclaims
beneficial interest in such shares, except to the extent of his interest
in the Sprout Entities.
(15) Excludes shares held by Enron. Mr. Harrison, as Chairman of Enron, may be
deemed to have voting and investment power over the shares held by Enron.
Mr. Harrison disclaims beneficial interest in such shares, except to the
extent of his interest in Enron.
(16) Excludes shares held by the Enterprise Entities. Mr. Stensrud, as a
General Partner of Enterprise Partners, may be deemed to have voting and
investment power over the shares held by the Enterprise Entities. Mr.
Stensrud disclaims beneficial interest in such shares, except to the
extent of his interest in the Enterprise Entities.
(17) Excludes shares held by the Brentwood Entities. Mr. Walecka, as a General
Partner of Brentwood Venture Capital, may be deemed to have voting and
investment power over the shares held by the Brentwood Entities. Mr.
Walecka disclaims beneficial interest in such shares, except to the extent
of his interest in the Brentwood Entities.
(18) Includes 1,425,000 shares issuable upon exercise of options exercisable
within 60 days of January 31, 1999 and excludes shares held by the
Brentwood Entities, the Enterprise Entities, the KPCB Entities, the Sprout
Entities and Enron Communications Group.
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<PAGE>
DESCRIPTION OF CAPITAL STOCK
After this offering, we will be authorized to issue shares of common
stock, $0.001 par value per share, of which shares will be issued and
outstanding, and shares of undesignated preferred stock, $0.001 par
value per share, of which no shares will be issued and outstanding.
COMMON STOCK
As of January 31, 1999, there were 6,763,708 shares of common stock
outstanding and held of record by approximately 40 stockholders. The holders of
common stock are entitled to one vote for each share held of record on all
matters submitted to a vote of the stockholders. Subject to preferences that may
be applicable to any outstanding shares of preferred stock, holders of common
stock are entitled to receive ratably such dividends as may be declared by the
Board of Directors out of funds legally available. See "Dividend Policy." All
outstanding shares of common stock are fully paid and nonassessable.
PREFERRED STOCK
After this offering of common stock, the Board of Directors will have the
authority, without further action by the stockholders, to issue up to
shares of preferred stock in one or more series and to fix the rights,
priorities, preferences, qualifications, limitations and restrictions, including
dividend rights, conversion rights, voting rights, terms of redemption, terms of
sinking funds, liquidation preferences and the number of shares constituting any
series or the designation of such series, which could decrease the amount of
earnings and assets available for distribution to holders of common stock or
adversely affect the rights and powers, including voting rights, of the holders
of the common stock. The issuance of preferred stock could have the effect of
delaying or preventing a change in control or make removal of our management
more difficult. Additionally, the issuance of preferred stock may have the
effect of decreasing the market price of the common stock and may adversely
affect the voting and other rights of the holders of common stock. After this
offering, there will be no shares of preferred stock outstanding.
WARRANTS
In connection with the issuance of the senior discount notes in May 1998, we
issued warrants to purchase an aggregate of 3,944,000 shares of common stock
with an exercise price of $0.005 per share. These warrants become exercisable on
May 4, 1999 and automatically expire on May 15, 2008. Following the occurrence
of a "repurchase event" as defined in the warrant agreement governing these
warrants, we must make an offer to repurchase for cash all outstanding warrants
issued in connection with the senior discount notes.
In May 1998, we also issued to Sun Financial Group Inc., now GATX Capital
Corporation, a warrant to purchase 478,650 shares of common stock with an
exercise price of $2.225 per share. This warrant is immediately exercisable and
expires on the later of 10 years from the date of grant or five years after the
closing of this offering.
REGISTRATION RIGHTS
Pursuant to the terms of the Amended and Restated Investors' Rights
Agreement, the holders of preferred stock acquired certain registration rights
with respect to our common stock. At any time after the earlier of (i) March 11,
2002 or (ii) six months after the effective date of the first registration
statement for a public offering of our securities we file under the Securities
Act:
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<PAGE>
- holders of 60% or more of the registrable securities, as defined in the
Amended and Restated Investors' Rights Agreement, may require us to
register for public sale no less than 20% of their shares then
outstanding; or
- Enron may require us to register for public sale no less than 20% of our
shares it then holds.
Our Board of Directors may defer any of the above demands for registration
for a period of 120 days. We are obligated to effect only:
- two such registrations pursuant to the request of holders of 60% or more
of the registrable securities; and
- one such registration pursuant to the request of Enron.
In addition, if we propose to register securities under the Securities Act
after this offering, with certain exceptions, then any of the parties to the
agreement has a right to request that we register such holder's registrable
securities, subject to quantity limitations determined by underwrtiers if the
offering involves an underwriting. All registration expenses incurred in
connection with the registrations described above and all piggyback
registrations will be borne by us. The participating stockholders will pay for
underwriting discounts and commissions incurred in connection with any such
registrations. Further, the holders of 40% or more of the registrable securities
may require us to register all or a portion of our registrable securities on
Form S-3 (a "Form S-3 Registration") when we qualify to file on such form,
provided that the aggregate proceeds of each such registration is at least
$5,000,000 and subject to certain other conditions and limitations, including
our ability to defer the filing of the Form S-3 Registration for a period of not
more than 120 days in certain circumstances. All expenses incurred in connection
with such a Form S-3 Registration shall be borne pro rata by the stockholders
participating in the Form S-3 Registration. All registration rights will
terminate no later than after five years following this offering. We have agreed
to indemnify the stockholders against certain liabilities in connection with any
registration effected pursuant to the Amended and Restated Investors' Rights
Agreement, including liabilities under the Securities Act. The holders of the
warrants issued in connection with the senior discount notes are entitled to
piggyback registration rights similar to those described above.
POSSIBLE ANTI-TAKEOVER MATTERS
CERTIFICATE OF INCORPORATION AND BYLAWS
Our certificate of incorporation authorizes our Board of Directors to
establish one or more series of undesignated preferred stock, the terms of which
can be determined by the Board of Directors at the time of issuance. See
"--Preferred Stock." Our certificate of incorporation also provides that all
stockholder action must be effected at a duly called meeting of stockholders and
not by a consent in writing. Our bylaws provide that our Board of Directors will
be classified into three classes of directors. Please see "Management--Directors
and Executive Officers." In addition, our bylaws do not permit our stockholders
to call a special meeting of stockholders; only our Chief Executive Officer,
President, Chairman of the Board or a majority of the Board of Directors are
permitted to call a special meeting of stockholders. Our bylaws also require
that stockholders give advance notice to our secretary of any nominations for
director or other business to be brought by stockholders at any stockholders'
meeting and require a supermajority vote of members of our Board of Directors
and/or stockholders to amend certain bylaw provisions. These provisions of the
certificate of incorporation and the bylaws could discourage potential
acquisition proposals and could delay or prevent a change in control of our
company. Such provisions may also have the effect of preventing changes in our
management.
DELAWARE ANTI-TAKEOVER STATUTE
We are subject to Section 203 of the Delaware General Corporation Law
("Section 203") which, subject to certain exceptions, prohibits a Delaware
corporation from engaging in any business
64
<PAGE>
combination with any interested stockholder -- defined as any person or entity
that is the beneficial owner of at least 15% of a corporation's voting stock --
for a period of three years following the time that such stockholder became an
interested stockholder, unless:
- prior to such time, such corporation's board of directors approved either
the business combination or the transaction that resulted in the
stockholder becoming an interested stockholder;
- upon consummation of the transaction that resulted in the stockholder
becoming an interested stockholder, the interested stockholder owned at
least 85% of such corporation's voting stock outstanding at the time the
transaction commenced, excluding, for purposes of determining the number
of shares outstanding, those shares owned (x) by persons who are directors
and also officers and (y) by employee stock plans in which employee
participants do not have the right to determine confidentially whether
shares held subject to the plan will be tendered in a tender or exchange
offer; or
- at or subsequent to such time, the business combination is approved by
such corporation's board of directors and authorized at an annual or
special meeting of stockholders, and not by written consent, by the
affirmative vote of at least two-thirds of the outstanding voting stock
that is not owned by the interested stockholder.
Section 203 defines business combination to include:
- any merger or consolidation involving the corporation and the interested
stockholder;
- any sale, lease, exchange, mortgage, transfer, pledge or other disposition
involving the interested stockholder and 10% or more of the assets of the
corporation;
- subject to certain exceptions, any transaction which results in the
issuance or transfer by the corporation of any stock of the corporation to
the interested stockholder;
- any transaction involving the corporation that has the effect of
increasing the proportionate share of the stock of any class or series of
the corporation beneficially owned by the interested stockholder; or
- the receipt by the interested stockholder of the benefit of any loans,
advances, guarantees, pledges or other financial benefits provided by or
through the corporation.
RIGHTS PLAN
Prior to the closing of this offering, it is anticipated that our Board of
Directors will adopt a rights plan (the "Rights Agreement") pursuant to which
one right (a "Right") to purchase one one-thousandth of a share of a series of
preferred stock, par value $0.001 per share (the "Rights Plan preferred stock"),
would be issued as a dividend for each outstanding share of common stock. Each
Right, when exercisable, would represent the right to purchase one
one-thousandth of a share of Rights Plan preferred stock at a specified price.
The Rights would become exercisable ten days after a person or group acquires
15% or more of the outstanding common stock or commences or announces a tender
or exchange offer which would result in such ownership.
If, after the Right becomes exercisable, we were to be acquired through a
merger or other business combination transaction or 50% or more of our assets or
earning power were sold, each Right would permit the holder to purchase, for the
exercise price, common stock of the acquiring company having a market value of
twice the exercise price. In addition, if any person acquires 15% or more of the
outstanding common stock, each Right not owned by such person would permit the
purchase, for the exercise price, of common stock having a market value of twice
the exercise price.
