<PAGE>
P_R_O_S_P_E_C_T_U_S
Filed Pursuant to Rule 424(b)(4)
Registration No. 333-82867
3,961,862 SHARES
[LOGO]
RHYTHMS NETCONNECTIONS INC.
COMMON STOCK
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All of the 3,961,862 shares of common stock offered hereby are being offered
by certain of our stockholders. We will not receive any proceeds from the shares
of common stock sold by the selling stockholders.
Our common stock is traded on the Nasdaq National Market under the symbol
"RTHM." On August 11, 1999, the last reported sale price for our common stock on
the Nasdaq National Market was $31 3/8 per share.
INVESTING IN THE COMMON STOCK INVOLVES RISKS WHICH ARE DESCRIBED IN THE
"RISK FACTORS" SECTION BEGINNING ON PAGE 8 OF THIS PROSPECTUS.
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<CAPTION>
PER SHARE TOTAL
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<S> <C> <C>
Public offering price........................................ $29.00 $114,893,998
Underwriting discount........................................ $1.38 $5,457,465
Proceeds, before expenses, to selling stockholders........... $27.62 $109,436,533
</TABLE>
The underwriters may also purchase up to an additional 594,279 shares of
common stock from Rhythms 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 August 17, 1999.
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JOINT BOOK-RUNNING MANAGERS
MERRILL LYNCH & CO. SALOMON SMITH BARNEY
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HAMBRECHT & QUIST THOMAS WEISEL PARTNERS LLC
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The date of this prospectus is August 11, 1999.
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TABLE OF CONTENTS
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PAGE
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<S> <C>
Summary.................................................................................................... 4
Risk Factors............................................................................................... 8
Use of Proceeds............................................................................................ 23
Dividend Policy............................................................................................ 23
Price Range of Our Common Stock............................................................................ 23
Capitalization............................................................................................. 24
Dilution................................................................................................... 25
Selected Consolidated Financial Data....................................................................... 26
Management's Discussion and Analysis of Financial Condition and Results of Operations...................... 27
Description of Certain Indebtedness........................................................................ 35
Business................................................................................................... 36
Management................................................................................................. 57
Certain Relationships and Related Transactions............................................................. 69
Principal and Selling Stockholders......................................................................... 73
Description of Capital Stock............................................................................... 76
Shares Eligible for Future Sale............................................................................ 80
Underwriting............................................................................................... 82
Legal Matters.............................................................................................. 84
Experts.................................................................................................... 84
Where You Can Find More Information........................................................................ 84
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.
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-; CHOICE
ROUTE-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.NET-TM-; RHYTHMS
NETCONNECTIONS-TM-; RHYTHMS NETSELECT-TM-; RHYTHMS NETWORKNOW-TM-; RHYTHMS
PBXPRESS-TM-; RHYTHMS TOOLBAR-TM-; RHYTHMS TOTAL ACCESS SOLUTIONS-TM-; RHYTHMS
U.S. LAN-TM-; RING.RHYTHMS-TM-; WORK.RHYTHMS-TM- and [LOGO].
This prospectus also refers to trade names and trademarks of other
companies.
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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. WHEN WE REFER TO
OUR COMPANY IN THIS PROSPECTUS, WE REFER TO US AND OUR SUBSIDIARIES, AS A
COMBINED ENTITY, EXCEPT WHERE WE INDICATE OTHERWISE. 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."
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 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 our first market in April 1998, and currently offer service in a
total of 17 markets: San Diego, San Francisco, San Jose, Oakland/East Bay,
Chicago, Los Angeles, Orange County, Boston, Sacramento, New York, Philadelphia,
Washington D.C., Detroit, Denver, Seattle, Portland and Baltimore. We intend to
continue our network rollout into an additional 16 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, BellSouth, GTE,
Pacific Bell and U S WEST, and we are currently pursuing interconnection
arrangements with three other incumbent carriers. As of June 30, 1999, we
provide service or have installed equipment in over 500 incumbent carrier
central offices. We have obtained competitive carrier authority or have been
permitted to operate as a competitive carrier in 28 states.
In March 1999, we entered into separate strategic arrangements with MCI
WorldCom, Inc. and Microsoft Corporation. As part of our strategic arrangements,
MCI WorldCom's investment fund and Microsoft each invested $30 million in us.
The MCI WorldCom arrangement also designates us as the first choice in its
alternative carrier access provisioning system for DSL services in certain
circumstances, and provides that MCI WorldCom is committed to sell at least
100,000 of our DSL lines over a period of five years, subject to penalties for
failure to reach target commitments. In turn, we have designated MCI WorldCom as
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. For instance, in June 1999, MCI WorldCom and we, in
conjunction with Cisco Systems, Inc. and Jetstream Communications, successfully
demonstrated toll-quality voice and high-speed data communications over a single
copper line utilizing DSL technology. In our Microsoft arrangement, we will
jointly develop and distribute with Microsoft a co-branded DSL version of the
Microsoft Network (MSN) service focused on our small business customers and on
our customers' teleworkers.
In April 1999, we entered into a customer relationship with Qwest
Communications Corporation, in connection with which Qwest's wholly owned
subsidiary, U.S. Telesource, Inc., invested $15 million in us. Qwest has
committed to purchase from us performance class DSL services for re-sale to its
customers. In return, we have agreed to use Qwest's network and application
hosting services in certain
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situations. The combined DSL line commitment from Qwest and MCI WorldCom totals
200,000 lines over several years.
We also market our services through our direct sales force and through our
partnerships with recognized leaders in the networking industry, including
Microsoft and Cisco. 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 June 30, 1999, we had over
3,200 lines in service, and we are currently under contract to supply over 9,000
additional DSL lines. Our business customers include QUALCOMM Incorporated,
Cisco, Silicon Graphics, Inc., Wind River Systems and Broadcom Corporation. Our
service provider customers include Epoch Internet, Ingram Micro, Intermedia
Communications Inc., Savvis Communications Corporation, Verio Inc. and Williams
Communications, Inc.
In April 1999, we completed an initial public offering of our common stock,
raising net proceeds of approximately $210.1 million. On April 23, 1999, we
completed the sale and issue of senior notes, raising net proceeds of
approximately $314.5 million, of which approximately $113.2 million was used to
purchase a portfolio of U.S. government securities to secure the payment of the
first six scheduled interest payments on the senior notes.
Our senior management team has extensive experience in developing
next-generation networking businesses. Our Chairman 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.
Steve Stringer, our President and Chief Operating Officer, was previously the
Global Chief Operating Officer of GE Capital IT Solutions. 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 Microsoft, MCI
WorldCom's investment fund, a subsidiary of Qwest, Kleiner Perkins Caufield &
Byers, Enterprise Partners, Brentwood Venture Capital, the Sprout Group and a
subsidiary of Enron Corp., have to date invested approximately $105.3 million.
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.
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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. 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 that extend the functionality
of corporate communications and networking resources to remote offices and
workers. We also offer high performance Internet 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 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.
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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.
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THE OFFERING
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<S> <C>
Common stock offered by the selling
stockholders............................... 3,961,862 shares (1)
Common stock to be outstanding after this
offering................................... 76,206,268 shares (2)(3)(4)
Use of proceeds.............................. We will not receive any proceeds from the
sale of shares of common stock by the selling
stockholders.
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.
Nasdaq National Market symbol................ RTHM
</TABLE>
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(1) Represents shares issuable upon a "net exercise" of warrants that were
issued in connection with our 1998 senior discount notes.
(2) Includes 3,961,862 shares of common stock issuable upon a "net exercise" of
outstanding warrants that were issued in connection with our 1998 senior
discount notes which are to be sold in this offering by the selling
stockholders.
(3) Excludes:
- 4,505,139 shares of common stock issuable upon the exercise of stock
options outstanding as of June 30, 1999, with a weighted average exercise
price of $17.63, all of which are exercisable and 85,758 of which are
vested;
- 2,203,402 shares of common stock issuable upon exercise of outstanding
warrants, with a weighted average price of $7.30 per share;
- 486,595 shares of treasury stock; and
- 770,629 shares of common stock issuable upon exercise of outstanding
warrants that were issued in connection with our 1998 senior discount
notes and which are not being sold in this offering.
(4) This number assumes that the over-allotment option is not exercised. If the
over-allotment option is exercised in full, we will issue and sell 594,279
shares in addition to the shares to be sold by the selling stockholders. See
"Use of Proceeds" for our anticipated uses of proceeds we will receive if
the over-allotment option is exercised in full and we sell these additional
shares.
7
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RISK FACTORS
AN INVESTMENT IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. YOU SHOULD
CAREFULLY CONSIDER THE RISKS AND UNCERTAINTIES DESCRIBED BELOW AND THE OTHER
INFORMATION IN THIS PROSPECTUS BEFORE DECIDING TO PURCHASE SHARES OF OUR COMMON
STOCK. THE RISKS AND UNCERTAINTIES DESCRIBED BELOW ARE NOT THE ONLY ONES FACING
OUR COMPANY.
WE CANNOT PREDICT OUR SUCCESS BECAUSE WE HAVE A SHORT OPERATING HISTORY
We formed our company in February 1997, and we have a short operating
history for you to review in evaluating our business. We have limited historical
financial and operating data upon which you can evaluate our business and
prospects. We entered into our first interconnection agreement with an incumbent
carrier in July 1997 and began to offer commercial services in our first market
in April 1998. We have limited commercial operations and have recognized limited
revenues since our inception. In addition, our senior management team and our
other employees have worked together at our company for only a short period of
time.
BECAUSE OUR MARKET IS NEW AND EVOLVING, WE CANNOT PREDICT ITS FUTURE GROWTH OR
ULTIMATE SIZE, AND WE MAY BE UNABLE TO COMPETE EFFECTIVELY
The market for packet-based high-speed digital communication services using
telephone lines is in the early stages of development. Since this market is new
and evolving and because our current and future competitors are likely to
introduce competing services, we cannot accurately predict the rate at which
this market will grow, if at all, or whether new or increased competition will
result in market saturation. Various providers of high-speed digital
communication services are testing products from various suppliers for various
applications, and suppliers have not broadly adopted an industry standard.
Certain critical issues concerning commercial use of DSL for Internet and local
area network access, including security, reliability, ease and cost of access
and quality of service, remain unresolved and may impact the growth of these
services. If the markets for our services fail to develop, grow more slowly than
anticipated or become saturated with competitors, these events could materially
and adversely affect our business, prospects, operating results and financial
condition.
Our success will depend on the development of this new and rapidly evolving
market and our ability to compete effectively in this market. To address these
risks, we must, among other things:
- rapidly expand the geographic coverage of our network services;
- raise additional capital;
- enter into interconnection agreements and working arrangements with
additional incumbent carriers, substantially all of which we expect to be
our competitors;
- deploy an effective network infrastructure;
- attract and retain customers;
- successfully develop relationships and activities with our partners and
distributors, including MCI WorldCom, Microsoft, Qwest and Cisco;
- continue to attract, retain and motivate qualified personnel;
- accurately assess potential markets and effectively respond to competitive
developments;
- continue to develop and integrate our operational support system and other
back office systems;
- obtain any required governmental authorizations;
- comply with evolving governmental regulatory requirements;
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- increase awareness of our services;
- continue to upgrade our technologies; and
- effectively manage our expanding operations.
We may not be successful in addressing these and other risks, and our
failure to address risks would materially and adversely affect our business,
prospects, operating results and financial condition.
WE CANNOT PREDICT OUR SUCCESS BECAUSE OUR BUSINESS MODEL IS UNPROVEN
We have not validated our business model and strategy in the market. We
believe that the combination of our unproven business model and the highly
competitive and fast changing market in which we compete makes it impossible to
predict the extent to which our network service will achieve market acceptance
and our overall success. To be successful, we must develop and market network
services that are widely accepted by businesses at profitable prices. We may
never be able to deploy our network as planned, achieve significant market
acceptance, favorable operating results or profitability or generate sufficient
cash flow to repay our debt. Of the approximately 12,200 lines that are in
service or that we have committed to deliver, we installed or committed
approximately 10,150 to only three 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 June 30, 1999, we had an accumulated
deficit of approximately $105.5 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 1998 senior discount notes and 1999 senior notes of
approximately $52.2 million in 1999 and increasing to $81.0 million in 2003. In
addition, we may incur more debt in the future. Furthermore, as a result of
recent business relationships arising from preferred stock and warrant issuances
and of previous stock option grants, we anticipate that there will be
significant charges to earnings in future periods. We estimate that these
charges will total approximately $8.5 million per year over each of the next
several years. As a result of these factors, we expect to incur substantial
operating and net losses and negative operating cash flow for the foreseeable
future. We will need to obtain additional financing to pay our expenses and to
make payments on our debt. We cannot give you any assurance about whether or
when we will have sufficient revenues to satisfy our funding requirements or pay
our debt service obligations.
OUR OPERATING RESULTS IN ONE OR MORE FUTURE PERIODS ARE LIKELY TO FLUCTUATE
SIGNIFICANTLY AND MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF SECURITIES
ANALYSTS OR INVESTORS
Our annual and quarterly operating results are likely to fluctuate
significantly in the future due to numerous factors, many of which are outside
of our control. These factors include:
- the rate of customer acquisition and turnover;
- the prices our customers are willing to pay;
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- the amount and timing of expenditures relating to the expansion of our
services and infrastructure;
- the timing and availability of incumbent carrier central office
collocation facilities and transport facilities;
- the success of our relationships with our partners and distributors,
including MCI WorldCom, Microsoft, Qwest and Cisco;
- our ability to deploy our network on a timely basis;
- introduction of new services or technologies by our competitors;
- price competition;
- the ability of our equipment and service suppliers to meet our needs;
- regulatory developments, including interpretations of the 1996
Telecommunications Act;
- technical difficulties or network downtime;
- the success of our strategic alliances; and
- the condition of the telecommunication and network service industries and
general economic conditions.
Because of these factors, our operating results in one or more future
periods could fail to meet or exceed the expectations of securities analysts or
investors. In that event, any trading price of our common stock would likely
decline.
IF SALES FORECASTED FOR A PARTICULAR PERIOD ARE NOT REALIZED IN THAT PERIOD DUE
TO THE LENGTHY SALES CYCLE OF OUR SERVICES, OUR OPERATING RESULTS FOR THAT
PERIOD WILL BE HARMED
The sales cycle of our network services can be very lengthy, particularly
for large businesses. The sales cycle for large businesses typically involves:
- a significant technical evaluation;
- an initial trial rollout to a relatively small number of end users;
- a commitment of capital and other resources by the customer;
- delays associated with the customer's internal procedures to approve large
capital expenditures;
- time required to engineer the deployment of our services;
- coordination of the activation of multiple access lines with incumbent
carriers; and
- testing and acceptance of our services.
For these and other reasons, our sales cycle for large businesses lasts at
least six months. During this lengthy sales cycle, we will incur significant
expenses in advance of the receipt of revenues. If sales that we forecast for a
particular period do not occur because of our lengthy sales cycle, this event
could materially and adversely affect our business, prospects, operating results
and financial condition during that period.
WE DEPEND ON INCUMBENT CARRIERS FOR COLLOCATION AND TRANSMISSION FACILITIES
We must use copper telephone lines controlled by the incumbent carriers to
provide DSL connections to customers. We also depend on the incumbent carriers
for collocation and for a substantial portion of the transmission facilities we
use to connect our equipment in incumbent carrier
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central offices to our Metro Service Centers. In addition, we depend on the
incumbent carriers to test and maintain the quality of the copper lines that we
use. We have not established a history of obtaining access to collocation and
transmission facilities from incumbent carriers in large volumes. In many cases,
we may be unable to obtain access to collocation and transmission facilities
from the incumbent carriers, or to gain access at acceptable rates, terms and
conditions, including timeliness. We have experienced, and expect to experience
in the future, lengthy periods between our request for and the actual provision
of the collocation space and telephone lines. An inability to obtain adequate
and timely access to collocation space or transmission facilities on acceptable
terms and conditions from incumbent carriers could have a material and adverse
effect on our business, prospects, operating results and financial condition.
Because we compete with incumbent carriers in our markets, they may be
reluctant to cooperate with us. The incumbent carriers may experience, or claim
to experience, a shortage of collocation space or transmission capacity. If this
occurs, we may not have alternate means of connecting our DSL equipment with the
copper lines or connecting our equipment in central offices to Metro Service
Centers. We have experienced rejections of some of our collocation applications
on the grounds that no space is available. We may receive additional rejections
in the future. The number of other competitive local exchange carriers that
request collocation space will also affect the availability of collocation space
and transmission capacity. If we are unable to obtain physical collocation space
or transmission capacity from our targeted incumbent carriers, we may face
delays, additional costs or an inability to provide services in certain
locations. In many cases where our application for physical collocation is
rejected, we expect to have the option of adjacent location -- where we install
our equipment in a building that is very close to the incumbent carrier central
office -- or virtual collocation -- where the incumbent carrier manages and
operates our equipment. While we have used adjacent and virtual collocation in
our network, those alternatives reduce our control over our equipment, and
therefore may reduce the level of quality and service we provide to our
customers. We are currently in an arbitration proceeding with SBC Communications
Inc. concerning the availability of DSL-enabled copper lines, as well as other
operational issues. Delays in obtaining access to collocation space and
telephone lines or the rejection of our applications for collocation could
result in delays in, and increased expenses associated with, the rollout of our
services, which in turn could have a material and adverse effect on our
business, prospects, operating results and financial condition.
WE ARE UNABLE TO CONTROL THE TERMS AND CONDITIONS UNDER WHICH WE GAIN ACCESS TO
INCUMBENT CARRIER COLLOCATION AND TRANSMISSION FACILITIES
We cannot control the terms under which we collocate our equipment, connect
to copper lines or gain the use of an incumbent carrier's transmission
facilities. State tariffs, state public utility commissions, the Federal
Communications Commission and interconnection agreements with the incumbent
carriers determine the price, terms and conditions under which collocation space
is made available, and they make these administrative determinations in ongoing
hearings. Interconnection agreements and state public utility commissions also
determine the terms and conditions of access to copper lines and other
components of an incumbent carrier's network. We may be unable to negotiate or
enter into interconnection agreements on acceptable terms or at all. In
addition, we cannot be sure that incumbent carriers will abide by their
obligations under those agreements. Delays in obtaining interconnection
agreements would delay our entry into certain markets. In addition, disputes may
arise between us and the incumbent carriers with respect to interconnection
agreements, and we may be unable to resolve disputes in our favor. If we are
unable to enter into, or experience a delay in obtaining, interconnection
agreements, this inability or delay could adversely affect our business,
prospects, operating results and financial condition. Further, the
interconnection agreements are generally short term, and we may be unable to
renew the interconnection agreements on acceptable terms or at all. The state
commissions, the Federal Communications Commission and the courts oversee, in
varying degrees, interconnection arrangements as well as the terms and
conditions under
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which we gain access to incumbent carrier copper lines and transmission
facilities. These government entities may modify the terms or prices of our
interconnection agreements and our access to incumbent carrier copper lines and
transmission facilities in ways that would be adverse to our business. The
Federal Communications Commission and state regulatory commissions establish the
rates for DSL-capable copper lines as well as other rates, terms and conditions
of our dealings with the incumbent carriers in ongoing public hearings.
Participation in these hearings will involve significant management time and
expense. Incumbent carriers may from time to time propose new rates, and the
outcomes of hearings and rulings could have a material and adverse effect on our
business, prospects, operating results and financial condition.
WE DEPEND ON THIRD PARTIES, PARTICULARLY MCI WORLDCOM, MICROSOFT, QWEST AND
CISCO, FOR THE MARKETING AND SALES OF OUR NETWORK SERVICES
We will rely significantly on indirect sales channels for the marketing and
sales of our network services. We will seek to establish relationships with
numerous service providers, including Internet Service Providers, interexchange
carriers, other competitive carriers and value-added resellers, to gain access
to customers. Our agreements to date with service providers are non-exclusive,
and we anticipate that future agreements will also be on a non-exclusive basis,
allowing service providers to resell services offered by our competitors. These
agreements are generally short term, and can be cancelled by the service
provider without significant financial consequence. We cannot control how these
service providers perform and cannot be certain that their performance will be
satisfactory to us or our customers. Many of these companies also compete with
us. If the number of customers we obtain through indirect sales channels is
significantly lower than our forecast for any reason, or if the service
providers with which we have contracted are unsuccessful in competing in their
own intensely competitive markets, these events would have a material and
adverse effect on our business, prospects, operating results and financial
condition.
We expect to rely particularly on the sales and marketing efforts of our
strategic partners, including MCI WorldCom, Microsoft, Qwest and Cisco. While
our agreements with MCI WorldCom and Qwest call for them to sell an aggregate of
200,000 DSL lines, the agreements also enable MCI WorldCom and Qwest to
terminate their respective agreements under certain circumstances and to receive
offsets and credits under other circumstances. Therefore, MCI WorldCom and Qwest
might sell significantly fewer than 200,000 DSL lines, or we might receive
significantly lower revenues than we otherwise would.
THE MARKET IN WHICH WE OPERATE IS HIGHLY COMPETITIVE, AND WE MAY NOT BE ABLE TO
COMPETE EFFECTIVELY, ESPECIALLY AGAINST ESTABLISHED INDUSTRY COMPETITORS WITH
SIGNIFICANTLY GREATER FINANCIAL RESOURCES
We will face competition from many competitors with significantly greater
financial resources, well-established brand names and large, existing installed
customer bases. We expect the level of competition to intensify in the future.
We expect significant competition from incumbent carriers, traditional and new
long distance carriers, cable modem service providers, Internet Service
Providers, wireless and satellite data service providers and other competitive
carriers. Incumbent carriers have existing metropolitan area networks and
circuit-switched local access networks. In addition, most incumbent carriers are
establishing their own Internet Service Provider businesses and are in some
stage of market trials and retail sales of DSL-based access services. Some
incumbent carriers have announced that they intend to aggressively market these
services to their residential customers at attractive prices. We believe that
incumbent carriers have the potential to quickly overcome many of the issues
that have delayed widespread deployment of DSL services in the past. In
addition, we may experience substantial customer turnover in the future. Many
providers of telecommunications and networking services experience high rates of
customer turnover.
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Many of the leading traditional long distance carriers, including AT&T
Corporation, MCI WorldCom and Sprint, are expanding their capabilities to
support high-speed, end-to-end networking services. The newer long distance
carriers, including Williams, Level 3 Communications, Inc. and Qwest, are
building and managing high bandwidth, nationwide packet networks and partnering
with Internet Service Providers to offer services directly to the public. Cable
modem service providers, like @Home Networks, are offering or preparing to offer
high-speed Internet access over hybrid fiber networks to consumers, and @Work
has positioned itself to do the same for businesses. Several new companies are
emerging as wireless, including satellite-based, data service providers.
Internet Service Providers, including some with significant and even nationwide
presences, provide Internet access to residential and business customers,
generally over the incumbent carriers' circuit switched networks, although some
have begun offering DSL-based access. Certain competitive carriers, including
Covad Communications Group, Inc. and NorthPoint Communications, Inc., have begun
offering DSL-based access services, and, like us, have attracted strategic
equity investors, marketing allies and product development partners. Others are
likely to do the same in the future. In addition, regional Internet Service
Providers and competitive carriers, including HarvardNet, Inc., Network Access
Solutions Corp. and DSL.net, Inc. have begun offering DSL-based access services
that compete with the services we offer. As a result of increasing competition
for our services, we are experiencing substantial price competition,
particularly with respect to sales generated through our indirect sales
channels.
Many of these competitors are offering, or may soon offer, technologies and
services that will directly compete with some or all of our service offerings.
