<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
- --- ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1998
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
- --- EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
FOR THE TRANSITION PERIOD FROM __________________ TO __________________
COMMISSION FILE NUMBER 333-59393
RHYTHMS NETCONNECTIONS INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0747515
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6933 SOUTH REVERE PARKWAY 80112
ENGLEWOOD, COLORADO
(Address of principal executive office) (Zip Code)
Registrant's telephone number, including area code: (303) 476-4200
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K, or any
amendment to this Form 10-K. X
---
Aggregate market value of the voting stock held by non-affiliates of the
registrant, computed using $16.00 for the Company's common stock on
March 26, 1999: $23,522,816.*
Indicate the number of shares outstanding of the registrant's common stock as of
the latest practicable date:
Outstanding at
Class March 26, 1999
----- --------------
Common Stock, $.001 par value 9,643,660
DOCUMENTS INCORPORATED BY REFERENCE
Certain Exhibits filed with the Registrant's Registration Statement on Form
S-1 (No. 333-72409), as amended, and Registrant's Registration Statement on Form
S-4 (No. 333-59393), as amended, are incorporated herein by reference into Part
IV of this Report.
- -------------------------------------
* Excludes 8,173,484 shares of Common Stock held by executive officers,
directors and stockholders whose ownership exceeds 5% of the Common Stock
outstanding at March 26, 1999. Exclusion of such shares should not be
construed to indicate that any such person possesses the power, direct or
indirect, to direct or cause the direction of the management or policies of
the Registrant or that such person is controlled by or under common control
with the Registrant.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
PART I
ITEM 1: BUSINESS
THE DISCUSSION OF OUR BUSINESS CONTAINED IN THIS ANNUAL REPORT ON FORM 10-K MAY
CONTAIN CERTAIN PROJECTIONS, ESTIMATES AND OTHER FORWARD-LOOKING STATEMENTS THAT
INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES, INCLUDING THOSE DISCUSSED BELOW AT
"RISKS AND UNCERTAINTIES." WHILE THIS OUTLOOK REPRESENTS OUR MANAGEMENT'S
CURRENT JUDGMENT ON THE FUTURE DIRECTION OF THE BUSINESS, SUCH RISKS AND
UNCERTAINTIES COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM ANY FUTURE
PERFORMANCE SUGGESTED BELOW. WE UNDERTAKE NO OBLIGATION TO RELEASE PUBLICLY THE
RESULTS OF ANY REVISIONS TO THESE FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS
OR CIRCUMSTANCES ARISING AFTER THE DATE HEREOF.
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 San Diego in April 1998, and have subsequently begun service in nine
additional markets: San Francisco, San Jose, Oakland/East Bay, Chicago, Los
Angeles, Orange County, Boston, Sacramento and New York. We intend to continue
our network rollout into an additional 23 markets in 1999 and a further 17
markets by the end of 2000. Upon completion of this network expansion, we
anticipate providing services in 50 of the nation's largest metropolitan areas,
which we believe contain 60% of the nation's local area networks. We have signed
interconnection agreements with Ameritech, Bell Atlantic, Bell South, GTE,
Pacific Bell and U S WEST, and we are currently pursuing interconnection
arrangements with two other incumbent carriers. As of January 31, 1999, we
provide service or have installed equipment in nearly 200 incumbent carrier
central offices. We have obtained competitive carrier authority or have been
permitted to operate as a competitive carrier in 21 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 MCI WorldCom's preferred provider of business
DSL lines 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. 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.
We also market our services through our direct sales force and through our
partnerships with recognized leaders in the networking industry, including
Microsoft, Cisco and a contemplated arrangement with Verio. Under our strategic
partnership with Cisco, Cisco agreed to jointly market and sell our networking
solutions to its customer base and will engage in joint development projects
with us. As of January 31, 1999, we had over 650 lines in service, and we are
currently under contract to supply over 9,000 additional DSL lines to our
business and service provider customers, including Cisco, Silicon Graphics,
Inc., QUALCOMM Incorporated, Wind River Systems and Broadcom Corporation.
Our senior management team has extensive experience in developing
next-generation networking businesses. Our President and Chief Executive
Officer, Catherine Hapka, was previously the founder, President and Chief
Operating Officer of !NTERPRISE Networking Services, U S WEST's data networking
business. Scott Chandler, our Chief Financial Officer, was previously President
and Chief Executive Officer of C-COR Electronics, Inc., a manufacturer of
broadband telecommunications equipment. James Greenberg, our Chief Network
Officer, directed
2
<PAGE>
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, Kleiner Perkins Caufield & Byers,
Enterprise Partners, Brentwood Venture Capital, the Sprout Group and a
subsidiary of Enron Corp., have to date invested approximately $90.3 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.
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.
3
<PAGE>
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.
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 creates 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
4
<PAGE>
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.
- PRODUCTIVITY ENHANCING FEATURES AND APPLICATIONS. We offer a growing
suite of network-enabled features and applications that extend the
functionality of corporate communications and networking resources to
remote offices and workers. We also offer remote offices and workers, as
well as small and medium businesses high performance Internet access
solutions in conjunction with our service provider customers.
- SERVICE FLEXIBILITY. We have designed our network so that we are able,
over a single DSL connection, to individually configure each network
user's features and applications.
- TURNKEY SOLUTION. We offer turnkey network solutions for our customers by
providing each customer with a single point of contact for a complete
package of services, including network implementation, maintenance,
billing and the DSL modem. For large customers, we provide complete
project management, including design, implementation and results
reporting. In some cases, we also seamlessly link our network operations
systems to existing customer information systems to ensure maximum
service efficiency.
BUSINESS STRATEGY
Our goal is to become the leading national service provider of high
performance networking solutions for remote offices and workers. We intend to
implement the following strategies to achieve our goal:
EXPLOIT EARLY MOVER ADVANTAGE
We intend to exploit our early market entrance to deploy our network and
establish strong relationships with business and service provider customers. As
of January 31, 1999, we provide service or had installed our network equipment
in nearly 200 central offices. Installation on this scale requires significant
time and resources; therefore, we believe our progress to date provides us a
significant time-to-market advantage over would-be competitors. We have gained
significant build-out experience, which we believe will streamline our further
expansion. We plan to construct our network rapidly so that we are an early
mover in our other target markets. We intend to exploit our early mover
advantage to gain significant market share in our target markets.
FOCUS ON PERFORMANCE-DRIVEN BUSINESS CUSTOMERS
We believe that the underserved segment of the business networking market
that demands high performance is currently relying on dial-up modems or
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.
5
<PAGE>
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 example, as part of our strategic
agreement with MCI WorldCom, we have agreed to jointly develop voice and data
applications over a single DSL connection. In addition, we believe that the
proliferation of high-speed local access networks, such as our own, will
encourage third parties to create more bandwidth-intensive features and
applications. One of our objectives in providing these enhanced features and
applications is to strengthen customer loyalty and increase revenue per network
user.
ESTABLISH STRONG DISTRIBUTION CHANNELS
We intend to build strong distribution channels. For large businesses, we
are building a direct sales force and are entering into strategic joint
marketing alliances. We have entered into a strategic alliance with Microsoft in
which 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. We have also entered into a strategic alliance with MCI
WorldCom in which we have been designated its preferred provider of business DSL
connections for large, medium and small businesses. In addition, we entered into
a strategic alliance with Cisco, in which we will jointly market and sell our
networking solutions to large businesses. For small and medium businesses, we
will distribute our services through our service provider customers. Over time,
we will seek to develop additional strategic alliances, focusing on partners
that can both add value to our network and give us a meaningful distribution
channel.
PROVIDE SUPERIOR CUSTOMER SERVICE
As part of our strategy to obtain and retain business and service provider
customers, we intend to provide superior service and customer care. We will
guarantee high-quality service by providing carrier-class networking solutions
and superior customer service. Our carrier-class networking solutions include
end-to-end proactive network monitoring and management through our Network
Operations Center, 24 hours a day, seven days a week. We also offer multiple
security features and a network that we can scale to meet demand. Our customer
service includes a personal and Web-based single point of contact, a complete
packaged solution including the DSL modem, installation, activation and network
management, and specific customer service objectives against which we measure
our performance. Our 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, we entered into a strategic partnership with MCI WorldCom,
pursuant to which, among other things:
- MCI WORLDCOM INVESTMENT. MCI WorldCom's investment fund invested $30
million in us, in return for 3,731,410 shares of our Series C preferred
stock, which are convertible into 4,477,692 shares of common stock, and a
warrant to purchase 720,000 shares of our common stock at $6.70 per
share. As the majority holder of Series C preferred stock, the fund has
the right to elect one of our directors.
- PROVIDING DSL TO MCI WORLDCOM. We have been designated MCI WorldCom's
preferred provider of business DSL access services in areas where we
deploy our network, except for services to certain subsidiaries and in
locations where MCI WorldCom deploys its own DSL equipment. We have a
right of first refusal to match offers made to MCI WorldCom by other
providers of DSL services.
- 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 least 29 metropolitan statistical areas. As part of our
agreement, we must provide specified service levels and have available
capacity.
6
<PAGE>
- 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.
- COLLABORATION. We will jointly develop voice and data applications over a
single DSL connection. We will also form a working group with MCI
WorldCom to develop and implement the systems and procedures necessary to
jointly deploy DSL service nationwide. We will 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,
pursuant to which, among other things:
- MICROSOFT INVESTMENT. Microsoft invested $30 million in us, in return for
3,731,409 shares of our Series C preferred stock, which are convertible
into 4,477,691 shares of common stock, and a warrant to purchase 720,000
shares of our common stock at $6.70 per share.
- CO-BRANDING FOR SMALL BUSINESSES AND TELEWORKERS. 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.
CISCO SYSTEMS
In October 1998, we entered into a strategic partnership with Cisco, in
which Cisco agreed to work jointly with us to sell our services to its customers
including providing compensation to its sales representatives for selling our
services. In addition, Cisco has committed to a joint marketing program with us
to increase our market recognition among businesses. We are also under contract
with Cisco to manage and upgrade its remote access program for 8,500 teleworkers
nationwide.
OTHER PARTNERS
In October 1998, we entered into a letter of intent contemplating a joint
marketing agreement with Verio to jointly fund an advertising and market
awareness program in the Chicago metropolitan area. In the future we intend to
pursue additional joint marketing relationships to strengthen our distribution
capabilities and enable us to penetrate our target markets more rapidly.
RHYTHMS NETWORK SERVICES, FEATURES AND APPLICATIONS
We offer our customers solutions that address many of their high
performance networking needs. Our local connection services use a variety of DSL
technologies to deliver high-speed, "always on" local access. We also aggregate
traffic within metropolitan areas and route or switch the traffic to our service
provider customers, or to a corporate local area network within the same
metropolitan area or another metropolitan area using our inter-network
connections. In addition to local connections and metropolitan and wide area
inter-network connections, we offer a growing suite of network-enabled features
and applications.
LOCAL CONNECTIONS
Our local connection services connect individual users or multiple users on
a local area network to our metropolitan or national network or to the Internet
using DSL technology over traditional telephone lines. Using DSL technology over
copper lines, our network is capable of data transfer rates ranging from 128
Kbps to 7.1 Mbps. Unlike dial-up modems and 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.
7
<PAGE>
For our local connection services, the speed and effectiveness of the DSL
connection will vary based on a number of factors, including the distance of the
end user from the central office and the condition of the copper line that
connects the end user to the central office. However, the specific number of
potential users for higher speeds will vary by central office and by region and
will be affected by line quality. In the future, we intend to examine adding a
variety of high-speed local access technologies as they are developed, including
emerging wireless technologies. The chart below compares the performance and
range for our local connection services as of February 1999:
<TABLE>
<CAPTION>
SPEED TO SPEED FROM RANGE(1)
END USER END USER (FEET) TECHNOLOGY(2)
---------------- ---------------- ----------------- ---------------
<S> <C> <C> <C>
144 Kbps 144 Kbps Unlimited IDSL(3)
256 Kbps 256 Kbps 18,000 SDSL
384 Kbps 384 Kbps 15,000 RADSL
512 Kbps 512 Kbps 14,000 RADSL
768 Kbps 768 Kbps 12,000 RADSL
1 Mbps 1 Mbps 12,000 RADSL
1.5 Mbps 1.5 Mbps 8,000 SDSL
3 Mbps 1 Mbps 10,700 RADSL
5 Mbps 1 Mbps 9,000 RADSL
7.1 Mbps 1 Mbps 7,800 RADSL
</TABLE>
- -----------------------
(1) Estimated maximum distance from the central office to the end user.
(2) The technologies are described more fully in "--DSL Technologies" below.
(3) Speeds are 128 Kbps under certain circumstances.
METROPOLITAN AREA AND WIDE AREA INTER-NETWORK CONNECTIONS
For our business and service provider customers, we offer high-speed
connections both within and among metropolitan areas. In order to switch and
route traffic aggregated from each central office to its ultimate local or long
distance destination, we offer two interconnection services.
Our 1.544 Mbps service--DS-1--is suitable for small business customers
or service providers. Our 45 Mbps service--DS-3--is intended for large
business customers or service providers. The monthly service charge for both
services is greater if traffic aggregated in one metropolitan area is terminated
in another metropolitan area, and varies based on the speed of the local access
connection.
Our wide area network currently operates between each of the metropolitan
areas in which we provide service, and is currently a frame relay network which
we lease from a long distance carrier. In the future, we expect to add
Asynchronous Transfer Mode capability.
NETWORK-ENABLED SERVICES, FEATURES AND APPLICATIONS
We intend to use our high-speed local access connection to provide multiple
network services, features and applications. Instead of just providing a
high-speed access connection, we intend to offer many network-enabled features
and applications, which we are able to configure to meet each user's needs. We
believe our strategy to provide additional network services, features and
applications for each user on our network allows us to address a larger market
opportunity than the market opportunity represented by connection services
alone. Our strategy is to benefit from additional recurring monthly revenue by
providing multiple network features and applications.
The features and applications that we currently offer are outlined below.
- CORPORATE TELEPHONE SYSTEM EXTENSION. This feature extends the
functionality of the corporate telephone system directly into a
teleworker's home or, in the future, a company's branch office. This
feature supports common corporate telephone functions such as four digit
dialing, conference calling and speed dialing. Benefits to our business
customers include increased worker productivity, reduced second line
expenses for voice service and the ability to aggregate and control long
distance charges.