The Rights would expire ten years after the adoption of the Rights
Agreement, unless earlier redeemed by us in accordance with the terms of the
Rights Agreement. The purchase price payable
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<PAGE>
and the shares of Rights Plan preferred stock issuable upon exercise of the
Rights would be subject to adjustment from time to time as specified in the
Rights Agreement. In addition, our Board of Directors would retain the authority
to redeem, at $0.001 per Right, and replace the Rights with new rights at any
time, provided that no such redemption could occur after a person or group
acquires 15% or more of the outstanding common stock.
Shares of Rights Plan preferred stock, when issued upon exercise of the
Rights, will be nonredeemable and will rank junior to all series of any other
class of preferred stock. Each share of Rights Plan preferred stock will be
entitled to a cumulative preferential quarterly dividend payment equal to the
greater of (1) $10 per share or (2) 1,000 times the dividend declared per share
of common stock. In the event of liquidation, the holders of shares of Rights
Plan preferred stock will be entitled to a preferential liquidation payment
equal to the greater of (a) $1,000 per share or (b) 1,000 times the payment made
per share of common stock. Each share of Rights Plan preferred stock will
entitle the holder to 1,000 votes, voting together with the common stock.
Finally, in the event of any merger, consolidation or other transaction in which
common stock is exchanged, each share of Rights Plan preferred stock will be
entitled to receive 1,000 times the amount received per share of common stock.
The foregoing rights would be subject to antidilution adjustments. The number of
shares constituting the series of Rights Plan preferred stock will be .
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for the common stock is
.
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<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of this offering, there will be shares of our common
stock outstanding. There were also approximately shares covered by
vested options outstanding at January 31, 1999, which are not considered to be
outstanding shares. Of the outstanding shares, shares, including the
shares of common stock sold in this offering and shares issuable
upon exercise of vested options, will be immediately eligible for resale in the
public market without restriction under the Securities Act, except that any
shares purchased in this offering by our affiliates, as that term is defined in
Rule 144 under the Securities Act ("Rule 144"), may generally only be resold in
compliance with applicable provisions of Rule 144.
Our executive officers and directors and substantially all of our security
holders, have agreed pursuant to certain agreements that they will not, without
the prior written consent of Merrill Lynch and Salomon Smith Barney, offer, sell
or otherwise dispose of the shares of common stock beneficially owned by them
for a period of 180 days from the date of this prospectus. The shares subject to
the lock-up agreements include approximately of the shares of common
stock (including approximately shares issuable upon exercise of vested
options) that would otherwise have become immediately eligible for resale in the
public market upon completion of this offering.
Under Rule 144, a stockholder, including an affiliate, who has beneficially
owned his or her restricted securities (as that term is defined in Rule 144) for
at least one year from the later of the date such securities were acquired from
us or (if applicable) the date they were acquired from an affiliate is entitled
to sell, within any three-month period, a number of such shares that does not
exceed the greater of 1% of the then outstanding shares of common stock
(approximately immediately after this offering) or the average weekly
trading volume in the common stock during the four calendar weeks preceding the
date on which notice of such sale was filed under Rule 144, provided certain
requirements concerning availability of public information, manner of sale and
notice of sale are satisfied. In addition, under Rule 144(k), if a period of at
least two years has elapsed between the later of the date restricted securities
were acquired from us or, if applicable, the date they were acquired from our
affiliate, a stockholder who is not our affiliate at the time of sale and has
not been our affiliate for at least three months prior to the sale is entitled
to sell the shares immediately without compliance with the foregoing
requirements under Rule 144.
Securities issued in reliance on Rule 701 (such as shares of common stock
that may be acquired pursuant to the exercise of certain options granted prior
to this offering) are also restricted securities and may be sold by stockholders
other than our affiliate subject only to the manner of sale provisions of Rule
144 and by our affiliate under Rule 144 without compliance with its one-year
holding period requirement.
Prior to this offering, there has been no public market for the common
stock. No prediction can be made as to the effect, if any, that market sales of
shares or the availability of shares for sale will have on the market price of
the common stock prevailing from time to time. We are unable to estimate the
number of shares that may be sold in the public market pursuant to Rule 144,
since this will depend on the market price of the common stock, the personal
circumstances of the sellers and other factors. Nevertheless, sales of
significant amounts of our common stock in the public market could adversely
affect the market price of the common stock and could impair our ability to
raise capital through an offering of our equity securities.
In addition, we intend to register on the effective date of this offering a
total of shares of common stock subject to outstanding options or
reserved for issuance under our stock incentive plans. Further, upon expiration
of such lock-up agreements, holders of approximately shares of common
stock will be entitled to certain registration rights with respect to such
shares. If such holders, by exercising their registration rights, cause a large
number of shares to be registered and sold in the public market, such sales
could have a material adverse effect on the market price of the common stock.
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UNDERWRITING
Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney
Inc., Hambrecht & Quist and Thomas Weisel Partners LLC are acting as
representatives of the underwriters. Subject to the terms and conditions
contained in a purchase agreement, we have agreed to sell to each underwriter,
and each underwriter severally has agreed to purchase from us, the numbers of
shares of common stock set forth opposite its name below. The underwriters are
committed to purchase and pay for all such shares if any are purchased.
<TABLE>
<CAPTION>
NUMBER OF
UNDERWRITER SHARES
- ---------------------------------------------------------------- -----------
<S> <C>
Merrill Lynch, Pierce, Fenner & Smith
Incorporated..........................................
Salomon Smith Barney Inc. ......................................
Hambrecht & Quist...............................................
Thomas Weisel Partners LLC......................................
-----------
Total.................................................
-----------
-----------
</TABLE>
The representatives have advised us that the underwriters propose to offer
the common stock to the public at the initial public offering price set forth on
the cover page of this prospectus and to certain dealers at such price less a
concession of not in excess of $ per share. The underwriters may allow, and
such dealers may reallow, a discount not in excess of $ per share to certain
other dealers. After the initial public offering, the public offering price,
concession and discount may be changed. No such change shall reduce the amount
of proceeds to be received by us as set forth on the cover page of this
prospectus.
We have granted to the underwriters an option, exercisable during the 30-day
period after the date of this prospectus, to purchase up to additional
shares of common stock, at the price set forth on the cover page of this
prospectus, less the underwriting discount. To the extent that the underwriters
exercise such option, each of the underwriters will have a firm commitment to
purchase approximately the same percentage of such additional shares that the
number of shares of common stock to be purchased by it shown in the above table
represents as a percentage of the shares offered hereby. If purchased,
such additional shares will be sold by the underwriters on the same terms as
those on which the shares are being sold.
The purchase agreement contains covenants of indemnity among the
underwriters and us against certain civil liabilities, including liabilities
under the Securities Act and liabilities arising from breaches of
representations and warranties contained in the purchase agreement.
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The following table shows the per share and total underwriting discount we
will pay to the underwriters. The amounts are shown assuming both no exercise
and full exercise of the underwriters' option to purchase additional
shares of common stock.
<TABLE>
<CAPTION>
TOTAL TOTAL
PER SHARE WITHOUT OPTION WITH OPTION
----------- -------------- --------------
<S> <C> <C> <C>
Public Offering Price............................
Underwriting Discount............................
Proceeds, before expenses, to Rhythms............
</TABLE>
We expect to incur expenses of approximately $1,200,000 in connection with
this offering.
The common stock is being offered by the underwriters, subject to prior
sale, when, as and if issued to and accepted by them, subject to approval of
certain conditions by counsel to the underwriters and certain other conditions.
The underwriters reserve the right to withdraw, cancel or modify such offer and
to reject orders in whole or in part.
Each of our officers and directors and substantially all of the holders of
common stock have agreed with the representatives, for a period of 180 days
after the date of this prospectus (the "Lock-Up Period"), subject to certain
exceptions, not to offer to sell, contract to sell, or otherwise sell, dispose
of, loan, pledge or grant any rights with respect to any shares of common stock,
any options or warrants to purchase any shares of common stock, or any
securities convertible into or exchangeable for shares of common stock owned as
of the date of this prospectus or thereafter acquired directly by such holders
or with respect to which they have or hereafter acquire the power of
disposition, without the prior written consent of Merrill Lynch and Salomon
Smith Barney. However, Merrill Lynch and Salomon Smith Barney may, in their sole
discretion and at any time without notice, release all or any portion of the
securities subject to lock-up agreements. We have agreed that during the Lock-Up
Period, we will not, subject to certain exceptions, without the prior written
consent of Merrill Lynch and Salomon Smith Barney, issue, sell, contract to sell
or otherwise dispose of, any shares of common stock, any options or warrants to
purchase any shares of common stock or any securities convertible into,
exercisable for or exchangeable for shares of common stock, other than the sale
of our shares in this offering, the issuance of common stock upon the exercise
of outstanding options and warrants and our issuance of options and stock under
the 1997 Stock Plan. See "Shares Eligible for Future Sale."
The representatives have advised us that they do not intend to confirm sales
to any accounts over which they exercise discretionary authority.
Prior to this offering, there has been no public market for our common
stock. Consequently, the initial public offering price for the common stock
offered hereby will be determined through negotiations between us and the
representatives. Among the factors to be considered in such negotiations are
prevailing market conditions, our financial information, market valuations of
other companies that we and the representatives believe to be comparable to us,
estimates of our business potential, the present state of our development and
other factors deemed relevant.
Certain persons participating in this offering may engage in transactions,
including syndicate covering transactions or the imposition of penalty bids,
which may involve the purchase of common stock on the Nasdaq National Market or
otherwise. Such transactions may stabilize or maintain the market price of the
common stock at a level above that which might otherwise prevail in the open
market and, if commenced, may be discontinued at any time.