Some of the technologies used by these competitors for local access connections
include integrated services digital network (ISDN), DSL, wireless data and cable
modems. Some of the competitive factors in our markets include transmission
speed, reliability of service, breadth of service availability, price
performance, network security, ease of access and use, content bundling,
customer support, brand recognition, operating experience, capital availability
and exclusive contracts. We believe that we compare unfavorably with many of our
competitors with regard to, among other things, brand recognition, existing
relationships with end users, available pricing discounts, central office
access, capital availability and exclusive contracts. Substantially all of our
competitors and potential competitors have substantially greater resources than
us. We may not be able to compete effectively in our target markets. Our failure
to compete effectively would have a material and adverse effect on our business,
prospects, operating results and financial condition. See
"Business--Competition."
OUR NETWORK SERVICES MAY NOT ACHIEVE SIGNIFICANT MARKET ACCEPTANCE BECAUSE OUR
PRICES ARE OFTEN HIGHER THAN THOSE CHARGED FOR COMPETING SERVICES
Our prices are in some cases higher than those that our competitors charge
for some of their services. Prices for digital communications services have
fallen historically, and we expect prices in the industry in general, and for
the services we offer now and plan to offer in the future, to continue to fall.
We may be required to reduce prices periodically to respond to competition and
to generate increased sales volume. Our prices may not permit our network
services to gain a desirable level of commercial acceptance, and we may be
unable to sustain any current or future pricing levels. Due to these factors, we
cannot accurately forecast our revenues or the rate at which we will add new
customers.
WE WILL NEED SIGNIFICANT ADDITIONAL FUNDS, WHICH WE MAY NOT BE ABLE TO OBTAIN
The expansion and development of our business will require significant
additional capital. We intend to seek substantial additional financing in the
future to fund the growth of our operations, including funding the significant
capital expenditures and working capital requirements necessary for us to
provide service in our targeted markets. We believe that our current capital
resources will be sufficient to fund our aggregate capital expenditures and
working capital requirements, including
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operating losses, through approximately June 2001. We will not have completed
our network rollout by this date and will need additional capital, whether or
not our estimate on how long current capital resources will last is accurate. In
addition, our actual funding requirements may differ materially if our
assumptions underlying this estimate turn out to be incorrect. Therefore, you
should consider our estimate in light of the following facts:
- we have no meaningful history of operations or revenues;
- our estimated funding requirements do not reflect any contingency amounts
and may increase, perhaps substantially, if we are unable to generate
revenues in the amount and within the time frame we expect or if we have
unexpected cost increases; and
- we face many challenges and risks, including those discussed elsewhere in
"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 indentures that govern
the 1998 senior discount notes and the 1999 senior notes restrict our ability to
obtain additional debt financing. Any future borrowing instruments, such as
credit facilities and lease agreements, are likely to contain similar or more
restrictive covenants and could require us to pledge assets as security for the
borrowings. If we are unable to obtain additional capital or are required to
obtain it on terms less satisfactory than what we desire, we will need to delay
deployment of our network services or take other actions that could adversely
affect our business, prospects, operating results and financial condition. If we
are unable to generate sufficient cash flow or obtain funds necessary to meet
required payments of our debt, then we will be in default on our debt
instruments. To date, our cash flow from operations has been insufficient to
cover our expenses and capital needs. Please see "Management's Discussion and
Analysis of Financial Condition and Results of Operations-- Liquidity and
Capital Resources."
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN CURRENT OR
FUTURE LAWS OR REGULATIONS COULD RESTRICT THE WAY WE OPERATE OUR BUSINESS
A significant portion of the services that we offer through our subsidiaries
is subject to regulation at the federal, state and/or local levels. Future
federal or state regulations and legislation may be less favorable to us than
current regulation and legislation and therefore have an adverse impact on our
business, prospects, operating results and financial condition. In addition, we
may expend significant financial and managerial resources to participate in
rule-setting proceedings at either the federal or state level, without achieving
a favorable result. The Federal Communications Commission prescribes rules
applicable to interstate communications, including rules implementing the 1996
Telecommun-
ications Act, a responsibility it shares with the state regulatory commissions.
In particular, we believe that incumbent carriers will work aggressively to
modify or restrict the operation of many provisions of the 1996
Telecommunications Act. We expect incumbent carriers will pursue litigation in
courts, institute administrative proceedings with the Federal Communications
Commission and other regulatory agencies and lobby the United States Congress,
all in an effort to affect laws and regulations in a manner favorable to the
incumbent carriers and against the interest of competitive carriers such as us.
If the incumbent carriers succeed in any of their efforts, if these laws and
regulations change or if the administrative implementation of laws develops in
an adverse manner, these events could have a material and adverse effect on our
business, prospects, operating results and financial condition. For more details
about our regulatory situation, please see "Business--Government Regulation."
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OUR FAILURE TO MANAGE GROWTH COULD ADVERSELY AFFECT US
We have rapidly and significantly expanded our operations. We anticipate
further significant expansion of our operations in an effort to achieve our
network rollout and deployment objectives. Our expansion to date has strained
our management, financial controls, operations systems, personnel and other
resources. Any future rapid expansion would increase these strains. If our
marketing strategy is successful, we may experience difficulties responding to
customer demand for services and technical support in a timely manner and in
accordance with their expectations. As a result, rapid growth of our business
would make it difficult to implement successfully our strategy to provide
superior customer service. To manage any growth of our operations, we must:
- improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
- hire, train and manage additional qualified personnel;
- expand and upgrade our core technologies; and
- effectively manage multiple relationships with our customers, suppliers
and other third parties.
We may not be able to install management information and control systems in
an efficient and timely manner, and our current or planned personnel, systems,
procedures and controls may not be adequate to support our future operations.
Failure to manage our future growth effectively could adversely affect the
expansion of our customer base and service offerings. Any failure to
successfully address these issues could materially and adversely affect our
business, prospects, operating results and financial condition.
OUR SUBSTANTIAL DEBT CREATES FINANCIAL AND OPERATING RISK
We are highly leveraged, and we intend to seek additional debt funding in
the future. As of June 30, 1999, we had approximately $494.3 million of
outstanding debt, and our debt made up 66.8% 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
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or at all, and we may be unable to adapt to new technologies and offer services
in a competitive manner. Our joint development projects with Cisco and MCI
WorldCom and our strategic arrangement with Microsoft may not produce useful
technologies or services for us. Further, new technologies and products may not
be compatible with our technologies and business plan. We believe that the
telecommunications industry must set standards to allow for the compatibility of
various products and technologies. However, the industry may not set standards
on a timely basis or at all. In addition, many of the products and technologies
that we intend to use in our network services are relatively new and unproven
and may be unreliable.
WE MAY BE UNABLE TO EFFECTIVELY EXPAND OUR NETWORK SERVICES AND PROVIDE HIGH
PERFORMANCE TO A SUBSTANTIAL NUMBER OF END USERS
Due to the limited deployment of our network services, we cannot guarantee
that our network will be able to connect and manage a substantial number of end
users at high transmission speeds. We may be unable to scale our network to
service a substantial number of end users while achieving high performance.
Further, our network may be unable to achieve and maintain competitive digital
transmission speeds. While digital transmission speeds of up to 7.1 Mbps are
possible on certain portions of our network, that speed is not available over a
majority of our network. Actual transmission speeds on our network will depend
on a variety of factors and many of these factors are beyond our control,
including the type of DSL technology deployed, the distance an end user is
located from a central office, the quality of the telephone lines, the presence
of interfering transmissions on nearby lines and other factors. As a result, we
may not be able to achieve and maintain digital transmission speeds that are
attractive in the market.
OUR SERVICES MAY SUFFER BECAUSE THE TELEPHONE LINES WE REQUIRE MAY BE
UNAVAILABLE OR IN POOR CONDITION
Our ability to provide DSL-based services to potential customers depends on
the quality, physical condition, availability and maintenance of telephone lines
within the control of the incumbent carriers. We believe that the current
condition of telephone lines in many cases will be inadequate to permit us to
fully implement our network services. In addition, the incumbent carriers may
not maintain the telephone lines in a condition that will allow us to implement
our network effectively. The telephone lines may not be of sufficient quality or
the incumbent carriers may claim they are not of sufficient quality to allow us
to fully implement or operate our network services. Further, some customers use
technologies other than copper lines to provide telephone services, and DSL
might not be available to these customers.
OUR SUCCESS DEPENDS ON OUR RETENTION OF CERTAIN KEY PERSONNEL AND ON THE
PERFORMANCE OF THOSE PERSONNEL
Our success depends on the performance of our officers and key employees,
especially our Chief Executive Officer. Members of our senior management team
have worked together for only a short period of time. We do not have "key
person" life insurance policies on any of our employees nor do we have
employment agreements for fixed terms with any of our employees. Any of our
employees, including any member of our senior management team, may terminate his
or her employment with us at any time. Given our early stage of development, we
depend on our ability to retain and motivate high quality personnel, 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
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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 suppliers may be unable to manufacture and deliver
the amount of equipment we order, or the available supply may be insufficient to
meet our demand. Currently, almost all of the DSL modem and DSL multiplexing
equipment we use for a single connection over a copper line must come from the
same vendor since there are no existing interoperability standards for the
equipment used in our higher speed services. If our suppliers or licensors enter
into competition with us, or if our competitors enter into exclusive or
restrictive arrangements with the suppliers or licensors, then these events may
materially and adversely affect the availability and pricing of the equipment we
purchase and the technology we license.
A SYSTEM FAILURE OR BREACH OF NETWORK SECURITY COULD CAUSE DELAYS OR
INTERRUPTIONS OF SERVICE TO OUR CUSTOMERS
Our operations depend on our ability to avoid damages from fires,
earthquakes, floods, power losses, excessive sustained or peak user demand,
telecommunications failures, network software flaws, transmission cable cuts and
similar events. A natural disaster or other unanticipated problem at our owned
or leased facilities could interrupt our services. Additionally, if an incumbent
carrier, competitive carrier or other service provider fails to provide the
communications capacity we require, as a result of a natural disaster,
operational disruption or any other reason, then this failure could interrupt
our services.
Despite the implementation of security measures, our network may be
vulnerable to unauthorized access, computer viruses and other disruptive
problems. Corporate networks and Internet Service Providers have in the past
experienced, and may in the future experience, interruptions in service as a
result of accidental or intentional actions of Internet users, current and
former employees and others. Unauthorized access could also potentially
jeopardize the security of confidential information stored in the computer
systems of our customers, which might cause us to be liable to our customers,
and also might deter potential customers. Eliminating computer viruses and
alleviating other security problems may require interruptions, delays or
cessation of service to our customers and our customers' end users.
INTERFERENCE OR CLAIMS OF INTERFERENCE COULD DELAY OUR ROLLOUT OR HARM OUR
SERVICES
All transport technologies deployed on copper telephone lines have the
potential to interfere with, or to be interfered with by, other transport
technologies on the copper telephone lines. We believe that our DSL
technologies, like other transport technologies, do not interfere with existing
voice services. We believe that a workable plan that takes into account all
technologies could be implemented in a scalable way across all incumbent
carriers using existing plant engineering principles. There are several
initiatives underway to establish national standards and principles for the
deployment of DSL technologies. We believe that our technologies can be deployed
consistently with these evolving standards. Nevertheless, incumbent carriers may
claim that the potential for interference permits them to restrict or delay our
deployment of DSL services. Interference could degrade the performance of our
services or make us unable to provide service on selected lines. The procedures
to resolve interference
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issues between competitive carriers and incumbent carriers are still being
developed, and these procedures may not be effective. We may be unable to
successfully negotiate interference resolution procedures with incumbent
carriers. Moreover, incumbent carriers may make claims regarding interference or
unilaterally take action to resolve interference issues to the detriment of our
services. State or federal regulators could also institute responsive actions.
Interference, or claims of interference, if widespread, would adversely affect
our speed of deployment, reputation, brand image, service quality and customer
satisfaction and retention.
WE DEPEND ON THIRD PARTIES FOR FIBER OPTIC TRANSPORT FACILITIES
We depend on the availability of fiber optic transmission facilities from
third parties to connect our equipment within and between metropolitan areas.
These third party fiber optic carriers include long distance carriers, incumbent
carriers and other competitive carriers. Many of these entities are, or may
become, our competitors. This approach includes a number of risks. For instance,
we may be unable to negotiate and renew favorable supply agreements. Further, we
depend on the timeliness of these companies to process our orders for customers
who seek to use our services. We have in the past experienced supply problems
with certain of our fiber optic suppliers, and they may not be able to meet our
needs on a timely basis in the future. Moreover, the fiber optic transport
providers whose networks we lease may be unable to obtain or maintain permits
and rights-of-way necessary to develop and operate existing and future networks.
UNCERTAIN FEDERAL AND STATE TAX AND OTHER SURCHARGES ON OUR SERVICES MAY
INCREASE OUR PAYMENT OBLIGATIONS
Telecommunications providers pay a variety of surcharges and fees on their
gross revenues from interstate and intrastate services. The division of our
services between interstate and intrastate services is a matter of
interpretation, and in the future the Federal Communications Commission or
relevant state commission authorities may contest this division. A change in the
characterization of the jurisdiction of our services could cause our payment
obligations to increase. In addition, pursuant to periodic revisions by state
and federal regulators of the applicable surcharges, we may be subject to
increases in the surcharges and fees currently paid.
OUR INTELLECTUAL PROPERTY PROTECTION MAY BE INADEQUATE TO PROTECT OUR
PROPRIETARY RIGHTS, AND WE MAY BE SUBJECT TO INFRINGEMENT CLAIMS
We rely on a combination of licenses, confidentiality agreements and other
contracts to establish and protect our technology and other intellectual
property rights. We have applied for trademarks and servicemarks on certain
terms and symbols that we believe are important for our business. We currently
have no patents or patent applications pending. The steps we have taken may be
inadequate to protect our technology or other intellectual property. Moreover,
our competitors may independently develop technologies that are substantially
equivalent or superior to ours. Third parties may assert infringement claims
against us and, in the event of an unfavorable ruling on any claim, we may be
unable to obtain a license or similar agreement to use technology we rely upon
to conduct our business. We also rely on unpatented trade secrets and know-how
to maintain our competitive positions, which we seek to protect, in part, by
confidentiality agreements with employees, consultants and others. However,
these agreements may be breached or terminated, and we may not have adequate
remedies for any breach. In addition, our competitors may otherwise learn or
discover our trade secrets. Our management personnel were previously employees
of other telecommunications companies. In many cases, these individuals are
conducting activities for us in areas similar to those in which they were
involved prior to joining us. As a result, we or our employees could be subject
to allegations of violation of trade secrets and other similar claims.
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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.
WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE COVENANTS
IN OUR EXISTING DEBT SECURITIES
The indentures governing our 1998 senior discount notes and 1999 senior
notes impose significant restrictions on how we can conduct our business. For
example, the restrictions prohibit or limit our ability to incur additional
debt, make dividend payments and engage in certain business activities. The
restrictions may materially and adversely affect our ability to finance future
operations or capital needs or conduct additional business activities. Any
future senior debt that we may incur will likely impose additional restrictions
on us. If we fail to comply with any existing or future restrictions, we could
default under the terms of the applicable debt and be unable to meet our debt
obligations. If we default, the holders of the applicable debt could demand that
we repay the debt, including interest, immediately. We may be unable to make the
required payments or raise sufficient funds from alternative sources to make the
payments. Even if additional financing is available in the event that we
default, it may not be on acceptable terms.
OUR PRINCIPAL STOCKHOLDERS AND MANAGEMENT OWN A SIGNIFICANT PERCENTAGE OF OUR
COMPANY AND WILL BE ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR COMPANY
Following this offering, our executive officers and directors and principal
stockholders together will beneficially own 75.7% of the total voting power of
our company. 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
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systems and believe that they are Year 2000 compliant. Because we are a young
company, we believe we have been able to build our business systems with the
Year 2000 issue in mind. Therefore, there have been few Year 2000 changes
required to our existing systems and applications. We have substantially
completed a compliance check of our external customers and providers, except for
the incumbent carriers. Based on responses from these third parties, other than
the incumbent carriers, we have no information or data to suggest that they will
not experience Year 2000 problems that would materially and adversely affect our
business. We have not been able to conduct a compliance check of incumbent
carriers nor assess the incumbent carriers' Year 2000 compliance. To the extent
that one or more incumbent carriers or other third parties experience Year 2000
problems, our network and services could be adversely affected. Furthermore, the
purchasing patterns of our customers may be affected by Year 2000 issues as
companies expend significant resources to correct their current systems for Year
2000 compliance. These expenditures may result in reduced funds available for
our services. Any of these developments could have a material and adverse effect
on our business, prospects, operating results and financial condition. We have
not fully determined the risks associated with the reasonably worst-case
scenario and have not formulated a contingency plan to address Year 2000 issues.
We do not expect to have a specific contingency plan in place in the future.
IF WE ARE REQUIRED TO REGISTER AS AN INVESTMENT COMPANY, WE WOULD BECOME SUBJECT
TO SUBSTANTIAL REGULATION WHICH WOULD INTERFERE WITH OUR ABILITY TO CONDUCT OUR
BUSINESS ACCORDING TO OUR BUSINESS PLAN
As a result of our previous financings, we have substantial cash, cash
equivalents and short-term investments. We plan to continue investing the excess
proceeds of these financings in short-term instruments consistent with prudent
cash management and not primarily for the purpose of achieving investment
returns. Investment in securities primarily for the purpose of achieving
investment returns could result in our being treated as an "investment company"
under the Investment Company Act of 1940. The Investment Company Act requires
the registration of companies that are primarily in the business of investing,
reinvesting or trading securities or that fail to meet certain statistical tests
regarding their composition of assets and sources of income even though they
consider themselves not to be primarily engaged in investing, reinvesting or
trading securities.
We believe that we are primarily engaged in a business other than investing
in or trading securities and, therefore, are not an investment company within
the meaning of the Investment Company Act. If the Investment Company Act
required us to register as an investment company, we would become subject to
substantial regulation with respect to our capital structure, management,
operations, transactions with affiliated persons and other matters. Application
of the provisions of the Investment Company Act to us would materially and
adversely affect our business, prospects, operating results and financial
condition.
WE EXPECT OUR STOCK PRICE TO BE VOLATILE
The trading price of our common stock has been and is likely to continue to
be highly volatile. Our stock price could fluctuate widely in response to many
factors, including the following:
- our historical and anticipated quarterly and annual operating results;
- announcements of new products or services by us or our competitors or new
competing technologies;
- the addition or loss of business or service provider customers;
- variations between our actual results and analyst and investor
expectations;
- investor perceptions of our company and comparable public companies;
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- conditions or trends in the telecommunications industry, including
regulatory developments;
- announcements by us of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
- additions or departures of key personnel;
- future equity or debt offerings or our announcements of such offerings;
and
- general market and economic conditions.
In addition, in recent years the stock market in general, and the Nasdaq
National Market and the market for Internet and technology companies in
particular, have experienced extreme price and volume fluctuations. These
fluctuations have often been unrelated or disproportionate to the operating
performance of these companies. These market and industry factors may materially
and adversely affect our stock price, regardless of our operating performance.
WE HAVE NOT PAID AND DO NOT INTEND TO PAY DIVIDENDS
We have not paid any dividends, and we do not intend to pay cash dividends
in the foreseeable future. Our current financing documents contain provisions
which restrict our ability to pay dividends.
ANTI-TAKEOVER PROVISIONS COULD NEGATIVELY IMPACT OUR STOCKHOLDERS
Our Board of Directors has adopted a stockholder rights plan. Our
stockholder rights plan would cause substantial dilution to any person or group
that attempts to acquire our company on terms not approved in advance by our
Board of Directors. In addition, some of the provisions that may be included in
our certificate of incorporation and bylaws may discourage, delay or prevent a
merger or acquisition at a premium price. These provisions include:
- authorizing the issuance of "blank check" preferred stock;
- providing for a classified Board of Directors with staggered, three-year
terms;
- eliminating the ability of stockholders to call a special meeting of
stockholders;
- limiting the removal of directors by the stockholders to removal for
cause; and
- requiring a super-majority stockholder vote to effect certain amendments.
In addition, certain provisions of the Delaware General Corporation Law and our
stockholder rights plan may deter someone from acquiring or merging with us,
including a transaction that results in stockholders receiving a premium over
the market price for the shares of common stock held by them. Section 203 of the
Delaware General Corporation Law also imposes certain restrictions on mergers
and other business combinations between us and any holder of more than 15% and
less than 85% of our common stock. See "Description of Capital Stock--Possible
Anti-Takeover Matters."
The indentures governing our 1998 senior discount notes and 1999 senior
notes require us to offer to repurchase all such notes for 101% of their
principal amount or accreted value, as the case may be, plus any accrued
interest and liquidated damages, within 30 days after a change of control. 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.
21
<PAGE>
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 is limited by
lock-up agreements that were entered into in connection with our initial public
offering and this offering. Under such lock-up agreements, the holders of
approximately 77.9% of our outstanding shares of common stock agreed not to sell
or otherwise dispose of any of their shares until October 4, 1999 and holders of
approximately 76.9% have agreed not to sell or otherwise dispose of any of their
shares for a period of 90 days after the date of this prospectus. 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
such 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
The public offering price is substantially higher than the net tangible book
value per share of the outstanding common stock after this offering.
Accordingly, if you purchase common stock in this offering at the offering price
of $29.00 per share, you will incur immediate and substantial dilution of $26.28
in the net tangible book value per share of the common stock from the price you
pay for the common stock in this offering.
22
<PAGE>
USE OF PROCEEDS
The selling stockholders will sell all of the shares offered by this
prospectus. We will not receive any proceeds from the sale of these shares. We
will pay some of the expenses relating to this offering, which we estimate will
total approximately $0.5 million.
If the over-allotment option is exercised in full, we will issue and sell
594,279 shares in addition to the shares to be sold by the selling stockholders.
We estimate that the net proceeds to us from the sale of these additional shares
(at an offering price of $29.00 per share) will be $15.9 million, after
deducting the underwriters' discount and other estimated offering expenses. We
expect to use these proceeds to fund the expenditures incurred in the continuing
deployment of network services in our existing markets, our planned rollout into
additional markets, working capital and for general corporate purposes.
DIVIDEND POLICY
We have not paid any dividends since our inception and do not intend to pay
any dividends on our capital stock in the foreseeable future. In addition, the
terms of the indentures relating to the 1998 senior discount notes and the 1999
senior notes restrict our ability to pay dividends on our capital stock.
PRICE RANGE OF OUR COMMON STOCK
Our common stock has been traded on the Nasdaq National Market under the
symbol "RTHM" since April 7, 1999, the date of our initial public offering.
Prior to April 7, 1999, there was no public market for our common stock. The
following table sets forth, for the period indicated, the high and low closing
daily sales prices for our common stock as reported by the Nasdaq National
Market.
<TABLE>
<CAPTION>
HIGH LOW
--------- -------
<S> <C> <C>
YEAR ENDED DECEMBER 31, 1999:
Second Quarter (from April 7, 1999
through June 30, 1999).............. $93 1/8 $45 1/4
Third Quarter (through August 11,
1999)............................... 68 15/16 31 1/4
</TABLE>
On August 11, 1999, the last reported sale price for our common stock on the
Nasdaq National Market was $31 3/8 per share. As of June 30, 1999, there were
approximately 100 holders of record.
23
<PAGE>
CAPITALIZATION
The following unaudited table sets forth our capitalization as of June 30,
1999:
- on an actual basis; and
- as adjusted to give effect to the "net exercise" of warrants issued in
connection with our 1998 senior discount notes to purchase 3,961,862
shares of common stock prior to the consummation 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 offering memorandum.