- COMPUTER BACKUP. The computer backup feature allows end users to
automatically backup data to a secure remote site. Computer backup
leverages our "always on," high-speed local access connection and allows
the backup to be done at the times most convenient for the end user. We
believe this feature is more cost effective
8
<PAGE>
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.
- TURNKEY INTERNET. This application allows small and medium businesses or
large business branch offices the ability to host Internet and intranet
Web sites. This application includes network equipment on the customer
premises that provides router, Web server, e-mail, file server, firewall
and Web-page caching. This premises-based Internet solution is combined
with our "always on" high-speed network connection and Internet services
from an Internet Service Provider customer.
In the future, we plan to continue to expand our network features and
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. 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 premise equipment that supports Web server, e-mail, file server,
firewall, Web-page caching and network backup.
TURNKEY SOLUTION
We offer a full service solution for the configuration, provisioning, and
installation of the local access connection at the end user location, for which
the customer pays a one-time charge. That charge covers the cost of installing
the DSL line, any required inside wiring, the DSL modem, attaching the DSL modem
to either a single computer, local area network or enterprise server,
installation of a single network interface card if required, and installing the
TCP/IP software if required. For our large business customers, we provide
complete project management, including design, implementation and results
reporting. In some cases we seamlessly link our network operations systems to
existing customer information systems through Web-based interfaces.
9
<PAGE>
CUSTOMERS, SALES AND MARKETING
We offer our services to large, medium and small businesses. As of January
31, 1999, we served more than 75 business and 20 service provider customers. For
these business and service provider customers we have over 650 lines in service
and are under contract to supply over 9,000 additional DSL lines. Selected
business customers include Cisco, Silicon Graphics and QUALCOMM. In addition,
our service provider customers include CTSNet, ConnectNet, Verio, Epoch
Networks, Inc. and Ingram Micro.
DIRECT SALES CHANNELS
We market our services to large businesses through a direct sales force.
Our target account profile is a large, information-intensive enterprise with
multiple locations and large numbers of distributed workers. Our sales force
seeks to deal directly with the Chief Information Officer and the
telecommunications manager responsible for remote access in the target account.
Sales teams are deployed in each of the metropolitan areas in which we offer our
services. As of January 31, 1999, we had 40 sales and technical personnel
supporting our direct sales efforts. We intend to increase the size of our sales
and technical support force to sell and support large businesses as we enter new
geographic markets.
Our relationship with large business customers can involve multiple phases.
A customer typically initially agrees to a first phase commitment for a specific
number of connections at a negotiated price and one year contract term.
Typically, three to six months into the first phase implementation, the customer
agrees to successive phases of implementation that could include additional
connections and upgrades in services, features and applications. In general, we
have experienced a six to nine month sales cycle prior to receiving significant
order volume from a business customer. We currently have two large business
customers that have committed to multi-phase implementation programs: Cisco and
Silicon Graphics. Collectively, these two customers account for over 90% of our
commitments to purchase our connections. Please see "Risks and Uncertainties--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 "Risks and Uncertainties--We depend on third parties, particularly
Microsoft, MCI WorldCom and Cisco, for the marketing and sales of our network
services."
CUSTOMER SERVICE
We offer our business and service provider customers a single point of
contact for implementation, maintenance and billing. Our Network Operations
Center provides both proactive and customer initiated maintenance services 24
hours a day, seven days a week. We also provide a broad range of customer
service and Network Operations Center services through our Web interface.
10
<PAGE>
- IMPLEMENTATION. Working with a business or service provider customer, our
customer service technicians and sales engineers will develop an
implementation plan for each customer. The plan will include qualifying
the customer for our service offerings, placing orders for the connection
facilities, coordinating the delivery of the connection, installation and
turn up.
- MAINTENANCE. Our Network Operations Center in Denver provides network
surveillance through standard Simple Network Management Protocol tools
for all equipment in our network. Because we have complete end-to-end
visibility of our network, we are able to proactively detect and correct
the majority of our customer's maintenance problems remotely. Our goal is
to proactively detect and repair 90% of our customer's maintenance
problems before our customer is aware of a problem. Customer initiated
maintenance and repair requests are managed and resolved primarily
through the Customer Service Center. We utilize a trouble ticket
management system to communicate customer maintenance problems from the
customer service center to the Network Operations Center engineers and
the field services engineers. Because our Network Operations Center is
fully staffed 24 hours a day, seven days a week, we believe our ability
to provide superior proactive maintenance is significantly enhanced.
- BILLING. Customer bills are currently issued on a monthly basis through
an internal billing system. Customer billing inquiries are managed by our
Customer Service Center. In the future, billing inquiries will also be
supported through our Web interface.
- CUSTOMER SUPPORT SYSTEMS. Our system architecture is designed to
facilitate rapid service responsiveness and reduce the cost of customer
support. We use an integrated set of standard, off-the-shelf systems to
support our business processes. We designed all business functions,
including sales, ordering, provisioning, maintenance and repair, billing,
accounting and decision support to use a single database, ensuring that
every function has accurate, up-to-date information. The use of
client-server tools and scalable Unix and Microsoft NT servers enables
automation within and between processes.
NETWORK ARCHITECTURE
NETWORK TECHNOLOGY
The key design features allowing us to be a business-class network are:
- CARRIER-CLASS NETWORK MANAGEMENT. Our network is designed to be
carrier-class throughout. For example, it has been designed with
redundant network electronics and transmission paths. We have the ability
to electronically view our entire network including the DSL modem located
at the end user's computer or located on our customer's local area
network from our Network Operations Center in Denver. We provide our
business and service provider customers with service level agreements
that guarantee specific levels of network performance. We have found that
by offering service level agreements, we are better able to convince
businesses to move their mission-critical applications onto our network.
- SCALABLE SYSTEMS. We use industry standard, off-the-shelf software to
support preordering, ordering, provisioning, billing, network monitoring
and trouble management. We have implemented these systems using a
distributed client-server systems architecture that operates using a
single, integrated database. This approach allows us to grow our customer
support and network management capabilities as customer demand increases
by giving our personnel faster, more accurate access to a fully
integrated business information system.
- NETWORK SECURITY. Non-dedicated access, such as dial-up modem or
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.
11
<PAGE>
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 January 31, 1999, we had Connection Points in nearly
200 central offices. Although we expect that many Connection Points will
be physically located within the central office, we have placed and will
continue to place our Connection Points in locations immediately adjacent
to central offices, when collocation space within the central office is
not available.
- HIGH-SPEED METROPOLITAN AREA NETWORK. In each of our targeted
metropolitan area markets, we operate a private metropolitan area
network. The network consists of high-speed Asynchronous Transfer Mode
communications circuits that we lease from 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 availability including battery backup power, redundant equipment and
active network monitoring.
- BACKBONE. Our backbone interconnects our Metro Service Centers so that
communications traffic can be transported among different metropolitan
areas. Currently, we lease a frame relay backbone from a long distance
carrier. We anticipate leasing a substantial portion of this capacity
from MCI WorldCom, as described in "--Strategic Partnerships." In the
future, we expect to add Asynchronous Transfer Mode capability.
- NETWORK OPERATIONS CENTER. Our entire network is managed from the Network
Operations Center located in Denver. From these centers, we provide
end-to-end network monitoring and management using advanced
12
<PAGE>
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 "Risks and Uncertainties--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 "Risks and Uncertainties--We may be unable to effectively expand our
network services and provide high performance to a substantial number of end
users."
DSL TECHNOLOGIES
We utilize various DSL equipment and technologies from different vendors.
The various DSL technologies allow us to offer a range of connection speeds.
Actual speeds are a function of the distance from the end user or local area
network to the central office and the quality of the copper line. We describe
the basic features and the market positioning of our primary DSL technologies
below.
RATE ADAPTIVE DIGITAL SUBSCRIBER LINE (RADSL)
RADSL technology allows each end user or local area network to utilize the
full digital capability of the underlying telephone line. Speeds reach up to 7.1
Mbps downstream and up to 1.1 Mbps upstream if the end user or local area
network is within 15,000 feet, or approximately 2.8 miles, from the central
office. We use this technology for end users or local area networks needing very
high access speeds. Our target customers for RADSL connections consist of small
and medium businesses and branch offices of large businesses needing T-1 or
higher speeds. We believe that these businesses often find the cost of dedicated
private line or frame relay services to be prohibitive. Our RADSL connection
competes favorably on a price/performance basis relative to traditional
fractional T-1 and frame relay services. The service also provides the highest
speed of any DSL service for bandwidth intensive applications.
SYMMETRIC DIGITAL SUBSCRIBER LINE (SDSL)
Our SDSL technology allows end users and local area network to achieve up
to 1.5 Mbps speeds both downstream and upstream. Depending on the quality of the
copper line, 1.5 Mbps can typically be achieved if the end user or local area
network is within 8,000 feet, or approximately 1.5 miles, from the central
office.
INTEGRATED DIGITAL SUBSCRIBER LINE (IDSL)
IDSL technology allows us to reach all end users or local area networks
within a central office serving area irrespective of the end user or local area
network distance from the central office. Our IDSL service operates at up to 144
Kbps in each direction. This service can use existing integrated 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. We believe that incumbent carriers have the potential to
quickly overcome many of the issues that
13
<PAGE>
have delayed widespread deployment of DSL services in the past. If a
Regional Bell Operating Company is authorized to provide in-region long
distance service in one or more states, by fulfilling the market-opening
provisions of the 1996 Telecommunications Act, the Regional Bell
Operating Company may be able to offer "one stop shopping" that would be
competitive with our offerings. The 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. We expect them to offer
combined data, voice and video services over these networks.
These carriers have deployed large scale networks, have large numbers of
existing business and residential customers and enjoy strong brand
recognition, and as a result represent significant competition. For
instance, they have extensive fiber networks in many metropolitan areas
that primarily provide high-speed data and voice communications to large
companies. They could deploy DSL services in combination with their
current fiber networks. They also have interconnection agreements with
many of the 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 Communications International and Level 3 Communications,
are building and managing high bandwidth, packet-based networks
nationwide. They are also building direct sales forces and partnering
with Internet Service Providers to offer services directly to business
customers. They could extend their existing networks to include fiber
metropolitan area networks and high-speed, off-net services using DSL,
either alone, or in partnership with others.
- CABLE MODEM SERVICE PROVIDERS. Cable modem service providers, like @Home
Networks and its cable partners, are offering or preparing to offer
high-speed Internet access over hybrid fiber coaxial cable networks to
consumers. @Work has positioned itself to do the same for businesses.
Where deployed, these networks provide local access services similar to
our services, and in some cases at higher speeds. They typically offer
these services at lower prices than our services, in part by sharing the
bandwidth available on their cable networks among multiple end users.
- 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, including HarvardNet,
Inc. in Massachusetts, 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.
14
<PAGE>
- COMPETITIVE CARRIERS. Certain competitive carriers, including Covad
Communications Group, Inc. and NorthPoint Communications, Inc., have
begun offering DSL-based data services. Other competitive carriers are
likely to do so in the future. 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 "Risks and Uncertainties--The market
in which we operate is highly competitive, and we may not be able to compete
effectively, especially against established industry competitors with
significantly greater financial resources." Some of the competitive factors we
face include:
- transmission speed,
- reliability of service,
- breadth of service availability,
- price performance,
- network security,
- ease of access and use,
- content bundling,
- customer support,
- brand recognition,
- operating experience,
- ability to scale,
- capital availability and
- exclusive contracts.
INTERCONNECTION AGREEMENTS WITH 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 special conditioning the incumbent carrier provides on certain of
these lines to enable the transmission of 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 23 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
15
<PAGE>
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, ACI Corp. and ACI Corp.--Virginia, may be subject
to regulation at the federal, state and/or local levels. Future federal or state
regulations and legislation may be less favorable to us than current regulation
and legislation and therefore have a material and adverse impact on our business
and financial prospects. In addition, we may expend significant financial and
managerial resources to participate in proceedings setting rules at either the
federal or state level, without achieving a favorable result.
FEDERAL LEGISLATION AND REGULATION
The 1996 Telecommunications Act, enacted on February 8, 1996, substantially
departs from prior legislation in the telecommunications industry by
establishing local exchange competition as a national policy. This act removes
state regulatory barriers to competition and preempts laws restricting
competition in the local exchange market.
The 1996 Telecommunications Act in some sections is self-executing, but in
addition, the 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
Telecommunications 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 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
16
<PAGE>
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. These decisions are
currently subject to reconsideration and appeal. The final outcome of these
decisions, originally scheduled to be announced on January 28, 1999, has been
postponed by the Federal Communications Commission while it considers the impact
of the Supreme Court's ruling on the 1996 Telecommunications Act. The final
outcome of these petitions or other proceedings interpreting the requirements of
the 1996 Telecommunications Act may adversely affect our business.
STATE REGULATION
Some of our services, particularly those of our subsidiaries, ACI Corp. and
ACI Corp.--Virginia, may be classified as intrastate services subject to state
regulation. All of the states where we operate, or will operate, require some
degree of state regulatory commission approval to provide certain intrastate
services. In most states, intrastate tariffs are also required for various
intrastate services, although we are not typically subject to price or rate of
return regulation for tariffed intrastate services. Actions by state public
utility commissions could cause us to incur substantial legal and administrative
expenses.
Under the 1996 Telecommunications Act, if we so request, 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, Bell South,
GTE, Pacific Bell and U S WEST. We have signed agreements with Ameritech for
Illinois and Michigan and currently are negotiating interconnection agreements
for Ohio and Wisconsin. We have signed agreements with Bell Atlantic for the
District of Columbia, Maryland, Massachusetts, New Jersey, New York,
Pennsylvania and Virginia. We have signed agreements with Bell South for
Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, North Carolina, South
Carolina and Tennessee. We have signed an agreement with GTE for California and
are currently completing agreements for Florida, Minnesota, North Carolina,
Oregon, Texas, Virginia and Washington. We have signed an agreement with Pacific
Bell for California. We have signed agreements with U S WEST for Arizona,
Colorado, Minnesota, Oregon, and Washington and are currently negotiating an
agreement for Utah. In addition, we are currently negotiating with SBC
Communications Inc. for Kansas and Missouri and with Sprint for several states.
These interconnection agreements may not be on terms that are entirely
satisfactory to us.
During these negotiations, either the 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.
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.
17
<PAGE>
EMPLOYEES
As of January 31, 1999, we had approximately 220 employees. We believe that
our future success will depend in part on our continued ability to attract, hire
and retain qualified personnel. Competition for such personnel is intense, and
we may be unable to identify, attract and retain such personnel in the future.
None of our employees are represented by a labor union or are the subject of a
collective bargaining agreement. We have never experienced a work stoppage and
believe that our employee relations are good.
