<PAGE>
As filed with the Securities and Exchange Commission on July 20, 1999
Registration No. 333-79909
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
AMENDMENT NO. 2
TO
FORM S-1
REGISTRATION STATEMENT
Under
The Securities Act of 1933
----------------
Splitrock Services, Inc.
(Exact name of Registrant as specified in its charter)
Delaware 7370 76-0529757
(State or other (Primary Standard (I.R.S. Employer
jurisdiction of Industrial Identification No.)
incorporation or Classification Code
organization) Number)
8665 New Trails Drive
The Woodlands, Texas 77381
(281) 465-1200
(Address, including zip code, and telephone number, including area code, of
registrants' principal executive offices)
----------------
Patrick J. McGettigan, Jr., Esq.
Senior Vice President
8665 New Trails Drive
The Woodlands, Texas 77381
(281) 465-1200
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
----------------
Copies to:
Andrew P. Varney, Esq. John D. Watson, Jr., Esq.
Fried, Frank, Harris, Shriver & Latham & Watkins
Jacobson 1001 Pennsylvania Avenue, N.W.
1001 Pennsylvania Avenue, N.W. Washington, D.C. 20004-2505
Washington, D.C. 20004-2505 (202) 637-2200
(202) 639-7000
----------------
Approximate date of commencement of proposed sale to public: As soon as
practicable after this registration statement becomes effective.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [_]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If this is a post-effective amendment filed pursuant to Rule 462(d) under
the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]
----------------
The registrant hereby amends this registration statement on such date or
dates as may be necessary to delay its effective date until the registrant
shall file a further amendment which specifically states that this
registration statement shall thereafter become effective in accordance with
Section 8(a) of the Securities Act of 1933 or until the registration statement
shall become effective on such date as the Securities and Exchange Commission,
acting pursuant to said Section 8(a), may determine.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+The information in this preliminary prospectus is not complete and may be +
+changed. We may not sell these securities until the registration statement +
+filed with the Securities and Exchange Commission is effective. This +
+preliminary prospectus is not an offer to sell these securities and it is not +
+soliciting an offer to buy these securities in any state where the offer or +
+sale is not permitted. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
SUBJECT TO COMPLETION, DATED JULY 19, 1999
PROSPECTUS
10,700,000 Shares
[LOGO OF SPLITROCK APPEARS HERE]
Common Stock
-----------
This is an initial public offering of shares of common stock of Splitrock
Services, Inc. We are selling the 10,700,000 shares of common stock offered
under this prospectus.
There is currently no public market for our shares. We currently estimate that
the initial public offering price will be between $13.00 and $15.00 per share.
We have applied to have our common stock approved for listing on the Nasdaq
National Market under the symbol "SPLT."
See "Risk Factors" beginning on page 8 to read about risks that you should
consider before buying shares of our common stock.
Neither the Securities and Exchange Commission nor any other regulatory body
has approved or disapproved these securities or passed upon the adequacy or
accuracy of this prospectus. Any representation to the contrary is a criminal
offense.
-----------
<TABLE>
<CAPTION>
Per Share Total
--------- -----
<S> <C> <C>
Public offering price.......................... $ $
Underwriting discount ......................... $ $
Proceeds, before expenses, to us............... $ $
</TABLE>
-----------
The underwriters may purchase up to an additional 1,447,628 shares of common
stock from us, and an additional 157,372 shares of common stock from some of
our stockholders, at the initial public offering price less the underwriting
discount to cover over-allotments.
The underwriters expect to deliver the shares against payment in New York, New
York on , 1999.
-----------
Bear, Stearns & Co. Inc.
Credit Suisse First Boston
Prudential Securities
The date of this prospectus is , 1999
<PAGE>
Inside front cover (first page of a three-page fold-out):
The text in the upper right corner of the page is: Next-Generation Data
Communications Company.
The left side of the page includes the following text:
<TABLE>
<S> <C>
[Splitrock Logo]
Vision Splitrock's long-term goal is to build a highly
profitable network company that is well-positioned
among the top tier providers of data communications
services.
Business Strategy Create a nationwide, facilities-based, broadband
data communications network that targets the needs
of Internet and corporate customers with a wide
range of high-performance, cost-competitive
services.
Marketing Strategy A key objective in the networking business is to
Maximize network usage load the network with traffic both in the evening
through a multi-service and daytime hours. To achieve that goal Splitrock is
strategy targeting both targeting both wholesale-consumer and business-
wholesale and customer segments with different services. The
business customers. company is already established as a major wholesale
dial and dedicated access provider in the Internet
industry, a major source of evening traffic. We
recently began targeting business customers with a
range of data communications and value-added
services. Splitrock reaches its markets with an
experienced direct sales force. We also utilize
resellers and partners to reach a variety of
markets.
Splitrock Advantage Broad Market Coverage
We are positioned to be a Splitrock provides coverage in 50 states and more
competitive player in than 800 cities, including the top 150 markets. Not
the Internet and data only do we connect all of these markets, but our
communications industry. platform is uniformly capable of providing the same
breadth and quality of service nationwide. In
simple terms, the services we provide in major
markets like Boston and Chicago are available at
the same level of quality and reliability in
smaller markets like Billings and Cheyenne.
Network Infrastructure
We are building a broadband access platform that
will have ATM switches in approximately 370 physical
locations. When linked with our fiber backbone, this
infrastructure will give us the capability and
flexibility to deliver a host of Internet access and
data services across a nationwide end-to-end
network.
Multi-Service Capability
We can deliver a wide range of high-speed, high-
performance data communications services to
corporate and wholesale users. Our marketing, sales,
and backoffice service and support capabilities are
designed for both types of customers.
Management Team
Splitrock has assembled a seasoned, highly motivated
management team with extensive experience in the
data communications industry. We believe that our
senior managers include some of the best technical
and marketing talent in the industry. Our employees
are stakeholders in the company and are committed to
making Splitrock the best company in the industry.
</TABLE>
The right side of the page includes a table with the following data:
Internet and Data Communications
Market Projections
<TABLE>
Projected
Projected compound market size
annual growth rate 2003
Target Markets 1998-2003 ($ billions)
<S> <C> <C>
Business Internet/(1)/............... 71% $41.9
Consumer Internet/(1)/............... 19% 19.9
Web Hosting and other
Value-Added Services/(1)/............ 76% 14.7
Frame Relay/(2)/..................... 19% 10.7
ATM/(2)/............................. 37% 1.6
</TABLE>
Source: (1) Forrester Research,Inc.
(2) International Data Corporation
Below the table on the right side of the page is a graphic image showing nine
different access services connected through an ATM switch to Splitrock's
nationwide fiber backbone, as described below.
The captions at the top of the graphic image are:
Splitrock Broadband Network
Broadband Access Platform
ATM-To-The-Edge
Listed down the left side of the graphic image are the following initials: IP,
ATM, FR, OC3, DS3, DS1, DSL, ISDN and V.90.
To the right of the initials are a triangle labeled "ATM" and a United States
map labeled "Nationwide Fiber Backbone."
The caption at the bottom of the graphic image is:
"The Flexible Splitrock network architecture
supports a range of broadband access services."
2
<PAGE>
PROSPECTUS SUMMARY
This summary highlights some of the information in this prospectus. The
summary may not contain all of the information that is important to you. This
prospectus includes forward-looking statements which involve risks and
uncertainties. You should carefully read the entire prospectus, including the
risk factors and the financial statements, before deciding whether to invest in
our common stock.
Splitrock Services, Inc.
Our Company
We are a facilities-based provider of advanced data communications services.
We market our services to Internet service providers, telecommunications
carriers and other businesses throughout the United States. We own and operate
a state-of-the-art, broadband access network that:
. consistently achieves among the highest performance ratings in the
industry for network reliability, speed and throughput;
. currently handles more than 1.3 billion minutes of use per month;
. reaches businesses and households in every U.S. market with a population
of at least 100,000 as well as many smaller markets; and
. employs asynchronous transfer mode (ATM) switches at every point-of-
presence (POP).
The combination of our existing broadband access network with our pending
acquisition of significant fiber optic facilities positions us to deliver a
broad array of end-to-end data communications services on our own network,
including:
. dial and dedicated Internet access;
. Internet access for higher bandwidth services, such as digital
subscriber line (DSL) and cable modem;
. value-added services such as virtual private networks and web hosting;
and
. bandwidth leasing and colocation services.
We currently provide Internet dial access and related services to Prodigy
Communications Corporation, our primary customer and one of the largest
Internet service providers in the United States. Prodigy recently announced a
definitive agreement to acquire the Internet access customer base of Cable &
Wireless USA, which we believe will result in a significant increase in Prodigy
subscribers. We believe that our relationship with Prodigy and our high
performance ratings have demonstrated our strength as a network operator and
positioned us to expand our customer base and service offerings. Leveraging our
demonstrated network capabilities, we have recently entered into significant
new customer relationships with Juno Online Services and InfiNet. Juno, a
leading provider of Internet and e-mail services, currently has more than
200,000 subscribers for its billable Internet services launched in July 1998
and has created more than 6.8 million free e-mail accounts since April 1996.
InfiNet, a consortium sponsored by Knight-Ridder, Gannett and Landmark
Communications, provides Internet access and web publishing solutions to nearly
100,000 subscribers nationwide.
1
<PAGE>
Our Strategy
Our mission is to strengthen our position as a leading facilities-based
provider of advanced data communications services. To achieve this objective,
our business strategy focuses on the following key principles:
. expanding our direct marketing activities, increasing the size of our
sales force and developing alternative distribution channels to
capitalize on the expected growth in demand for network services;
. broadening our portfolio of service offerings;
. exploiting the capabilities of our advanced nationwide communications
network;
. building strong customer loyalty through superior customer service;
. leveraging our experienced management team;
. increasing and optimizing total network utilization by offering
comprehensive services and targeting both daytime business users and
evening consumer users to balance our network's usage; and
. evaluating strategic alliances and acquisitions that increase traffic
over our network.
Our Market Opportunity
According to industry reports, data communications is one of the fastest
growing segments of the global telecommunications market. Forrester Research
estimates that business Internet access, web hosting and other value-added
services will grow from $3.7 billion in 1998 to approximately $57 billion in
2003. Forrester also projects that consumer Internet access spending will grow
from approximately $7 billion in 1998 to approximately $19.9 billion in 2003.
Our Network
As of May 31, 1999, our broadband access network included 239 operational
POPs. When our network is completed later this year, we expect to have
approximately 370 active POPs with a physical presence in all 50 states,
targeting over 90% of all U.S. businesses and households with a local call. We
have deployed ATM switches at every core, hub and remote POP of our network.
This network architecture, which we call "ATM-to-the-Edge(TM)," enables us to
serve as a broad-based provider of data communications services through the
creation of a platform that efficiently delivers multiple services, such as
Internet access, virtual private networks and web hosting, across multiple
protocols, including Internet Protocol (IP), frame relay and ATM. The
flexibility inherent in our network design allows us to expand our service
offerings to provide fully integrated data, video and voice services. This
flexibility also allows us to incorporate future technological innovations into
our network architecture with a lower incremental investment than that required
by other communications service providers with legacy systems that have
separate networks for voice and data.
As part of our ongoing efforts to further expand and enhance our network and
service offerings, we have agreed to acquire the indefeasible rights to use
four dark fiber strands in a state-of-the-art fiber optic network currently
under construction by Level 3 Communications, with an option to use up to 12
additional fibers. This nationwide fiber network will cover approximately
15,000 route miles and will be delivered in segments that are expected to
become available from the end of 1999 through the first quarter of 2001. The
combination of this fiber optic backbone with our broadband access network
positions us to:
. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers;
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit
arrangements with various telecommunications carriers;
2
<PAGE>
. expand our service offerings by providing bandwidth leasing services on
a stand-alone basis or bundled with our other services;
. increase the reliability and redundancy of our network; and
. increase the variety of service options and speeds available to
customers.
----------------
We were incorporated in Texas on March 5, 1997 and reincorporated in
Delaware on May 8, 1998. Our headquarters are located at 8665 New Trails Drive,
The Woodlands, Texas 77381. Our telephone number at that location is (281) 465-
1200. Our website address is www.splitrock.net. The information contained on
our website is not part of this prospectus.
----------------
The terms "the Company," "Splitrock," "we," "our," and "us," as used in this
prospectus refer to Splitrock Services, Inc. Investors should carefully
consider the information set forth under "Risk Factors." Technical terms that
are important to an understanding of our business are defined in the Glossary
of Terms beginning on page G-1 of this prospectus. Except as otherwise noted,
the information in this prospectus (1) assumes that the underwriters' over-
allotment option will not be exercised and (2) reflects a 100-for-1 split of
our common stock that was effected on June 3, 1997, a 10-for-1 split of our
common stock that was effected on August 8, 1997, and a 0.563-for-1 reverse
stock split that was effected on July 12, 1999.
3
<PAGE>
The Offering
Common stock offered by
us..........................
10,700,000 shares
Common stock to be
outstanding after this
offering....................
57,381,427 shares
Use of proceeds.............
We intend to use the net proceeds from this
offering to fund:
. capital expenditures, including the
acquisition of rights to use dark fiber, the
acquisition of related electronics equipment
and the completion of our broadband access
network;
. operating losses, working capital requirements
and other general corporate purposes; and
. possible future acquisitions or strategic
investments.
Proposed Nasdaq National Market SPLT
symbol..........................
The number of shares of common stock to be outstanding after this offering
is based on the 46,681,427 shares outstanding as of June 30, 1999 and includes
the 10,700,000 shares of common stock being sold by us in this offering. The
shares of common stock to be outstanding after this offering excludes:
. any shares of common stock to be issued pursuant to the over-allotment
option;
. 1,487,791 shares of common stock issuable on or after July 26, 1999 upon
the exercise of outstanding warrants with an exercise price of $0.02 per
share;
. 2,896,128 shares of common stock issuable upon the exercise of
outstanding options with a weighted average exercise price of $5.10 per
share; and
. 7,735,845 shares of common stock reserved for issuance upon the exercise
of options available to be granted under our stock option plans.
4
<PAGE>
SUMMARY FINANCIAL DATA
Our statement of operations data for the period from inception (March 5,
1997) to December 31, 1997 and for the year ended December 31, 1998, and our
balance sheet data as of December 31, 1997 and 1998, shown in the table below
are derived from our audited financial statements. Our statement of operations
data for the three months ended March 31, 1998 and 1999 and our balance sheet
data as of March 31, 1999 have been derived from our unaudited financial
statements which, in the opinion of management, include all adjustments,
consisting only of normal recurring adjustments, necessary for a fair statement
of the results for the unaudited interim periods presented. You should read
this information together with our financial statements and the notes relating
to those statements and with the section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations" appearing elsewhere
in this prospectus. Results of operations for the periods presented are not
necessarily indicative of results of operations for future periods.
The "As Adjusted" summary balance sheet data reflects the sale of the shares
of common stock offered by this prospectus at an assumed initial public
offering price of $14.00 per share, after deducting the underwriting discount
and the estimated offering expenses payable by us. For more information, see
"Use of Proceeds."
<TABLE>
<CAPTION>
Period from
Inception
(March 5, Year Ended
1997) through December Three Months Ended March 31,
December 31, 31, ------------------------------
1997 1998 1998 1999
------------- ----------- -------------- --------------
(in thousands, except share and per share data)
<S> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues.............. $ 22,708 $ 63,611 $ 16,494 $ 16,352
Operating expenses:
Splitrock network
costs.............. 2,362 32,912 3,955 16,022
Legacy network
costs.............. 25,804 58,292 12,316 13,029
Selling, general and
administrative..... 1,276 6,390 859 2,570
Depreciation and
amortization....... 3,500 13,850 2,820 4,635
----------- ----------- -------------- --------------
Total operating
expenses......... 32,942 111,444 19,950 36,256
----------- ----------- -------------- --------------
Loss from operations.. (10,234) (47,833) (3,456) (19,904)
Other income
(expense):
Interest income..... 348 5,393 107 2,604
Interest expense.... (235) (15,390) (349) (8,191)
----------- ----------- -------------- --------------
Loss before income
tax.................. (10,121) (57,830) (3,698) (25,491)
Provision for income
tax.................. -- -- -- --
----------- ----------- -------------- --------------
Net loss.............. $ (10,121) $ (57,830) $ (3,698) $ (25,491)
=========== =========== ============== ==============
Net loss per share--
basic and diluted.... $ (0.42) $ (1.30) $ (0.09) $ (0.55)
=========== =========== ============== ==============
Weighted average
shares--basic and
diluted.............. 24,109,912 44,389,172 43,238,400 46,659,188
</TABLE>
5
<PAGE>
(Unaudited)
As of March 31, 1999
--------------------
Actual As Adjusted
-------- -----------
(in thousands)
Balance Sheet Data
Cash and cash equivalents ........................... $ 23,365 $ 162,428
Unrestricted investments ............................ 87,793 87,793
Restricted investments (1) .......................... 44,356 44,356
Property and equipment, net ......................... 84,833 84,833
Total assets ........................................ 257,065 396,128
Long-term debt and capital lease obligations
(including current portion) ........................ 272,844 272,844
Stockholders' equity (deficit) ...................... (55,925) 83,138
<TABLE>
<CAPTION>
Period from
Inception (Unaudited)
(March 5, Three Months Ended
1997) through Year Ended March 31,
December 31, December 31, -------------------
1997 1998 1998 1999
------------- ------------ --------- ---------
(in thousands)
<S> <C> <C> <C> <C>
Other Financial Data:
Capital expenditures..................... $ 16,969 $ 45,261 $ 2,508 $ 15,292
EBITDA (2)............................... (6,734) (33,983) (636) (15,269)
Cash provided by (used in):
Operating activities................... (2,233) (735) (4,874) (32,052)
Investing activities................... (17,198) (169,512) (2,740) 29,765
Financing activities................... 27,141 190,867 3,253 (2,678)
</TABLE>
- --------
(1) Restricted investments as of March 31, 1999, represent escrowed funds that,
together with interest received on those funds, will be sufficient to pay,
when due, the next three semi-annual interest payments on our outstanding
11 3/4% senior notes.
(2) EBITDA is defined as net loss plus net interest expense, provision for
income taxes, depreciation and amortization. EBITDA is presented as it is
commonly used by certain investors to analyze and compare operating
performance and to determine a company's ability to service and/or incur
debt. However, EBITDA should not be considered in isolation or as a
substitute for net income, cash flow or other income or cash flow data or
as a measure of a company's profitability or liquidity and is not a measure
calculated in accordance with generally accepted accounting principles.
EBITDA is not necessarily comparable with similarly titled measures
reported by other companies.
6
<PAGE>
RECENT DEVELOPMENTS
On July 19, 1999, we announced our results for the second quarter of 1999.
Revenues for the second quarter of 1999 were $17.9 million, an increase of
13.8% over the $15.7 million reported for the second quarter of 1998 and an
increase of 9.4% over the $16.4 million reported for the first quarter of 1999.
Total network costs were $27.0 million in the second quarter of 1999 versus
$21.6 million in the second quarter of 1998 and $29.1 million in the first
quarter of 1999. Legacy network costs, a component of total network costs, were
$8.8 million in the quarter, a decrease of 40% from the second quarter of 1998
and a decrease of 32.1% from the first quarter of 1999.
EBITDA for the second quarter of 1999 was a loss of $12.8 million,
representing a $2.4 million decrease or 15.8% improvement when compared to the
first quarter of 1999. The EBITDA loss for the second quarter of 1998 was $7.4
million. The net loss for the quarter was $25.9 million compared to $25.5
million during the first quarter of 1999 and $9.9 million for the corresponding
period a year ago.
<TABLE>
<CAPTION>
(Unaudited) (Unaudited)
Three Months Six Months
Ended June 30, Ended June 30,
----------------- ------------------
1998 1999 1998 1999
------- -------- -------- --------
(in thousands)
<S> <C> <C> <C> <C>
Statement of Operations Data:
Revenues.................... $15,720 $ 17,889 $ 32,214 $ 34,241
Operating expenses:
Splitrock network costs... 6,769 18,128 10,724 34,150
Legacy network costs...... 14,795 8,842 27,111 21,871
Selling, general and
administrative........... 1,582 3,768 2,441 6,338
Depreciation and
amortization............. 2,087 6,602 4,907 11,237
------- -------- -------- --------
Total operating
expenses............... 25,233 37,340 45,183 73,596
------- -------- -------- --------
Loss from operations.......... (9,513) (19,451) (12,969) (39,355)
Other income (expense):
Interest income............. 76 1,731 183 4,335
Interest expense............ (493) (8,155) (842) (16,346)
------- -------- -------- --------
Loss before income tax........ $(9,390) $(25,875) $(13,628) $(51,366)
Provision for income tax...... -- -- -- --
------- -------- -------- --------
Net loss...................... $(9,930) $(25,875) $(13,628) $(51,366)
======= ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
(Unaudited)
As of December 31, 1998 As of June 30, 1999
----------------------- -------------------
(in thousands)
<S> <C> <C>
Balance Sheet Data:
Cash and cash equivalents......... $ 28,330 $ 8,327
Unrestricted investments.......... 120,475 56,166
Restricted investments............ 58,477 44,840
Property and equipment, net....... 73,899 88,721
Total assets...................... 296,141 232,729
Long-term debt and capital lease
obligations (including current
portion)......................... 275,581 270,769
Stockholders' equity (deficit).... (30,291) (81,925)
</TABLE>
<TABLE>
<CAPTION>
(Unaudited) (Unaudited)
Three Months Six Months
Ended June 30, Ended June 30,
----------------- -----------------
1998 1999 1998 1999
------- -------- ------- --------
(in thousands)
<S> <C> <C> <C> <C>
Other Financial Data:
Capital expenditures..................... $ 3,040 $ 10,019 $ 5,548 $ 25,311
EBITDA................................... (7,426) (12,849) (8,062) (28,118)
Cash provided by (used in):
Operating activities.................... 1,162 (15,671) (3,712) (47,723)
Investing activities.................... (4,974) 3,299 (7,714) 33,064
Financing activities.................... 5,640 (2,666) 8,893 (5,344)
</TABLE>
7
<PAGE>
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Additional risks and uncertainties not presently
known to us or that we currently consider immaterial may also impair our
operations. If any of the following risks actually occur, our business,
financial condition or results of operations could be materially adversely
affected. In this case, the trading price of the common stock could decline,
and you may lose all or part of your investment.
We make many forward-looking statements in this prospectus that are not
based on historical facts, but discuss our future expectations. You can
identify these statements by our use of forward-looking terms, such as
"anticipates," "believes," "plans," "expects," "future," "intends" and similar
expressions. Because these forward-looking statements involve risks and
uncertainties, there are important factors that may cause our actual results to
differ materially from those expressed or implied in our forward-looking
statements, including those discussed under this section and elsewhere in this
prospectus.
Our business is difficult to evaluate because we have a limited operating
history and implementation of our current business plan is not reflected in our
historical financial statements.
We were incorporated and commenced operations in March 1997. Accordingly, we
have a limited operating history from which you can evaluate our business and
prospects. In addition, we currently derive substantially all of our revenues
from Internet dial access services. We are now significantly expanding our
sales and marketing effort and our service offerings with the expectation of
broadening our customer base. We are also making a substantial capital
investment to acquire exclusive rights to use a fiber optic backbone, and
neither the revenues nor the expenses that may be associated with this
investment are reflected in our historical financial statements. As a result,
not only is our operating history limited, but our historical financial
statements do not reflect important elements of our business plan on a going
forward basis. The combination of these factors may make evaluation of our
business and prospects difficult.
As a participant in a new and rapidly evolving business, we face risks and
uncertainties relating to our ability to successfully implement our business
plan.
We have developed a business plan in the context of the rapidly evolving
data communications industry that leverages our current service offerings and
technical expertise and expands our operations into new service areas. The
risks and uncertainties associated with implementing our business plan relate
to:
. completing the construction and installation of our broadband access
network;
. expanding our sales and marketing activities;
. expanding and scaling operations support systems for planned services;
. providing services to our customers that are reliable and cost-
effective;
. responding to technological development or service offerings by
competitors;
. acquiring and integrating our fiber backbone into our network;
. increasing awareness of our brand;
. identifying and integrating strategic acquisitions and alliances; and
. attracting and retaining qualified personnel.
If we are unsuccessful in addressing these risks and uncertainties, our
business, results of operations and financial condition will be materially
adversely affected.
8
<PAGE>
We have a history of losses and we expect to continue to incur losses in the
foreseeable future.
We have incurred net losses and negative cash flows from operations since
our inception and we expect to continue to do so for the foreseeable future.
Starting up our company and building our network has required substantial
capital and other expenditures. As a result, we reported net losses of
approximately $57.8 million and $25.5 million, respectively during the year
ended December 31, 1998 and the three months ended March 31, 1999, and incurred
negative cash flows from operations of approximately $0.7 million and
$32.1 million for the same periods. As of March 31, 1999, we had an accumulated
deficit of $93.4 million. We cannot assure you that we will be able to achieve
or sustain revenue growth, profitability or positive cash flow on either a
quarterly or annual basis.
We currently depend on Prodigy for substantially all of our revenues, and our
revenues could decrease significantly if the number or usage of Prodigy
subscribers decreases or if Prodigy ceases to be a customer.
We currently derive substantially all of our revenues from Prodigy. Prodigy
accounted for 100%, 99% and 99% of our revenues for the period from inception
through December 31, 1997, the year ended December 31, 1998, and the three
months ended March 31, 1999, respectively. While we expect revenues from
Prodigy to decrease as a percentage of our total revenues in future periods, we
believe that Prodigy will continue to account for a significant portion of our
revenues. The initial four-year term of our agreement with Prodigy expires on
June 30, 2001. Prodigy may also terminate our agreement prior to June 30, 2001
if (1) we fail to meet specified service level objectives or otherwise fail to
comply with the agreement or (2) Prodigy gives us 12 months' notice of
termination and pays us a termination fee of $3.0 million. The loss of Prodigy
as a customer would have a material adverse effect on our business, financial
condition and results of operation.
Prodigy operates in a highly competitive environment and competes with a
wide range of national, regional and local Internet service providers. A
decrease in the number of Prodigy subscribers or their usage would likely
result in a corresponding decrease in our revenues under our agreement with
Prodigy. Prodigy reports that a majority of its subscriber enrollments result
from bundling arrangements with personal computer manufacturers and Microsoft.
Prodigy's loss of these arrangements and relationships or a decrease in the
number of enrollments it receives as a result of these marketing channels could
adversely affect our results of operations.
Prodigy's results may be affected by seasonal factors. Historically, the
growth in Prodigy subscribers and their total usage has been higher in the
first and fourth quarters of the calendar year, in part due to increased
marketing efforts and consumer demand during the year-end holiday season. The
seasonal nature of Prodigy's business could affect our quarterly revenues.
We may not be able to hire and retain qualified employees.
Our future success depends on our ability to attract, train, motivate and
retain highly skilled employees, especially qualified, competent and motivated
sales and marketing staff with contacts and expertise in the communications
sector. Competition for employees in the data communications industry,
especially sales and marketing personnel, is intense and our business plan
depends on hiring a significant number of these individuals. We may be unable
to retain our key employees or attract, assimilate or retain other highly
qualified employees in the future. We have from time to time in the past
experienced, and we expect to continue to experience in the future, difficulty
in hiring and retaining highly skilled employees with appropriate
qualifications.
We depend on our key management personnel for our future success.
Our future success depends to a significant extent on the continued service
and coordination of our management team, particularly Kwok L. Li, our Chairman
of the Board and Chief Technical Officer, and
9
<PAGE>
William R. Wilson, our Chief Executive Officer. The departure of any of our
officers or key employees could have a material adverse effect on our business,
financial condition and results of operations. Mr. Li currently acts as a
consultant for Lucent Technologies, Inc. and is the majority owner of Linsang
Partners L.L.C. Mr. Li devotes a portion of his work time to Lucent and
Linsang. Mr. Li's inability to devote his time exclusively to our affairs could
have a material adverse effect on our business.
Our quarterly financial results may not be a good indicator of future results
and may fluctuate significantly and could result in lower prices for our stock.
We expect our quarterly revenues, expenses and operating results to
fluctuate significantly in the future as a result of a variety of factors, some
of which are outside of our control. As a result, we believe that quarter to
quarter comparisons of our operating results are not a good indication of our
future performance and it is possible that our operating results may be below
the expectations of securities analysts or investors in some future period. If
the latter occurs, the trading price of our common stock would likely decline,
perhaps significantly. The factors which affect whether our results fluctuate
include:
. the number and level of usage of Prodigy subscribers;
. demand for network and Internet access services;
. capital expenditures and other costs relating to the construction and
installation of our network;
. marketing and other expenses aimed at increasing our customer base;
. pricing changes and the introduction of new products or services by us
or our competitors;
. our ability to obtain sufficient supplies of sole- or limited-source
equipment and telecom facilities on a timely basis;
. our ability to balance the use of our network over a 24-hour period;
. potential adverse regulatory developments;
. delays in the construction of our fiber optic backbone network;
. technical difficulties, system downtime, undetected software errors and
other problems affecting the Internet generally or the operation of our
network;
. economic conditions specific to the Internet and online media and
general economic conditions; and
. longer sales cycles for newer service offerings.
We base our expenses to a significant extent on our expectations of future
revenues. Most of our expenses are fixed in the short term, and we may not be
able to quickly reduce spending if our revenues are lower than we expect.
Moreover, in an attempt to enhance our long-term competitive position, we may
from time to time make decisions regarding pricing, marketing, services and
technology that could have a near-term material adverse effect on our business,
financial condition and operating results. For more information, see "Selected
Financial Data" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
We face intense competition in the data communications services industry.
The market for data communications, Internet and related services is
intensely competitive, quickly evolving and subject to rapid technological
change. We anticipate that competition will continue to intensify as the use of
data communications and the Internet grows. The tremendous growth and potential
size of the market have attracted many new start-ups as well as established
businesses from different industries. Our current and prospective competitors
fall into three major categories:
. companies that provide access services to Internet service providers
with both residential and small business customers, including Verio,
UUNET Technologies, Concentric Network, PSINet, and Netcom On-Line
Communications Services;
10
<PAGE>
. companies that provide access, virtual private network and other value-
added services to medium and large businesses, including UUNET
Technologies, Concentric Network, GTE Internetworking, and DIGEX, as
well as most major long distance telephone companies; and
. companies with high-speed networks that provide bandwidth capacity and
other network services, including IXC Communications, Qwest and Level 3
Communications.
Some of these competitors have significantly greater market presence, brand
recognition and financial, technical and personnel resources than we do. Many
of our competitors may also have the ability to bundle Internet access and data
transmission with basic local and long distance telecommunications services.
This bundling of services may have an adverse effect on our ability to compete
effectively with them and may result in pricing pressure on us.
We also believe that new competitors will enter the network services market
with new technologies and methods of distribution, including large computer
hardware, software and media and other technology and telecommunications
companies, resulting in greater competition and pricing pressure as more
capacity becomes available. For instance, cable companies, AT&T and Microsoft
have announced that they are exploring broadband services for high speed
Internet connectivity that will rely on cable modems and economical network
upgrades. Other companies have announced plans to provide Internet access via
wireless terrestrial and satellite-based technologies. This capacity will be
added to that of the U.S. long distance fiber optic networks owned by each of
AT&T, MCI WorldCom and Sprint, as well as numerous local networks. Others,
including Qwest, IXC Communications and Williams Companies, are deploying
additional networks that use advanced technology similar to that of our fiber
backbone being constructed by Level 3.
The increase in the number of competitors in this industry has been
accompanied by vertical and horizontal integration and consolidation among
competitors. The number of businesses providing Internet-related and network
services is growing rapidly. We are aware of other companies, in addition to
those named above, that have entered into or are forming joint ventures or
consortia to provide services similar to those provided by us. Others may
acquire the capabilities necessary to compete with us through acquisitions.
As a result of the increase in the number of competitors and the vertical
and horizontal integration in the industry, we currently encounter and expect
to continue to encounter significant pricing pressure and other competition in
the future. Increased price or other competition could result in erosion of our
market share and could have a material adverse effect on our business,
financial condition and results of operations. We cannot assure you that we
will have the financial resources, technical expertise, portfolio of services
or marketing and support capabilities to continue to compete successfully. For
more information, see "Business--Competition."
Increased industry capacity and other factors could lead to lower prices for
our services.
The long distance transmission industry has been characterized by
overcapacity and falling prices since shortly after the break-up of AT&T in
1984. We expect that prices for communications services generally will continue
to fall over the next several years, primarily due to:
. recent technological advances that permit large increases in the
transmission capacity of both new and existing fiber;
. strategic alliances or similar transactions, such as purchasing
alliances for long distance capacity among local exchange carriers that
increase the parties' purchasing power; and
. construction of new networks and competing satellite systems.
11
<PAGE>
We face risks associated with entering new lines of business that could cause
our results to suffer.
A key component of our strategy is to acquire fiber optic backbone that
increases our capacity to deliver services that require higher bandwidth and to
lease some of our fiber optic capacity to other companies. The following risks
are inherent in entering this new line of business:
. a potential decrease in the price for our bandwidth capacity resulting
from a significant increase in capacity in the marketplace as networks
currently under construction come on line;
. a lack of financial resources to make the necessary capital expenditures
to take full advantage of the bandwidth available to us;
. unexpected changes in regulatory requirements as a result of combining
our old lines of business with the new lines of business;
. loss of management and marketing staff focus and attention;
. problems reaching our new target market for bandwidth leasing services;
. failure to integrate the sales and marketing of our new lines of
business with our existing services; and
. inability to compete in the new line of business against established
brand names.
We have incurred substantial indebtedness and may not be able to service our
debt.
We have and will continue to have a significant amount of outstanding
indebtedness and debt service requirements. At March 31, 1999, our total debt
(including current portion of capital lease obligations) was $272.8 million and
stockholders' deficit was $55.9 million. Interest on this indebtedness totals
approximately $33 million per year. Our debt has important consequences for our
company and for you, including the following:
. our ability to obtain additional financing in the future, whether for
working capital, capital expenditures, acquisitions or other purposes,
may be impaired;
. a substantial portion of our cash flow from operations is dedicated to
the payment of interest on our debt, which reduces the funds available
to us for other purposes;
. our flexibility in planning for or reacting to changes in market
conditions may be limited; and
. we may be more vulnerable in the event of a downturn in our business.
Our ability to meet our debt service obligations will depend on our future
operating performance and financial results. This ability will be subject in
part to factors beyond our control. Although we believe that our cash flow will
be adequate to meet our interest payments, we cannot assure you that we will
continue to generate sufficient cash flow in the future to meet our debt
service requirements. If we are unable to generate cash flow in the future
sufficient to cover our fixed charges and are unable to borrow sufficient funds
from other sources, then we may be required to:
. refinance all or a portion of our existing debt;
. attempt to issue additional equity securities, which may result in
dilution of ownership percentages for our existing shareholders; or
. sell all or a portion of our assets.
We cannot assure you that a refinancing or offering of equity securities
would be possible. We cannot assure you that any asset sales would be timely or
that the proceeds which we could realize from asset sales would be sufficient
to meet our debt service requirements. In addition, the terms of our debt
securities and fiber agreements restrict our ability to sell or sublease our
assets and our use of the proceeds from any asset sale.
12
<PAGE>
We will need additional capital in the future and additional financing may not
be available.
We currently anticipate that our available cash resources, combined with the
net proceeds from this offering, will be sufficient to meet our anticipated
working capital and capital expenditure requirements through the end of 2000.
We cannot assure you that these resources will be sufficient for unanticipated
working capital and capital expenditure requirements during this period.
Moreover, we expect that full implementation of our current business plan will
require that we raise substantial additional capital for the needs that we
anticipate funding during 2001 and 2002. We may also need to raise additional
funds in order to:
. take advantage of unanticipated opportunities, including more rapid
international expansion or acquisitions of complementary businesses or
technologies;
. develop new services; or
. respond to unanticipated competitive pressures.
We may also raise additional funds through public or private debt or equity
financings if these sources of financing become available on favorable terms.
We cannot assure you that the additional financing we will need will be
available on terms favorable to us, or at all. If adequate funds are not
available or are not available on acceptable terms, we may not be able to take
advantage of unanticipated opportunities, develop new services or otherwise
respond to unanticipated competitive pressures. In that case, our business,
results of operations and financial condition could be materially adversely
affected. Our forecast of the period of time through which our financial
resources will be sufficient to support our operations is a forward looking
statement that involves risks and uncertainties, and actual results could vary
materially as a result of a number of factors, including those set forth above.
Restrictions imposed on us as a result of our current indebtedness could
adversely affect our ability to raise further capital.
The terms of our current indebtedness contain financial and operating
covenants that limit the discretion of our management. These covenants place
significant restrictions on our ability to:
. incur additional indebtedness;
. create liens or other encumbrances;
. make dividend payments and investments;
. sell or otherwise dispose of assets; or
. merge or consolidate with other companies.
These restrictions could adversely affect our ability to raise further capital.
Any failure or delays by Level 3 in completing our new fiber optic backbone
network could materially and adversely affect our business.
In April 1999, we entered into an agreement with Level 3 Communications
which gives us the exclusive right to use portions of Level 3's nationwide
fiber network for a 20-year period. Our ability to fully implement our present
business plan could be adversely affected if Level 3 fails to perform its
obligations under this agreement. Level 3 may be delayed or prevented from
completing its fiber network and performing its obligations under our agreement
due to:
. insufficient capital resources;
. failure of its suppliers to provide the necessary equipment and
services;
. regulatory changes affecting its rights of way;
. a change in management strategy; or
. presently unforeseeable legal, technical or other factors.