<TABLE>
<CAPTION>
AS OF
JUNE 30, 1999
(UNAUDITED)
----------------------
ACTUAL AS ADJUSTED
--------- -----------
(IN THOUSANDS)
<S> <C> <C>
Cash, cash equivalents and short-term investments........................................ $ 516,025 $ 515,525
--------- -----------
--------- -----------
Restricted cash (1)...................................................................... $ 113,211 $ 113,211
--------- -----------
--------- -----------
Debt:
Bank note (2).......................................................................... $ 611 $ 611
13 1/2% senior discount notes due 2008................................................. 168,701 168,701
12 3/4% senior notes due 2009.......................................................... 325,000 325,000
--------- -----------
Total debt........................................................................... 494,312 494,312
--------- -----------
Mandatorily redeemable common stock warrants............................................. 6,567 1,070
--------- -----------
Stockholders' equity:
Common stock, $0.001 par value; 250,000,000 shares authorized actual and pro forma;
72,708,777 shares issued actual and 76,670,639 shares issued pro forma (3)............. 73 77
Treasury stock, at cost; 486,595 shares.................................................. (20) (20)
Additional paid-in capital............................................................... 344,394 349,887
Warrants................................................................................. 10,247 10,247
Deferred compensation.................................................................... (10,086) (10,086)
Accumulated deficit...................................................................... (105,511) (106,011)
--------- -----------
Total stockholders' equity........................................................... 239,097 244,094
--------- -----------
Total capitalization............................................................... $ 739,976 $ 739,476
--------- -----------
--------- -----------
</TABLE>
- ------------------------------
(1) Reflects the portion of the net proceeds from the issuance of the 12 3/4%
senior notes used to purchase a portfolio of U.S. government securities to
fund the first six scheduled interest payments on the notes.
(2) 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.
(3) Excludes 22,224 shares of common stock issued between July 1, 1999 and
August 10, 1999 upon the exercise of options. Also excludes 2,974,031 shares
of common stock issuable upon the exercise of outstanding warrants and
4,505,139 shares of common stock issuable upon the exercise of outstanding
options as of August 10, 1999.
24
<PAGE>
DILUTION
As of June 30, 1999 we had an as adjusted net tangible book value of
approximately $207.3 million, or $2.72 per share of our common stock, after
giving effect to the exercise of warrants issued in connection with the 1998
senior discount notes to purchase 3,961,862 shares of our common stock prior to
the consummation of this offering. As adjusted net tangible book value per share
represents the amount of our as adjusted total tangible assets reduced by our
total liabilities, after giving effect to this offering, divided by the as
adjusted number of shares of our common stock outstanding, excluding treasury
stock. We will not receive any proceeds from the sale of shares of common stock
by the selling stockholders in this offering. As a result, our as adjusted net
tangible book value per share will neither increase nor decrease.
The new investors purchasing shares at the public offering price of $29.00
will have an immediate dilution in net tangible book value of $26.28 per share.
Dilution in net tangible book value per share represents the difference between
the amount per share paid by purchasers of shares of our common stock in this
offering and the as adjusted net tangible book value per share of our common
stock as of June 30, 1999. The following table illustrates this per share
dilution:
<TABLE>
<S> <C> <C>
Public offering price per share............................. $ 29.00
As adjusted net tangible book value per share as of
June 30, 1999........................................... $ 2.72
---------
Dilution per share to new investors(1)...................... $ 26.28
---------
---------
</TABLE>
- ------------------------
(1) If the underwriters' overallotment option is exercised in full, the dilution
to new investors would be $26.09.
25
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following statement of operations data for the period from February 27,
1997 to December 31, 1997, the year ended December 31, 1998 and for the
six-month periods ended June 30, 1998 and June 30, 1999, and the balance sheet
data as of December 31, 1997, December 31, 1998 and June 30, 1999 (actual) 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 offering memorandum.
<TABLE>
<CAPTION>
SIX MONTHS ENDED
FEBRUARY 27, 1997 --------------------------------
(INCEPTION) TO YEAR ENDED JUNE 30, 1998 JUNE 30, 1999
DECEMBER 31, 1997 DECEMBER 31, 1998 (UNAUDITED) (UNAUDITED)
----------------- ----------------- --------------- ---------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue................................. $ -- $ 528 $ 82 $ 2,300
Operating expenses:
Network and service costs............. -- 4,695 665 18,170
Selling, marketing, general and
administrative...................... 2,534 23,153 6,984 36,118
Depreciation and amortization......... 1 1,081 35 3,796
-------- -------- --------------- ---------------
Total operating expenses............ 2,535 28,929 7,684 58,084
-------- -------- --------------- ---------------
Loss from operations.................... (2,535) (28,401) (7,602) (55,784)
Interest and other income (expense),
net................................... 113 (7,933) (1,547) (10,971)
-------- -------- --------------- ---------------
Net loss................................ $ (2,422) $ (36,334) $ (9,149) $ (66,755)
-------- -------- --------------- ---------------
-------- -------- --------------- ---------------
Net loss per share (basic and
diluted).............................. $ (1.12) $ (12.18) $ (4.02) $ (1.97)
-------- -------- --------------- ---------------
-------- -------- --------------- ---------------
OTHER FINANCIAL DATA:
EBITDA (1).............................. $ (2,342) $ (26,562) $ (7,329) $ (50,341)
Adjusted EBITDA (2)..................... (2,342) (24,970) (7,224) (44,128)
Net cash used for operating
activities............................ (1,560) (19,024) (5,529) (45,900)
Net cash used for investing
activities............................ (1,345) (139,032) (6,485) (304,288)
Net cash provided by financing
activities............................ 13,071 169,205 165,216 626,056
</TABLE>
<TABLE>
<CAPTION>
AS OF JUNE 30, 1999
(UNAUDITED)
AS OF AS OF --------------------------
DECEMBER 31, 1997 DECEMBER 31, 1998 ACTUAL AS ADJUSTED (3)
------------------- ----------------- --------- ---------------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term
investments................................. $ 10,166 $ 136,812 $ 516,025 $ 515,525
Restricted cash (4)........................... -- -- 113,211 113,211
Equipment and furniture, net.................. 1,621 11,510 73,243 73,243
Total assets.................................. 12,241 171,726 789,315 788,815
Total debt.................................... 568 158,270 494,312 494,312
Mandatorily redeemable common stock
warrants.................................... -- 6,567 6,567 1,070
Total stockholders' equity (deficit).......... 10,346 (6,747) 239,097 244,094
</TABLE>
- ------------------------------
(1) EBITDA consists of the net loss excluding net interest, depreciation and
amortization of capital assets, deferred business acquisition costs 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 year ended December 31, 1998 and the three
months ended June 30, 1998 and June 30, 1999 include $1,592,000, $105,000
and $6,213,000, respectively, of operating lease expense to GATX Capital
Corporation and Cisco Capital Corporation. No amounts were incurred for
operating leases for the period ended December 31, 1997. Adjusted EBITDA
reflects EBITDA excluding the GATX and Cisco operating lease expense.
(3) Adjusts the actual information to give effect to the exercise of warrants
issued in connection with our 1998 senior discount notes to purchase
3,961,862 shares of common stock prior to consummation of this offering.
(4) Reflects the portion of the net proceeds from the issuance of the 12 3/4%
senior notes used to purchase a portfolio of U.S. government securities to
fund the first six scheduled interest payments on the notes.
26
<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 our first market in April 1998, and currently offer service in a
total of 17 markets: San Diego, San Francisco, San Jose, Oakland/East Bay,
Chicago, Los Angeles, Orange County, Boston, Sacramento, New York, Philadelphia,
Washington D.C., Detroit, Denver, Seattle, Portland and Baltimore. We intend to
continue our network rollout into an additional 16 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 incumbent
carriers;
- entering into strategic alliances;
- identifying collocation space and locations for our connection points,
metro service centers and business offices;
- acquiring and deploying equipment and facilities;
- launching service trials;
- hiring management and other personnel;
- raising capital; and
- developing and integrating our operations support 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 June 30, 1999, we had an
accumulated deficit of approximately $105.5 million. We intend to substantially
increase our expenditures and operating expenses 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 March 1999, we entered into separate strategic arrangements with MCI
WorldCom and Microsoft. As part of our strategic arrangements, MCI WorldCom's
investment fund and Microsoft each invested $30 million in us. The MCI WorldCom
arrangement also designates us as the first choice in its alternative carrier
access provisioning system for DSL services in certain circumstances, and
provides that MCI WorldCom is committed to sell at least 100,000 of our DSL
lines over a period of five years, subject to penalties for failure to reach
target commitments. In turn, we have designated MCI WorldCom as our preferred
provider of network services in certain circumstances. In our Microsoft
arrangement, we will jointly distribute with Microsoft a co-branded DSL version
of the Microsoft Network (MSN) service focused on our small business customers
and on our customers' teleworkers. In April 1999, we entered into a customer
relationship with Qwest Communications Corporation, in connection with which
Qwest's subsidiary, U.S. Telesource, Inc., invested $15 million in us. Qwest has
committed to purchase from us performance class DSL services for re-sale to its
customers. In return, we have agreed to use Qwest's network and application
hosting services in certain situations. The combined DSL line commitment from
Qwest and MCI WorldCom totals 200,000 lines over several years.
As a result of recent business relationships arising from preferred stock
and warrant issuances and of previous stock option grants, we anticipate that
there will be significant charges to earnings in future periods. We estimate
that these charges to earnings will total approximately $8.5 million per year
over each of the next several years.
27
<PAGE>
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 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. 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 premises equipment at end
user locations. We currently outsource most of this function.
- MONTHLY RECURRING AND NONRECURRING LINE AND SERVICE CHARGES. We pay
incumbent carriers 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
competitive carrier or incumbent carrier. 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.
- 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.
28
<PAGE>
SELLING, MARKETING, GENERAL AND ADMINISTRATIVE COSTS
Our selling, marketing, 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, competitive carriers 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
SIX MONTHS ENDED JUNE 30, 1999 COMPARED TO SIX MONTHS ENDED JUNE 30, 1998
REVENUE AND NETWORK AND SERVICE COSTS
We recorded $2.3 million in revenues for the six months ended June 30, 1999
compared to $82,000 in revenues for the six months ended June 30, 1998. Our
network and service costs for the six-month periods were $18.2 million in 1999
compared to $665,000 in 1998. The increases in both revenues and costs resulted
from the continued expansion of our operations, as more fully detailed above.
SELLING, MARKETING, GENERAL AND ADMINISTRATIVE
During the first half of 1999, our selling, marketing, general, and
administrative expenses were $36.1 million, which compares to $7.0 million
during the first half of 1998. This increase resulted primarily from additional
salary, overhead, marketing, and legal expenses associated with our continuing
expansion, as more fully detailed above.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the six-month periods was $2.1 million in
1999 and $35,000 in 1998. As we continue our expansion into additional markets
and central offices, as discussed above, we employ additional equipment and
collocation sites that we begin depreciating when we place them in service.
The increase in amortized deferred business acquisition costs between years
from zero in 1998 to $1.7 million in 1999 is a result of the Microsoft and Qwest
business relationships as discussed above.
OTHER INCOME AND EXPENSE
Interest income was $8.3 million and interest expense was $19.4 million for
the six months ended June 30, 1999. This compares to interest income of $1.7
million and interest expense of $3.2 million for the same six-month period in
1998. The increases in 1999 resulted from our financing activities that are
described above. These financing activities included our initial public offering
of common stock and our issuance of senior debt in April 1999. We invested the
proceeds from these financings, which provided
29
<PAGE>
increased interest income. Interest and issue cost amortization on the debt,
however, contributed to a large increase in interest expense for 1999.
INCOME TAXES
We continue to be in a net operating loss tax position through June 30,
1999; consequently, we have not recorded a provision for income taxes for
periods through June 30, 1999.
YEAR ENDED DECEMBER 31, 1998
REVENUE
We did not offer commercial services in 1997 and, as a result, did not
record any revenue in 1997. During the year ended December 31, 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, the Los Angeles and Orange County markets in September and the
Chicago market in October. We recorded revenue of $528,000 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 year ended December 31, 1998, we
recorded network and service costs of $4.7 million. We expect network and
service costs to increase significantly in future periods as we expand our
network into additional markets.
SELLING, MARKETING, GENERAL AND ADMINISTRATIVE
From inception through December 31, 1997 selling, marketing, 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 year ended December 31, 1998, we recorded selling,
marketing, general and administrative expenses of $23.2 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,
marketing, general and administrative expenses to continue to increase
significantly as we expand our business.
DEPRECIATION AND AMORTIZATION
Depreciation from network equipment is minimal since substantially all of
this equipment is currently leased. Depreciation and amortization was $1,000 for
the period from inception through December 31, 1997 and was $1.1 million for the
year ended December 31, 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 year ended December 31, 1998, we
recorded net interest expense of $8.0 million, consisting of interest income of
$5.8 million generated from invested cash balances, offset by $13.8 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.
30
<PAGE>
INCOME TAXES
We generated net operating loss carryforwards of $2.1 million from inception
to December 31, 1997 and $35.0 million during the year ended December 31, 1998.
We expect significant consolidated losses for the foreseeable future which will
generate additional net operating loss carryforwards. However, our ability to
use net operating losses 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 net
operating losses 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 1998.
LIQUIDITY AND CAPITAL RESOURCES
The development and expansion of our business requires significant capital
expenditures. These capital expenditures primarily include build-out costs such
as the procurement, design and construction of our connection points and one or
two metro service center locations in each market, as well as other costs that
support our network design.
The number of targeted central offices in each market varies, as does the
average capital cost to build our connection points in such market. Capital
expenditures, including payments for collocation fees, were $87.7 million during
the first half of 1999. We expect our capital expenditures to be higher in
future periods, arising primarily from payments of collocation fees and the
purchase of infrastructure equipment necessary for the development and expansion
of our network.
Through June 30, 1999, we have financed our operations and market build-outs
primarily through:
- issuing 12.75 percent senior notes in April 1999 for $314.5 million in net
proceeds;
- issuing common stock in April 1999 in our initial public offering for
$210.1 million in net proceeds;
- issuing 13.50 percent senior discount notes in May 1998 for $144.0 million
in net proceeds;
- private placements of equity totaling $105.8 million; and
- executing equipment lease lines totaling $68.5 million.
As of June 30, 1999, we had $629.2 million in cash and investments and we
had an accumulated deficit of $105.5 million.
For the year ended December 31, 1998, the net cash used in our operating
activities was $19.0 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 year
ended December 31, 1998 was $139.0 million and was used primarily for purchases
of short-term investments and equipment and payments of collocation fees. Net
cash provided by financing activities for the year ended December 31, 1998 was
$169.2 million and primarily came from the issuance of the senior discount notes
and of preferred stock.
For the six months ended June 30, 1998 and June 30, 1999, we used cash of
$5.5 million and $45.9 million, respectively, in our operating activities.
Salaries, consulting and legal expenses, network operations and overhead
expenses all contributed to the operating cash expenditures. For the six months
ended June 30, 1998 and June 30, 1999, we used net cash of $6.5 million and
$304.3 million, respectively, for investing activities. We used this cash
primarily for purchases of short-term investments and equipment and payments of
collocation fees. Net cash provided by financing activities for the six months
ended June 30, 1998 and June 30, 1999 was $165.2 million and $626.1 million,
respectively. These funds were generated primarily from the issuances of equity
and senior debt as described above.
We had $136.8 million in cash and investments at the beginning of 1999.
During the first half of 1999, we received $75.0 million from selling Series C
and Series D preferred stock and warrant, we received $213.0 million from the
sale of common stock, we received $314.5 million from issuing senior debt and we
received $23.8 million from the sale/leaseback of operating equipment.
31
<PAGE>
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.
We have not paid any dividends to our shareholders and will not pay
dividends for the foreseeable future. Our senior notes contain covenants that
restrict our ability to make certain payments, including dividend payments.
We believe that our existing cash and investment balances as of June 30,
1999, together with the anticipated future revenue generated from operations,
will be sufficient to fund our operating losses, capital expenditures, lease
payments, and interest payments through approximately June 2001. We expect our
operating losses and capital expenditures to increase substantially in the
near-term, 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
financings, or the private or public sale of equity or debt securities. Future
equity or debt financings may not be available to us at all, or, if available,
may not be on favorable terms. If we are unable to obtain financing in the
future, we will continue the expansion of our operations on a reduced scale
based on our existing capital resources.
IMPACT OF THE YEAR 2000 ISSUE
Many computer programs have been written using two digits rather than four
to define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year 1900
rather than the year 2000. This, in turn, could result in major system failures
or miscalculations, and is generally referred to as the "Year 2000 issue." We
have formulated and, to a large extent, effected a plan to address our Year 2000
issues.
Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year 2000
compliance testing for all of our internal systems and believe that they are
Year 2000 compliant. Because we are a young company, we believe we have been
able to build our business systems with the Year 2000 issue in mind. Therefore,
there have been few Year 2000 changes required to our existing systems and
applications. We have substantially completed a compliance check of our external
customers and providers, except for the incumbent carriers. Based on responses
from these third parties, other than the incumbent carriers, we have no
information or data to suggest that they will not experience Year 2000 problems
that would materially and adversely affect our business. We have not been able
to conduct a compliance check of incumbent carriers nor assess the incumbent
carriers' Year 2000 compliance. To the extent that one or more incumbent
carriers or other third parties experience Year 2000 problems, our network and
services could be adversely affected. Furthermore, the purchasing patterns of
our customers may be affected by Year 2000 issues as companies expend
significant resources to correct their current systems for Year 2000 compliance.
These expenditures may result in reduced funds available for our services. Any
of these developments could have a material and adverse effect on our business,
prospects, operating results and ability to repay our debt, including the notes.
We have not fully determined the risks associated with the reasonably worst-case
scenario and have not formulated a contingency plan to address Year 2000 issues.
We do not expect to have a specific contingency plan in place in the future.
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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;
- 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;
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- 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 incumbent carriers.
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.
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DESCRIPTION OF CERTAIN INDEBTEDNESS
In December 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 574,380 shares of common stock at a price of $1.85 per
share. GATX transferred warrants to purchase an aggregate of 258,472 of these
shares to two parties. These transferred warrants have been exercised. The
remaining GATX warrant, exercisable for 315,908 shares of common stock, is
immediately exercisable. In March 1999, we entered into additional 36-month
lease lines for an aggregate of up to $24 million in lease financing with GATX
to be used for equipment. In connection with these March 1999 leases, we issued
to GATX warrants to purchase an aggregate of 45,498 shares of common stock at a
price of $10.55 per share. These warrants are immediately exercisable. In July
1999, we entered into an additional 36-month lease line for an aggregate of up
to $26 million in lease financing with GATX to be used for equipment. In
connection with this July 1999 lease, we issued to GATX a warrant to purchase
10,000 shares of common stock at a price of $50 per share. This warrant is
immediately exercisable. In April 1999, we entered into an agreement with Cisco
Systems Capital Corporation for up to $20 million in equipment lease financing
and issued to Cisco a warrant to purchase up to 75,000 shares of common stock at
an exercise price per share of $10.55. This warrant is immediately exercisable.
We also have outstanding $290 million in aggregate principal amount at
maturity of 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 1998 senior
discount notes; cash interest on the 1998 senior discount 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. The 1998 senior discount
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. Upon a change of control, each holder
of the 1998 senior discount 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. The 1998 senior discount 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.
In addition, in April 1999 we issued $325 million aggregate principal amount
of 12 3/4% senior notes due 2009. In that offering, we raised net proceeds of
approximately $314.5 million, of which approximately $113.2 million was used to
purchase a portfolio of U.S. government securities to secure payment of the
first six scheduled interest payments on the senior notes. These senior notes
are our general unsecured obligations that mature on April 15, 2009. The senior
notes are redeemable at our option, in whole or in part, at any time after April
15, 2004 at predetermined redemption prices, together with any accrued and
unpaid interest and liquidated damages through the date of redemption. Upon a
change of control, each holder of the senior notes may require us to purchase
the notes at 101% of the principal amount thereof, plus any accrued and unpaid
interest and liquidated damages to the date of purchase. The senior notes
contain certain restrictive covenants, including limitations on future
indebtedness, restricted payments, transactions with affiliates, liens, sale of
stock of subsidiaries, entering new lines of business, 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 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 our first market in April 1998, and currently offer service in a
total of 17 markets: San Diego, San Francisco, San Jose, Oakland/East Bay,
Chicago, Los Angeles, Orange County, Boston, Sacramento, New York, Philadelphia,
Washington D.C., Detroit, Denver, Seattle, Portland and Baltimore. We intend to
continue our network rollout into an additional 16 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, BellSouth, GTE,
Pacific Bell and U S WEST, and we are currently pursuing interconnection
arrangements with three other incumbent carriers. As of June 30, 1999, we
provide service or have installed equipment in over 500 incumbent carrier
central offices. We have obtained competitive carrier authority or have been
permitted to operate as a competitive carrier in 28 states.
In March 1999, we entered into separate strategic arrangements with MCI
WorldCom and Microsoft. As part of our strategic arrangements, MCI WorldCom's
investment fund and Microsoft each invested $30 million in us. The MCI WorldCom
arrangement also designates us as the first choice in its alternative carrier
access provisioning system for DSL services in certain circumstances, and
provides that MCI WorldCom is committed to sell at least 100,000 of our DSL
lines over a period of five years, subject to penalties for failure to reach
target commitments. In turn, we have designated MCI WorldCom as 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. For instance, in June 1999, MCI WorldCom and we, in conjunction with
Cisco and Jetstream Communications, successfully demonstrated toll-quality voice
and high-speed data communications over a single copper line utilizing DSL
technology. In our Microsoft arrangement, we will jointly develop and distribute
with Microsoft a co-branded DSL version of the Microsoft Network (MSN) service
focused on our small business customers and on our customers' teleworkers.
In April 1999, we entered into a customer relationship with Qwest
Communications Corporation, in connection with which Qwest's wholly owned
subsidiary, U.S. Telesource, Inc., invested $15 million in us. Qwest has
committed to purchase from us performance class DSL services for re-sale to its
customers. In return, we have agreed to use Qwest's network and application
hosting services in certain situations. The combined DSL line commitment from
Qwest and MCI WorldCom totals 200,000 lines over several years.
We also market our services through our direct sales force and through our
partnerships with recognized leaders in the networking industry, including
Microsoft and Cisco. Under our strategic partnership with Cisco, Cisco agreed to
jointly market and sell our networking solutions to its customer
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base and will engage in joint development projects with us. As of June 30, 1999,
we had over 3,200 lines in service, and we are currently under contract to
supply over 9,000 additional DSL lines. Our business customers include Broadcom,
Cisco, Wind River Systems, QUALCOMM and Silicon Graphics. Our service provider
customers include Epoch Internet, Ingram Micro, Intermedia Communications,
Savvis Communications, Verio and Williams Communications.
In April 1999, we completed an initial public offering of our common stock,
raising net proceeds of approximately $210.1 million. On April 23, 1999, we
completed the sale and issue of senior notes, raising net proceeds of
approximately $314.5 million, of which approximately $113.2 million was used to
purchase a portfolio of U.S. government securities to secure the payment of the
first six scheduled interest payments on the senior notes.
Our senior management team has extensive experience in developing
next-generation networking businesses. Our Chairman 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.
Steve Stringer, our President and Chief Operating Officer, was previously the
Global Chief Operating Officer of GE Capital IT Solutions. 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 Microsoft, MCI
WorldCom's investment fund, a subsidiary of Qwest, Kleiner Perkins Caufield &
Byers, Enterprise Partners, Brentwood Venture Capital, the Sprout Group and a
subsidiary of Enron Corp., have to date invested approximately $105.3 million.