The representatives have advised us that, pursuant to Regulation M under the
Securities Act, certain persons participating in this offering may engage in
transactions, including stabilizing bids, syndicate covering transactions or the
imposition of penalty bids, which may have the effect of
69
<PAGE>
stabilizing or maintaining the market price of the common stock at a level above
that which might otherwise prevail in the open market. A "stabilizing bid" is a
bid for or the purchase of the common stock on behalf of the underwriters for
the purpose of fixing or maintaining the price of the common stock. A "syndicate
covering transaction" is the bid for or the purchase of the common stock on
behalf of the underwriters to reduce a short position incurred by the
underwriters in connection with the offering. A "penalty bid" is an arrangement
permitting the representatives to reclaim the selling concession otherwise
accruing to an underwriter or syndicate member in connection with this offering
if the common stock originally sold by such underwriter or syndicate member is
purchased by the representatives in a syndicate covering transaction and has
therefore not been effectively placed by such underwriter or syndicate member.
The representatives have advised us that such transactions may be effected on
the Nasdaq National Market or otherwise and, if commenced, may be discontinued
at any time.
Merrill Lynch acted as an initial purchaser of our senior discount notes in
May 1998, for which they received usual and customary fees.
Thomas Weisel Partners LLC was formed in October 1998.
LEGAL MATTERS
Brobeck, Phleger & Harrison LLP ("BPH"), San Diego, California, will pass
upon the validity of the issuance of the shares of common stock offered hereby
for us. Baker & McKenzie, New York, New York, will pass upon certain legal
matters related to the issuance of the shares of common stock offered hereby for
the underwriters. The BPH investment fund and certain BPH attorneys hold in the
aggregate 30,000 shares of Series A preferred stock.
EXPERTS
The financial statements of the Company as of December 31, 1997 and for the
period from February 27, 1997 through December 31, 1997, included in this
prospectus, have been included herein in reliance on the report of
PricewaterhouseCoopers LLP, independent accountants, given on the authority of
that firm as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the SEC a registration statement on Form S-1 under the
Securities Act with respect to the common stock. This prospectus does not
contain all of the information contained in the registration statement, and the
exhibits and schedules to the registration statement. For further information
with respect to us and our common stock, we refer you to the registration
statement, and the exhibits and schedules filed as part of the registration
statement. Statements in this prospectus concerning the contents of any contract
or any other document are not necessarily complete. If a contract or document
has been filed as an exhibit to the registration statement, we refer you to that
exhibit. Each statement in this prospectus relating to a contract or document
filed as an exhibit to the registration statement is qualified by the filed
exhibits.
IN ADDITION, WE FILE REPORTS, PROXY STATEMENTS AND OTHER INFORMATION WITH
THE SEC. YOU MAY READ AND COPY ANY DOCUMENT WE FILE, INCLUDING THE REGISTRATION
STATEMENT, AT THE SEC'S PUBLIC REFERENCE ROOMS IN WASHINGTON, D.C., NEW YORK,
NEW YORK AND CHICAGO, ILLINOIS. PLEASE CALL THE SEC AT 1-800-SEC-0330 FOR
FURTHER INFORMATION ON THE PUBLIC REFERENCE ROOMS. OUR SEC FILINGS ARE ALSO
AVAILABLE TO THE PUBLIC ON THE SEC'S WEBSITE AT HTTP://WWW.SEC.GOV.
70
<PAGE>
GLOSSARY OF TERMS
<TABLE>
<S> <C>
ATM.......................... ASYNCHRONOUS TRANSFER MODE. High bandwidth, low-delay,
connection- oriented, packet-like switching and multiplexing
technique requiring 53-byte, fixed-sized cells.
Backbone..................... An element of the network infrastructure that provides
high-speed, high capacity connections among the network's
physical points of presence, i.e., connection points and
Metro Service Centers. The backbone is used to transport end
user traffic across the metropolitan area and across the
United States.
Bandwidth.................... Refers to the maximum amount of data that can be transferred
through a computer's backbone or communication channel in a
given time. It is usually measured in Hertz, cycles per
second, for analog communications and bits per second for
digital communications.
Central Office............... Incumbent Local Exchange Carrier facility where subscriber
lines are joined to ILEC switching equipment.
CLEC......................... COMPETITIVE LOCAL EXCHANGE CARRIER. Category of telephone
service provider, or carrier, that offers local exchange and
other services similar to and in competition with those of
the ILEC, as allowed by recent changes in telecommunications
law and regulation. A CLEC may also provide other types of
services such as long distance telephone, data
communications, Internet access and video.
Collocation.................. A location where a CLEC network interconnects with the
network of an ILEC inside an ILEC central office.
Copper Line or Loop.......... A pair of traditional copper telephone lines using electric
current to carry signals.
Digital...................... Describes a method of storing, processing and transmitting
information through the use of distinct electronic or optical
pulses that represent the binary digits 0 and 1. Digital
transmission and switching technologies employ a sequence of
these pulses to convey information, as opposed to the
continuously variable analog signal. The precise digital
numbers preclude distortion, such as graininess or "snow", in
the case of video transmission, or static or other background
distortion in the case of audio transmission.
Downstream................... Refers to the transmission speed of a connection between our
connection point and the end user.
DS-0......................... DIGITAL SERVICE 0. Standard telecommunications industry
digital signal format, which is distinguishable by bit rate
-- the number of binary digits transmitted per second. DS-0
service has a bit rate of 64 Kilobits per second.
DS-1......................... DIGITAL SERVICE 1. In the digital hierarchy, this signaling
standard defines a transmission speed of 1.544 Mbps.
DS-3......................... DIGITAL SERVICE 3. In the digital hierarchy, this signaling
standard defines a transmission speed of 44.736 Mbps,
equivalent to 28 T-1 channels. This term is often used
interchangeably with T-3.
</TABLE>
A-1
<PAGE>
<TABLE>
<S> <C>
DSL.......................... DIGITAL SUBSCRIBER LINE. A transmission technology enabling
high-speed access in the local copper loop, often referred to
as the last mile between the network service provider --
I.E., an ILEC, CLEC or an internet service provider -- and
end user.
E-Commerce................... ELECTRONIC COMMERCE. An Internet service that supports
electronic transactions between customers and vendors to
purchase goods and services.
Encryption................... Applying a specific algorithm to data so as to alter the
data's appearance and prevent other devices from reading the
information. Decryption applies the algorithm in reverse to
restore the data to its original form.
Firewall..................... A computer device that separates a local area network from a
wide area network and prevents unauthorized access to the
local area network through the use of electronic security
mechanisms.
Frame Relay.................. A form of packet switching with variable length frames that
may be used with a variety of communications protocols.
ILEC......................... INCUMBENT LOCAL EXCHANGE CARRIER. A company providing local
exchange services on the date of enactment of the
Telecommunications Act of 1996. These companies consist of
the Regional Bell Operating Companies, GTE and numerous
independent telephone companies.
Interconnection Agreement.... A contract between an ILEC and a CLEC for the connection of a
CLEC network to the public switched telephone network, as
well as CLEC access to ILEC unbundled network elements, e.g.,
copper loops. This agreement sets out some of the financial
agreement and operational aspects of such interconnection and
access.
Internet..................... An array of interconnected networks using a common set of
protocols defining the information coding and processing
requirements that can communicate across hardware platforms
and over many links; now operated by a consortium of
telecommunications service providers and others.
Internet Protocol............ A standard for software that keeps track of the inter-network
addresses for different nodes, routes outgoing messages and
recognizes incoming messages.
ISDN......................... INTEGRATED SERVICES DIGITAL NETWORK. A transmission method
that provides circuit-switched access to the public network
at speeds of 64 or 128 Kbps for voice, data and video
transmission.
Internet Service Provider.... A company that provides direct access to the Internet.
Interexchange Carrier........ Usually referred to as a long-distance service provider.
There are many interexchange carriers, including AT&T, MCI
WorldCom, Sprint and Qwest.
Kbps......................... KILOBITS PER SECOND. 1,000 bits per second.
Long Distance Carrier........ A long distance carrier providing services between local
exchanges on an intrastate or interstate basis, also referred
to in the industry as an "interexchange carrier". A long
distance carrier may also be a long distance resale company.
</TABLE>
A-2
<PAGE>
<TABLE>
<S> <C>
Mbps......................... MEGABITS PER SECOND. Millions of bits per second.
Modem........................ An abbreviation of Modulator-Demodulator. An electronic
signal-conversion device used to convert digital signals from
a computer to analog form for transmission over the telephone
network. At the transmitting end, a modem working as a
modulator converts the computer's digital signals into analog
signals that can be transmitted over a telephone line. At the
receiving end, another modem working as a demodulator
converts analog signals back into digital signals and sends
them to the receiving computer.
Multiplexing................. An electronic or optical process that combines several lower
speed transmission signals into one higher speed signal.
Network...................... An integrated system composed of switching equipment and
transmission facilities designed to provide for the
direction, transport and recording of telecommunications
traffic.
OC-3......................... OPTICAL CARRIER 3. Standard telecommunications industry
digital single format, which is distinguishable by bit rate
-- the number of binary digits transmitted per second. OC-3
service has a bit rate of 155.5 Mbps.
OC-12........................ OPTICAL CARRIER 12. Standard telecommunications industry
digital single format, which is distinguishable by bit rate
-- the number of binary digits transmitted per second. OC-12
service has a bit rate of 622.8 Mbps.
Packets...................... Information represented as bytes grouped together through a
communication node with a common destination address and
other attribute information.
Resellers.................... Generally used to refer to a telecommunications provider who
does not own any switching or transmission facilities. In
reality, a large number of providers furnish services through
a combination of owned and resold facilities.
Router....................... A device that accepts the Internet Protocol from a local area
network or another wide area network device and
switches/routes Internet Protocol packets across a network
backbone. Routers also provide protocol conversion services
to transfer Internet Protocol packets over frame relay, ATM,
and other backbone network services.