13
<PAGE>
Our business plan assumes that we will use dark fiber strands from Level 3
to deliver our services on the fiber optic portion of our network. If Level 3
does not successfully complete the installation of these dark fiber segments,
we may not be able to provide our services or provide them at the level of
quality, efficiency and economy assumed in our business plan. While we believe
that we could transfer our business to another supplier if Level 3's segments
are not available, we may not find an alternate network which would provide
comparable technology at a competitive cost. Level 3 has not completed
construction of its network segments. Any failure by Level 3 to complete
construction of, or deploy and maintain, its dark fiber segments could hurt our
business.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, we may be
required to notify the Federal Trade Commission of the transactions
contemplated by our agreement with Level 3. If this notification is required,
we will not be able to consummate the transactions contemplated by the Level 3
agreement until the requirements of the Hart-Scott-Rodino Act have been
satisfied and any applicable waiting period has expired or terminated.
Our business plan assumes that we will be able to expand and scale our network
infrastructure to accommodate increased volumes of traffic and customers;
however, our ability to scale our network by large proportions is unproven.
Our network currently handles approximately 1.3 billion minutes of use per
month. However, our ability to scale the network up to meet our expected
customer usage levels while maintaining superior performance and integrating
and managing the fiber optic backbone is unproven. As the number of our
customers grows or as network usage increases, we may need to make additional
investments to expand and adapt our network infrastructure and maintain
adequate data transmission speeds. Any future expansion and adaptation of our
communications and facility infrastructure could require substantial financial,
operational, technical and management resources. If we are required to expand
our network significantly and rapidly due to increased usage, additional stress
will be placed upon our network hardware, traffic management systems and
facilities.
Our business depends on the continued growth of the Internet and the demand for
data communications services and could suffer if demand declines.
Our business would be adversely affected if use of the Internet and the data
communications industry does not continue to grow or grows more slowly than
expected. Factors that may inhibit the continued growth of the Internet and the
data communications industry include the following:
. the ability of the Internet and data networking infrastructure to
support the growing demands placed on it;
. access costs;
. the performance and reliability of products and services as the number
of users and amount of traffic increases;
. the ability of businesses to adequately address security and privacy
concerns;
. the development of legislation or regulation related to the Internet;
and
. the nature and pace of technological changes relating to the Internet
and data communications.
In addition, websites have experienced interruptions in their service as a
result of outages and other delays occurring throughout the Internet network
infrastructure. If these outages or delays occur frequently, use of the
Internet as a commercial or business medium could, in the future, grow more
slowly than expected or decline. This would have an adverse affect on our
business.
14
<PAGE>
Our network system could fail resulting in losses and loss of user confidence.
Our success depends upon our ability to deliver reliable, high-speed access
to the Internet and upon the ability and willingness of our telecommunications
providers to deliver reliable, high-speed telecommunications service through
their networks. Our network, and other networks providing services to us, are
vulnerable to damage or cessation of operations from fire, earthquakes, severe
storms, power loss, telecommunications failures, excessive, sustained, or peak
user demand, and similar events, particularly if these events occur within a
high traffic location of the network. We cannot assure you that we will not
experience failures or shutdowns relating to individual POPs or even
catastrophic failure of the entire network. We carry business personal property
insurance to protect us against losses due to property damage and business
interruption. This coverage, however, may not be adequate or available to
compensate us for all losses that may occur. In any event, significant or
prolonged system failures or shutdowns could damage our reputation and result
in the loss of customers.
Our network is potentially vulnerable to viruses, break-ins or disruptions.
Despite our security measures, our network's infrastructure is potentially
vulnerable to computer viruses, break-ins and similar disruptive problems
caused by our customers or others. Computer viruses, break-ins or other
problems could lead to interruptions, delays or cessation in service to our
customers. Furthermore, inappropriate use of the Internet by third parties
could also potentially jeopardize the security of confidential information
stored in the computer systems of our customers. This could, in turn, deter
potential customers and adversely affect our existing customer relationships.
Security problems represent an ongoing threat to public and private data
networks. The security services that we offer in connection with our customers'
networks cannot assure complete protection from computer viruses, break-ins and
other disruptive problems. Although we attempt to limit contractually our
liability in these instances, the occurrence of problems may result in claims
against us or liability on our part. These claims, regardless of their ultimate
outcome, could result in costly litigation and could have a material adverse
effect on our business or reputation or on our ability to attract and retain
customers for our products. Moreover, until more consumer reliance is placed on
security technologies available, the security and privacy concerns of existing
and potential customers may inhibit the growth of the Internet service industry
and our customer base and revenues.
We must keep pace with technological change and evolving industry standards to
remain competitive and increase our revenues.
The market for data communications and Internet access and related services
is characterized by rapidly changing technology, evolving industry standards,
changes in customer needs and frequent new product and service introductions.
Our future success will depend, in part, on our ability to:
. effectively use and develop leading technologies;
. continue to develop our technical expertise;
. enhance our current services;
. develop new services that meet changing customer needs; and
. respond to emerging industry standards and technological changes in a
cost-effective manner.
If our services do not continue to be compatible and interoperable with
products and architectures offered by various other members of the industry,
our ability to compete could be impaired. We cannot assure you that we will be
successful in responding to changing technology or market trends. In addition,
services or technologies developed by others may render our services or
technologies uncompetitive or obsolete. Furthermore, changes to our services in
response to market demand may require the adoption of new technologies that
could likewise render many of our assets technologically uncompetitive or
obsolete. Even if we do successfully respond to technological advances and
emerging industry standards, the integration of new technology may require
substantial time and expense, and we cannot assure you that we will succeed in
adapting our network infrastructure in a timely and cost-effective manner.
15
<PAGE>
Changes in government regulations could adversely affect our business by
increasing costs or imposing limitations on the services we provide.
To date, we have not been subject to common carrier regulation by the FCC or
state public utility commissions, but the growth of Internet telephony and
changing technology has led regulators to consider regulating some Internet
services. We do not believe that we are subject to this type of regulation.
However, if such regulation is applied to us, we could incur substantial
regulatory costs, including obligations to contribute directly to federal and
state universal service funds. Government entities have also attempted to apply
various forms of content regulation to Internet service providers, though in
some cases Congress or the courts have made decisions that shielded Internet
service providers from liability for the content that they convey. Other
legislative and regulatory decisions designed to encourage the development of
competition in the provision of telecommunications services could benefit
certain of our competitors that are affiliated with facilities-based carriers,
and may provide at least a temporary competitive advantage to those companies.
For more information, see "Business--Regulation."
The imposition of taxes on our services could adversely affect our business.
We are uncertain what additional laws and regulations regarding taxation of
our services may be adopted due to the increasing popularity, development and
use of data communications facilities and services and the Internet in
particular. A number of state and local government officials have asserted the
right or indicated a willingness to impose taxes on Internet-related services
and commerce, including sales, use and access taxes. We cannot predict how the
activities in our industry will be taxed, and therefore how the costs of
supplying our services may be affected, in the future because there is no
precedent for many of these activities. The imposition of new taxes, directly
or indirectly, on our services could adversely affect our business, financial
condition and results of operations depending on their magnitude and our
ability to pass on the costs to end-users.
The services we provide to Prodigy may be subject to sales or use taxes in a
number of states. We believe that, under our agreement with Prodigy, we are
entitled to be reimbursed by Prodigy for these taxes if they are due. We
recently billed Prodigy for $240,000 to cover taxes on services provided during
May of 1999 and have informed Prodigy that we will be billing it for prior
periods. Prodigy has asserted that we may not be entitled to recover these
charges under the terms of our agreement. If our services to Prodigy are
ultimately determined to be subject to sales, use or other taxes and we are
unable to pass along these charges to Prodigy, our results of operations could
be materially adversely affected.
Potential problems related to the Year 2000 may decrease use of Internet
services, cause us reputational harm and adversely affect our business.
Some computer programs and systems use two digits, rather than four digits,
to define the applicable year and could fail or misfunction because they cannot
distinguish between 20th century and 21st century dates. This, in turn, could
result in a major system failure or miscalculations, including an inability to
process transactions, send invoices or engage in similar normal business
activities. The Internet and related service industries are susceptible to
year-2000 problems due to their reliance on computer hardware and software. If
these systems and programs should cause widespread problems across the
Internet, we expect users to curtail their use of the Internet dramatically
with consequent material adverse consequences to our revenues. However, we
cannot reasonably assess the magnitude of the consequences and risks of the
year-2000 problems on the basis of information currently available to us.
A failure of our systems or the systems of our suppliers, customers and
third parties with whom we do business could result in financial losses, legal
liability and reputational harm to our customers. If Internet usage and our
customers' subscriber count is reduced, it could result in a significant
reduction in our revenues and have a material adverse effect on our business.
Furthermore, Prodigy's and our other customers' purchasing patterns may be
affected by year-2000 issues as they expend significant resources to correct
their current systems for year 2000 compliance. We have not incurred material
costs in ensuring year-2000 compliance to date and do not expect to incur
material costs to make our software year-2000 compliant.
16
<PAGE>
We depend on sole- and limited-source suppliers for critical products and
services.
We rely on other companies to supply key components of our network,
operations support, and administration infrastructure. These components include
critical telecommunications services and networking equipment, which, in the
quantities and quality demanded by us, are available only from sole- or
limited-sources. We depend on sole- or limited-source suppliers for the
following products or services:
. ATM switching products--Lucent Technologies supplies us with all of our
ATM switching products, including the AC-120 switch, which is a key
component of our network.
. Internet dial access platform--Bay Networks provides us with its
Internet dial access platform.
. Routers--Cisco Systems manufactures the routers used in our network.
We do not carry significant inventories of these components and have no
guaranteed supply arrangements for these components. Our suppliers also sell
products to our competitors and may in the future themselves become our
competitors. We cannot assure you that our suppliers will not enter into
exclusive arrangements with our competitors or stop selling their products or
components to us at commercially reasonable prices, or at all. Our inability to
obtain sufficient quantities of sole- or limited-source components or to
develop alternative sources, if required, could result in delays and increased
costs in expanding, and overburdening of, our network infrastructure. Any
delay, increased costs or overburdening of our network would have a material
adverse effect on our business, financial condition and results of operations.
We also depend on local and long distance telephone companies to provide
telecommunications services to us and our customers. We experience delays from
time to time in receiving supplies and telecommunications services from our
suppliers. We cannot assure you that we will be able to obtain these supplies
or services on the scale, of the quality, and within the time frames required
by us at an affordable cost, or at all. Any failure to obtain these services on
a sufficient scale, on a timely basis or at an affordable cost would have a
material adverse effect on our business, financial condition and results of
operations.
We may be subject to legal liability for distributing or publishing content
over the Internet which could be costly for us to defend.
Congress and several states have enacted or are considering measures that
would, under some circumstances, impose civil and criminal liability upon
Internet service providers, or providers of transmission capacity to Internet
service providers, for the transmission or dissemination of information and
materials. It is possible that costly claims will be made against us in
connection with the nature and content of the materials disseminated through
our networks. Currently, several private lawsuits of this sort are pending
against other online services companies and Internet access providers. Given
the heightened attention this topic has recently received, and will continue to
receive if any of the current lawsuits are successful, we might be required to
respond by investing substantial resources or discontinuing some of our service
offerings. These factors may also cause growth of Internet use to decline.
Finally, although we carry general liability insurance, it may not be adequate
to compensate us or it may not cover us in the event we become liable for
information carried on or disseminated through our networks. Any costs not
covered by insurance incurred as a result of liability or asserted liability
for information carried on or disseminated through our networks could hurt our
business.
We depend on other companies for peering and interconnection arrangements.
We maintain peering and interconnection arrangements with other network
service providers so that we can exchange traffic with them. Recently,
companies that previously offered peering have eliminated peering relationships
or established new, more restrictive criteria for peering. We are uncertain
whether other network service providers will continue peering and
interconnection arrangements on acceptable terms or impose settlement charges
as a result of an increasingly competitive Internet services industry dominated
by a smaller group of national network providers. For more information, see
"Business--Our Network--Peering and Interconnection."
17
<PAGE>
The network design and technical expertise that we depend on may be developed
or similarly deployed by others.
Our success and ability to compete is dependent in part upon our technical
expertise. We do not have proprietary rights that would prevent our competitors
from deploying technologies or independently developing a network design and
technical expertise that are substantially equivalent or superior to our own.
For example, Sprint is in the process of designing a network which will contain
ATM switches at every core, hub and remote site. The construction by our
competitors of networks similar to our own may adversely affect our ability to
compete effectively.
Third parties may claim we infringe their proprietary rights and these claims
could result in increased costs.
Although we do not believe we infringe the proprietary rights of any third
parties, we cannot assure you that third parties will not assert claims against
us in the future or that those claims will not be successful. We could incur
substantial costs and diversion of management resources to defend any claims
relating to proprietary rights, which could have a material adverse effect on
our business, financial condition and results of operations. Furthermore,
parties making those claims could secure a judgment awarding substantial
damages, as well as injunctive or other equitable relief that could effectively
block our ability to license our products in the United States or abroad. Such
a judgment would have a material adverse effect on our business, financial
condition and results of operations. In addition, we are obligated under
various agreements to indemnify the other party for claims that we infringe on
the proprietary rights of third parties. If we are required to indemnify
parties under these agreements, our business, financial condition and results
of operations could be materially adversely affected. If someone asserts a
claim relating to proprietary technology or information against us, we may seek
licenses to that intellectual property. We cannot assure you, however, that we
could obtain licenses on commercially reasonable terms, if at all. The failure
to obtain the necessary licenses or other rights could have a material adverse
effect on our business, financial condition and results of operations.
We may not be able to successfully manage our expansion.
Our anticipated future growth will continue to place a significant strain on
our management systems and resources. We expect that we will need to continue
to improve our financial and managerial controls and reporting systems and
procedures. We will also need to continue to expand and maintain close
coordination among our technical, accounting, finance and sales and marketing
organizations. Key members of our management team, including our Chief
Financial Officer, Chief Marketing Officer and Senior Vice President for
Network Operations, have joined us within the last few months. These
individuals have not previously worked together and are becoming integrated
into our management team. They may not be able to work together effectively or
successfully manage our growth. Our inability to manage growth effectively
could have a material adverse effect on our business, financial condition and
results of operations.
We may be unable to successfully acquire other companies, form strategic
alliances or successfully integrate any acquisition or alliance.
We will evaluate strategic alliances and acquisitions both domestically and
internationally as they present themselves. Any future strategic alliance or
acquisition involves risks commonly encountered in business relationships. We
may encounter obstacles while integrating the operations and personnel of the
companies and the integration efforts may disrupt our ongoing business. Our
management may be unable to successfully incorporate licensed or acquired
technology and rights into our service offerings or maintain uniform standards,
controls, procedures and policies within the two organizations. Changes in
management resulting from an alliance or acquisition could impair relationships
with employees and customers. Any international alliance or acquisition would
involve the additional risks of doing business abroad, including unexpected
changes in the regulatory environments, export controls, tariffs, fluctuations
in currency exchange rates and potentially adverse tax consequences. We may not
successfully overcome these risks or any other problems encountered in
connection with strategic alliances or acquisitions. In addition, we could
incur substantial expenses, including the expenses of integrating the parties'
businesses in a strategic alliance or after an acquisition, which could, in
turn, adversely affect our business, financial condition and results of
operations.
18
<PAGE>
Our directors have relationships that could present conflicts of interest.
Our directors have relationships with other companies that could result in
potential conflicts of interest.
. Since 1991, Mr. Nakfoor has served as the Vice President of Securities
Trading for Inversora Bursatil, S.A. de C.V., a wholly-owned subsidiary
of Grupo Financiera Inbursa, S.A. de C.V., and an affiliate of our
second largest shareholder, Carso Global. Carso Global currently
controls our largest customer, Prodigy, on whose board Mr. Nakfoor has
served since September 1997. Prodigy's President and Chief Executive
Officer, Samer Salameh, was a member of our board of directors until
April 1999.
. Mr. Li was Director, Vice Chairman, Chief Technology Officer and owner
of 12.4% of the common stock of Yurie, which was one of our principal
suppliers until it was sold to Lucent. In connection with the sale of
Yurie to Lucent, Linsang has agreed to make the services of Mr. Li
available to Lucent to provide technical guidance for both the Lucent
AC-120 and Lucent's entire line of other ATM switches. The agreement has
a term of three years and terminates on May 29, 2001. Mr. Li is Chief
Technical Officer, Carrier Network Division of Lucent and has agreed not
to participate in designing, developing, producing, manufacturing or
marketing multi-service access equipment other than for Lucent. Mr. Li
and members of his family also control Linsang, which is our largest
shareholder.
. Mr. Turner is also a member of the board of directors of our largest
shareholder, Linsang Partners, LLC, a limited liability company
controlled by Mr. Li and members of his family.
As a result of these relationships, there is a potential for conflicts of
interest to arise when our directors are faced with a decision that could have
different implications for our company and the other companies with which our
directors have a relationship. Due to the nature of the potential conflicts of
interest presented by these relationships on an ongoing basis, we cannot
assure you that the directors involved will act in the best interests of our
company and our stockholders.
Affiliates of ours have engaged in numerous transactions with us in the
past. These transactions were not necessarily a result of arms'-length
negotiations. We may engage in additional related party transactions in the
future and we cannot assure you that these transactions will be on arms'-
length terms. For more information, see "Certain Transactions."
Investors in this offering will suffer immediate and substantial dilution.
The initial public offering price of our common stock will be substantially
higher than the net tangible book value per share of the common stock
outstanding immediately after this offering. Therefore, investors purchasing
shares in this offering will incur immediate and substantial dilution in net
tangible book value per share. You will incur further dilution if outstanding
options or warrants to purchase common stock are exercised. For more
information, see "Dilution."
We will retain broad discretion in using the net proceeds of this offering and
may spend a substantial portion in ways with which you do not agree.
We will retain a significant amount of discretion over the application of
the net proceeds of this offering as well as over the timing of our
expenditures. Because of the number and variability of factors that determine
our use of the net proceeds of the offering, we may apply the net proceeds of
this offering in ways that vary substantially from our current intentions. For
more information, see "Use of Proceeds."
Our existing stockholders will maintain control of us following the offering.
Our executive officers and directors and entities affiliated with them
will, in the aggregate, beneficially own approximately 79.5% of our common
stock following this offering and 77.3% if the over-allotment option is
exercised in full. These stockholders will be able to exercise control over
all matters requiring approval by our stockholders, including the election of
directors and the approval of significant corporate transactions. This
19
<PAGE>
concentration of ownership may also have the effect of delaying or preventing a
change in control of our company, which could negatively affect our stock
price. For more information, see "Principal Stockholders."
Future sales of our common stock may negatively affect our stock price.
Following the offering, we will have a large number of shares of common
stock outstanding and available for resale beginning at various points in time
in the future. The market price of our common stock could decline as a result
of sales of a large number of shares of our common stock in the market
following this offering, or the perception that sales could occur. These sales
also might make it more difficult for us to sell equity securities in the
future at a time and at a price that we deem appropriate. For more information,
see "Shares Eligible for Future Sale." Our directors, executive officers, and
two largest shareholders, Linsang and Carso Global, who collectively hold a
total of 45,508,979 shares of common stock, have agreed not to dispose of any
shares of common stock, subject to limited exceptions, for a period of 180 days
after the date of this prospectus, without the prior written consent of Bear,
Stearns & Co. Inc., on behalf of the underwriters.
Provisions of our certificate of incorporation, bylaws and Delaware law could
deter takeover attempts.
Our certificate of incorporation and bylaws and the Delaware corporations
law contain provisions that could have the effect of making it more difficult
for a third party to acquire, or discourage a third party from attempting to
acquire, control of us. These provisions could limit the price that investors
might be willing to pay in the future for shares of our common stock. For more
information, see "Description of Capital Stock."
There has been no prior public market for our common stock, and our stock price
may experience extreme price and volume fluctuations.
Prior to this offering, there has been no public market for our common
stock. The initial public offering price for the shares will be determined by
negotiation between us and the representatives of the underwriters based upon
several factors and may not be indicative of prices that will prevail in the
trading market. For a discussion of the factors to be considered in determining
the initial public offering price, see "Underwriting."
The stock market has experienced extreme price and volume fluctuations. The
market prices of the securities of technology companies and Internet-related
companies in particular have been especially volatile. This volatility has
included rapid and significant increases in the trading prices of Internet
companies following initial public offerings to levels that do not bear any
reasonable relationship to the operating performance of those companies and
large inter-day swings in the trading prices of their securities. These
fluctuations may materially affect the trading price of our common stock. We
cannot guarantee that you will be able to sell your shares at or above the
initial public offering price.
In the past, stockholders have often instituted securities class action
litigation following periods of volatility in the market price for a company's
securities. Such litigation could result in substantial costs and the diversion
of management's attention and resources, which could have a material adverse
effect on our business, financial condition and results of operations.
The reliability of market data included in this prospectus is uncertain.
Since we are a new company and operate in a new and rapidly changing market,
we have included market data from industry publications, including reports
produced by Forrester Research, Inc. and International Data Corporation. The
reliability of these data cannot be assured. These industry publications
generally indicate that they have obtained information from sources believed to
be reliable, but do not guarantee the accuracy and completeness of their
information. While we believe these industry publications to be reliable, we
have not independently verified their data. We also have not sought the consent
of any of these organizations to refer to their reports in this prospectus.
20
<PAGE>
USE OF PROCEEDS
We estimate that we will receive net proceeds from the sale of our common
stock offered by this prospectus of approximately $139.1 million, or
approximately $157.0 million if the underwriters' over-allotment option is
exercised in full. These estimates are based on an assumed initial public
offering price of $14.00 per share and include the deduction of the
underwriting discount and other estimated fees and expenses payable by us.
We intend to use the net proceeds from this offering principally for capital
expenditures, including:
. the acquisition of rights to use dark fiber and of the related
electronics equipment necessary to transmit data over the fiber;
. the completion of our broadband access network;
. the enhancement of our network to provide additional value-added services;
and
. the improvement of our network management, billing, and other back office
systems.
We will also use a portion of the net proceeds from this offering to fund
operating losses, working capital requirements and other general corporate
purposes.
In addition, we may use a portion of the net proceeds from this offering for
possible future investments, acquisitions or strategic alliances in businesses
or assets that are related or complementary to our existing business. We
periodically evaluate investment, acquisition and strategic alliance candidates
as a key part of our growth strategy. We currently have no commitments or
agreements and are not involved in any negotiations with respect to these
transactions.
We currently intend to allocate substantial proceeds among the foregoing
uses. The precise allocation of funds among these uses will depend on future
commercial, technological, regulatory and other developments in or affecting
our business, the competitive climate in which we operate and the emergence of
future opportunities. Because of the number and variability of factors that
determine our use of the net proceeds of the offering, we cannot assure that
our application of the net proceeds will not vary substantially from our
current intentions. Pending these uses, we intend to invest the net proceeds of
this offering in short-term U.S. investment grade and government securities.
DIVIDEND POLICY
We have never paid any cash dividends on our common stock and do not
anticipate declaring or paying any cash dividends in the foreseeable future. We
currently intend to retain future earnings, if any, to fund the development and
growth of our business. Declaration or payment of future dividends, if any,
will be at the discretion of our board of directors after taking into account
various factors, including our financial condition, operating results and
current and anticipated cash needs and plans for expansion. In addition, our
ability to pay dividends on the common stock is restricted by certain covenants
in the indenture governing our outstanding 11 3/4% senior notes.
21
<PAGE>
CAPITALIZATION
The following table shows our cash and cash equivalents, investments and
total capitalization:
. on an actual basis as of March 31, 1999; and
. as adjusted to reflect the sale of 10,700,000 shares of common stock
offered by this prospectus at an assumed initial public offering price
of $14.00 per share, after deducting the underwriting discount and the
estimated offering expenses payable by us.
You should read this information together with our financial statements and
the notes relating to those statements and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Use of
Proceeds" appearing elsewhere in this prospectus.
<TABLE>
<CAPTION>
As of March 31, 1999
-------------------------------------
Actual As Adjusted
---------------- -------------------
(in thousands, except share data)
<S> <C> <C>
Cash and cash equivalents................. $ 23,365 $ 162,428
================ ================
Investments:
Unrestricted investments--short term.... $ 87,793 $ 87,793
Restricted investments--short term...... 28,191 28,191
Restricted investments--long term....... 16,165 16,165
---------------- ----------------
Total investments......................... $ 132,149 $ 132,149
================ ================
Long Term Debt:
11 3/4% senior notes due 2008........... $ 258,257 $ 258,257
Capital lease obligations............... 14,587 14,587
---------------- ----------------
Total long term debt (including current
portion)................................. 272,844 272,844
Stockholders' Equity (Deficit):
Preferred stock, $.001 par value,
25,000,000
shares authorized, no shares issued.... -- --
Common stock, $.001 par value,
150,000,000 shares authorized,
46,671,996 shares issued and
outstanding actual; 57,371,996 shares
issued and outstanding, as adjusted.... 47 57
Additional paid-in capital.............. 34,816 173,869
Common stock warrants................... 2,849 2,849
Accumulated other comprehensive (loss).. (195) (195)
Accumulated deficit..................... (93,442) (93,442)
---------------- ----------------
Total stockholders' equity (deficit).. (55,925) 83,138
---------------- ----------------
Total capitalization...................... $ 216,919 $ 355,982
================ ================
</TABLE>
The number of shares as adjusted for this offering excludes:
. any shares of common stock to be issued pursuant to the underwriters'
over-allotment option;
. 1,487,791 shares of common stock issuable on or after July 26, 1999 upon
the exercise of outstanding warrants with an exercise price of $0.02 per
share;
. 2,896,128 shares of common stock issuable upon the exercise of
outstanding options at June 30, 1999 with a weighted average exercise
price of $5.10 per share; and
. 7,735,845 shares of common stock reserved for issuance upon the exercise
of options available at June 30, 1999 to be granted under our stock
option plans.
22
<PAGE>
DILUTION
You will experience immediate and substantial dilution in the net tangible
book value per share of your common stock.
We calculate dilution to new investors by subtracting net tangible book
value per share of common stock after this offering from the per share price
paid by new investors in this offering. We calculate net tangible book value
per share by subtracting total liabilities from total tangible assets and then
dividing that number by the number of shares of common stock outstanding at
March 31, 1999. The following table illustrates the per share dilution:
<TABLE>
<S> <C> <C>
Assumed initial public offering price per share....................... $14.00
Net tangible book value deficit per share as of March 31,
1999......................................................... $ (1.20)
Increase attributable to new investors........................ 2.65
------
Net tangible book value per share after this offering................. 1.45
------
Dilution per share to new investors in this offering.................. $12.55
======
</TABLE>
The following table summarizes, after giving effect to this offering as of
March 31, 1999, the total number of shares of common stock purchased from us,
the total consideration paid to us and the average consideration per share paid
by the existing stockholders and by the investors purchasing shares of common
stock in this offering at an assumed initial public offering price of $14.00
per share:
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
------------------ -------------------- Price Per
Number Percent Amount Percent Share
---------- ------- ------------ ------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockholders......... 46,671,996 81.3% $ 34,788,000 18.8% $ 0.75
New investors................. 10,700,000 18.7% 149,800,000 81.2% 14.00
---------- ----- ------------ ------ ------
Total....................... 57,371,996 100% 184,588,000 100.0% 3.22
========== ===== ============ ====== ======
</TABLE>
The calculations above exclude from the number of outstanding shares of
common stock:
. any shares to be issued pursuant to the underwriters' over-allotment
option;
. 1,487,791 shares of common stock issuable on or after July 26, 1999,
upon the exercise of outstanding warrants with an exercise price of
$0.02 per share;
. 2,896,128 shares of common stock issuable upon the exercise of
outstanding options at June 30, 1999 with a weighted average exercise
price of $5.10 per share; and
. 7,735,845 shares of common stock reserved for issuance upon the exercise
of options available at June 30, 1999 to be granted under our stock
option plans.
If all of the options and warrants outstanding as of March 31, 1999, had
been exercised at that date, dilution to new investors in this offering would
be $12.42 per share.
23
<PAGE>
SELECTED FINANCIAL DATA
Our statement of operations data for the period from inception (March 5,
1997) to December 31, 1997 and for the year ended December 31, 1998, and our
balance sheet data as of December 31, 1997 and 1998, shown in the table below
are derived from our audited financial statements. Our statement of operations
data for the three months ended March 31, 1998 and 1999 and our balance sheet
data as of March 31, 1999 have been derived from our unaudited financial
statements which, in the opinion of management, include all adjustments,
consisting only of normal recurring adjustments, necessary for a fair statement
of the results for the unaudited interim periods presented. You should read
this information together with our financial statements and the notes relating
to those statements and with the section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations" appearing elsewhere
in this prospectus.
The "As Adjusted" balance sheet data reflects the sale of the shares of
common stock offered by this prospectus at an assumed initial public offering
price of $14.00 per share, after deducting the underwriting discount and the
estimated offering expenses payable by us.
<TABLE>
<CAPTION>
Period from
Inception
(March 5,
1997) through Year Ended Three Months Ended March 31,
December 31, December 31, -----------------------------------------
1997 1998 1998 1999
------------- ---------------------- ------------------------- --------------
(in thousands, except share and per share data)
<S> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues.............. $ 22,708 $ 63,611 $ 16,494 $ 16,352
Operating expenses:
Splitrock network
costs.............. 2,362 32,912 3,955 16,022
Legacy network
costs.............. 25,804 58,292 12,316 13,029
Selling, general and
administrative..... 1,276 6,390 859 2,570
Depreciation and
amortization....... 3,500 13,850 2,820 4,635
---------- --------------------- ------------------------- --------------
Total operating
expenses......... 32,942 111,444 19,950 36,256
---------- --------------------- ------------------------- --------------
Loss from operations.. (10,234) (47,833) (3,456) (19,904)
Other income
(expense):
Interest income..... 348 5,393 107 2,604
Interest expense.... (235) (15,390) (349) (8,191)
---------- --------------------- ------------------------- --------------
Loss before income
tax.................. (10,121) (57,830) (3,698) (25,491)
Provision for income
tax.................. -- -- -- --
---------- --------------------- ------------------------- --------------
Net Loss.............. $ (10,121) $ (57,830) $ (3,698) $ (25,491)
========== ===================== ========================= ==============
Net Loss per share--
basic and diluted.... $ (0.42) $ (1.30) $ (0.09) $ (0.55)
========== ===================== ========================= ==============
Weighted average
shares--basic and
diluted.............. 24,109,912 44,389,172 43,238,400 46,659,188
</TABLE>
24
<PAGE>
<TABLE>
<CAPTION>
As of December As of March 31,
31, 1999
-------------- --------------------
1997 1998 Actual As Adjusted
------ ------- ------- -----------
(in thousands)
<S> <C> <C> <C> <C>
Balance Sheet Data:
Cash and cash equivalents............... $7,710 $28,330 $23,365 $162,428
Unrestricted investments................ -- 120,475 87,793 87,793
Restricted investments (1).............. 3,472 58,477 44,356 44,356
Property and equipment, net............. 38,504 73,899 84,833 84,833
Total assets.......................... 54,388 296,141 257,065 396,128
Long-term debt and capital lease
obligations (including current
portion)............................... 25,120 275,581 272,844 272,844
Stockholders' equity (deficit).......... 20,407 (30,291) (55,925) 83,138
</TABLE>
<TABLE>
<S> <C> <C> <C> <C>
<CAPTION>
Period from
Inception
(March 5,
1997) through Year Ended Three Months Ended March 31,
December 31, December 31, -----------------------------
1997 1998 1998 1999
------------- ------------ -------------- --------------
(in thousands)
<S> <C> <C> <C> <C>
Other Financial Data:
Capital expenditures.. $16,969 $ 45,261 $ 2,508 $ 15,292
EBITDA (2)............ (6,734) (33,983) (636) (15,269)
Cash provided by (used
in):
Operating
activities......... (2,233) (735) (4,874) (32,052)
Investing
activities......... (17,198) (169,512) (2,740) 29,765
Financing
activities......... 27,141 190,867 3,253 (2,678)
</TABLE>
- --------
(1) Restricted investments as of March 31, 1999, represent escrowed funds that,
together with interest received those funds, will be sufficient to pay,
when due, the next three semi-annual interest payments on our outstanding
11 3/4% senior notes.
(2) EBITDA is defined as net loss plus interest expense, provision for income
taxes, depreciation and amortization. EBITDA is presented as it is commonly
used by certain investors to analyze and compare operating performance and
to determine a company's ability to service and/or incur debt. However,
EBITDA should not be considered in isolation or as a substitute for net
income, cash flows or other income or cash flow data or as a measure of a
company's liquidity and is not a measure calculated in accordance with
generally accepted accounting principles. EBITDA is not necessarily
comparable with similarly titled measures reported by other companies.
25
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion together with our financial
statements and the notes to those statements included elsewhere in this
prospectus. The results shown in this prospectus are not necessarily indicative
of the results we will achieve in any future periods. This discussion contains
forward-looking statements based upon our current expectations which involve
risks and uncertainties. Our actual results could differ materially from those
described in the forward-looking statements due to a number of factors,
including those set forth in the section entitled "Risk Factors" and elsewhere
in this prospectus.
Overview
We are a facilities-based provider of advanced data communications services.
We market our services to Internet service providers, telecommunications
carriers and other businesses throughout the United States. Our services
include an array of Internet access and data communications services delivered
over our high capacity, facilities-based network.
We were founded in March 1997. In July 1997, we acquired the existing legacy
network infrastructure of Prodigy Communications Corporation, and agreed to
build and operate a nationwide communications network and to provide network
services for Prodigy's customers. We initially provided service to Prodigy's
subscribers using Prodigy's legacy network. For locations outside the coverage
area of the legacy network, we have been using the IBM Global Services network.
From September 1997 through April 1998, we deployed our broadband access
network in metropolitan areas across the country. Over time, as more coverage
has become available on our access network, we have been decommissioning the
Prodigy legacy network POPs and reducing our usage of the IBM network. In July
1998, we raised $261 million through the issuance of our 11 3/4% senior notes
and warrants to purchase common stock principally to finance capital
expenditures related to the construction and installation of our broadband
access network. As of May 31, 1999, our network included 239 operational POPs.
Later this year, we expect to have approximately 370 active POPs, giving us a
physical presence in all 50 states, and targeting 90% of U.S. businesses and
households with a local call. Our expanding network is supported by two network
operations centers equipped with state-of-the-art network management systems.
As part of our ongoing efforts to further expand and enhance our network and
service offerings, we have agreed to acquire indefeasible rights to use four
dark fiber strands in a state-of-the-art fiber optic network currently under
construction by Level 3 Communications, LLC, with an option to acquire
indefeasible rights to use an additional 12 fibers. This nationwide fiber
network will cover approximately 15,000 route miles and will be delivered in
segments that are expected to become available from the end of 1999 through the
first quarter of 2001. The combination of this fiber optic backbone with our
broadband access network positions us to:
. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers;
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit
arrangements with various telecommunications carriers;
. expand our service offerings by providing bandwidth leasing services on
a stand alone basis or bundled with our other services;
. increase the reliability and redundancy of our network; and
. increase the variety of service options and speeds available to
customers.
Revenues
Historically, Prodigy has been our primary customer and has accounted for
substantially all of our revenues since our inception. For both the year ended
December 31, 1998 and the three months ended March 31, 1999 Prodigy accounted
for 99% of our revenues. While we expect revenues from Prodigy to decrease as a
percentage of our total revenues in future periods, we believe that Prodigy
will continue to account for a significant portion of our revenues.
26
<PAGE>
We provide network services, including Internet dial services and other
network connections, to Prodigy in exchange for a monthly service charge. The
service charge is calculated based on the lower of two alternative rates,
subject to a minimum. One rate is calculated based upon the total hours of
usage and the other rate is calculated based upon the total number of
subscribers. The minimum monthly service charge is $3.5 million and will
increase to $4.0 million and $4.5 million on July 1, 1999 and July 1, 2000,
respectively. Through March 31, 1998, our Prodigy revenues were a function of
the amount of usage rather than the number of subscribers. However, since April
1998, these revenues have been, and over the long term are expected to continue
to be, a function of the number of subscribers rather than the amount of usage.
In addition, if the average monthly hours per subscriber exceeds a target
amount, we will be entitled to receive additional fees.
Our original four-year agreement with Prodigy expires on June 30, 2001.
After the initial term either party may terminate the agreement upon 12 months'
prior written notice. If no notice is received, the term of the agreement is
automatically extended for successive 12-month terms. Under the agreement, we
are required, among other things, to provide Prodigy with financial and other
information and to meet network performance standards. We are required to
provide credits to Prodigy if we fail to meet these standards. Prodigy may
terminate the agreement following a cure period if we fail to meet specified
service level objectives or otherwise fail to comply with our agreement.
Prodigy may also terminate the agreement during the initial term without cause
by providing 12 months' prior written notice and paying a termination charge of
$3.0 million.
Prodigy has announced plans to discontinue Prodigy Classic, its original on-
line service, on or before October 31, 1999 because of a shift in business
focus to Internet-based products and services and a determination not to make
Prodigy Classic Year 2000 compliant. Prodigy has reported that, although it
will continue to encourage Prodigy Classic subscribers to migrate to Prodigy
Internet, it has had difficulty in generating this migration and a substantial
portion of the remaining Prodigy Classic subscribers lack the minimum hardware
requirements for the Prodigy Internet service. While we expect continued growth
in Prodigy Internet subscribers, we do not expect that any significant portion
of this growth will be attributable to the migration of Prodigy Classic
subscribers.
On May 27, 1999, Prodigy announced that it had entered into a definitive
agreement to acquire the Internet access customer base of Cable & Wireless USA,
which we believe will result in a significant increase in Prodigy subscribers.