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.
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LIMITATIONS OF DIAL-UP MODEMS AND INTEGRATED SERVICES DIGITAL NETWORK (ISDN)
Because only five percent of buildings in the United States are currently
connected to high-speed fiber rings -- typically large buildings in metropolitan
areas 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 integrated services
digital network (ISDN) line, is only 128 Kbps. While integrated services digital
network (ISDN) technology provides improved capacity relative to dial-up modems,
the cost of an integrated services digital network (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
expenditures to purchase equipment to support dial-up modems and integrated
services digital network (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 integrated services digital network (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:
incumbent carriers 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.
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1996 TELECOMMUNICATIONS ACT
The 1996 Telecommunications Act allows competitive carriers to leverage the
existing incumbent carrier infrastructure, as opposed to building a competing
infrastructure at significant cost. The 1996 Telecommunications Act requires all
incumbent carriers to allow competitive carriers to collocate their equipment
along with incumbent carrier equipment in incumbent carrier central offices,
which enables competitive carriers to access end users through existing
telephone line connections. The 1996 Telecommunications Act was designed to
create an incentive for incumbent carriers that were formerly part of the Bell
system to cooperate with competitive carriers: these incumbent carriers cannot
provide long distance service until regulators determine that there is
competition in the incumbent carrier'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
- 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 integrated services
digital network (ISDN) line. Moreover, unlike dial-up modems and
integrated services digital network (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.
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- 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 June 30, 1999, we provide service or had installed our network equipment in
over 500 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. In addition, we plan to construct our network rapidly and intend to
evaluate the potential acquisition of other companies 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
integrated services digital network (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. We intend to evaluate offering new or enhanced products and
services to the consumer market.
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,
Microsoft and Cisco, we intend to jointly develop features and applications that
will meet the needs of our customers. For instance, in June 1999,
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MCI WorldCom and we, in conjunction with Cisco and Jetstream Communications,
successfully demonstrated toll-quality voice and high-speed data communications
over a single copper line utilizing DSL technology. 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 entered into strategic alliances with Microsoft,
MCI WorldCom, Qwest and Cisco. Pursuant to our alliance with Microsoft, we will
jointly distribute with Microsoft a co-branded DSL version of the Microsoft
Network service focused on our small business customers and our customers'
teleworkers. Our strategic alliance with MCI WorldCom designates us as its
preferred provider of business DSL connections for large, medium and small
businesses. Under our Qwest alliance, Qwest has committed to purchase from us
performance class DSL services for re-sale to its customers. In return, we have
agreed to use Qwest's network and application hosting services in certain
situations. The combined DSL line commitment from Qwest and MCI WorldCom totals
200,000 lines over several years. In our alliance with Cisco, we have agreed
with Cisco to 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 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 March 1999 (as amended in April, May and July 1999), we entered into a
strategic partnership with MCI WorldCom in which MCI WorldCom invested $30.0
million in us. Please see "Certain Relationships and Related
Transactions--Series C Purchase Agreement; Other Agreements with MCI WorldCom."
- PROVIDING DSL TO MCI WORLDCOM. We have been designated MCI WorldCom's
first choice in its alternative carrier access provisioning system for DSL
services in areas where we deploy our network for all new DSL services,
except for services to certain subsidiaries and in locations where MCI
WorldCom deploys its own DSL equipment. In addition, MCI WorldCom has
committed to sell a minimum of 100,000 business quality DSL lines, subject
to penalties for failure to reach target commitments. 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
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least 29 metropolitan statistical areas. As part of our agreement, we must
provide specified service levels and have available capacity.
- OBTAINING NETWORK SERVICES FROM MCI WORLDCOM. We have designated MCI
WorldCom as our preferred provider of network services, including
metropolitan area network services, long-haul backbone services and
Internet Protocol backbone services. MCI WorldCom has a right of first
refusal to provide all of these services to us at market competitive
terms.
- COLLABORATION. We are jointly developing voice and data applications over
a single DSL connection. For instance, in June 1999, MCI WorldCom and we,
in conjunction with Cisco and Jetstream Communications, successfully
demonstrated toll-quality voice and high-speed data communications over a
single copper line utilizing DSL technology. We have also formed a working
group with MCI WorldCom to develop and implement the systems and
procedures necessary to jointly deploy DSL service nationwide. We will
collaborate with MCI WorldCom in selecting technologies and vendors to
support our network deployments.
MICROSOFT
In March 1999, we entered into a strategic partnership with Microsoft, in
which Microsoft invested $30.0 million in us. Pursuant to this relationship,
among other things, Microsoft has agreed to jointly distribute with us over the
Internet a co-branded DSL version of the Microsoft Network service focused on
our small business customers and on our customers' teleworkers. This agreement
expires in March 2002. Please see "Certain Relationships and Related
Transactions--Series C Purchase Agreement; Other Agreements with Microsoft."
QWEST
In April 1999, we entered into a customer relationship with Qwest, in which
Qwest invested $15.0 million in us. Pursuant to this relationship, among other
things, Qwest has committed to purchase from us performance class DSL services
for re-sale to its customers. In return, we have agreed to use Qwest's network
and application hosting services in certain situations. The combined DSL line
commitment from Qwest and MCI WorldCom totals 200,000 lines over several years.
Please see "Certain Relationships and Related Transactions--Series C Purchase
Agreement and Series D Purchase Agreement; Other Agreements with Qwest."
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.
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
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.
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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 integrated services digital network
(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 incumbent carrier 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 June 30, 1999.
<TABLE>
<CAPTION>
SPEED TO SPEED FROM RANGE(1)
END USER END USER (FEET) TECHNOLOGY(2)
- ----------- ----------- ----------- -------------
<C> <C> <C> <S>
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 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. We currently lease frame relay backbone and
Asynchronous Transfer Mode backbone
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capacity from a number of long distance carriers. We have almost completed
upgrading our nationwide network to Asynchronous Transfer Mode.
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
websites. 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
applications 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 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. For instance, in June 1999, MCI WorldCom and we, in
conjunction with Cisco and Jetstream Communications, successfully demonstrated
toll-quality voice and high-speed data communications over a single copper line
utilizing DSL technology. Our strategic relationship with Microsoft will focus
on delivering co-branded network applications that will facilitate our
customers' access to the Internet and other destinations.
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 premises 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 June 30,
1999, we served approximately 430 business and 18 service provider customers.
For these business and service provider customers we have more than 3,200 lines
in service and are under contract to supply over 9,000 additional DSL lines.
Selected business customers include Broadcom, Cisco, Wind River Systems,
QUALCOMM and Silicon Graphics. In addition, our service provider customers
include Epoch Internet, Ingram Micro, Intermedia Communications, Savvis, Verio
and Williams Communications.
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 June 30, 1999, we had
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approximately 140 sales and technical personnel supporting our direct and
indirect 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.
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 three large business
customers that have committed to multi-phase implementation programs.
Collectively, these three customers account for approximately 80% of our lines
in service and 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,
competitive carriers, 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, Microsoft, Qwest 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.
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- 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 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 web-based
and distributed client-server systems architecture. This approach allows
us to grow our customer support and network management capabilities as
customer demand increases.
- NETWORK SECURITY. Non-dedicated access, such as dial-up modem or
integrated services digital network (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 incumbent
carriers, metropolitan fiber from incumbent carriers or competitive carriers 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 incumbent carrier. Currently, almost all of the DSL modem
and DSL multiplexing equipment we use for a single connection over a
copper line must come from the same vendor since there are no existing
interoperability standards for the equipment used in our higher speed
services.
- 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 incumbent carrier 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 incumbent
carrier or a competitive carrier.
- CONNECTION POINTS. Through our interconnection agreements with the
incumbent carriers, 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 incumbent carrier'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 June 30, 1999, we had Connection Points in over 500
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 competitive carriers or incumbent carriers 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. We currently lease frame relay backbone and Asynchronous Transfer
Mode backbone capacity from a number of long distance carriers. We have
almost completed upgrading our nationwide network to Asynchronous Transfer
Mode.
- 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 7,800 feet 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 IDSL service operates at up to 144
Kbps in each direction. This service can use existing integrated
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services digital network (ISDN) equipment at the end user site, and is targeted
at the integrated services digital network (ISDN) replacement market. For
information intensive users, we believe that IDSL compares favorably with
integrated services digital network (ISDN) on a price/performance basis when the
monthly flat rate IDSL charge is compared with the per minute integrated
services digital network (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:
- INCUMBENT CARRIERS. Incumbent carriers, 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 incumbent carriers have announced deployment of commercial
DSL services in certain areas. In addition, most incumbent carriers are
combining their DSL service with their own Internet Service Provider
businesses or entering into cooperative or exclusive relationships with
established Internet Service Providers. We believe that incumbent carriers
have the potential to quickly overcome many of the issues that have
delayed widespread deployment of DSL services in the past. 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. In addition, proposed mergers involving Regional Bell
Operating Companies, including SBC's proposed merger with Ameritech and
Qwest's proposed merger with U S WEST, could ease each combined entity's
ability to provide end-to-end high-speed data offerings. The incumbent
carriers 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. For example, AT&T's acquisition of
MediaOne will exploit ubiquitous local cable infrastructure. 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 have announced deployment of DSL services in combination
with their current fiber networks. They also have interconnection
agreements with many of the incumbent carriers 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 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.
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- 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.
- 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 incumbent carriers' circuit switched
networks at integrated services digital network (ISDN) speeds or below.
However, some Internet Service Providers have begun offering DSL-based
access using their own DSL services, or DSL services offered by the
incumbent carrier or other DSL-based competitive carriers. Some Internet
Service Providers have significant and even nationwide marketing presences
and combine these with strategic or commercial alliances with DSL-based
competitive carriers. Some Internet Service Providers, such as Concentric
Network Corporation, Mindspring Enterprises, Inc., PSINet Inc. and Verio
have significant and even nationwide presences.
- COMPETITIVE CARRIERS. Certain competitive carriers, including Covad
Communications Group, Inc. and NorthPoint Communications, Inc., have begun
offering DSL-based data services. In addition, regional competitive
carriers, including HarvardNet, Inc., Network Access Solutions Corp. and
DSL.net have begun offering DSL-based access services that compete with
the services we offer. Other competitive carriers are likely to do so in
the future. Conditions attached to the proposed merger between SBC and
Ameritech may make entry and operation in affected regions easier for our
competitors. The 1996 Telecommunications Act specifically grants
competitive carriers the right to negotiate interconnection agreements
with incumbent carriers, 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 integrated services digital network (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,
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- customer support,
- brand recognition,
- operating experience,
- ability to scale,
- capital availability and
- exclusive contracts.
INTERCONNECTION AGREEMENTS WITH INCUMBENT CARRIERS
Interconnection agreements with incumbent carriers are critical to our
business. These agreements cover a number of aspects of our relationships with
incumbent carriers, including:
- the price we pay to lease and the access we have to the incumbent
carrier's copper lines;
- the removal by the incumbent carrier of equipment or electronics from
lines to enable these lines to transmit DSL signals;
- the price and terms for collocation of our equipment in the incumbent
carrier central offices;
- the price we pay and the access we have to the incumbent carrier's
transport facilities;
- the ability we have to access conduits and other rights of way the
incumbent carrier 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 incumbent carrier's response to our
requests;
- the dispute resolution process we use with the incumbent carrier 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 incumbent carrier.
We have signed interconnection agreements with six different major incumbent
carriers covering 24 states and the District of Columbia. In many cases,
incumbent carriers 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 incumbent carriers. 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 incumbent carriers are also permitting competitive carriers 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, Federal Communications Commission 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, Rhythms Links Inc. (formerly 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.
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<PAGE>
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 Federal Communications Commission 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 Federal
Communications Commission rulemaking proceedings or judicial appeals of such
proceedings could materially affect our business and financial prospects.
The Federal Communications Commission prescribes rules applicable to
interstate communications, including rules implementing the 1996
Telecommunications Act, a responsibility it shares with the state regulatory
commissions. The 1996 Telecommunications Act, and the Federal Communications
Commission'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 Federal
Communications Commission has broad authority to interpret the 1996 Telecommun-
ications Act and issue rules for its implementation, specifically including
authority over pricing methodology. The Supreme Court upheld the Federal
Communications Commission's orders to the incumbent carriers 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 Federal Communications Commission's interpretation of the rules
for establishing unbundled elements was not consistent with the 1996
Telecommunications Act, and required the Federal Communications Commission to
reconsider its delineation of unbundled elements. The Federal Communications
Commission's replacement decision on unbundled elements may adversely affect our
business. In addition, some incumbent carriers may take the position that they
have no obligation to provide unbundled elements, including copper loops, until
the Federal Communications Commission issues new rules, which could adversely
affect our business.
In November, 1998, the Federal Communications Commission ruled that DSL
services provided as dedicated access services in connection with interstate
services such as Internet access are interstate services subject to the Federal
Communications Commission'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 Federal Communications Commission, and they and others
have initiated legislative efforts since then, 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 Federal Communications Commission 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 Federal Communications Commission also issued a Notice of
Proposed Rulemaking indicating its intention to clarify expanded rights of
competitive carriers for collocation, access to copper loops, and various other
issues of consequence to competitive carriers deploying DSL services. The
Federal Communications Commission also indicated its intention to allow
incumbent carriers to create separate affiliates for their DSL businesses that
would have to operate as competitive carriers and would be permitted to operate
free of the resale and unbundling obligations of the 1996 Telecommunications
Act. The final outcome of these decisions, originally scheduled to be announced
on January 28, 1999, had been postponed by the Federal Communications Commission
while it considered the impact of the Supreme Court's ruling on the 1996
Telecommunications Act. On March 31, 1999, the Federal
53
<PAGE>
Communications Commission issued a decision on collocation issues which was
generally favorable to the competitive carriers. This decision has been appealed
to the D.C. Circuit by U S WEST and GTE, although it has not been stayed. In the
same decision the Federal Communications Commission established further
proceedings to consider issues related to unbundled network elements. The
Federal Communications Commission is also engaged in a proceeding to define what
the incumbent carriers' obligations are to make available unbundled network
elements. The final outcome of these petitions or other proceedings or
initiatives interpreting the requirements of the 1996 Telecommunications Act may
adversely affect our business.
STATE REGULATION
Some of our services, particularly those of our subsidiaries, Rhythms Links
Inc. 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, incumbent carriers
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 interconnection agreements with Ameritech, Bell Atlantic, BellSouth, GTE,
Pacific Bell and U S WEST. We have signed agreements with Ameritech for Illinois
and Michigan and currently are negotiating interconnection agreements for
Indiana, Ohio and Wisconsin. We have signed agreements with Bell Atlantic for
the District of Columbia, Maryland, Massachusetts, New Jersey, New York,
Pennsylvania and Virginia and are currently negotiating agreements for
Connecticut, Delaware, New Hampshire and Rhode Island. We have signed agreements
with BellSouth for Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi,
North Carolina, South Carolina and Tennessee. We have signed agreements with GTE
for California, Florida, North Carolina and Washington and are currently
completing agreements for Ohio, Oregon, Texas and Virginia. 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
Florida, Minnesota, Nevada, New Jersey, North Carolina, Ohio, Pennsylvania,
Tennessee and Virginia, with the Southern New England Telephone Company for
Connecticut and with Cincinnati Bell for Ohio and Kentucky. These
interconnection agreements may not be on terms that are entirely satisfactory to
us.
During these negotiations, either the incumbent carrier 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.
We are subject to requirements in some states to obtain prior approval for,
or notify the state commission of, any transfers of control, sales of assets,
corporate reorganizations, issuances of stock or debt instruments and related
transactions. Although we believe such authorizations could be obtained,
54
<PAGE>
there can be no assurance that the state commissions would grant us authority to
complete any transactions.
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 June 30, 1999, we had approximately 580 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.
LEGAL PROCEEDINGS
In December 1998, we instituted an arbitration proceeding, before the Public
Utility Commission of Texas, with Southwestern Bell Telephone Company regarding
the terms of interconnection with Southwestern Bell in Texas. The dispute
involves the terms and conditions of issues related to DSL-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, among other issues.
In addition, on March 12, 1999, our subsidiary Rhythms Links Inc. (formerly
ACI Corp.) filed a complaint with the Oregon Public Utilities Commission (the
"Oregon PUC") against U S WEST requesting that the Oregon PUC determine that U S
WEST permit collocation by Rhythms Links in several central offices in which U S
WEST claimed that it had no space available. U S WEST agreed to permit Rhythms
Links collocation in the disputed central offices just before hearings were
scheduled to begin in June 1999.
On February 18, 1999, we filed a complaint for declaratory relief in San
Diego County Superior Court (North County) against Thomas R. Lafleur. Mr.
Lafleur was a former employee who resigned and/or was terminated in 1998. After
he left, we sent him a check for the repurchase or buy-back of his unvested
shares; Mr. Lafleur refused to cash this check. The declaratory relief action is
to determine that his shares were unvested and thus properly repurchased. On or
about March 26, 1999, Mr. Lafleur filed an answer to the complaint and also
filed a cross-complaint against us for fraud, breach of the covenant of good
faith and fair dealing, conspiracy to inflict emotional distress, intentional
infliction of emotional distress, conversion and declaratory relief. The
cross-complaint seeks compensatory and punitive damages according to proof, and
438,115 shares of common stock. Mr. Lafleur alleges in his
55
<PAGE>
cross-complaint that since we failed to purchase his shares within 60 days
following his termination, the terms of his stock purchase agreement prevent us
from repurchasing his shares. On April 24, 1999, we filed a demurrer and motion
to strike the cross-complaint filed by Mr. Lafleur. In response, Mr. Lafleur
decided to withdraw and amend his cross-complaint rather than oppose the
demurrer, which had been scheduled for hearing on June 24, 1999. On or about
June 23, 1999, Mr. Lafleur filed his first amended cross-complaint wherein he
dropped four of the claims alleged in his original cross-complaint: fraud,
breach of the covenant of good faith and fair dealing, conspiracy to inflict
emotional distress, and intentional infliction of emotional distress. Mr.
Lafleur also added a claim for breach of contract. On July 23, 1999, we filed a
demurrer to the first amended cross-complaint, which is set for hearing before
the Court on September 2, 1999. The Court has scheduled trial on this matter in
January 2000. We intend to vigorously defend against the amended
cross-complaint. We are currently accounting for these 438,115 shares as
treasury stock.
In addition, we are subject to state commission, Federal Communications
Commission and court decisions as they relate to the interpretation and
implementation of the 1996 Telecommunications Act, the interpretation of
competitive carrier 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.
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MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth 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 Chief Executive Officer and Chairman
Steve Stringer............................... 44 President and Chief Operating Officer
B.P. Rick Adams, Jr.......................... 61 Chief Marketing Officer
Scott C. Chandler............................ 37 Chief Financial Officer
James A. Greenberg........................... 38 Chief Network Officer
Michael S. Lanier............................ 55 Chief Information Officer
Frank J. Tolve, Jr........................... 54 Chief Sales Officer
Jeffrey Blumenfeld........................... 51 Vice President and General Counsel
Michael E. Calabrese......................... 33 Vice President, Sales Engineering
Eric H. Geis................................. 53 Vice President of National Deployment
David J. Shimp............................... 53 Senior Vice President, Human Resources
Kevin R. Compton............................. 40 Director
Keith B. Geeslin............................. 46 Director
Ken L. Harrison.............................. 56 Director
Susan Mayer.................................. 48 Director
William R. Stensrud.......................... 48 Director
John L. Walecka.............................. 39 Director
Edward J. Zander............................. 52 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 Chief Executive Officer and a director since
June 1997. In addition, she was elected chairman of our board of directors in
June 1999. Prior to joining us, Ms. Hapka served as President of NETS, Inc., an
electronic commerce software company, from March 1997 to May 1997. NETS, Inc.
filed a bankruptcy petition in 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 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.
STEVE STRINGER has been our President and Chief Operating Officer since May
1999. Prior to joining us, Mr. Stringer served in various positions at GE
Capital from 1991 to May 1999, most recently as Global Chief Operating Officer
at GE Capital IT Solutions. At GE Capital, Mr. Stringer also held the position
of President and CEO of the United States Division, President of the Midwest and
Atlantic regions and CEO of GE Capital's Federal Systems group.
B.P. RICK ADAMS, JR. became our Chief Marketing Officer in June 1999. From
September 1998 until he joined us in June 1999, Mr. Adams was President of Adams
Consulting Group, a consulting practice
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specializing in marketing, strategic planning, sales and communications. From
December 1996 to April 1998, Mr. Adams served as Group Vice President, Marketing
at Microage, Inc. From April 1990 to November 1996, Mr. Adams held various
management positions at AT&T where he served as Vice President, Sales Support
for the Americas and Vice President, Marketing and Business Development at
AT&T-NCR, and as Marketing Vice President for AT&T Global Communications
Systems.
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.
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.
MICHAEL S. LANIER has been our Chief Information Officer since May 1999.
Prior to joining us, Mr. Lanier was most recently President and CEO of the
Technology Extension Company, a consulting firm specializing in business systems
architecture and design, a position he held from March 1996 to April 1999. Prior
to that Mr. Lanier served as Chief Information Officer at Intelligent
Electronics, Inc. from May 1993 to May 1996.
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.
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.
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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, incumbent carriers, 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.
DAVID J. SHIMP has served as our Senior Vice President, Human Resources,
since June 1999, and prior to that, served as our Chief Marketing Officer
beginning 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.
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., Global Village Communication, Inc., OneWorld Systems, Inc.,
Verisign, 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 Corporation, Quintus
Corporation, GlobeSpan Corporation, SDL, Inc. and Paradyne Corporation, a DSL
equipment manufacturer and supplier to us, and is also a director of several
privately held companies. 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 Corp., 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.
SUSAN MAYER has been a director since March 1999. Ms. Mayer is the President
of the MCI WorldCom Venture Fund and a Senior Vice President of MCI WorldCom
Inc. Previously, she was Senior Vice President of MCI Communications Corporation
from 1994 to 1998. From 1996 to 1997, Ms. Mayer was also President and Chief
Operating Officer of Sky MCI. From 1993 to 1994, Ms. Mayer was Vice President of
MCI Communications Corporation.
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 Juniper Networks and Paradyne
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Corporation, a DSL equipment manufacturer and supplier to us, and of several
privately held companies. 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 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.
EDWARD J. ZANDER has been a director since March 1999. Since 1987, Mr.
Zander has held various management positions at Sun Microsystems, Inc., where he
currently serves as its Chief Operating Officer, a position he has held since
February 1998. Mr. Zander is a director of Documentum, Inc. and one privately
held company.
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.
CLASSIFIED BOARD
The board of directors is divided into three classes. The term of office and
directors consisting of each class is as follows:
<TABLE>
<CAPTION>
CLASS DIRECTORS TERM OF OFFICE
- ----------------- ------------------------ --------------------------------------------------------------------
<S> <C> <C>
Class I.......... Keith B. Geeslin expires at the annual meeting of stockholders in 2000 and at each
Ken L. Harrison third succeeding annual meeting thereafter
Edward J. Zander
Class II......... Susan Mayer expires at the annual meeting of stockholders in 2001 and at each
William R. Stensrud third succeeding annual meeting thereafter
John L. Walecka
Class III........ Catherine M. Hapka expires at the annual meeting of stockholders in 2002 and at each
Kevin R. Compton third succeeding annual meeting thereafter
</TABLE>
The classification of directors has the effect of making it more difficult
to change the composition of the board of directors.
COMMITTEES OF THE BOARD OF DIRECTORS
We have a standing compensation committee currently composed of Messrs.
Harrison, Stensrud and Walecka. 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.