RISKS AND UNCERTAINTIES
IN ADDITION TO THE OTHER INFORMATION CONTAINED HEREIN, YOU SHOULD CAREFULLY
CONSIDER THE FOLLOWING RISK FACTORS IN EVALUATING OUR COMPANY.
WE CANNOT PREDICT OUR SUCCESS BECAUSE WE HAVE A SHORT OPERATING HISTORY
We formed our company in February 1997, and we have a short operating
history for you to review in evaluating our business. We have limited historical
financial and operating data upon which you can evaluate our business and
prospects. We entered into our first interconnection agreement with an incumbent
carrier in July 1997 and began to offer commercial services in San Diego in
April 1998. We have limited commercial operations and have recognized limited
revenues since our inception. In addition, our senior management team and our
other employees have worked together at our company for only a short period of
time.
BECAUSE OUR MARKET IS NEW AND EVOLVING, WE CANNOT PREDICT ITS FUTURE GROWTH
OR ULTIMATE SIZE, AND WE MAY BE UNABLE TO COMPETE EFFECTIVELY
The market for packet-based high-speed digital communication services using
telephone lines is in the early stages of development. Since this market is new
and evolving and because 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 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;
18
<PAGE>
- comply with evolving governmental regulatory requirements;
- increase awareness of our services; o 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 9,800 lines that we have committed to
deliver to date, we committed approximately 8,700 to only two customers. None of
our large business customers has rolled out our services broadly to its
employees, and we cannot be certain when or if these rollouts will occur. We
will not receive significant revenue from our large customers unless these
rollouts occur. Any continued or ongoing failure for any reason of large
business customers to roll out our services, failure to validate our business
model in the market, including failure to build out our network, achieve
widespread market acceptance or sustain desired pricing would materially and
adversely affect our business, prospects, operating results and financial
condition.
WE EXPECT OUR LOSSES TO CONTINUE
We have incurred losses and experienced negative operating cash flow for
each month since our formation. As of December 31, 1998, we had an accumulated
deficit of approximately $38.8 million. We intend to rapidly and substantially
increase our expenditures and operating expenses in an effort to expand our
network services. We expect to have annual interest and amortization expense
relating to our senior discount notes of approximately $23.6 million in 1999 and
increasing to $41.5 million in 2003. In addition, we intend to seek additional
debt financing in the future. As a result of these factors, we expect to incur
substantial operating and net losses and negative operating cash flow for the
foreseeable future. We will need to obtain additional financing to pay our
expenses and to make payments on our debt. We cannot give you any assurance
about whether or when we will have sufficient revenues to satisfy our funding
requirements or pay our debt service obligations.
OUR OPERATING RESULTS IN ONE OR MORE FUTURE PERIODS ARE LIKELY TO FLUCTUATE
SIGNIFICANTLY AND MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF SECURITIES
ANALYSTS OR INVESTORS
Our annual and quarterly operating results are likely to fluctuate
significantly in the future due to numerous factors, many of which are outside
of our control. These factors include:
- the rate of customer acquisition and turnover;
- the prices our customers are willing to pay;
- the amount and timing of expenditures relating to the expansion of our
services and infrastructure;
- the timing and availability of incumbent carrier central office
collocation facilities and transport facilities;
- the success of our relationships with our partners and distributors,
including MCI WorldCom, Microsoft and Cisco;
- our ability to deploy our network on a timely basis;
- introduction of new services or technologies by our competitors;
19
<PAGE>
- 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.
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.
WE DEPEND ON INCUMBENT CARRIERS FOR COLLOCATION AND TRANSMISSION FACILITIES
We must use copper telephone lines controlled by the incumbent carriers to
provide DSL connections to customers. We also depend on the incumbent carriers
for collocation and for a substantial portion of the transmission facilities we
use to connect our equipment in incumbent carrier central offices to our Metro
Service Centers. In addition, we depend on the incumbent carriers to test and
maintain the quality of the copper lines that we use. We have not established a
history of obtaining access to collocation and transmission facilities from
incumbent carriers in large volumes. In many cases, we may be unable to obtain
access to collocation and transmission facilities from the incumbent carriers,
or to gain access at acceptable rates, terms and conditions, including
timeliness. We have experienced, and expect to experience in the future, lengthy
periods between our request for and the actual provision of the collocation
space and telephone lines. An inability to obtain adequate and timely access to
collocation space or transmission facilities on acceptable terms and conditions
from incumbent carriers could have a material and adverse effect on our
business, prospects, operating results and financial condition.
Because we compete with incumbent carriers in our markets, they may be
reluctant to cooperate with us. The incumbent carriers may experience, or claim
to experience, a shortage of collocation space or transmission capacity. If this
occurs, we may not have alternate means of connecting our DSL equipment with the
copper lines or connecting our equipment in central offices to Metro Service
Centers. We have experienced rejections of some of our collocation applications
on the grounds that no space is available. We may receive additional rejections
in the future. The number of other competitive local exchange carriers that
request collocation space will also affect the
20
<PAGE>
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 and interconnection
agreements with the incumbent carriers determine the price, terms and conditions
under which collocation space is made available, and they make these
administrative determinations in ongoing hearings. Interconnection agreements
and state public utility commissions also determine the terms and conditions of
access to copper lines and other components of an incumbent carrier's network.
We may be unable to negotiate or enter into interconnection agreements on
acceptable terms or at all. In addition, we cannot be sure that incumbent
carriers will abide by their obligations under those agreements. Delays in
obtaining interconnection agreements would delay our entry into certain markets.
In addition, disputes may arise between us and the incumbent carriers with
respect to interconnection agreements, and we may be unable to resolve disputes
in our favor. If we are unable to enter into, or experience a delay in
obtaining, interconnection agreements, this inability or delay could adversely
affect our business, prospects, operating results and financial condition.
Further, the interconnection agreements are generally short term, and we may be
unable to renew the interconnection agreements on acceptable terms or at all.
The state commissions, the Federal Communications Commission and the courts
oversee, in varying degrees, interconnection arrangements as well as the terms
and conditions under which we gain access to incumbent carrier copper lines and
transmission facilities. These government entities may modify the terms or
prices of our interconnection agreements and our access to incumbent carrier
copper lines and transmission facilities in ways that would be adverse to our
business. State regulatory commissions establish the price rates for DSL-capable
copper lines as well as other rates, terms and conditions of our dealings with
the 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 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 and Cisco. While our
agreement with MCI WorldCom calls for it to sell 100,000 DSL lines, the
agreement also enables MCI WorldCom to terminate the agreement under certain
circumstances and to receive offsets and credits under other circumstances.
Therefore, MCI WorldCom might sell significantly fewer than 100,000 DSL lines,
or we might receive significantly lower revenues than we otherwise would.
21
<PAGE>
THE MARKET IN WHICH WE OPERATE IS HIGHLY COMPETITIVE, AND WE MAY NOT BE
ABLE TO COMPETE EFFECTIVELY, ESPECIALLY AGAINST ESTABLISHED INDUSTRY
COMPETITORS WITH SIGNIFICANTLY GREATER FINANCIAL RESOURCES
We will face competition from many competitors with significantly greater
financial resources, well-established brand names and large, existing installed
customer bases. We expect the level of competition to intensify in the future.
We expect significant competition from incumbent carriers, traditional and new
long distance carriers, cable modem service providers, Internet Service
Providers, wireless and satellite data service providers and other competitive
carriers. Incumbent carriers have existing metropolitan area networks and
circuit-switched local access networks. In addition, most incumbent carriers are
establishing their own Internet Service Provider businesses and are in some
stage of market trials and retail sales of DSL-based access services. Some
incumbent carriers have announced that they intend to aggressively market these
services to their residential customers at attractive prices. We believe that
incumbent carriers have the potential to quickly overcome many of the issues
that have delayed widespread deployment of DSL services in the past. In
addition, we may experience substantial customer turnover in the future. Many
providers of telecommunications and networking services experience high rates of
customer turnover.
Many of the leading traditional long distance carriers, including AT&T
Corporation, MCI WorldCom and Sprint, are expanding their capabilities to
support high-speed, end-to-end networking services. The newer long distance
carriers, including Williams Companies Inc., Qwest Communications International,
Inc. and Level 3 Communications, Inc., are building and managing high bandwidth,
nationwide packet networks and partnering with Internet Service Providers to
offer services directly to the public. Cable modem service providers, like @Home
Networks, are offering or preparing to offer high-speed Internet access over
hybrid fiber networks to consumers, and @Work positioned itself to do the same
for businesses. Several new companies are emerging as wireless, including
satellite-based, data service providers. Internet Service Providers, including
some with significant and even nationwide 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.
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." Please see Item 7: "Management's Discussion and
Analysis of Financial Condition and Results of Options--Liquidity and Capital
Resources."
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
22
<PAGE>
capital expenditures and working capital requirements necessary for us to
provide service in our targeted markets. We believe that our current capital
resources will be sufficient to fund our aggregate capital expenditures and
working capital requirements, including operating losses, through 1999. 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
"Risks and Uncertainties."
We may be unable to obtain any future equity or debt financing on
acceptable terms or at all. Recently the financial markets have experienced
extreme price fluctuations. A market downturn or general market uncertainty may
adversely affect our ability to secure additional financing. The indenture that
governs our senior discount notes restricts our ability to obtain additional
debt financing. Any future borrowing instruments, such as credit facilities and
lease agreements, are likely to contain similar or more restrictive covenants
and could require us to pledge assets as security for the borrowings. If we are
unable to obtain additional capital or are required to obtain it on terms less
satisfactory than what we desire, we will need to delay deployment of our
network services or take other actions that could adversely affect our business,
prospects, operating results and financial condition. If we are unable to
generate sufficient cash flow or obtain funds necessary to meet required
payments of our debt, then we will be in default on our debt instruments. To
date, our cash flow from operations has been insufficient to cover our expenses
and capital needs. Please see "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
OUR SERVICES ARE SUBJECT TO GOVERNMENT REGULATION, AND CHANGES IN CURRENT
OR FUTURE LAWS OR REGULATIONS COULD RESTRICT THE WAY WE OPERATE OUR
BUSINESS
A significant portion of the services that we offer through our
subsidiaries 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
Telecommunications Act, a responsibility it shares with the state regulatory
commissions. In particular, we believe that incumbent carriers will work
aggressively to modify or restrict the operation of many provisions of the 1996
Telecommunications Act. We expect incumbent carriers will pursue litigation in
courts, institute administrative proceedings with the Federal Communications
Commission and other regulatory agencies and lobby the United States Congress,
all in an effort to affect laws and regulations in a manner favorable to the
incumbent carriers and against the interest of competitive carriers such as us.
If the incumbent carriers succeed in any of their efforts, if these laws and
regulations change or if the administrative implementation of laws develops in
an adverse manner, these events could have a material and adverse effect on our
business, prospects, operating results and financial condition. For more details
about our regulatory situation, please see "Business--Government Regulation."
OUR FAILURE TO MANAGE GROWTH COULD ADVERSELY AFFECT US
We have rapidly and significantly expanded our operations. We anticipate
further significant expansion of our operations in an effort to achieve our
network rollout and deployment objectives. Our expansion to date has strained
our management, financial controls, operations systems, personnel and other
resources. Any future rapid expansion would increase these strains. If our
marketing strategy is successful, we may experience difficulties responding to
customer demand for services and technical support in a timely manner and in
accordance with their expectations. As a result, rapid growth of our business
would make it difficult to implement successfully our strategy to provide
superior customer service. To manage any growth of our operations, we must:
23
<PAGE>
- 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 December 31, 1998, we had approximately $158.3 million of
outstanding debt, and our debt made up 100% of our capitalization. We are not
generating any meaningful revenue to fund our operations or to repay our debt.
Our substantial leverage poses the risks that:
- we may be unable to repay our debt due to one or more events discussed in
"Risks and Uncertainties;"
- we may be unable to obtain additional financing;
- we must dedicate a substantial portion of our cash flow from operations
to servicing our debt once our debt requires us to make cash interest
payments, and any remaining cash flow may not be adequate to fund our
planned operations; and
- we may be more vulnerable during economic downturns, less able to
withstand competitive pressures and less flexible in responding to
changing business and economic conditions.
THE TELECOMMUNICATIONS INDUSTRY IS UNDERGOING RAPID TECHNOLOGICAL CHANGE,
AND NEW TECHNOLOGIES MAY BE SUPERIOR TO THE TECHNOLOGY WE USE
The telecommunications industry is subject to rapid and significant
technological changes, such as continuing developments in DSL technology and
alternative technologies for providing high-speed data communications. We cannot
predict the effect of technological changes on our business. We will rely in
part on third parties, including certain of our competitors and potential
competitors, for the development of and access to communications and networking
technology. We expect that new products and technologies applicable to our
market will emerge. New products and technologies may be superior and/or render
obsolete the products and technologies that we currently use. Our future success
will depend, in part, on our ability to anticipate and adapt to technological
changes and evolving industry standards. We may be unable to obtain access to
new technology on acceptable terms or at all, and we may be unable to adapt to
new technologies and offer services in a competitive manner. Our joint
development 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
24
<PAGE>
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 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
25
<PAGE>
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 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
26
<PAGE>
may otherwise learn or discover our trade secrets. Our management personnel were
previously employees of other telecommunications companies. In many cases, these
individuals are conducting activities for us in areas similar to those in which
they were involved prior to joining us. As a result, we or our employees could
be subject to allegations of violation of trade secrets and other similar
claims.
RISKS ASSOCIATED WITH POTENTIAL GENERAL ECONOMIC DOWNTURN
In the last few years the general health of the economy, particularly the
economy of California where we have conducted a significant portion of our
operations to date, has been relatively strong and growing, a consequence of
which has been increasing capital spending by individuals and growing companies
to keep pace with rapid technological advances. To the extent the general
economic health of the United States or of California declines from recent
historically high levels, or to the extent individuals or companies fear a
decline is imminent, these individuals and companies may reduce expenditures
such as those for our services. Any decline or concern about an imminent decline
could delay decisions among certain of our customers to roll out our services or
could delay decisions by prospective customers to make initial evaluations of
our services. Any delays would have a material and adverse effect on our
business, prospects, operating results and financial condition.