In addition to providing Internet dial access and related services to
Prodigy, we began offering Internet dedicated access services on a limited
basis to select customers during the second half of 1998. Given the nature of
our network costs and the fact that current network utilization peaks in the
evening hours to support Prodigy's residential Internet subscribers, we are
targeting providers of daytime intensive traffic as well as providers of
evening intensive traffic to maximize network utilization throughout a 24-hour
period. We plan to focus on providing virtual private network services,
Internet dedicated access, web hosting and Internet dial access services.
Historically, in the data communications industry, providing virtual private
network services increases the length of the sales cycle when compared to
providing Internet dedicated access services. Because we are in the early
stages of building our sales force, we expect growth in revenues to fluctuate
from quarter to quarter depending on the volume of monthly revenue of our
customers and the actual date the service becomes billable to our customers. We
cannot assure you that we will achieve the balance of utilization of the
network facilities necessary to attain or maximize profitability or positive
cash flow from operations.
Leveraging our demonstrated network capabilities, we have recently entered
into significant new customer relationships with Juno Online Services and
InfiNet. Juno, a leading provider of Internet and e-mail services, currently
has more than 200,000 subscribers for its Internet services launched in July
1998 and has created more than 6.8 million free e-mail accounts since April
1996. InfiNet, a consortium sponsored by Knight-Ridder, Gannett and Landmark
Communications, provides Internet access and web publishing solutions to nearly
100,000 subscribers nationwide. We began providing Internet dial access to
InfiNet's subscribers in the second quarter of 1999.
27
<PAGE>
As segments of our fiber backbone are constructed, we plan to use the
additional network capacity to offer bandwidth leasing services. However,
overcapacity could result from the construction of competing networks,
technological advances, strategic alliances, or a decline in the growth rate of
demand for bandwidth capacity. If this occurs, we could encounter significant
pricing pressure, which could limit the amount we could competitively charge
for these services.
Splitrock Network Costs
Our Splitrock network costs include all expenses incurred in connection with
designing, deploying and operating our network. These costs primarily include
leased telecommunication line charges for connecting our POPs to local central
offices and for backbone transmission, personnel expenses, and operating
expenses related to network operations, maintenance field operations and
facility management.
Increases in Splitrock network operating costs relate to the increase in
Splitrock network facilities and line charges incurred in connection with the
growth in total subscriber usage. As of May 31, 1999, we had 239 operational
POPs and we expect to have approximately 370 operational POPs when our network
construction is completed later this year. We anticipate continued increases in
our network operating costs as additional lines and facilities are deployed.
We are deliberately increasing our network operating expenditures to expand
our broadband access network and backbone capacity in anticipation of expected
increases in dial access and other services. We may incur expenditures to
increase our capacity to serve customers in advance of entering into new
customer relationships.
During March 1999, in order to maintain the quality and reliability of our
network performance, we entered into an agreement with Lucent Technologies to
provide us with maintenance on our broadband access network. Prior to entering
into this maintenance arrangement with Lucent, we had performed our own
maintenance of equipment and have relied on warranties from our vendors. We
expect our maintenance costs to increase as POP sites are added to the
maintenance contract through year end.
We expect our network operating costs to decrease significantly as a
percentage of revenues as we substitute our acquired fiber optic backbone
network for existing leased circuit arrangements with various
telecommunications carriers. Although we expect to incur new costs for
maintenance, colocation and software in connection with the fiber optic
network, we expect these new costs to be offset in future years by a larger
reduction in charges for backbone transmission. In connection with the services
we will provide to InfiNet, we will incur additional network operating expenses
that will largely offset our revenue from that customer through the end of
1999, while we transition InfiNet traffic from its legacy network to our
network.
Legacy Network Costs
Legacy network costs include all expenses incurred in connection with
operating and decommissioning the Prodigy legacy network. This includes
facility leases, line charges for Prodigy legacy network POPs, occupancy costs,
equipment maintenance costs and access fees for the IBM network, as well as
significant transition costs.
Legacy network costs are expected to decline, as more coverage becomes
available on our own broadband access network. As the construction and
installation of our own network progresses, the Prodigy legacy network is being
decommissioned and usage of the IBM network is declining. As of April 30, 1999,
we had fully deactivated 94% of the original Prodigy legacy network POPs. We do
not expect to incur any significant legacy network costs beyond the end of
1999.
The largest component of our legacy network costs are paid to IBM for usage
incurred on the IBM network. We have incurred quarterly costs from IBM of $6.3
million, $7.3 million, $11.0 million, $12.0 million, $12.6 million, and $11.5
million, respectively, for the six quarters from October 1, 1997 through March
31, 1999. The increase in costs through the fourth quarter of 1998 related to a
continued quarterly increase in total subscriber usage, coupled with an
increase in the hourly usage rate that went into effect at the beginning of the
second quarter of 1998. The IBM network costs have declined since the fourth
quarter of 1998 and we expect those costs to be substantially eliminated by the
end of 1999.
28
<PAGE>
During construction of new POP sites, access and transmission lines are
installed and charges are incurred as a POP site becomes operational.
Transition costs result from a duplication of expenses on both the new POP and
the associated legacy network POP until the new POP is operational and the
associated legacy network POP is decommissioned.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist of personnel and
operating costs relating to executive management, accounting and finance,
information systems, human resources, sales and marketing, customer support,
network planning, development, and administrative employees. We expect our
selling, general and administrative expenses to continue to increase in dollar
amount and as a percentage of revenue in 1999, 2000 and 2001 principally due to
the following factors:
. expansion of our sales and marketing force; and
. expansion of our back-office, customer care, billing, and administrative
functions.
We expect to make a substantial investment in our sales and marketing
programs to achieve and properly support the intended expansion in our customer
base. Through the combination of a direct sales force and alternative
distribution channels, we believe that we will be able to access markets and
increase revenue-producing traffic on our network. To implement our
distribution strategy, we are developing an in-house direct sales force. We
intend to utilize our direct sales force to market our services directly to
Internet service providers, carriers, value added service providers, and medium
and large businesses. We intend to utilize alternate distribution channels,
such as agents, resellers and wholesalers, to market our services to medium and
small businesses. We cannot assure you that we will be successful in our
marketing plan. In addition to the expanded sales force, we anticipate
continued back-office expansion, including the continued implementation of a
new customer care and billing system. We have also signed a lease for 69,000
square feet of additional office space, which we expect to be available for
occupancy by August 1999. This office lease will increase selling, general and
administrative costs and will also require additional capital expenditures for
furniture and fixtures and leasehold improvements.
Depreciation and Amortization
Depreciation and amortization expense consists primarily of depreciation of
network equipment. We anticipate that our depreciation and amortization
expenses will increase significantly as we record amortization on amounts
expected to be paid to acquire dark fiber rights and depreciation expenses for
the related electronic equipment.
Net Losses
We have incurred net losses since our inception in March 1997. We anticipate
that we will continue to incur net losses while we complete the construction
and installation of our nationwide network and expand our sales and marketing
force. The extent to which we continue to incur net losses is largely dependent
upon the timely deployment of the network, the rate at which we can expand our
customer and revenue base and our ability to maximize use of our nationwide
network.
Results of Operations
Three Months Ended March 31, 1999 Compared to Three Months Ended March 31,
1998
Revenues. Revenues for the three months ended March 31, 1999 totaled $16.4
million, a decrease of $0.1 million from revenues of $16.5 million for the
three months ended March 31, 1998. This decrease was due to a decrease in
revenues from Prodigy partially offset by a modest increase in revenues from
other customers. The decrease in revenues from Prodigy was a result of a change
in the methodology for calculating our charges to Prodigy. Our revenues from
Prodigy in the first quarter of 1998 were based upon the total hours of usage.
In contrast, our revenues from Prodigy in the first quarter of 1999 were based
on the total number of subscribers.
29
<PAGE>
Splitrock Network Costs. Splitrock network costs for the three months ended
March 31, 1999 were $16.0 million compared to $4.0 million for the three months
ended March 31, 1998. This increase was due to the growth in the size of our
network from 53 operational POPs as of March 31, 1998 to 192 operational POPs
as of March 31, 1999. As a percentage of revenues, Splitrock network costs
increased to 98.0% of revenue for the three months ended March 31, 1999 from
24.0% of revenues for the three months ended March 31, 1998.
Legacy Network Costs. Legacy network costs for the three months ended March
31, 1999 were $13.0 million compared to $12.3 million for the three months
ended March 31, 1998. This increase was attributable to an increase in total
subscriber usage coupled with an increase in the hourly usage rate for the IBM
Network. As a percentage of revenues, legacy network costs increased to 79.7%
of revenue for the three months ended March 31, 1999 from 74.4% of revenues for
the three months ended March 31, 1998.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the three months ended March 31, 1999 were $2.6
million compared to $0.9 million for the three months ended March 31, 1998. The
majority of this increase was due to an increase in personnel to support the
growth in the size of our network. In addition, in the third quarter of 1998,
we moved into a 25,000 square foot office facility in The Woodlands, Texas,
which significantly increased our occupancy costs. As a percentage of revenues,
selling, general and administrative expenses increased to 15.7% of revenue for
the three months ended March 31, 1999 from 5.2% of revenues for the three
months ended March 31, 1998.
Depreciation and Amortization. Depreciation and amortization was $4.6
million for the three months ended March 31, 1999 compared to $2.8 million for
the three months ended March 31, 1998. This increase was due to the increase in
equipment and facilities placed in service throughout 1998 and 1999.
Interest Expense. Interest expense was $8.2 million for the three months
ended March 31, 1999, compared to $0.4 million for the three months ended March
31, 1998. Historical interest expense was related to capital leases on
equipment and loans from a stockholder prior to completion of the senior notes
offering in July 1998. Beginning in the third quarter of 1998, interest expense
increased significantly due to the issuance of the 11 3/4% senior notes.
Interest Income. Interest income relates to the interest earned on
investments of cash on hand in investment grade commercial paper and money
market accounts. Interest income was $2.6 million for the three months ended
March 31, 1999, compared to $0.1 million for the three months ended March 31,
1998. This increase is due to the interest earned on the proceeds from our
senior notes offering. We anticipate a continued decline in interest income as
we use these funds to fund capital expenditures and operations.
Income Taxes. No provision for income taxes has been recognized because we
had operating losses for both tax and financial reporting purposes in all
periods.
On March 31, 1999, we had approximately $35 million of gross deferred tax
assets comprised primarily of net operating loss carryforwards. Given our
history of operating losses, it is uncertain that we would realize such assets,
and so we have provided a reserve to reduce the carrying value of the asset to
zero. We will continue to assess the ability to realize the deferred tax assets
based on actual and forecasted results.
Year Ended December 31, 1998 Compared to Period from Inception on March 5,
1997 through December 31, 1997
From inception on March 5, 1997 through June 30, 1997, we had not yet begun
deploying our network nor had we entered into our agreement with Prodigy. As a
result, we generated no revenue and incurred limited operating expenses prior
to the third quarter of 1997. Thus, any comparison of our results of operations
for the year ended December 31, 1998 with those results for the period from our
inception to December 31, 1997 is not meaningful.
30
<PAGE>
Since inception, we have focused on the construction and installation of our
network while maintaining and decommissioning, when appropriate, the Prodigy
legacy network. Through December 31, 1998, we had not focused on increasing
sales, as our network had not yet been completed. Prodigy represented our
primary source of revenue during both 1997 and 1998. In the second quarter of
1998, we began our efforts to raise capital to complete the construction and
installation of our nationwide network. On July 24, 1998, we issued and sold
$261.0 million in senior notes and warrants to acquire 1,487,791 shares of
common stock and began a campaign to recruit and employ the personnel necessary
to complete, operate and maintain our network.
To support our expansion, we have been adding employees. At the end of 1997
and 1998, respectively, we had 67 and 188 full time employees and contractors.
Additionally, during 1998, we added our second state-of-the-art network
operations center in The Woodlands, Texas.
Many of the employees we added represent field and office personnel for
construction management, assembly and installation, provisioning, and related
project management services for POP shelters.
Liquidity and Capital Resources
Our operations have required substantial capital investment for the purchase
of communications equipment and the design and development of our network.
Capital expenditures were $45.3 million and $15.3 million for the year ended
December 31, 1998 and the three months ended March 31, 1999, respectively. We
expect that our capital expenditures will be substantially higher in future
periods in connection with the purchase of dark fiber and the related
facilities and telecommunications equipment.
Since our inception, we have satisfied our cash requirements primarily
through the issuance of equity or debt securities. As of March 31, 1999, we had
raised approximately $298.1 million, including:
. $34.8 million through private sales of our equity securities, including
$18.0 million invested by our senior management and directors and $15.6
million invested by another major stockholder; and
. $263.3 million through the issuance of debt.
In addition we have arranged $30.6 million in equipment financing, primarily
from equipment vendors and leasing companies.
As of March 31, 1999, we had an accumulated deficit of $93.4 million, cash
and cash equivalents of $23.4 million, and restricted and unrestricted
investments of $132.1 million.
Net cash used in operating activities was $32.1 million during the three
months ended March 31, 1999. The net cash used in operating activities in this
period was primarily attributable to the Company's net losses. Net cash used in
operating activities was $0.7 million for the year ended December 31, 1998.
During the year-ended December 31, 1998, the cash flow effect of net losses
were largely offset by increases of $42.0 million in current liabilities due to
the timing of payments for purchases to equipment vendors and accrued interest
to bond holders.
Net cash provided by investing activities during the three months ended
March 31, 1999 was $29.8 million. This consisted of net proceeds of $46.6
million from the liquidation of restricted and unrestricted investments, offset
by $15.3 million used for purchases of property and equipment. Net cash used by
investing activities for the year ended December 31, 1998 was $169.5 million
and consisted primarily of the purchase of unrestricted investments of $119.5
million and $45.3 million in equipment purchases.
Net cash used in financing activities for the three months ended March 31,
1999 was $2.7 million and consisted primarily of principal payments on capital
leases. Net cash provided by financing activities for the year ended December
31, 1998 was $190.9 million, which was derived primarily from the issuance of
our senior notes, net of issuance costs and proceeds restricted to finance
future interest payments.
31
<PAGE>
As of March 31, 1999, we had aggregate operating and capital lease payments
of $8.3 million remaining in 1999, and $9.0 million, $2.5 million, $1.4 million
and $0.9 million due over the next four years.
We also have agreed to acquire indefeasible rights to use four dark fibers,
with an option to use up to 12 additional fibers, in the fiber optic network
under construction by Level 3. We are required to pay for the dark fiber in
segments as they become available, which is expected to occur from the end of
1999 through the first quarter of 2001.
We expect our future liquidity and capital requirements to relate primarily
to:
. capital expenditures;
. operating losses;
. debt service payments; and
. working capital and other corporate purposes.
We currently estimate that our capital expenditures for 1999, 2000 and 2001
will be approximately $73 million, $139 million and $76 million, respectively,
including capital expenditures for:
. the acquisition of rights to use four dark fiber strands and the related
electronics necessary to transmit data over the fiber;
. the completion of our broadband access network;
. the enhancement of our network to provide additional value added
services; and
. the improvement of our network management, billing and other back office
systems.
Actual capital expenditures will depend on numerous factors beyond our control
or ability to predict, including the availability of financing, the timing of
our acquisition of dark fiber, customer demand, competition, regulatory
developments, and general economic conditions. Moreover, our capital
requirements would increase significantly if we were to exercise our options to
acquire rights to use up to 12 additional dark fiber strands over and above the
four strands for which we have committed.
We believe that the net proceeds from this offering will be sufficient to
meet our anticipated cash needs through the end of 2000. However, we cannot
assure you that our financial resources will be adequate to fund all of our
anticipated or unanticipated working capital requirements and capital
expenditures during this period. Moreover, we expect that full implementation
of our current business plan will require that we raise substantial additional
capital for the needs that we anticipate funding during 2001 and 2002. We may
be required to raise additional funds through public or private financing,
strategic relationships or other arrangements. The terms of our debt securities
restrict our ability to incur indebtedness, create liens, and make dividend
payments and investments, and may make it more difficult for us to raise the
capital we will need to fully implement our business plan. We cannot assure you
that the additional financing we will need, will be available on terms
acceptable to us, or at all. Furthermore, any additional equity financing may
be dilutive to stockholders, and debt financing, if available, may involve
restrictive covenants and significant interest expense.
Year 2000
The year-2000 issue is the result of computer programs being written using
two digits, rather than four digits, to define the applicable year. Programs
that have time-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. This could result in a major system failure or
miscalculations, including an inability to process transactions, send invoices
or engage in similar normal business activities. Due to its reliance on
computer hardware and software, the Internet and related service industries are
highly susceptible to the year-2000 issue. If the year-2000 issue should cause
widespread problems across the Internet, usage can be expected to decline
dramatically. Such an event would have a material adverse effect on our
financial condition and results of operations, the nature and extent of which
cannot reasonably be determined by us on the basis of information currently
available to us.
32
<PAGE>
Our Year 2000 Program
We have established a program to ensure that, to the extent reasonably
possible, all systems are or will be year-2000 compliant prior to the end of
1999. Our Y2K program, designed with the assistance of an outside consultant,
consists of five phases:
. inventory of our potential exposures, including significant third-party
supplier and customer relationships;
. analysis of the assets to determine compliance or non-compliance;
. remediation and contingency plan development;
. remediation; and
. testing of affected systems.
A team consisting of our managers from Information Technology, Finance and
Operations has been established as the Y2K Readiness Team. With the assistance
of our outside consultant, the Y2K Readiness Team has designed an aggressive
schedule to identify information technology (IT) and non-IT assets requiring
compliance upgrades and a timetable for performance and testing of the affected
systems. In addition, the Y2K Program calls for validation of compliance by
significant suppliers and customers.
Once identified, we will schedule detailed remediation steps to ensure that
internal systems and significant external suppliers and customers meet Y2K
Program compatibility requirements, or that sufficient contingency plans are in
place. Remediation and compliance validation are estimated for completion
during the second quarter of 1999.
Current Status
Our Year 2000 assessment is approaching final completion. An inventory of
computing, communications and facility systems has been prepared and validated.
Significant suppliers, including competitive local exchange carriers, have also
been identified for validation.
We have completed the inventory for both our IT and non-IT systems and have
completed most of the analysis phase for these systems. We expect to complete
the analysis phases for these systems during the second quarter of 1999. The
Y2K Program calls for the completion of all phases for both IT and non-IT
Systems by the end of the second quarter of 1999.
We have performed a technical review of significant third party suppliers
and customers and, if available, have surveyed the public year-2000 statements
issued by them. In addition, we have sent inquiry letters to certain third
party suppliers and customers requesting information regarding their
vulnerability to year-2000 issues. We will respond to these inquiries and
evaluate the responses we receive to determine if alternate business actions
will be necessary.
To date, we have not incurred and do not anticipate incurring a significant
amount of costs to implement remedial actions required for year-2000
compliance.
Contingency Plans
If any significant systems, customers or suppliers are determined to have
questionable remediation potential, the Y2K Readiness Team will establish a
contingency plan to address the at-risk area during the analysis phase of the
overall project now underway. We are unable at this time to determine what
contingency plans, if any, may need to be implemented. As we progress through
the Y2K Program and identify specific risk areas, we will take appropriate
steps to implement remedial actions and contingency plans as required under the
circumstances.
33
<PAGE>
Risks
The failure to correct a year-2000 issue could result in the interruption or
failure of certain normal business activities or operations. We believe that
the most reasonably likely worst-case scenario would result from interruption
or failure of third party services. Because we are dependent on a number of
third party vendors to provide network services, a significant year-2000-
related disruption of these network services could cause customers to consider
seeking alternate service providers, decrease Internet traffic generally or
cause a significant burden on customer service and technical support.
We are not presently aware of any vendor-related year-2000 issue that is
likely to result in any disruption of this type. Although there is inherent
uncertainty in the year-2000 issue, we expect that as we progress in our Y2K
Program, the level of uncertainty about the impact of the year-2000 issue will
be reduced significantly.
Disclosures about Market Risk
The following discusses our exposure to market risk related to changes in
interest rates, equity prices and foreign currency exchange rates. Market risk
generally represents the risk of loss that may result from the potential change
in the value of a financial instrument as a result of fluctuations in interest
rates and market prices. We have not traded or otherwise bought and sold
derivatives nor do we expect to in the future. We also do not invest in market
risk sensitive instruments for trading purposes.
This discussion contains forward-looking statements that are subject to
risks and uncertainties. Actual results could vary materially as a result of a
number of factors including those set forth under the captions "Risk Factors--
We have incurred substantial indebtedness and may not be able to service our
debt" and "Risk Factors--We may need additional capital in the future and
additional financing may not be available."
Interest Rate Risk
We may be exposed to market risk related to changes in interest rates. At
this time, we have not entered into any interest rate risk arrangements, and
while we may enter into interest rate risk hedging arrangements in the future,
we cannot assure you that we will be able to find commercially satisfactory
terms at that time. Our investment policy is to manage our investment portfolio
to preserve principal and liquidity while maximizing the return on the
investment portfolio through the full investment of available funds. We
diversify our marketable securities portfolio by investing in multiple types of
investment-grade securities. Our investment portfolio is primarily invested in
short-term securities with at least an investment grade rating to minimize
interest rate and credit risk as well as to provide for an immediate source of
funds. Although changes in interest rates may affect the fair value of the
investment portfolio and cause unrealized gains or losses, such gains or losses
would not be realized unless the investments are sold.
Our Short-Term Investments. As of March 31, 1999, we had unrestricted
short-term investments of $87.8 million and restricted short-term investments
of $28.2 million. These short-term investments are highly liquid investments
with original maturities at the date of purchase of between three and twelve
months and consist primarily of money market funds and high-grade securities
such as corporate notes, municipal securities and U.S. Treasury notes. We value
these investments at fair market value. These investments are subject to
interest rate risk and will fall in value if market interest rates increase. A
hypothetical increase in market interest rates by 10% from levels at March 31,
1999 would cause the fair value of these short-term investments to decline by
an immaterial amount. We have the ability to hold these investments until
maturity, and therefore would not expect the value of these investments to be
affected to any significant degree by the effect of a sudden change in market
interest rates. Declines in interest rates over time will, however, reduce our
interest income, especially from money market funds whose rates change on a
daily basis. For more information, see Note 1 to the Financial Statements.
34
<PAGE>
Our Long-Term Investments. As of March 31, 1999, we maintained restricted
long-term investments totaling $16.2 million in connection with our 11 3/4%
senior notes due 2008. These long-term investments consist of high-grade
securities such as corporate notes, municipal securities and U.S. Treasury
notes, all of which are considered liquid and available for sale. Certain of
these securities will not be held to maturity. A hypothetical increase in
market interest rates by 10% from levels at March 31, 1999 would cause the fair
value of these securities to decline by an immaterial amount.
Outstanding Debt. As of March 31, 1999, the carrying value of our
outstanding senior notes was approximately $258.3 million at a fixed interest
rate of 11 3/4%. In certain circumstances, we may redeem this long-term debt.
Because the interest rates on these instruments are fixed, a hypothetical 10%
decrease in interest rates would not have a material impact on our financial
condition, revenues or operations. Increases in interest rates could, however,
increase the interest expense associated with future borrowings, if any. We do
not hedge against interest rate increases.
Equity Price Risk
We do not own an equity stake or investment in another company or business
entity and therefore we do not believe that we have any direct equity price
risk. We do not hedge against equity price changes.
Foreign Currency Exchange Rate Risk
All of our revenues are realized in dollars and all of our revenues are from
customers in the United States. Therefore, we do not believe that we have any
significant direct foreign currency exchange rate risk. We do not hedge against
foreign currency exchange rate changes.
35
<PAGE>
BUSINESS
Our Company
We are a facilities-based provider of advanced data communications services.
We market our services to Internet service providers, telecommunications
carriers and other businesses throughout the United States. We own and operate
a state-of-the-art, broadband access network that:
. consistently achieves among the highest performance ratings in the
industry for network reliability, speed and throughput;
. currently handles more than 1.3 billion minutes of use per month;
. reaches businesses and households in every U.S. market with a population
of at least 100,000 as well as several smaller markets; and
. employs ATM switches at every POP.
We recently agreed to acquire indefeasible rights to use four dark fiber
optic strands, with an option to use up to 12 additional fibers, in a
nationwide network that will cover approximately 15,000 route miles. The
combination of our existing broadband access network with our pending
acquisition of significant fiber optic facilities positions us to deliver a
broad array of end-to-end data communications services on our own network,
including:
. dial and dedicated Internet access;
. Internet access for higher bandwidth services, such as DSL and cable
modem;
. value-added services such as virtual private networks and web hosting; and
. bandwidth leasing and colocation services.
As compared to router-based, data-oriented networks we believe our network
platform is more flexible for handling and deploying multiple and new services.
Our broadband access network can accept input from a wide range of devices
under all widely deployed protocols over all commercially deployed transmission
speeds. This enables quicker and more economical deployment of new service
offerings when combined with intelligent ATM processing residing solely at the
core sites.
We currently provide nationwide Internet dial access and related services to
Prodigy, our primary customer and one of the largest Internet service providers
in the United States. We are also offering to businesses nationwide dial and
dedicated access for virtual private network services, and plan to begin
offering web hosting and other value-added services by year end 1999. We
believe that our relationship with Prodigy and our high network performance
have demonstrated our strength as a network operator and positioned us to
expand our customer base and service offerings. Leveraging our demonstrated
network capabilities, we have recently entered into significant new customer
relationships with Juno Online Services, Inc. and InfiNet. Juno, a leading
provider of Internet and e-mail services, currently has more than 200,000
subscribers for its Internet services launched in July 1998, and has created
more than 6.8 million free e-mail accounts since April 1996. InfiNet, a
consortium sponsored by Knight-Ridder, Gannett and Landmark Communications,
provides Internet access and web publishing solutions to nearly 100,000
subscribers nationwide.
Industry Overview
Data communications services, including Internet and other network services,
is one of the fastest growing segments of the global telecommunications market
place. Businesses of all sizes are demanding advanced, highly reliable
solutions for their data transmission needs that enhance productivity, improve
efficiency and reduce operating expenses. As a result, businesses are seeking
communications providers that can securely and
36
<PAGE>
efficiently connect geographically-dispersed locations uniformly and offer a
full range of value-added services that meet their data networking needs.
Businesses have begun to utilize value-added data communications services such
as web hosting, e-mail, file transfer and, more recently, intranet and extranet
services, e-mail outsourcing, e-mail broadcast and security. High speed data
communications access services link businesses or individual consumers to the
Internet's resources or to corporate intranets and extranets. Access services
include dial-up access for individuals and small businesses and the high-speed
dedicated access services used primarily by mid-sized and larger organizations.
Businesses have also rapidly established corporate websites as a means to
expand customer reach and improve communications efficiency. Many businesses
are currently using the Internet as a lower cost alternative to building
expensive private data communications networks. For example, many corporations
are connecting their remote locations using intranets to enable efficient
communications with employees, customers and suppliers, reducing
telecommunications costs by using IP-based faxing and migrating legacy database
applications to run over IP-based networks.
Market Size and Growth
According to industry reports, data communications services is one of the
fastest growing segments of the global telecommunications market. For example,
according to Forrester Research:
. business Internet access services are projected to grow at a compound
annual growth rate of 71% from $2.8 billion in 1998 to $41.9 billion in
2003;
. consumer Internet access spending will increase from approximately $7
billion in 1998 to approximately $19.9 billion in 2003; and
. web hosting and other value-added services are projected to grow at a
compound annual growth rate of 76% from $0.9 billion in 1998 to $14.7
billion in 2003.
In addition, according to International Data Corporation:
. frame relay services are projected to grow at a compound annual rate of
19% from $4.4 billion in 1998 to $10.7 billion in 2003; and
. ATM services are projected to grow at a compound annual rate of 37%
from $0.3 billion in 1998 to $1.6 billion in 2003.
Our Strategy
Our mission is to strengthen our position as a leading facilities-based
provider of advanced data communications services. To achieve this objective,
our business strategy focuses on the following key principles:
Expand Our Marketing Activities to Capitalize on Expected Demand
We intend to capitalize on the expected growth in demand for network
services from businesses by aggressively marketing our services through a
variety of distribution channels. We believe that utilizing a range of
distribution channels will enable us to cost-effectively reach a broad base of
potential customers. We are significantly expanding our direct sales force to
attract Internet service providers, telecommunications carriers, value-added
service providers and medium and large businesses. We are hiring highly
motivated personnel who have a background in or experience with the data
communications industry. In addition, we intend to use alternative distribution
channels, including agents, resellers and wholesalers, to gain access to a
substantially larger base of potential customers than we could otherwise
initially address through our direct sales force. Through the combination of a
direct sales force and alternative distribution channels, we will seek to
rapidly increase network traffic, market penetration and customer base.
Broaden Our Portfolio of Service Offerings
We are broadening our portfolio of value-added services to address business
customers who are increasingly outsourcing their critical applications and
integrating web-based services as part of their core data networking strategy.
We are positioned to offer a number of value-added services, including virtual
private
37
<PAGE>
networks with a wide range of access options and speeds, web hosting and
colocation on our nationwide broadband access network. These services can be
bundled with Internet access services to provide complete, turnkey solutions.
We have begun construction on our first web hosting data center in Houston,
Texas and plan to build three additional data centers later this year. In
addition, the enhanced capacity resulting from our recent acquisition of dark
fiber capacity will enable us to offer a wider variety of data services on our
own network, including bandwidth leasing. We believe that providing value-added
services not only improves customer loyalty by making our services more
attractive as a package but also improves profitability, as value-added
services often provide higher margins.
Exploit the Capabilities of Our Advanced Nationwide Communications Network
We are completing deployment of our advanced, high-capacity, facilities-
based nationwide communications network. We believe that our ATM-to-the-
Edge(TM) network results in:
. an easily scalable network architecture;
. the ability to efficiently add new services and integrate further
technological innovations at a lower incremental investment than that
required by other communications service providers with legacy systems
that have separate networks for voice and data;
. interoperability with other network platforms; and
. improved network manageability.
To enhance our broadband access network, we have agreed to acquire
indefeasible rights to use four dark fiber strands, with options to acquire
indefeasible rights to use an additional 12 fibers, in a state-of-the-art
nationwide fiber optic network currently under construction by Level 3. We
believe that the combination of this fiber optic backbone with our broadband
access network positions us to:
. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers;
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit
arrangements with various telecommunications carriers;
. expand our service offerings by providing bandwidth leasing services on
a stand-alone basis or bundled with our other services;
. increase the reliability and redundancy of our network; and
. increase the variety of service options and speeds available to customers.
Build Strong Customer Loyalty Through Superior Customer Service
We believe that superior customer service is a critical element in
attracting and retaining customers. Our broadband network is designed to
provide uniform quality and consistent service offerings at every point
nationwide. We have also made significant investments in personnel and our
scalable operating support systems. We believe that these systems give us a
competitive advantage relative to traditional network service providers because
we can better meet new customer demands and accommodate new service offerings.
We oversee our network operations from two existing network operating centers
24 hours a day, seven days a week. With our integrated web-based network
management tools we can monitor every POP in our network for quick and
efficient problem resolution from our network operations centers.
Leverage Our Experienced Management Team
Our senior management team has extensive experience in the data
communications industry. Our ten most senior executives have an average of over
15 years of industry experience. We believe that our ability to combine and
draw upon the collective talent and expertise of our senior managers gives us a
competitive
38
<PAGE>
advantage in the effective and efficient execution of network deployment,
sales, provisioning, service installation, billing and collection, customer
service and delivering communications solutions to businesses. Our co-founders,
Mr. Li and Mr. Wilson, were both executives at WilTel and helped establish that
organization's ATM and frame relay marketing strategies. Mr. Li was part of the
leadership team that established Yurie Systems as a start-up company, took the
company public and built it into a successful organization that was sold to
Lucent Technology, Inc. for approximately $1 billion in 1998.
Our senior management team also includes experienced marketing, finance and
operating personnel. David Boatner, our Executive Vice President and Chief
Marketing Officer, has built effective nationwide sales teams that target
business customers in the telecommunications industry for McLeodUSA, LDDS-
WorldCom, WilTel, Southwestern Bell and AT&T. Robert Fugate, our Chief
Financial Officer, was part of the team that successfully built SkyTel into a
leading provider of domestic and international wireless messaging services.
Larry Walberg, our Senior Vice President of Operations, has had significant
management experience at both WilTel and MCI WorldCom, where he served as Vice
President, Global Data Network Operations. Todd Wilkens, our Senior Vice
President of Engineering, managed the deployment of a nationwide frame
relay/ATM network at GridNet, now a subsidiary of MCI WorldCom. Other key
executives have significant experience in the critical functions of network
operations, sales and marketing, customer and operations support systems,
finance and regulatory affairs.
Increase and Optimize Network Utilization
Given the nature of our network costs and the fact that our current network
utilization peaks in the evening hours to support Prodigy's residential
Internet subscribers, we seek to increase and optimize total network
utilization primarily by targeting providers of business services with daytime
intensive traffic as well as providers of consumer services with evening
intensive traffic. By pursuing this strategy, we believe that we will be able
to optimize network utilization throughout a 24-hour period by offering both
business-oriented services, such as dial virtual private networks and dedicated
and dial Internet access services, during the day, and consumer-oriented
services, such as Internet dial access services in the evening.
Evaluate Strategic Alliances and Acquisitions That Increase Our Network
Traffic
We also intend to evaluate strategic alliances and acquisitions that could
provide additional traffic over our network. We are primarily focused on the
domestic services market and we believe that many opportunities for strategic
alliances and acquisitions will be available to us in the future. For example,
we may enter into joint marketing relationships with other companies that offer
complementary services to business customers. We may also acquire companies
that would drive increased traffic on our network without corresponding cost
increases.
We also believe that the demand for Internet services outside the United
States will grow over the next few years. We intend to enter into international
alliances to originate and terminate international traffic on our network. We
will be targeting international Internet service providers and other carriers
for two types of opportunities--traffic termination in the United States and
data transport via the United States for termination in other countries. For
example, in cooperation with Telefonos de Mexico, Mexico's primary telephone
company and an affiliate of Prodigy, we intend to test connectivity between our
respective data networks. In addition, we have engaged European Marketing
Services, a marketing firm that successfully introduced Dell and other
technology firms to the European markets, to facilitate our own entry into the
European market.
Our Services
We currently provide Internet dial access services and Internet dedicated
access services, as well as value-added services such as dial and dedicated
virtual private networks. We also have the ability to provide frame relay and
ATM virtual private network services and web hosting and will begin to market
these services by the end of this year. The addition of the fiber optic
backbone to our network and acquisition of dark fiber will also allow us to
offer bandwidth capacity and related colocation services as well.
39
<PAGE>
Internet Access Services
Dial Access. Our Internet dial access services offer a cost effective
Internet solution with V.90 modem access to our advanced network via ordinary
telephone lines. Regional Internet service providers using our Internet dial
service can rapidly scale their service from regional or local coverage to
national coverage. National Internet service providers can expand their market
share by using our extensive local dial and 800 services to reach more
customers. We are primarily targeting Internet service providers with business
as well as residential customers to maximize traffic throughout our network.
We currently provide Internet dial access services to Prodigy for its
subscribers. Leveraging on our demonstrated network capabilities, we have
recently entered into significant new customer relationships with Juno Online
Services and InfiNet.
Dedicated Access. We offer high speed dedicated connectivity to the Internet
for both business users and Internet service providers. Our Internet dedicated
access services provide connectivity at access speeds ranging from 1.54 Mbps to
155 Mbps. We are targeting corporate users and carriers, including Internet
service providers, local exchange companies, regional long distance providers
and wireless providers as potential customers for this service.
In the future, we believe that our fiber backbone positions us to support
Internet access for higher bandwidth services, such as DSL and cable modem.
These high-speed access methods will enable new Internet services such as video
and high quality audio services.
Value-Added Services
We believe that business customers will continue to increase their use of
the Internet and other data services. Customers increasingly rely on a range of
value-added services, including virtual private networks and web hosting. We
will continue to develop new services to meet these business needs that
capitalize on our technologically advanced, high-speed broadband access network
and our fiber optic backbone.
Virtual Private Network Services. Many companies today have private data
communication networks built on expensive leased lines designed to transfer
data between office locations. Private data networks are expensive to set up,
operate and maintain, requiring the use of leased lines and the purchase of
networking hardware and software. Our virtual private network services can
provide businesses with a lower-cost alternative to private data networks.
Virtual private network services are valuable to business customers because
they:
. eliminate the need to invest significant amounts in proprietary equipment
and software;
. securely and efficiently connect multiple, geographically dispersed
locations;
. provide remote access capabilities; and
. allow businesses to add, delete or move company locations to meet changing
needs.
We have begun offering both dial and dedicated access for frame relay and
ATM virtual private network services to businesses, Internet service providers,
competitive local exchange carriers and others. We expect that the provision of
virtual private network services will be an important focus of our future
business.
Web Hosting. We now offer, on a limited basis, web hosting services bundled
with our Internet access services that permit companies to market themselves
and their products on the Internet without having to invest in technology,
infrastructure and operations staff. We are developing for roll-out later this
year a web hosting service that will be marketed on a stand-alone basis or
bundled with our Internet access and virtual private network services. Web
hosting is an ideal solution for customers who want to "publish" web pages on
the
40
<PAGE>
Internet without purchasing, configuring, maintaining and administering the
necessary sophisticated hardware and software. Due to economies of scale, we
can generally offer more sophisticated web hosting solutions than our customers
can provide for themselves. Our data centers will be located at selected core
POP sites and will make use of multiple high bandwidth connections to the
Internet. File structure directories, domain name registration and security
privileges can be set up for customers on our hosting servers, thus enabling
customers to remotely "publish" their content for distribution over the
Internet. In addition, we can provide network and systems administration and
maintenance, tape back-ups and security. In the future, we may also offer
applications hosting and other e-commerce services.