T-1.......................... This is a Bell System term for a digital transmission link
with a capacity of 1.544 Mbps.
TCP/IP....................... TRANSMISSION CONTROL PROTOCOL/INTERNET PROTOCOL. A set of
network protocols that allow computers with different
architectures and operating system software to communicate
with other computers on the Internet.
Upstream..................... Refers to the transmission speed of a connection between the
end user and our connection point.
</TABLE>
A-3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Accountants.................................................... F-2
Financial Statements:
Consolidated Balance Sheets........................................................ F-3
Consolidated Statements of Operations.............................................. F-4
Consolidated Statements of Cash Flows.............................................. F-5
Consolidated Statement of Stockholders' Equity..................................... F-6
Notes to Consolidated Financial Statements......................................... F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of Rhythms NetConnections Inc.
In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of operations, of cash flows, and of stockholders'
equity present fairly, in all material respects, the financial position of
Rhythms NetConnections Inc. at December 31, 1997, and the results of its
operations and its cash flows for the period from February 27, 1997 (inception)
through December 31, 1997 in conformity with generally accepted accounting
principles. These financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements based on our audit. We conducted our audit of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for the opinion expressed
above.
As explained in note 3, the consolidated financial statements were restated
to record additional compensation in connection with common stock options issued
during the period from February 27, 1997 (inception) to December 31, 1997.
PRICEWATERHOUSECOOPERS LLP
San Diego, California
March 13, 1998, except as to
note 3 which is as of October 15, 1998
and to the last paragraph of note 7
which is as of November 4, 1998
F-2
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31 SEPTEMBER 30,
1997 1998
(RESTATED) (UNAUDITED)
------------- --------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents....................................................... $ 10,166,000 $ 20,236,000
Short-term investments.......................................................... -- 133,703,000
Accounts, loans and other receivables, net...................................... -- 1,179,000
Inventory....................................................................... -- 285,000
Prepaid expenses and other current assets....................................... 95,000 160,000
------------- --------------
Total current assets............................................................ 10,261,000 155,563,000
Equipment and furniture, net...................................................... 1,621,000 3,166,000
Collocation fees, net............................................................. 327,000 8,740,000
Deferred debt issue costs......................................................... -- 6,274,000
Other assets...................................................................... 32,000 239,000
------------- --------------
$ 12,241,000 $ 173,982,000
------------- --------------
------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt............................................... $ 126,000 $ 333,000
Accounts payable................................................................ 992,000 4,340,000
Accrued expenses................................................................ 335,000 1,665,000
------------- --------------
Total current liabilities..................................................... 1,453,000 6,338,000
Long-term debt.................................................................... 442,000 528,000
13.5% senior discount notes, net.................................................. -- 152,115,000
Other liabilities................................................................. -- 209,000
------------- --------------
Total liabilities............................................................. 1,895,000 159,190,000
------------- --------------
Commitments (note 11)
Mandatorily redeemable common stock warrants...................................... -- 6,567,000
------------- --------------
Stockholders' equity:
Series A Convertible preferred stock, $0.001 par value; 17,000,000 shares
authorized in 1997, 12,900,000 shares in 1998; 12,490,000 shares issued and
outstanding in 1997, 12,855,094 shares in 1998................................ 12,000 13,000
Series B Convertible preferred stock, $0.001 par value; no shares authorized in
1997, 4,044,943 shares in 1998; no shares issued and outstanding in 1997,
4,044,943 shares in 1998...................................................... -- 4,000
Common stock, $0.001 par value; 45,529,412 shares authorized in 1997, 66,708,243
shares in 1998; 2,068,518 shares issued in 1997, 6,645,608 shares in 1998..... 2,000 7,000
Treasury stock, at cost; 365,096 shares......................................... -- (19,000)
Additional paid-in capital...................................................... 14,012,000 34,547,000
Deferred compensation........................................................... (1,258,000) (2,875,000)
Accumulated deficit............................................................. (2,422,000) (23,452,000)
------------- --------------
Total stockholders' equity.................................................... 10,346,000 8,225,000
------------- --------------
$ 12,241,000 $ 173,982,000
------------- --------------
------------- --------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM
PERIOD FROM FEBRUARY 27, 1997
FEBRUARY 27, 1997 (INCEPTION)
(INCEPTION) THROUGH
THROUGH SEPTEMBER 30, 1997 NINE MONTHS ENDED
DECEMBER 31, 1997 (UNAUDITED) SEPTEMBER 30, 1998
(RESTATED) (RESTATED) (UNAUDITED)
------------------ ------------------ ------------------
<S> <C> <C> <C>
Revenue:
Service and installation, net....................... $ -- $ -- $ 248,000
------------------ ------------------ ------------------
Operating Expenses:
Network and service costs........................... -- -- 2,072,000
Selling, general and administrative................. 2,534,000 938,000 14,040,000
Depreciation and amortization....................... 1,000 -- 507,000
------------------ ------------------ ------------------
Total operating expenses.......................... 2,535,000 938,000 16,619,000
------------------ ------------------ ------------------
Loss from Operations.................................. (2,535,000) (938,000) (16,371,000)
------------------ ------------------ ------------------
Other Income and Expense:
Interest income..................................... 114,000 55,000 3,834,000
Interest expense (including amortized debt discount
and issue costs).................................. (1,000) -- (8,501,000)
Other............................................... -- -- 8,000
------------------ ------------------ ------------------
Net Loss.............................................. $ (2,422,000) $ (883,000) $ (21,030,000)
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Net Loss Per Share:
Basic............................................... $ (1.34) $ (0.49) $ (9.49)
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Diluted............................................. $ (1.34) $ (0.49) $ (9.49)
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Shares Used in Computing Net Loss Per Share:
Basic............................................... 1,801,470 1,801,470 2,216,188
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Diluted............................................. 1,801,470 1,801,470 2,216,188
------------------ ------------------ ------------------
------------------ ------------------ ------------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD FROM
PERIOD FROM FEBRUARY 27, 1997
FEBRUARY 27, 1997 (INCEPTION)
(INCEPTION) THROUGH
THROUGH SEPTEMBER 30, 1997 NINE MONTHS ENDED
DECEMBER 31, 1997 (UNAUDITED) SEPTEMBER 30, 1998
(RESTATED) (RESTATED) (UNAUDITED)
------------------ ------------------ ------------------
<S> <C> <C> <C>
Cash Flows from Operating Activities:
Net Loss............................................ $ (2,422,000) $ (883,000) $ (21,030,000)
Adjustments to reconcile net loss to net cash used
for operating activities:
Depreciation of equipment and furniture........... 1,000 -- 470,000
Amortization of collocation fees.................. -- -- 37,000
Amortization of debt discount and deferred debt
issue costs..................................... -- -- 8,446,000
Amortization of deferred compensation............. 192,000 102,000 407,000
Compensation expense from stock option issued to
employee........................................ 73,000 -- --
Changes in assets and liabilities:
Increase in accounts, loans and other
receivables................................... -- -- (1,179,000)
Increase in inventory........................... -- -- (285,000)
Increase in prepaid expenses and other current
assets........................................ (95,000) (14,000) (65,000)
Increase in other assets........................ (32,000) (5,000) (207,000)
Increase in accounts payable.................... 388,000 80,000 2,708,000
Increase in accrued expense..................... 335,000 41,000 1,330,000
Increase in other liabilities................... -- -- 209,000
------------------ ------------------ ------------------
Net cash used for operating activities............ (1,560,000) (679,000) (9,159,000)
------------------ ------------------ ------------------
Cash Flows from Investing Activities:
Purchases of short-term investments................. -- -- (133,703,000)
Purchases of equipment and furniture................ (1,018,000) (42,000) (7,981,000)
Payment of collocation fees......................... (327,000) (215,000) (8,450,000)
------------------ ------------------ ------------------
Net cash used for investing activities............ (1,345,000) (257,000) (150,134,000)
------------------ ------------------ ------------------
Cash Flows from Financing Activities:
Proceeds from leasing company for equipment......... -- -- 6,606,000
Proceeds from issuance of 13.5% senior discount
notes............................................. -- -- 150,365,000
Payment of debt issue costs on 13.5% senior discount
notes............................................. -- -- (6,403,000)
Proceeds from borrowings on long-term debt.......... 568,000 -- 432,000
Repayments on long-term debt........................ -- -- (139,000)
Proceeds from issuance of common stock.............. 13,000 3,000 229,000
Proceeds from issuance of preferred stock........... 12,490,000 6,137,000 18,292,000
Purchase of treasury stock.......................... -- -- (19,000)
------------------ ------------------ ------------------
Net cash provided by financing activities......... 13,071,000 6,140,000 169,363,000
------------------ ------------------ ------------------
Net increase in cash and cash equivalents............. 10,166,000 5,204,000 10,070,000
Cash and cash equivalents at beginning of period...... -- -- 10,166,000
------------------ ------------------ ------------------
Cash and cash equivalents at end of period............ $ 10,166,000 $5,204,000 $ 20,236,000
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Supplemental schedule of cash flow information:
Cash paid for interest.............................. $ 3,000 $ -- $ 53,000
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Supplemental schedule of non-cash financing
activities:
Equipment purchases payable, to be financed through
operating leases.................................. $ 604,000 $ -- $ 640,000
------------------ ------------------ ------------------
------------------ ------------------ ------------------
Warrants issued in conjunction with senior discount
notes............................................. $ -- $ -- $ 6,567,000
------------------ ------------------ ------------------