WE MAY BE UNABLE TO SATISFY, OR MAY BE ADVERSELY CONSTRAINED BY, THE
COVENANTS IN OUR EXISTING DEBT SECURITIES
The indenture for our senior discount notes imposes significant
restrictions on how we can conduct our business. For example, the restrictions
prohibit or limit our ability to incur additional debt, make dividend payments
and engage in certain business activities. The restrictions may materially and
adversely affect our ability to finance future operations or capital needs or
conduct additional business activities. Any future senior debt that we may incur
will likely impose additional restrictions on us. If we fail to comply with any
existing or future restrictions, we could default under the terms of the
applicable debt and be unable to meet our debt obligations. If we default, the
holders of the applicable debt could demand that we pay the debt, including
interest, immediately. We may be unable to make the required payments or raise
sufficient funds from alternative sources to make the payments. Even if
additional financing is available in the event that we default, it may not be on
acceptable terms.
OUR PRINCIPAL STOCKHOLDERS AND MANAGEMENT OWN A SIGNIFICANT PERCENTAGE OF
OUR COMPANY, AND WILL BE ABLE TO EXERCISE SIGNIFICANT INFLUENCE OVER OUR
COMPANY
Our executive officers and directors and principal stockholders together
beneficially own 96.3% of our common stock on an as-converted basis.
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.
OUR FAILURE AND THE FAILURE OF THIRD PARTIES TO BE YEAR 2000 COMPLIANT
COULD NEGATIVELY IMPACT OUR BUSINESS
Many computer programs have been written using two digits rather than four
to define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year 1900
rather than the year 2000. This, in turn, could result in major system failures
or miscalculations, and is generally referred to as the "Year 2000 issue." We
have formulated and, to a large extent, effected a plan to address our Year 2000
issues.
Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year 2000
compliance testing for all of our internal systems and believe that they are
Year 2000 compliant. Because we are a young company, we believe we have been
able to build our business systems with the Year 2000 issue in mind in a more
effective manner than many older companies. Therefore, there have been few Year
2000 changes required to our existing systems and applications. We have
substantially completed a compliance check of our external customers and
providers, except for the incumbent carriers. Based on responses from these
third parties, other than the incumbent carriers, we believe that they will not
experience Year 2000 problems that would materially and adversely affect our
business. We have not been able to conduct a compliance check of incumbent
carriers nor assess the incumbent carriers' Year 2000 compliance. To the extent
that one or more incumbent carriers or other third parties experience Year 2000
problems, our network and services could be adversely affected. Furthermore, the
purchasing patterns of our customers may be affected by Year 2000 issues as
27
<PAGE>
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 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.
THE TERMS OF OUR EXISTING DEBT MAY LIMIT OUR ABILITY TO ENTER INTO A CHANGE
OF CONTROL TRANSACTION
The indenture governing our senior discount notes requires us to offer to
repurchase all senior discount notes for 101% of their principal amount or
accreted value, plus any accrued interest due, within 30 days after a change of
control. 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.
ITEM 2: 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.
ITEM 3: LEGAL PROCEEDINGS
We are currently a party to an arbitration proceeding between us and SBC
Communications regarding the terms of interconnection with Southwestern Bell in
Texas. This arbitration, instituted December 11, 1998, is pending before the
Public Utility Commission of Texas. The dispute involves the terms and
conditions of issues related to 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.
In addition, on March 12, 1999, ACI Corp. filed a complaint with the
Oregon Public Utilities Commission (the "Oregon PUC") against US West
Communications regarding collocation matters. ACI has requested the Oregon
PUC to intervene in an on-going dispute between ACI and US West
Communications regarding ACI's ability to collocate in three central offices
located in Portland, Oregon pursuant to Section 251(c)(6) of the 1996
Telecommunications Act. ACI has requested that the Oregon PUC make a
determination that US West Communications can, in fact, accommodate ACI's
requests for collocation and, if such a determination is made, that the
Oregon PUC immediately order US West Communications to make space available to
ACI on the terms and conditions set forth in the existing interconnection
agreement between the companies. ACI has also sought monetary damages in an
amount to be proven at a hearing to compensate for ACI's economic losses. No
hearing date or schedule has yet been set for this proceeding.
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 stock. We intend to
vigorously defend against such cross-claims, and intend to file a demurrer to
the cross-complaint. We are currently accounting for these 438,115 shares as
treasury stock.
28
<PAGE>
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.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Our stockholders approved by written consent, effective October 29,
1998, an amendment to our Restated Certificate of Incorporation, as amended,
to effect a stock split, whereby each one outstanding share of common stock
was split and converted into two shares of common stock. This amendment was
effected on November 4, 1998. The numbers of shares voting in favor of the
amendment (pre-split) were 2,642,860 shares of common stock, 12,385,927
shares of Series A preferred stock and 4,044,943 shares of Series B preferred
stock. Votes were not received with respect to 697,944 shares of common stock
and 469,167 shares of Series A preferred stock.
PART II
ITEM 5: MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
There is no established public trading market for our equity securities.
As of March 19, 1999, there were approximately 50 record holders of common
stock, 31 record holders of Series A preferred stock, 12 record holders of
Series B preferred stock and 2 record holders of Series C preferred stock.
DIVIDEND POLICY
We have not paid dividends on our common stock and currently intend to
continue this policy in order to retain earnings for use in our business. In
addition, the terms of the indenture governing our senior discount notes contain
restrictions on our ability to pay dividends or other distributions.
SALES OF UNREGISTERED SECURITIES
Since our incorporation in February 1997, we have issued and sold
unregistered securities as follows (adjusted for subsequent stock splits):
(1) An aggregate of 2,161,764 shares of common stock was issued in
private placements in February through June 1997 to Enterprise Partners in
connection with our initial funding. The consideration received for such shares
was $901.
(2) An aggregate of 6,140,000 shares of Series A preferred stock (which
are currently convertible into 14,736,000 shares of common stock) was issued in
a private placement in July 1997 to Brentwood Venture Capital, Enterprise
Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and certain other
purchasers pursuant to a Series A Preferred Stock Purchase Agreement. The
consideration received for such shares was $6,138,500.
(3) An aggregate of 6,350,000 shares of Series A preferred stock (which
are currently convertible into 15,240,000 shares of common stock) was issued in
a private placement in December 1997 to Brentwood Venture
29
<PAGE>
Capital, Enterprise Partners, Kleiner Perkins Caufield & Byers, the Sprout Group
and certain other purchasers pursuant to a Series A Preferred Stock Purchase
Agreement and a Subsequent Closing Purchase Agreement. The consideration
received for such shares was $6,350,000.
(4) An aggregate of 365,094 shares of Series A preferred stock (which
are currently convertible into 876,226 shares of common stock) was issued in a
private placement in February 1998 to Catherine Hapka in connection with the
Series A Preferred Stock Purchase Agreement, the Subsequent Closing Purchase
Agreement and an employment agreement between us and Ms. Hapka. The
consideration received for such shares was $292,075.
(5) An aggregate of 4,044,943 shares of Series B preferred stock (which
are currently convertible into 9,707,863 shares of common stock) was issued in a
private placement in March 1998 to Brentwood Venture Capital, Enterprise
Partners, Kleiner Perkins Caufield & Byers, the Sprout Group and Enron
Communications Group, Inc. The consideration received for such shares was
$18,000,000.
(6) In May 1998 we issued 290,000 units consisting of 13 1/2% senior
discount notes due 2008 and warrants to purchase an aggregate of 4,732,800
shares of common stock with exercise prices of $0.004 per share to Merrill Lynch
& Co. and Donaldson, Lufkin & Jenrette Securities Corporation, as initial
purchasers, for resale to qualified institutional buyers. Merrill Lynch & Co.
and Donaldson, Lufkin & Jenrette Securities Corporation received commissions of
$5,262,920 for acting as initial purchasers in connection with this transaction.
(7) In May 1998 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 in connection with an equipment lease
financing.
(8) In March 1999 we issued to MCI WorldCom Venture Fund, Inc. and to
Microsoft Corporation 3,731,410 and 3,731,409 shares of Series C preferred
stock, respectively, and issued to each of them a warrant to purchase 720,000
shares of common stock for an aggregate purchase price of $60.0 million.
(9) From August 1997 through March 19, 1999, we granted stock options
to purchase an aggregate of 10,508,781 shares of common stock to employees and
consultants with aggregate exercise prices ranging from $0.04 to $3.33 per share
pursuant to our stock option plan. As of March 19, 1999, 7,014,376 shares of
common stock have been issued upon exercise of options.
No underwriters were used in connection with these sales and issuances
except for the issuance of the senior discount notes and related warrants in (6)
above. The sales and issuances of these securities except for those in (6) above
were exempt from registration under the Securities Act pursuant to Rule 701
promulgated thereunder on the basis that these securities were offered and sold
either pursuant to a written compensatory benefit plan or pursuant to written
contracts relating to consideration, as provided by Rule 701, or pursuant to
Section 4(2) thereof on the basis that the transactions did not involve a public
offering. The sales and issuance in (6) above were exempt from registration
under the Securities Act pursuant to Section 4(2) and, in connection with the
resale by the initial purchasers of the securities described in (6) above, Rule
144A thereunder.
30
<PAGE>
ITEM 6: SELECTED FINANCIAL DATA
The following statement of operations data for the periods from our
inception on February 27, 1997 to December 31, 1997 and for the year ended
December 31, 1998, and the balance sheet data as of December 31, 1997 and 1998
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 herein.
<TABLE>
<CAPTION>
FEBRUARY 27, 1997
(INCEPTION) TO YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
----------------- -----------------
(DOLLARS IN THOUSANDS, EXCEPT
PER SHARE DATA)
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue............................................................ $-- $ 528
Operating expenses:
Network and service costs........................................ -- 4,695
Selling, marketing, general and administrative................... 2,534 23,153
Depreciation and amortization.................................... 1 1,081
-------- --------
Total operating expenses........................................ 2,535 28,929
-------- --------
Loss from operations............................................... (2,535) (28,401)
Interest and other income (expense), net........................... 113 (7,933)
-------- --------
Net loss........................................................... $(2,422) $(36,334)
-------- ---------
-------- ---------
Net loss per share (basic and diluted)............................. $ (1.12) $ (12.18)
-------- ---------
-------- ---------
OTHER FINANCIAL DATA:
EBITDA (1)......................................................... $(2,342) $(26,628)
Adjusted EBITDA (2)................................................ (2,342) (25,036)
Net cash used for operating activities............................. (1,560) (19,024)
Net cash used for investing activities............................. (1,345) (139,032)
Net cash provided by financing activities.......................... 13,071 169,205
<CAPTION>
AS OF DECEMBER 31
1997 1998
-------- ---------
<S> <C> <C>
BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments.................. $10,166 $136,812
Equipment and furniture, net....................................... 1,621 11,510
Total assets....................................................... 12,241 171,726
Total debt......................................................... 568 158,270
Mandatorily redeemable common stock warrants....................... -- 6,567
Total stockholders' equity (deficit)............................... 10,346 (6,747)
</TABLE>
- -----------------------
(1) EBITDA consists of the net loss excluding net interest, depreciation and
amortization of capital assets and deferred compensation expense. EBITDA
is presented to enhance an understanding of our operating results and is
not intended to represent cash flow or results of operations in accordance
with generally accepted accounting principles for the period indicated and
may be calculated differently than EBITDA for other companies.
(2) Total operating expenses for the year ended December 31, 1998 include
$1,592,000 of operating lease expense to GATX Capital Corporation. No
amounts were incurred to GATX for operating leases in 1997. Adjusted
EBITDA reflects EBITDA excluding the GATX operating lease expense.
31
<PAGE>
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THIS ANNUAL REPORT ON FORM 10-K MAY CONTAIN CERTAIN PROJECTIONS, ESTIMATES
AND OTHER FORWARD-LOOKING STATEMENTS THAT INVOLVE A NUMBER OF RISKS AND
UNCERTAINTIES, INCLUDING THOSE DISCUSSED ABOVE AT "BUSINESS--RISKS AND
UNCERTAINTIES." WHILE THIS OUTLOOK REPRESENTS OUR MANAGEMENT'S CURRENT JUDGMENT
ON THE FUTURE DIRECTION OF THE BUSINESS, SUCH RISKS AND UNCERTAINTIES COULD
CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM ANY FUTURE PERFORMANCE SUGGESTED
BELOW. WE UNDERTAKE NO OBLIGATION TO RELEASE PUBLICLY THE RESULTS OF ANY
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES
ARISING AFTER THE DATE HEREOF.
OVERVIEW
We are a leading service provider of high-speed local access networking
solutions using DSL technology to businesses. We began offering commercial
services in San Diego in April 1998, and have subsequently begun service in nine
additional markets: San Francisco, San Jose, Oakland/East Bay, Chicago, Los
Angeles, Orange County, Boston, Sacramento and New York. We intend to continue
our network rollout into an additional 23 markets in 1999 and a further 17
markets by the end of 2000.
Since our inception in February 1997, our primary activities have consisted
of:
- obtaining required governmental authorizations;
- negotiating and executing interconnection agreements with 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 December 31, 1998, we had an
accumulated deficit of $38.8 million. We currently intend to substantially
increase our operating expenses and capital expenditures in an effort to rapidly
expand our infrastructure and network services. We expect to incur substantial
operating losses, net losses and negative cash flow during the network build-out
and initial penetration of each new market we enter. These losses are expected
to continue for at least the next several years.
In 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 MCI WorldCom's preferred provider of business
DSL lines 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.
FACTORS AFFECTING OPERATIONS
REVENUE
The following factors affect our revenue:
32
<PAGE>
- 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. We believe that our initial ten markets contain
23% of all local area networks in the United States. Our goal is to cover
60% of the local area networks in the United States, which we believe is
achievable by building out a total of 50 markets. Initially, DSL is
expected to reach over 70% of the businesses and residences served from
the central offices. Within each metropolitan area, we expect to
collocate in the appropriate number of central offices to cover 75% of
the total market opportunity.
- TURNOVER. To date, our customer turnover has been minimal. We expect this
to increase in the future as competition intensifies.
NETWORK AND SERVICE COSTS
Our network and service costs are generally comprised of the following:
- EQUIPMENT INSTALLATION CHARGES. In each market, we will require a number
of field service technicians to install customer premise equipment at end
user locations. We currently outsource most of this function.
- MONTHLY RECURRING AND NONRECURRING LINE AND SERVICE CHARGES. We pay
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.
- COST OF CUSTOMER PREMISE EQUIPMENT. As part of our DSL product offering,
we provide the customer premise equipment and expense the cost of the
customer premise equipment for each customer line.
- EQUIPMENT OPERATING LEASE EXPENSES. We currently take advantage of
short-term operating leases to finance the acquisition of substantially
all of our network equipment, including DSL multiplexers, Asynchronous
Transfer Mode switches and routers. We may decide to purchase and to
capitalize some or all of this equipment in the future.