Bandwidth Leasing
With control over our fiber optic backbone network, we expect to offer
bandwidth leasing services that allow Internet service providers and other
business customers to transfer their traffic through our network. Bandwidth
leasing services will enable customers to reduce their data communications
expense by leasing network utilization from us in lieu of leasing point-to-
point circuits from other communications providers. We expect to be able to
offer high volume transmission capacity at a variety of speeds over our fiber
optic network. We may also target large capacity users who want to augment
their own networks or provide diverse routing alternatives in strategic areas
of their systems. Our potential customers for these services include
interexchange carriers, cable, data and transmission companies, the regional
Bell operating companies, Internet service providers, and local exchange
carriers. We expect to offer a variety of pricing and system options to meet
the specific needs of each customer. For instance, a customer may lease the
bandwidth capacity on a short or long term basis for extensive or minimal
coverage.
Colocation
We plan to house business-critical servers and other electrical, networking
and communications equipment in our secure network facilities on behalf of our
customers. The demand for these colocation services has increased as companies
expand into geographic areas in which they do not have appropriate space or
technical personnel to support their equipment and operations. Colocation
customers are typically larger enterprises employing more sophisticated
Internet hardware, software, and web servers, and have the expertise to
maintain their own web sites and related equipment. We plan to offer customers,
including Internet service providers, the opportunity to colocate their web-
server computers at our sites.
Our Network
We own and operate a state-of-the-art, broadband access network that employs
ATM technology at every core, hub and remote POP site. When our broadband
access network is completed later this year, it will include approximately 370
active POPs, giving us a physical presence in all 50 states, and targeting over
90% of U.S. businesses and households with a local call.
We recently agreed to acquire indefeasible rights to use four dark fiber
strands, with an option to acquire indefeasible rights to use an additional 12
fibers, in an approximately 15,000 route mile nationwide fiber optic network.
The combination of our existing broadband access network with our pending
acquisition of significant fiber optic facilities will allow us to deliver a
broad array of end-to-end data communications services on our own facilities at
the high level of quality, cost-effectiveness and reliability increasingly
demanded by customers. The increased bandwidth capacity will allow the network
to support advanced services such as DSL and video.
Through its ATM-to-the-Edge(TM) architecture, our broadband access network
allows us to concurrently provide multiple services such as data, video and
voice to customers and to incorporate future technology changes at relatively
low incremental investments. As a result, we believe that we have created a
more efficient
41
<PAGE>
network than our competitors, thereby reducing future operating costs and
improving reliability to the end user. Older networks were typically designed
to provide one type of service, such as voice or data, and are less efficient
at carrying other traffic. Unlike many networks which deploy ATM switching only
along the core sites in the backbone, our broadband access network deploys ATM
switching at every POP site--core, hub and remote. Each POP is supported by the
Lucent AC-120 switch which we believe provides significant quality of service
advantages over typical ATM switches. Our management believes that our network
contains more ATM-based switches than any other commercial network.
Our network was designed to meet the following strategic goals:
. provide uniform service nationwide that is reliable, fast, efficient and
easy to access;
. build high capacity to move data more quickly, more efficiently and at
greater traffic volumes;
. provide better quality service than our competitors at a lower cost;
. provide broad coverage to points not served by other networks;
. use the industry's best suppliers for network components; and
. build redundancy into the network for better reliability.
Network Performance
We believe that our network delivers the high level of quality increasingly
demanded by customers. We have consistently achieved among the highest
performance ratings in the industry for network reliability, speed and
throughput. Inverse Technology measures and reports on nine network performance
parameters of Internet service providers. Our ratings exceeded or equaled the
industry average in each of the categories shown below for five of the last six
months.
<TABLE>
<CAPTION>
Inverse 1999 Rating
-----------------------------
Selected Performance Attributes Jan Feb Mar Apr May June
- ------------------------------- --- --- --- --- --- ----
<S> <C> <C> <C> <C> <C> <C>
24-Hour Call Success................................... A A+ A A A+ A
Evening-Hour Call Success.............................. B A+ A+ A+ A+ A
Business-Hour Call Success............................. A A+ A A A+ B
Modem Connect Speed.................................... A+ A+ A+ A+ A+ A+
Average Web Throughput................................. A+ A+ A+ A+ A+ A+
</TABLE>
Inverse Technology rates the network performance of all major nationwide
Internet service providers by making more than 250,000 test calls per month.
The national providers compared in the Inverse rating are: AOL, AT&T, Cable &
Wireless, CompuServe, Earthlink, GTE, IBM, Microsoft Network, Mindspring,
NETCOM, Prodigy (Splitrock) and UUNET. In addition to the performance
attributes in the table above, Inverse Technology also rates average time to
login, average domain name system lookup time, average download time, and
average total web failures/timeouts. In our view, however, these attributes
reflect the performance of the Internet service provider and do not reflect the
performance of the underlying network. You should not place undue reliance on
Inverse Technology's reports as a measure of network performance because these
reports do not measure all factors that may affect the quality of our services
and are based on a random sampling of our network's POPs.
42
<PAGE>
Network Infrastructure
We believe that we have provided for future growth by ensuring that our
network is:
. scalable;
. flexible;
. fault tolerant;
. based on open standards and interoperable; and
. manageable from remote locations.
Scalable. Our flexible, multi-layer network architecture utilizes a high-
speed switching fabric that enables us to increase the number of POPs and the
number of users served in an incremental manner that matches investment with
demand. Our network's scalability extends beyond the currently installed base
of POPs to allow for growth without fundamental design changes or loss of
service quality.
Flexible. We believe that our network will enable us to adapt to new
services and manage network resources according to each service's needs,
permitting us to efficiently offer data, video and voice services concurrently.
Fault Tolerant. Redundancy and adaptive technology in our network reduces
the impact of isolated failures. For example, all core sites are
interconnected, allowing traffic to be transferred among sites in case of a
failure. In addition, key switches, routers and workstations are configured to
search for alternate paths if an individual component or transmission line
fails. We also have an uninterruptible power supply at each POP, limiting the
impact of local power outages on our network.
Open Standards and Interoperable. Our entire network supports various
protocols, including IP, ATM, frame relay, ISDN, video and SS7. This
architecture allows us to interconnect freely with other carrier networks or
customer networks. As a result, we can extend services of another carrier
outside of that carrier's own region. In addition, potential virtual private
network clients that use standards-based protocols can easily access our
network without having to purchase special equipment that would otherwise be
necessary with a proprietary network.
Manageable. From our network operations centers, we are able to monitor our
network remotely, perform network diagnostics and equipment surveillance, and
inform customers when a network problem occurs. Our network operations centers
are open 24-hours a day, seven days a week. As a result of our network
architecture, these tasks may be performed remotely regardless of POP location
or network status. This capability allows us to control costs associated with
on-site network configuration and repair.
Broadband Access Network
Communication service providers have typically provided services using two
predominant types of infrastructure, one geared towards voice service and the
other designed to optimize data communications. Practical considerations and
equipment constraints have led to the development of these two types of
distinct network infrastructures. Voice telecommunications service providers
historically have needed to provide a high level of reliability and depend upon
equipment reliability, network architecture design, network management and
maintenance to meet their service needs and reliability constraints. Data
telecommunications service providers, on the other hand, benefit from highly
intelligent terminals at the end-user that usually can determine if a
transmission error has occurred and automatically re-transmit data and even
reconnect a session if necessary. With the help of intelligent terminals, data
communication networks run complex routing algorithms that allow them to locate
and find the best route to transmit data. While providing a high degree of
flexibility, data communication service networks often have unpredictable
performance.
43
<PAGE>
In order to create a network which efficiently supplies multiple types of
services, such as data, video and voice, a company must make the platform
reliable enough to support voice, yet flexible enough to support data. To date,
companies successfully providing voice and data concurrently have partitioned
their network's bandwidth to support two separate service infrastructures. Part
of their bandwidth is used for voice, employing voice telecommunications
service switches, and the other part is used for data, employing standard data
telecommunication equipment in the network.
Separating bandwidth use has been a practical way for older networks to
provide multiple services. As long as data represents a small portion of
network traffic, this partitioning remains practical. However, it is expected
that the rapid growth of data will soon cause data to consume more bandwidth
than voice. When that occurs, partitioning will make network bandwidth
utilization very difficult to optimize while creating significant management
complexity.
Our network was designed to address constraints facing older networks by not
requiring the separation of bandwidth for different types of services. In the
process of designing our network we sought to create a network infrastructure
which could:
. efficiently offer data, video, and voice services concurrently;
. reduce operating costs by more efficient utilization of network resources;
and
. provide high quality service for all services offered on the network.
We believe that three features distinguish our network from other data
communications networks. First, we use the Lucent AC-120 switch which supports
multiple services at every POP of the network. We believe that this
"intelligent" ATM switch differs from typical ATM backbone switch engines
because it supports many access protocols to the network whereby an array of
data, video and voice services can be sent and/or received, including IP, frame
relay, ATM, Ethernet, T-1, T-3, OC-3 and many other digital as well as analog
interfaces. Also, the Lucent AC-120 is scalable with up to 14 interface module
slots designed to house interface cards supporting these various services. The
Lucent AC-120 translates these native service protocols into standard ATM
format and transports any service as an ATM connection. In addition, the Lucent
AC-120 implements a patented queuing algorithm that eliminates the need for
bandwidth allocation to different kinds of services and simultaneously supports
data, video and voice services on a unified platform without loss of quality of
service even during periods of high network utilization.
Second, to manage the large number of ATM switches in our network, we
organized the network architecture into classes and regions. This architecture
allows us to introduce new services more quickly because all new services can
be layered on the network's ATM switching fabric without alterations being made
to the fabric itself. A new network service has two components, the protocol
that defines the format of the information payload and the signaling or routing
instructions required to direct the information to its destination in the
network. Our network ATM switching platform streamlines the signaling process
because routing information is concentrated in a limited number of central
sites in the network known as core sites rather than having signaling or
routing information interpreted by switches or routers at every point of the
network as occurs, for example, in a traditional IP-based network. Therefore,
to introduce a new service, we only need to deploy the proper signaling or
routing processors at a few core sites instead of hundreds of switch or router
sites distributed around the network. This reduced number of routing decisions
also permits better management and typically faster throughput than other
networks.
Third, most modern networks achieve transmission efficiencies by deploying
ATM switching engines in three to 20 access sites only in the core backbone of
their network. In contrast, ATM switches are located in all POPs throughout the
network. At the completion of our network construction and installation, we
expect to have approximately 370 ATM switches deployed in our network. The ATM-
to-the-Edge(TM) network forms the basic platform for us to offer multiple
services to all users on the network.
44
<PAGE>
Network Organization
Our network is organized into three classes of access sites: core sites, hub
sites and remote sites. The architecture partitions the entire network into 21
regions, with a core site in each region. The core site is generally located in
the city with the most traffic in that region. Users access the network within
a region by connecting to either a core, a hub or a remote site. The core sites
form the backbone of the network, with the hub and remote access sites
extending the reach of the backbone.
Our 21 core sites are logically and fully meshed to allow traffic to pass
directly from any one region to any other region. The core sites are
interconnected by standard transmission links such as DS-3 or OC-3. We can
purchase bandwidth on an actual need basis between each site and upgrade these
links as the bandwidth demand increases because the Lucent AC-120 conforms to
standard transmission specifications.
In addition, each core site is equipped with special protocol processors to
enable our network to accommodate demand for a wide variety of services. IP
protocol, for instance is supported by routers at each core site as compared to
other networks that must install routers at each POP. As a result of our
design, each of our routers is directly connected to every other router in the
network and can forward packets from region to region efficiently via simple
routing tables.
Hub sites service the major cities within a region and connect to core sites
over a DS-3 line or multiple T-1 lines depending on the traffic requirements.
Hub sites can be connected redundantly to other hub sites or to core sites to
increase network reliability. For IP traffic, all packets from a hub site are
forwarded directly to the region's core site, and then forwarded to their
destination region by the core site router.
Our network has a large number of remote sites to reach the smaller cities
within a region. These sites allow user access to the same services as
elsewhere in the network. Remote access sites connect to a hub site, usually
with a T-1 line. The remote sites can also be protected from transmission
failures by being connected redundantly to other access sites in the region.
Fiber Optic Backbone
As part of our ongoing efforts to further expand and enhance our network, we
recently entered into an agreement to acquire long-term indefeasible rights to
use four dark fiber strands, with an option to use up to 12 additional fibers,
in the nationwide fiber optic network currently under construction by Level 3
Communications.
Fiber optic technology uses light to transport information from one point to
another. Fiber optic strands are thin filaments of glass through which light
beams are transmitted over long distances carrying large amounts of data.
Modulating light on thin strands of glass produces major benefits including
high bandwidth, relatively low cost, low power consumption, small space needs
and total insensitivity to electromagnetic interference.
The optical fiber strands that will comprise our fiber backbone network are
designed to accommodate dense wave division multiplexing transmission
technology. As a result, we can deploy equipment which transmits signals on 32
or more individual wavelengths of light per strand. This capability will
significantly increase the potential capacity of our fiber backbone relative to
older networks which generally use fiber optic strands that transmit fewer
wavelengths per strand. In addition, we believe that the installation of newer
optical fibers will allow a combination of greater wavelengths of light per
strand, higher digital transmission speeds, and greater spacing of network
electronics.
Network Management and Customer Service
We believe that superior customer service is a critical element in
attracting and retaining new customers and expanding value-added services to
existing customers. In particular, we believe that it is critical to maintain
two geographically dispersed network operations centers, each of which enables
us to monitor our entire network and provide rapid problem resolution. We have
established two 24-hours per day, seven days per week network operations center
facilities located in The Woodlands, Texas and Yorktown Heights, New York. Each
of these network operations centers permits us to manage traffic, monitor
system status and remotely implement solutions to system interruptions.
45
<PAGE>
In the first half of 1998, we implemented a number of new systems and
procedures to provide superior customer service. We have installed a leading
customer support trouble ticketing and workflow management system to track,
route and report on customer service issues. We also implemented new industry-
standard billing systems in late 1998. We expect to offer wholesale customers a
system that generates invoices tailored to the client's service mix and use a
second billing system for retail customers that authenticates and bills through
credit cards. To support anticipated growth in customers on our network, we
have established a customer call center to provide customer support 24 hours
per day, seven days a week.
Through the development of scalable operating support systems, we believe
that we have the opportunity to establish a competitive advantage relative to
traditional network service providers. Traditional network service providers
typically operate extensive legacy operating support systems with
compartmentalized architectures that limit their ability to scale rapidly and
introduce enhanced services and features. In connection with the expansion of
our network, we are creating operating support systems with an architecture
designed to maximize both reliability and scalability. Furthermore, in
establishing our operating support systems, we have attempted to develop
company-wide standardization of hardware, software, database platforms and
problem solving in order to maximize system automation and minimize employee
manual processing. Operating support systems are, or will be, distributed
throughout our network, which improves network performance, recovery and
reliability, while also providing real-time capture of statistical and
accounting data. We utilize, when available, industry-standard software systems
developed and maintained by third party vendors but customized for our specific
needs.
We believe that an up-to-date management platform is critical for us to be
competitive and provide customers with quality services. We have put in place a
modern management platform to manage our extensive network. The new management
platform performs operations, administration and management tasks. We have
customized most of these platforms to ensure maximum network flexibility and
efficiency.
Peering and Interconnection
Peering and interconnection agreements with other carriers enable us to
exchange traffic destined for other networks and allow external traffic access
to our network. With Prodigy as a customer, we carry a significant amount of
Internet traffic. Currently, we have direct connection with all major carriers,
including Cable & Wireless, MCI WorldCom, PSINet, Sprint, UUNET and others, and
we are currently in discussions with other Internet service providers in order
to broaden our interconnection capabilities. We interconnect with other
networks from a core site through an industry standard Cisco router, which
promotes proper protocol exchange between us and other Internet service
providers.
Transmission Services
We lease long distance connections of various bandwidths to connect sites in
our network. The choice of long distance carriers is based on their network
reliability, bandwidth availability, responsiveness and pricing. We currently
lease a majority of our long distance connections from MCI WorldCom and
periodically review the capability and costs of these services by other
suppliers, such as Sprint and Qwest. Prior to the completion of our fiber
network, we expect to receive interim backbone transmission services from Level
3 beginning in the third quarter of 1999. As these services become available,
they will replace backbone transmission services we currently receive from
third parties. As segments of our fiber optic backbone network are constructed,
we will use this bandwidth in lieu of existing leased circuit arrangements.
We lease local connections (DS-1, T-1 or ISDN PRI) to access the end-user.
The local service providers are selected based on their reliability, service
availability, responsiveness, pricing and minimum switch congestion during busy
hours. Based on these criteria, we have existing relationships with many
competitive local exchange carriers and all major incumbent local exchange
carriers in the country.
Sales and Marketing
We are deploying multiple distribution sales channels to rapidly increase
our market penetration and customer base. The primary sales distribution
channel will be a direct sales force. Additional channels will include agents,
wholesalers and resellers.
46
<PAGE>
Our focus on multiple, leading-edge offerings makes it essential to create a
sophisticated sales organization. We began developing our direct sales force in
the first quarter of 1999 and are actively recruiting highly experienced data
communications sales professionals. This sales force will have a nationwide
presence, and will market our services directly to Internet service providers,
telecommunications carriers, value-added service providers, and medium and
large businesses. To support our direct sales force, we are developing web-
based tools, such as sales automation and sales tracking systems, that will
integrate pricing, order management, provisioning and billing systems.
Additionally, the salesforce will be equipped with customer-tailored marketing
material.
We also intend to utilize alternate distribution channels, which include
agents, resellers and wholesalers, to market our products and services to
medium and small businesses. As independent entities, agents sell our services
under the Splitrock brand name to end-users in exchange for revenue based
commissions. We intend to identify agents that generally focus on specific
market segments, such as medium and small businesses, and have existing
customer bases. Resellers are independent companies that would purchase our
services and then "repackage" under their own brand name these services for
sale to their customers. Finally, wholesalers are independent companies that
will purchase network service capabilities in large quantities from us in order
to market their own services under a brand name other than Splitrock. These
alternative channels are expected to optimize revenue growth and market
penetration.
We are creating a marketing infrastructure with three primary areas of
responsibility: marketing communications, marketing management and product
development.
Marketing communications builds Splitrock's image and provides
communications interface to customers on services. Marketing communications
will also promote Splitrock's services at industry conferences, trade shows
and other events.
Marketing management develops service literature, price positioning,
sales support materials, service revenue forecasts, competitive industry
and service analysis for our suite of service offerings.
Product development will work with internal organizations such as
information technology, engineering, operations and billing to develop and
enhance our services.
Relationship with Level 3 Communications
On April 26, 1999, we entered into a Cost Sharing National IRU Agreement
with Level 3 Communications, LLC, a subsidiary of Level 3 Communications, Inc.
Under this agreement, Level 3 has granted to us indefeasible rights to use four
dark fibers, with an option to use up to 12 additional fibers, in the
nationwide multiconduit fiber optic communications system currently under
construction by Level 3. The fiber will be delivered in segments that are
expected to become available from the end of 1999 through the first quarter of
2001. When completed, the fiber network will cover approximately 15,000 route
miles. If Level 3 expands its nationwide fiber optic network by adding
additional routes or otherwise enhances its network, Level 3 has agreed to give
us the opportunity to participate in that expansion or enhancement, subject to
Level 3's own business needs and subject to our agreeing on the allocation of
costs in the expansion or enhancement. Our agreement with Level 3 relates to
dark fiber only and does not include the electronic equipment necessary to
allow the fiber to transmit communications.
Under our agreement, we have made a down payment of $11.2 million to Level 3
and we are required to make additional payments as we accept delivery of
segments of the dark fiber. The total amount we will be required to pay Level 3
is dependent on the number of fibers we acquire and the number of actual route
miles. In addition to IRU payments, we are required to make payments to Level 3
for facilities, maintenance and utilities charges.
We anticipate that the acquisition of the right to use the four dark fiber
strands and the related electronics equipment, will require capital
expenditures of approximately $34 million, $89 million, and $27 million in
1999, 2000 and 2001, respectively.
47
<PAGE>
We have agreed that prior to the fourth anniversary of the agreement, we
will not grant any dark fiber IRU or assign or transfer any IRU or other
similar right or interest in any IRU to anyone other than an affiliate of ours.
However, the agreement allows us to sell or lease capacity over the fibers.
Our agreement with Level 3 has an initial term of 20 years and may be
extended. If we default in any payments due to Level 3 under the agreement,
Level 3 may terminate the agreement, provided that Level 3 may not terminate
the agreement or our rights to use fiber in segments for which we have paid in
full. We have the right to terminate the agreement prior to October 31, 1999,
under certain circumstances, but we would forfeit up to 80% of our down payment
if we exercise that right.
Level 3 has agreed to provide interim backbone transmission services at
capacities ranging from DS-3 to OC-48 for a monthly charge per DS-0 mile,
subject to an aggregate monthly minimum of $0.5 million. We expect to receive
these services beginning in the third quarter of 1999. As these services become
available, they will replace backbone transmission services we currently
receive from other third parties.
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, we may be
required to notify the Federal Trade Commission of the transactions
contemplated by our agreement with Level 3. If this notification is required,
we will not be able to consummate the transactions contemplated by the Level 3
agreement until the requirements of the Hart-Scott-Rodino Act have been
satisfied and any applicable waiting period has expired to terminated.
Suppliers
We depend on third parties for key components of our network infrastructure,
including leased lines, transmission services and networking equipment, such as
routers, switches and modems. The quantities and quality of such networking
equipment that we require are available only from limited sources. We currently
utilize Lucent for ATM switching products, Bay Networks for our Internet dial
access platform, Cisco for routers and Sun Microsystems and Compaq for servers.
We also depend upon a variety of local exchange carriers and interexchange
carriers to provide telecommunication services, including leased line and
colocation facilities. For long distance connections and backbone long distance
transmission facilities, we currently use MCI WorldCom. In addition, we obtain
bandwidth capacity under leased line connection agreements with local exchange
carriers, including regional Bell operating companies. We also obtain
telecommunications services and lease physical space under local
access/colocation agreements with various competitive local exchange carriers.
We continue to monitor our needs for greater bandwidth and may enter into
agreements to enlarge our bandwidth capability.
We have entered into an agreement with IBM to use the IBM network to cover
market areas that are not served by our network or the Prodigy network. Under
this agreement, either party may terminate its obligations under the contract
for the remaining POP sites, upon 60 days prior notice. During March 1999, we
entered into an agreement with Lucent to provide us with maintenance on our
broadband access network in order to maintain the quality and reliability of
our network performance. Prior to entering into this maintenance arrangement
with Lucent, we had performed our own maintenance of equipment and have relied
on warranties from our vendors.
We rely upon third parties to provide equipment and services to assist in
the construction and installation of our broadband access network. As of May
31, 1999, we had 239 operational POPs and we expect to have approximately 370
operational POPs when our construction is completed later this year.
As previously disclosed in our annual report on Form 10-K for 1998, we
entered into an agreement with a contractor to construct 99 POP sites on a
turnkey basis. By November 1998, the contractor had failed to meet construction
milestones under our agreement. As a result, we had to hire other service
providers and suppliers in addition to supervisory field and office personnel
to complete the network on schedule. We also incurred additional expenses to
maintain POP sites on our legacy network. We have received invoices totaling
$9.1 million from the contractor and we are disputing the amount due. The
contractor has indicated that it will
48
<PAGE>
seek to secure payment of these invoices. We believe that the amounts the
contractor has claimed are not owed because of the contractor's failure to
perform under the terms of our agreement and the offsetting expenses we
incurred to complete the work. We also believe that resolution of this matter
will not have a material adverse effect on our business.
Competition
The data communications service industry is highly competitive. We expect
that competition will continue to intensify as customers seek additional
capacity to satisfy the continued growth of the Internet. In addition, numerous
competitors, including major telecommunications carriers such as AT&T, MCI
WorldCom, Sprint and Cable & Wireless, are rapidly expanding their data network
capabilities. We believe that the primary competitive factors for the provision
of data network services are quality of service, network coverage, reliability,
price, and service innovation.
Our current and prospective competitors generally may be divided into three
groups:
. companies that provide access services to Internet service providers
with both residential and small business customers, including UUNET
Technologies, Verio, Concentric Network, PSINet, and Netcom On-Line
Communications Services;
. companies that provide access, virtual private network and other value-
added services to medium and large businesses, including Concentric,
UUNET, GTE Internetworking, and DIGEX, as well as most major long
distance telephone companies; and
. companies with high-speed networks that provide bandwidth capacity and
other network services, including IXC Communications, Qwest and Level 3.
Internet Service Providers
According to International Data Corporation, there are over 4,000 Internet
service providers in the United States, consisting of national, regional and
local providers. We intend to market Internet dial access services to these
Internet service providers. Our competitors in this market will be other
companies that provide Internet access service to Internet service providers as
well as Internet service providers which possess backbone networks enabling
them to provide capacity to other Internet service providers. While we believe
that our status as an independent service provider distinguishes us from many
of these competitors, some of these competitors have significantly greater
market presence, brand recognition and financial, technical and personnel
resources than we do.
Corporate Internet Access and Virtual Private Networks
In the corporate Internet access and virtual private network markets, the
competitors include Internet service providers as well as traditional
telecommunications carriers. Many of these competitors, in addition to their
substantially greater market presence and financial, technical and personnel
resources, also have large existing commercial customer bases. Furthermore,
many of these competitors have the ability to bundle Internet dial access and
virtual private network services with other services such as web hosting or
long distance services. This bundling of services may have a material adverse
effect on our ability to compete effectively and thus could have an adverse
effect on our business, financial condition and results of operations.
Other Network Services
We believe that significant new competitors will enter the data network
services market. Other companies are in the process of building or expanding
networks that will have the ability to provide services comparable to ours. In
addition, many of our competitors have the financial and operational resources
to construct networks similar to our own. For example, Sprint is in the process
of designing a network which will contain ATM switches at every core, hub and
remote site. We cannot assure you that we will be able to compete effectively
with these companies. The market for the colocation of web-servers is extremely
competitive. In this market, we would compete with Internet service providers
and network providers as well as others, including inter exchange carriers,
companies that provide only web hosting and IP colocation services and a number
of companies in the computer industry.
49
<PAGE>
There are currently three principal facilities-based long distance fiber
optic networks, as well as numerous incumbent local exchange carrier and
competitive local exchange carrier networks. Others, including Qwest, IXC and
Williams, are building additional networks that employ advanced technology
similar to that of the Level 3 network and offer significantly more capacity to
the marketplace. The additional capacity that is expected to become available
in the next several years may cause significant decreases in the prices for
services. Our ability to compete effectively in this market will depend upon
our ability to maintain high quality services at prices equal to or below those
charged by our competitors. Interexchange carriers and competitive local
exchange carriers with excess fiber optic strands may be competitors in the
dark fiber business.
Recent reforms in the federal regulation of the telecommunications industry
have also created greater opportunities for local exchange carriers, including
the regional Bell operating companies, to enter the Internet network services
market and therefore compete with us. This increased competition could have a
material adverse effect on our business. We believe that there is a trend
toward horizontal integration through acquisitions of, joint ventures with, and
the wholesale purchase of connectivity from, Internet service providers. The
WorldCom/MFS/UUNET/MCI consolidation, the Netcom/ICG Communications merger, the
Intermedia/DIGEX merger and GTE's acquisition of BBN are indicative of this
trend. These consolidations may increase competition.
Regulation
Overview
Although we are not currently subject to direct regulation by the FCC, the
telecommunications industry is highly regulated. As a result, changes in the
regulatory environment relating to the Internet and telecommunications
services, including regulatory changes which directly or indirectly affect
telecommunications costs or increase the likelihood or scope of competition
from regional Bell operating companies or other telecommunication companies,
could have a material adverse effect on our financial position or results of
operations.
Various existing federal and state regulations are currently the subject of
judicial proceedings, legislative hearings and administrative proposals which
could change, in varying degrees, the manner in which the industry operates. We
cannot predict the outcome of these proceedings, or the impact they may have on
the telecommunications or Internet services industries generally, or on us
particularly. In addition, over the past several years both the federal and
state governments have adopted new legislation and rules profoundly affecting
the telecommunications and Internet services industries. We cannot assure you
that the changes in current legislation or new legislation, and the regulations
adopted by the FCC or state regulators pursuant to that legislation, would not
have a material adverse impact on our business.
Regulation of Internet Communications
In 1980, the FCC created a distinction between "basic" services, which it
regulated as common carrier services, and "enhanced services," which it
deregulated. The FCC exempted enhanced service providers from federal
regulations governing common carriers, including the obligation to pay access
charges and contribute to universal services.
The Federal Telecommunications Act of 1996 established a similar distinction
between "telecommunications services" and "information services," but a
combination of changing technology and other provisions of the Federal
Telecommunications Act have made it increasingly difficult to discern the
boundary between unregulated and regulated services. The act directs the FCC to
adopt regulations requiring all telecommunications service providers to
contribute to the federal Universal Service Fund. When fully implemented, that
fund will be greatly enlarged. This distinction greatly magnifies the
significance of the boundary between regulated and unregulated services.
50
<PAGE>
Since the Federal Telecommunications Act was adopted, several companies have
begun providing voice telephony services over Internet-style packet-switched
networks, and traditional long distance telephone companies have announced
plans to migrate their services to packet-switched networks. As a consequence,
the regulatory status of communications services over Internet-style packet-
switched networks is presently uncertain. In an April 10, 1998 Report to
Congress regarding Universal Service, the FCC concluded that the provision of
underlying transmission capacity to Internet service providers constitutes
"telecommunications" under the Federal Telecommunications Act. The FCC has also
indicated in the report that it would consider, in an upcoming proceeding,
issues related to whether Internet service providers that own transmission
facilities and engage in data transport over those facilities in order to
provide information services are providing telecommunications to themselves,
and therefore ought to be required to contribute to universal service. While
the report containing this conclusion does not have the force of law, it
provides a strong indication of regulatory action that may be taken by the FCC
in the future. A finding by the FCC that Internet service providers and
carriers providing service to Internet service providers must make universal
service contributions could increase our cost of doing business and have a
material adverse effect on our business.
On April 5, 1999, US WEST, Inc. filed a petition asking the FCC to rule that
providers of certain forms of IP telephony services must pay the same charges
that traditional interexchange carriers pay for access to local telephone
exchanges. If US WEST's request is granted, we could be subjected to regulation
that would have the practical effect of forcing us to differentiate data
transmission provided in support of black phone to black phone IP telephony
from data transmission provided in support of other services. This type of
regulation could impose substantial operational inefficiencies and attendant
costs upon us depending upon the method of implementation required. We cannot
predict how or when the FCC will respond to the US WEST petition.
We operate as an Information Services Provider
We operate as an unregulated provider of information services, as that term
is defined in the Federal Telecommunications Act, and as an enhanced service
provider, as that term is defined in FCC rules. Because the regulatory
boundaries in this area are unclear and subject to dispute, however, the FCC
could seek to characterize some or all of our services as "telecommunications
services." If that happens, we will be required to contribute directly to
universal service.
Our status as a reseller of underlying telecommunications services provided
by others has reinforced our status as an unregulated information service
provider. A longstanding FCC policy holds that, when a reseller enhances some
of the transmission capacity that it obtains from an unaffiliated facilities-
based common carrier by modifying or adding content to transmitted messages,
the entire package of resold services will be classified as an unregulated
enhanced service, even if much of the resold transmission capacity is not being
modified by the reseller. By contrast, the FCC has required some enhanced
service providers that use their own facilities to segregate those facilities
and subscribe to them as regulated common carrier offerings. To the extent that
we begin to provide our own transmission facilities, parts of our company could
thus become exposed to common carrier regulation.
Recently, we obtained rights to use several strands of unlit fiber, referred
to as "dark fiber," on another company's nationwide fiber network. The FCC and
at least one federal district court have taken the position that provision of
dark fiber is a form of "wire communications," not a sale of facilities. On
that basis, we believe that our acquisition of previously installed dark fiber
capacity does not transform us into a facilities-based provider of
telecommunications, and that we remain a reseller and provider of unregulated,
enhanced services. The treatment of dark fiber under these circumstances is an
unsettled area of the law, however, and we cannot predict with certainty
whether the FCC, or state regulatory commissions, will regulate this kind of
service.
51
<PAGE>
Under current FCC policy, enhanced service providers are exempted from
having to pay access charges to local telephone companies. Without this
exemption, the local telephone companies could charge enhanced service
providers for connecting the customer to the enhanced service provider.
Recently, the FCC has determined that both dedicated access and dial-up calls
from a customer to an Internet service provider are interstate, not local,
calls, and, therefore, are subject to the FCC's jurisdiction. The FCC
determined that, for the time being, it will allow states to continue tariffing
dial-up Internet access as a local business line service. However, it did not
require states to do so. If the access charge exemption for enhanced service
providers is eliminated, our costs of providing service may increase
substantially, which could have a detrimental effect on our business.
Universal Service Proceeding
If we maintain our current unregulated status, we may contribute indirectly
to universal service to the extent that we are billed by telecommunications
providers for the underlying service. Beginning on July 1, 1999, the federal
universal service program is scheduled to provide subsidy support for service
to high-cost areas served by so-called "non-rural" incumbent local exchange
carriers. We cannot predict the potential impact of these universal service
funding reforms on the rates that we are charged for the underlying
telecommunications services we receive from our telecommunications providers.
Regulatory Safeguards Affecting Underlying Service Providers
We are heavily dependent upon telecommunications carriers for the
transmission capacity that underlies our enhanced network. Some of these
carriers are considered dominant in their geographic markets and may compete
with us in providing enhanced services. This creates an incentive and potential
means for those carriers to discriminate against us. At present, the regional
Bell operating companies are allowed to provide information services within
local access and transport areas (LATAs) but they are restricted from providing
information services on an inter-LATA basis.
Under Section 271 of the Federal Telecommunications Act, the regional Bell
operating companies will be allowed to provide inter-LATA service, including
inter-LATA information services, when the FCC determines that they satisfy a
regulatory checklist of local competition requirements. No regional Bell
operating company has yet obtained a determination by the FCC that it has
satisfied the checklist of local competition requirements, but it is likely
that such determinations will eventually be issued. We cannot assure you that
we will be able to compete effectively with the regional Bell operating
companies once they are permitted to provide inter-LATA services.
Potential Liability of Internet Service Providers
Because we do not hold ourselves out as editing or otherwise controlling the
content of communications that traverse our network, we are generally
unaffected by government content regulation. However, the law in the United
States relating to the liability of Internet service providers and providers of
transmission capacity for information carried on, disseminated through or
hosted on their systems is currently unsettled. Congress and several states
have enacted or are considering measures that would, under some circumstances,
impose civil and criminal liability upon Internet service providers, or
providers of transmission capacity to Internet service providers, for the
transmission or dissemination of information and materials. The imposition of
this type of liability, if upheld by the courts, may require us to implement
measures to reduce our exposure to this liability, which may require us to
expend substantial resources and could affect the demand for our services.
Trademarks and Trade Names
We filed federal trademark applications for the marks "Splitrock" and "A
Carrier of Wisdom" on September 18, 1997, and "splitrock.net" on March 6, 1998.
We also filed separate federal trademark applications for logos on the above
dates, for the Splitrock with triangle design on June 16, 1998, for the mark
"splitrock.com" on July 27, 1998, and for the mark "ATM-to-the-Edge" in March,
1999. We have also filed
52
<PAGE>
trademark applications for the marks "Splitrock", "A Carrier of Wisdom" and the
Splitrock with triangle design in numerous foreign countries. These
applications are pending and we cannot assure you that they will be granted.
"Splitrock Services, Inc." is a trade name of our company.
Insurance
We have insurance coverage that we believe to be adequate for the risks of
our business. We carry property, general liability and directors and officers
liability insurance. In addition, we have an umbrella policy applicable to
general liability, auto liability, and employer's liability. Our insurance
coverage may not be adequate or available to compensate us for all losses that
may occur. The occurrence of a significant loss not fully covered by insurance
could have a material adverse effect on our company.
Employees
As of May 31, 1999, we had 272 full-time employees and 27 independent
contract workers. None of our employees is represented by a union, and we have
experienced no strikes or work stoppages. Our management believes that we have
good relations with our employees.
Properties
We are headquartered in The Woodlands, Texas in a leased facility consisting
of approximately 25,000 square feet. This facility houses our principal
executive and administrative offices as well as one of our network operations
centers. The lease on this facility expires in 2003. In March 1999, we entered
into a long-term lease agreement for approximately 69,000 square feet in The
Woodlands, Texas and expect the new facility will be ready for occupancy not
later than August 1999. The new facility will become our headquarters, and the
existing space will continue to be utilized as a network operations center and
customer care center.
We also sublease from Prodigy a facility of approximately 12,500 square feet
in Yorktown Heights, New York for our Yorktown Heights office and network
operations center. This lease expires on February 28, 2001 but is subject to
early termination on December 31, 1999 upon three months written notice. We
intend to exercise the early termination provision, and currently plan to move
our Yorktown Heights, New York facility to another location in the New York
metropolitan area.
In connection with our network operations, we lease commercial space or have
colocation agreements for our installed communications equipment throughout the
United States.
We believe that our facilities are adequate for our present purposes and
that suitable additional facilities will be available as needed.
Legal Proceedings
We are not currently a party to any material legal proceedings.