------------------ ------------------ ------------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES A SERIES B
CONVERTIBLE CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK COMMON 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>
Issuance of common stock to Founders (at
inception)............................ -- $ -- -- $-- 1,801,470 $2,000
Issuance of Series A preferred stock for
cash ($1.00 per share)................ 12,490,000 12,000 -- -- -- --
Issuance of common stock upon exercise
of options ($0.05 per share exercise
price)................................ -- -- -- -- 267,048 --
Grant of options to purchase Series A
preferred stock ($0.80 per share
exercise price)....................... -- -- -- -- -- --
Deferred compensation from grants of
options to purchase common stock...... -- -- -- -- -- --
Amortization of deferred compensation... -- -- -- -- -- --
Net loss for 1997....................... -- -- -- -- -- --
---------- ------- --------- ------ --------- ------
Balance at December 31, 1997
(restated)............................ 12,490,000 12,000 -- -- 2,068,518 2,000
Issuance of common stock upon exercise
of options ($0.05 per share exercise
price) (unaudited).................... -- -- -- -- 4,577,090 5,000
Issuance of Series A preferred stock for
cash ($0.80 per share) in February
1998 (unaudited)...................... 365,094 1,000 -- -- -- --
Issuance of Series B preferred stock for
cash ($4.45 per share) in March 1998
(unaudited)........................... -- -- 4,044,943 4,000 -- --
Deferred compensation from grants of
options to purchase common stock
(unaudited)........................... -- -- -- -- -- --
Amortization of deferred compensation
(unaudited)........................... -- -- -- -- -- --
Purchase of treasury stock for cash
($0.05 per share) in September 1998
(unaudited)........................... -- -- -- -- -- --
Net loss for the nine months ended
September 30, 1998 (unaudited)........ -- -- -- -- -- --
---------- ------- --------- ------ --------- ------
Balance at September 30, 1998
(unaudited)........................... 12,855,094 $13,000 4,044,943 $4,000 6,645,608 $7,000
---------- ------- --------- ------ --------- ------
---------- ------- --------- ------ --------- ------
<CAPTION>
TREASURY STOCK
AT COST ADDITIONAL TOTAL
------------------- PAID-IN DEFERRED ACCUMULATED STOCKHOLDERS'
# SHARES AMOUNT CAPITAL COMPENSATION DEFICIT EQUITY
-------- -------- ----------- ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Issuance of common stock to Founders (at
inception)............................ -- $ -- $ -- $ -- $ -- $ 2,000
Issuance of Series A preferred stock for
cash ($1.00 per share)................ -- -- 12,477,000 -- -- 12,489,000
Issuance of common stock upon exercise
of options ($0.05 per share exercise
price)................................ -- -- 12,000 -- -- 12,000
Grant of options to purchase Series A
preferred stock ($0.80 per share
exercise price)....................... -- -- 73,000 -- -- 73,000
Deferred compensation from grants of
options to purchase common stock...... -- -- 1,450,000 (1,450,000) -- --
Amortization of deferred compensation... -- -- -- 192,000 -- 192,000
Net loss for 1997....................... -- -- -- -- (2,422,000 ) (2,422,000)
-------- -------- ----------- ------------ ------------ -------------
Balance at December 31, 1997
(restated)............................ -- -- 14,012,000 (1,258,000) (2,422,000 ) 10,346,000
Issuance of common stock upon exercise
of options ($0.05 per share exercise
price) (unaudited).................... -- -- 224,000 -- -- 229,000
Issuance of Series A preferred stock for
cash ($0.80 per share) in February
1998 (unaudited)...................... -- -- 291,000 -- -- 292,000
Issuance of Series B preferred stock for
cash ($4.45 per share) in March 1998
(unaudited)........................... -- -- 17,996,000 -- -- 18,000,000
Deferred compensation from grants of
options to purchase common stock
(unaudited)........................... -- -- 2,024,000 (2,024,000) -- --
Amortization of deferred compensation
(unaudited)........................... -- -- -- 407,000 -- 407,000
Purchase of treasury stock for cash
($0.05 per share) in September 1998
(unaudited)........................... 365,096 (19,000) -- -- -- (19,000)
Net loss for the nine months ended
September 30, 1998 (unaudited)........ -- -- -- -- (21,030,000 ) (21,030,000)
-------- -------- ----------- ------------ ------------ -------------
Balance at September 30, 1998
(unaudited)........................... 365,096 $(19,000) $34,547,000 $(2,875,000) $(23,452,000) $ 8,225,000
-------- -------- ----------- ------------ ------------ -------------
-------- -------- ----------- ------------ ------------ -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--ORGANIZATION AND BASIS OF PRESENTATION
THE COMPANY: Rhythms NetConnections Inc. (the "Company"), a Delaware
corporation, was organized under the name Accelerated Connections Inc. effective
February 27, 1997. The Company's name was changed to Rhythms NetConnections Inc.
as of August 15, 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
seek additional sources of financing to fund its development. If unsuccessful in
obtaining such 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 balance sheet at
September 30, 1998, the related statements of operations and of cash flows for
the nine months ended September 30, 1998 and the period from February 27, 1997
through September 30, 1997, and the related consolidated statement of
stockholders' equity for the nine months ended September 30, 1998 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 at such date and
for such periods are also unaudited. The operating results for the interim
periods are not necessarily indicative of the results to be expected for a full
fiscal year or for any future periods.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial
statements include the transactions and balances of Rhythms NetConnections Inc.
and its wholly owned subsidiaries ACI Corp. and ACI Corp.--Virginia (since
February 1998). All material intercompany transactions and balances have been
eliminated.
USE OF ESTIMATES: The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities 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.
F-7
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
REVENUE RECOGNITION: Revenue is recorded in the period services are
provided to customers.
CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand,
money market funds, certificates of deposit, obligations of the U.S. Government
and its agencies and commercial paper with a maturity of 90 days or less at the
time of purchase.
SHORT-TERM INVESTMENTS. Short-term investments consist of obligations of
the U.S. Government and its agencies and commercial paper that have an original
maturity between 91 days and one year from the date of purchase.
FAIR VALUE OF FINANCIAL INSTRUMENTS: The carrying amounts of the Company's
financial instruments as presented are reasonable estimates of those
instruments' fair values because of the short maturity of those instruments or
based on the current rates offered to the Company for debt of the same remaining
maturities.
INVENTORY: Inventory consists of communications equipment that will be
installed at customer locations. Inventory is accounted for on a FIFO basis.
EQUIPMENT AND FURNITURE: Equipment and furniture consists of purchased
equipment, furniture, computer software, and leasehold improvements. Equipment
and furniture is recorded at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets, generally
three to seven years.
COLLOCATION FEES: Collocation fees represent nonrecurring fees paid to
secure Central Office space for location of certain Company equipment. The fees
are amortized over their estimated useful lives of ten years.
IMPAIRMENT OF LONG-LIVED ASSETS: The Company investigates potential
impairments of its long-lived assets on an exception basis when evidence exists
that events or changes in circumstances may have made recovery of an asset's
carrying value unlikely. An impairment loss is recognized when the sum of the
expected undiscounted future net cash flows is less than the carrying amount of
the asset. No such losses have been identified.
CONCENTRATIONS OF CREDIT RISK: Credit risk is primarily concentrated in
cash equivalents and short-term investments. Cash in excess of operating
requirements is conservatively invested in money market funds, certificates of
deposit with high-quality financial institutions, obligations of the U.S.
Government and its agencies and commercial paper rated A-1, P-1 to minimize
risk.
INCOME TAXES: The Company provides for income taxes utilizing the liability
method. Under the liability method, current income tax expense or benefit
represents income taxes expected to be payable or refundable for the current
period. Deferred income tax assets and liabilities are established for both the
impact of differences between the financial reporting bases and tax bases of
assets and liabilities and for the expected future tax benefit to be derived
from tax credits and tax loss carryforwards. Deferred income tax expense or
benefit represents the change during the reporting period in the net deferred
income tax assets and liabilities. Deferred tax assets are reduced by a
valuation allowance when, in the opinion of management, it is more likely than
not that some portion or all of the deferred tax assets will not be realized.
F-8
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NET LOSS PER SHARE: The Company has adopted Statement of Financial
Accounting Standard ("SFAS") No. 128, "Earnings Per Share." Basic earnings per
share ("EPS") 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
the Series A preferred stock, upon the exercise of outstanding stock options and
shares issued subject to repurchase by the Company totaling 30,544,950 at
December 31, 1997 have been excluded from the computation since their effect
would be antidilutive.
NET LOSS PER SHARE FOR INTERIM PERIODS (UNAUDITED): As of September 30,
1997 and 1998, the diluted net loss per share computation excludes 12,280,000
and 41,771,084 shares, respectively, subject to conversion or repurchase by the
Company, since the effect of these shares would be antidilutive.
STOCK-BASED COMPENSATION: The Company measures compensation expense for its
employee stock-based compensation using the intrinsic value method and provides
pro forma disclosures of net loss as if the fair value method had been applied
in measuring compensation expense. Under the intrinsic value method of
accounting for stock-based compensation, when the exercise price of options
granted to employees is less than the fair value of the underlying stock on the
date of grant, compensation expense is to be recognized over the applicable
vesting period.
NEW ACCOUNTING PRONOUNCEMENTS: In June 1997, SFAS No. 130, "Reporting
Comprehensive Income," was issued. The Company adopted SFAS No. 130 as required
in 1998. This statement establishes standards for reporting and presenting
comprehensive income and its components in the financial statements.
Comprehensive income is defined as "the change in equity (net assets) of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources. It includes all changes in equity during a
period except those resulting from investments by owners or distributions to
owners." The adoption had no impact on the Company's consolidated statement of
operations. In June 1997, SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," was issued. Among other things, SFAS No.
131 establishes standards regarding the information a company is required to
disclose about its operating segments and provides guidance regarding what
constitutes a reportable operating segment. The Company will adopt SFAS No. 131
as required at December 31, 1998 but anticipates no significant changes in its
disclosures to arise from this implementation. In June 1998, SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," was issued. This
statement establishes accounting and reporting standards for derivative
instruments and for hedging activities. The Company will adopt SFAS No. 133 as
required in 2000. The Company expects that adoption will have no impact on the
Company's consolidated financial statements.