- LINE REPAIR AND SUPPORT COSTS. Similar to other telecommunications
providers, we estimate that a small percentage of our lines may require
repair or support. These costs will consist of field dispatch labor and a
portion of our Network Operations Center costs.
SELLING, GENERAL AND ADMINISTRATIVE COSTS
Our selling, general and administrative expenses include customer service
and technical support, information systems, billing and collections, general
management and overhead, and administrative functions. Headcount in
33
<PAGE>
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
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 negligible
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
34
<PAGE>
expense. The increase in the interest expense is substantially due to the
accretion of interest on the senior discount notes that were issued in May 1998.
INCOME TAXES
We generated net operating loss 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. The principal capital expenditures incurred during the build-out
phase of any market involve the procurement, design and construction of our
Connection Points, one or two Metro Service Centers and other elements of our
network design.
The number of targeted central offices in a market varies, as does the
average capital cost to build our Connection Points in a given market. Capital
expenditures, including payments for collocation fees, were $23.5 million for
the year ended December 31, 1998. We expect our capital expenditures to be
substantially higher in future periods, arising primarily from payment of
collocation fees and the purchase of infrastructure equipment necessary for the
development and expansion of our network.
Through December 31, 1998, we financed our operations primarily through
private placements of equity totaling $30.8 million, of which we received $30.3
million from our venture capital and institutional sponsors, the use of
operating equipment leases totaling $26.5 million, borrowings under a note
payable from Silicon Valley Bank of $1.0 million, and $144.0 million in net
proceeds raised from the issuance of the senior discount notes. As of December
31, 1998, we had an accumulated deficit of $38.8 million and cash, cash
equivalents and short-term investments of $136.8 million. In March 1999, we
received $60.0 million in separate investments by Microsoft and MCI WorldCom's
investment fund.
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 from the issuance of preferred stock.
We believe that our current capital resources will be sufficient to fund
our aggregate capital expenditures and working capital requirements,
including operating losses, through 1999. We expect our operating losses and
capital expenditures to increase substantially primarily due to our network
expansion. We expect that additional financing will be required in the
future. We may attempt to raise financing through some combination of
commercial bank borrowings, leasing, vendor financing or the private or
public sale of equity or debt securities. We have received a financing
proposal from GATX Capital Corporation for up to $30 million of additional
lease financing, of which $24 million is allocated for equipment and $6
million is allocated for collocation fees. This proposal also contains a
provision for another $20 million of available financing, for a total of $50
million, that would be available upon the occurrence of certain events. Our
senior discount notes contain covenants that restrict the our ability to make
certain payments, including dividend payments, and incur additional debt.
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
35
<PAGE>
- we accelerate deployment of our network services or otherwise alter the
schedule or targets of our rollout plan.
Equity or debt financing may not be available to us on favorable terms or
at all. See "Business--Risks and Uncertainties--We will need significant
additional funds, which we may not be able to obtain."
IMPACT OF THE YEAR 2000 ISSUE
Many computer programs have been written using two digits rather than four
to define the applicable year. This poses a problem at the end of the century
because these computer programs may recognize a date using "00" as the year 1900
rather than the year 2000. This, in turn, could result in major system failures
or miscalculations, and is generally referred to as the "Year 2000 issue." We
have formulated and, to a large extent, effected a plan to address our Year 2000
issues.
Our Year 2000 plan applies to two areas: internal business systems and
compliance by external customers and providers. We have completed our Year 2000
compliance testing for all of our internal systems and believe that they are
Year 2000 compliant. Because we are a young company, we believe we have been
able to build our business systems with the Year 2000 issue in mind in a more
effective manner than many older companies. Therefore, there have been few Year
2000 changes required to our existing systems and applications. We have
substantially completed a compliance check of our external customers and
providers, except for the incumbent carriers. Based on responses from these
third parties, other than the incumbent carriers, we believe that they will not
experience Year 2000 problems that would materially and adversely affect our
business. We have not been able to conduct a compliance check of incumbent
carriers nor assess the incumbent carriers' Year 2000 compliance. To the extent
that one or more incumbent carriers or other third parties experience Year 2000
problems, our network and services could be adversely affected. Furthermore, the
purchasing patterns of our customers may be affected by Year 2000 issues as
companies expend significant resources to correct their current systems for Year
2000 compliance. These expenditures may result in reduced funds available for
our services. Any of these developments could have a material and adverse effect
on our business, prospects, operating results and 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.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is included in Part IV, Item 14(a)(1)
and (2).
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
36
<PAGE>
PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth, as of March 19, 1999, the names, ages and
positions of our executive officers and directors. Their respective backgrounds
are described below.
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
- ---------------------------------------------------- ------ ---------------------------------------------------
<S> <C> <C>
Catherine M. Hapka.................................. 44 President, Chief Executive Officer and Director
Jeffrey Blumenfeld.................................. 51 Vice President and General Counsel
Michael E. Calabrese................................ 33 Vice President, Sales Engineering
Scott C. Chandler................................... 37 Chief Financial Officer
Eric H. Geis........................................ 52 Vice President of National Deployment
James A. Greenberg.................................. 38 Chief Network Officer
David J. Shimp...................................... 53 Chief Marketing Officer
Frank J. Tolve, Jr.................................. 54 Chief Sales Officer
Kevin R. Compton.................................... 40 Director
Keith B. Geeslin.................................... 45 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 President, Chief Executive Officer and a
director since June 1997. Prior to joining us, Ms. Hapka served as President of
NETS, Inc., an electronic commerce software company, from March 1997 to May
1997. Prior to joining NETS, Inc., Ms. Hapka served as Executive Vice President,
Markets, for U S WEST Communications, Inc. from January 1995 to October 1996. In
this capacity, Ms. Hapka led business and consumer telecommunications units
responsible for the voice, data, wireless, video and long distance businesses.
From 1991 to 1994, Ms. Hapka served as President and Chief Operating Officer of
the !NTERPRISE Networking Services Unit of U S WEST. Prior to joining U S WEST,
Ms. Hapka held general management positions with General Electric and McKinsey &
Co., Inc.
JEFFREY BLUMENFELD has been our Vice President and General Counsel since
August 1997, and has been a partner in the Washington, D.C. law firm of
Blumenfeld & Cohen since 1984, which specializes in pro-competition advocacy for
technology-intensive companies. Since 1995, Mr. Blumenfeld has served as senior
trial counsel to the Antitrust Division of the U.S. Department of Justice in
several matters. Before starting Blumenfeld & Cohen in 1984, Mr. Blumenfeld held
positions with the U.S. Department of Justice from 1973 to 1984, most recently
as Chief of the U.S. V. AT&T staff of the Antitrust Division. Mr. Blumenfeld is
an adjunct professor of communications law at the Georgetown University Law
Center. Pursuant to his employment agreement, Mr. Blumenfeld has agreed to
expend approximately 24 hours a week in his capacity as one of our officers. For
more information on Mr. Blumenfeld's relationship with us, please see "Certain
Relationships and Related Transactions--Legal Services."
37
<PAGE>
MICHAEL E. CALABRESE has been our Vice President, Sales Engineering since
August 1998. Prior to joining us, Mr. Calabrese served in various positions at
Cisco Systems, Inc. from August 1995 to August 1998, most recently as Account
Manager of the Data Equipment Group. In that capacity, Mr. Calabrese maintained
primary responsibility for managing Cisco's major accounts. From January 1993 to
August 1995, Mr. Calabrese held management positions at Sprint Communications.
First, as Manager, Project Engineering, Mr. Calabrese led Sprint Communication's
new product rollouts. Subsequently, as Manager, Network Planner, Mr. Calabrese
was responsible for the design and build-out of Sprint Communications Data
Networks.
SCOTT C. CHANDLER has served as our Chief Financial Officer since April
1998. From August 1996 to April 1998, Mr. Chandler served as President and Chief
Executive Officer of C-COR Electronics, Inc., a manufacturer of broadband
telecommunications equipment. From June 1990 to August 1996, Mr. Chandler served
in various positions at U S WEST and its subsidiaries, most recently as Vice
President and General Manager of U S WEST Cable and Multimedia from September
1995 to August 1996. While at U S WEST, Mr. Chandler also served as Vice
President and General Manager of the U S WEST subsidiary, !NTERPRISE AMERICA,
from January 1994 to August 1995 and as Director of Vendor Relations and Channel
Support of !NTERPRISE Networking Services from January 1992 to December 1993.
ERIC H. GEIS has been our Vice President of National Deployment since
January 1, 1999. Prior to that, he served as our Vice President and General
Manager, Western Region beginning June 1997 and was a consultant to us from
April 1997 to June 1997. From November 1995 to December 1996, Mr. Geis served as
National Sales Director at GRC International, a producer and seller of wide area
data network design and optimization software applications. Between July 1990
and November 1995, Mr. Geis served as President and Chief Executive Officer of
Quintessential Solutions Inc., a provider of wide area network design, pricing
and optimization software applications for interexchange carriers, regional bell
operating companies, 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.
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.
DAVID J. SHIMP has served as our Chief Marketing Officer since October
1998. Prior to joining us, Mr. Shimp was a partner at LAI Ward Howell, Inc., a
professional services firm, where he implemented that firm's first systems group
and was a leader in the technology department during his tenure from January
1991 to October 1998. Previously, Mr. Shimp held management positions at
McKinsey & Co. and the Deerpath Group.
FRANK J. TOLVE, JR. has served as our Chief Sales Officer since December
1998. From November 1994 to September 1998, Mr. Tolve served as Vice President,
Sales Operations at Bay Networks. In that capacity, Mr. Tolve's responsibilities
included sales administration, channel strategy and worldwide
telesales/telemarketing. Mr. Tolve also served as Vice President, Sales
Operations for SynOptics Communications from November 1992 to November 1994.
KEVIN R. COMPTON has been a director since July 1997. Since 1990, Mr.
Compton has served as a general partner of Kleiner Perkins Caufield & Byers, a
venture capital investment firm ("KPCB"). Mr. Compton is a director of Citrix
Systems, Inc., Digital Generation Systems, Inc., Global Village Communication,
Inc. and Corsair Communications, Inc., and is also a director of several
privately held companies. Mr. Compton was elected a director as the nominee of
KPCB, pursuant to the terms of a voting agreement.
KEITH B. GEESLIN has been a director since July 1997. Since 1988, Mr.
Geeslin has served as a general partner of The Sprout Group, a venture capital
investment firm. Mr. Geeslin is a director of SDL, Inc., and is also a director
of several privately held companies, including Paradyne Corporation, a DSL
equipment manufacturer and supplier to us. Please see "Certain Relationships and
Related Transactions--Director Relationships." Mr. Geeslin was elected a
director as the nominee of The Sprout Group, pursuant to the terms of a voting
agreement.
KEN L. HARRISON has been a director since March 1998. Since 1975, Mr.
Harrison has held various management positions at Portland General Electric
Company, where he currently serves as its Chairman and Chief Executive
Officer, a position he has held since December 1988. In addition, Mr.
Harrison currently serves as Vice Chairman and is a director of Enron Corp.,
a position he has held since July 1997. Mr. Harrison has also served as
38
<PAGE>
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 several privately held companies, including Paradyne
Corporation. Please see "Certain Relationships and Related
Transactions--Director Relationships." Mr. Stensrud was elected a director as
the nominee of Enterprise Partners, pursuant to the terms of a voting agreement.
JOHN L. WALECKA has been a director since July 1997. Since 1984, Mr.
Walecka has been at Brentwood Venture Capital, a venture capital investment
firm, and has been a general partner since 1990. Mr. Walecka is a director of
Documentum, Inc. and Xylan Corporation, and is also a director of several
privately held companies. Please see "Certain Relationships and Related
Transactions--Director Relationships." Mr. Walecka was elected a director as the
nominee of Brentwood Venture Capital, pursuant to the terms of a voting
agreement.
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.
Members of the Board of Directors currently hold office and serve until our
next annual meeting of stockholders or until their respective successors have
been elected.
All of our executive officers are appointed annually by and serve at the
discretion of the Board of Directors. All of our executive officers are at-will
employees.
COMMITTEES OF THE BOARD OF DIRECTORS
We have a standing compensation committee currently composed of Messrs.
Walecka, Harrison and Stensrud. The compensation committee reviews and acts on
matters relating to compensation levels and benefit plans for our executive
officers and key employees, including salary and stock options. The compensation
committee is also responsible for granting stock awards, stock options and stock
appreciation rights and other awards to be made under our existing incentive
compensation plans. We also have a standing audit committee composed of Messrs.
Compton and Geeslin. The audit committee assists in selecting our independent
auditors and in designating services to be performed by, and maintaining
effective communication with, those auditors.
DIRECTOR COMPENSATION
Directors do not receive compensation for services provided as a director
or for participation on any committee of the Board of Directors. All directors
are reimbursed for their out-of-pocket expenses in serving on the Board of
Directors or any committee thereof.
ITEM 11: 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.
39
<PAGE>
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION AWARDS
-------------------------------
ANNUAL COMPENSATION SECURITIES
------------------------ UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION(S) YEAR SALARY BONUS OPTIONS(#) COMPENSATION
- ------------------------------ ------ ---------- ----------- -------------- --------------
<S> <C> <C> <C> <C> <C>
Catherine M. Hapka (1)............................. 1998 $339,583 $134,584 -- $--
President, Chief Executive Officer and Director 1997 163,654 50,000 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) --
Chief Network Officer 1997 63,205 16,615 547,642(2) 50,000(7)
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. We did not grant any stock appreciation rights
to the Named Executive Officers during 1998.
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS (1) POTENTIAL REALIZABLE
------------------------------------------------------------ VALUE AT ASSUMED
NUMBER OF % OF TOTAL ANNUAL RATES OF STOCK
SECURITIES OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM (3)
OPTIONS EMPLOYEES PRICE PER -------------------------
NAME GRANTED IN 1998 (2) SHARE EXPIRATION DATE 5% 10%
- ---- ------------ ------------- ----------- ------------------ ------------ -----------
<S> <C> <C> <C> <C> <C> <C>
Catherine M. Hapka......... -- -- -- -- -- --
Michael E. Calabrese....... 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.
Please see "--1997 Stock Option/Stock Issuance Plan."
(2) We granted options to purchase 3,364,680 shares of common stock during
1998.