53
<PAGE>
MANAGEMENT
Directors and Executive Officers
Our directors and executive officers are as follows:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Kwok L. Li ............. 42 Chairman of the Board of Directors and Chief Technical Officer
William R. Wilson ...... 51 President, Chief Executive Officer and Director
J. Robert Fugate ....... 38 Executive Vice President and Chief Financial Officer
David M. Boatner ....... 51 Executive Vice President and Chief Marketing Officer
Larry A. Walberg ....... 50 Senior Vice President of Network Operations
Todd W. Wilkens ........ 32 Senior Vice President of Engineering
Patrick J. McGettigan,
Jr. ................... 46 Senior Vice President, Secretary and General Counsel
Roy A. Wilkens ......... 56 Director
Marshall C. Turner ..... 57 Director
James M. Nakfoor ....... 35 Director
</TABLE>
Kwok L. Li has served as Chairman of the Board since July 1997 and has
served as Chief Technical Officer of Splitrock since April 1998. Mr. Li is a
co-founder of Splitrock. Mr. Li has also been the Chairman and managing member
of Linsang since July 1997. Linsang is a technology investment company in which
Mr. Li owns a controlling interest. Mr. Li was a director of Yurie Systems from
1995 until the consummation of the sale of Yurie to Lucent in 1998. Mr. Li also
served as Vice Chairman of Yurie from June 1997 until the sale, as President
and Chief Operating Officer of Yurie from March 1996 to June 1997, and as
Executive Vice President and Chief Technical Officer of Yurie from August 1994
through March 1996. From 1991 to 1994, Mr. Li was Director of Strategic
Planning at WilTel. Mr. Li is the primary technical architect of the Lucent AC-
120 switch technology. Mr. Li received a B.E.S. in electrical engineering from
The Johns Hopkins University in 1979.
William R. Wilson has served as President of Splitrock since its inception
and as Chief Executive Officer since April 1997. Mr. Wilson is a co-founder of
Splitrock. Prior to joining Splitrock, Mr. Wilson was the Chief Executive
Officer of OneLine Management, a telecommunications consulting firm
specializing in strategic positioning founded by Mr. Wilson in 1995. In that
capacity, Mr. Wilson advised Carso Global and Telmex on strategic matters. From
1989 to 1995, Mr. Wilson was Vice President of Strategic Planning at WilTel.
Previously, Mr. Wilson taught at Rice University, The University of Texas at
Austin, and The University of Michigan. Mr. Wilson holds a Ph.D. in Social
Psychology from The University of Michigan and an M.B.A. from The University of
Texas at Austin.
J. Robert Fugate joined Splitrock as Executive Vice President and Chief
Financial Officer in March 1999. From 1997 to 1999, Mr. Fugate served as
Executive Vice President and Chief Financial Officer of Fuego Technology
Corporation, a privately held software development company based in Dallas,
Texas. From 1996 to 1997 Mr. Fugate was Vice President, Corporate Development
for General Wireless Inc., a private Dallas-based company with licenses to
develop personal communications services. In addition, Mr. Fugate served as
Senior Vice President, Finance and Chief Financial Officer of Mobile
Telecommunication Technologies Corp. (since renamed SkyTel Communications,
Inc.) from 1988 to 1996, a publicly traded nationwide and international
provider of personal messaging services. Mr. Fugate received an M.B.A. from
Harvard University and a B.B.A. from The University of Mississippi.
David M. Boatner joined Splitrock in March 1999 as Executive Vice President
and Chief Marketing Officer. Prior to joining Splitrock, Mr. Boatner was the
President of Business Services for McLeodUSA, an integrated telecommunications
provider in the Midwest, where he was responsible for sales, marketing and
54
<PAGE>
customer support for business subscribers. From January 1995 to February 1996,
Mr. Boatner served as Regional Vice President of Sales for LDDS-WorldCom, where
he was responsible for business telecommunications sales in the central,
southwest and western United States. Mr. Boatner was employed as Vice President
of Sales for WilTel from 1985 until WilTel was acquired by LDDS-WorldCom in
1995. In this capacity he managed the nationwide data and long distance sales
for WilTel. Prior to joining WilTel, Mr. Boatner held numerous sales and
marketing positions at Southwestern Bell and AT&T.
Larry A. Walberg joined Splitrock as Senior Vice President of Network
Operations in April 1999. Prior to joining us, Mr. Walberg was Vice President,
Global Data Network Operations, at MCI WorldCom, where he managed the
operational expansion of a data network from North America into five
continents, directed the merger of operations of local and long-distance data
network platforms and integrated and migrated the data network platforms of
WorldCom, MCI, MFS and BrooksFiber into a single network architecture.
Previously, Mr. Walberg served as Director/Manager of Advanced Product Support
for WilTel and successor entities from May 1992 to May 1997 where he
established the operational model for the first public frame relay offering.
Todd W. Wilkens has served as Vice President of Engineering of Splitrock
since July 1997 and as Senior Vice President since April 1999. From 1996 to
1997, Mr. Wilkens was Vice President, Engineering and Operations, at GridNet
International, where he helped GridNet, a start-up Internet services company,
implement a nationwide frame relay/ATM network. From 1994 to 1996, Mr. Wilkens
was Manager, Advanced Products Support, at WorldCom where he helped build the
Internet Support Organization which specialized in building and operating
Internet service provider backbones. Prior to that, Mr. Wilkens supported
offshore communications in the Gulf of Mexico for Conoco/Dupont. Mr. Wilkens
holds a B.S.E.E. from Oklahoma State University. Mr. Wilkens is the son of
Roy A. Wilkens, a director of Splitrock.
Patrick J. McGettigan, Jr., has served as General Counsel of Splitrock since
September 1997, as Secretary since March 1998, and as Senior Vice President
since April 1998. Prior to joining Splitrock, Mr. McGettigan was in the private
practice of law, having been a partner in the firm he founded in the early
1980s. Mr. McGettigan served as outside counsel to Splitrock when it was formed
in March 1997. Mr. McGettigan received a B.A. degree from The University of
Texas and his J.D. degree from South Texas College of Law, and is a member of
the State Bar of Texas.
Roy A. Wilkens has served as a director of Splitrock since April 1998. Mr.
Wilkens was President of The Williams Pipeline Company when he founded WilTel
in 1985. He was Founder/Chief Executive Officer of WilTel Network Services from
1985 to 1995. In 1995, WilTel Network Services was acquired by LDDS
Communications, which now operates under the name WorldCom. Mr. Wilkens served
as Vice Chairman of WorldCom until his retirement in 1997. In 1992, Mr. Wilkens
was appointed by President George Bush to the National Security
Telecommunications Advisory Council. He has also served as chairman of both the
Competitive Telecommunications Association (CompTel) and the National
Telecommunications Network. Mr. Wilkens is a member of the board of directors
of McLeodUSA, Paging Network, Inc., UniDial Inc., Invensys Corporation Inc. and
Williams Communications. Mr. Wilkens is the father of Todd Wilkens, Splitrock's
Vice President of Engineering.
Marshall C. Turner joined our board of directors in April 1999. Since 1990
Mr. Turner has been an independent consultant and technology venture investor.
From 1981 through 1998, Mr. Turner was General Partner of Taylor & Turner
Associates, Ltd., which itself was a general partner of several venture capital
partnerships. Mr. Turner has been a venture capital principal or operating
executive in technology industries for 25 years. He is a director of the
Alliance Technology Fund, Inc., DuPont Photomasks, Inc., and four privately-
held companies, including Linsang Partners, LLC, one of our largest
shareholders. In June 1999, Mr. Turner was appointed as acting Chief Executive
Officer and Chairman of the Board of DuPont Photomasks, Inc. Mr. Turner is also
a Vice Chairman of the board of the Public Broadcasting Service, of the
Smithsonian Museum of Natural History, and director of the George Lucas
Educational Foundation. Mr. Turner received B.S. and M.S. degrees in Mechanical
Engineering and Product Design from Stanford University and an M.B.A. from
Harvard University.
55
<PAGE>
James M. Nakfoor joined our board of directors in April 1999. Since 1991,
Mr. Nakfoor has served as Vice President of Securities Trading for Inversora
Bursatil, S.A. de C.V., a wholly-owned subsidiary of Grupo Financiero Inbursa,
S.A. de C.V., which is engaged in the securities brokerage, investment banking
and money management business in Mexico. Grupo Financiero, which is affiliated
with Carso Global Telecom, is a Mexican financial group whose businesses
include banking, brokerage, insurance, leasing, factoring and other financial
services. Since September 1997, Mr. Nakfoor has been a member of the Board of
Directors of Prodigy Communication Corporation. Mr. Nakfoor holds a B.A. degree
in Economics and an M.B.A. degree from The University of Texas at Austin.
Other Significant Employees
Tracy Hammond joined Splitrock as Controller in September 1997. In October
of 1998, Ms. Hammond was named Vice-President and Controller. From 1995 to
1997, Ms. Hammond served as Vice President--Finance and Administration of
Comsul, Ltd., a privately held national communications consulting firm. From
1992 to 1995, Ms. Hammond was Principal Financial Officer at Optex Biomedical,
a high-tech biomedical start-up company. Previously, Ms. Hammond worked for
seven years in Arthur Andersen's emerging business practice group, achieving
the level of audit manager. Ms. Hammond is a CPA, and holds a B.S. in
Accountancy from The University of Missouri.
Frank W. Williams joined Splitrock in December of 1998 as Vice President of
Operations. Prior to joining Splitrock, Mr. Williams held several management
and senior executive positions with WilTel. His most recent position was as
Senior Operations Executive where he directed and developed the National
Technical Resource Center. This center supported 2,500 field technicians
servicing digital communications products manufactured by Nortel, NEC, Octel,
Cisco, Bay Networks and 3Com. Mr. Williams received a B.A. in Business from
Trinity University and an Associate of Arts from the Marion Institute in
Marion, Alabama.
Ralph Freeman joined Splitrock as Vice President of Information Services in
February 1999. From 1996 to June 1998, Dr. Freeman was Chief Information
Officer at American Telco. In June 1998, he became Vice President of
Information Systems at Logix Communications Enterprises, one of the largest
competitive local exchange carriers in the country, which acquired American
Telco. During this tenure, he helped build a new multi-state network
architecture. From 1991 to 1994, Dr. Freeman was the manager in the electronics
and software departments of Walt Disney Imagineering. Dr. Freeman holds a B.S.
in Engineering Management from the Air Force Academy; a M.S. in Business
Administration, Computer Methods from The University of California at Los
Angeles; and a Ph.D. in Information Technology from George Mason University.
Board of Directors
Our board of directors is divided into three classes. Each class consists of
up to two directors elected for staggered, three-year terms.
<TABLE>
<CAPTION>
Directors whose Directors Directors whose
terms expire in 2000 whose terms expire in 2001 terms expire in 2002
-------------------- -------------------------- --------------------
<S> <C> <C>
Marshall C. Turner William R. Wilson Kwok L. Li
Roy A. Wilkens James M. Nakfoor
</TABLE>
Committees of the Board of Directors
Our board has standing audit and compensation committees. The compensation
committee currently consists of Kwok L. Li, William R. Wilson and Roy A.
Wilkens, although membership may change to consist solely of non-employee
directors after the 1999 stock incentive plan is adopted. The audit committee
members are Roy A. Wilkens, Marshall C. Turner and James M. Nakfoor.
56
<PAGE>
Director Compensation
Directors who are employed by our company are not entitled to receive any
additional compensation for serving on our board of directors. We pay each of
our non-employee directors an annual fee of $10,000 and a fee of $500 for
attending each committee meeting not held on the same date as a regular meeting
of directors. We also reimburse directors for reasonable expenses incurred in
conjunction with attending meetings. We did not make any cash compensation
payments to our directors in 1998, except for the reimbursement of expenses.
Each of our non-employee directors waived all cash compensation for 1998.
Directors are also eligible for grants of awards under our stock option plan.
On May 28, 1998, we granted our outside directors --Messrs. Salameh and
Wilkens-- options to purchase 45,040 shares of common stock at $1.95 per share,
with options to purchase 11,260 shares vesting on each of the first four
anniversaries of the date of grant. On April 22, 1999, our board accelerated
the vesting of 11,260 of Mr. Salameh's options otherwise due to vest on May 28,
1999 as a result of his service on the board. On April 22, 1999, we granted
each of our new outside directors --Messrs. Turner and Nakfoor-- options to
purchase 45,040 shares of common stock at $9.77 per share, with options to
purchase 11,260 shares vesting on each of the first four anniversaries of the
date of grant.
Executive Compensation
The following table sets forth certain information regarding the
compensation earned by or awarded to our Chief Executive Officer and each
executive officer whose compensation exceeded $100,000 for the year ended
December 31, 1998.
Summary Compensation Table
<TABLE>
<CAPTION>
Long-term
Compensation
Annual Compensation Awards
------------------------------- ------------
Securities
Other Annual Underlying
Year Salary ($) Compensation ($) Options(#)
---- --------- --------------- ------------
<S> <C> <C> <C> <C>
Kwok L. Li, Chairman of the Board
and Chief Technical Officer..... 1998 -- -- --
1997 -- $10,600 --
William R. Wilson, President and
Chief Executive Officer......... 1998 $151,440 -- --
1997 62,980 $16,400
Patrick J. McGettigan, Jr.,
Senior
Vice President, Secretary and
General Counsel................. 1998 $150,833 -- --
1997 46,933 $65,000 140,750
</TABLE>
The other annual compensation for services rendered by Mr. Li and Mr. Wilson
was paid in the form of shares of common stock in May 1997. Mr. McGettigan
became an employee of Splitrock in September 1997. Prior to being employed by
Splitrock, Mr. McGettigan performed legal services on behalf of Splitrock and
his former law firm received approximately $18,000 from Splitrock in 1997. The
other annual compensation for Mr. McGettigan was granted to him as a bonus upon
becoming an employee of Splitrock. In 1997 Mr. McGettigan also received options
to acquire 140,750 shares of our common stock with an exercise price of $1.12,
of which 45,040 vested immediately and the balance vests over four years in
equal installments.
Option Grants in Fiscal Year 1998
We did not grant any stock options to the executive officers named in the
Summary Compensation Table during 1998.
57
<PAGE>
Aggregated Fiscal Year-End Option Values
The following table shows information with respect to unexercised options
held by the executive officers named in the Summary Compensation Table as of
December 31, 1998. No stock options were exercised by any executive officers
during the year ended December 31, 1998.
<TABLE>
<CAPTION>
Number of Securities
Underlying Value of Unexercised
Unexercised Options In-the-Money Options
at December 31, 1998 at December 31, 1998
------------------------- -------------------------
Exercisable Unexercisable Exercisable Unexercisable
----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Kwok L. Li................ -- -- -- --
William R. Wilson......... -- -- -- --
Patrick J. McGettigan,
Jr....................... 68,967 71,783 $333,813 $347,438
</TABLE>
Options are "in-the-money" if the value of our common stock exceeds the
exercise price of the options. There was no public market for our common stock
as of December 31, 1998. Accordingly, we have calculated these values on the
basis of a valuation of our common stock made by an independent firm and which
was determined to be $5.95 per share.
Employment Agreements
We have entered into employment agreements with Messrs. Wilson, McGettigan,
Boatner and Fugate.
Under Mr. Wilson's employment agreement, which terminates on March 15, 2002,
he is entitled to receive an annual base salary of $150,000, subject to
adjustment by the board of directors or the Compensation Committee. The board
adjusted Mr. Wilson's annual salary to $200,000 as of January 1, 1999. If Mr.
Wilson's employment is terminated upon his death or disability or by us without
cause, then he is entitled to continue to receive his base salary through the
remaining term of the agreement. The agreement further provides that Mr. Wilson
may engage in other business endeavors without violating any of provisions of
the agreement.
Under Mr. McGettigan's employment agreement, which terminates on August 31,
1999, he is entitled to receive an annual base salary of $140,000, subject to
adjustment by the board of directors or the Compensation Committee. We adjusted
Mr. McGettigan's annual salary to $180,000 as of January 1, 1999. If we
terminate Mr. McGettigan's employment without cause, then he is entitled to
continue to receive his base salary through the remaining term of the
agreement. Under his employment agreement, Mr. McGettigan received a signing
bonus of $65,000 and was granted options to purchase 140,750 shares of our
common stock at an exercise price of $1.12 per share. 45,040 shares of these
options vested immediately and the remaining 95,710 shares will vest in four
equal annual installments.
Under Mr. Boatner's employment agreement, which terminates on February 28,
2001, he is entitled to receive an annual base salary of $175,000. Mr. Boatner
also received a signing bonus of $75,000 and was granted options to acquire
225,200 shares of our common stock at an exercise price of $9.77 per share.
These options vest in four equal annual installments beginning on March 1,
2000. If we terminate Mr. Boatner's employment without cause, then he is
entitled to continue to receive his base salary through the remaining term of
his agreement.
Under Mr. Fugate's employment agreement, which terminates on March 21, 2001,
he is entitled to an annual base salary of $185,000. Mr. Fugate also received a
signing bonus of $50,000 and was granted options to purchase 197,050 shares of
our common stock at an exercise price of $9.77 per share. These options vest in
four equal annual installments beginning on March 21, 2000. If we terminate Mr.
Fugate's employment without cause, then he is entitled to continue to receive
his base salary for 12 months following termination, if his employment is
terminated before March 21, 2000, or for six months following termination, if
his employment is terminated after March 21, 2000.
58
<PAGE>
Stock Incentive Plans
1997 Incentive Share Plan
Our 1997 incentive share plan became effective on June 16, 1997. On April 1,
1998, our board of directors approved and adopted an amendment and restatement
of the plan which was subsequently approved and adopted by our stockholders on
April 27, 1998. The purpose of the plan is to provide employees, and non-
employee directors, and consultants with additional incentives by increasing
their ownership interests in our company.
Individual awards under the plan may take the form of one or more of :
. either incentive or non-qualified stock options;
. stock appreciation rights;
. restricted stock; and
. other awards, the value of which is based in whole or in part upon the
value of our common stock.
Options under the 1997 plan have a term of ten years and are generally
granted with an exercise price equivalent to fair market value at the date of
grant. Individual option grants vest over time, based upon a schedule approved
by our board of directors, which is generally four years. All of our common
stock options vest automatically upon a change in control, as defined in the
1997 plan.
Our compensation committee administers the 1997 plan, determines the persons
who will receive awards and establishes the terms and conditions of those
awards. Our President is also authorized to grant awards to other employees who
are not executive officers. The maximum number of shares of common stock that
may be subject to outstanding awards is 11,260,000. As of June 30, 1999,
options for 3,702,908 shares had been granted, of which:
. options to purchase 628,027 shares had been exercised, including an
option to purchase 563,000 shares granted to a former director of our
company;
. options to purchase 2,896,128 shares were outstanding; and
. options to purchase 178,753 shares, which were previously granted, had
been canceled or forfeited.
Shares of common stock which are attributable to awards which have expired,
terminated or been canceled or forfeited are available for issuance or use in
connection with future awards.
Awards under the 1997 plan may be made until January 1, 2007, although we do
not expect to make additional grants under the 1997 plan after the 1999 stock
incentive plan described below goes into effect. The 1997 plan may be amended
by our board of directors without the consent of our stockholders.
1999 Stock Incentive Plan
We intend to adopt the Splitrock Services, Inc. 1999 stock incentive plan
prior to completion of this offering. The 1999 stock incentive plan will become
effective upon its adoption by our board of directors and ratification by our
stockholders. The purpose of the 1999 stock incentive plan is to strengthen our
company by providing an incentive to our employees, officers, consultants,
directors and advisors through the granting or awarding of incentive and
nonqualified stock options, stock appreciation and dividend equivalent rights,
restricted stock, performance units, performance shares, share awards and
phantom stock awards, thereby encouraging these individuals to devote their
abilities and energies to our success.
59
<PAGE>
The 1999 stock incentive plan will be administered by our compensation
committee, which will consist of non-employee directors, although our President
may be authorized to grant options or awards to eligible persons who are not
executive officers. Under the 1999 stock incentive plan, the compensation
committee will have the authority to, among other things:
. select the employees to whom stock options and other incentive awards
will be granted;
. determine the type, size and the terms and conditions of stock options
and other incentive awards; and
. establish the terms for treatment of stock options and other incentive
awards upon a termination of employment.
The 1999 stock incentive plan will replace the 1997 plan on a going-forward
basis, but the adoption of the 1999 plan will not increase the total number of
shares available for the grant of options or awards. Upon the effective date of
the 1999 plan:
. no further options will be granted under the 1997 plan;
. each option outstanding under the 1997 plan will remain outstanding and
continue to be subject to the terms of the 1997 plan and the agreement
under which it was granted;
. the shares initially available for options or awards under the 1999 plan
will be equal to the approximately 7.7 million shares currently
available for option grants under the 1997 plan; and
. any shares that are the subject of an option granted under the 1997
plan, but not exercised prior to the time the option expires or is
otherwise terminated, will become available for the granting of
additional options or awards under the 1999 plan.
We will authorize shares of common stock for issuance under the 1999 stock
incentive plan for the grant of stock options and other incentive awards to
eligible individuals. The 1999 stock incentive plan will terminate on the day
preceding the tenth anniversary of the date of its adoption by our board of
directors. The board of directors will be able to at any time and from time to
time amend or terminate the 1999 stock incentive plan; provided, however, that,
to the extent necessary under applicable law, no such change will be effective
without the requisite approval of our stockholders. In addition, no such change
will alter or adversely impair any rights or obligations under any stock
options and other incentive awards previously granted, except with the written
consent of the grantee.
Compensation Committee Interlocks and Insider Participation
In 1997, the compensation of our executive officers was determined by our
board of directors. In April 1998, the board of directors appointed a
compensation committee that now consists of Kwok L. Li, William R. Wilson, and
Roy A. Wilkens, who will determine the compensation of our executive officers
consistent with guidelines established by the board of directors. Mr. Li and
Mr. Wilson are executive officers of Splitrock.
Kwok L. Li, our Chairman and Chief Technical Officer, was also the Vice
Chairman and a director of Yurie, one of our principal suppliers, until its
acquisition by Lucent. Mr. Li acts as a consultant to Lucent. As of March 31,
1999, we had purchased approximately $12.4 million of products and $1.5 million
of services from Yurie.
Samer Salameh, a member of our board of directors until April 1999, is
chairman of the board of directors and Chief Executive Officer of Prodigy, our
principal customer, and James M. Nakfoor, a current member of our board of
directors, has been a member of Prodigy's board of directors and its
compensation committee since September 1997. We have entered into an agreement
to provide network services to Prodigy for its subscribers in exchange for a
monthly service charge. During the fiscal year ended December 31, 1998, we
received approximately $63.6 million in revenues from Prodigy.
60
<PAGE>
CERTAIN TRANSACTIONS
Financings
In March 1997, we issued to our founders, Kwok L. Li and William R. Wilson,
225,200 and 337,800 shares, respectively, of our common stock for $0.00297 per
share. In May 1997, we issued 6.0 million and 9.2 million shares of our common
stock, respectively, to Mr. Li and Mr. Wilson in consideration of services
performed since March 1997.
In June 1997, Mr. Li advanced $10.0 million to us, evidenced by a $10.0
million convertible note. Mr. Li subsequently assigned the convertible note to
Linsang, which converted it into 9.0 million shares of common stock on August
9, 1997.
In August 1997, Linsang acquired 6.8 million shares in a private transaction
for $7.5 million. In December 1997, we borrowed $1.0 million from Linsang. This
loan was repayable 30 days after written demand or, if no demand was made, on
December 1, 2002 and bore interest at the rate of 9.75% per annum beginning in
February 1998. In January, March and June 1998, we borrowed an additional $3.0
million, $2.0 million and $5.0 million, respectively, from Linsang on similar
terms. In July 1998, outstanding indebtedness was refinanced in connection with
our senior notes offering. In connection with this refinancing, Linsang
purchased 11,000 units in the senior notes offering.
In August 1997, Roy Wilkens and Sandra Wilkens purchased 450,400 shares of
our common stock for $0.5 million. Mr. Wilkens became a member of our board of
directors in April 1998.
In September 1997, Orient Star, a wholly owned subsidiary of Carso Global,
purchased 11.3 million shares of our common stock for $12.5 million. Orient
Star subsequently acquired, pursuant to an option, an additional 2.8 million
shares for $3.1 million and merged into Carso Global. Carso Global currently
holds approximately 30.2% of our outstanding common stock at April 30, 1999.
Samer Salameh, the Chairman of Prodigy, an affiliate of Carso Global, was a
member of our board of directors from April 1998 to April 1999, when he was
succeeded on the board of directors by James Nakfoor, another director of
Prodigy. Mr. Nakfoor is Vice President of another Carso Global affiliate,
Inversora Bursatil, S.A. de C.V., a wholly-owned subsidiary of Grupo Financiero
Inbursa, S.A. de C.V. Carso Global is a controlling stockholder of Prodigy and
an affiliate of Telefonos de Mexico. We are currently testing connectivity
between our network and Telmex's network in anticipation of possible future
business relationships. As a result of Mr. Nakfoor's relationships with Carso
Global and Prodigy, conflicts of interest may arise, including conflicts
relating to potential corporate opportunities. If any conflict arises, we
anticipate that the non-interested members of the board of directors will pass
on the appropriateness of any particular matter.
In June 1998, Clark McLeod, Chief Executive Officer of McLeodUSA, then one
of our directors, exercised in full a stock option previously granted to him
and purchased 563,000 shares of our common stock for $1.1 million. Mr. McLeod
was a member of our board of directors from May 1998 to May 1999.
On July 24, 1998, we offered and sold 261,000 units pursuant to the senior
notes offering, of which 250,000 units were resold to "qualified institutional
buyers" (as defined in Rule 144A under the Securities Act) and 11,000 units to
Linsang, as stated above. Each unit consisted of a senior note and a warrant to
purchase approximately 5.7 shares of our common stock at an exercise price of
$0.02 per share. We received gross proceeds of $261.0 million from the senior
notes offering.
Other
Kwok L. Li, our Chairman and Chief Technical Officer, was also the Vice
Chairman and a director of Yurie, one of our principal suppliers, until its
acquisition by Lucent. Mr. Li acts as a consultant to Lucent. As of March 31,
1999, we had purchased approximately $12.4 million of products and $1.5 million
of services from Yurie. As a result of Mr. Li's relationship with Lucent and
with Linsang, each of which has business relationships with us, there may be
conflicts of interest that arise including conflicts relating to potential
corporate opportunities. If any conflict arises we anticipate that the non-
interested members of our board of directors will pass on the appropriateness
of any particular matter.
In March and April 1999, we granted executive officers options to purchase a
total of 506,700 shares of our common stock as follows: David Boatner, 225,200
shares; Robert Fugate, 197,050 shares; and Larry Walberg, 84,450 shares. These
options were granted under our 1997 incentive plan, are exercisable at a price
of $9.77 per share, and vest in four equal annual installments beginning on the
first anniversary of the grant date.
61
<PAGE>
PRINCIPAL STOCKHOLDERS
The following table provides information regarding the beneficial ownership
of our common stock as of June 30, 1999 by:
. each stockholder known by us to own beneficially 5% or more of our
outstanding common stock;
. each of our current directors;
. our Chief Executive Officer and each executive officer whose
compensation exceeded $100,000 during 1998; and
. all of our directors and executive officers as a group.
As of June 30, 1999, there were 46,681,427 shares of our common stock
outstanding. Following this offering, there will be 57,381,427 shares of our
common stock outstanding. Beneficial ownership is determined in accordance with
the rules of the Securities and Exchange Commission. In computing the number of
shares beneficially owned by a person and the percentage ownership of that
person, shares of common stock subject to options and warrants held by that
person that are currently exercisable or exercisable with 60 days of June 30,
1999, are treated as outstanding. However, these shares are not deemed to be
outstanding for the purpose of computing the percentage ownership of any other
person.
<TABLE>
<CAPTION>
Beneficially Owned Securities
Number of Shares Beneficially Percentage of Shares
Owned Includes Beneficially Owned
-------------------------------- ------------------------
Total Number
of shares Securities Securities
Beneficially Underlying Underlying Before After
Owned Warrants Options Offering Offering
------------ -------------- --------------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Kwok L. Li.............. 21,599,143 62,704 -- 46.2% 37.7%
Linsang Partners,
L.L.C.................. 15,425,848 62,704 -- 33.0% 27.0%
8301 Professional Drive
Landover, MD 20785
William R. Wilson....... 9,571,000 -- -- 20.5% 16.7%
Roy A. Wilkens.......... 309,650 -- 11,260 * *
Marshall C. Turner...... 28,150 -- -- * *
Patrick J. McGettigan,
Jr..................... 92,895 92,895 * *
James M. Nakfoor........ -- -- -- -- --
Carso Global Telecom,
S.A. de C.V............ 14,075,000 -- -- 30.2% 24.5%
Paseo de las Palmas
#736
Col Lomas de
Chapultepec
Mexico DF CP 11000
Directors and executive
officers
as a group (10 people)
....................... 31,882,338 62,704 385,655 67.6% 55.2%
</TABLE>
- --------
* Less than 1%.
The shares beneficially owned by Mr. Li include 1,182,300 shares owned by
his spouse, 30,402 shares owned by his minor children, and 15,425,848 shares
owned beneficially and of record by Linsang, a limited liability company
controlled by Mr. Li, and members of his family.
The shares beneficially owned by Linsang include 62,704 shares issuable upon
exercise of warrants included as part of the units purchased by Linsang in the
senior notes offering.
The shares beneficially owned by Mr. Nakfoor exclude stock owned by Carso
Global Telecom, S.A. de C.V. Carso Global is an affiliate of Grupo Financiera
Inbursa, S.A. de C.V. and Mr. Nakfoor is a Vice President of Inbursa. Mr.
Carlos Slim Helu, a Mexican citizen, and members of his immediate family,
directly and through their ownership of a majority of the voting and economic
interests in two trusts, own a majority of the outstanding voting equity
securities of Carso Global.
62
<PAGE>
The shares beneficially owned by Mr. Wilkens are held by Mr. Wilkens and
Sandra L. Wilkens jointly. These shares exclude 281,500 shares attributable to
vested options beneficially owned by Mr. Wilkens' son and 152,010 shares owned
by other family members of Mr. Wilkens.
The shares beneficially owned by Mr. Turner do not include shares
beneficially owned by Linsang, of which Mr. Turner is a director.
Messrs. William R. Wilson, Patrick J. McGettigan, Jr., and six other selling
stockholders have granted the underwriters an option to purchase up to 100,000,
25,000 and 32,372 shares of common stock, respectively, at the initial public
offering price less the underwriting discount, as part of the underwriters'
over-allotment option. The six stockholders other than Messrs. Wilson and
McGettigan are partners or advisors of Linsang Partners, L.L.C. but otherwise
have no relationship to us. If the underwriters' over-allotment is exercised in
full, after the offering Mr. Wilson will beneficially own 9,471,000 shares, or
16.1% of our outstanding common stock, and Mr. McGettigan will own 67,895
shares, or less than 1% of our outstanding common stock. The other six selling
stockholders will own 136,528 shares in the aggregate, which is also less than
1% of our outstanding common stock.
63
<PAGE>
DESCRIPTION OF LONG-TERM INDEBTEDNESS
11 3/4% Senior Notes
On July 24, 1998, we issued $261.0 million aggregate principal amount of our
11 3/4% senior notes. The senior notes are due July 15, 2008 and are senior
obligations, ranking pari passu with all of our existing and future senior
indebtedness and senior to all of our future subordinated obligations. The
senior notes bear interest at a rate of 11 3/4% per year, payable semi-annually
on January 15 and July 15 of each year. We have deposited into an escrow
account funds that, together with interest on those funds, will be sufficient
to pay the first four semi-annual interest payments on the senior notes. Except
as described in the preceding sentence, the senior notes are unsecured
obligations.
The senior notes may be redeemed at any time, in whole or in part, on or
after July 15, 2003 at a redemption price equal to 105.875% of the principal
amount of the notes in the first year and declining yearly to par at July 15,
2006, plus accrued and unpaid interest, if any, to the date of redemption. In
addition, on or prior to July 15, 2001, we may also redeem with the proceeds of
one or more equity offerings up to 35% of the original aggregate principal
amount of the notes originally issued at a redemption price equal to 111.75% of
the aggregate principal amount of the notes plus accrued and unpaid interest,
if any, to the date of redemption; provided that at least 65% of the original
aggregate principal amount of the notes remain outstanding immediately after
each redemption.
Upon the occurrence of a change of control, we will be required to make an
offer to repurchase all notes properly tendered at a price equal to 101% of the
principal amount plus accrued and unpaid interest to the date of repurchase.
The indenture governing the notes contains covenants that limit our ability,
directly or through our subsidiaries, to:
. incur additional indebtedness or liens or enter into sale/leaseback
transactions;
. pay dividends or make other distributions;
. make investments;
. repurchase equity interests or subordinated obligations;
. consummate asset sales;
. enter into transactions with affiliates;
. engage in any business other than a telecommunications business; and
. merge or consolidate with any other person or sell, assign, transfer,
lease, convey or otherwise dispose of all or substantially all of our
assets.
64
<PAGE>
DESCRIPTION OF CAPITAL STOCK
Authorized stock; issued and outstanding shares
Our authorized capital stock consists of 150,000,000 shares of common stock,
par value $0.001 per share, and 25,000,000 shares of preferred stock, par value
$0.001 per share.
Common Stock
Following this offering 57,381,427 shares of our common stock will be
outstanding. All of the issued and outstanding shares of common stock are and,
upon the completion of this offering, the shares of common stock offered in
this offering will be, fully paid, validly issued and non-assessable.
The following summarizes the rights of holders of our common stock:
. each holder of shares of common stock is entitled to one vote per share
on all matters to be voted on by stockholders generally, including the
election of directors;
. there are no cumulative voting rights;
. the holders of our common stock are entitled to dividends and other
distributions as may be declared from time to time by the board of
directors out of funds legally available for that purpose, if any;
. upon our liquidation, dissolution or winding up, the holders of shares
of common stock will be entitled to share ratably in the distribution of
all of our assets remaining available for distribution after
satisfaction of all our liabilities and the payment of the liquidation
preference of any outstanding preferred stock; and
. the holders of common stock have no preemptive or other subscription
rights to purchase shares of our stock, nor will holders be entitled to
the benefits of any redemption or sinking fund provisions.
As of June 30, 1999, there were 46,681,427 shares of our common stock
outstanding, held of record by 52 persons.
Preferred Stock
Our certificate of incorporation authorizes our board of directors to create
and issue one or more series of preferred stock and determine the rights and
preferences of each series within the limits set forth in our certificate of
incorporation and applicable law. Among other rights, the board of directors
may determine, without further vote or action by our stockholders:
. the number of shares constituting the series and the distinctive
designation of the series;
. the dividend rate on the shares of the series, whether dividends will be
cumulative, and if so, from which date or dates, and the relative rights
of priority, if any, of payment of dividends on shares of the series;
. whether the series will have voting rights in addition to the voting
rights provided by law and, if so, the terms of the voting rights;
. whether the series will have conversion privileges and, if so, the terms
and conditions of conversion;
. whether or not the shares of the series will be redeemable or
exchangeable, and, if so, the dates, terms and conditions of redemption
or exchange, as the case may be;
. whether the series will have a sinking fund for the redemption or
purchase of shares of that series, and, if so, the terms and amount of
the sinking fund; and
. the rights of the shares of the series in the event of our voluntary or
involuntary liquidation, dissolution or winding up and the relative
rights or priority, if any, of payment of shares of the series.
65
<PAGE>
Unless otherwise provided by our board of directors, the shares of all
series of preferred stock will rank on a parity with respect to the payment of
dividends and to the distribution of assets upon liquidation. Although we have
no present plans to issue any shares of preferred stock, any future issuance of
shares of preferred stock, or the issuance of rights to purchase preferred
shares, may have the effect of delaying, deferring or preventing a change of
control in our company or an unsolicited acquisition proposal. The issuance of
preferred stock also could decrease the amount of earnings and assets available
for distribution to the holders of common stock or could adversely affect the
rights and powers, including voting rights, of the holders of the common stock.
Warrants
As part of the senior notes offering, we have issued warrants to purchase
1,487,791 shares of our common stock at an exercise price of $.02 per share.
The warrants become exercisable on July 26, 1999 and expire on July 15, 2008.
Anti-Takeover Effects of Delaware Law and Our Certificate of Incorporation and
Bylaws
Section 203 of the Delaware General Corporation Law
We are subject to the provisions of Section 203 of the Delaware General
Corporation Law. Under Section 203, business combinations between a Delaware
corporation whose stock generally is publicly traded or held of record by more
than 2,000 stockholders and an interested stockholder are generally prohibited
for a three-year period following the date that such a stockholder became an
interested stockholder, unless:
. the corporation has elected in its original certificate of incorporation
not to be governed by Section 203. We did not make this election;
. the business combination was approved by the board of directors of the
corporation before the other party to the business combination became an
interested stockholder;
. upon consummation of the transaction that made it an interested
stockholder, the interested stockholder owned at least 85% of the voting
stock of the corporation outstanding at the commencement of the
transaction, excluding voting stock owned by directors who are also
officers or held in employee benefit plans in which the employees do not
have a confidential right to tender or vote stock held by the plan; or
. the business combination was approved by the board of directors of the
corporation and ratified by two-thirds of the voting stock not owned by
the interested stockholder.
The three-year prohibition also does not apply to some business combinations
proposed by an interested stockholder following the announcement or
notification of an extraordinary transaction involving the corporation and a
person who had not been an interested stockholder during the previous three
years or who became an interested stockholder with the approval of the majority
of the corporation's directors. The term "business combination" is defined
generally under Section 203 to include mergers or consolidations between a
Delaware corporation and an interested stockholder, transactions with an
interested stockholder involving the assets or stock of the corporation or its
majority-owned subsidiaries and transactions which increase an interested
stockholder's percentage ownership of stock. The term "interested stockholder"
is defined generally under Section 203 as a stockholder who, together with
affiliates and associates, owns or within three years prior did own 15% or more
of a Delaware corporation's voting stock. Section 203 could prohibit or delay a
merger, takeover or other change in control of Splitrock and therefore could
discourage attempts to acquire us.