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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 and Chief Executive Officer 1997 163,654 50,000 3,504,905(2) --
365,094(3)
Michael E. Calabrese(4)........................... 1998 42,417 157,623(5) 360,000(2) --
Vice President, Sales Engineering 1997 -- -- -- --
James A. Greenberg(6)............................. 1998 145,000 31,538 48,000(2) 50,000 (7)
Chief Network Officer 1997 63,205 16,615 547,642(2)
Gloria A. Farler(8)............................... 1998 137,500 29,906 24,000(2) --
Vice President, Marketing Support 1997 25,781 7,161 48,000(2)
Eric H. Geis(9)................................... 1998 136,000 29,580 -- --
Vice President of National Deployment 1997 96,519 18,417 132,000(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.
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, which has been superseded by our 1999 Stock
Incentive Plan. We did not grant any stock appreciation rights to the Named
Executive Officers during 1998.
<TABLE>
<CAPTION>
POTENTIAL
REALIZABLE
VALUE AT ASSUMED
INDIVIDUAL GRANTS(1) ANNUAL
-------------------------------------------------------- RATES OF STOCK
NUMBER OF % OF TOTAL APPRECIATION
SECURITIES OPTIONS FOR OPTION
UNDERLYING GRANTED TO EXERCISE 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......................... 360,000 10.7% $0.25 September 9, 2008 $56,601 $143,437
James A. Greenberg........................... 48,000 1.4% 0.25 September 9, 2008 7,547 19,125
Gloria A. Farler(4).......................... 24,000 0.7% 0.25 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.
(2) We granted options to purchase 3,364,680 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.
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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-MONEY
UNEXERCISED OPTIONS AT OPTIONS AT
SHARES DECEMBER 31, 1998 DECEMBER 31, 1998(1)
ACQUIRED ON VALUE --------------------------- ------------------------------
NAME EXERCISE(2) REALIZED(3) EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ----------------------------------- ----------- ----------- ----------- ------------- ------------ ---------------
<S> <C> <C> <C> <C> <C> <C>
Catherine M. Hapka................. 3,869,999(4) $73,019 -- -- -- --
Michael E. Calabrese............... -- -- 360,000 -- $1,440,000 --
James A. Greenberg................. 547,642(5) -- 48,000 -- 192,000 --
Gloria A. Farler(6)................ 43,200(7) -- 24,000 -- 96,000 --
Eric H. Geis....................... 132,000(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.
(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.
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 3,504,905 shares of common stock at an exercise price of
$0.04 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. 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. 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. Stringer's employment agreement provides for a salary of $300,000 per
year, payable in accordance with Rhythms' regular pay period practices, and
subject to periodic increases by the Board of Directors at its discretion. It
also provides for guaranteed bonus compensation during the first year of
employment of $200,000, payable in quarterly installments. For any future years
of performance, Mr. Stringer's bonus will be consistent with the bonus plan
applicable to other members of the Rhythms management team, as approved by the
Board of Directors. In connection with his employment, Mr. Stringer was granted
options to purchase 350,000 shares of common stock at an
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exercise price equal to the common stock's fair market value on the date of the
grant. The options will vest over four years in accordance with the standard
vesting schedule under our 1999 Stock Incentive Plan. Mr. Stringer has yet to
exercise these options. In addition, Mr. Stringer was also granted an option to
purchase 69,040 shares of common stock at an exercise price of $14.48 per share.
This second option will vest over a two-year period in 24 equal monthly
installments beginning on his hire date. Mr. Stringer has yet to exercise these
options. In the event Mr. Stringer's employment is terminated without cause, he
will be eligible to receive monthly payments at his then applicable monthly base
salary for a period of 12 months from the date of termination of his employment.
Mr. Lanier's employment agreement provides for a salary of $250,000 per
year, subject to periodic increases by the Board of Directors at its discretion.
In addition, the agreement provides for an annual bonus of up to 25% of his
annual salary. Mr. Lanier also received, as part of the acceptance of his
employment, a hiring bonus of $50,000. In connection with his employment, Mr.
Lanier was granted options to purchase 300,000 shares of common stock at an
exercise price equal to the fair market price of the common stock on the date of
the grant. Mr. Lanier has yet to exercise these options.
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 1999 Stock Incentive Plan. The compensation committee currently
consists of Messrs. Harrison, Stensrud and Walecka.
BENEFIT PLANS
1999 STOCK INCENTIVE PLAN
Our 1999 Stock Incentive Plan is the successor equity incentive program to
the 1997 Stock Option/ Stock Issuance Plan. The 1999 Stock Incentive Plan was
adopted by the board on March 16, 1999 and became effective in April 1999. All
outstanding options under the 1997 Stock Option/Stock Issuance Plan were at that
time incorporated into the 1999 Stock Incentive Plan, and no further option
grants may be made under the 1997 Stock Option/Stock Issuance Plan. The
incorporated options will continue to be governed by their existing terms,
unless the plan administrator elects to extend one or more features of the 1999
Incentive Plan to those options. Except as otherwise noted below, the
incorporated options have substantially the same terms as grants made under the
Discretionary Option Grant Program of the 1999 Stock Incentive Plan.
As of June 30, 1999, we had reserved 8,161,944 shares of common stock for
issuance under the 1999 Stock Incentive Plan. The number of shares of common
stock reserved for issuance under the 1999 Stock Incentive Plan will
automatically increase on the first trading day in January each calendar
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year, beginning in calendar year 2000, by an amount equal to four percent (4%)
of the total number of shares of common stock outstanding on the last trading
day in December in the preceding calendar year, but in no event will this annual
increase exceed 2,880,000 shares. In addition, no participant in the 1999 Stock
Incentive Plan may be granted stock options, separately exercisable stock
appreciation rights and direct stock issuances for more than 900,000 shares of
common stock in the aggregate per calendar year.
The 1999 Stock Incentive Plan is divided into five separate components:
- the Discretionary Option Grant Program, under which eligible individuals
in our employ or service (including officers, non-employee board members
and consultants) may, at the discretion of the plan administrator, be
granted options to purchase shares of common stock at an exercise price
not less than 100% of the fair market value of those shares on the grant
date;
- the Stock Issuance Program under which eligible individuals may, in the
plan administrator's discretion, be issued shares of common stock
directly, upon the attainment of designated performance milestones or upon
the completion of a specified service requirement or as a bonus for past
services;
- the Salary Investment Option Grant Program, which may, at the plan
administrator's sole discretion, be activated for one or more calendar
years and, if so activated, will allow executive officers and other highly
compensated employees the opportunity to apply a portion of their base
salary each year to the acquisition of special below-market stock option
grants;
- the Automatic Option Grant Program, under which option grants will
automatically be made at periodic intervals to eligible non-employee board
members to purchase shares of common stock at an exercise price equal to
100% of the fair market value of those shares on the grant date; and
- the Director Fee Option Grant Program, which may, in the plan
administrator's sole discretion, be activated for one or more calendar
years and, if so activated, will allow non-employee board members the
opportunity to apply a portion of the annual retainer fee otherwise
payable to them in cash each year to the acquisition of special
below-market option grants.
The Discretionary Option Grant Program and the Stock Issuance Program are
administered by the compensation committee. The compensation committee as plan
administrator has complete discretion to determine which eligible individuals
are to receive option grants or stock issuances under those programs, the time
or times when the grants or issuances are to be made, the number of shares
subject to each grant or issuance, the status of any granted option as either an
incentive stock option or a non-statutory stock option under the Federal tax
laws, the vesting schedule to be in effect for the option grant or stock
issuance and the maximum term for which any granted option is to remain
outstanding. However, the board acting by disinterested majority has the
exclusive authority to make any discretionary option grants or stock issuances
to members of the compensation committee. The compensation committee also has
the exclusive authority to select the executive officers and other highly
compensated employees who may participate in the Salary Investment Option Grant
Program in the event that program is activated for one or more calendar years.
Neither the compensation committee nor the board may exercise any administrative
discretion with respect to option grants under the Salary Investment Option
Grant Program or under the Automatic Option Grant or Director Fee Option Grant
Program for the non-employee board members. All grants under those latter three
programs shall be made in strict compliance with the express provisions of each
program.
The exercise price for the shares of common stock subject to option grants
made under the 1999 Stock Incentive Plan may be paid in cash or in shares of
common stock valued at fair market value on the exercise date. The option may
also be exercised through a same-day sale program without any cash outlay by the
optionee.
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The plan administrator has the authority to effect the cancellation of
outstanding options under the Discretionary Option Grant Program (including
options incorporated from the 1997 Stock Option/ Stock Issuance Plan) in return
for the grant of new options for the same or different number of option shares
with an exercise price per share based upon the fair market value of the common
stock on the new grant date.
Stock appreciation rights are authorized for issuance under the
Discretionary Option Grant Program. These rights provide the holders with the
election to surrender their outstanding options for an appreciation distribution
from us equal to the excess of (i) the fair market value of the vested shares of
common stock subject to the surrendered option over (ii) the aggregate exercise
price payable for those shares. Such appreciation distribution may be made in
cash or in shares of common stock. None of the incorporated options from the
1997 Stock Option/Stock Issuance Plan contain any stock appreciation rights.
In the event that we are acquired by merger or asset sale, each outstanding
option under the Discretionary Option Grant Program which is not to be assumed
by the successor corporation will automatically accelerate in full, and all
unvested shares under the Discretionary Option Grant and Stock Issuance Programs
will immediately vest, except to the extent our repurchase rights with respect
to those shares are to be assigned to the successor corporation. The plan
administrator has complete discretion to grant one or more options under the
Discretionary Option Grant Program which will vest and become exercisable for
all the option shares in the event those options are assumed in the acquisition
and the optionee's service with us or the acquiring entity is terminated within
a designated period (not to exceed eighteen months) following that acquisition.
The vesting of outstanding shares under the Stock Issuance Program may be
accelerated upon similar terms and conditions.
The plan administrator is also authorized to grant options and structure
repurchase rights so that the shares subject to those options or repurchase
rights will immediately vest in connection with a change in ownership or control
(whether by successful tender offer for more than fifty percent of our
outstanding voting stock or by a change in the majority of our board through one
or more contested elections for board membership). Such accelerated vesting may
occur either at the time of such change or upon the subsequent termination of
the individual's service within a designated period (not to exceed eighteen
months) following the change.
The options incorporated from the 1997 Stock Option/Stock Issuance Plan will
immediately vest if we are acquired by merger or asset sale, unless our
repurchase rights with respect to the unvested shares subject to those options
are assigned to the successor entity. In addition, such options will vest and
become exercisable for all the option shares in the event those options are
assumed in the acquisition and the optionee's service with us or the acquiring
entity is terminated within 24 months following that acquisition.
In the event the plan administrator elects to activate the Salary Investment
Option Grant Program for one or more calendar years, each executive officer and
other highly compensated employee selected for participation may elect, prior to
the start of the calendar year, to reduce his or her base salary for that
calendar year by a specified dollar amount not less than $10,000 nor more than
$50,000. Each selected individual who files this timely election will
automatically be granted, on the first trading day
in January of the calendar year for which that salary reduction is to be in
effect, a non-statutory option to purchase that number of shares of common stock
determined by dividing the salary reduction amount by two-thirds of the fair
market value per share of common stock on the grant date. The option will be
exercisable at a price per share equal to one-third of the fair market value of
the option shares on the grant date. As a result, the total spread on the option
shares at the time of grant (the fair market value of the option shares on the
grant date less the aggregate exercise price payable for those shares) will be
equal to the amount of salary invested in that option. The option will vest and
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become exercisable in a series of twelve equal monthly installments over the
calendar year for which the salary reduction is to be in effect.
Under the Automatic Option Grant Program, eligible non-employee board
members will receive a series of option grants over their period of board
service. Each individual who first becomes a non-employee board member at any
time at or after April 6, 1999 will receive an option grant for 28,800 shares of
common stock on the date such individual joins the board, provided such
individual has not been in our prior employ. In addition, on the date of each
annual stockholders meeting held after April 6, 1999, each non-employee board
member who is to continue to serve as a non-employee board member (including the
individuals who are currently serving as non-employee board members) will
automatically be granted an option to purchase 7,200 shares of common stock,
provided such individual has served on the board for at least six months. There
will be no limit on the number of such 7,200 share option grants any one
eligible non-employee Board member may receive over his or her period of
continued board service, and non-employee board members who have previously been
in our employ will be eligible to receive one or more such annual option grants
over their period of board service.
Each automatic grant will have an exercise price per share equal to the fair
market value per share of common stock on the grant date and will have a term of
10 years, subject to earlier termination following the optionee's cessation of
board service. Each automatic option will be immediately exercisable for all of
the option shares; however, any unvested shares purchased under the option will
be subject to repurchase by us, at the exercise price paid per share, should the
optionee cease to serve on the board service prior to vesting in those shares.
The shares subject to each initial 28,800-share automatic option grant will vest
in a series of six successive equal semi-annual installments upon the optionee's
completion of each six-month period of board service over the thirty-six-month
period measured from the grant date. The shares subject to each annual
7,200-share automatic grant will vest in two successive equal semi-annual
installments upon the optionee's completion of each six-month period of board
service measured from the grant date. However, the shares will immediately vest
in full upon certain changes in control or ownership or upon the optionee's
death or disability while a board member. Following the optionee's cessation of
board service for any reason, each option will remain exercisable for a 12-month
period and may be exercised during that time for any or all shares in which the
optionee is vested at the time of such cessation of service.
If the Director Fee Option Grant Program is activated in the future, each
non-employee board member will have the opportunity to apply all or a portion of
any annual retainer fee otherwise payable in cash to the acquisition of a
below-market option grant. The option grant will automatically be made on the
first trading day in January in the year for which the retainer fee would
otherwise be payable in cash. The option will have an exercise price per share
equal to one-third of the fair market value of the option shares on the grant
date, and the number of shares subject to the option will be determined by
dividing the amount of the retainer fee applied to the program by two-thirds of
the fair market value per share of common stock on the grant date. As a result,
the total spread on the option (the fair market value of the option shares on
the grant date less the aggregate exercise price payable for those shares) will
be equal to the portion of the retainer fee invested in that option. The option
will vest and become exercisable for the option shares in a series of twelve
equal monthly installments over the calendar year for which the election is to
be in effect. However, the option will become immediately exercisable and vested
for all the option shares upon (i) certain changes in the ownership or control
or (ii) the death or disability of the optionee while serving as a board member.
The shares subject to each option under the Salary Investment Option Grant,
Automatic Option Grant and Director Fee Option Grant Programs will immediately
vest upon (i) an acquisition of us by merger or asset sale or (ii) the
successful completion of a tender offer for more than 50% of our outstanding
voting stock or a change in the majority of our board effected through one or
more contested elections for board membership.
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Limited stock appreciation rights will automatically be included as part of
each grant made under the Automatic Option Grant, Salary Investment Option Grant
and Director Fee Option Grant Programs and may be granted to one or more
officers as part of their option grants under the Discretionary Option Grant
Program. Options with this limited stock appreciation right may be surrendered
to us upon the successful completion of a hostile tender offer for more than 50%
of our outstanding voting stock. In return for the surrendered option, the
optionee will be entitled to a cash distribution from us in an amount per
surrendered option share equal to the excess of (i) the highest price per share
of common stock paid in connection with the tender offer over (ii) the exercise
price payable for such share.
The board may amend or modify the 1999 Stock Incentive Plan at any time,
subject to any required stockholder approval. The 1999 Stock Incentive Plan will
terminate on the earliest of (i) February 28, 2009, (ii) the date on which all
shares available for issuance under the 1999 Stock Incentive Plan have been
issued as fully vested shares or (iii) the termination of all outstanding
options in connection with certain changes in control or ownership of us.
1999 EMPLOYEE STOCK PURCHASE PLAN
Our 1999 Employee Stock Purchase Plan was adopted by the board on March 16,
1999 and became effective in April 1999. The plan is designed to allow our
eligible employees and those of our participating subsidiaries to purchase
shares of common stock, at semi-annual intervals, through their periodic payroll
deductions under the plan.
One million two hundred thousand shares (1,200,000) of common stock have
been reserved for issuance under the plan. The reserve will automatically
increase on the first trading in January each year, beginning with calendar year
2000, by an amount equal to one percent of the total number of outstanding
shares of our common stock on the last trading day in December in the
immediately preceding calendar year, but in no event will any such annual
increase exceed 780,000 shares.
The plan will be implemented in a series of successive offering periods,
each with a maximum duration of 24 months. However, the initial offering period
began on April 6, 1999 and will end on the last business day in April 2001. The
next offering period will commence on the first business day in May 2001, and
subsequent offering periods will commence as designated by the plan
administrator.
Individuals who are eligible employees (scheduled to work more than 20 hours
per week for more than five calendar months per year) on the start date of any
offering period may enter the plan on that start date or on any subsequent
semi-annual entry date (the first business day of May or November each year).
Individuals who become eligible employees after the start date of the offering
period may join the plan on any subsequent semi-annual entry date within that
offering period.
Payroll deductions may not exceed 15% of the participant's cash earnings,
and the accumulated payroll deductions of each participant will be applied to
the purchase of shares on his or her behalf on each semi-annual purchase date
(the last business day in April and October each year) at a purchase price per
share equal to 85% of the lower of (i) the fair market value of the common stock
on the participant's entry date into the offering period or (ii) the fair market
value on the semi-annual purchase date. In no event, however, may any
participant purchase more than 900 shares on any semi-annual purchase date, nor
may all participants in the aggregate purchase more than 300,000 shares on any
semi-annual purchase date.
If the fair market value per share of our common stock on any purchase date
is less than the fair market value per share on the start date of the two-year
offering period, then that offering period will automatically terminate, and a
new two-year offering period will begin on the next business day, with all
participants in the terminated offering to be automatically transferred to the
new offering period.
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Should we be acquired by merger, sale of substantially all our assets or
sale of securities possessing more than fifty percent of the total combined
voting power of our outstanding securities, then all outstanding purchase rights
will automatically be exercised immediately prior to the effective date of an
acquisition. The purchase price will be equal to 85% of the lower of (i) the
fair market value per share of common stock on the participant's entry date into
the offering period in which an acquisition occurs or (ii) the fair market value
per share of common stock immediately prior to an acquisition. The limitation on
the maximum number of shares purchasable in the aggregate on any one purchase
date will not be in effect for any purchase date attributable to such an
acquisition.
The plan will terminate on the earlier of (i) the last business day of April
2009, (ii) the date on which all shares available for issuance under the plan
shall have been sold pursuant to purchase rights exercised thereunder or (iii)
the date on which all purchase rights are exercised in connection with an
acquisition of us by merger or asset sale.
The board may at any time alter, suspend or discontinue the plan. However,
certain amendments may require stockholder approval.
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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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, which converted into 29,472,000
shares of common stock upon the closing of the initial public offering of our
common stock in April 1999. 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, which converted into
504,000 shares of common stock upon the closing of the initial public offering
of our common stock in April 1999. 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. This investors' rights agreement
and addendum has been superseded by the 1999 Investors' Rights Agreement from
the Qwest investment. Please see "--Investors' Rights Agreement."
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, which converted into 876,226 shares of common
stock upon the closing of the initial public offering of our common stock in
April 1999. 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 (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, which converted into 9,707,863 shares of common
stock upon the closing of the initial public offering of our common stock in
April 1999. 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. This agreement replaced the investors' rights
agreement and addendum from the Series A preferred stock financing and has been
superseded by the 1999 Investors' Rights Agreement from the Qwest investment.
Please see "--Investors' Rights Agreement."
SERIES C PURCHASE AGREEMENT; OTHER AGREEMENTS WITH MCI WORLDCOM
In March 1999, we entered into a Series C Preferred Stock and Warrant
Purchase Agreement with MCI WorldCom's investment fund, pursuant to which the
fund acquired, for an aggregate purchase price of $30.0 million, 3,731,410
shares of Series C preferred stock, which converted into 4,477,692 shares of
common stock upon the closing of the initial public offering of our common stock
in April 1999, and a warrant to purchase an aggregate of 720,000 shares of our
common stock at $6.70 per share. In April 1999, we issued to MCI WorldCom's
investment fund a warrant to purchase an additional 136,996 shares of common
stock at $21.00 per share. In connection with this purchase agreement, we
entered into an Amended and Restated Investors' Rights Agreement, which replaced
the investors' rights agreement from the Series B Preferred Stock financing and
has been superseded by the 1999 Investors' Rights Agreement from the Qwest
investment. Please see "--Investors' Rights Agreement."
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The MCI WorldCom investment was part of a broader strategic arrangement
between us and MCI WorldCom. As part of this strategic arrangement, we also
entered into an agreement with MCI WorldCom which designates us as the first
choice in its alternative access provisioning system for DSL services in certain
circumstances, and which provides that MCI WorldCom is committed to sell at
least 100,000 of our DSL lines over a period of five years, subject to penalties
for failure to reach target commitments. In turn, we have designated MCI
WorldCom as our preferred provider of network services. See "Business--Strategic
Partnerships."
SERIES C PURCHASE AGREEMENT; OTHER AGREEMENTS WITH MICROSOFT
In March 1999, we entered into a Series C Preferred Stock and Warrant
Purchase Agreement with Microsoft, pursuant to which Microsoft acquired, for an
aggregate purchase price of $30.0 million, 3,731,409 shares of Series C
preferred stock, which converted into 4,477,691 shares of common stock upon the
closing of the initial public offering of our common stock in April 1999, and a
warrant to purchase an aggregate of 720,000 shares of our common stock at a
purchase price of $6.70 per share. In connection with this purchase agreement,
we entered into an Amended and Restated Investors' Rights Agreement dated March
16, 1999 which replaced the investors' rights agreement from the MCI WorldCom
investment and has been superseded by the 1999 Investors' Rights Agreement from
the Qwest investment. Please see "--Investors' Rights Agreement."
The Microsoft investment was also part of a broader strategic arrangement.
As part of the Microsoft arrangement, we entered into an agreement in which
Microsoft agreed to jointly distribute with us a co-branded DSL version of the
Microsoft Network service focused on our small business customers. See
"Business--Strategic Partnerships."
SERIES C PURCHASE AGREEMENT AND SERIES D PURCHASE AGREEMENT; OTHER AGREEMENTS
WITH QWEST
In connection with a broader customer relationship between us and Qwest, in
April 1999 we entered into a Series C Preferred Stock and Warrant Purchase
Agreement and a Series D Preferred Stock Purchase Agreement with U.S.
Telesource, Qwest's wholly owned subsidiary. Pursuant to these agreements it
acquired, for an aggregate purchase price of approximately $15 million, 932,836
shares of Series C preferred stock, which converted into 1,119,403 shares of
common stock upon the closing of the initial public offering of our common stock
in April 1999, 441,176 shares of Series D preferred stock, which converted into
441,176 shares of common stock upon the closing of the initial public offering
of our common stock in April 1999, and a warrant to purchase an aggregate of
180,000 shares of our common stock at a purchase price of $6.70 per share. In
connection with these purchase agreements, we entered into an Amended and
Restated Investors' Rights Agreement (the "1999 Investors' Rights Agreement"),
that replaced the investors' rights agreement from the Microsoft investment.
Please see "--Investors Rights Agreement."
The Qwest investment was also part of a broader strategic arrangement
between us and Qwest. As part of the Qwest relationship, Qwest has committed to
purchase from us performance class DSL services for re-sale to its customers. In
return, we have agreed to use Qwest's network and application hosting services
in certain situations.