40
<PAGE>
(3) Amount represents potential realizable value of option grants, assuming
that our common stock appreciates at the annual rate shown, compounded
annually, from the date of grant until expiration of the granted
options. These numbers are calculated based on Securities and Exchange
Commission requirements and do not reflect our projection or estimate
of future stock price growth. Actual gains, if any, on stock option
exercises are dependent on the future performance of our common stock.
(4) Ms. Farler resigned her position in February 1999.
FISCAL YEAR-END 1998 OPTION VALUES
The following table provides information with respect to each of the Named
Executive Officers, concerning the exercise of common and preferred stock
options during 1998 and unexercised options held by them at the end of 1998.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED IN-THE-
UNDERLYING UNEXERCISED MONEY OPTIONS AT DECEMBER
SHARES OPTIONS AT DECEMBER 31, 1998 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. Please see "--1997 Stock Option/Stock Issuance
Plan."
(3) Amount based on the fair market value, as determined by our Board of
Directors, of our common stock and Series A preferred stock on the
exercise date for such shares, less the exercise price paid for such
shares.
(4) Ms. Hapka exercised all of these options in February 1998 for a net
purchase price of $146,038 for common stock and $292,075 for Series A
preferred stock. Ms. Hapka purchased the shares of Series A preferred
stock at a $0.20 per share discount from market value, for an aggregate
discount of $73,019.
(5) Mr. Greenberg exercised all of these options in January 1998 for a net
purchase price of $22,818.
(6) Ms. Farler resigned her position in February 1999.
(7) Ms. Farler exercised all of these options in March 1998 for a net
purchase price of $1,800.
(8) Mr. Geis exercised all of these options in January 1998 for a net
purchase price of $5,500.
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. Please see
"--1997 Stock Option/Stock Issuance Plan." In connection with her employment,
Ms. Hapka was also given the right to purchase up to 365,094 shares of Series A
preferred stock at $0.80 per share. In February 1998, Ms. Hapka purchased these
shares for an aggregate purchase price of $292,075. We do not hold a right to
repurchase these shares of Series A preferred stock. In the event Ms. Hapka's
employment is terminated involuntarily and without cause, Ms. Hapka will be
entitled to receive a lump sum payment in an amount equal to her then-current
annual salary.
41
<PAGE>
Mr. Calabrese's employment agreement provides for an annual salary of
$130,000, subject to periodic increases by the Board of Directors at its
discretion. It provides for an annual bonus of up to 20% of his annual salary.
In addition, Mr. Calabrese received, as part of the acceptance of his
employment, a cash payment of $150,000, which also covered relocation expenses.
In the event Mr. Calabrese's employment is terminated involuntarily and without
cause during the first year of employment, which ends in August 1999, Mr.
Calabrese will be entitled to receive a payment equal to one year's base salary
payable in 12 monthly installments.
Mr. Greenberg's employment agreement provides for an annual salary of
$145,000, subject to periodic increases by the Board of Directors at its
discretion.
Mr. Geis' employment agreement provides for an annual salary of $136,000,
subject to periodic increases by the Board of Directors at its discretion. It
provides for an annual bonus of up to 25% of his base salary.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Our Board of Directors currently has a compensation committee that reviews
and approves the compensation and benefits to be provided to our executive
officers and other key employees. In addition, the compensation committee
administers the 1997 Stock Option/Stock Issuance Plan. The compensation
committee currently consists of Messrs. Harrison, Stensrud and Walecka.
1997 STOCK OPTION/STOCK ISSUANCE PLAN
As of January 31, 1999, we had reserved 11,673,530 shares of common stock
for issuance pursuant to our 1997 Stock Option/Stock Issuance Plan (the "1997
Stock Plan"), which has been approved by our Board of Directors and
stockholders. The 1997 Stock Plan provides for the granting to employees and
officers of qualified "incentive stock options" within the meaning of Section
422 of the Internal Revenue Code of 1986, as amended (the "Code"), and for the
granting to employees, officers and directors and consultants of nonqualified
stock options. The 1997 Stock Plan also provides for the granting of restricted
stock. As of January 31, 1999, options to purchase an aggregate of 10,208,872
shares of common stock had been granted, net of cancellations, and 1,464,659
shares of common stock remained available for future grants. From January 1,
1998 through January 31, 1999, 5,634,228 options to purchase common stock were
exercised, of which an aggregate of 4,227,747 were exercised by the Named
Executive Officers as a group, an aggregate of 438,115 were exercised by our
other executive officers as a group, and an aggregate of 968,366 were exercised
by our non-officer employees. To date, we have not granted any shares of
restricted stock under the 1997 Stock Plan.
The 1997 Stock Plan is administered by the compensation committee of our
Board of Directors. Options granted generally vest at a rate of 25% of the
shares at the end of the first year and 2.083% of the shares at the end of each
month thereafter and generally expire ten years from the date of grant. All
options granted are immediately exercisable, subject to a repurchase right at
the original purchase price that we hold that lapses in accordance with the
vesting schedule of the options. If an optionee exercises an option to purchase
shares in which such optionee has not acquired a vested interest in accordance
with the applicable vesting provisions, then the purchased shares are deposited
in escrow with our corporate secretary, where they continue to vest in
accordance with the applicable vesting provisions. We hold a right, exercisable
at any time during the sixty-day period following the date an optionee ceases
for any reason to remain in service, to repurchase at the exercise price for
such options all or, at our discretion and with the consent of the optionee, any
portion of such unvested shares.
If we merge with or into another corporation or sell all or substantially
all of our assets, all outstanding options shall be assumed or an equivalent
option substituted by the successor corporation. If a successor corporation
refuses to assume or substitute for the options, a portion of each outstanding
option shall be accelerated so that such portion becomes fully vested. Please
see "--Employment Agreements and Change in Control Arrangements."
The exercise price of incentive stock options granted under the 1997 Stock
Plan must be at least equal to the fair value of our common stock on the date of
grant. The exercise price of options to an optionee who owns more than 10% of
our outstanding voting securities must equal at least 110% of the fair value of
the common stock on the date of grant, and the option term shall not exceed ten
years measured from the option grant date.
42
<PAGE>
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.
43
<PAGE>
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
<TABLE>
<CAPTION>
Series A Preferred Series B Preferred
Common Stock (2) Stock (3) Stock (4)
--------- ------- --------- ------- --------- -------
Beneficial Owner (1) Number Percent Number Percent Number Percent
- --------------------------------------- --------- ------- --------- ------- --------- -------
<S> <C> <C> <C> <C> <C> <C>
Brentwood Venture Capital (7).......... - - 3,000,000 23.3% 449,438 11.1%
Enterprise Partners (8)................ 2,161,764 24.7% 3,000,000 23.3% 449,438 11.1%
Kleiner Perkins Caufield & Byers (9)... - - 3,000,000 23.3% 449,438 11.1%
MCI WorldCom Venture Fund, Inc. (10)... 720,000 7.6% - - - -
The Sprout Group (11).................. - - 3,000,000 23.3% 449,438 11.1%
Enron Communications Group (12)........ - - - - 2,247,191 55.6%
Microsoft Corporation (13) ............ 720,000 7.6% - - - -
Catherine M. Hapka (14)................ 3,744,904 42.8% 365,094 2.8% - -
Michael E. Calabrese (15).............. 360,000 4.0% - - - -
Eric H. Geis (16)...................... 150,000 1.7% - - - -
James A. Greenberg (17)................ 715,642 8.0% - - - -
Gloria Farler (18)..................... 36,000 * - - - -
Kevin R. Compton (19).................. - - - - - -
Keith B. Geeslin (20).................. - - - - - -
Ken L. Harrison (21)................... - - - - - -
Susan Mayer (22)....................... - - - - - -
William R. Stensrud (23)............... - - - - - -
John L. Walecka (24)................... - - - - - -
Edward J. Zander....................... - - - - - -
All directors and officers as a
group (16 persons) (25)................ 6,574,660 68.3% 420,094 3.3% - -
<CAPTION>
Series C Preferred Beneficial Ownership of
Stock (5) Common Stock (6)
--------- ------- -------------- -------
Beneficial Owner (1) Number Percent Total shares Percent
- --------------------------------------- --------- ------- -------------- -------
<S> <C> <C> <C> <C>
Brentwood Venture Capital (7).......... - - 8,278,651 14.2%
Enterprise Partners (8)................ - - 10,440,415 17.9%
Kleiner Perkins Caufield & Byers (9)... - - 8,278,651 14.2%
MCI WorldCom Venture Fund, Inc. (10)... 3,731,410 50.0% 5,197,692 8.8%
The Sprout Group (11).................. - - 8,278,651 14.2%
Enron Communications Group (12)........ - - 5,393,258 9.3%
Microsoft Corporation (13) ............ 3,731,409 50.0% 5,197,691 8.8%
Catherine M. Hapka (14)................ - - 4,621,130 7.9%
Michael E. Calabrese (15).............. - - 360,000 *
Eric H. Geis (16)...................... - - 150,000 *
James A. Greenberg (17)................ - - 715,642 1.2%
Gloria Farler (18)..................... - - 36,000 *
Kevin R. Compton (19).................. - - - -
Keith B. Geeslin (20).................. - - - -
Ken L. Harrison (21)................... - - - -
Susan Mayer (22)....................... - - - -
William R. Stensrud (23)............... - - - -
John L. Walecka (24)................... - - - -
Edward J. Zander....................... - - - -
All directors and officers as a
group (16 persons) (25)................ - - 7,582,886 12.8%
</TABLE>
- ----------------------------------
* Represents beneficial ownership of less than one percent of the
outstanding shares of our common stock.
(1) Except as indicated by footnote, we understand that the persons named in
the table above, have sole voting and investment power with respect to all
shares shown as beneficially owned by them, subject to community property laws
where applicable.
(2) Shares of common stock subject to options, which are currently
exercisable or exercisable within 60 days of March 19, 1999, are deemed
outstanding for computing the percentages of the person holding such
options but are not deemed outstanding for computing the percentages of
any other person. Percentage ownership is based on shares of common stock
outstanding as of March 19, 1999.
(3) The number of shares reflects the shares of common stock in the aggregate
issuable upon the conversion of the Series A preferred stock. Each share of
Series A preferred stock is currently convertible into 2.4 shares of common
stock.
(4) The number of shares reflects the number of shares of common stock in the
aggregate issuable upon the conversion of the Series B preferred stock. Each
share of Series B preferred stock is currently convertible into 2.4 shares of
common stock.
(5) The number of shares reflects the number of shares of common stock in the
aggregate issuable upon the conversion of the Series C preferred Stock. Each
share of Series C preferred stock is currently convertible into 1.2 shares of
common stock.
(6) Reflects the beneficial ownership of common stock, assuming the
conversion of the Series A preferred stock, Series B preferred stock and Series
C preferred stock. Shares of common stock subject to options or warrants, which
are currently exercisable or exercisable within 60 days of March 19, 1999, are
deemed outstanding for computing the percentage of the person holding such
options or warrants but are not deemed outstanding for computing the percentage
of any other person.
(7) 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.
(8) 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.
(9) 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.
(10) Includes 720,000 shares of common stock issuable upon exercise of a
warrant exercisable within 60 days of March 19, 1999. The address for MCI
WorldCom Venture Fund, Inc. is 1801 Pennsylvania Avenue, Washington, DC 20006
(11) 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."
(12) These shares are subject to a voting trust agreement, which terminates
on the earlier to occur of (i) March 11, 2008, (ii) our initial public
offering, (iii) a merger or sale of our company or (iv) the effective date of
a liquidation or dissolution of our company. We serve as the trustee and,
except with respect to electing the director to be elected by the holders of
Series B preferred stock or with respect to the protective provisions of the
Series B preferred stock, vote the shares held in trust for or against any
stockholder proposal in the same proportion as a majority of the then
outstanding shares of Series A preferred stock, voting as a separate class
are voted or abstain. The address for Enron Communications Group, Inc. is
210 Southwest Morrison Street, Suite 400, Portland, Oregon 97204.
44
<PAGE>
(13) Includes 720,000 shares issuable upon exercise of a warrant exercisable
within 60 days of March 19, 1999. The address for Microsoft Corporation is One
Microsoft Way, Redmond, Washington 98052.
(14) 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.
(15) Includes 180,000 shares issuable upon exercise of options exercisable
within 60 days of March 19, 1999.
(16) Includes 18,000 shares issuable upon exercise of options exercisable
within 60 days of March 19, 1999.
(17) Includes 168,000 shares issuable upon exercise of options exercisable
within 60 days of March 19, 1999.
(18) Ms. Farler resigned in February 1999.
(19) Excludes shares held by 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.
(20) 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.
(21) 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.
(22) 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.
(23) 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 Enterprise Entities. Mr. Stensrud
disclaims beneficial interest in such shares, except to the extent of his
interest in the Enterprise Entities.
(24) 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.
(25) Includes 1,182,000 shares issuable upon exercise of options or warrants
exercisable within 60 days of March 19, 1999 and excludes shares held by the
Brentwood Entities, the Enterprise Entities, the KPCB Entities, MCI WorldCom,
the Sprout Entities, Enron Communications Group and Microsoft Corporation.
ITEM 13: 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 are currently convertible
into 29,472,000 shares of common stock. 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 are currently convertible into 504,000 shares of common stock. In
connection with these sales, we entered into an Investors' Rights Agreement and
Addendum with the Series A Purchasers and the Additional Series A Purchasers,
which provided the Series A Purchasers and Additional Series A Purchasers with
certain demand and piggyback registration rights, and certain rights of first
offer in the event we propose to offer for sale certain of our securities. The
Investors' Rights Agreement and Addendum was replaced by the Amended and
Restated Investors' Rights Agreement which has been superseded by the 1999
Investors' Rights Agreement. 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 are currently convertible into 876,226
shares of common stock. Please see "Executive Compensation--Employment
Agreements and Change in Control Arrangements."
SERIES B PURCHASE AGREEMENT
On March 12, 1998, we entered into a Series B Preferred Stock Purchase
Agreement with certain of the Series A Purchasers and Enron Communications
Group, Inc. (together, the "Series B Purchasers"). Under this agreement, the
Series B Purchasers acquired an aggregate of 4,044,943 shares of Series B
preferred stock for an aggregate purchase price of $18.0 million, which are
currently convertible into 9,707,863 shares of common stock. In connection with
the Series B preferred stock Purchase Agreement, we entered into an Amended and
Restated Investors' Rights
45
<PAGE>
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.
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, in the aggregate 3,731,410 shares of Series C preferred stock,
which are convertible into 4,477,692 shares of common stock, and a warrant to
purchase an aggregate of 720,000 shares of our common stock for an aggregate
purchase price of $30.0 million. In connection with this purchase agreement, we
entered into an Amended and Restated Investors' Rights Agreement, which has been
replaced by the 1999 Investors' Rights Agreement from the Microsoft investment.