NOTE 3--RESTATEMENT OF FINANCIAL STATEMENTS
The consolidated balance sheet at December 31, 1997 and the related
consolidated statements of operations, of cash flows, and of stockholders'
equity for the period from February 27, 1997 (inception) to December 31, 1997
were restated to record additional compensation in connection with common
F-9
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 3--RESTATEMENT OF FINANCIAL STATEMENTS (CONTINUED)
stock options issued during the period, based on the difference between the
estimated fair value of the underlying common stock at the date of grant of the
options and the exercise price of $0.05 per share. The additional compensation
expense of $192,000 increased the net loss for the period from $2,230,000 to
$2,422,000. The related deferred compensation is being amortized over the
vesting period of the options and the unamortized portion of the deferred
compensation at December 31, 1997, in the amount of $1,258,000, was recorded as
an increase to additional paid-in capital.
NOTE 4--EQUIPMENT AND FURNITURE
<TABLE>
<CAPTION>
SEPTEMBER 30, 1998
DECEMBER 31, 1997 (UNAUDITED)
----------------- ------------------
<S> <C> <C>
Equipment and furniture, net, consists of the
following:
Operating equipment.................................. $ 1,241,000 $ 1,879,000
Computer software licenses........................... 173,000 338,000
Computer equipment................................... 133,000 56,000
Office furniture..................................... 43,000 706,000
Leasehold improvements............................... 32,000 331,000
Less accumulated depreciation........................ (1,000) (144,000)
----------------- ------------------
$ 1,621,000 $ 3,166,000
----------------- ------------------
----------------- ------------------
</TABLE>
NOTE 5--DEBT
As of December 31, 1997, the Company had borrowed $568,000 from a financial
institution, with an additional $432,000 available to be drawn under the note at
any time through April 29, 1998. Terms of the note payable include an interest
rate of prime plus 0.25 percent (8.75 percent at December 31, 1997). The note is
secured by assets of the Company. Through April 29, 1998, interest only is due
monthly on the outstanding principal. As of April 29, 1998, the outstanding
principal will be amortized over a 36-month repayment period; the outstanding
principal will continue to bear interest. If no additional amounts are drawn by
April 29, 1998, the $568,000 will be repaid during the years 1998 through 2001
in the amounts of $111,000 in 1998, $189,000 each in 1999 and 2000, and $79,000
in 2001.
NOTE 6--DEBT AND WARRANTS (UNAUDITED)
On May 5, 1998, the Company issued 13.5 percent senior discount notes due
2008 in the principal amount of $290,000,000 at maturity, combined with warrants
to purchase 3,944,000 shares of common stock. The notes were issued at a
discount; cash proceeds from the issuance of the notes and warrants were
$150,365,000. The Company additionally incurred approximately $6,046,000 in debt
issue costs. The notes will accrete in value through May 15, 2003 at a rate of
13.5 percent per annum, compounded semi-annually; no cash interest will be
payable prior to that date. Upon a change in control or upon certain asset
sales, the Company must offer to repurchase all or a portion of the outstanding
notes. The notes contain covenants that restrict the Company's ability to make
certain payments, including dividend payments, and incur additional debt.
F-10
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 6--DEBT AND WARRANTS (UNAUDITED) (CONTINUED)
The warrants are exercisable upon certain events, which occurred in November
1998, at an exercise price of $0.005 per share. The warrants expire May 15,
2008. The warrants may be required to be repurchased by the Company for cash
upon the occurrence of a repurchase event, such as a consolidation, merger, or
sale of assets to another entity, as defined in the provisions of the Warrant
Agreement, at a price to be determined by an independent financial expert
selected by the Company. In the event a repurchase event occurs, the difference
between the repurchase price and the carrying value of the warrants would be
charged to equity. The value ascribed to the warrants of $6,567,000 resulted in
additional debt discount, which, together with the debt issue costs are being
amortized to interest expense using the effective interest method over the
period that the notes are outstanding.
During May 1998 the Company entered into a 36-month lease line that provides
for $24.5 million in equipment on an operating lease basis. In connection with
this lease agreement, the Company issued 478,650 warrants to purchase common
stock at a price of $2.23 per share, exercisable immediately.
NOTE 7--STOCKHOLDERS' EQUITY
The Company was initially capitalized in February 1997 with common stock. In
July 1997, the Company was granted authority to issue two classes of stock
consisting of up to 17,000,000 shares of Series A preferred stock and 45,529,412
shares of common stock, both with a $0.001 par value per share.
The Company's Series A preferred stock may be converted, at the option of
the holder, into the Company's common stock on a two-for-one basis, subject to
antidilution protection on a broad-based weighted-average basis. The Series A
preferred stock will also be automatically converted upon certain closings of
registered public offerings of common stock. The holders of the Series A
preferred stock are entitled to receive non-cumulative dividends in the amount
equal to $0.08 per share per annum, as and if declared by the Board of
Directors, or an amount equal to that paid on any other outstanding shares of
the Company, payable quarterly, as and if declared by the Board of Directors. In
the event of a liquidation of the Company, the holders of the Series A preferred
stock will be entitled, in preference to the holders of common stock, to an
amount equal to $1.00 per share, plus all declared and unpaid dividends. The
preferred shares entitle holders to two votes per share, on an "as-converted"
basis.
During January and February 1998, a total of 4,537,090 shares of common
stock were issued upon the exercise of stock options; proceeds to the Company
were $227,000. During February 1998, 365,094 shares of Series A preferred stock
were issued to an employee for proceeds of $292,000 upon the exercise of an
option.
Effective March 6, 1998, the Company amended its Certificate of
Incorporation to increase the number of authorized common shares to 22,909,650,
to decrease the number of authorized Preferred shares to 16,944,943, and to
designate 12,900,000 of the Preferred shares as Series A and 4,044,943 shares as
Series B.
During March 1998, the Company issued 4,044,943 shares of its Series B
preferred stock to new and existing investors at a price of $4.45 per share.
Proceeds to the Company were $18,000,000. The Company's Series B preferred stock
may be converted, at the option of the holder, into the Company's common stock
on a two-for-one basis, subject to antidilution protection on a broad-based
weighted-average basis. The Series B preferred stock will also be automatically
converted upon certain closings of registered public offerings of common stock.
The holders of the Series B preferred stock are entitled
F-11
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--STOCKHOLDERS' EQUITY (CONTINUED)
to receive non-cumulative dividends in the amount equal to $0.356 per share per
annum, as and if declared by the Board of Directors, or an amount equal to that
paid on any other outstanding shares of the Company, payable quarterly, as and
if declared by the Board of Directors. In the event of a liquidation of the
Company, the holders of the Series B preferred stock will be entitled, in
preference to the holders of common stock, to an amount equal to $4.45 per
share, plus all declared and unpaid dividends. The preferred shares entitle
holders to two votes per share, on an "as-converted" basis.
Effective November 4, 1998, the Company completed a two-for-one split of its
common stock. As a result of this stock split, the Company's number of
authorized shares (including common and preferred) increased to 83,653,186. The
accompanying consolidated financial statements have been restated for all
periods presented to reflect the stock split.
NOTE 8--STOCK OPTIONS
The Company has established the 1997 Stock Option/Stock Issuance Plan (the
"Plan"), which provides for the grant of options to employees, directors and
outside consultants for purchase of up to an aggregate of 9,727,942 shares of
common stock. The options are immediately exercisable and expire within ten
years after the date of grant. Shares acquired upon exercise are subject to
repurchase by the Company ratably over a four-year period from the date of
grant, at the option of the Company and at the exercise price. The Plan provides
for both incentive option and non-statutory option grants and for accelerated
vesting in the event of a 50 percent or more change in control of the Company.
Through December 31, 1997, plan activity consisted only of incentive options.
Plan activity through December 31, 1997 is as follows:
<TABLE>
<CAPTION>
WEIGHTED AVERAGE WEIGHTED AVERAGE
NUMBER OF SHARES FAIR VALUE EXERCISE PRICE
----------------- ----------------- -----------------
<S> <C> <C> <C>
Granted................................ 4,834,762 $ 0.35 $ 0.05
Exercised.............................. (267,048) $ 0.35 $ 0.05
Canceled............................... -- -- --
-----------------
Outstanding at December 31, 1997....... 4,567,714 $ 0.35 $ 0.05
-----------------
-----------------
</TABLE>
The following summarizes the outstanding and exercisable options under the
Plan at December 31, 1997:
<TABLE>
<CAPTION>
WEIGHTED
EXERCISE NUMBER WEIGHTED AVERAGE WEIGHTED AVERAGE NUMBER AVERAGE
PRICE OUTSTANDING REMAINING LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
---------------- --------------------- ---------------- ---------------
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- --------- ----------- --------------------------------------- ---------------------------------
<C> <C> <S> <C> <C> <C>
$0.05 4,567,714 9.63 years $ 0.05 4,567,714 $ 0.05
</TABLE>
During 1997, options were granted to employees at less than fair value on
the date of grant, resulting in $1,450,000 of deferred compensation recorded as
a reduction of stockholders' equity through December 31, 1997. This amount is
being amortized as a charge to selling, general and administrative expenses over
the vesting periods of the applicable options; such amortization totaled
$192,000 for the period ended December 31, 1997.
F-12
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 8--STOCK OPTIONS (CONTINUED)
An option to purchase 365,094 shares of Series A preferred stock at $0.80
per share was granted to an employee during 1997. The Company recorded $73,000
in compensation expense during 1997 related to this grant.