INVESTORS' RIGHTS AGREEMENT
Pursuant to the terms of the 1999 Investors' Rights Agreement, the former
holders of preferred stock acquired certain registration rights with respect to
our common stock. At any time after October 6, 1999:
- holders of 60% or more of the registrable securities, as defined in the
1999 Investors' Rights Agreement, may require us to register for public
sale no less than 20% of their shares then outstanding; or
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- Enron may require us to register for public sale no less than 20% of our
shares it then holds; or
- MCI WorldCom's investment fund may require us to register for public sale
no less than 20% of our shares it then holds.
In addition, if certain competitors of MCI WorldCom or Qwest acquire greater
than 5% of our common stock, then MCI WorldCom's investment fund or Qwest's
wholly owned subsidiary, as the case may be, may require us to register for
public sale all of its shares of our stock (each, a "Contingent Demand for
Registration").
Our Board of Directors may defer any of the above demands for registration
for a period up to 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,
- one such registration pursuant to the request of Enron,
- one such registration pursuant to the request of MCI WorldCom's investment
fund,
- one Contingent Demand for Registration pursuant to the request of MCI
WorldCom's investment fund, and
- one Contingent Demand for Registration pursuant to the request of Qwest's
subsidiary.
In addition, if we propose to register securities under the Securities Act,
with certain exceptions, then any of the parties to the 1999 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
1999 Investors' Rights Agreement, including Securities Act liabilities. 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 are at least $5.0 million 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
April 12, 2004. We have agreed to indemnify the stockholders against certain
liabilities in connection with any registration effected pursuant to the 1999
Investors' Rights Agreement, including liabilities under the Securities Act.
OFFERING OF NOTES AND WARRANTS
On May 5, 1998, we closed a private placement of units consisting of $290
million aggregate principal amount at maturity of senior discount notes and
warrants to purchase 4,732,800 shares of our common stock. In October 1998, we
exchanged our senior discount notes for a like principal amount of 1998 senior
discount 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 8,278,651 shares of our
common stock, which represent in the aggregate approximately 11.5% of our
outstanding equity.
Of these, Sprout Capital VII, L.P. beneficially owns 7,201,565 shares of our
common stock, which represent in the aggregate approximately 10.0% 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
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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.
Also, Mr. Keith B. Geeslin is currently a member of our Board of Directors.
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, both 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, served until
July 1999 as a director for Xylan Corporation, an indirect vendor to us. For the
period ended December 31, 1997 and for the year ended December 31, 1998, we made
purchases totaling approximately $419,000 and $13.0 million, 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.
Susan Mayer, a member of our Board of Directors, also serves as President of
MCI WorldCom's investment fund and a Senior Vice President of MCI WorldCom, Inc.
In March 1999, we entered into a strategic arrangement with MCI WorldCom, Inc.
As part of this strategic arrangement, MCI WorldCom's investment fund invested
$30.0 million in us. Please see "Business--Strategic Partnerships."
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 438,115 shares of common stock at an exercise price of $0.04 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, which converted into
336,000 shares of common stock upon the closing of the initial public offering
of our common stock in April 1999. For the period ended December 31, 1997 and
for the year ended December 31, 1998, we incurred expenses for legal fees to
Blumenfeld & Cohen of approximately $92,000 and $1.3 million, 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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PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth certain information as of August 11, 1999,
except as otherwise indicated in the footnotes below, with respect to the
beneficial ownership of our common stock by:
- each person known by us to own beneficially more than five percent, in the
aggregate, of the outstanding shares of our common stock,
- our directors and our Named Executive Officers,
- all executive officers and directors as a group, and
- the selling stockholders.
Share ownership in each case includes shares issuable upon exercise of
outstanding options and warrants that are exercisable within 60 days of August
11, 1999 as described in the footnotes below. Percentage ownership is calculated
pursuant to SEC Rule 13d-3(d)(1). Unless otherwise indicated, the address for
each stockholder is c/o Rhythms NetConnections Inc., 6933 South Revere Parkway,
Englewood, Colorado 80112.
<TABLE>
<CAPTION>
SHARES
BENEFICIALLY
OWNED AFTER
SHARES BENEFICIALLY OWNED THE
OFFERING
PRIOR TO THE OFFERING (1) (1)
-------------------------- SHARES TO -----------
BENEFICIAL OWNER (1) NUMBER PERCENTAGE BE SOLD NUMBER
- ----------------------------------------------------------------- ----------- ------------- ---------- -----------
<S> <C> <C> <C> <C>
FIVE PERCENT STOCKHOLDERS:
Brentwood Venture Capital (2).................................. 8,278,651 11.5% -- 8,278,651
Enterprise Partners (3)........................................ 10,440,415 14.5 -- 10,440,415
Kleiner Perkins Caufield & Byers (4)........................... 8,278,651 11.5 -- 8,278,651
MCI WorldCom Venture Fund, Inc. (5)............................ 5,334,688 7.3 -- 5,334,688
The Sprout Group (6)........................................... 8,278,651 11.5 -- 8,278,651
Enron Communications Investments Corp. (7)..................... 5,393,258 7.5 -- 5,393,258
Microsoft Corporation (8)...................................... 5,197,691 7.1 -- 5,197,691
DIRECTORS AND NAMED EXECUTIVE OFFICERS:
Catherine M. Hapka (9)......................................... 4,621,130 6.4 -- 4,621,130
Michael E. Calabrese........................................... 360,000 * -- 360,000
Eric H. Geis................................................... 150,000 * -- 150,000
James A. Greenberg (10)........................................ 715,642 1.0 -- 715,642
Gloria Farler (11)............................................. 30,000 * -- 30,000
Kevin R. Compton (12).......................................... -- -- -- --
Keith B. Geeslin (13).......................................... -- -- -- --
Ken Harrison (14).............................................. -- -- -- --
Susan Mayer (15)............................................... -- -- -- --
William R. Stensrud (16)....................................... -- -- -- --
John L. Walecka (17)........................................... -- -- -- --
Edward J. Zander (18).......................................... 50,000 * -- 50,000
All directors and executive officers as a group
(18 persons) (19)............................................ 8,451,926 11.5 -- 8,451,926
SELLING STOCKHOLDERS:
Fidelity Management & Research Company on behalf of certain
funds and private accounts for which it serves as investment
advisor (20)................................................. 1,240,830 1.7 981,730 259,100
Fidelity Management Trust Company on behalf of certain accounts
for which it serves as investment manager (21)............... 213,116 * 43,816 169,300
The Putnam Advisory Company, Inc. on behalf of certain private
accounts for which it serves as investment advisor (22)...... 50,265 * 50,265 --
Putnam Investment Management, Inc. on behalf of certain funds
for which it serves as investment advisor (23)............... 1,105,594 1.5 1,105,594 --
Putnam Fiduciary Trust Company on behalf of certain private
accounts for which it serves as investment advisor (24)...... 35,576 * 35,576 --
Other selling shareholders (11 persons) as a group, each of
whom owns less than 1% of the outstanding common stock
immediately prior to this offering........................... 1,777,521 2.5 1,744,881 32,640
<CAPTION>
BENEFICIAL OWNER (1) PERCENTAGE
- ----------------------------------------------------------------- -------------
<S> <C>
FIVE PERCENT STOCKHOLDERS:
Brentwood Venture Capital (2).................................. 10.9%
Enterprise Partners (3)........................................ 13.7
Kleiner Perkins Caufield & Byers (4)........................... 10.9
MCI WorldCom Venture Fund, Inc. (5)............................ 6.9
The Sprout Group (6)........................................... 10.9
Enron Communications Investments Corp. (7)..................... 7.1
Microsoft Corporation (8)...................................... 6.8
DIRECTORS AND NAMED EXECUTIVE OFFICERS:
Catherine M. Hapka (9)......................................... 6.1
Michael E. Calabrese........................................... *
Eric H. Geis................................................... *
James A. Greenberg (10)........................................ *
Gloria Farler (11)............................................. *
Kevin R. Compton (12).......................................... --
Keith B. Geeslin (13).......................................... --
Ken Harrison (14).............................................. --
Susan Mayer (15)............................................... --
William R. Stensrud (16)....................................... --
John L. Walecka (17)........................................... --
Edward J. Zander (18).......................................... *
All directors and executive officers as a group
(18 persons) (19)............................................ 11.0
SELLING STOCKHOLDERS:
Fidelity Management & Research Company on behalf of certain
funds and private accounts for which it serves as investment
advisor (20)................................................. *
Fidelity Management Trust Company on behalf of certain accounts
for which it serves as investment manager (21)............... *
The Putnam Advisory Company, Inc. on behalf of certain private
accounts for which it serves as investment advisor (22)...... --
Putnam Investment Management, Inc. on behalf of certain funds
for which it serves as investment advisor (23)............... --
Putnam Fiduciary Trust Company on behalf of certain private
accounts for which it serves as investment advisor (24)...... --
Other selling shareholders (11 persons) as a group, each of
whom owns less than 1% of the outstanding common stock
immediately prior to this offering........................... --
</TABLE>
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- ------------------------------
* 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) Includes 856,996 shares issuable upon exercise of warrants exercisable
within 60 days of August 11, 1999. The address for MCI WorldCom Venture
Fund, Inc. is 1801 Pennsylvania Avenue, Washington, D.C. 20006.
(6) 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
7,201,565 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 Notes and Warrants."
(7) The address for Enron Communications Investments Corp. is 210 Southwest
Morrison Street, Suite 400, Portland, Oregon 97204.
(8) Includes 720,000 shares issuable upon exercise of a warrant exercisable
within 60 days of August 11, 1999. The address for Microsoft Corporation is
One Microsoft Way, Redmond, Washington 98052.
(9) Includes shares held by Ms. Hapka's children, Christopher H. Safaya and
Catherine A. Safaya, in the amount of 5,333 shares each and shares held by
Christopher H. Safaya 1999 Trust and Catherine A. Safaya 1999 Trust in the
amount of 120,000 shares each.
(10) Includes 120,000 shares issuable upon exercise of options exercisable
within 60 days of August 11, 1999.
(11) Ms. Farler resigned in February 1999.
(12) 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.
(13) 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.
(14) 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.
(15) Excludes shares held by MCI WorldCom's investment fund. Ms. Mayer, as
President of MCI WorldCom's investment fund, may be deemed to have voting
and investment power over the shares held by MCI WorldCom's investment
fund. Ms. Mayer disclaims beneficial interest on such shares, except to
the extent of her interest in MCI WorldCom's investment fund.
(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 50,000 shares issuable upon exercise of options exercisable
within 60 days of August 11, 1999.
(19) Includes 989,040 shares issuable upon exercise of options or warrants
exercisable within 60 days of August 11, 1999 and excludes shares held by
the Brentwood Entities, the Enterprise Entities, the KPCB Entities, MCI
WorldCom, the Sprout Entities, Enron and Microsoft.
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(20) Includes the following share amounts that are held and being sold
severally, and not jointly or jointly and severally, by the following
funds or private investment accounts: Variable Insurance Products Fund:
High Income Portfolio (365,374); Fidelity Advisor Series II: Fidelity
Advisor High Yield Fund (234,662); Fidelity Puritan Trust: Fidelity
Puritan Fund (231,112); Fidelity Summer Street Trust: Fidelity Capital &
Income Fund (87,958); Fidelity Global Yield Trust (32,964); Fidelity
Advisor Series I: Fidelity Advisor Balanced Fund (22,806); Fidelity
Advisor Series II: Fidelity Advisor Strategic Income Fund (5,222); and
Variable Insurance Products Fund III: Balanced Portfolio (1,632). The
share amounts that are not being sold in this offering reflect holdings as
of July 26, 1999. Fidelity Management & Research Company (FMR Co.) is a
Massachusetts corporation and an investment advisor registered under
section 203 of the Investment Advisers Act of 1940, as amended, and
provides investment advisory services to each entity identified above, and
to other investment companies and other funds which may hold securities
issued by us. FMR Co. is a wholly-owned subsidiary of FMR Corp. (FMR), a
Massachusetts corporation. The address of FMR Co. is 82 Devonshire Street,
Boston, Massachusetts 02109.
(21) Shares indicated as owned by such entity are owned directly by various
private investment accounts and employee benefit plans, for which Fidelity
Management Trust Company (FMTC) serves as trustee or investment manager.
The share amount not being sold in this offering reflects holdings as of
July 26, 1999. FMTC is a wholly-owned subsidiary of FMR and a bank as
defined in Section 3(a)(6) of the Securities Exchange Act of 1934, as
amended. The address of FMTC is 82 Devonshire Street, Boston,
Massachusetts 02109.
(22) Shares are held and being sold severally, and not jointly or jointly and
severally, by the following funds or private investment accounts: Agway,
Inc. Employees Retirement Trust (2,938); Abbott Laboratories Annuity
Retirement Plan (4,243); Mobil Oil Corporation Retirement Plan Trust
(3,427); Strategic Global Fund--High Yield Fixed Income (Putnam) Fund
(4,733); Ameritech Pension Trust (9,955); Central States, Southeast and
Southwest Areas Pension Fund (21,705) and Southern Farm Bureau Annuity
Insurance Company (3,264). Putnam Advisory Company, Inc. provides
investment advisory services to each entity identified above, and to other
investment companies and to certain other funds which may hold securities
issued by us. The address of The Putnam Advisory Company, Inc. is One Post
Office Square, Boston, Massachusetts 02109.
(23) Shares are held and being sold severally, and not jointly or jointly and
severally, by the following funds or private investment accounts: The
George Putnam Fund of Boston (15,013); Putnam Income Fund (29,048); Putnam
Equity Income Fund (816); Putnam High Yield Trust (301,894); Putnam
Balanced Retirement Fund (2,611); Putnam High Yield Advantage Fund
(330,126); Putnam High Income Convertible and Bond Fund (3,672); Putnam
Variable Trust-Putnam VT High Yield Fund (75,392); Putnam Variable
Trust-Putnam VT Global Asset Allocation Fund (3,264); Putnam Master Income
Trust (14,850); Putnam Premier Income Trust (37,370); Putnam Master
Intermediate Income Trust (22,521); Putnam Diversified Income Trust
(171,183); Putnam Convertible Opportunities and Income Trust (3,427);
Putnam Asset Allocation Funds-Growth Portfolio (4,570); Putnam Asset
Allocation Funds-Balanced Portfolio (11,749); Putnam Asset Allocation
Funds-Conservative Portfolio (3,917); Putnam Funds Trust-Putnam High Yield
Trust II (40,144); Putnam Managed High Yield Trust (7,426); Putnam
Strategic Income Fund (5,712); Putnam Variable Trust-Putnam VT Diversified
Income Fund (19,420) and Lincoln National Global Asset Allocation Fund,
Inc. (1,469). The address of Putnam Investment Management, Inc. is One
Post Office Square, Boston, Massachusetts 02109.
(24) Shares are held and being sold severally, and not jointly or jointly and
severally, by the following funds or private investment accounts: Putnam
High Yield Managed Trust (28,558); Putnam High Yield Fixed Income Fund,
LLC (6,528) and Ameritech Non-Management Umbrella Welfare Benefit Plan
(490). The address of Putnam Fiduciary Trust Company is One Post Office
Square, Boston, Massachusetts 02109.
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DESCRIPTION OF CAPITAL STOCK
The following summary describes the material terms of our capital stock.
However, it does not purport to be complete and is qualified in its entirety by
the actual terms of our capital stock contained in our Restated Certificate of
Incorporation and other agreements referenced below.
We are authorized to issue 250,000,000 shares of common stock, $0.001 par
value per share, 1,000,000 shares of Series 1 Junior Participating preferred
stock, $0.001 par value per share, and 4,000,000 shares of undesignated
preferred stock, $0.001 par value per share.
COMMON STOCK
As of August 11, 1999, there were 72,244,406 shares of common stock
outstanding and held of record by approximately 100 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
We are authorized to issue up to 1,000,000 shares of Series 1 Junior
Participating preferred stock and the Board of Directors has the authority,
without further action by the stockholders, to issue 4,000,000 additional 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. As of June 30, 1999,
there were 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 4,732,800 shares of common stock
with an exercise price of $0.004 per share. After a "net exercise" of these
warrants, an aggregate of 3,961,862 of these shares are being sold by the
selling stockholders in this offering. These warrants became 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 issued to Sun Financial Group Inc., now GATX Capital
Corporation, a warrant to purchase 574,380 shares of common stock with an
exercise price of $1.85 per share. GATX transferred warrants to purchase an
aggregate of 258,472 of these shares to two parties. These transferred warrants
have been exercised. The remaining GATX warrant, exercisable for 315,908 shares
of common stock, is immediately exercisable. In March 1999, we issued to GATX
warrants to purchase an additional 45,498 shares of common stock with an
exercise price of $10.55 per share. These warrants are immediately exercisable
and expire in March 2009.
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In connection with its $30 million equity investment in us in March 1999, we
issued to MCI WorldCom's investment fund a warrant to purchase up to 720,000
shares of common stock at an exercise price of $6.70 per share. This warrant is
immediately exercisable and expires on March 2, 2004. In April 1999, we issued
to MCI WorldCom's investment fund a warrant to purchase an additional 136,996
shares of common stock at an exercise price of $21.00 per share. This warrant is
immediately exercisable and expires on April 4, 2004.
In connection with its $30 million equity investment in us in March 1999, we
issued to Microsoft a warrant to purchase up to 720,000 shares of common stock
at an exercise price of $6.70 per share. This warrant is immediately exercisable
and expires on March 15, 2004.
In connection with its $15 million equity investment in us in April 1999, we
issued to Qwest's wholly-owned subsidiary a warrant to purchase up to 180,000
shares of our common stock at an exercise price of $6.70 per share. This warrant
is immediately exercisable and expires on April 4, 2004.
In April 1999, we issued to Cisco Systems Capital Corporation a warrant to
purchase up to 75,000 shares of common stock at an exercise price of $10.55 per
share. This warrant is immediately exercisable and expires on April 5, 2002.
In July 1999, we issued a warrant to GATX Capital Corporation to purchase up
to 10,000 shares of common stock at an exercise price of $50.00 per share. This
warrant is exercisable immediately and expires on July 30, 2004.
REGISTRATION RIGHTS
Pursuant to the terms of the 1999 Investors' Rights Agreement, the holders
of preferred stock acquired certain registration rights with respect to our
common stock. For a description of these rights, see "Certain Relationships and
Related Transactions--Investors' Rights Agreement." The holders of the warrants
issued in connection with the senior discount notes, GATX and Cisco are entitled
to piggyback registration rights similar to those held by the parties to the
1999 Investors' Rights Agreement.
Furthermore, we are obligated to register, no later than November 8, 1999,
the shares issuable upon exercise of any warrants issued in connection with the
senior discount notes that remain outstanding after this offering, and to keep
such registration statement effective for up to 120 days.
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.
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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 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
Our Board of Directors has adopted a rights plan (the "Rights Agreement")
pursuant to which one right (a "Right") to purchase one one-thousandth of a
share (a "Unit") of a series of preferred stock, par value $0.001 per share (the
"Rights Plan preferred stock") at $115 per Unit was issued as a dividend for
each outstanding share of common stock. 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 Rights become 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.
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<PAGE>
The Rights expire on April 2, 2009, unless earlier redeemed by us in
accordance with the terms of the Rights Agreement. The purchase price payable
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 non-redeemable 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) $115 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 anti-dilution adjustments. The number
of shares constituting the series of Rights Plan preferred stock will be
1,000,000.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for the common stock is American Securities
Transfer & Trust, Inc.
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<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
The market price of our common stock could decline as a result of sales of a
large number of shares of our common stock in the market after this offering, or
the perception that such sales could occur. Such sales also might make it more
difficult for us to sell equity securities in the future at a time and price
that we deem appropriate. After this offering, 76,206,268 shares of common stock
will be outstanding, and 486,595 shares will be held as treasury stock. Of the
76,206,268 outstanding shares, the 3,961,862 shares of common stock sold in this
offering are freely tradable, unless such shares are purchased by "affiliates"
as that term is defined in Rule 144 under the Securities Act. In addition, the
10,781,250 shares of common stock that we sold in our initial public offering
are freely tradeable. The remaining 61,463,156 shares of our common stock (the
"Restricted Shares") were issued and sold by us in reliance on exemptions from
the registration requirements of the Securities Act. These shares may be sold in
the public market only if they are registered or if they qualify for an
exemption from registration, such as Rule 144 or 701 under the Securities Act,
which are summarized below. These remaining shares are eligible for sale in the
public market as follows:
<TABLE>
<CAPTION>
NUMBER OF SHARES DATE
- ----------------- -----------------------------------------------------------------------------------------------
<C> <S>
2,103,942 After the date of this prospectus (subject, in some cases, to volume limitations) (Rule 144)
790,740 At various times after October 4, 1999 (181st day after the date of the prospectus covering our
initial public offering) (subject, in some cases, to volume limitations) (lock-up and Rule
144)
58,568,474 At various times after November 9, 1999 (90 days from the date of this prospectus) (subject, in
some cases, to volume limitations) (lock-up and Rule 144)
</TABLE>
LOCK-UP AGREEMENTS
The following lock-up agreements restrict the ability of our stockholders,
option holders and warrant holders to sell shares of common stock in the public
market.
- All our directors and officers and certain of our stockholders who in the
aggregate beneficially own 59,865,535 of the Restricted Shares, have
agreed that they will not offer, sell, or otherwise dispose of, directly
or indirectly, any shares of common stock without the prior written
consent of Merrill Lynch and Salomon Smith Barney until October 4, 1999,
the 181st day after the date of the prospectus covering our initial public
offering.
- All our directors and officers and certain of our stockholders who in the
aggregate beneficially own 58,568,474 of the Restricted Shares, have
agreed that they will not offer, sell, or otherwise dispose of, directly
or indirectly, any shares of common stock without the prior written
consent of Merrill Lynch and Salomon Smith Barney for a period of 90 days
after the date of this prospectus.
- Holders of warrants that were issued in connection with the 1998 senior
discount notes are subject to an agreement pursuant to which they are
restricted from selling or otherwise disposing of their warrants or the
shares of common stock issuable upon exercise of the warrants until
October 4, 1999.
Merrill Lynch and Salomon Smith Barney may, in their sole discretion and at
any time without notice, release all or any portion of these securities subject
to the lock-up agreements.
STOCK PLANS
As of June 30, 1999, options to purchase a total of 4,505,139 shares of
common stock are outstanding and immediately exercisable, of which 85,758 shares
are currently vested. Shares issued
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upon the exercise of stock options granted under our stock option plans will be
eligible for resale in the public market from time to time subject to vesting
and, in the case of certain options, the expiration of the lock-up agreements
referred to above.
WARRANTS
Warrants to purchase 2,974,031 shares of common stock will be outstanding
after this offering. 1,217,035 of the shares underlying these warrants will be
eligible for sale at various times after October 4, 1999 (the 181st day after
the date of the prospectus covering our initial public offering) and an
additional 1,756,996 of these underlying shares will be eligible for sale at
various times after 90 days from the date of this prospectus. Holders of these
warrants have the right, subject to certain conditions and limitations, to
include their shares in certain registration statements relating to our
securities. By exercising their registration rights and causing a large number
of shares to be registered and sold in the public market, these holders may
cause the price of the common stock to fall. In addition, any demand to include
such shares in our registration statements could have an adverse effect on our
ability to raise needed capital. Please see "Business--Legal Proceedings,"
"Management--Benefit Plans," "Principal and Selling Stockholders," "Description
of Securities--Registration Rights" and "Underwriting."