Please see "--Investors' Rights Agreement."
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 MCI
WorldCom's preferred provider of business DSL lines 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, in the
aggregate 3,731,409 shares of Series C preferred stock, which are convertible
into 4,477,691 shares of common stock, and a warrant to purchase an aggregate of
720,000 shares of our common stock for an aggregate purchase price of $30.0
million. In connection with this purchase agreement, we entered into an Amended
and Restated Investors' Rights Agreement dated March 16, 1999 (the "1999
Investors' Rights Agreement"). The 1999 Investors' Rights Agreement replaced the
investors' rights agreement from the MCI WorldCom 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."
INVESTORS' RIGHTS AGREEMENT
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. At any time after the earlier of (i) March 11, 2002 or (ii) six
months after the effective date of the first registration statement for a public
offering of our securities we file under the Securities Act:
- holders of 60% or more of the registrable securities, as defined in the
1999 Investors' Rights Agreement, may require us to register for public
sale no less than 20% of their shares then outstanding; or
- Enron may require us to register for public sale no less than 20% of our
shares it then holds; 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 acquire greater than 5%
of our common stock, then MCI WorldCom's investment fund may require us to
register for public sale all of its shares of our stock (the "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,
46
<PAGE>
- one such registration pursuant to the request of Enron,
- one such registration pursuant to the request of MCI WorldCom's
investment fund, and
- one Contingent Demand for Registration pursuant to the request of MCI
WorldCom's investment fund.
In addition, if we propose to register securities under the Securities Act
after an initial public offering, with certain exceptions, then any of the
parties to the Amended and Restated Investors' Rights Agreement has a right to
request that we register such holder's registrable securities, subject to
quantity limitations determined by underwriters if the offering involves an
underwriting. All registration expenses incurred in connection with the
registrations described above and all piggyback registrations will be borne by
us. The participating stockholders will pay for underwriting discounts and
commissions incurred in connection with any such registrations. We have agreed
to indemnify the parties to the agreement against certain liabilities in
connection with any registration effected pursuant to the 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 $5,000,000 and subject to certain other conditions and
limitations, including our ability to defer the filing of the Form S-3
Registration for a period of not more than 120 days in certain circumstances.
All expenses incurred in connection with such a Form S-3 Registration shall be
borne pro rata by the stockholders participating in the Form S-3 Registration.
All registration rights will terminate no later than after five years following
the consummation of an initial public offering of our common stock. 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 Notes
that we registered under the Securities Act. Certain associates of Donaldson,
Lufkin & Jenrette Securities Corporation ("DLJSC"), an initial purchaser in the
May 1998 offering, own an aggregate of 3,000,000 shares of Series A preferred
stock and 449,438 shares of Series B preferred stock, which represent in the
aggregate approximately 14.2% of our outstanding equity.
Of these, Sprout Capital VII, L.P. beneficially owns 2,609,686 shares of
Series A preferred stock and 390,966 shares of Series B preferred stock, which
represent in the aggregate approximately 12.4% of our outstanding equity. All of
the shares owned by Sprout Capital VII, L.P. are subject to a voting trust and
are held by an independent third party as trustee. The trustee will vote such
shares in its sole and absolute discretion as advised by an independent adviser
who is not affiliated with Sprout Capital VII, L.P. and DLJSC and subject to the
Amended and Restated Voting Agreement dated March 12, 1998.
Also, pursuant to the Amended and Restated Voting Agreement, Sprout Capital
VII, L.P., The Sprout CEO Fund, L.P., DLJ Capital Corporation and DLJ First ESC
L.L.C., all of which are affiliates of DLJSC, collectively have the right to
designate one member of the Board of Directors. Their current designee is Keith
B. Geeslin. Mr. Geeslin is a Divisional Senior Vice President of DLJ Capital
Corporation, a wholly owned subsidiary of Donaldson, Lufkin & Jenrette, Inc.,
the parent of DLJSC. Mr. Geeslin is also one of several individuals who serve as
general partners of DLJ Associates VII, L.P., which is a general partner of
Sprout Capital VII, L.P. DLJ Capital Corporation is the managing general partner
of each of Sprout Capital VII, L.P. and The Sprout CEO Fund, L.P.
DIRECTOR RELATIONSHIPS
William R. Stensrud, a member of our Board of Directors, also served as our
President and Chief Executive Officer from February 1997 through June 1997. Mr.
Stensrud and Mr. Geeslin, also a member of our Board of Directors, each also
serve as directors for Paradyne Corporation, one of our vendors. Additionally,
from June 1996 through December 1996, Mr. Stensrud served as President of
Paradyne Corporation. John L. Walecka, a member of our Board of Directors, also
serves as a director for Xylan Corporation, an indirect vendor to us. For the
period ended December 31, 1997 and for the 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
47
<PAGE>
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. 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.
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) THE FOLLOWING DOCUMENTS ARE FILED AS PART OF, OR INCORPORATED BY
REFERENCE INTO, THIS ANNUAL REPORT ON FORM 10-K:
(1) FINANCIAL STATEMENTS. The following Consolidated Financial Statements
of Rhythms NetConnections, Inc. and Report of Independent Accountants are
included in a separate section of this Report beginning on page F-1:
<TABLE>
<CAPTION>
Page
Description Number
----------- ------
<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 Statements of Stockholders' Equity......................................F-6
Notes to Consolidated Financial Statements...........................................F-7
</TABLE>
(2) FINANCIAL STATEMENT SCHEDULES Financial statement schedules have
been omitted because they are either not required, not applicable or the
information is otherwise included.
48
<PAGE>
(3) EXHIBITS:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ---------- -----------------------------------------------------------------------------------------------------
<C> <S>
3.1+ Restated Certificate of Incorporation of the Company, as amended.
3.2+ Bylaws of the Company, as amended.
4.1* Indenture, dated as of May 5, 1998, by and between the Company and State Street Bank and Trust
Company of California, N.A., as trustee, including form of the Company's 13 1/2% Senior Discount
Notes due 2008, Series A and form of the Company's 13 1/2% Senior Discount Notes due 2008,
Series B.
4.2* Warrant Agreement, dated as of May 5, 1998, by and between the Company and State Street Bank and
Trust Company of California, N.A.
4.3* Warrant Registration Rights Agreement, dated as of May 5, 1998, by and among the Company and
Merrill Lynch & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, and Donaldson, Lufkin &
Jenrette Securities Corporation.
4.4+ Warrant to Purchase Shares of Common Stock, dated May 19, 1998, by and between the Company and Sun
Financial Group, Inc.
4.5+ Common Stock Purchase Warrant, dated March 3, 1999, by and between the Company and MCI WorldCom
Venture Fund, Inc.
4.6+ Common Stock Purchase Warrant, dated March 16, 1999, by and between the Company and Microsoft
Corporation.
9.1* Voting Trust Agreement, dated as of May 5, 1998, by and among Sprout Capital VII, L.P., Donaldson
Lufkin & Jenrette Securities Corporation, and First Union Trust Company, National Association, as
trustee.
9.2* Voting Trust Agreement, dated as of March 12, 1998, by and between Enron Communications Group, Inc.
and the Company, as trustee.
9.3* Amended and Restated Voting Agreement, dated March 12, 1998, by and among the Company and the
parties listed on the Schedule of Investors attached thereto as Schedule A, as amended.
9.4+ Voting Trust Agreement, dated March 3, 1999, by and between MCI WorldCom Venture Fund, Inc. and the
Company, as trustee.
10.1* Series A Preferred Stock Purchase Agreement, dated July 3, 1997, by and among the Company and the
Investors listed on Schedule A thereto.
10.2* Subsequent Closing Purchase Agreement, dated December 23, 1997, by and among the Company and the
Investors listed on Schedule A thereto.
10.3* Series B Preferred Stock Purchase Agreement, dated March 12, 1998, by and among the Company and
the Investors listed on Schedule A thereto.
10.4+** Enterprise Services Solution Agreement between Cisco Systems, Inc. and the Company, dated December
3, 1998
10.5+ Series C Preferred Stock Purchase Agreement, dated March 3, 1999, by and among the Company and MCI
WorldCom Venture Fund, Inc.
10.6+ Amended and Restated Investors' Rights Agreement, dated March 3, 1999, by and among the Company
and the Investors listed on Schedule A thereto.
10.7+** Agreement, dated March 3, 1999, by and between the Company and MCI WorldCom, Inc.
10.8+ Series C Preferred Stock and Warrant Purchase Agreement, dated March 16, 1999, by and among the
Company and Microsoft Corporation.
10.9+ Amended and Restated Investors' Rights Agreement, dated March 16, 1999, by and among the Company
and the Investors listed on Schedule A thereto.
10.10+ Distribution Agreement, dated March 16, 1999, by and among the Company and Microsoft Corporation.
</TABLE>
49
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ----------- -----------------------------------------------------------------------------------------------------
<C> <S>
10.11* Master Lease Agreement No. 1642 and Addendum thereto, each dated November 19, 1997, and Second
Addendum thereto, dated as of May 19, 1998, between the Company and Sun Financial Group, Inc.
10.12+ Business Lease (Single Tenant) between the Company and BR Venture, LLC dated September 1998.
10.13* Employment Agreement between the Company and Catherine M. Hapka, dated June 10, 1997.
10.14* Employment Agreement between the Company and Jeffrey Blumenfeld, dated August 10, 1997.
10.15* Employment Agreement between the Company and James A. Greenberg, dated July 14, 1997.
10.16* Employment Agreement between the Company and Rand A. Kennedy, dated August 22, 1997.
10.17* 1997 Stock Option/Stock Issuance Plan.
10.18* Form of Indemnification Agreement between the Company and each of its directors.
10.19* Form of Indemnification Agreement between the Company and each of its officers.
10.20* QuickStart Loan and Security Agreement, dated October 29, 1997, between the Company and Silicon
Valley Bank.
21.1* Subsidiaries of the Company.
23.1 Consent of PricewaterhouseCoopers LLP.
24.1 Power of Attorney (see page 51).
27.1 Financial Data Schedule.
</TABLE>
- ------------------------
+ Previously filed with the Commission as an exhibit to the registration
statement on Form S-1 filed on February 16, 1999 (File No. 333-72409)
and incorporated herein by reference.
* Previously filed with the Commission as an exhibit to the registration
statement on Form S-4 filed on July 17, 1998 (File No. 333-59393) and
incorporated herein by reference.
** Certain confidential portions of this Exhibit were omitted by means of
marking such portions with an asterisk (the "Mark"). This Exhibit has been
filed separately with the Secretary of the Commission without the Mark
pursuant to the Company's Application Requesting Confidential Treatment
under Rule 24b-2 under the Exchange Act of 1934, as amended.
(b) REPORTS ON FORM 8-K
Inapplicable.
(c) EXHIBITS
The exhibits required by this Item are listed under Item 14(a)(3).
(d) FINANCIAL STATEMENT SCHEDULES
The consolidated financial statement schedules required by this Item are
listed under Item 14(a)(2).
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO
SECTION 15(d) OF THE ACT BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES
PURSUANT TO SECTION 12 OF THE ACT.
The registrant has not sent to security holders any annual report
covering the registrant's last fiscal year or any proxy material relating to
a meeting of security holders. Copies of such annual report and proxy will be
furnished to the Commission when it is sent to security holders.
50
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.
RHYTHMS NETCONNECTIONS, INC.
By /s/ CATHERINE M. HAPKA Date: March 31, 1999
------------------------------------- ------------------------
Catherine M. Hapka
Chief Executive Officer
By /s/ SCOTT C. CHANDLER Date: March 31, 1999
------------------------------------- ------------------------
Scott C. Chandler
Chief Financial Officer
POWER OF ATTORNEY
Know all men by these presents, that each person whose signature appears below
constitutes and appoints Catherine M. Hapka or Scott C. Chandler, his or her
attorney-in-fact, with power of substitution in any and all capacities, to sign
any amendments to this Annual Report on Form 10-K, and to file the same with
exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, hereby ratifying and confirming all that the
attorney-in-fact or his substitute or substitutes may do or cause to be done by
virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report
has been signed below by the following persons on behalf of the Registrant in
the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
<S> <C> <C>
/s/ CATHERINE M. HAPKA President and
- ------------------------------- Chief Executive Officer March 31, 1999
(Catherine M. Hapka) (Principal Executive Officer)
/s/ SCOTT C. CHANDLER Chief Financial Officer
- ------------------------------- March 31, 1999
(Scott C. Chandler)
/s/ KEVIN R. COMPTON Director
- ------------------------------- March 31, 1999
(Kevin R. Compton)
/s/ KEITH B. GEESLIN Director
- ------------------------------- March 31, 1999
(Keith B. Geeslin)
/s/ KEN L. HARRISON Director
- ------------------------------- March 31, 1999
(Ken L. Harrison)
/s/ SUSAN MAYER Director
- ------------------------------- March 31, 1999
(Susan Mayer)
/s/ William R. Stensrud Director
- ------------------------------- March 31, 1999
(William R. Stensrud)
51
<PAGE>
/s/ JOHN L. WALECKA Director
- ------------------------------- March 31, 1999
(John L. Walecka)
/s/ Edward J. Zander Director
- ------------------------------- March 31, 1999
(Edward J. Zander)
</TABLE>
52
<PAGE>
RHYTHMS NETCONNECTIONS INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Accountants.................................................... F-2
Financial Statements:
Consolidated Balance Sheets........................................................ F-3
Consolidated Statements of Operations.............................................. F-4
Consolidated Statements of Cash Flows.............................................. F-5
Consolidated Statement of Stockholders' Equity..................................... F-6
Notes to Consolidated Financial Statements......................................... F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders
of Rhythms NetConnections Inc.