Had compensation expense for the Company's 1997 Stock Option/Stock Issuance
Plan and the preferred stock option been determined based on the fair value
method of accounting for stock-based compensation, the Company's net loss and
net loss per share for the period ended December 31, 1997 would have been
increased by $11,000 and $0.01 per share, respectively. For purposes of
determining this compensation expense, the fair value of each option grant is
estimated on the grant date using the Black Scholes option pricing model with
the following weighted average assumptions used for grants during the period
ended December 31, 1997: no dividend yield, risk free interest rate of 5.3
percent, expected volatility of nil, and expected term of four years for common
stock options and six months for the preferred stock Option.
NOTE 9--INCOME TAXES
As of December 31, 1997, the Company had net operating loss carryforwards of
approximately $2,117,000, which are available to offset future taxable income
through 2016 for federal taxes and 2005 for state taxes, subject to the
limitations of Internal Revenue Code Section 382 relating to changes in
ownership of the Company. The deferred tax asset arising from the loss
carryforwards has been fully offset by a valuation allowance since it is more
likely than not that it will not be realized.
Components of deferred income taxes are as follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------
<S> <C>
Deferred tax assets:
Net operating loss carryforwards......................................... $ 908,000
Accrued vacation and other............................................... 89,000
--------
Gross deferred tax asset................................................... 997,000
Valuation allowance........................................................ (997,000)
--------
Net deferred income taxes.................................................. $ --
--------
--------
</TABLE>
The provision for (benefit from) income taxes reconciles to the statutory
federal tax rate as follows:
<TABLE>
<S> <C>
Statutory federal tax rate........................................... 34.0%
State income tax..................................................... 8.4
Other................................................................ (1.2)
Deferred tax asset valuation allowance............................... (41.2)
---------
--%
---------
---------
</TABLE>
NOTE 10--RELATED PARTY TRANSACTIONS
The Company's in-house counsel is also a partner in a law firm used
externally by the Company. During 1997 and for the nine months ended September
30, 1998, the Company incurred legal fees and
F-13
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 10--RELATED PARTY TRANSACTIONS (CONTINUED)
expenses of approximately $92,000 and $897,000 (unaudited), respectively, to the
external firm, in addition to the salary paid to the in-house counsel.
Two members of the Company's Board of Directors serve as directors to a
company that supplies equipment to the Company. The total purchases during 1997
and for the nine months ended September 30, 1998 from the equipment supplier
were approximately $419,000 and $4,798,000 (unaudited), respectively.
NOTE 11--COMMITMENTS
The Company leases office space and certain office equipment under
non-cancelable operating lease agreements. The leases range in term from 24
months to 60 months and, in certain instances, provide for options to extend.
Rent expense under the operating leases for 1997 totaled $46,000. Future minimum
rental payments under the leases are $270,000 in 1998, $250,000 in 1999,
$110,000 in 2000, $30,000 in 2001, and $30,000 in 2002.
NOTE 12--SUBSEQUENT EVENTS (UNAUDITED)
Effective October 21, 1998, the Company began an exchange offer of its
$290,000,000 principal amount at maturity of 13.5 percent senior discount notes
that would allow for registration of such notes under the Securities Act of
1933, as amended. The exchange offer was completed November 20, 1998, at which
time $289,000,000 of the notes had been exchanged for registered notes that have
substantially the same terms and conditions as the unregistered notes, except
that the registered notes are not subject to the restrictions on resale or
transfer that apply to the unregistered notes.
In January 1999, the Company entered into a letter of intent with MCI
WorldCom, Inc. ("MCI WorldCom"). The terms of the letter contemplate that MCI
WorldCom's investment fund will purchase $30,000,000 of the Company's preferred
stock for an approximate eight percent ownership interest. The letter also
provides for the Company and MCI WorldCom to enter into various business
relationships, including MCI WorldCom's contracting to sell 100,000 of the
Company's DSL lines over a period of five years.
F-14
<PAGE>
[MAPS OF SAN DIEGO, CA AND CHICAGO, IL SHOWING RHYTHMS DEPLOYMENT]
<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SHARES
[LOGO]
RHYTHMS NETCONNECTIONS INC.
COMMON STOCK
------------------
P R O S P E C T U S
------------------
MERRILL LYNCH & CO.
SALOMON SMITH BARNEY
HAMBRECHT & QUIST
THOMAS WEISEL PARTNERS
, 1999
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION.
The following table sets forth all expenses, other than underwriting
discounts and commissions, payable by the Registrant in connection with the sale
of the common stock being registered. All the amounts shown are estimates,
except for the registration fee, the Nasdaq National Market filing fee and the
NASD fee.
<TABLE>
<S> <C>
Registration fee................................................ $ 45,870
Nasdaq National Market fee...................................... 5,000
NASD fee........................................................ 17,000
Blue Sky fees and expenses...................................... 5,000
Printing and engraving expenses................................. 350,000
Legal fees and expenses......................................... 500,000
Accounting fees and expenses.................................... 200,000
Transfer Agent and Registrar fees............................... 10,000
Miscellaneous expenses.......................................... 67,130
---------
Total....................................................... $1,200,000
---------
---------
</TABLE>
ITEM 14. INDEMNIFICATION OF OFFICERS AND DIRECTORS.
Section 145 of the Delaware General Corporation Law permits indemnification
of the Registrant's officers and directors under certain conditions and subject
to certain limitations. Section 145 of the Delaware General Corporation Law also
provides that a corporation has the power to purchase and maintain insurance on
behalf of its officers and directors against any liability asserted against such
person and incurred by him or her in such capacity, or arising out of his or her
status as such, whether or not the corporation would have the power to indemnify
him or her against such liability under the provisions of Section 145 of the
Delaware General Corporation Law.
Article VII, Section 1 of the Registrant's Restated Bylaws provides that the
Registrant shall indemnify its directors and executive officers to the fullest
extent not prohibited by the Delaware General Corporation Law. The rights to
indemnity thereunder continue as to a person who has ceased to be a director,
officer, employee or agent and inure to the benefit of the heirs, executors and
administrators of the person. In addition, expenses incurred by a director or
executive officer in defending any civil, criminal, administrative or
investigative action, suit or proceeding by reason of the fact that he or she is
or was a director or officer of the Registrant (or was serving at the
Registrant's request as a director or officer of another corporation) shall be
paid by the Registrant in advance of the final disposition of such action, suit
or proceeding upon receipt of an undertaking by or on behalf of such director or
officer to repay such amount if it shall ultimately be determined that he or she
is not entitled to be indemnified by the Registrant as authorized by the
relevant section of the Delaware General Corporation Law.
As permitted by Section 102(b)(7) of the Delaware General Corporation Law,
Article V, Section (A) of the Registrant's Restated Certificate of Incorporation
provides that a director of the Registrant shall not be personally liable for
monetary damages for breach of fiduciary duty as a director, except for
liability (i) for any breach of the director's duty of loyalty to the Registrant
or its stockholders, (ii) for acts or omissions not in good faith or acts or
omissions that involve intentional misconduct or a knowing violation of law,
(iii) under Section 174 of the Delaware General Corporation Law or (iv) for any
transaction from which the director derived any improper personal benefit.
II-1
<PAGE>
The Registrant has entered into indemnification agreements with each of its
directors and executive officers. Generally, the indemnification agreements
attempt to provide the maximum protection permitted by Delaware law as it may be
amended from time to time. Moreover, the indemnification agreements provide for
certain additional indemnification. Under such additional indemnification
provisions, however, an individual will not receive indemnification for
judgments, settlements or expenses if he or she is found liable to the
Registrant (except to the extent the court determines he or she is fairly and
reasonably entitled to indemnity for expenses), for settlements not approved by
the Registrant or for settlements and expenses if the settlement is not approved
by the court. The indemnification agreements provide for the Registrant to
advance to the individual any and all reasonable expenses (including legal fees
and expenses) incurred in investigating or defending any such action, suit or
proceeding. In order to receive an advance of expenses, the individual must
submit to the Registrant copies of invoices presented to him or her for such
expenses. Also, the individual must repay such advances upon a final judicial
decision that he or she is not entitled to indemnification.
The Registrant has purchased directors' and officers' liability insurance.
The Registrant intends to enter into additional indemnification agreements with
each of its directors and executive officers to effectuate these indemnity
provisions.
The underwriting agreement (Exhibit 1.1 hereto) contains provisions by which
the underwriters have agreed to indemnify the Registrant, each person, if any,
who controls the Registrant within the meaning of Section 15 of the Securities
Act, each director of the Registrant, and each officer of the Registrant who
signs this registration statement, with respect to information furnished in
writing by or on behalf of the underwriters for use in the registration
statement.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES.
Since its incorporation in February 1997, the Registrant has issued and sold
unregistered securities as follows:
(1) An aggregate of 1,801,470 shares of common stock was issued in
private placements in February through June 1997 to Enterprise Partners in
connection with the Registrant's initial funding. The consideration received
for such shares was $901.
(2) An aggregate of 6,140,000 shares of Series A preferred stock (which
are currently convertible into 12,280,000 shares of common stock) was issued
in a private placement in July 1997 to Brentwood Venture Capital, Enterprise
Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and certain
other purchasers pursuant to a Series A preferred stock Purchase Agreement.
The consideration received for such shares was $6,138,500.
(3) An aggregate of 6,350,000 shares of Series A preferred stock (which
are currently convertible into 12,700,000 shares of common stock) was issued
in a private placement in December 1997 to Brentwood Venture Capital,
Enterprise Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and
certain other purchasers pursuant to a Series A preferred stock Purchase
Agreement and a Subsequent Closing Purchase Agreement. The consideration
received for such shares was $6,350,000.
(4) An aggregate of 365,094 shares of Series A preferred stock (which
are currently convertible into 730,188 shares of common stock) was issued in
a private placement in February 1998 to Catherine Hapka in connection with
the Series A preferred stock Purchase Agreement, the Subsequent Closing
Purchase Agreement and an employment agreement between the Company and Ms.