Board of Directors Vacancies. Our certificate of incorporation authorizes
the board of directors to fill vacant directorships or increase the size of the
board of directors. This may deter a stockholder from removing incumbent
directors and simultaneously gaining control of the board of directors by
filling the vacancies created by this removal with its own nominees.
66
<PAGE>
Special Meeting of Stockholders. Our bylaws provide that special meetings of
our stockholders may be called only by the board of directors.
Advance Notice Requirements for Stockholder Proposals and Director
Nominations. Our bylaws provide that stockholders seeking to bring business
before an annual meeting of stockholders, or to nominate candidates for
election as directors at an annual meeting of stockholders, must provide timely
notice in writing. To be timely, a stockholder's notice must be delivered to or
mailed and received at our principal executive offices not less than 90 days
prior to the anniversary of the previous year's annual meeting of stockholders.
If no annual meeting of stockholders was held in the previous year or the date
of the annual meeting of stockholders has been changed to be more than 30
calendar days earlier than or 60 calendar days after this anniversary, notice
by the stockholder, to be timely, must be received not later than the later of:
. 90 days prior to the annual meeting of stockholders or
. the close of business on the 10th day following the date on which notice
of the date of the meeting is mailed to stockholders or made public,
whichever occurs first.
According to our bylaws, stockholders seeking to nominate candidates for
election as directors at special meetings of stockholders must also provide
timely notice in writing in accordance with restrictions similar to those for
annual meetings.
Our bylaws also specify certain requirements as to the form and content of a
stockholder's notice. These provisions may preclude stockholders from bringing
matters before an annual meeting of stockholders or from making nominations for
directors at an annual meeting of stockholders.
Authorized But Unissued Shares. The authorized but unissued shares of common
stock and preferred stock are available for future issuance without stockholder
approval, subject to various limitations imposed by the Nasdaq National Market.
These additional shares may be utilized for a variety of corporate purposes,
including future public offerings to raise additional capital, corporate
acquisitions and employee benefit plans. The existence of authorized but
unissued and unreserved common stock and preferred stock could make more
difficult or discourage an attempt to obtain control of us by means of a proxy
contest, tender offer, merger or otherwise.
Delaware law provides generally that the affirmative vote of a majority of
the shares entitled to vote on any matter is required to amend a corporation's
certificate of incorporation or bylaws, unless a corporation's certificate of
incorporation or bylaws, as the case may be, requires a greater percentage.
Limitation of Liability and Indemnification Matters
Our certificate of incorporation provides that the liability of our
directors shall be eliminated or limited to the fullest extent permitted by
Delaware law. Under Delaware law, the directors have a fiduciary duty to us
that is not eliminated by this provision of our certificate of incorporation
and, in appropriate circumstances, equitable remedies such as injunctive or
other forms of non-monetary relief will remain available. In addition, each
director will continue to be subject to liability under Delaware law for:
. breach of the director's duty of loyalty to us or our stockholders;
. acts or omissions which are found by a court of competent jurisdiction
to be not in good faith or which involve intentional misconduct, or
knowing violations of law;
. actions leading to improper personal benefit to the director; and
. payment of dividends or approval of stock repurchases or redemptions
that are prohibited by the Delaware law.
This provision also does not affect the directors' responsibilities under any
other laws, such as the federal securities laws.
67
<PAGE>
Our certificate of incorporation also generally provides that we are
required to fully indemnify any person who was or is a party or is threatened
to be made a party to any threatened, pending or completed action, suit or
proceeding, whether civil, criminal, administrative or investigative, by
reason of the fact that that person is or was a director or officer of
Splitrock, or is or was serving at our request as a director or officer of
another corporation, partnership, joint venture, trust, employee benefit plan
or other enterprise. This indemnification covers expenses including attorney's
fees, judgments, fines and amounts paid in settlement actually and reasonably
incurred by the indemnitee in connection with such action, suit or proceeding.
Transfer agent and registrar
The transfer agent and registrar for our common stock is Continental Stock
Transfer & Trust Company.
68
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Immediately following this offering, there will be 57,381,427 shares of our
common stock issued and outstanding. Of these shares, the 10,700,000 shares of
common stock to be sold in this offering will be immediately eligible for sale
in the public market, except for shares owned at any time by our affiliates
within the meaning of Rule 144 under the Securities Act. The remaining
46,681,427 issued and outstanding shares are restricted securities within the
meaning of Rule 144 and may not be publicly resold, except in compliance with
the registration requirements of the Securities Act or pursuant to an exemption
from registration, including that provided by Rule 144.
Outstanding warrants to purchase 1,487,791 shares of common stock at a
purchase price of $.02 per share become exercisable on July 26, 1999. Shares
issued upon the cashless exercise of these warrants will be immediately
eligible for sale in the public market, except for shares owned at any time by
our affiliates.
Rule 144
In general, under Rule 144, a person, or persons whose shares are
aggregated, who has beneficially owned restricted securities for at least one
year, including a person who may be deemed affiliate, is entitled to sell
within any three month period a number of our shares of common stock that does
not exceed the greater of:
. 1% of the then-outstanding shares of our common stock; or
. the average weekly trading volume of our common stock on the Nasdaq
National Market during the four calendar weeks preceding the date on
which notice of the sale is filed with the Securities and Exchange
Commission.
Sales under Rule 144 are subject to restrictions relating to manner of sale,
notice and the availability of current public information about us. A person
who is not our affiliate at any time during the 90 days preceding a sale and
who has beneficially owned shares for at least two years would be entitled to
sell shares following this offering under Rule 144(k) without regard to the
volume limitations, manner of sale provisions or notice requirements of Rule
144.
Rule 701
Our employees, directors, officers or consultants who purchased our shares
in connection with a written compensatory plan or contract may be entitled to
rely on the resale provisions of Rule 701. Rule 701 permits non-affiliates to
sell their Rule 701 shares without having to comply with the public
information, holding period, volume limitation or notice provisions of Rule
144. Affiliates may sell their Rule 701 shares without having to comply with
Rule 144's holding period restrictions. In each of these cases, Rule 701 allows
the shareholders to sell 90 days after the date of this prospectus.
Lock-up agreements
Our directors, executive officers, and our two largest shareholders, Linsang
and Carso Global, who collectively hold 45,508,979 of the outstanding shares of
our common stock, have agreed, subject to limited exceptions, not to sell,
offer to sell or otherwise dispose of our common stock or securities
convertible into or exercisable or exchangeable for our common stock for a
period of 180 days after the date of this prospectus without the prior written
consent of Bear, Stearns & Co. Inc., on behalf of the underwriters.
Registration Statement on Form S-8
Following this offering, we intend to file a registration statement on Form
S-8 under the Securities Act to register the shares of common stock reserved
for issuance under our employee benefit plans. The stock registered under that
registration statement will thereafter be available for sale in the public
market, subject to the resale limitations of Rule 144 applicable to our
affiliates.
69
<PAGE>
Prior to the date of this prospectus, no public market has existed for our
common stock. We expect that trading of our common stock on the Nasdaq National
Market will commence on the date of this prospectus. We do not make any
prediction regarding the effect, if any, that future sales of shares, or the
availability of our shares for future sale, will have on the market price of
our common stock. The market price of our common stock can be adversely
affected by sales of substantial amounts of common stock or by the perception
that these sales could occur.
U.S. FEDERAL TAX CONSIDERATIONS FOR NON-U.S. HOLDERS
The following is a general discussion of the principal United States federal
income and estate tax consequences of the ownership and disposition of common
stock by a Non-U.S. Holder, as defined below. As used herein, the term "Non-
U.S. Holder" means a holder that for United States federal income tax purposes
is an individual or entity other than:
. a citizen or individual resident of the United States,
. a corporation or partnership created or organized in or under the laws
of the United States or of any state thereof, unless in the case of a
partnership or in the District of Columbia, U.S. Treasury regulations
provide otherwise,
. an estate the income of which is subject to U.S. federal income taxation
regardless of its source or
. a trust if a U.S. court is able to exercise primary supervision over the
administration of the trust and one or more U.S. persons have the
authority to control all substantial decisions of the trust.
In general, an individual may be deemed to be a resident alien, as opposed
to a nonresident alien, by virtue of being present in the United States for at
least 31 days in the calendar year and for an aggregate of at least 183 days
during a three-year period ending in the current calendar year, counting for
these purposes all of the days present in the current year, one-third of the
days present in the immediately preceding year and one-sixth of the days
present in the second preceding year. Resident aliens are subject to U.S.
federal tax as if they were U.S. citizens.
This discussion does not address all aspects of United States federal income
and estate taxes that may be relevant to Non-U.S. Holders in light of their
personal circumstances, including the fact that in the case of a Non-U.S.
Holder that is a partnership, the U.S. tax consequences of holding and
disposing of shares of common stock may be affected by determinations made at
the partner level, or that may be relevant to various types of Non-U.S. Holders
which may be subject to special treatment under United States federal income
tax laws, including, for example, insurance companies, tax-exempt
organizations, financial institutions, dealers in securities and holders of
securities held as part of a "straddle," "hedge," or "conversion transaction,"
and does not address U.S. state or local or foreign tax consequences.
Furthermore, this discussion is based on provisions of the Internal Revenue
Code of 1986, as amended, existing and proposed regulations promulgated
thereunder and administrative and judicial interpretations thereof, all as of
the date of this prospectus, and all of which are subject to change, possibly
with retroactive effect. The following summary is included herein for general
information. Accordingly, prospective investors may wish to consult their tax
advisers regarding the United States federal, state, local and non-U.S. income
and other tax consequences of acquiring, holding and disposing of shares of
common stock.
Dividends
We do not anticipate declaring or paying cash dividends on our common stock
in the near future. However, if dividends are paid on shares of our common
stock, dividends paid to a Non-U.S. Holder of common stock generally will be
subject to withholding of United States federal income tax at a 30% rate, or
the lower rate provided by the income tax treaty between the United States and
a foreign country if the Non-U.S. Holder is treated as a resident of that
foreign country within the meaning of the applicable treaty. Non-U.S. Holders
should consult their tax advisors regarding their entitlement to benefits under
a relevant income tax treaty.
70
<PAGE>
Dividends that are effectively connected with a Non-U.S. Holder's conduct of
a trade or business in the United States or, if an income tax treaty applies,
attributable to a permanent establishment in the United States, are generally
subject to U.S. federal income tax on a net income basis at regular graduated
rates, but are not generally subject to the 30% withholding tax if the Non-U.S.
Holder files the appropriate U.S. Internal Revenue Service form with the payor,
which form under U.S. Treasury regulations generally requires the Non-U.S.
Holder to provide a U.S. taxpayer identification number. Any U.S. trade or
business income received by a Non-U.S. Holder that is a corporation may also be
subject to an additional "branch profits tax" at a 30% rate or the lower rate
specified by an applicable income tax treaty.
Under currently applicable U.S. Treasury regulations, dividends paid to an
address in a foreign country are presumed, absent actual knowledge to the
contrary, to be paid to a resident of that country for purposes of the
withholding discussed above and for purposes of determining the applicability
of a tax treaty rate. Under U.S. Treasury regulations generally effective for
payments made after December 31, 2000 (the Final Regulations), however, a Non-
U.S. Holder of our common stock who wishes to claim the benefit of an
applicable treaty rate generally will be required to satisfy applicable
certification and other requirements. In addition, under the Final Regulations,
in the case of our common stock held by a foreign partnership, (1) the
certification requirement will generally be applied to the partners of the
partnership and (2) the partnership will be required to provide certain
information, including a United States taxpayer identification number. The
Final Regulations also provide look-through rules for tiered partnerships.
Further, the Internal Revenue Service intends to issue regulations under which
a foreign trustee or foreign executor of a U.S. or foreign trust or estate,
depending on the circumstances, will be required to furnish the appropriate
withholding certificate on behalf of the beneficiaries, grantor trust or
estate, as the case may be.
A Non-U.S. Holder of our common stock that is eligible for a reduced rate of
U.S. withholding tax under an income tax treaty may obtain a refund of any
excess amounts withheld by filing an appropriate claim for a refund with the
Internal Revenue Service.
The Final Regulations also provide special rules for dividend payments made
to foreign intermediaries, U.S. or foreign wholly owned entities that are
disregarded for U.S. federal income tax purposes and entities that are treated
as fiscally transparent in the United States, the applicable income tax treaty
jurisdiction, or both. In addition, recently enacted legislation, effective
August 5, 1997, denies income tax treaty benefits to foreigners receiving
income derived through a partnership, or another otherwise fiscally transparent
entity, in certain circumstances. Prospective investors should consult with
their own tax advisers concerning the effect, if any, of Final Regulations and
this recent legislation on an investment in our common stock.
Gain on disposition of common stock
A Non-U.S. Holder generally will not be subject to U.S. federal income tax
in respect of gain recognized on a disposition of our common stock unless:
(a) the gain is U.S. trade or business income, in which case, the branch
profits tax described above may also apply to a corporate Non-U.S.
Holder,
(b) the Non-U.S. Holder is an individual who holds our common stock as a
capital asset within the meaning of Section 1221 of the Internal
Revenue Code, is present in the United States for 183 or more days in
the taxable year of the disposition and meets other requirements,
(c) the Non-U.S. Holder is subject to tax under the provisions of the U.S.
tax law applicable to United States expatriates or
(d) we are or have been a "U.S. real property holding corporation" for
federal income tax purposes at any time during the shorter of the five-
year period preceding the disposition or the period that the Non-U.S.
Holder held our common stock.
Generally, a corporation is a "U.S. real property holding corporation" if the
fair market value of its "U.S. real property interests" equals or exceeds 50%
of the sum of the fair market value of its worldwide real property interests
plus its other assets used or held for use in a trade or business. We believe
that we have not
71
<PAGE>
been, are not currently, and do not anticipate becoming, a "U.S. real property
holding corporation" for U.S. federal income tax purposes. The tax with
respect to stock in a "U.S. real property holding corporation" does not apply
to a Non-U.S. Holder whose holdings, direct and indirect, at all times during
the applicable period, constituted 5% or less of our common stock, provided
that our common stock was regularly traded on an established securities
market. If we were, or were to become, a U.S. real property holding
corporation, we believe that our common stock would be treated as "regularly
traded."
If a Non-U.S. Holder who is an individual is subject to tax under clause
(a) above, the individual generally will be taxed on the net gain derived from
a sale of common stock under regular graduated United States federal income
tax rates. If an individual Non-U.S. Holder is subject to tax under clause (b)
above, the individual generally will be subject to a flat 30% tax on the gain
derived from a sale, which may be offset by particular United States capital
losses, notwithstanding the fact that the individual is not considered a
resident alien of the United States. Thus, individual Non-U.S. Holders who
have spent, or expect to spend, more than a de minimis period of time in the
United States in the taxable year in which they contemplate a sale of common
stock are urged to consult their tax advisers prior to the sale concerning the
U.S. tax consequences of that sale.
If a Non-U.S. Holder that is a foreign corporation is subject to tax under
clause (a) above, it generally will be taxed on its net gain under regular
graduated United States federal income tax rates and, in addition, will be
subject to the branch profits tax equal to 30% of its "effectively connected
earnings and profits," within the meaning of the Internal Revenue Code for the
taxable year, as adjusted for certain items, unless it qualifies for a lower
rate under an applicable tax treaty.
Federal estate tax
Common stock owned or treated as owned by an individual who is neither a
United States citizen nor a United States resident, as defined for United
States federal estate tax purposes, at the time of death will be included in
the individual's gross estate for United States federal estate tax purposes,
unless an applicable estate tax or other treaty provides otherwise and,
therefore, maybe subject to United States federal estate tax.
Information reporting and backup withholding tax
Under United States Treasury regulations, we must report annually to the
Internal Revenue Service and to each Non-U.S. Holder the amount of dividends
paid to that holder and the tax withheld with respect to those dividends.
Copies of the information returns reporting dividends and withholding may also
be made available to the tax authorities in the country in which the Non-U.S.
Holder is a resident under the provisions of an applicable income tax treaty
or agreement.
United States backup withholding, which generally is a withholding tax
imposed at the rate of 31% on payments to persons that fail to furnish
information under the United States information reporting requirements,
generally will not apply:
. to dividends paid to Non-U.S. Holders that are subject to the 30%
withholding discussed above or that are not so subject because a tax
treaty applies that reduces or eliminates such 30% withholding or
. before January 1, 2001, to dividends paid to a Non-U.S. Holder at an
address outside of the United States unless the payor has actual
knowledge that the payee is a U.S. Holder.
Backup withholding and information reporting generally will apply to dividends
paid to addresses inside the United States on shares of our common stock to
beneficial owners that are not "exempt recipients" and that fail to provide
identifying information in the manner required.
The payment of the proceeds of the disposition of our common stock by a
holder to or through the U.S. office of a broker or through a non-U.S. branch
of a U.S. broker generally will be subject to information reporting and backup
withholding at a rate of 31% unless the holder either certifies its status as
a Non-U.S.
72
<PAGE>
Holder under penalties of perjury or otherwise establishes an exemption. The
payment of the proceeds of the disposition by a Non-U.S. Holder of common stock
to or through a non-U.S. office of a non-U.S. broker will not be subject to
backup withholding or information reporting unless the non-U.S. broker has
particular types of U.S. relationships. In the case of the payment of proceeds
from the disposition of our common stock effected by a foreign office of a
broker that is a U.S. person or a "U.S. related person," existing regulations
require information reporting on the payment unless the broker receives a
statement from the owner, signed under penalty of perjury, certifying its non-
U.S. status or the broker has documentary evidence in its files as to the Non-
U.S. Holder's foreign status and the broker has no actual knowledge to the
contrary. For this purpose, a "U.S. related person" is:
. a "controlled foreign corporation" for U.S. federal income tax purposes;
or
. a foreign person 50% or more of whose gross income from all sources for
the three-year period ending with the close of its taxable year
preceding the payment or for such part of the period that the broker has
been in existence is derived from activities that are effectively
connected with the conduct of a U.S. trade or business.
The Final Regulations alter the foregoing rules in certain respects. Among
other things, these regulations provide presumptions under which a Non-U.S.
Holder is subject to backup withholding at the rate of 31% and information
reporting unless we receive certification from the holder of non-U.S. status.
Depending on the circumstances, this certification will need to be provided:
. directly by the Non-U.S. Holder;
. in the case of a Non-U.S. Holder that is treated as a partnership or
other fiscally transparent entity, by the partners, stockholders or
other beneficiaries of that entity; or
. by particular qualified financial institutions or other qualified
entities on behalf of the Non-U.S. Holder.
Any amounts withheld under the backup withholding rules from a payment to a
Non-U.S. Holder will be refunded or credited against the holder's U.S. federal
income tax liability, if any, provided that the required information is
furnished to the Internal Revenue Service.
73
<PAGE>
UNDERWRITING
Subject to the terms and conditions set forth in an underwriting agreement
dated , 1999, each of the underwriters named below, through their
representatives Bear, Stearns & Co. Inc., Credit Suisse First Boston
Corporation, and Prudential Securities Incorporated, has severally agreed to
purchase from us the aggregate number of shares of common stock set forth
opposite its name below at the public offering price less the underwriting
discount set forth on the cover page of this prospectus:
<TABLE>
<CAPTION>
Underwriters Number of Shares
- ------------ ----------------
<S> <C>
Bear, Stearns & Co. Inc........................................
Credit Suisse First Boston Corporation.........................
Prudential Securities Incorporated ............................
----------
Total...................................................... 10,700,000
==========
</TABLE>
The underwriting agreement provides that the obligations of the several
underwriters are subject to approval of legal matters by their counsel and to
various other conditions. Under the underwriting agreement, the underwriters
are obligated to purchase and pay for all of the above shares of common stock,
other than those covered by the over-allotment option described below, if they
purchase any of the shares.
The underwriters propose to initially offer some of the shares directly to
the public at the offering price set forth on the cover page of this prospectus
and some of the shares to dealers at this price less a concession not in excess
of $ per share. The underwriters may allow, and dealers may re-allow,
concessions not in excess of $ per share on sales to other dealers. After the
initial offering of the shares to the public, the underwriters may change the
offering price, concessions and other selling terms. The underwriters do not
intend to confirm sales to any accounts over which they exercise discretionary
authority.
We and some of our stockholders have granted the underwriters an option
exercisable for 30 days from the date of the underwriting agreement to purchase
up to 1,447,628 and 157,372 additional shares, respectively, at the offering
price less the underwriting discount. The underwriters may exercise this option
solely to cover over-allotments, if any, made in connection with this offering.
To the extent underwriters exercise this option in whole or in part then each
of the underwriters will become obligated, subject to conditions, to purchase a
number of additional shares approximately proportionate to each underwriter's
initial purchase commitment as indicated in the preceding table.
We have agreed to indemnify the underwriters against certain liabilities,
including liabilities under the Securities Act.
Our directors and executive officers and Linsang and Carso Global, who
collectively hold a total of 45,508,979 shares of common stock, have agreed,
subject to limited exceptions, not to sell or offer to sell or otherwise
dispose of any shares of common stock or securities convertible into or
exercisable or exchangeable for our common stock, for a period of 180 days
after the date of this prospectus without the prior written consent of Bear,
Stearns & Co. Inc., on behalf of the underwriters.
In addition, we have agreed that for a period of 180 days after the date of
this prospectus we will not offer, sell or otherwise dispose of any shares of
common stock except for the shares offered in this offering and any shares
offered in connection with employee benefit plans, without the consent of Bear,
Stearns & Co. Inc., on behalf of the underwriters.
Prior to the offering, there has been no public market for our common stock.
Consequently, the initial offering price for the common stock will be
determined by negotiations between us and the representatives of the
underwriters. Among the factors to be considered in these negotiations will be:
74
<PAGE>
. our results of operations in recent periods;
. estimates of our business potential;
. an assessment of our management;
. prevailing market conditions; and
. the prices of similar securities of generally comparable companies.
We have applied to have our common stock listed on the Nasdaq National
Market under the symbol "SPLT." We cannot assure you, however, that an active
or orderly trading market will develop for the common stock or that our common
stock will trade in the public markets subsequent to the offering at or above
the initial offering price.
In order to facilitate the offering, the underwriters may engage in
transactions that stabilize, maintain or otherwise affect the price of the
common stock during and after the offering. Specifically, the underwriters may
over-allot or otherwise create a short position in the common stock for their
own account by selling more shares of common stock than we have actually sold
to them. The underwriters may elect to cover any short position by purchasing
shares of common stock in the open market or by exercising the over-allotment
option granted to the underwriters. In addition, the underwriters may stabilize
or maintain the price of the common stock by bidding for or purchasing shares
of common stock in the open market and may impose penalty bids, under which
selling concessions allowed to syndicate members or other broker-dealers
participating in the offering are reclaimed if shares of common stock
previously distributed in the offering are repurchased in connection with
stabilization transactions or otherwise. The effect of these transactions may
be to stabilize or maintain the market price at a level above that which might
otherwise prevail in the open market. The imposition of a penalty bid may also
affect the price of the common stock to the extent that it discourages resales.
No representation is made as to the magnitude or effect of these activities.
The underwriters have reserved for sale, at the initial public offering
price, up to 535,000 shares of common stock for employees, directors and other
persons associated with us who express an interest in purchasing these shares
of common stock in the offering. The number of shares available for sale to the
general public in the offering will be reduced to the extent these persons
purchase reserved shares. Any reserved shares not purchased by these persons
will be offered by the underwriters to the general public on the same terms as
the other shares offered in this offering.
The underwriters may, from time to time, engage in transactions with, and
perform services for, us in the ordinary course of their business. Prudential
Securities acted as our financial advisor in connection with our agreement to
acquire rights to use dark fiber from Level 3, for which Prudential Securities
will be entitled to receive customary compensation.
The following table shows the underwriting discount to be paid to the
underwriters in connection with this offering. These amounts are shown assuming
both no exercise and full exercise of the underwriters' option to purchase
additional shares of common stock.
<TABLE>
<CAPTION>
No Full
Exercise Exercise
-------- --------
<S> <C> <C>
Per share.................................................. $ $
Total...................................................... $ $
</TABLE>
Other expenses of this offering (including the registration fees and the
fees of financial printers, counsel and accountants) payable by us are expected
to be approximately $1 million.
75
<PAGE>
LEGAL MATTERS
The validity of the shares of common stock offered by this prospectus will
be passed upon for us by Fried, Frank, Harris, Shriver & Jacobson, a
partnership including professional corporations, Washington, D.C., and for the
underwriters by Latham & Watkins, Washington, D.C.
EXPERTS
The financial statements as of December 31, 1998 and 1997 and for the year
ended December 31, 1998 and for the period from inception (March 5, 1997) to
December 31, 1997 included in this prospectus have been so included in reliance
on the report of PricewaterhouseCoopers LLP, independent accountants, given on
the authority of said firm as experts in auditing and accounting.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the Securities and Exchange Commission a registration
statement on Form S-1 under the Securities Act of 1933 with respect to the
shares of common stock offered by this prospectus. This prospectus does not
contain all of the information set forth in the registration statement and its
exhibits and schedules. Particular items are omitted in accordance with the
rules and regulations of the Securities and Exchange Commission. For further
information about our company and the common stock offered by this prospectus,
we refer you to the registration statement, including its exhibits and
schedules. You may read and copy the registration statement at the Securities
and Exchange Commission's following locations:
<TABLE>
<S> <C> <C>
Public Reference Room New York Regional Office Chicago Regional Office
Room 1024 Seven World Trade Center Citicorp Center
450 Fifth Street, N.W. Suite 1300 500 West Madison Street
Washington, DC 20549 New York, NY 10048 Suite 1400
Chicago, IL 60661-2511
</TABLE>
You may also obtain copies of the registration statement by mail from the
Public Reference Section of the Securities and Exchange Commission at 450 Fifth
Street, N.W., Judiciary Plaza, Washington, D.C. 20549 or by telephone at 1-800-
SEC-0330. The registration statement is also available to the public from
commercial document retrieval services and at the Securities and Exchange
Commission's World Wide Web site located at http://www.sec.gov. Upon approval
of our common stock for quotation on The Nasdaq Stock Market's National Market,
you will be able to read our filings with the Securities and Exchange
Commission at the office of Nasdaq Operations, 1734 K Street, N.W. Washington,
DC 20006.
Statements in this prospectus as to the contents of any contract or other
document are not necessarily complete, and in each instance we refer you to the
full text of such contract or document filed as an exhibit to the registration
statement, each such statement being qualified in all respects by such
reference.
We intend to furnish our stockholders with annual reports containing
financial statements audited by an independent public accounting firm and make
available to our stockholders quarterly reports for the first three quarters of
each fiscal year containing interim unaudited financial information.
76
<PAGE>
SPLITROCK SERVICES, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Financial Statements:
Report of Independent Accountants....................................... F-2
Balance Sheets as of December 31, 1997 and 1998 and March 31, 1999
(unaudited)............................................................ F-3
Statements of Operations and Comprehensive Loss for the Period from
Inception (March 5, 1997) Through December 31, 1997, the year ended
December 31, 1998 and the three months ended March 31, 1998 and 1999
(unaudited)............................................................ F-4
Statements of Stockholders' Equity (Deficit) for the Period from
Inception (March 5, 1997) Through December 31, 1998 and the three
months ended March 31, 1999 (unaudited)................................ F-5
Statements of Cash Flows for the Period from Inception (March 5, 1997)
Through December 31, 1997, the year ended December 31, 1998 and the
three months ended March 31, 1999 (unaudited).......................... F-6
Notes to Financial Statements........................................... F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Splitrock Services, Inc.
In our opinion, the accompanying balance sheets and the related statements
of operations and comprehensive loss, of cash flows and of changes in
stockholders' equity, present fairly, in all material respects, the financial
position of Splitrock Services, Inc. at December 31, 1997 and 1998, and the
results of its operations and its cash flows for the period from inception
(March 5, 1997) to December 31, 1997 and 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
Houston, Texas
March 24, 1999, except as to Note 12 which is as of July 12, 1999.
F-2
<PAGE>
SPLITROCK SERVICES, INC.
BALANCE SHEETS
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
December 31,
------------------ March 31,
1997 1998 1999
-------- -------- -----------
(unaudited)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.................... $ 7,710 $ 28,330 $ 23,365
Unrestricted investments--short term......... -- 120,475 87,793
Restricted investments--short term........... 3,472 39,476 28,191
Accounts receivable, net of $0, $537 and
$537, respectively.......................... 4,252 3,205 4,134
Prepaid expenses and other current assets.... 221 480 319
-------- -------- --------
Total current assets....................... 15,655 191,966 143,802
Property and equipment, net.................... 38,504 73,899 84,833
Restricted investments--long term.............. -- 19,001 16,165
Other assets, net.............................. 229 11,275 12,265
-------- -------- --------
$ 54,388 $296,141 $257,065
======== ======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Current maturities of capital lease
obligations................................. $ 11,010 $ 9,121 $ 9,051
Accounts payable............................. 3,086 21,582 18,467
Accrued interest payable..................... -- 13,375 6,475
Accrued liabilities and other current
liabilities................................. 5,775 15,894 15,204
-------- -------- --------
Total current liabilities.................. 19,871 59,972 49,197
Senior notes payable ($261,000 face value net
of $2,783 and $2,743 unamortized discount,
respectively (Note 5))........................ -- 258,217 258,257
Capital lease obligations...................... 13,110 8,243 5,536
Note payable to stockholder.................... 1,000 -- --
-------- -------- --------
Total liabilities.......................... 33,981 326,432 312,990
Commitments and contingencies (Note 7)
Stockholders' equity (deficit):
Preferred stock, $.001 par value, 25,000,000
shares authorized, no shares issued......... -- -- --
Common stock, $.001 par value, 150,000,000
shares authorized, 43,238,400, 46,624,845,
and 46,671,996 shares issued and outstanding
as of December 31, 1997, 1998, and March 31,
1999, respectively.......................... 43 47 47
Additional paid-in capital................... 30,485 34,717 34,816
Common stock warrants........................ -- 2,849 2,849
Accumulated other comprehensive income
(loss)...................................... -- 47 (195)
Accumulated deficit.......................... (10,121) (67,951) (93,442)
-------- -------- --------
Total stockholders' equity (deficit)....... 20,407 (30,291) (55,925)
-------- -------- --------
$ 54,388 $296,141 $257,065
======== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE>
SPLITROCK SERVICES, INC.
STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Period from
Inception Three Months Three Months
(March 5, 1997) to Year Ended Ended Ended
December 31, 1997) December 31, 1998 March 31, 1998 March 31, 1999
------------------ ----------------- -------------- --------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Revenue................. $ 22,708 $ 63,611 $ 16,494 $ 16,352
Operating expenses:
Splitrock network
costs................ 2,362 32,912 3,955 16,022
Legacy network costs.. 25,804 58,292 12,316 13,029
Selling, general and
administrative....... 1,276 6,390 859 2,570
Depreciation and
amortization......... 3,500 13,850 2,820 4,635
---------- ---------- ---------- ----------
32,942 111,444 19,950 36,256
---------- ---------- ---------- ----------
Loss from operations.... (10,234) (47,833) (3,456) (19,904)
Other income (expense):
Interest income....... 348 5,393 107 2,604
Interest expense...... (235) (15,390) (349) (8,191)
---------- ---------- ---------- ----------
Loss before income
taxes.................. (10,121) (57,830) (3,698) (25,491)
Provision for income
taxes.................. -- -- -- --
---------- ---------- ---------- ----------
Net loss................ (10,121) (57,830) (3,698) (25,491)
Other comprehensive
income (loss):
Unrealized gain (loss)
on securities........ -- 47 -- (242)
---------- ---------- ---------- ----------
Comprehensive loss...... $ (10,121) $ (57,783) $ (3,698) $ (25,733)
========== ========== ========== ==========
Net loss per share--
basic and diluted...... $ (0.42) $ (1.30) $ (0.09) $ (0.55)
========== ========== ========== ==========
Weighted average
shares--basic and
diluted................ 24,109,912 44,389,172 43,238,400 46,659,188
========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE>
SPLITROCK SERVICES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
Period From Inception (March 5, 1997) Through March 31, 1999
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Common Stock Accumulated
---------------- Additional Common Other
Par Paid-in Stock Comprehensive Accumulated
Shares Value Capital Warrants Income Deficit Total
---------- ----- ---------- -------- ------------- ----------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Initial capitalization.. 15,764,000 $16 $12 -- -- -- $ 28
Issuances of Common
Stock for cash of
$1.12 per share and
warrant............... 18,466,400 18 $20,482 -- -- -- 20,500
Conversion of note
payable to Common
Stock at $1.12 per
share................. 9,008,000 9 9,991 -- -- -- 10,000
Net loss............... -- -- -- -- -- $(10,121) (10,121)
---------- --- ------- ------ ----- -------- --------
Balance at December 31,
1997................... 43,238,400 43 30,485 -- -- (10,121) 20,407
Unrealized gain on
securities............ -- -- -- -- $ 47 -- 47
Issuance of warrants to
purchase 1,487,791
shares of Common Stock
in connection with
Senior Notes (Note
5).................... -- -- -- $2,849 -- -- 2,849
Exercise of stock
options and Warrant... 3,386,445 4 4,232 -- -- -- 4,236
Net loss............... -- -- -- -- -- (57,830) (57,830)
---------- --- ------- ------ ----- -------- --------
Balance at December 31,
1998................... 46,624,845 $47 $34,717 $2,849 $ 47 $(67,951) $(30,291)
Net loss (unaudited)... -- -- -- -- -- (25,491) (25,491)
Unrealized loss on
securities
(unaudited)........... -- -- -- -- (242) -- (242)
Exercise of stock
options (unaudited)... 47,151 -- 99 -- -- -- 99
---------- --- ------- ------ ----- -------- --------
Balance at March 31,
1999 (unaudited)....... 46,671,996 $47 $34,816 $2,849 $(195) $(93,442) $(55,925)
========== === ======= ====== ===== ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE>
SPLITROCK SERVICES, INC.
STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Period from
Inception (March Three Months Three Months
5, 1997) through Year Ended Ended Ended
December 31, 1997 December 31, 1998 March 31, 1998 March 31, 1999
----------------- ----------------- -------------- --------------
(Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Cash flows from
operating activities:
Net loss............... $(10,121) $(57,830) $(3,698) $(25,491)
Adjustments to
reconcile net loss to
net cash used by
operating activities:
Depreciation and
amortization.......... 3,500 13,850 2,820 4,635
Amortization of debt
discount and deferred
financing costs....... -- 467 -- 277
Changes in assets and
liabilities:
(Increase) decrease in
accounts receivable,
net................... (4,252) 1,047 (2,356) (929)
(Increase) decrease in
prepaid and other
current assets........ (221) (259) (91) 161
Increase (decrease) in
accounts payable and
accrued liabilities... 8,861 28,615 (1,549) (3,805)
Increase (decrease) in
accrued interest
payable............... -- 13,375 -- (6,900)
-------- -------- ------- --------
Net cash used in
operating activities.. (2,233) (735) (4,874) (32,052)
-------- -------- ------- --------
Cash flows from
investing activities:
Purchase of equipment.. (16,969) (45,261) (2,508) (15,292)
Increase in
unrestricted
investments........... -- (119,462) -- --
Use of unrestricted
investments........... -- -- -- 32,664
Use of restricted
investments........... -- -- (232) 13,897
Reinvestment of
interest earned on
unrestricted
investments........... -- (966) -- --
Reinvestment of
interest earned on
restricted
investments........... -- (1,725) -- --
Increase in other
assets................ (229) (2,098) -- (1,504)
-------- -------- ------- --------
Net cash used by
investing activities.. (17,198) (169,512) (2,740) 29,765
-------- -------- ------- --------
Cash flows from
financing activities:
Proceeds from senior
notes payable and
warrants issued....... -- 261,000 -- --
Proceeds from notes
payable to
stockholder........... 11,750 10,000 5,000 --
Repayments of notes
payable to
stockholder........... (750) (11,000) -- --
Proceeds from notes
payable............... -- 1,477 -- --
Repayments of notes
payable............... -- (1,477) -- --
Financing costs
incurred.............. -- (9,501) -- --
Restriction of cash
under senior note
agreement............. -- (56,752) -- --
Sale of common stock
and exercise of stock
options and warrant... 20,528 4,236 -- 99
Proceeds from sale-
leaseback of
equipment............. 1,152 960 -- --
Principal payments on
capital lease
obligations........... (2,067) (11,548) (5,219) (2,777)
Restriction of cash
under credit
agreement............. (3,472) 3,472 3,472 --
-------- -------- ------- --------
Net cash provided by
financing activities.. 27,141 190,867 3,253 (2,678)
-------- -------- ------- --------
Increase (decrease) in
cash and cash
equivalents............ 7,710 20,620 (4,361) (4,965)
Cash and cash
equivalents:
Beginning of period.... -- 7,710 7,710 28,330
-------- -------- ------- --------
End of period.......... $ 7,710 $ 28,330 $ 3,349 $ 23,365
======== ======== ======= ========
Supplemental cash flow
information:
Cash paid for
interest.............. $ 235 $ 1,536 $ 316 $ 14,816
======== ======== ======= ========
Approximately $18,400
of the increase in
accounts payable and
accrued liabilities at
December 31, 1998, was
related to equipment
purchases.............