SUMMARY OF RULE 144
In general, under Rule 144, as currently in effect, an affiliate of Rhythms
or a person (or persons whose shares are required to be aggregated) who has
beneficially owned shares for at least one year is entitled to sell, within any
three-month period, a number of shares that does not exceed the greater of (1)
1% of the then outstanding shares of common stock 762,063 shares immediately
after this offering) or (2) the average weekly trading volume in the common
stock during the four calendar weeks preceding the date on which notice of such
sale is filed, subject to certain restrictions. In addition, a person who is not
deemed to have been our affiliate at any time during the 90 days preceding a
sale, and who has beneficially owned the shares proposed to be sold for at least
two years, would be entitled to sell such shares under Rule 144(k) without
regard to the requirements described above. To the extent that shares were
acquired from one of our affiliates, such person's holding period for the
purpose of effecting a sale under Rule 144 commences on the date of transfer
from the affiliate. 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 affiliates subject only to the manner of sale
provisions of Rule 144 and by our affiliates under Rule 144 without compliance
with its one-year holding period requirement.
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UNDERWRITING
Merrill Lynch, Pierce, Fenner & Smith Incorporated, Salomon Smith Barney
Inc., Hambrecht & Quist LLC and Thomas Weisel Partners LLC are acting as
representatives of the underwriters named below. In a purchase agreement among
us, the selling stockholders and the underwriters, the selling stockholders have
agreed to sell to the underwriters, and each of the underwriters, severally and
not jointly, has agreed to purchase from the selling stockholders, the number of
shares of common stock shown opposite its name below. The obligations of the
underwriters to purchase these shares are subject to the terms and conditions
contained in the purchase agreement.
<TABLE>
<CAPTION>
NUMBER OF
UNDERWRITER SHARES
- ---------------------------------------------------------------- -----------
<S> <C>
Merrill Lynch, Pierce, Fenner & Smith
Incorporated.......................................... 992,901
Salomon Smith Barney Inc........................................ 992,901
Hambrecht & Quist LLC........................................... 425,530
Thomas Weisel Partners LLC...................................... 425,530
Deutsche Bank Securities Inc.................................... 125,000
FAC/Equities.................................................... 125,000
Ferris, Baker Watts, Incorporated............................... 125,000
Gerard Klauer Mattison & Co., Inc............................... 125,000
Janco Partners, Inc............................................. 125,000
Kaufman Bros., L.P.............................................. 125,000
Kirkpatrick, Pettis, Smith, Polian Inc.......................... 125,000
Pacific Crest Securities, Inc................................... 125,000
Brad Peery Inc.................................................. 125,000
-----------
Total................................................. 3,961,862
-----------
-----------
</TABLE>
The representatives have advised us and the selling stockholders that the
underwriters propose to offer the shares of common stock to the public at the
public offering price appearing on the cover page of this prospectus, and to
certain dealers at that price less a concession that will not exceed $.83 per
share of common stock. The underwriters may allow, and those dealers may
reallow, a discount that will not exceed $.10 per share of common stock to
certain other dealers. After the public offering, the public offering price,
concession and discount may change.
We have granted the underwriters an option, exercisable during the 30-day
period after the date of this prospectus, to purchase up to 594,279 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 3,961,862 shares offered hereby. If purchased,
such additional shares will be sold by the underwriters on the same terms on
which the 3,961,862 shares are being sold.
The purchase agreement contains covenants of indemnity among the
underwriters, the selling stockholders 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 public offering price, the
underwriting discounts to be paid to the underwriters and the proceeds before
expenses to the selling stockholders and, if the over-allotment option is
exercised in full, to us. This information is presented assuming either no
exercise or full exercise by the underwriters of the over-allotment option.
<TABLE>
<CAPTION>
PER SHARE WITHOUT OPTION WITH OPTION
--------- -------------- --------------
<S> <C> <C> <C>
Public offering price................................................ $29.00 $114,893,998 $132,128,089
Underwriting discount................................................ $1.38 $5,457,465 $6,276,084
Proceeds to selling stockholders..................................... $27.62 $109,436,533 $109,436,533
Proceeds, before expenses, to Rhythms................................ $27.62 $-- $16,415,472
</TABLE>
The expenses of this offering, exclusive of the underwriting discount, are
estimated at $0.5 million and are payable by us.
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 certain of our directors and stockholders who
beneficially own an aggregate of 58,568,474 shares of our outstanding common
stock have agreed with the representatives, during the period commencing on the
date of this prospectus until November 9, 1999 (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 1999 Stock Incentive 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.
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 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
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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. Merrill Lynch and
Salomon Smith Barney participated as underwriters in our initial public offering
in April 1999, for which they received usual and customary fees. Merrill Lynch
and Salomon Smith Barney acted as initial purchasers of our senior notes in
April 1999, for which they received usual and customary fees.
Thomas Weisel Partners LLC, one of the representatives of the underwriters,
was organized and registered as a broker-dealer in December 1998. Since December
1998, Thomas Weisel Partners LLC has been named as a lead or co-manager on 42
filed public offerings of equity securities, of which 24 have been completed,
and has acted as a syndicate member in an additional 19 public offerings of
equity securities. Thomas Weisel Partners LLC does not have any material
relationship with us or any of our officers, directors or other controlling
persons, except with respect to its contractual relationship with us under the
purchase agreement entered into in connection with this offering.
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 approximately 79,500 shares of common stock.
EXPERTS
The financial statements of the Company as of December 31, 1997 and 1998,
for the period from February 27, 1997 through December 31, 1997 and for the year
ended December 31, 1998, 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, of which
this prospectus is a part, under the Securities Act with respect to the shares
of common stock offered hereby. 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 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.
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GLOSSARY OF TERMS
<TABLE>
<S> <C>
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 carrier facility where subscriber lines are joined
to ILEC switching equipment.
Collocation.................. A location where a competitive carrier network interconnects
with the network of an incumbent carrier inside an incumbent
carrier's central office.
Competitive Carrier.......... Category of telephone service provider, or carrier, that
offers local exchange and other services similar to and in
competition with those of the incumbent carrier, as allowed
by recent changes in telecommunications law and regulation. A
competitive carrier may also provide other types of services
such as long distance telephone, data communications,
Internet access and video.
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 incumbent carrier, competitive carrier 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.
Incumbent 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 incumbent carrier and a competitive
carrier for the connection of a competitive carrier network
to the public switched telephone network, as well as
competitive carrier access to incumbent carrier 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.
</TABLE>
A-2
<PAGE>
<TABLE>
<S> <C>
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.
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,
Asynchronous Transfer Mode, 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
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-8
</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 sheets 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. and subsidiaries at December 31, 1997 and 1998, and
the results of their operations and their cash flows for the period from
February 27, 1997 (inception) through December 31, 1997 and for the year ended
December 31, 1998 in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.
PRICEWATERHOUSECOOPERS LLP
Denver, Colorado
March 4, 1999, except for the last paragraph of Note 11 as to which the date
is March 19, 1999
F-2
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31, JUNE 30, 1999
1997 1998 (UNAUDITED)
------------ ------------- -------------
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents......................................................... $10,166,000 $ 21,315,000 $ 297,183,000
Short-term investments............................................................ -- 115,497,000 218,842,000
Restricted cash................................................................... -- -- 34,963,000
Accounts, loans, interest and other receivables, net.............................. -- 2,376,000 6,541,000
Inventory......................................................................... -- 340,000 1,417,000
Prepaid expenses and other current assets......................................... 95,000 230,000 628,000
------------ ------------- -------------
Total current assets............................................................ 10,261,000 139,758,000 559,574,000
Equipment and furniture, net........................................................ 1,621,000 11,510,000 73,243,000
Collocation fees, net............................................................... 327,000 13,804,000 39,690,000
Restricted cash..................................................................... -- -- 78,248,000
Deferred business acquisition costs, net............................................ -- -- 21,388,000
Deferred debt issue costs, net...................................................... -- 6,304,000 16,514,000
Other assets........................................................................ 32,000 350,000 658,000
------------ ------------- -------------
$12,241,000 $ 171,726,000 $ 789,315,000
------------ ------------- -------------
------------ ------------- -------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt................................................. $ 126,000 $ 333,000 $ 333,000
Accounts payable.................................................................. 951,000 10,601,000 32,866,000
Interest payable.................................................................. -- 39,000 7,866,000
Accrued expenses and other current liabilities.................................... 376,000 2,816,000 8,426,000
------------ ------------- -------------
Total current liabilities....................................................... 1,453,000 13,789,000 49,491,000
Long-term debt...................................................................... 442,000 472,000 278,000
13.5% senior discount notes due 2008, net........................................... -- 157,465,000 168,701,000
12.75% senior notes due 2009........................................................ -- -- 325,000,000
Other liabilities................................................................... -- 180,000 181,000
------------ ------------- -------------
Total liabilities............................................................... 1,895,000 171,906,000 543,651,000
------------ ------------- -------------
Commitments (note 10)
Mandatorily redeemable common stock warrants........................................ -- 6,567,000 6,567,000
------------ ------------- -------------
Stockholders' equity (deficit):
Series A Convertible Preferred Stock, $0.001 par value; 17,000,000 shares
authorized in 1997, 12,900,000 shares in 1998 and no shares 1999; 12,490,000
shares issued and outstanding in 1997, 12,855,094 shares in 1998 and no shares
in 1999......................................................................... 12,000 13,000 --
Series B Convertible Preferred Stock, $0.001 par value; no shares authorized in
1997, 4,044,943 shares in 1998 and no shares 1999; no shares issued and
outstanding in 1997, 4,044,943 shares in 1998 and no shares 1999................ -- 4,000 --
Common Stock, $0.001 par value; 54,635,294 shares authorized in 1997, 80,049,892
shares in 1998 and 250,000,000 shares in 1999; 2,482,222 shares issued in 1997,
8,042,530 shares in 1998 and 72,708,777 shares in 1999.......................... 2,000 8,000 73,000
Treasury Stock, at cost; 438,115 shares in 1998 and 486,595 shares in 1999........ -- (18,000) (20,000)
Additional paid-in capital........................................................ 14,012,000 37,212,000 344,394,000
Warrants.......................................................................... -- -- 10,247,000
Deferred compensation............................................................. (1,258,000) (5,210,000) (10,086,000)
Accumulated deficit............................................................... (2,422,000) (38,756,000) (105,511,000)
------------ ------------- -------------
Total stockholders' equity (deficit)............................................ 10,346,000 (6,747,000) 239,097,000
------------ ------------- -------------
$12,241,000 $ 171,726,000 $ 789,315,000
------------ ------------- -------------
------------ ------------- -------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 27,
1997
(INCEPTION) SIX MONTHS ENDED
THROUGH YEAR ENDED -----------------------------
DECEMBER 31, DECEMBER 31, JUNE 30, 1998 JUNE 30, 1999
1997 1998 (UNAUDITED) (UNAUDITED)
------------- -------------- ------------- --------------
<S> <C> <C> <C> <C>
Revenue:
Service and installation, net.................... $ -- $ 528,000 $ 82,000 $ 2,300,000
------------- -------------- ------------- --------------
Operating Expenses:
Network and service costs........................ -- 4,695,000 665,000 18,170,000
Selling and marketing............................ 33,000 3,776,000 928,000 3,904,000
General and administrative....................... 2,501,000 19,377,000 6,056,000 32,214,000
Depreciation and amortization.................... 1,000 1,081,000 35,000 2,144,000
Amortized deferred business acquisition costs.... -- -- -- 1,652,000
------------- -------------- ------------- --------------
Total operating expenses....................... 2,535,000 28,929,000 7,684,000 58,084,000
------------- -------------- ------------- --------------
Loss from Operations............................... (2,535,000) (28,401,000) (7,602,000) (55,784,000)
------------- -------------- ------------- --------------
Other Income and Expense:
Interest income.................................. 114,000 5,813,000 1,674,000 8,329,000
Interest expense (including amortized debt
discount and issue costs)...................... (1,000) (13,779,000) (3,221,000) (19,372,000)
Other............................................ -- 33,000 -- 72,000
------------- -------------- ------------- --------------
Net Loss........................................... $ (2,422,000) $ (36,334,000) $ (9,149,000) $ (66,755,000)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Net Loss Per Share:
Basic............................................ $ (1.12) $ (12.18) $ (4.02) $ (1.97)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Diluted.......................................... $ (1.12) $ (12.18) $ (4.02) $ (1.97)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Shares Used in Computing Net Loss Per Share:
Basic............................................ 2,161,764 2,984,216 2,277,529 33,820,672
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Diluted.......................................... 2,161,764 2,984,216 2,277,529 33,820,672
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 27,
1997
(INCEPTION) SIX MONTHS ENDED
THROUGH YEAR ENDED -----------------------------
DECEMBER 31, DECEMBER 31, JUNE 30, 1998 JUNE 30, 1999
1997 1998 (UNAUDITED) (UNAUDITED)
------------- ------------- ------------- --------------
<S> <C> <C> <C> <C>
Cash Flows from Operating Activities:
Net Loss......................................................... $(2,422,000) $(36,334,000) $ (9,149,000) $ (66,755,000)
Adjustments to reconcile net loss to net cash used for operating
activities:
Depreciation of equipment and furniture........................ 1,000 454,000 23,000 1,807,000
Amortization of collocation fees............................... -- 85,000 12,000 337,,000
Amortization of deferred business acquisition costs............ -- -- -- 1,652,000
Amortization of debt discount and deferred debt issue costs.... -- 13,882,000 3,188,000 11,515,000
Amortization of deferred compensation.......................... 192,000 725,000 238,000 1,575,000
Compensation expense from stock option issued to employee...... 73,000 -- -- --
Loss (gain) on sale of equipment to leasing company............ -- 387,000 -- (70,000)
Changes in assets and liabilities:
Increase in accounts, loans, interest and other receivables,
net........................................................ -- (2,376,000) (260,000) (4,165,000)
Increase in inventory........................................ -- (340,000) (364,000) (1,077,000)
Increase in prepaid expenses and other current assets........ (95,000) (135,000) (38,000) (398,000)
Increase in other assets..................................... (32,000) (318,000) (15,000) (308,000)
Increase (decrease) in accounts payable...................... 388,000 2,287,000 298,000 (3,521,000)
Increase in interest payable................................. -- 39,000 -- 7,827,000
Increase in accrued expenses and other current liabilities... 335,000 2,479,000 538,000 5,610,000
Increase in other liabilities................................ -- 180,000 -- 71,000
------------- ------------- ------------- --------------
Net cash used for operating activities......................... (1,560,000) (19,024,000) (5,529,000) (45,900,000)
------------- ------------- ------------- --------------
Cash Flows from Investing Activities:
Purchases of short-term investments.............................. -- (451,870,000) -- (168,839,000)
Maturities of short-term investments............................. -- 336,373,000 -- 65,494,000
Purchases of government securities as restricted cash............ -- -- -- (113,211,000)
Purchases of equipment and furniture............................. (1,018,000) (9,973,000) (3,742,000) (61,509,000)
Payments of collocation fees..................................... (327,000) (13,562,000) (2,743,000) (26,223,000)
------------- ------------- ------------- --------------
Net cash used for investing activities......................... (1,345,000) (139,032,000) (6,485,000) (304,288,000)
------------- ------------- ------------- --------------
Cash Flows from Financing Activities:
Proceeds from leasing company for equipment...................... -- 6,606,000 2,000,000 23,755,000
Proceeds from issuance of 13.5% senior discount notes and
warrants....................................................... -- 150,365,000 150,365,000 --
Proceeds from issuance of 12.75% senior notes.................... -- -- -- 325,000,000
Payments of debt issue costs..................................... -- (6,519,000) (6,046,000) (10,489,000)
Proceeds from borrowings on long-term debt....................... 568,000 432,000 432,000 --
Repayments on long-term debt..................................... -- (195,000) (56,000) (194,000)
Proceeds from issuance of common stock........................... 13,000 242,000 229,000 229,476,000
Proceeds from issuance of preferred stock and warrants........... 12,490,000 18,292,000 18,292,000 75,000,000
Payments of equity issue costs................................... -- -- -- (16,490,000)
Purchases of treasury stock...................................... -- (18,000) -- (2,000)
------------- ------------- ------------- --------------
Net cash provided by financing activities...................... 13,071,000 169,205,000 165,216,000 626,056,000
------------- ------------- ------------- --------------
Net increase in cash and cash equivalents.......................... 10,166,000 11,149,000 153,202,000 275,868,000
Cash and cash equivalents at beginning of period................... -- 10,166,000 10,166,000 21,315,000
------------- ------------- ------------- --------------
Cash and cash equivalents at end of period......................... $10,166,000 $21,315,000 $ 163,368,000 $ 297,183,000
------------- ------------- ------------- --------------
------------- ------------- ------------- --------------
Supplemental schedule of cash flow information:
Cash paid for interest........................................... $ 3,000 $ 66,000 $ 25,000 $ 30,000
------------- ------------- ------------- --------------
------------- ------------- ------------- --------------
Supplemental schedule of non-cash financing activities:
Equipment purchases payable, to be financed through operating
leases......................................................... $ 604,000 $ -- $ 2,299,000 $ --
------------- ------------- ------------- --------------
------------- ------------- ------------- --------------
Equipment and furniture purchases payable........................ $ -- $ 7,363,000 $ -- $ 25,786,000
------------- ------------- ------------- --------------
------------- ------------- ------------- --------------
Intangible business acquisition costs arising from issuance of
preferred stock and warrants................................... $ -- $ -- $ -- $ 23,040,000
------------- ------------- ------------- --------------
------------- ------------- ------------- --------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES D
CONVERTIBLE
SERIES A CONVERTIBLE SERIES B CONVERTIBLE SERIES C CONVERTIBLE PREFERRED
STOCK
PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK $0.001 PAR
$0.001 PAR VALUE $0.001 PAR VALUE $0.001 PAR VALUE VALUE
----------------------- ------------------------ ------------------------ ----------
# SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT # SHARES
---------- ----------- ----------- ----------- ----------- ----------- ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Issuance of common stock to
Founders (at inception).......... -- $ -- -- $ -- -- $ -- --
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 ($0.04 per
share exercise price)............ -- -- -- -- -- --
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....... 12,490,000 12,000 -- -- -- -- --
Issuance of Series A preferred
stock for cash ($0.80 per
share)........................... 365,094 1,000 -- -- -- -- --
Issuance of Series B preferred
stock for cash ($4.45 per
share)........................... -- -- 4,044,943 4,000 -- -- --
Issuance of common stock upon
exercise of options ($0.04 to
$0.25 per share exercise
price)........................... -- -- -- -- -- -- --
Purchase of treasury stock for cash
($0.04 per share)................ -- -- -- -- -- -- --
Deferred compensation from grants
of options to purchase common
stock............................ -- -- -- -- -- -- --
Amortization of deferred
compensation..................... -- -- -- -- -- -- --
Reversal of deferred compensation
from cancellation of grants to
purchase common stock............ -- -- -- -- -- -- --
Net loss for 1998.................. -- -- -- -- -- -- --
---------- ----------- ----------- ----------- ----------- ----------- ----------
Balance at December 31, 1998....... 12,855,094 13,000 4,044,943 4,000 -- -- --
<CAPTION>
COMMON STOCK TREASURY STOCK
$0.001 PAR VALUE AT COST ADDITIONAL
------------------------ ---------------------- PAID-IN
AMOUNT # SHARES AMOUNT # SHARES AMOUNT CAPITAL WARRANTS
----------- ----------- ----------- ----------- --------- ------------ ----------
<S> <C> <C> <C>
Issuance of common stock to
Founders (at inception).......... $ -- 2,161,764 $ 2,000 -- $ -- $ -- $ --
Issuance of Series A preferred
stock for cash ($1.00 per
share)........................... -- -- -- -- -- 12,477,000 --
Issuance of common stock upon
exercise of options ($0.04 per
share exercise price)............ 320,458 -- -- -- 12,000 --
----
Grant of options to purchase Series
A preferred stock ($0.80 per
share exercise price)............ -- -- -- -- 73,000 --
----
Deferred compensation from grants
of options to purchase common
stock............................ -- -- -- -- -- 1,450,000 --
Amortization of deferred
compensation..................... -- -- -- -- -- -- --
Net loss for 1997.................. -- -- -- -- -- -- --
----------- ----------- ----------- ----------- --------- ------------ ----------
Balance at December 31, 1997....... -- 2,482,222 2,000 -- -- 14,012,000 --
Issuance of Series A preferred
stock for cash ($0.80 per
share)........................... -- -- -- -- -- 291,000 --
Issuance of Series B preferred
stock for cash ($4.45 per
share)........................... -- -- -- -- -- 17,996,000 --
Issuance of common stock upon
exercise of options ($0.04 to
$0.25 per share exercise
price)........................... -- 5,560,308 6,000 -- -- 236,000 --
Purchase of treasury stock for cash
($0.04 per share)................ -- -- -- 438,115 (18,000) -- --
Deferred compensation from grants
of options to purchase common
stock............................ -- -- -- -- -- 4,908,000 --
Amortization of deferred
compensation..................... -- -- -- -- -- -- --
Reversal of deferred compensation
from cancellation of grants to
purchase common stock............ -- -- -- -- -- (231,000) --
Net loss for 1998.................. -- -- -- -- -- -- --
----------- ----------- ----------- ----------- --------- ------------ ----------
Balance at December 31, 1998....... -- 8,042,530 8,000 438,115 (18,000) 37,212,000 --
<CAPTION>
TOTAL
STOCKHOLDERS'
DEFERRED ACCUMULATED EQUITY
COMPENSATION DEFICIT (DEFICIT)
------------- ------------ -------------
Issuance of common stock to
Founders (at inception).......... $ -- $ -- $ 2,000
Issuance of Series A preferred
stock for cash ($1.00 per
share)........................... -- -- 12,489,000
Issuance of common stock upon
exercise of options ($0.04 per
share exercise price)............ -- -- 12,000
Grant of options to purchase Series
A preferred stock ($0.80 per
share exercise price)............ -- -- 73,000
Deferred compensation from grants
of options to purchase common
stock............................ (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....... (1,258,000) (2,422,000) 10,346,000
Issuance of Series A preferred
stock for cash ($0.80 per
share)........................... -- -- 292,000
Issuance of Series B preferred
stock for cash ($4.45 per
share)........................... -- -- 18,000,000
Issuance of common stock upon
exercise of options ($0.04 to
$0.25 per share exercise
price)........................... -- -- 242,000
Purchase of treasury stock for cash
($0.04 per share)................ -- -- (18,000)
Deferred compensation from grants
of options to purchase common
stock............................ (4,908,000) -- --
Amortization of deferred
compensation..................... 725,000 -- 725,000
Reversal of deferred compensation
from cancellation of grants to
purchase common stock............ 231,000 -- --
Net loss for 1998.................. -- (36,334,000) (36,334,000)
------------- ------------ -------------
Balance at December 31, 1998....... (5,210,000) (38,756,000) (6,747,000)
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES A CONVERTIBLE SERIES B CONVERTIBLE SERIES C CONVERTIBLE SERIES D CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK PREFERRED STOCK
$0.001 PAR VALUE $0.001 PAR VALUE $0.001 PAR VALUE $0.001 PAR VALUE
----------------------- ---------------------- ---------------------- ----------------------
# SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT
---------- ----------- --------- ----------- --------- ----------- --------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Issuance of common stock in initial
public offering in April 1999
(unaudited)...................... -- -- -- -- -- -- -- --
Issuance of common stock upon
exercise of options for cash
($0.04 to $6.37 per share)
(unaudited)...................... -- -- -- -- -- -- -- --
Issuance of common stock upon
cashless exercise of warrants
($0.004 per share) in May and
June 1999 (unaudited)............ -- -- -- -- -- -- -- --
Issuance of Series C preferred
stock and warrants for cash
($8.04 per share) in March and
April 1999 (unaudited)........... -- -- -- -- 8,395,655 8,000 -- --
Issuance of Series D preferred
stock and warrants for cash
($17.00 per share) in April 1999
(unaudited)...................... -- -- -- -- -- -- 441,176 --
Business relationship value arising
from issuance of Series C and
Series D preferred stock in March
and April 1999 (unaudited) -- -- -- -- -- -- -- --
Conversion of preferred stock to
common upon initial public
offering in April 1999
(unaudited) (12,855,094) (13,000) (4,044,943) (4,000) (8,395,655) (8,000) (441,176) --
Costs arising from issuances of
Series C and Series D preferred
stock in March and April 1999
(unaudited)...................... -- -- -- -- -- -- -- --
Costs arising from initial public
offering in April 1999
(unaudited)...................... -- -- -- -- -- -- -- --
Purchase of treasury stock for cash
($0.04 to $0.25 per share)
(unaudited)...................... -- -- -- -- -- -- -- --
Issuance of warrants to leasing
companies in March and April 1999
(unaudited)...................... -- -- -- -- -- -- -- --
Issuance of warrants to business
partner in April 1999
(unaudited)...................... -- -- -- -- -- -- -- --
Deferred compensation from grants
of options to purchase common
stock (unaudited)................ -- -- -- -- -- -- -- --
Amortization of deferred
compensation (unaudited)......... -- -- -- -- -- -- -- --
Reversal of deferred compensation
from cancellation of grants to
purchase common stock
(unaudited)...................... -- -- -- -- -- -- -- --
Net loss through June 30, 1999
(unaudited)...................... -- -- -- -- -- -- -- --
---------- ----------- --------- ----------- --------- ----------- --------- -----------
Balance at June 30, 1999
(unaudited)...................... -- $ -- -- $ -- -- $ -- -- $ --
---------- ----------- --------- ----------- --------- ----------- --------- -----------
---------- ----------- --------- ----------- --------- ----------- --------- -----------
<CAPTION>
COMMON STOCK TREASURY STOCK
$0.001 PAR VALUE AT COST ADDITIONAL
---------------------- ---------------------- PAID-IN DEFERRED
# SHARES AMOUNT # SHARES AMOUNT CAPITAL WARRANTS COMPENSATION
--------- ----------- ----------- --------- ----------- ---------- -------------
<S> <C> <C>
Issuance of common stock in initial
public offering in April 1999
(unaudited)...................... 10,781,250 11,000 -- -- 226,395,000 -- --
Issuance of common stock upon
exercise of options for cash
($0.04 to $6.37 per share)
(unaudited)...................... 2,556,834 3,000 -- -- 3,067,000 -- --
Issuance of common stock upon
cashless exercise of warrants
($0.004 per share) in May and
June 1999 (unaudited)............ 252,112 -- -- -- -- -- --
Issuance of Series C preferred
stock and warrants for cash
($8.04 per share) in March and
April 1999 (unaudited)........... -- -- -- -- 60,368,000 7,124,000 --
Issuance of Series D preferred
stock and warrants for cash
($17.00 per share) in April 1999
(unaudited)...................... -- -- -- -- 6,317,000 1,183,000 --
Business relationship value arising
from issuance of Series C and
Series D preferred stock in March
and April 1999 (unaudited) -- -- -- -- 21,100,000 -- --
Conversion of preferred stock to
common upon initial public
offering in April 1999
(unaudited) 51,076,051 51,000 -- -- (26,000) -- --
Costs arising from issuances of
Series C and Series D preferred
stock in March and April 1999
(unaudited)...................... -- -- -- -- (234,000) -- --
Costs arising from initial public
offering in April 1999
(unaudited)...................... -- -- -- -- (16,256,000) -- --
Purchase of treasury stock for cash
($0.04 to $0.25 per share)
(unaudited)...................... -- -- 48,480 (2,000) -- -- --
Issuance of warrants to leasing
companies in March and April 1999
(unaudited)...................... -- -- -- -- -- 1,030,000 --
Issuance of warrants to business
partner in April 1999
(unaudited)...................... -- -- -- -- -- 910,000 --
Deferred compensation from grants
of options to purchase common
stock (unaudited)................ -- -- -- -- 7,009,000 -- (7,009,000)
Amortization of deferred
compensation (unaudited)......... -- -- -- -- -- -- 1,575,000
Reversal of deferred compensation
from cancellation of grants to
purchase common stock
(unaudited)...................... -- -- -- -- (558,000) -- 558,000
Net loss through June 30, 1999
(unaudited)...................... -- -- -- -- -- -- --
--------- ----------- ----------- --------- ----------- ---------- -------------
Balance at June 30, 1999
(unaudited)...................... 72,708,777 $ 73,000 486,595 $ (20,000) $344,394,000 $10,247,000 $(10,086,000)
--------- ----------- ----------- --------- ----------- ---------- -------------
--------- ----------- ----------- --------- ----------- ---------- -------------
<CAPTION>
TOTAL
STOCKHOLDERS'
ACCUMULATED EQUITY
DEFICIT (DEFICIT)
------------- ------------
Issuance of common stock in initial
public offering in April 1999
(unaudited)...................... -- 226,406,000
Issuance of common stock upon
exercise of options for cash
($0.04 to $6.37 per share)
(unaudited)...................... -- 3,070,000
Issuance of common stock upon
cashless exercise of warrants
($0.004 per share) in May and
June 1999 (unaudited)............ -- --
Issuance of Series C preferred
stock and warrants for cash
($8.04 per share) in March and
April 1999 (unaudited)........... -- 67,500,000
Issuance of Series D preferred
stock and warrants for cash
($17.00 per share) in April 1999
(unaudited)...................... -- 7,500,000
Business relationship value arising
from issuance of Series C and
Series D preferred stock in March
and April 1999 (unaudited) -- 21,100,000
Conversion of preferred stock to
common upon initial public
offering in April 1999
(unaudited) -- --
Costs arising from issuances of
Series C and Series D preferred
stock in March and April 1999
(unaudited)...................... -- (234,000)
Costs arising from initial public
offering in April 1999
(unaudited)...................... -- (16,256,000)
Purchase of treasury stock for cash
($0.04 to $0.25 per share)
(unaudited)...................... -- (2,000)
Issuance of warrants to leasing
companies in March and April 1999
(unaudited)...................... -- 1,030,000
Issuance of warrants to business
partner in April 1999
(unaudited)...................... -- 910,000
Deferred compensation from grants
of options to purchase common
stock (unaudited)................ -- --
Amortization of deferred
compensation (unaudited)......... -- 1,575,000
Reversal of deferred compensation
from cancellation of grants to
purchase common stock
(unaudited)...................... -- --
Net loss through June 30, 1999
(unaudited)...................... (66,755,000) (66,755,000)
------------- ------------
Balance at June 30, 1999
(unaudited)...................... $(105,511,000) $239,097,000
------------- ------------
------------- ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-7
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--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 use
currently available funds and seek additional sources of financing. If
unsuccessful in obtaining additional financing, the Company will continue
expansion of its operations on a reduced scale based on its existing capital
resources.