Hapka. The consideration received for such shares was $292,075.
(5) An aggregate of 4,044,943 shares of Series B preferred stock (which
are currently convertible into 8,089,866 shares of common stock) was issued
in a private placement in March 1998 to Brentwood Venture Capital,
Enterprise Partners, Kleiner Perkins Caufield & Byers, the
II-2
<PAGE>
Sprout Group and Enron Communications Group, Inc. The consideration received
for such shares was $18,000,000.
(6) In May 1998 the Registrant issued 290,000 units consisting of
13 1/2% senior discount notes due 2008 and warrants to purchase an aggregate
of 3,944,000 shares of common stock with exercise prices of $0.005 per share
to Merrill Lynch & Co. and Donaldson, Lufkin & Jenrette Securities
Corporation, as initial purchasers, for resale to qualified institutional
buyers. Merrill Lynch & Co. and Donaldson, Lufkin & Jenrette Securities
Corporation received commissions of $5,262,920 for acting as initial
purchasers in connection with this transaction.
(7) In May 1998 the Registrant issued to Sun Financial Group, Inc., now
GATX Capital Corporation, a warrant to purchase 478,650 shares of common
stock with an exercise price of $2.225 per share in connection with an
equipment lease financing.
(8) From August 1997 through January 31, 1999, the Registrant granted
stock options to purchase an aggregate of 8,507,393 shares of common stock
to employees and consultants with aggregate exercise prices ranging from
$0.05 to $4.00 per share pursuant to the Registrant's stock option plan. As
of January 31, 1999, 4,962,238 shares of common stock have been issued upon
exercise of options.
No underwriters were used in connection with these sales and issuances
except for the issuance of the senior discount notes and related warrants in (6)
above. The sales and issuances of these securities except for those in (6) above
were exempt from registration under the Securities Act pursuant to Rule 701
promulgated thereunder on the basis that these securities were offered and sold
either pursuant to a written compensatory benefit plan or pursuant to written
contracts relating to consideration, as provided by Rule 701, or pursuant to
Section 4(2) thereof on the basis that the transactions did not involve a public
offering. The sales and issuance in (6) above were exempt from registration
under the Securities Act pursuant to Section 4(2) and, in connection with the
resale by the initial purchasers of the securities described in (6) above, Rule
144A thereunder.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) Exhibits.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
1.1+ Form of Underwriters Agreement
3.1+ Restated Certificate of Incorporation of the Company, as amended.
3.2+ Form of Restated Certificate of Incorporation of the Company to become effective immediately prior to
the Offering.
3.3* Bylaws of the Company.
3.4+ Form of Restated Bylaws of the Company to be effective upon completion of the Offering.
4.1+ Form of Certificate of common stock.
4.2* Indenture, dated as of May 5, 1998, by and between the Company and State Street Bank and Trust Company
of California, N.A., as trustee, including form of the Company's 13 1/2% Senior Discount Notes due 2008,
Series A and form of the Company's 13 1/2% Senior Discount Notes due 2008, Series B.
4.3* Warrant Agreement, dated as of May 5, 1998, by and between the Company and State Street Bank and Trust
Company of California, N.A.
4.4* Warrant Registration Rights Agreement, dated as of May 5, 1998, by and among the Company and Merrill
Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, and Donaldson, Lufkin & Jenrette
Securities Corporation.
</TABLE>
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<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ----------- --------------------------------------------------------------------------------------------------------
<C> <S>
5.1+ Opinion of Brobeck, Phleger & Harrison LLP with respect to the common stock being registered.
9.1* Voting Trust Agreement, dated as of May 5, 1998, by and among Sprout Capital VII, L.P., Donaldson Lufkin
& Jenrette Securities Corporation, and First Union Trust Company, National Association, as trustee.
9.2* Voting Trust Agreement, dated as of March 12, 1998, by and between Enron Communications Group, Inc. and
the Company, as trustee.
9.3* Amended and Restated Voting Agreement, dated March 12, 1998, by and among the Company and the parties
listed on the Schedule of Investors attached thereto as Schedule A, as amended.
10.1* Series A preferred stock Purchase Agreement, dated July 3, 1997, by and among the Company and the
Investors listed on Schedule A thereto.
10.2* Subsequent Closing Purchase Agreement, dated December 23, 1997, by and among the Company and the
Investors listed on Schedule A thereto.
10.3* Series B preferred stock Purchase Agreement, dated March 12, 1998, by and among the Company and the
Investors listed on Schedule A thereto.
10.4* Amended and Restated Investors' Rights Agreement, dated March 12, 1998, by and among the Company and the
Investors listed on Schedule A thereto.
10.5+ Enterprise Services Solution Agreement between Cisco Systems, Inc. and the Company, dated December 3,
1998
10.6* Master Lease Agreement No. 1642 and Addendum thereto, each dated November 19, 1997, and Second Addendum
thereto, dated as of May 19, 1998, between the Company and Sun Financial Group, Inc.
10.7+ Business Lease (Single Tenant) between the Company and BR Venture, LLC dated September 1998.
10.8* Employment Agreement between the Company and Catherine M. Hapka, dated June 10, 1997.
10.9* Employment Agreement between the Company and Jeffrey Blumenfeld, dated August 10, 1997.
10.10* Employment Agreement between the Company and James A. Greenberg, dated July 14, 1997.
10.11* Employment Agreement between the Company and Rand A. Kennedy, dated August 22, 1997.
10.12* 1997 Stock Option/Stock Issuance Plan.
10.13* Form of Indemnification Agreement between the Company and each of its directors.
10.14* Form of Indemnification Agreement between the Company and each of its officers.
10.15* QuickStart Loan and Security Agreement, dated October 29, 1997, between the Company and Silicon Valley
Bank.
21.1* Subsidiaries of the Company.
23.1+ Consent of Brobeck, Phleger & Harrison LLP (filed with Exhibit 5.1)
23.2 Consent of PricewaterhouseCoopers LLP.
24.1 Powers of Attorney (See page II-6).
</TABLE>
- ------------------------
* Previously filed with the Commission as an exhibit to the registration
statement on Form S-4 (File No. 333-59393) and incorporated herein by
reference.
II-4
<PAGE>
+ To be filed by amendment.
(b) Financial Statement Schedules included separately in the registration
statement.
All other schedules are omitted because they are not required, are not
applicable or the information is included in the Financial Statements or notes
thereto.
ITEM 17. UNDERTAKINGS.
The undersigned hereby undertakes to provide to the underwriters at the
closing specified in the underwriting agreement certificates in such
denominations and registered in such names as required by the underwriters to
permit prompt delivery to each purchaser.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
Registrant pursuant to the provisions described in Item 14, or otherwise, the
Registrant has been advised that in the opinion of the Securities and Exchange
Commission such indemnification is against public policy as expressed in the
Securities Act and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the
Registrant of expenses incurred or paid by a director, officer or controlling
person of the Registrant in the successful defense of any action, suit or
proceeding) is asserted by such director, officer or controlling person in
connection with the securities being registered, the Registrant will, unless in
the opinion of its counsel the matter has been settled by controlling precedent,
submit to a court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the Securities
Act and will be governed by the final adjudication of such issue.
The undersigned registrant hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act, the
information omitted from the form of prospectus filed as part of this
registration statement in reliance upon Rule 430A and contained in a form of
prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h)
under the Securities Act shall be deemed to be part of this registration
statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities Act,
each post-effective amendment that contains a form of prospectus shall be deemed
to be a new registration statement relating to the securities offered therein,
and the offering of such securities at that time shall be deemed to be the
initial bona fide offering thereof.
II-5
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this Registration Statement to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Englewood, State of
Colorado, on the 16th day of February 1999.
RHYTHMS NETCONNECTIONS INC.
By: /s/ SCOTT C. CHANDLER
-----------------------------------------
Scott C. Chandler
CHIEF FINANCIAL OFFICER
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Catherine M. Hapka and Scott C. Chandler, or
either of them, as his or her true and lawful attorneys-in-fact and agents, with
full power of substitution and resubstitution, for him or her and in his or her
name, place and stead, in any and all capacities, to sign any and all amendments
(including post-effective amendments) to this Registration Statement and any
registration statement related to this Registration Statement and filed pursuant
to Rule 462 under the Securities Act of 1933, and to file the same, with all
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorneys-in-fact and
agents, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in connection therewith as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorneys-in-fact and agents, or their substitute or
substitutes may lawfully do or cause to be done by virtue hereof.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
<C> <S> <C>
/s/ CATHERINE M. HAPKA
- ------------------------------ President, Chief Executive February 16, 1999
Catherine M. Hapka Officer and Director
/s/ SCOTT C. CHANDLER
- ------------------------------ Chief Financial Officer February 16, 1999
Scott C. Chandler
/s/ KEVIN R. COMPTON
- ------------------------------ Director February 16, 1999
Kevin R. Compton
/s/ KEITH B. GEESLIN
- ------------------------------ Director February 16, 1999
Keith B. Geeslin
/s/ KEN L. HARRISON
- ------------------------------ Director February 16, 1999
Ken L. Harrison
</TABLE>
II-6
<PAGE>
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
<C> <S> <C>
/s/ WILLIAM R. STENSRUD
- ------------------------------ Director February 16, 1999
William R. Stensrud
/s/ JOHN L. WALECKA
- ------------------------------ Director February 16, 1999
John L. Walecka
</TABLE>
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<PAGE>
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the inclusion in this registration statement on Form S-1 (File No.
_____) of our report dated March 13, 1998, except as to note 3 which is as of
October 15, 1998 and to the last paragraph of note 7 which is as of November 4,
1998, on our audit of the financial statements of Rhythms NetConnections Inc.
We also consent to the reference to our firm under the caption "Experts."
PricewaterhouseCoopers LLP
San Diego, California
February 16, 1999