Noncash investing and
financing activities:
Assumption of capital
lease obligations and
other liabilities
(Note 2).............. $ 5,900 $ -- $ -- $ --
======== ======== ======= ========
Capital lease
obligations incurred.. $ 20,916 $ 4,792 $ 2,314 $ --
======== ======== ======= ========
Conversion of note
payable to stockholder
into common stock..... $ 10,000 $ -- $ -- $ --
======== ======== ======= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS
(amounts in thousands, except share and per share amounts)
1. Organization and Summary of Significant Accounting Policies
Splitrock Services, Inc. (the "Company") was formed on March 5, 1997 as a
Texas corporation and was reincorporated in Delaware on May 8, 1998. The
Company was formed to build a nationwide, facilities-based telecommunications
network with the goal of providing telecommunications services. The Company has
designed and is in the process of deploying a network based on Asynchronous
Transfer Mode ("ATM") switching technology which it believes will provide high-
quality communications services on a flexible multi-service platform. On June
24, 1997, the Company entered into a four-year service agreement to provide
Internet dial access services to Prodigy (Note 2).
During 1997, the Company began building its "ATM-to-the-Edge"(TM) network.
The Company expects to have approximately 370 points of presence operational in
the United States upon completion of its network build in mid-1999. This
network is currently supported by two network operating centers equipped with
state-of-the-art network management systems. In July 1998 the Company issued
Senior Notes (Note 5) in order to finance the expansion of the network. Upon
completion of the network build, the Company expects to offer value-added data,
video and voice products to business customers.
Interim Financial Information. The accompanying unaudited interim condensed
financial statements, as of March 31, 1999, and for the three months ended
March 31, 1999 and 1998, reflect all adjustments (consisting of normal
recurring adjustments) which, in the opinion of management, are necessary for a
fair presentation of the results for the interim periods presented.
Accordingly, they do not include all information and notes required by
generally accepted accounting principles for complete financial statements. The
results for the interim period ended March 31, 1999, are not necessarily
indicative of results to be expected for the entire year ending December 31,
1999, or future operating results. Certain amounts previously reported have
been reclassified in order to ensure comparability among the periods reported.
The following is a summary of the Company's significant accounting policies:
Use of Estimates. The preparation of the Company's financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, as well as disclosures of contingent assets
and liabilities. Because of inherent uncertainties in this process, actual
future results could differ from those expected at the reporting date.
Management believes the estimates are reasonable.
Cash and Cash Equivalents and Investments. The Company considers highly
liquid investments with an original maturity of three months or less from the
date of purchase to be classified as cash and cash equivalents. Cash and cash
equivalents are stated at cost, which approximates fair value.
Short-term investments have original maturities of more than three months
and a remaining maturity of less than one year at the date of purchase. At
December 31, 1998, cash equivalents and short-term investments consisted
primarily of money market funds and securities of the highest grade. All short-
term investments have been classified as available for sale under the
provisions of Statement of Financial Accounting Standards No. ("SFAS") 115,
Accounting for Certain Investments in Debt and Equity Securities, and have
various maturity dates which do not exceed one year. Available for sale
securities are carried at fair value, with the unrealized gains and losses, net
of tax, reported as a separate component of stockholders' equity. The cost of
investments sold is determined on the specific identification or the first-in,
first-out method.
F-7
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The following is a summary of the investments classified as restricted and
unrestricted as of December 31, 1998:
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
<S> <C> <C> <C> <C>
Available for sale securities:
Money market funds.............. $ 23,557 $-- $ -- $ 23,557
Corporate notes................. 108,496 3 (80) 108,419
Municipal securities............ 12,061 -- (6) 12,055
U.S. Treasury notes............. 34,791 181 (51) 34,921
-------- ---- ----- --------
$178,905 $184 $(137) $178,952
======== ==== ===== ========
</TABLE>
The following is a summary of the investments classified as restricted and
unrestricted as of March 31, 1999 (unaudited):
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- --------
<S> <C> <C> <C> <C>
Available for sale securities:
Money market funds.............. $ 12,353 $ -- $ -- $ 12,353
Corporate notes................. 81,931 4,485 (4,626) 81,790
Municipal securities............ 6,000 -- (1) 5,999
U.S. Treasury notes............. 32,060 47 (100) 32,007
-------- ------ ------- --------
$132,344 $4,532 $(4,727) $132,149
======== ====== ======= ========
</TABLE>
The restricted investment at December 31, 1997 was a three-month time
deposit held as collateral on a letter of credit. In the first quarter of 1998,
the letter of credit was retired with the Company's exercise of its early
purchase option with regard to the related capital lease. The restricted
investments at December 31, 1998 and March 31, 1999, relate to funds held in
escrow to pay future semi-annual interest payments due under the terms of the
Senior Note obligation (Note 5).
Concentration of Credit Risk. Financial instruments which potentially
subject the Company to concentration of credit risk are primarily cash and cash
equivalents, investments and receivables. The Company's cash investment
policies limit investments to short-term, investment grade instruments with
quality financial institutions. The Company's revenues and its trade receivable
balances for the periods ended December 31, 1997 and 1998, were derived
primarily from services provided to Prodigy, the Company's major customer
during the periods. Any interruption of this relationship could adversely
affect the Company. Management believes that the risk of incurring material
losses related to credit risk is remote.
Fair Values of Financial Instruments. Due to the short-term nature of the
Company's financial instruments, management believes the carrying values of the
Company's assets, short-term liabilities and lease obligations approximate
their fair values. The fair value of the Company's Senior Notes (Note 5) at
December 31, 1998 and March 31, 1999, approximated $227,000 and $249,255,
respectively, based upon quoted market prices.
Property and Equipment. Property and equipment are stated at cost.
Depreciation and amortization of telecommunications network equipment,
including assets under capital leases, is provided when placed into service
using the straight-line method over the estimated useful lives of three years
from the date of installation. Shelters are depreciated using the straight-line
method over its estimated useful life of twenty
F-8
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
years. Software, furniture, fixtures and office equipment is depreciated using
the straight-line method over the useful lives of the assets, which range from
three to ten years. Equipment acquired from Prodigy is depreciated over its
estimated useful life of nine months to three years.
Other Assets. Other assets consist primarily of debt issuance costs, net of
accumulated amortization. Amortization is computed using the effective interest
rate method.
Long-Lived Assets. The Company reviews for the impairment of long-lived
assets whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. The carrying amount of a long-lived
asset is considered impaired when anticipated undiscounted cash flows expected
to result from the use of the asset and its eventual disposition are less than
its carrying amount. The Company believes that no material impairment exists at
December 31, 1998.
Income Taxes. Deferred tax assets and liabilities are determined based on
the temporary differences between the financial statement carrying amounts and
the tax bases of assets and liabilities using the enacted tax rates in effect
in the years in which the differences are expected to reverse. In estimating
future tax consequences, all expected future events are considered with the
exception of enacted changes in the tax law or rates.
Stock-Based Compensation. The Company has adopted SFAS No. 123, Accounting
for Stock-Based Compensation, for disclosure purposes. Under SFAS No. 123, the
Company measures compensation expense for its stock-based employee compensation
plan using the intrinsic value method prescribed in Accounting Principles Board
("APB") No. 25, Accounting for Stock Issued to Employees. The Company provides
disclosure of the effect on net loss as if the fair value-based method
prescribed in SFAS No. 123 has been applied in measuring compensation expense.
Revenue Recognition. The Company recognizes revenue when services are
provided and collectibility is deemed probable under its agreement with the
customer. Prodigy was the Company's only customer through December 31, 1997 and
the Company's major customer (99% of revenue) through December 31, 1998 and
March 31, 1999.
Legacy Network Costs. The Legacy Network refers to the operations related to
certain assets which the Company acquired from Prodigy on July 1, 1997 related
to Prodigy's existing network infrastructure, in order to provide services to
Prodigy while the Splitrock Network is being deployed (Note 2). These costs
contain all expenses incurred in connection with operating and decommissioning
of the Legacy Network. This includes facility fees, line charges for Prodigy
Legacy Network POPs, certain personnel costs, occupancy costs, equipment
maintenance costs and access fees for the IBM Global Services Network.
Comprehensive Income. Effective January 1, 1998, the Company adopted SFAS
No. 130, Reporting Comprehensive Income, as displayed in its Statements of
Operations for all periods presented. This SFAS establishes standards for
reporting and display of comprehensive income and its components. The Company's
comprehensive income is comprised of net loss and unrealized gains and losses
on available for sale securities.
Net Loss Per Share. Basic and diluted net loss per share have been computed
in accordance with SFAS No. 128, Earnings Per Share. SFAS No. 128 requires the
Company to report both basic earnings per share, which is based on the weighted
average number of common shares outstanding, and diluted earnings per share,
which is based on the weighted average number of common shares outstanding and
all dilutive potential common shares outstanding. At December 31, 1997, options
to acquire 1,058,440 shares of Common Stock at the weighted-average exercise
price of $1.12 and a warrant to purchase 2,815,000 shares of Common Stock at
$1.12 and at December 31, 1998, options to acquire 1,801,882 shares of Common
Stock at the weighted-average exercise price of $2.31 and warrants to acquire
1,487,791 shares of Common Stock at an exercise price
F-9
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
of $0.02 were not included in the computation of diluted earnings per share
because their effect is anti-dilutive. At March 31, 1998, options to acquire
1,320,517 shares of Common Stock at the weighted-average exercise price of
$1.12 and a warrant to acquire 2,815,000 shares of Common Stock at an exercise
price of $1.12 were not included in the computation of diluted earnings per
share because their effect is anti-dilutive. At March 31, 1999, options to
acquire 2,421,604 shares of Common Stock at the weighted average exercise price
of $4.03 and warrants to acquire 1,487,791 shares of Common Stock at an
exercise price of $0.02, were not included in the computation of diluted
earnings per share because their effect is anti-dilutive.
Segment Reporting. The Company conducts its business within one industry
segment. The Company presents its financial statements to reflect how the "key
operating decision maker" views the business and has made the appropriate
enterprise-wide disclosures in accordance with SFAS No. 131, Disclosures About
Segments of an Enterprise and Related Information.
New Accounting Pronouncements. In June 1998, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 133 Accounting for Derivative
Instruments and Hedging Activities, which is effective for fiscal years
beginning after June 15, 1999, and establishing accounting and reporting
standards for derivative instruments. The Company has historically not engaged
in derivative instrument activity. The adoption of this standard is not
expected to have a material effect on the Company's financial position or
results of operations.
In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use. This standard
requires that certain costs related to the development or purchase of internal-
use software be capitalized and amortized over the estimated useful life of the
software. This SOP also requires that costs related to the preliminary project
stage, data conversion and the post-implementation/operation stage of an
internal-use computer software development project be expensed as incurred. SOP
98-1 is effective for financial statements issued for fiscal years beginning
after December 15, 1998. The adoption of this Statement did not have a material
effect on the Company's financial position or results of operations.
2. Prodigy Transactions
On June 24, 1997, the Company entered a four-year Full Service Agreement
with Prodigy, in which the Company agreed to provide certain network services
to Prodigy from July 1, 1997 through June 30, 2001 for the lower of a price per
hour of usage or a price per subscriber as stipulated. Monthly minimum service
charges under this contract has increased from $3,500 to $4,000 and will
increase $4,500 July 1, 2000. Monthly maximum service charges are based on
average usage per subscriber and the number of subscribers. Prodigy may
terminate the Full Service Agreement without termination charges in an event of
default by the Company; such defaults include documented failures (without
cure) to meet certain network performance standards. The agreement also allows
Prodigy to terminate its arrangement with the Company at any time upon the
payment of a termination charge.
The Company also entered into a transition agreement with Prodigy in which
Prodigy agreed to provide certain network infrastructure support for the
Company for the period July 1, 1997 through December 31, 1997. The
infrastructure support included the services of selected Prodigy employees and
services provided under vendor arrangements related to the Prodigy network
infrastructure. The costs of these services and other reasonable and customary
charges incurred by Prodigy in connection with the continued operations of the
network during this transition period are included in Legacy Network costs. The
Company assumed no contractual liabilities of any services related to Prodigy's
existing network infrastructure as part of the transition agreement.
Also on June 24, 1997, the Company entered into a Definitive Agreement with
Prodigy pursuant to which the Company acquired selected data transmission
equipment from Prodigy. In consideration for the equipment, the Company assumed
approximately $5,900 in equipment lease obligations and other liabilities.
F-10
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
3. Property and Equipment
Property and equipment consisted of the following:
<TABLE>
<CAPTION>
December 31,
----------------- March 31,
1997 1998 1999
------- -------- -----------
(unaudited)
<S> <C> <C> <C>
Telecommunications network equipment and
shelters................................... $ 3,464 $ 43,275 $ 51,778
Software.................................... 94 2,186 2,682
Furniture, fixtures and office equipment.... -- 1,749 1,775
Telecommunications network equipment under
construction............................... 12,248 13,289 19,556
------- -------- --------
15,806 60,499 75,791
Less--accumulated depreciation.............. (103) (10,392) (13,007)
------- -------- --------
Purchased property and equipment, net..... 15,703 50,107 62,784
------- -------- --------
Leased telecommunications network
equipment.................................. 13,648 29,102 29,102
Leased office equipment..................... 388 1,496 1,496
Leased telecommunications network equipment
under construction......................... 12,162 -- --
------- -------- --------
26,198 30,598 30,598
Less--accumulated amortization.............. (3,397) (6,806) (8,549)
------- -------- --------
Leased property and equipment, net........ 22,801 23,792 22,049
------- -------- --------
Property and equipment, net................. $38,504 $ 73,899 $ 84,833
======= ======== ========
4. Accrued Liabilities
Accrued liabilities consisted of the following:
<CAPTION>
December 31,
----------------- March 31,
1997 1998 1999
------- -------- -----------
(unaudited)
<S> <C> <C> <C>
Telecommunications network equipment and
shelters................................... $ -- $ 9,900 $ 7,994
Access and transmission telecommunications
line costs (Note 7)........................ 41 3,172 4,307
Other....................................... 5,734 2,822 2,903
------- -------- --------
Accrued liabilities....................... $ 5,775 $ 15,894 $ 15,204
======= ======== ========
5. Indebtedness
The components of indebtedness are summarized as follows:
<CAPTION>
December 31,
----------------- March 31,
1997 1998 1999
------- -------- -----------
(unaudited)
<S> <C> <C> <C>
Senior Notes................................ $ -- $258,217 $258,257
Capital lease obligations................... 24,120 17,364 14,587
Note payable to stockholder................. 1,000 -- --
------- -------- --------
25,120 275,581 272,844
Less--current maturities.................... (11,010) (9,121) (9,051)
------- -------- --------
$14,110 $266,460 $263,793
======= ======== ========
</TABLE>
F-11
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
On July 24, 1998, the Company sold 261,000 units consisting of $261,000
principal amount of 11 3/4% Senior Notes due 2008 ("Senior Notes") and warrants
to purchase 1,487,791 shares of common stock ("the Senior Notes Offering").
Upon issuance, the Senior Notes were recorded in the Company's financial
statements net of a $2,849 discount. The discount was attributable to the
Company's estimate of the value of the warrants based on an independent third
party valuation. The discount is amortized as a component of interest expense
over the life of the Senior Notes using the effective interest rate method.
This amortization will result in an increase in the financial statement balance
of the Senior Notes to a $261,000 face value by 2008.
Upon the occurrence of a change of control (as defined in the Indenture for
the Senior Notes) the Company will be required to make an offer to repurchase
all Senior Notes properly tendered at a price equal to 101% of the principal
amount plus accrued and unpaid interest to the date of repurchase. The
indenture also provides for redemption of the Senior Notes at any time, in
whole or in part, on or after July 15, 2003 at a premium through July 15, 2005.
In addition, on or prior to July 15, 2001, the Company may redeem up to 35% of
the original aggregate principal amount of the Senior Notes at a premium with
the proceeds of one or more equity offerings.
The Senior Note indenture also restricts the Company's ability to incur
additional indebtedness, to create liens or other encumbrances, to make certain
payments, investments, loans and guarantees and to sell or otherwise dispose of
a substantial portion of assets to, or merge or consolidate with, an
unaffiliated entity.
In connection with the Senior Notes Offering, the Company repaid $1,477
outstanding under a credit facility and refinanced $11,000 of indebtedness owed
to Linsang Partners L.L.C. ("Linsang"), a stockholder of the Company. In
connection with the refinancing, Linsang acquired 11,000 units in the Senior
Notes Offering. The net proceeds to the Company, after the Senior Notes
Offering expenses and retirement and refinancing of debt, approximated
$239,000.
In November 1998, the Senior Notes were exchanged in an offering registered
under the Securities Act of 1933 for $261,000 in principal amount of Series B
Senior Notes, which have substantially the same terms as the Senior Notes,
except that there is no restriction on transferability.
Capital leases require payments on a monthly basis over periods ranging from
24 to 48 months, with implicit interest rates of 9% to 12%.
In December 1997, the Company borrowed $1,000 from Linsang. The unsecured
note had a stated rate of interest of 9.75% and provided for monthly interest
payments beginning February 1, 1998, with the principal due on demand after
December 31, 1998, and maturing December 31, 2002. During 1998, the Company
borrowed $10,000 from Linsang on terms substantially the same as the previous
note. The Linsang notes were refinanced in July 1998, in connection with the
Senior Notes Offering, as stated above.
6. Income Taxes
A provision for income taxes for the periods ended December 31, 1997 and
1998 has not been recognized as the Company had operating losses for both tax
and financial reporting purposes. Due to the uncertainty
surrounding the timing of realizing the benefits of its favorable tax
attributes in future tax returns, the Company has recorded a full valuation
allowance against its net deferred tax asset.
F-12
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Deferred tax assets (liabilities) consist of the following:
<TABLE>
<CAPTION>
December 31,
-----------------
1997 1998
------- --------
<S> <C> <C>
Net operating loss carryforward........................... $ 3,248 $ 22,465
Depreciation.............................................. 167 3,325
Other..................................................... 21 429
------- --------
Deferred tax assets..................................... 3,436 26,219
------- --------
Leases.................................................... -- (474)
------- --------
Deferred tax liabilities................................ -- (474)
------- --------
Net deferred tax assets................................... 3,436 25,745
Valuation allowance....................................... (3,436) (25,745)
------- --------
Net deferred tax assets................................... $ -- $ --
======= ========
</TABLE>
The Company's net operating loss carryforward totaled approximately $59,000
at December 31, 1998, of which approximately $9,500 expires in 2012 and the
remainder expires in 2013. Certain changes in ownership of the Company could
result in limitations on the Company's ability to utilize the losses.
7. Commitments and Contingencies
The Company leases office space, equipment facilities and equipment under
noncancelable operating and capital leases expiring through the year 2003. Rent
expense for noncancelable operating leases amounted to $218 in 1997 and $663 in
1998.
Future minimum payments by year and in the aggregate related to
noncancelable operating and capital leases at December 31, 1998 are:
<TABLE>
<CAPTION>
Capital Operating
Leases Leases Total
------- --------- -------
<S> <C> <C> <C>
1999............................................ $10,576 $1,049 $11,625
2000............................................ 7,101 903 8,004
2001............................................ 746 801 1,547
2002............................................ 37 422 459
2003............................................ -- 265 265
------- ------ -------
Total minimum lease payments.................. 18,460 $3,440 $21,900
====== =======
Less amount representing interest............. (1,096)
-------
Present value of minimum capital lease
payments....................................... $17,364
=======
</TABLE>
In March 1999, the Company signed a lease for sixty-nine thousand square
feet of additional office space, which the Company expects to be available for
occupancy in August 1999. In connection with this lease, the Company issued a
$850 letter of credit.
The Company leases telephone lines from competitive local exchange
suppliers, interexchange carriers and long distance telephone companies
primarily for access and transport purposes ("line costs"). These line costs
are leased under both cancelable and noncancelable operating leases over
periods ranging from month-to-month to five years and are included in Splitrock
network costs on the statement of operations. The Company has commitments to
certain of these telecommunication vendors to meet minimum usage volumes.
Additionally,
F-13
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
the Company is subject to cancellation penalties which could become applicable
upon termination of a number of these agreements. The cancellation penalties
typically require a payment of a percentage of the remaining amounts due under
the contract, depending on the year in which cancellation may occur.
Line costs included in the Splitrock network costs were $547 and $22,617
during the period from inception (March 5, 1997) to December 31, 1997 and the
year ended December 31, 1998, respectively. Line costs incurred during the
period from inception (March 5, 1997) to December 31, 1997 and the year ended
December 31, 1998, comprise a substantial portion of the Legacy network costs.
The Company is in the process of resolving certain issues related to the
collection and remittance of certain taxes. The Company believes resolution of
these issues will not have a material adverse effect on the Company's financial
condition or results of operations.
The Company had an outstanding letter of credit in the amount of $3,472 as
of December 31, 1997. This letter of credit was maintained as security for
performance under a certain capital lease obligation and was retired in the
first quarter of 1998 with the Company's exercise of its early purchase option
on the related capital lease.
The Company has an agreement with a telecommunication supplier to provide
certain installation services for the Company. The minimum amount of services
for which the Company is required to pay is approximately $1,300. As of
December 31, 1998, the Company has incurred approximately $700 of such amount
in connection with this agreement.
8. Equity Transactions
The Company effected a 100-for-1 stock split on June 3, 1997 and a 10-for-1
stock split on August 8, 1997. All share amounts included in these financial
statements have been adjusted to reflect the effect of the stock splits.
Warrants issued in connection with the Company's Senior Note Offering are
exercisable at $.02 per share at any time on or after July 26, 1999 through
July 15, 2008 for 1,487,791 shares of Common Stock.
9. Stock Options
The Company's 1997 Incentive Share Plan (the "Plan") provides that options
to purchase up to 11,260,000 shares of common stock may be granted to certain
directors, employees or consultants of the Company. Options under the Plan have
a term of ten years and are granted with an exercise price equivalent to
estimated fair market value at the date of grant which has been determined by
the Board of Directors for periodic intervals based upon actual issuances of
shares in exchange for cash, third party appraisals and significant events
effecting the value of the Company. Individual option grants vest over time,
based upon a schedule approved by the Board of Directors, which is generally
four years. All of the Company's common stock options vest automatically upon a
change in control of the Company, as defined in the Plan.
F-14
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The following summarizes the activity for the Plan:
<TABLE>
<CAPTION>
1997 1998 March 31, 1999
------------------ ------------------ ------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
--------- -------- --------- -------- --------- --------
(unaudited)
<S> <C> <C> <C> <C> <C> <C>
Options outstanding at
beginning of fiscal pe-
riod................... -- -- 1,058,440 $1.12 1,801,882 $2.31
Granted............... 1,058,440 $1.12 1,443,251 $2.97 675,882 $8.53
Exercised............. -- -- 571,445 $1.94 47,151 $1.92
Canceled.............. -- -- 128,364 $1.49 9,007 $5.95
--------- --------- ---------
Options outstanding at
end of period.......... 1,058,440 $1.12 1,801,882 $2.31 2,421,604 $4.03
</TABLE>
The following table summarizes information about the Company's stock options
outstanding at December 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
---------------------------------- ---------------------
Number Weighted- Number
Outstanding Average Weighted Exercisable Weighted
Range of At Remaining Average at Average
Exercise December 31, Contractual Exercise December 31, Exercise
Prices 1998 Life (Years) Price 1998 Price
-------- ------------ ------------ -------- ------------ --------
<S> <C> <C> <C> <C> <C>
$1.12.............. 1,193,842 8.71 $1.12 446,670 $1.12
$1.95.............. 197,050 9.37 $1.95 704 $1.95
$5.95.............. 410,990 9.75 $5.95 -- $ --
--------- -------
$1.12--$5.95....... 1,801,882 9.02 $2.31 447,374 $1.12
</TABLE>
In October 1996, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation," which allows the Company to account for its employee stock-based
compensation plans under APB No. 25 and the related interpretations. According
to APB No. 25, deferred compensation is recorded for stock-based compensation
grants based on the excess of the market value of the common stock on the
measurement date over the exercise price. The deferred compensation is
amortized over the vesting period of each unit of stock-based compensation
grant. If the exercise of the stock-based compensation grants is equal to the
market price of the Company's stock on the date of grant, no compensation
expense is recorded.
During the year ended December 31, 1998, the Company recognized compensation
expense of $46 for options granted at a discount from the then estimated fair
market value of the Company's Common Stock.
Had compensation cost for the Company's stock option plan been determined
based on the estimated fair market value at the grant date, consistent with the
provisions of SFAS No. 123, the Company's pro forma net loss would have been as
follows:
<TABLE>
<CAPTION>
Pro forma
Period from
Inception
(March 5,
1997) Pro forma
through Year ended
December 31, December 31,
1997 1998
------------ ------------
<S> <C> <C>
Net loss........................................... $(10,141) $(58,254)
Net loss per share--basic and diluted.............. (0.42) (1.31)
</TABLE>
F-15
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Options granted in 1997 and 1998 had weighted-average fair values of $0.14
and $1.78, respectively. For purposes of estimating the fair value of options
granted, the Company used no future dividends, used average U.S. government
security interest rates for its risk-free interest rates of 5.80% and 4.39%,
assumed no volatility and 70.5% volatility, and assumed expected life of the
options of five and four years in 1997 and 1998, respectively.
10. Related Party Transactions
The Company's chairman of the Board of Directors (the "Chairman") was also
the Vice Chairman and a director of Yurie Systems, Inc. ("Yurie"), a principal
supplier of the Company until its acquisition by Lucent Technologies. The
Company purchased from Yurie approximately $11,000 in equipment through
December 31, 1997 and approximately $1,400 during the year ended December 31,
1998.
The Company also retained Yurie to perform assembly services related to the
deployment of network equipment to the field during 1997. The Company incurred
approximately $1,500 for these services of which approximately $990 were
expensed in 1997. As of December 31, 1997 and 1998, the Company owed $1,461 and
$0 to Yurie, respectively.
Linsang, an affiliate of the Chairman, loaned $1,000 to the Company for the
purchase of certain network equipment in December 31, 1997. During 1998, the
affiliate made further advances of $10,000 under this agreement. The unsecured
notes had a stated rate of interest of 9.75% and provided for monthly interest
payments beginning February 1, 1998, with the principal due on demand after
December 31, 1998, and maturing December 31, 2002. The Notes were refinanced in
July 1998, in connection with the Senior Notes Offering (Note 5).
A director of the Company exercised an option to purchase 563,000 shares of
the Company Common Stock for $1,100 in June 1998.
In September 1997, Orient Star Holdings, a wholly-owned subsidiary of Carso
Global Telecom, S.A. de C.V. (the controlling stockholder of Prodigy),
purchased 11,260,000 shares of the Company for $1.12 per share and paid $0.1,
for a warrant to purchase an additional 2,815,000 shares of the Company through
September 18, 1998 for $1.12 per share. The warrants were exercised in
September 1998 (Note 8).
11. Subsequent Events (unaudited)
In April 1999, the Company entered into a cost sharing agreement with a
national telecommunications provider (the Provider). The agreement grants the
Company an exclusive indefeasible right of use (IRU) in 4 dark fibers in the
nationwide fiber optic communication system currently under construction by the
Provider with an option to acquire the indefeasible rights to use an additional
12 dark fibers. The Company made an initial payment of $11,200 to the Provider
and is required to make additional payments as dark fiber segments are
accepted, which is expected to occur from the end of 1999 through the first
quarter of 2001. The Company expects to incur approximately $150,000 in capital
expenditures over the next three years related to its current network fiber
optic deployment plans, including the electronic equipment necessary to operate
its fiber optic network. The Company does not currently expect to deploy all 16
dark fiber strands in the next two years. The Company may terminate the
agreement prior to October 31, 1999, under certain circumstances, but the
Company would forfeit up to 80% of its initial payment to the Provider if it
exercises that termination right.
12. Subsequent Event--Reverse Stock Split
All share and per share amounts included in these financial statements have
been retroactively adjusted to give effect to the 0.563-for-1 reverse stock
split of the Common Stock of the Company effected on July 12, 1999.
F-16
<PAGE>
GLOSSARY OF TERMS
Set forth below are definitions of some of the technical terms used in this
prospectus.
ATM.......................... Asynchronous Transfer Mode. A communications
standard that provides for information transfer
in the form of fixed-length cells of 53 bytes
each. The ATM format can be used to deliver
data, video and voice traffic at varying rates.
backbone..................... A centralized high-speed network that
interconnects smaller, independent networks.
bandwidth.................... The number of bits of information which can
move over a communications medium in a given
amount of time; the capacity of a
telecommunications circuit/network to carry
data, video and voice information. Typically
measured in Kbps and Mbps. Bandwidth from
public networks is typically available to
business and residential end-users in
increments from 56 Kbps to T-3.
competitive local exchange A category of telephone service provider that
carrier...................... offers services similar to the former monopoly
local telephone company and other types of
telecommunications.
dark fiber................... Fiber which does not have connected to it the
electronics required to transmit data on that
fiber.
DSL.......................... Digital Subscriber Line. A high-speed data
delivery technology that uses standard copper
wires and is the main broadband alternative to
cable modems.
DS-3 or T-3.................. A data communications line capable of
transmitting data at 45 Mbps
Ethernet..................... A local area network protocol which supports
data transfer rates of up to 10 Mbps.
Extranet..................... An Intranet expanded to include selected
business partners through secured links on the
Internet.
56k.......................... Equivalent to a single high-speed telephone
service line; capable of transmitting one voice
call or 56 Kbps of data. Currently in
widespread use by medium and large businesses
primarily for entry level high-speed data and
very low-speed video applications.
frame relay.................. A communications standard that is optimized for
efficient switching of variable-length data
packets.
host......................... A computer with direct access to the Internet.
incumbent local exchange The local carrier exchange that was the
carrier...................... monopoly carrier, prior to the opening of local
exchange services to competition.
Internet..................... An open global network of interconnected
commercial, educational and governmental
computer networks which utilize TCP/IP, a
common communications protocol.
Internet dial access.........
Communications circuit that is established by a
switched-circuit connection using the telephone
network.
G-1
<PAGE>
intranet.................... A TCP/IP based network and Web site which is
securely isolated from the Internet and serves
the internal needs of a company or institution.
IP.......................... Internet protocol. Network protocols that allow
computers with different architectures and
operating system software to communicate with
other computers on the Internet.
ISDN........................ Integrated Services Digital Network. A network
that provides digital, voice and data services
through a single medium.
Internet service Companies formed to provide access to the
providers................... Internet to consumers and business customers
via local networks.
interexchange carrier....... A telecommunications company that provides
telecommunications services between local
exchanges on an interstate or intrastate basis.
IRUs........................ Indefeasible rights of use in network bandwidth
capacity.
K or Kbps................... Kilobits per second. A measure of digital
information transmission rates. One kilobit
equals 1,000 bits of digital information.
Normally, 10 bits are used for each alpha-
numeric character.
local area network.......... A data communications network designed to
interconnect personal computers, workstations,
minicomputers, file servers and other
communications and computing devices within a
localized environment.
local exchange carrier...... A telecommunications company that provides
telecommunications services in a geographic
area in which calls generally are transmitted
without toll charges. Local exchange carriers
include both regional Bell operating companies
and competitive local exchange carriers.
Mbps........................ Megabits per second. A measure of digital
information transmission rates. One megabit
equals 1,000 kilobits.
modem....................... A device for transmitting information over an
analog communications channel such as a
telephone circuit.
network..................... A collection of distributed computers which
share data and information through inter-
connected lines of communication.
OC-3........................ A high capacity optical data communications
line capable of transmitting data at 155 Mbps.
OC-48....................... A high capacity optical data communications
line capable of transmitting data at 2488 Mbps.
peering..................... The commercial practice under which nationwide
Internet service providers exchange each
other's traffic, in most cases without the
payment of settlement charges.
POPs........................ Points-of-Presence. An interlinked group of
modems, routers and other computer equipment,
located in a particular city or metropolitan
area, that allows a nearby subscriber to access
the Internet through a local telephone call or
using a short-distance permanent data circuit.
G-2
<PAGE>
PRI.......................... Primary Rate Interface. ISDN interface to
primary rate access.
protocol..................... A formal description of message formats and the
rules two or more machines must follow in order
to communicate.
regional Bell operating One of the local exchange carriers created by
company...................... the divestiture of the local exchange business
by AT&T. These include BellSouth, Bell
Atlantic, Ameritech, US West, SBC, and PacTel.
route mile................... One mile of actual geographic length of the
high capacity telecommunications fiber route.
router....................... A device that receives and transmits data
packets between segments in a network or
different networks.
server....................... Software that allows a computer to offer a
service to another computer. Other computers
contact the server program by means of matching
client software. The term also refers to the
computer on which server software runs.
SS7.......................... Signaling System No. 7. The current(seventh)
version of the protocol used by switches to
establish a connection or call feature between
central offices.
T-1.......................... A data communications line capable of
transmitting data at 1.5 Mbps.
T-3 or DS-3.................. A data communications line capable of
transmitting data at 45 Mbps.
virtual private network...... A network providing secure transmission of IP
traffic through the Internet.
Web or World Wide Web........ A network of computer servers that uses a
special communications protocol to link
different servers throughout the Internet and
permits communication of graphics, video and
sound.
G-3
<PAGE>
(This page has been left blank intentionally)
<PAGE>
NEXT-GENERATION DATA COMMUNICATIONS COMPANY
[LOGO OF SPLITROCK APPEARS HERE]
<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Prospective investors may rely only on the information contained in this
prospectus. Neither Splitrock Services, Inc. nor any underwriter has authorized
anyone to provide prospective investors different or additional information.
This prospectus is not an offer to sell nor is it seeking an offer to buy these
securities in any jurisdiction where the offer or sale is not permitted. The
information contained in this prospectus is accurate only as of the date of
this prospectus, regardless of the time of delivery of this prospectus or of
any sale of these securities.
No action is being taken in any jurisdiction outside the United States to
permit a public offering of the common stock or possession or distribution of
this prospectus in any such jurisdiction. Persons who come into possession of
this prospectus in jurisdictions outside the United States are required to in-
form themselves about and to observe the restrictions of that jurisdiction re-
lated to this offering and the distribution of this prospectus.
----------------
TABLE OF CONTENTS
----------------
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary......................................................... 1
Risk Factors............................................................... 8
Use of Proceeds............................................................ 21
Dividend Policy............................................................ 21
Capitalization............................................................. 22
Dilution................................................................... 23
Selected Financial Data.................................................... 24
Management's Discussion and Analysis
of Financial Condition and Results
of Operations............................................................. 26
Business................................................................... 36
Management................................................................. 54
Certain Transactions....................................................... 61
Principal Stockholders..................................................... 62
Description of Long-Term Indebtedness...................................... 64
Description of Capital Stock............................................... 65
Shares Eligible for Future Sale............................................ 69
U.S. Federal Tax Considerations for
Non-U.S. Holders.......................................................... 70
Underwriting............................................................... 74
Legal Matters.............................................................. 76
Experts.................................................................... 77
Where You Can Find More Information........................................ 77
Index to Financial Statements.............................................. F-1
Glossary of Terms.......................................................... G-1
</TABLE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
[LOGO OF SPLITROCK APPEARS HERE]
10,700,000 Shares
Common Stock
----------------
PROSPECTUS
----------------
Bear, Stearns & Co. Inc.
Credit Suisse First Boston
Prudential Securities
, 1999
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
Item 13. Other Expenses of Issuance and Distribution.
The following table sets forth expenses and costs payable by Splitrock
(other than underwriting discounts and commissions) expected to be incurred in
connection with the issuance and distribution of the securities described in
this registration statement. All amounts are estimated except for the
Securities and Exchange Commission's registration fee and the National
Association of Securities Dealers' filing fee.
<TABLE>
<CAPTION>
Amount
----------
<S> <C>
Registration fee under Securities Act......................... $ 51,312
NASD filing fee............................................... 17,750
The Nasdaq National Market fees............................... 95,000
Legal fees and expenses....................................... 350,000
Accounting fees and expenses.................................. 150,000
Printing and engraving expenses............................... 280,000
Registrar and transfer agent fees............................. 10,000
Miscellaneous expenses........................................ 45,938
----------
Total......................................................... $1,000,000
==========
</TABLE>
Item 14. Indemnification of Directors and Officers.
Splitrock is incorporated under the laws of the State of Delaware. Section
145 of the General Corporation Law of the State of Delaware (Section 145)
provides that a Delaware corporation may indemnify any person who was or is a
party or is threatened to be made a party to any threatened, pending or
completed action, suit or proceeding, whether civil, criminal, administrative
or investigative, by reason of the fact that such person is or was an officer,
director, employee or agent of such corporation, or is or was serving at the
request of such corporation as a director, officer, employee or agent of
another corporation, partnership, joint venture, trust or enterprise, including
an employee benefit plan. The indemnity may include expenses, such as
attorneys' fees, as well as judgments, fines and amounts paid in settlement
actually and reasonably incurred by such person in connection with such action,
suit or proceeding. The termination of any action, suit, or proceeding by
judgment, order, settlement, conviction or upon a plea of nolo contendere or
its equivalent, shall not, of itself, create a presumption that the person did
not act in good faith and in a manner which he reasonably believed to be in or
not opposed to the best interests of the corporation, and, with respect to any
criminal action or proceeding, had reasonable cause to believe that his conduct
was unlawful. Section 145 also provides that to the extent that a director,
officer, employee or agent of the corporation has been successful on the merits
or otherwise in defense of any action, suit or proceeding referred to above, or
in defense of any claim, issue or matter therein, the corporation must
indemnify him against expenses, including attorneys' fees, actually and
reasonably incurred by him in connection therewith. Section 145 further
provides that any indemnification, unless ordered by a court, must be made only
as authorized in the specific case upon a determination that indemnification of
the director, officer, employee or agent is proper in the circumstances because
he has met the applicable standard of conduct set forth above. Section 145
further provides that a corporation may purchase and maintain liability
insurance covering such liability and expenses under the provisions described
in the preceding paragraphs. Splitrock maintains liability insurance covering
its directors and officers.