In our opinion, the accompanying consolidated balance 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,
1997 1998
------------- --------------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents....................................................... $ 10,166,000 $ 21,315,000
Short-term investments.......................................................... -- 115,497,000
Accounts, loans and other receivables, net...................................... -- 2,376,000
Inventory....................................................................... -- 340,000
Prepaid expenses and other current assets....................................... 95,000 230,000
------------- --------------
Total current assets............................................................ 10,261,000 139,758,000
Equipment and furniture, net...................................................... 1,621,000 11,510,000
Collocation fees, net............................................................. 327,000 13,804,000
Deferred debt issue costs, net.................................................... -- 6,304,000
Other assets...................................................................... 32,000 350,000
------------- --------------
$ 12,241,000 $ 171,726,000
------------- --------------
------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt............................................... $ 126,000 $ 333,000
Accounts payable................................................................ 951,000 10,601,000
Accrued expenses and other current liabilities.................................. 376,000 2,855,000
------------- --------------
Total current liabilities..................................................... 1,453,000 13,789,000
Long-term debt.................................................................... 442,000 472,000
13.5% senior discount notes, net.................................................. -- 157,465,000
Other liabilities................................................................. -- 180,000
------------- --------------
Total liabilities............................................................. 1,895,000 171,906,000
------------- --------------
Commitments (note 10)
Mandatorily redeemable common stock warrants...................................... -- 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; 12,490,000 shares issued and
outstanding in 1997, 12,855,094 shares in 1998................................ 12,000 13,000
Series B convertible preferred stock, $0.001 par value; no shares authorized in
1997, 4,044,943 shares in 1998; no shares issued and outstanding in 1997,
4,044,943 shares in 1998...................................................... -- 4,000
Common stock, $0.001 par value; 54,635,294 shares authorized in 1997, 80,049,892
shares in 1998; 2,482,222 shares issued in 1997, 8,042,530 shares in 1998..... 2,000 8,000
Treasury stock, at cost; 438,115 shares......................................... -- (18,000)
Additional paid-in capital...................................................... 14,012,000 37,212,000
Deferred compensation........................................................... (1,258,000) (5,210,000)
Accumulated deficit............................................................. (2,422,000) (38,756,000)
------------- --------------
Total stockholders' equity (deficit).......................................... 10,346,000 (6,747,000)
------------- --------------
$ 12,241,000 $ 171,726,000
------------- --------------
------------- --------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 27, 1997
(INCEPTION)
THROUGH YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
------------------ -----------------
<S> <C> <C>
Revenue:
Service and installation, net......................................... $ -- $ 528,000
------------------ -----------------
Operating Expenses:
Network and service costs............................................. -- 4,695,000
Selling and marketing................................................. 33,000 3,776,000
General and administrative............................................ 2,501,000 19,377,000
Depreciation and amortization......................................... 1,000 1,081,000
------------------ -----------------
Total operating expenses............................................ 2,535,000 28,929,000
------------------ -----------------
Loss from Operations.................................................... (2,535,000) (28,401,000)
------------------ -----------------
Other Income and Expense:
Interest income....................................................... 114,000 5,813,000
Interest expense (including amortized debt discount and issue
costs).............................................................. (1,000) (13,779,000)
Other................................................................. -- 33,000
------------------ -----------------
Net Loss................................................................ $ (2,422,000) $ (36,334,000)
------------------ -----------------
------------------ -----------------
Net Loss Per Share:
Basic................................................................. $ (1.12) $ (12.18)
------------------ -----------------
------------------ -----------------
Diluted............................................................... $ (1.12) $ (12.18)
------------------ -----------------
------------------ -----------------
Shares Used in Computing Net Loss Per Share:
Basic................................................................. 2,161,764 2,984,216
------------------ -----------------
------------------ -----------------
Diluted............................................................... 2,161,764 2,984,216
------------------ -----------------
------------------ -----------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD FROM
FEBRUARY 27, 1997
(INCEPTION)
THROUGH YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
------------------ -----------------
<S> <C> <C>
Cash Flows from Operating Activities:
Net Loss................................................................. $ (2,422,000) $ (36,334,000)
Adjustments to reconcile net loss to net cash used for operating
activities:
Depreciation of equipment and furniture................................ 1,000 454,000
Amortization of collocation fees....................................... -- 85,000
Amortization of debt discount and deferred debt issue costs............ -- 13,882,000
Amortization of deferred compensation.................................. 192,000 725,000
Compensation expense from stock option issued to employee.............. 73,000 --
Loss on sale of equipment to leasing company........................... -- 387,000
Changes in assets and liabilities:
Increase in accounts, loans and other receivables, net............... -- (2,376,000)
Increase in inventory................................................ -- (340,000)
Increase in prepaid expenses and other current assets................ (95,000) (135,000)
Increase in other assets............................................. (32,000) (318,000)
Increase in accounts payable......................................... 388,000 2,287,000
Increase in accrued expenses and other current liabilities........... 335,000 2,479,000
Increase in other liabilities........................................ -- 180,000
------------------ -----------------
Net cash used for operating activities................................. (1,560,000) (19,024,000)
------------------ -----------------
Cash Flows from Investing Activities:
Purchases of short-term investments...................................... -- (451,870,000)
Maturities of short-term investments..................................... -- 336,373,000
Purchases of equipment and furniture..................................... (1,018,000) (9,973,000)
Payment of collocation fees.............................................. (327,000) (13,562,000)
------------------ -----------------
Net cash used for investing activities................................. (1,345,000) (139,032,000)
------------------ -----------------
Cash Flows from Financing Activities:
Proceeds from leasing company for equipment.............................. -- 6,606,000
Proceeds from issuance of 13.5% senior discount notes and warrants....... -- 150,365,000
Payment of debt issue costs on 13.5% senior discount notes............... -- (6,519,000)
Proceeds from borrowings on long-term debt............................... 568,000 432,000
Repayments on long-term debt............................................. -- (195,000)
Proceeds from issuance of common stock................................... 13,000 242,000
Proceeds from issuance of preferred stock................................ 12,490,000 18,292,000
Purchase of treasury stock............................................... -- (18,000)
------------------ -----------------
Net cash provided by financing activities.............................. 13,071,000 169,205,000
------------------ -----------------
Net increase in cash and cash equivalents.................................. 10,166,000 11,149,000
Cash and cash equivalents at beginning of period........................... -- 10,166,000
------------------ -----------------
Cash and cash equivalents at end of period................................. $ 10,166,000 $ 21,315,000
------------------ -----------------
------------------ -----------------
Supplemental schedule of cash flow information:
Cash paid for interest................................................... $ 3,000 $ 66,000
------------------ -----------------
------------------ -----------------
Supplemental schedule of non-cash financing activities:
Equipment purchases payable, to be financed through operating leases..... $ 604,000 $ --
------------------ -----------------
------------------ -----------------
Equipment and furniture purchases payable................................ $ -- $ 7,363,000
------------------ -----------------
------------------ -----------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE>
RHYTHMS NETCONNECTIONS INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
SERIES A SERIES B
CONVERTIBLE CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK COMMON STOCK
$0.001 PAR VALUE $0.001 PAR VALUE $0.001 PAR VALUE
------------------- ----------------- -----------------
# SHARES AMOUNT # SHARES AMOUNT # SHARES AMOUNT
---------- ------- --------- ------ --------- ------
<S> <C> <C> <C> <C> <C> <C>
Issuance of common stock to Founders (at
inception)............................ -- $ -- -- $-- 2,161,764 $2,000
Issuance of Series A preferred stock for
cash ($1.00 per share)................ 12,490,000 12,000 -- -- -- --
Issuance of common stock upon exercise
of options ($0.04 per share exercise
price)................................ -- -- -- -- 320,458 --
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 -- -- 2,482,222 2,000
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)....................... -- -- -- -- 5,560,308 6,000
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 8,042,530 $8,000
---------- ------- --------- ------ --------- ------
---------- ------- --------- ------ --------- ------
<CAPTION>
TREASURY STOCK TOTAL
AT COST ADDITIONAL STOCKHOLDERS'
------------------- PAID-IN DEFERRED ACCUMULATED EQUITY
# SHARES AMOUNT CAPITAL COMPENSATION DEFICIT (DEFICIT)
-------- -------- ----------- ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Issuance of common stock to Founders (at
inception)............................ -- $ -- $ -- $ -- $ -- $ 2,000
Issuance of Series A preferred stock for
cash ($1.00 per share)................ -- -- 12,477,000 -- -- 12,489,000
Issuance of common stock upon exercise
of options ($0.04 per share exercise
price)................................ -- -- 12,000 -- -- 12,000
Grant of options to purchase Series A
preferred stock ($0.80 per share
exercise price)....................... -- -- 73,000 -- -- 73,000
Deferred compensation from grants of
options to purchase common stock...... -- -- 1,450,000 (1,450,000) -- --
Amortization of deferred compensation... -- -- -- 192,000 -- 192,000
Net loss for 1997....................... -- -- -- -- (2,422,000) (2,422,000)
-------- -------- ----------- ------------ ------------ -------------
Balance at December 31, 1997............ -- -- 14,012,000 (1,258,000) (2,422,000) 10,346,000
Issuance of Series A preferred stock for
cash ($0.80 per share)................ -- -- 291,000 -- -- 292,000
Issuance of Series B preferred stock for
cash ($4.45 per share)................ -- -- 17,996,000 -- -- 18,000,000
Issuance of common stock upon exercise
of options ($0.04 to $0.25 per share
exercise price)....................... -- -- 236,000 -- -- 242,000
Purchase of treasury stock for cash
($0.04 per share)..................... 438,115 (18,000) -- -- -- (18,000)
Deferred compensation from grants of
options to purchase common stock...... -- -- 4,908,000 (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) 231,000 -- --
Net loss for 1998....................... -- -- -- -- (36,334,000) (36,334,000)
-------- -------- ----------- ------------ ------------ -------------
Balance at December 31, 1998............ 438,115 $(18,000) $37,212,000 $(5,210,000) $(38,756,000) $(6,747,000)
-------- -------- ----------- ------------ ------------ -------------
-------- -------- ----------- ------------ ------------ -------------
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1--THE COMPANY
Rhythms NetConnections Inc. (the "Company"), a Delaware corporation, was
organized under the name Accelerated Connections Inc. effective February 27,
1997. The Company's name was changed to Rhythms NetConnections Inc. as of August
15, 1997. The Company is in the business of providing high-speed data
communications services on an end-to end basis to business customers and end
users. The Company began service trials in the San Diego, California, market in
December 1997 and began commercial operations in San Diego effective April 1,
1998.
The Company's ultimate success depends upon, among other factors, rapidly
expanding the geographic coverage of its network services; entering into
interconnection agreements with incumbent local exchange carriers, some of which
are competitors or potential competitors of the Company; deploying network
infrastructure; attracting and retaining customers; accurately assessing
potential markets; continuing to develop and integrate its operational support
system and other back office systems; obtaining any required governmental
authorizations; responding to competitive developments; continuing to attract,
retain and motivate qualified personnel; and continuing to upgrade its
technologies and commercialize its network services incorporating such
technologies. There can be no assurance that the Company will be successful in
addressing these matters and failure to do so could have a material adverse
effect on the Company's business, prospects, operating results and financial
condition. As the Company continues the development of its business, it will
seek additional sources of financing to fund its development. If unsuccessful in
obtaining such financing, the Company will continue expansion of its operations
on a reduced scale based on its existing capital resources.
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION: The accompanying consolidated financial
statements include the transactions and balances of Rhythms NetConnections Inc.
and its wholly owned subsidiaries ACI Corp. and ACI Corp.--Virginia (since
February 1998). All material intercompany transactions and balances have been
eliminated.
USE OF ESTIMATES: The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the
financial statement date, as well as the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
REVENUE RECOGNITION: Revenue is recorded in the period services are
provided to customers.
CASH AND CASH EQUIVALENTS: Cash and cash equivalents include cash on hand,
money market funds, certificates of deposit, obligations of the U.S. Government
and its agencies and commercial paper with a maturity of 90 days or less at the
time of purchase.
SHORT-TERM INVESTMENTS. Short-term investments consist of obligations of
the U.S. Government and its agencies and commercial paper that have an original
maturity between 91 days and one year from the date of purchase. 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
F-7
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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 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
F-8
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
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, 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-9
<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-10
<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-11
<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
EXERCISE PRICE OUTSTANDING LIFE EXERCISE PRICE EXERCISABLE 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-12
<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-13
<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)
On March 16, 1999, the Company issued 3,731,409 shares of its Series C
Preferred Stock to Microsoft at a price of $8.04 per share for total proceeds to
the Company of $30,000,000. In connection with this investment, Microsoft 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
Microsoft to enter into various business relationships.
The Company has filed a registration statement for a public offering of
approximately 9,375,000 shares of common stock.
F-14
<PAGE>
RHYTHMS NETCONNECTIONS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 12--SUBSEQUENT EVENTS (UNAUDITED) (CONTINUED)
On March 16, 1999, the Company's Board of Directors approved the 1999
Stock Incentive Plan and the 1999 Employee Stock Purchase Plan, subject to
stockholder approval. The 1999 Stock Incentive Plan is intended to serve as
the successor equity incentive program to the 1997 Stock Option/Stock
Issuance Plan. An initial reserve of 7,440,000 shares of common stock has
been authorized for issuance under the 1999 Stock Incentive Plan. The Company
has also initially reserved an additional 1,200,000 shares of common stock
for the 1999 Employee Stock Purchase Plan. The 1999 Stock Incentive Plan will
become effective upon the effectiveness of the public offering. The 1999
Employee Stock Purchase Plan will become effective upon the execution of an
Underwriting Agreement for the public offering.
F-15
<PAGE>
EXHIBIT 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statement of
Rhythms NetConnections Inc. on Form S-8 of our report dated March 4, 1999,
except for the last paragraph of Note 11 as to which the date is March 19,
1999, on our audits of the consolidated financial statements of Rhythms
NetConnections Inc. as of December 31, 1997 and 1998 and for the period from
February 27, 1997 (inception) to December 31, 1997 and the year ended
December 31, 1998, which report is included in this Annual Report on Form 10-K
PricewaterhouseCoopers LLP
Denver, Colorado
March 30, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM DECEMBER 31,
1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 21,315
<SECURITIES> 115,497
<RECEIVABLES> 247
<ALLOWANCES> 50
<INVENTORY> 340
<CURRENT-ASSETS> 139,758
<PP&E> 11,965
<DEPRECIATION> 455
<TOTAL-ASSETS> 171,726
<CURRENT-LIABILITIES> 13,789
<BONDS> 157,465
0
17
<COMMON> 8
<OTHER-SE> (6,772)
<TOTAL-LIABILITY-AND-EQUITY> 171,726
<SALES> 528
<TOTAL-REVENUES> 528
<CGS> 4,695
<TOTAL-COSTS> 4,695
<OTHER-EXPENSES> 24,234
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 13,779
<INCOME-PRETAX> (36,334)
<INCOME-TAX> 0
<INCOME-CONTINUING> (36,334)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (36,334)
<EPS-PRIMARY> (12.18)
<EPS-DILUTED> (12.18)
</TABLE>