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 Rhythms Links Inc. (formerly 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.
INTERIM RESULTS (UNAUDITED): The interim consolidated financial statements
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 operating results for the interim period are not
necessarily indicative of the results to be expected for a full fiscal year or
for any future periods. All information subsequent to March 4, 1999 is
unaudited.
REVENUE RECOGNITION: Revenue is recorded in the period services are
provided to customers.
F-8
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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. Management
determines the appropriate classification of marketable debt and equity
securities at the time of purchase and reevaluates such designation as of each
balance sheet date.
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 at
the lower of cost or market.
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 or the lease term if shorter. When equipment and furniture
is retired, sold or otherwise disposed of, the cost and related accumulated
depreciation are removed from the accounts and gains and losses resulting from
such transactions are reflected in operations.
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 their
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.
Two customers comprise 14.9 percent and 7.5 percent of the Company's net
trade receivable balance at December 31, 1998 and 36.7 percent and 13.7 percent
of revenues for the year ended December 31, 1998.
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
F-9
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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.
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 and Series B preferred stock, upon the exercise of outstanding
stock options and warrants and shares issued subject to repurchase by the
Company totaling 36,653,940 and 52,958,513 at December 31, 1997 and 1998, and
20,915,262 and 15,931,733 at June 30, 1998 and 1999, respectively, have been
excluded from the computation since their effect would be antidilutive.
STOCK-BASED COMPENSATION: The Company measures compensation expense for
their 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 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 their consolidated
financial statements.
RECLASSIFICATIONS: Certain 1997 balances have been reclassified to conform
to the 1998 presentation.
NOTE 3--SHORT-TERM INVESTMENTS
The Company's marketable debt securities are classified as held-to-maturity
and carried at amortized cost, which approximates fair value. Short-term
investments consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1997 1998
--------------- ---------------
<S> <C> <C>
Commercial Paper........................................... $ -- $ 33,170,000
U.S. Government Securities................................. -- 82,327,000
--------------- ---------------
$ -- $ 115,497,000
--------------- ---------------
--------------- ---------------
</TABLE>
F-10
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4--COMPOSITION OF CERTAIN BALANCE SHEET COMPONENTS
<TABLE>
<CAPTION>
DECEMBER 31, DECEMBER 31,
1997 1998
--------------- ---------------
<S> <C> <C>
Accounts, loans and other receivables, net:
Interest................................................. $ -- $ 2,135,000
Trade, net of allowance for doubtful accounts of $50,000
in 1998................................................ -- 197,000
Employee expense advances and loans...................... -- 44,000
--------------- ---------------
$ -- $ 2,376,000
--------------- ---------------
--------------- ---------------
Equipment and furniture, net:
Operating equipment...................................... $ 1,241,000 $ 9,633,000
Office furniture......................................... 43,000 917,000
Leasehold improvements................................... 32,000 668,000
Computer software........................................ 173,000 456,000
Computer equipment....................................... 133,000 274,000
Lab equipment............................................ -- 17,000
Accumulated depreciation................................. (1,000) (455,000)
--------------- ---------------
$ 1,621,000 $ 11,510,000
--------------- ---------------
--------------- ---------------
Accrued expenses and other current liabilities:
Accrued payroll.......................................... $ 217,000 $ 1,524,000
Carrier services and other operating costs............... -- 991,000
Other.................................................... 159,000 340,000
--------------- ---------------
$ 376,000 $ 2,855,000
--------------- ---------------
--------------- ---------------
</TABLE>
NOTE 5--DEBT
As of December 31, 1997 and 1998, the Company had a note payable of $568,000
and $805,000, respectively, to a financial institution. Terms of the note
payable include an interest rate of prime plus 0.25 percent (8.75 percent and
8.0 percent at December 31, 1997 and 1998, respectively) payable monthly on the
outstanding principal. The note is collateralized by assets of the Company and
is to be amortized over a 36-month repayment period. The $805,000 will be repaid
during the years 1999 through 2001 in the amounts of $333,000 each in 1999 and
2000 and $139,000 in 2001.
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 4,732,800 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 $6,519,000 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. In addition, the Company has the option to repurchase the notes upon
payment of a premium of accreted value at that point in time. The notes contain
covenants that restrict the Company's ability to make certain payments,
including dividend payments, and incur additional debt.
F-11
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 5--DEBT (CONTINUED)
The warrants issued in connection with the senior discount notes are
exercisable at a price of $0.004 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.
Effective November 20, 1998, the Company completed an exchange offer of the
13.5 percent senior discount notes that allowed for registration of such notes
under the Securities Act of 1933, as amended. $289,000,000 of the original issue
notes were tendered for exchange. The registered notes 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 applied to
the unregistered notes.
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 574,380 warrants to purchase common
stock at a price of $1.85 per share, exercisable immediately.
NOTE 6--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 54,635,294
shares of common stock, as adjusted for the November 1998 and March 1999 stock
splits, both with a $0.001 par value per share.
Effective March 6, 1998, the Company amended its Certificate of
Incorporation to increase the number of authorized common shares to 54,983,160,
as adjusted for the November 1998 and March 1999 stock splits, 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.
Effective April 28, 1998, the Company amended its Certificate of
Incorporation to increase the number of authorized common shares to 59,715,960,
as adjusted for the November 1998 and March 1999 stock splits.
Effective November 4, 1998, the Company completed a two-for-one split of its
common stock. The accompanying consolidated financial statements have been
restated for all periods presented to reflect the stock split.
The Company's Series A and Series B preferred stock may be converted, at the
option of the holder, into the Company's common stock on a 2.4 to 1 basis,
subject to antidilution protection on a broad-based weighted-average basis. The
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 and the holders of the Series B preferred
stock are entitled to receive non-cumulative dividends of $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 A and
F-12
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 6--STOCKHOLDERS' EQUITY (CONTINUED)
Series B preferred stock will be entitled, in preference to the holders of
common stock, to an amount equal to $1.00 per share and $4.45 per share,
respectively, plus all declared and unpaid dividends. The preferred shares
entitle holders to two votes per share, on an "as-converted" basis.
NOTE 7--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 11,673,530 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.
Plan activity is as follows:
<TABLE>
<CAPTION>
NUMBER OF WEIGHTED AVERAGE WEIGHTED AVERAGE
SHARES FAIR VALUE EXERCISE PRICE
------------- ----------------- -----------------
<S> <C> <C> <C>
Granted..................................................... 5,801,714 $ 0.29 $ 0.04
Exercised................................................... (320,458) $ 0.29 $ 0.04
-------------
Outstanding at December 31, 1997.......................... 5,481,256 $ 0.29 $ 0.04
Granted..................................................... 3,364,680 $ 2.62 $ 0.84
Exercised................................................... (5,560,308) $ 0.30 $ 0.04
Canceled.................................................... (136,348) $ 1.10 $ 0.22
-------------
Outstanding at December 31, 1998.......................... 3,149,280 $ 2.73 $ 0.89
-------------
-------------
</TABLE>
The following summarizes the outstanding and exercisable options under the
Plan at December 31, 1998:
<TABLE>
<CAPTION>
WEIGHTED
AVERAGE WEIGHTED WEIGHTED
NUMBER REMAINING AVERAGE NUMBER AVERAGE
OUTSTANDING LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
----------- ------------- --------------- --------- ---------------
EXERCISE PRICE
- -----------------
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
<S> <C> <C> <C> <C> <C>
------------------------------ --------------------------
$0.04 177,480 9.03 years $ 0.04 177,480 $ 0.04
$0.21 to $0.25 1,591,680 9.42 years $ 0.23 1,591,680 $ 0.23
$1.67 to $1.88 1,380,120 9.83 years $ 1.75 1,380,120 $ 1.75
</TABLE>
During 1997 and 1998, all options were granted to employees at less than
fair value on the date of grant, resulting in $1,450,000 and $4,908,000,
respectively, of deferred compensation recorded as a reduction of stockholders'
equity. These amounts are being amortized as a charge to general and
administrative expenses over the vesting periods of the applicable options; such
amortization totaled $192,000 and $725,000 for the periods ended December 31,
1997 and 1998, respectively.
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.
F-13
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7--STOCK OPTIONS (CONTINUED)
Had compensation expense for the Company's 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
periods ended December 31, 1997 and 1998 would have been increased by $11,000
and $60,000 and $0.01 and $0.02 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 periods
ended December 31, 1997 and 1998, respectively: no dividend yield, risk free
interest rates of 5.3 percent and 4.9 percent, respectively, expected volatility
of nil, and expected term of four years for common options and six months for
the preferred option.
NOTE 8--INCOME TAXES
As of December 31, 1998, the Company had net operating loss carryforwards of
approximately $37,000,000, which are available to offset future taxable income
through 2018 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. The valuation allowance increased
by $13,905,000 during 1998, primarily as a result of the additional losses in
1998.
Components of deferred income taxes are as follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1997 DECEMBER 31, 1998
----------------- -----------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards..................... $ 908,000 $ 14,724,000
Accrued vacation and other........................... 89,000 178,000
----------------- -----------------
Gross deferred tax asset............................... 997,000 14,902,000
Valuation allowance.................................... (997,000) (14,902,000)
----------------- -----------------
Net deferred income taxes.............................. $ -- $ --
----------------- -----------------
----------------- -----------------
</TABLE>
The provision for (benefit from) income taxes reconciles to the statutory
federal tax rate as follows:
<TABLE>
<CAPTION>
DECEMBER 31, 1997 DECEMBER 31, 1998
----------------- -----------------
<S> <C> <C>
Statutory federal tax rate............................. (34.0)% (34.0)%
State income tax, net of federal benefit............... (5.4) (5.4)
Other.................................................. (1.8) 0.9
Deferred tax asset valuation allowance................. 41.2 38.5
------- -------
-- % -- %
------- -------
------- -------
</TABLE>
NOTE 9--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 1998, the Company incurred legal fees
and expenses of approximately $92,000 and
F-14
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9--RELATED PARTY TRANSACTIONS (CONTINUED)
$1,269,000, respectively, to the external firm, in addition to the salary paid
to the in-house counsel. At December 31, 1998, the Company had a balance payable
of $372,000 to this entity.
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 1998 from the equipment supplier were approximately $419,000 and
$13,005,000, respectively. At December 31, 1998, the Company had a balance
payable of $2,451,000 to this entity.
NOTE 10--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 and 1998 totaled $46,000 and
$2,044,000, respectively. Future minimum rental payments under the leases are
$11,169,000 in 1999, $11,251,000 in 2000, $9,667,000 in 2001, $1,710,000 in
2002, and $1,190,000 in 2003.
NOTE 11--SUBSEQUENT EVENTS
Effective March 2, 1999, the Company amended its Certificate of
Incorporation to increase the number of authorized common shares to 84,527,584,
as adjusted for the November 1998 and March 1999 stock splits, and to authorize
3,731,410 shares of Series C Preferred Stock.
Effective March 4, 1999, the Company issued 3,731,410 shares of its Series C
preferred stock to MCI WorldCom's investment fund at a price of $8.04 per share
for total proceeds to the Company of $30,000,000. In connection with this
investment, MCI WorldCom also received warrants to purchase up to 720,000 shares
of common stock at a price of $6.70 per share. The terms of the transaction also
provide for the Company and MCI WorldCom to enter into various business
relationships, including MCI WorldCom's commitment to sell 100,000 of the
Company's DSL lines over a period of five years, subject to penalties for
failure to reach target commitments.
During January and February 1999, the Company granted options to purchase
1,615,686 shares of common stock pursuant to the Plan. The grant of these
options will result in additional deferred compensation in 1999 and compensation
expense in 1999 and future years as the options vest.
On March 19, 1999, the Company completed a six for five split of its common
stock. The accompanying consolidated financial statements have been restated for
all periods presented to reflect the stock split.
NOTE 12--SUBSEQUENT EVENTS (UNAUDITED)
Effective March 15, 1999, the Company amended its Certificate of
Incorporation to increase the number of authorized Common shares to 74,171,062
and to authorize an additional 3,731,409 shares of Series C Preferred Stock.
On March 16, 1999, the Company issued Series C Preferred Stock and Warrants
to Microsoft Corporation for $30,000,000. A total of 3,731,409 shares of Series
C Preferred Stock and Warrants to purchase 720,000 shares of Common Stock at a
price of $6.70 per share were issued in this transaction. Of the proceeds
received, the Company allocated $26,544,000 to the Preferred Stock and
$3,456,000 to the Warrants. The terms of the transaction also provide for the
Company and Microsoft to enter into
F-15
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
various business relationships. In connection with these business relationships,
the Company capitalized $10,000,000 in business acquisition costs that will be
amortized to operating expense over a three-year period beginning March 1999.
On March 16, 1999 the Company's Board of Directors approved the 1999 Stock
Incentive Plan and the 1999 Employee Stock Purchase Plan, each plan subject to
shareholder approval. The 1999 Stock Incentive Plan serves as the successor
equity incentive program to the 1997 Stock Option/Stock Issuance Plan and became
effective April 6, 1999. An initial reserve of 8,161,944 shares of Common Stock
has been authorized for issuance under the 1999 Stock Incentive Plan. The 1999
Employee Stock Purchase Plan has an initial reserve of 1,200,000 shares of
Common Stock and became effective April 6, 1999.
On March 31, 1999, the Company entered into a 36-month lease line that
provides for $24,000,000 in equipment on an operating lease basis. In connection
with this lease agreement, the Company issued 45,498 Warrants to purchase Common
Stock at a price of $10.55 per share, exercisable immediately. The value of
these Warrants, estimated to be $250,000, is being amortized over the life of
the lease.
On April 5, 1999, the Company entered into a 36-month lease line that
provides for $20,000,000 in equipment on an operating lease basis. In connection
with this lease agreement, the Company issued 75,000 warrants to purchase Common
Stock at a price of $10.55 per share, exercisable immediately.
Effective April 5, 1999, the Company restated its Certificate of
Incorporation to increase the number of authorized Common shares to 81,000,000,
to authorize an additional 932,836 shares of Series C Preferred Stock, to
authorize 441,176 shares of Series D Preferred Stock, and to designate 1,000,000
shares as Series 1 Junior Participating Preferred Stock.
On April 6, 1999, the Company issued 932,836 shares of its Series C
Preferred Stock at a price of $8.04 per share and 441,176 shares of its Series D
Preferred Stock at a price of $17.00 per share to a wholly owned subsidiary of
Qwest Communications Corporation for total proceeds of $15,000,000. In
connection with this investment, Qwest also received warrants to purchase
180,000 shares of Common Stock at a price of $6.70 per share and MCI WorldCom
received an additional warrant to purchase 136,996 shares of Common Stock at a
price of $21.00 per share. In accordance with provisions of the agreement
underlying this investment, the Company and Qwest have entered into certain
business relationships. Although a value has not been finalized for this
business relationship, the Company estimates that approximately $10,500,000 will
be capitalized with respect to the relationship and that the amount capitalized
will be amortized to operating expense over a five-year period.
Effective April 12, the Company restated its Certificate of Incorporation to
increase the number of authorized Common shares to 250,000,000 and to decrease
the number of authorized Preferred Shares to 5,000,000.
Effective April 12, 1999, the Company completed an initial public offering
of its Common Stock. A total of 10,781,250 shares were issued at $21.00 per
share; net proceeds to the Company were approximately $211,407,000, after
payment of underwriting fees but before payment of related issue expenses. Upon
completion of the offering, all classes of Preferred Stock automatically
converted to Common Stock, resulting in an additional 51,076,051 shares of
Common Stock being issued and a resulting zero shares of Preferred Stock being
issued and outstanding.
F-16
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
On April 23, 1999, the Company issued 12.75 percent Senior Notes due 2009 in
the principal amount of $325,000,000, due at maturity. Cash proceeds from the
issuance, after payment of underwriting fees but before payment of related issue
expenses, were $315,250,000. Of these proceeds, approximately $113,211,000 was
used to purchase a portfolio of U.S. government securities and will be used for
the first three years' interest payments.
On July 14, 1999, the Company filed a registration statement on Form S-1
with the Securities and Exchange Commission for up to 4,732,800 shares of common
stock to be offered for sale by certain of the Company's stockholders. On July
29, 1999, the Company filed an amendment to this registration statement and
reduced the amount of shares to be sold to 3,919,087. An underwriters'
over-allotment of 15 percent of the shares sold will also be registered with
this offering.
On July 30, 1999, the Company entered into a 36-month lease line that
provides for $26,000,000 in equipment on an operating lease basis. In connection
with this lease agreement, the Company issued 10,000 warrants to purchase common
stock at a price of $50.00 per share, exercisable immediately.
F-17
<PAGE>
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3,961,862 SHARES
[LOGO]
RHYTHMS NETCONNECTIONS INC.
COMMON STOCK
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P R O S P E C T U S
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MERRILL LYNCH & CO.
SALOMON SMITH BARNEY
HAMBRECHT & QUIST
THOMAS WEISEL PARTNERS LLC
AUGUST 11, 1999
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