Section 102(b)(7) of the General Corporation Law of the State of Delaware
permits a Delaware corporation to include a provision in its Certificate of
Incorporation eliminating or limiting the personal liability of a director to
the corporation or its stockholders for monetary damages for breach of
fiduciary duty as a director, except (i) for any breach of the director's duty
of loyalty to the corporation or its stockholders, (ii) for
II-1
<PAGE>
acts or omissions not in good faith or which involve intentional misconduct or
a knowing violation of law,(iii) pursuant to Section 174 of the General
Corporation Law of the State of Delaware (providing for liability of directors
for unlawful payment of dividends or unlawful stock purchases or redemptions),
or (iv) for any transaction from which the director derived an improper
personal benefit. Article VI of Splitrock's Amended and Restated Certificate of
Incorporation eliminates liability of directors of Splitrock to Splitrock or
its shareholders for monetary damages for breach of fiduciary duty to the
extent permitted by Section 102(b)(7) of the General Corporation Law of the
State of Delaware.
Article VII of Splitrock's Amended and Restated Certificate of Incorporation
requires Splitrock to indemnify Splitrock's directors and officers to the
extent permitted under Section 145.
Article VII of Splitrock's Amended and Restated Certificate of Incorporation
also provides that Splitrock shall indemnify any person who was or is a party
or is threatened to be made a party to any threatened, pending, or completed
action, suit, or proceeding whether civil, criminal, administrative, or
investigative, by reason of the fact that he is or was a director or officer of
Splitrock, or is or was serving at the request of Splitrock as a director,
officer, employee or agent of another corporation, partnership, joint venture,
trust, or other enterprise, in accordance with provisions corresponding to
Section 145. Further, Splitrock's Bylaws provide that any person, other than an
officer or director, who was or is a party or is threatened to be made a party
to any threatened, pending, or completed action, suit or proceeding, whether
civil, criminal, administrative, or investigative, by reason of the fact that
he is or was an employee or agent of Splitrock, or was serving at the request
of Splitrock as a director, officer, employee or agent of another corporation,
partnership, joint venture, trust, or other enterprise, and who desires
indemnification shall make written application for such indemnification to the
Board of Directors for its determination that indemnification is appropriate,
and if so, to what extent.
Splitrock's Amended and Restated Certificate of Incorporation also provide
that Splitrock may indemnify, to the extent of the provisions set forth
therein, any person other than an officer or director who was or is a party or
is threatened to be made a party to any threatened, pending or completed
action, suit or proceeding, whether civil, criminal, administrative or
investigative, by reason of the fact that he is or was serving at the request
of Splitrock as a director, officer, employee or agent of another corporation,
partnership, joint venture, trust or other enterprise, if such person makes
written application for such indemnification to the Splitrock Board and the
Splitrock Board determines that indemnification is appropriate and the extent
thereof. Splitrock's Amended and Restated Certificate of Incorporation further
provide that the indemnification described therein is not exclusive, and shall
not exclude any other rights to which the person seeking to be indemnified may
be entitled under statute, any bylaw, agreement, vote of shareholders or
disinterested directors, or otherwise, both as to action in his official
capacity and to his action in another capacity while holding such office.
The above discussion of Section 145 and of Splitrock's Amended and Restated
Certificate of Incorporation and Amended and Restated Bylaws is not intended to
be exhaustive and is respectively qualified in its entirety by such statute,
the Amended and Restated Certificate of Incorporation and the Amended and
Restated Bylaws.
Splitrock intends to obtain primary and excess insurance policies insuring
its directors and officers against certain liabilities they may incur in their
capacity as directors and officers. Under such policies, the insurer, on behalf
of Splitrock, may also pay amounts for which Splitrock has granted
indemnification to the directors or officers.
Additionally, reference is made to the Underwriting Agreement filed as
Exhibit 1.1 hereto, which provides for indemnification by the Underwriters of
Splitrock, its directors and officers who sign the registration statement and
persons who control Splitrock, under certain circumstances.
Item 15. Recent Sales of Unregistered Securities.
Splitrock has issued securities in the following transactions, each of
which, unless otherwise indicated, was intended to be exempt from the
registration requirements of the Securities Act by virtue of Section 4(2) or
Regulation D thereunder.
II-2
<PAGE>
In March 1997, the Company issued shares to its founders, William R. Wilson
and Kwok L. Li, in the amounts of 600 and 400 shares of common stock,
respectively (337,800 and 225,200 shares following three subsequent stock
splits). In June of 1997 Mr. Wilson and Mr. Li were each granted additional
shares for services rendered in the amounts of 1,640,000 shares and 1,060,000
shares, respectively (9,233,200 and 5,967,800 on a post-split basis).
In August 1997, Linsang acquired 6,756,000 shares in a private transaction
for $7,500,000 and converted a $10,000,000 note into an additional 9,008,000
shares. In that same month, Roy Wilkens purchased 450,400 shares in a private
transaction for $500,000.
In September 1997, Orient Star acquired 11,260,000 shares and a warrant to
acquire an additional 2,815,000 shares exercisable on or before September 18,
1998 in a private transaction for $12,500,100.
In June 1998, Clark McLeod acquired 563,000 shares pursuant to the exercise
of an option issued in a private offering at an aggregate exercise price of
$1,100,000.
On July 24, 1998, the Company offered and sold 261,000 Units to a broker-
dealer, of which 250,000 Units were resold to "qualified institutional buyers"
(as defined in Rule 144A under the Securities Act) and 11,000 Units to Linsang,
a stockholder of the Company. Each Unit consisted of an 11 3/4% Senior Note due
2008 ("Senior Notes") in the principal amount of $1,000 and a Warrant to
purchase 5.7 shares of Common Stock of the Company. On August 12, 1998, the
Company filed an exchange offer registration statement offering to exchange a
substantially similar 11 3/4% Series B Senior Note due 2008 ("Series B Notes")
for each outstanding 11 3/4% Senior Note due 2008 held by a qualified
institutional buyer. In October 1998, Linsang exchanged its Senior Notes for
Series B Notes in a private offering.
From July 1997 through June 28, 1999, the Company granted options under its
1997 stock option plan to purchase an aggregate of 3,702,908 shares of Common
Stock at exercise prices ranging from $1.12 per share to $9.77 per share to
employees and officers and directors. The Company issued an aggregate of
628,027 shares of Common Stock pursuant to option exercises under the 1997 Plan
at exercise prices ranging from $1.12 to $1.95 per share through June 28, 1999.
In addition, each non-employee director as of April 1998 was granted an option
to purchase 45,040 common shares under the 1997 Incentive Share Plan, to vest
in installments of 11,260 shares per year beginning one year from the date of
grant, May 28, 1998, at an exercise price of $1.95 per share. On April 22,
1999, the Company granted each of the two new non-employee directors options to
purchase 45,040 shares of Common Stock pursuant to the 1997 stock option plan
at an exercise price of $9.77 per share. The options vest at a rate of 11,260
upon each anniversary of the grant date. The Company accelerated the vesting of
11,260 of Mr. Salameh's options on April 22, 1999 when his term as a director
expired; those options were scheduled to vest on May 28, 1999.
Item 16. Exhibits and Financial Statement Schedules.
a. The following documents are filed as exhibits to this registration
statement:
<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<C> <S>
1.1 Form of Underwriting Agreement. (3)
3.1 Restated Certificate of Incorporation of the Company.
3.2 Restated By-laws of the Company.
4.1 Form of certificate of common stock. (3)
4.2 Indenture dated as of July 24, 1998, by and between Bank of Montreal
Trust Company (as trustee) and the Company. (1)
4.3 Specimen 11 3/4% Series B Senior Note due 2008. (1)
4.4 Escrow and Disbursement Agreement dated as of July 24, 1998, among the
Chase Manhattan Bank (as escrow agent), the Bank of Montreal Trust
Company, and the Company. (1)
</TABLE>
II-3
<PAGE>
<TABLE>
<C> <S>
4.5 Exchange and Registration Rights Agreement dated as of July 24, 1998, by
and between Chase Securities, Inc. and the Company. (1)
4.6 Warrant Agreement dated as of July 29, 1998, by and between the Company
and Bank of Montreal Trust Company. (1)
5.1 Opinion of Fried, Frank, Harris, Shriver & Jacobson. (3)
10.1 Purchase Agreement dated as of July 21, 1998, by and between the Company
and Chase Securities, Inc. (1)
10.2 Plan of Merger dated as of May 7, 1998, by and between Splitrock
Services, Inc. (a Texas Corporation) and Splitrock Services, Inc. (a
Delaware Corporation). (1)
10.3 Splitrock Full Service Agreement dated as of June 24, 1997, by and
between the Company and Prodigy Services Corporation (certain portions
omitted based on grant of confidential treatment and filed separately
with the Commission). (1)
10.4 Amendment to Full Service Agreement between the Company and Prodigy
Communications Corporation dated May 18, 1999. (2) (4)
10.5 Definitive Agreement dated as of June 24, 1997, by and between Prodigy
Services Corporation and the Company. (1)
10.6 Transition Services Agreement dated as of June 24, 1997, by and between
Prodigy Services Corporation and the Company. (1)
10.7 Network Implementation Agreement effective as of April 23, 1998, by and
between the Company and Ericsson, Inc. (1)
10.8 Purchase Agreement effective July 1, 1997, by and between the Company
and Yurie Systems, Inc.(1)
10.9 Customer Service Agreement effective April 1, 1998, by and between the
Company and International Business Machines Corporation ("IBM"). (1)
10.10 IBM Customer Agreement effective April 1, 1998, by and between the
Company and IBM. (1)
10.11 Product Support Services Agreement dated February 27, 1998, together
with Addendum effective March 1, 1998. (1)
10.12 Splitrock Services, Inc. 1997 Incentive Share Plan. (1)
10.13 Employment Agreement effective March 15, 1997, between William R. Wilson
and the Company. (1)
10.14 Employment Agreement effective September 1, 1998, between Patrick J.
McGettigan, Jr. and the Company. (1)
10.15 Employment Contract, effective March 1, 1999, between the Company and
David M. Boatner. (2)
10.16 Employment Contract, effective March 22, 1999, between the Company and
J. Robert Fugate. (2)
10.17 Cost Sharing National IRU Agreement effective April 26, 1999 by and
between Level 3 Communications, LLC and the Company. (2) (4)
10.18 First Amendment to Cost Sharing National IRU Agreement by and between
Level 3 Communications, LLC and the Company. (2) (4)
23.1 Consent of PricewaterhouseCoopers LLP.
23.2 Consent of Fried, Frank, Harris, Shriver & Jacobson (included in Exhibit
5.1 above). (3)
24.1 Power of Attorney. (2)
27.1 Financial data schedule (2)
99.1 Schedule II: Valuation and Qualifying Accounts (2)
99.2 Report of Independent Accountants on Financial Statement Schedule (2)
</TABLE>
- --------
(1) Incorporated by reference to our Registration Statement on Form S-4, File
No. 333-61293.
(2) Previously filed.
(3) To be filed by amendment.
(4) Portions of this exhibit have been redacted and are subject to a request
for confidential treatment that has been or will be filed with the
Securities and Exchange Commission.
II-4
<PAGE>
Item 17. Undertakings.
The undersigned registrant hereby undertakes that, for purposes of
determining any liability under the Securities Act, each filing of the
registrant's annual reports pursuant to section 13(a) or section 15(d) of the
Securities Exchange Act of 1934 (and, where applicable, each filing of an
employee benefit plan's annual report pursuant to section 15(d) of the
Securities Exchange Act of 1934) that is incorporated by reference in the
registration statement shall be deemed to be a new registration statement
relating to the securities offered therein, and the offering of such securities
at that time shall be deemed to be the initial bona fide offering thereof.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
registrant pursuant to the foregoing provisions, or otherwise, the registrant
has been advised that in the opinion of the Securities and Exchange Commission
such indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable. In the event that a claim for indemnification against
such liabilities (other than payment by the registrant of expenses incurred or
paid by a director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted by such
director, officer or controlling person in connection with the securities being
registered, the registrant will, unless in the opinion of its counsel the
matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Act and will be governed by the final
adjudication of such issue.
The undersigned registrant hereby undertakes that:
(1) To provide to the Underwriters at the closing specified in the
underwriting agreement certificates in such denominations and
registered in such names as required by the Underwriters to permit
proper delivery to each purchaser.
(2) For purposes of determining any liability under the Securities Act, the
information omitted from the form of prospectus filed as part of this
registration statement in reliance upon Rule 430A and contained in a
form of prospectus filed by the registrant pursuant to Rule 424b(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of
this registration statement as of the time it was declared effective.
(3) For purposes of determining any liability under the Securities Act,
each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall
be deemed to be the initial bona fide offering thereof.
II-5
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
has duly caused this amendment to the registration statement to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of The
Woodlands, State of Texas, on July 19, 1999.
SPLITROCK SERVICES, INC.
By:/s/ William R. Wilson
---------------------------------
William R. Wilson
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Act, this registration
statement has been signed by the following persons in the capacities and on the
dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
* Chairman of the Board of Directors and
- --------------------------------- Chief Technical Officer
Kwok L. Li July 19, 1999
President, Chief Executive Officer and
Director (Principal Executive Officer)
/s/ William R. Wilson
- --------------------------------- July 19, 1999
William R. Wilson
Executive Vice President and
* Chief Financial Officer (Principal
- ---------------------------------
J. Robert Fugate Financial and Accounting Officer) July 19, 1999
*
- ---------------------------------
James M. Nakfoor Director July 19, 1999
*
- ---------------------------------
Marshall C. Turner Director July 19, 1999
*
- ---------------------------------
Roy A. Wilkens Director July 19, 1999
*By: /s/ William R. Wilson
- ---------------------------------
William R. Wilson Attorney-in-fact July 19, 1999
</TABLE>
II-6
<PAGE>
Index to Exhibits
<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<C> <S>
1.1 Form of Underwriting Agreement. (3)
3.1 Restated Certificate of Incorporation of the Company.
3.2 Restated By-laws of the Company. (2)
4.1 Form of certificate of common stock. (3)
4.2 Indenture dated as of July 24, 1998, by and between Bank of Montreal
Trust Company (as trustee) and the Company. (1)
4.3 Specimen 11 3/4% Series B Senior Note due 2008. (1)
4.4 Escrow and Disbursement Agreement dated as of July 24, 1998, among the
Chase Manhattan Bank (as escrow agent), the Bank of Montreal Trust
Company, and the Company. (1)
4.5 Exchange and Registration Rights Agreement dated as of July 24, 1998,
by and between Chase Securities, Inc. and the Company. (1)
4.6 Warrant Agreement dated as of July 29, 1998, by and between the
Company and Bank of Montreal Trust Company. (1)
5.1 Opinion of Fried, Frank, Harris, Shriver & Jacobson. (3)
10.1 Purchase Agreement dated as of July 21, 1998, by and between the
Company and Chase Securities, Inc. (1)
10.2 Plan of Merger dated as of May 7, 1998, by and between Splitrock
Services, Inc. (a Texas Corporation) and Splitrock Services, Inc. (a
Delaware Corporation). (1)
10.3 Splitrock Full Service Agreement dated as of June 24, 1997, by and
between the Company and Prodigy Services Corporation (certain portions
omitted based on grant of confidential treatment and filed separately
with the Commission). (1)
10.4 Amendment to Full Service Agreement between the Company and Prodigy
Communications Corporation dated May 18, 1999. (2) (4)
10.5 Definitive Agreement dated as of June 24, 1997, by and between Prodigy
Services Corporation and the Company. (1)
10.6 Transition Services Agreement dated as of June 24, 1997, by and
between Prodigy Services Corporation and the Company. (1)
10.7 Network Implementation Agreement effective as of April 23, 1998, by
and between the Company and Ericsson, Inc. (1)
10.8 Purchase Agreement effective July 1, 1997, by and between the Company
and Yurie Systems, Inc. (1)
10.9 Customer Service Agreement effective April 1, 1998, by and between the
Company and International Business Machines Corporation ("IBM"). (1)
10.10 IBM Customer Agreement effective April 1, 1998, by and between the
Company and IBM. (1)
10.11 Product Support Services Agreement dated February 27, 1998, together
with Addendum effective March 1, 1998. (1)
10.12 Splitrock Services, Inc. 1997 Incentive Share Plan. (1)
10.13 Employment Agreement effective March 15, 1997, between William R.
Wilson and the Company. (1)
10.14 Employment Agreement effective September 1, 1998, between Patrick J.
McGettigan, Jr. and the Company. (1)
10.15 Employment Contract, effective March 1, 1999, between the Company and
David M. Boatner. (2)
10.16 Employment Contract, effective March 22, 1999, between the Company and
J. Robert Fugate. (2)
10.17 Cost Sharing National IRU Agreement effective April 26, 1999 by and
between Level 3 Communications, LLC and the Company. (2) (4)
10.18 First Amendment to Cost Sharing National IRU Agreement by and between
Level 3 Communications, LLC and the Company. (2) (4)
23.1 Consent of PricewaterhouseCoopers LLP.
23.2 Consent of Fried, Frank, Harris, Shriver & Jacobson (included in
Exhibit 5.1 above). (3)
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<C> <S>
24.1 Power of Attorney. (2)
27.1 Financial data schedule. (2)
99.1 Schedule II: Valuation and Qualifying Accounts. (2)
99.2 Report of Independent Accountants on Financial Statement Schedule. (2)
</TABLE>
- --------
(1) Incorporated by reference to our Registration Statement on Form S-4, File
No. 333-61293.
(2) Previously filed.
(3) To be filed by amendment.
(4) Portions of this exhibit have been redacted and are subject to a request
for confidential treatment that has been or will be filed with the
Securities and Exchange Commission.
<PAGE>
Exhibit 3.1
RESTATED
CERTIFICATE OF INCORPORATION
OF
SPLITROCK SERVICES, INC.
Splitrock Services, Inc., a Delaware corporation, the original certificate
of incorporation of which was filed with the secretary of State of the State of
Delaware on April 15, 1998 under the name Splitrock Services, Inc., HEREBY
CERTIFIES that this Restated Certificate of Incorporation, restating,
integrating and amending its Certificate of Incorporation, was duly adopted by
its Board of Directors and its stockholders in accordance with Sections 228, 242
and 245 of the Delaware General Corporation Law (the "DGCL"). The Certificate
of Incorporation of Splitrock Services, Inc., is hereby amended and restated in
its entirety to read as follows:
ARTICLE I
NAME
The name of the Corporation is Splitrock Services, Inc. (the
"Corporation").
ARTICLE II
REGISTERED OFFICE AND AGENT
The address of the Corporation's registered office in the State of Delaware
is 9 East Loockerman Street, City of Dover, Kent County, Delaware 19901. The
name of its registered agent at such address is Capitol Services, Inc.
ARTICLE III
PURPOSE
The purpose of the Corporation is to engage in any lawful act or activity
for which corporations may be organized under the DGCL.
ARTICLE IV
CAPITAL STOCK
(A) General.
-------
(1) Authorized Stock. The total number of shares of all classes of
----------------
capital stock which the Corporation shall have authority to issue is one hundred
seventy-five million (175,000,000) shares, of which:
(i) one hundred fifty million (150,000,000) shares, par value $.001
per share, shall be shares of common stock (the "Common Stock"); and
<PAGE>
(ii) twenty-five million (25,000,000) shares, par value $.001 per
share, shall be shares of preferred stock (the "Preferred Stock").
(2) Reclassification. Immediately upon the effectiveness of this
-----------------
Restated Certificate of Incorporation (the "Effective Date"), each one (1) share
of the Corporation's common stock, par value $0.001 per share, issued and
outstanding immediately prior to the Effective Date (the "Old Common Stock"),
shall automatically and without any action on the part of the holder thereof be
reclassified and changed into 0.563 of a share of the Corporation's Common
Stock, subject to the treatment of fractional share interests as described
below. Each holder of a certificate or certificates, which immediately prior to
the Effective Date represented outstanding shares of Old Common Stock (the "Old
Certificates," whether one or more), shall be entitled to receive, upon
surrender of such Old Certificates to the Corporation for cancellation, a
certificate or certificates (the "New Certificates," whether one or more)
representing the number of whole shares of Common Stock into which and for which
the shares of the Old Common Stock formerly represented by such Old Certificates
so surrendered are reclassified under the terms hereof. From and after the
Effective Date, Old Certificates shall represent only (i) the number of shares
of Common Stock into which the shares of Old Common Stock represented thereby
were reclassified and (ii) the right to receive New Certificates pursuant to the
provisions hereof. No certificates or scrip representing fractional share
interests in New Common Stock will be issued, and no such fractional share
interest will entitle the holder thereof to vote, or to any rights of a
shareholder of the Corporation. In lieu of any fractional shares, each holder
who would otherwise be entitled to a fractional share shall be entitled to
receive an amount in cash, without interest, equal to such fraction multiplied
by the fair market value of the Common Stock as determined by the Corporation's
board of directors. If more than one Old Certificate shall be surrendered for
the account of the same stockholder, the number of full shares of Common Stock
for which New Certificates shall be issued shall be computed on the basis of the
aggregate number of shares represented by the Old Certificates so surrendered.
If any New Certificate is to be issued in a name other than that in which the
Old Certificates surrendered for exchange are issued, the Old Certificates so
surrendered shall be properly endorsed and otherwise in proper form for
transfer, and the person or persons requesting such exchange shall affix any
requisite stock transfer tax stamps to the Old Certificates surrendered, or
provide funds for their purchase, or establish to the satisfaction of the
Corporation that such taxes are not payable.
(B) Common Stock. Except as (1) otherwise required by law or (2) expressly
------------
provided in this Restated Certificate of Incorporation (as amended from time to
time), each share of Common Stock shall have the same powers, rights and
privileges and shall rank equally, share ratably and be identical in all
respects as to all matters.
(1) Dividends. Subject to the rights of the holders of Preferred
---------
Stock and to the other provisions of this Restated Certificate of Incorporation
(as amended from time to time), holders of Common Stock shall be entitled to
receive equally, on a per share basis, such dividends and other distributions in
cash, securities or other property of the Corporation as may be declared thereon
by the Board of Directors from time to time out of assets or funds of the
Corporation legally available therefore.
-2-
<PAGE>
(2) Voting Rights. At every annual or special meeting of stockholders
-------------
of the Corporation, each holder of Common Stock shall be entitled to cast one
(1) vote for each share of Common Stock standing in such holder's name on the
stock transfer records of the Corporation.
(3) Liquidation Rights. In the event of any liquidation, dissolution or
------------------
winding up of the affairs of the Corporation, whether voluntary or involuntary,
after payment or provision for payment of the Corporation's debts and amounts
payable upon shares of Preferred Stock entitled to a preference, if any, over
holders of Common Stock upon such dissolution, liquidation or winding up, the
remaining net assets of the Corporation shall be distributed among holders of
shares of Common Stock equally on a per share basis. A merger or consolidation
of the Corporation with or into any other corporation or other entity, or a sale
or conveyance of all or any part of the assets of the Corporation (which shall
not in fact result in the liquidation of the Corporation and the distribution of
assets to its stockholders) shall not be deemed to be a voluntary or involuntary
liquidation or dissolution or winding up of the Corporation within the meaning
of this Paragraph (B)(3).
(C) Preferred Stock. The Board of Directors is authorized, subject to
---------------
limitations prescribed by law, to provide by resolution or resolutions for the
issuance of shares of Preferred Stock in one or more series, to establish the
number of shares to be included in each such series, and to fix the voting
powers (if any), designations, powers, preferences, and relative, participating,
optional or other rights, if any, of the shares of each such series, and any
qualifications, limitations or restrictions thereof. Irrespective of the
provisions of Section 242(b)(2) of the DGCL, the number of authorized shares of
Preferred Stock may be increased or decreased (but not below the number of
shares thereof then outstanding) by the affirmative vote of the holders of a
majority in voting power of the stock of the Corporation entitled to vote,
without the separate vote of the holders of the Preferred Stock as a class.
ARTICLE V
BOARD OF DIRECTORS
(A) Management. The business and affairs of the Corporation shall be
----------
managed by or under the direction of the Board of Directors. The Board of
Directors may exercise all such authority and powers of the Corporation and do
all such lawful acts and things as are not by statute or this Restated
Certificate of Incorporation directed or required to be exercised or done by the
stockholders.
(B) Number of Directors. The number of directors of the Corporation shall
-------------------
be fixed from time to time by, or in the manner provided in, the Bylaws;
provided, however, that the number of directors shall not be fewer than three
(3).
(C) Classes and Terms of Directors. The directors shall be divided into
------------------------------
three classes (I, II and III), as nearly equal in number as possible, and no
class shall include less than one director. The initial term of office for
members of Class II shall expire at the annual meeting of stockholders in 2000;
the initial term of office for members of Class III shall expire at the annual
meeting of stockholders in 2001; and the initial term of office for members of
Class I shall expire at the annual meeting of stockholders in 2002. At each
annual meeting of stockholders
-3-
<PAGE>
following such initial classification and election, directors elected to
succeed those directors whose terms expire shall be elected for a term of office
to expire at the third succeeding annual meeting of stockholders after their
election, and shall continue to hold office until their respective successors
are elected and qualified. In the event of any increase in the number of
directors fixed by the Board of Directors, the additional directors shall be
classified so that all classes of directors have as nearly equal numbers of
directors as may be possible. In the event of any decrease in the number of
directors, all classes of directors shall be decreased equally as nearly as may
be possible.
(D) Newly-Created Directorships and Vacancies. Subject to the rights of
-----------------------------------------
the holders of any class of Common Stock or series of Preferred Stock then
outstanding, newly created directorships resulting from any increase in the
number of directors or any vacancies in the Board of Directors resulting from
death, resignation, retirement, disqualification, removal from office or any
other cause may be filled by the Board of Directors, provided that a quorum is
then in office and present, or by a majority of the directors then in office, if
less than a quorum is then in office, or by the sole remaining director.
Directors elected to fill a newly created directorship or other vacancies shall
hold office for the remainder of the full term of the class of directors in
which the new directorship was created or the vacancy occurred and until such
director's successor has been elected and has qualified.
(E) Removal of Directors. Subject to the rights of the holders of any
--------------------
series of Preferred Stock then outstanding, any director may be removed from
office at any time, with or without cause, at a meeting called for that purpose,
and only by the affirmative vote of the holders of at least a majority of the
voting power of all shares of Common Stock entitled to vote generally in the
election of directors, voting together as a single class.
(F) Rights of Holders of Preferred Stock. Notwithstanding the foregoing
------------------------------------
provisions of this Article V, whenever the holders of one or more series of
Preferred Stock issued by the Corporation shall have the right, voting
separately or together by series, to elect directors at an annual or special
meeting of stockholders, the election, term of office, filling of vacancies and
other features of such directorship shall be governed by the rights of such
Preferred Stock as set forth in the certificate of designations governing such
series.
(G) Written Ballot Not Required. Elections of directors need not be by
---------------------------
written ballot unless the By-laws of the Corporation shall otherwise provide.
(H) By-laws. The Board of Directors is expressly authorized to adopt,
-------
amend or repeal the by-laws of the Corporation. Any by-laws made by the
directors under the powers conferred hereby may be amended or repealed by the
directors or by the stockholders. Notwithstanding the foregoing and anything
contained in this Restated Certificate of Incorporation to the contrary, the by-
laws of the Corporation shall not be amended or repealed by the stockholders,
and no provision inconsistent therewith shall be adopted by the stockholders,
without the affirmative vote of the holders of 66-2/3% of the voting power of
all shares of the Corporation entitled to vote generally in the election of
directors, voting together as a single class.
-4-
<PAGE>
ARTICLE VI
LIMITATION OF LIABILITY
A director of the Corporation shall not be personally liable to the
Corporation or its stockholders for monetary damages for breach of fiduciary
duty as a director; provided, however, that the foregoing shall not eliminate or
limit the liability of a director (i) for any breach of the director's duty of
loyalty to the Corporation or its stockholders, (ii) for acts or omissions not
in good faith or which involve intentional misconduct or a knowing violation of
law, (iii) under Section 174 of the DGCL, or (iv) for any transaction from which
the director derived an improper personal benefit. If the DGCL is hereafter
amended to permit further elimination or limitation of the personal liability of
directors, then the liability of a director of the Corporation shall be
eliminated or limited to the fullest extent permitted by the DGCL as so amended.
Any repeal or modification of this Article VI by the stockholders of the
Corporation or otherwise shall not adversely affect any right or protection of a
director of the Corporation existing at the time of such repeal or modification.
ARTICLE VII
INDEMNIFICATION
Each person who was or is made a party or is threatened to be made a party
to or is involved (including, without limitation, as a witness) in any actual or
threatened action, suit or proceeding, whether civil, criminal, administrative
or investigative (hereinafter a "proceeding"), by reason of the fact that he is
or was a director or officer of the Corporation or is or was serving at the
request of the Corporation as a director, officer, agent or employee of another
corporation or of a partnership, limited liability company, joint venture, trust
or other enterprise, including service with respect to an employee benefit plan
(hereinafter an "Indemnitee"), whether the basis of such proceeding is alleged
action in an official capacity as a director or officer or in any other capacity
while so serving, shall be indemnified and held harmless by the Corporation to
the full extent authorized by the DGCL, as the same exists or may hereafter be
amended (but, in the case of any such amendment, only to the extent that such
amendment permits the Corporation to provide broader indemnification rights than
said law permitted the Corporation to provide prior to such amendment), or by
other applicable law as then in effect, against all expense, liability and loss
(including attorneys' fees and related disbursements, judgments, fines, excise
taxes or penalties under the Employee Retirement Income Security Act of 1974, as
amended from time to time ("ERISA"), penalties and amounts paid or to be paid in
settlement) actually and reasonably incurred or suffered by such Indemnitee in
connection therewith, and such indemnification shall continue as to a person who
has ceased to be a director, officer, partner, member or trustee and shall inure
to the benefit of his or her heirs, executors and administrators. Each person
who is or was serving as a director or officer of a subsidiary of the
Corporation shall be deemed to be serving, or have served, at the request of the
Corporation.
(A) Procedure. Any indemnification (but not advancement of expenses) under
---------
this Article VII (unless ordered by a court) shall be made by the Corporation
only as authorized in the specific case upon a determination that
indemnification of the director or officer is proper in the circumstances
because he has met the applicable standard of conduct set forth in the DGCL, as
the same exists or hereafter may be amended (but, in the case of any such
amendment, only to the extent that such amendment permits the Corporation to
provide broader indemnification
-5-
<PAGE>
rights than said law permitted the Corporation to provide prior to such
amendment). Such determination shall be made with respect to a person who is a
director or officer at the time of such determination (a) by a majority vote of
the directors who were not parties to such proceeding (the "Disinterested
Directors"), even though less than a quorum, (b) by a committee of Disinterested
Directors designated by a majority vote of Disinterested Directors, even though
less than a quorum, (c) if there are no such Disinterested Directors, or if such
Disinterested Directors so direct, by independent legal counsel in a written
opinion, or (d) by the stockholders.
(B) Advances for Expenses. Expenses (including attorneys' fees, costs and
---------------------
charges) incurred by a director or officer of the Corporation in defending a
proceeding shall be paid by the Corporation in advance of the final disposition
of such proceeding upon receipt of an undertaking by or on behalf of the
director or officer to repay all amounts so advanced in the event that it shall
ultimately be determined that such director or officer is not entitled to be
indemnified by the Corporation as authorized in this Article VII. The majority
of the Disinterested Directors may, in the manner set forth above, and upon
approval of such director or officer of the Corporation, authorize the
Corporation's counsel to represent such person, in any proceeding, whether or
not the Corporation is a party to such proceeding.
(C) Procedure for Indemnification. Any indemnification or advance of
-----------------------------
expenses (including attorney's fees, costs and charges) under this Article VII
shall be made promptly, and in any event within 60 days upon the written request
of the director or officer (and, in the case of advance of expenses, receipt of
a written undertaking by or on behalf of Indemnitee to repay such amount if it
shall ultimately be determined that Indemnitee is not entitled to be indemnified
therefor pursuant to the terms of this Article VII). The right to
indemnification or advances as granted by this Article VII shall be enforceable
by the director or officer in any court of competent jurisdiction, if the
Corporation denies such request, in whole or in part, or if no disposition
thereof is made within 60 days. Such person's costs and expenses incurred in
connection with successfully establishing his/her right to indemnification, in
whole or in part, in any such action shall also be indemnified by the
Corporation. It shall be a defense to any such action (other than an action
brought to enforce a claim for the advance of expenses (including attorney's
fees, costs and charges) under this Article VII where the required undertaking,
if any, has been received by the Corporation) that the claimant has not met the
standard of conduct set forth in the DGCL, as the same exists or hereafter may
be amended (but, in the case of any such amendment, only to the extent that such
amendment permits the Corporation to provide broader indemnification rights than
said law permitted the Corporation to provide prior to such amendment), but the
burden of proving such defense shall be on the Corporation. Neither the failure
of the Corporation (including its Board of Directors, its independent legal
counsel and its stockholders) to have made a determination prior to the
commencement of such action that indemnification of the claimant is proper in
the circumstances because he/she has met the applicable standard of conduct set
forth in the DGCL, as the same exists or hereafter may be amended (but, in the
case of any such amendment, only to the extent that such amendment permits the
Corporation to provide broader indemnification rights than said law permitted
the Corporation to provide prior to such amendment), nor the fact that there has
been an actual determination by the Corporation (including its Board of
Directors, its independent legal counsel and its stockholders) that the claimant
has not met such applicable standard of conduct, shall be a defense to the
action or create a presumption that the claimant has not met the applicable
standard of conduct.
-6-
<PAGE>
(D) Other Rights; Continuation of Right to Indemnification. The
------------------------------------------------------
indemnification and advancement of expenses provided by this Article VII shall
not be deemed exclusive of any other rights to which a person seeking
indemnification or advancement of expenses may be entitled under any law (common
or statutory), by-law, agreement, vote of stockholders or disinterested
directors or otherwise, both as to action in his/her official capacity and as to
action in another capacity while holding office or while employed by or acting
as agent for the Corporation, and shall continue as to a person who has ceased
to be a director or officer, and shall inure to the benefit of the estate,
heirs, executors and administers of such person. All rights to indemnification
under this Article VII shall be deemed to be a contract between the Corporation
and each director or officer of the Corporation who serves or served in such
capacity at any time while this Article VII is in effect. Any repeal or
modification of this Article VII or any repeal or modification of relevant
provisions of the DGCL or any other applicable laws shall not in any way
diminish any rights to indemnification of such director or officer or the
obligations of the Corporation arising hereunder with respect to any proceeding
arising out of, or relating to, any actions, transactions or facts occurring
prior to the final adoption of such modification or repeal. For the purposes of
this Article VII, references to "the Corporation" include all constituent
corporations absorbed in a consolidation or merger as well as the resulting or
surviving corporation, so that any person who is or was a director or officer of
such a constituent corporation or is or was serving at the request of such
constituent corporation as a director or officer of another corporation,
partnership, joint venture, trust or other enterprise shall stand in the same
position under the provisions of this Article VII, with respect to the resulting
or surviving corporation, as he would if he/she had served the resulting or
surviving corporation in the same capacity.
(E) Insurance. The Corporation shall have power to purchase and maintain
---------
insurance on behalf of any person who is or was or has agreed to become a
director or officer of the Corporation, or is or was serving at the request of
the Corporation as a director or officer of another corporation, partnership,
joint venture, trust or other enterprise, against any liability asserted against
him and incurred by him or on his behalf in any such capacity, or arising out of
his status as such, whether or not the Corporation would have the power to
indemnify him against such liability under the provisions of this Article VII,
provided, however, that such insurance is available on acceptable terms, which
determination shall be made by a vote of a majority of the Board of Directors.
(F) Savings Clause. If this Article VII or any portion hereof shall be
--------------
invalidated on any ground by any court of competent jurisdiction, then the
Corporation shall nevertheless indemnify each person entitled to indemnification
under the first paragraph of this Article VII as to all expense, liability and
loss (including attorneys' fees and related disbursements, judgments, fines,
ERISA excise taxes and penalties, penalties and amounts paid or to be paid in
settlement) actually and reasonably incurred or suffered by such person and for
which indemnification is available to such person pursuant to this Article VII
to the full extent permitted by any applicable portion of this Article VII that
shall not have been invalidated and to the full extent permitted by applicable
law.
-7-
<PAGE>
ARTICLE VIII
AMENDMENT
The Corporation reserves the right to amend, alter, change or repeal any
provision contained in this Restated Certificate of Incorporation, in the manner
now or hereafter prescribed by statute, and all rights conferred upon
stockholders herein are granted subject to this reservation.
IN WITNESS WHEREOF, this Restated Certificate of Incorporation which
restates, integrates and amends the provisions of the Certificate of
Incorporation of the Corporation, and which has been duly adopted in accordance
with the provisions of Sections 228, 242 and 245 of the DGCL, has been executed
by the undersigned on this 12 day of July, 1999.
SPLITROCK SERVICES, INC.
By: /s/ William R. Wilson
-------------------------
Name: William R. Wilson
Title: President
-8-
<PAGE>
IN WITNESS WHEREOF, this Restated Certificate of Incorporation which
restates, integrates and amends the provisions of the Certificate of
Incorporation of the Corporation, and which has been duly adopted in accordance
with the provisions of Sections 228, 242 and 245 of the DGCL, has been executed
by the undersigned on this day of July, 1999.
----
SPLITROCK SERVICES, INC.
By:
-----------------------------
Name: William R. Wilson
Title: President
-9-
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the use in this Registration Statement on Form S-1 of our
reports dated March 24, 1999, except as to the reverse stock split described in
Note 12 which is as of July 12, 1999, relating to the financial statements and
financial statement schedule of Splitrock Services, Inc., which appear in such
Registration Statement. We also consent to the reference to us under the heading
"Experts" in such Registration Statement.
PricewaterhouseCoopers LLP
Houston, TX
July 19, 1999
