<PAGE>
Filed Pursuant to Rule 424(b)(4)
Registration No. 333-77039
PROSPECTUS
6,000,000 Shares
Digital Island, Inc.
Common Stock
[DIGITAL ISLAND LOGO]
----------------
We are offering 6,000,000 shares of our common stock. This is our initial
public offering.
Our common stock has been approved for listing on the Nasdaq National Market
under the symbol "ISLD."
See "Risk Factors" beginning on page 7 to read about certain 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 of these securities or passed upon the adequacy or
accuracy of this prospectus. Any representation to the contrary is a criminal
offense.
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<TABLE>
<CAPTION>
Per
Share Total
------------ ------------
<S> <C> <C>
Public offering price................................. $10.00 $60,000,000
Underwriting discounts and commissions................ $ 0.70 $ 4,200,000
Proceeds, before expenses, to us...................... $ 9.30 $55,800,000
</TABLE>
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The underwriters may purchase up to an additional 900,000 shares of common
stock from us at the initial public offering price less the underwriting
discount, solely to cover over-allotments.
The underwriters expect to deliver the shares against payment in New York, New
York on or about July 2, 1999.
----------------
Bear, Stearns & Co. Inc.
Lehman Brothers
Thomas Weisel Partners LLC
The date of this prospectus is June 29, 1999
<PAGE>
[Description of Company's business and map
depicting the Company's global network]
<PAGE>
PROSPECTUS SUMMARY
This summary contains basic information about us and this offering. Because
it is a summary, it does not contain all of the information that you should
consider before investing. You should read the entire prospectus carefully,
including the section entitled "Risk Factors" and our consolidated financial
statements and the related notes before making an investment decision. Our
fiscal year ends on September 30.
DIGITAL ISLAND, INC.
We offer a global network and related services for companies that are using
the Internet to deploy key business applications worldwide. Our services make
it easier for companies to globalize their operations and to provide a higher
quality of service and more functions than on the public Internet. We target
corporations that are increasingly relying on the Internet to conduct business
but are constrained by its unreliability, slow performance and limited range of
functions. Our global private network and services enable customers to
effectively deploy and manage global applications by combining the reliability,
performance and broad range of functions available in private intranets
operated by individual companies for their own users, with the global access of
the public Internet. Our customers, which include multinational corporations
such as Autodesk, Cisco Systems, E*TRADE Group and National Semiconductor, use
our services and proprietary technology to facilitate the deployment of a wide
variety of applications, including electronic commerce, online customer
service, software, document and multimedia distribution, sales management and
online training. Autodesk, Cisco Systems, E*TRADE Group and National
Semiconductor, in the aggregate, accounted for 49% and 30%, respectively, of
our revenues during the fiscal year ended September 30, 1998, and the six
months ended March 31, 1999.
The public Internet infrastructure was designed for applications requiring
limited communications bandwidth capacity, and was not designed for core
business uses, such as electronic commerce, that require greater capacity over
communications networks for the transmission of data. For enterprises requiring
global solutions, the U.S.-centric nature of the public Internet results in
poor response times, particularly for applications requiring large file
transfers, instantaneous interaction between networked users, and country-to-
country transport. This occurs because data transmitted between countries must
travel through telecommunications lines in the U.S., where the Internet
originated and where most of its infrastructure is still located, and make a
large number of connections through various regional and national Internet
service providers before reaching a destination. Data packets often are lost in
the transfer process, resulting in additional delays for users.
Our global private network consists of a centralized high-speed network
which acts as a backbone connecting four strategically located data centers.
This core network architecture connects over dedicated lines directly to local
Internet service providers in 18 countries. This enables our customers to
transmit their international Internet traffic with dedicated capacity directly
to international users through local Internet service providers. We also help
our customers distribute content over the Internet by replicating and storing
their applications and Internet content in multiple locations close to their
end-users. This allows our customers to benefit from the lower overall cost of
data storage versus transport and to provide a better online experience for
their end-users.
We offer service level guarantees, customized billing, security services to
protect the integrity of data transmissions, network management and other high
quality services designed to improve the operation of the applications deployed
on our network. In addition, we operate Web sites and Internet applications,
manage computer servers and maintain networking equipment for our customers in
our state-of-the-art network data centers, and offer a range of data transport
options which allow customers to reserve network capacity on request consistent
with their expected network usage. These services are designed to allow
customers to
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outsource Internet activities to us, thereby transferring to us the burden of
attracting and retaining scarce technical staff and adopting continuously
changing technologies, while lowering their operating costs and speeding
deployment of applications over the Internet.
Our objective is to be the leader in providing network services for
globalizing Internet business applications. In order to achieve this objective,
we intend to continue to:
. focus on leading corporations in targeted industries that utilize the
Internet for global business;
. continue to expand our customer base and provide additional services
and network usage to our existing customers;
. develop and implement new technologies and services that will allow
our customers to improve the deployment and operation of their
Internet applications globally;
. expand strategic relationships with potential partners such as
systems integrators who design and install systems, software vendors,
and some of our customers in targeted markets; and
. expand our sales capabilities in the U.S., Asia and Europe by hiring
more direct sales personnel and developing additional agents and
reseller channels.
----------------
We were incorporated in the State of California on February 10, 1994 and
changed our name to Digital Island, Inc. on August 15, 1996. Our principal
headquarters are located at 353 Sacramento Street, Suite 1520, San Francisco,
California 94111, and our telephone number is (415) 228-4100. Information
contained on our web site is not a part of this prospectus.
The Digital Island name and logo, Digital Island Intelligent Network,
Digital Island Global IP Applications Network, Digital Island Application
Hosting and Content Distribution, Globeport, Digital Island Local Content
Managers, TraceWare and the names of products and services offered by Digital
Island (including those referred to in "Business") are trademarks, registered
trademarks, service marks or registered service marks of Digital Island. This
prospectus also includes product names, trade names and trademarks of other
companies.
----------------
Unless we indicate otherwise, all information in this prospectus assumes:
. our recent reincorporation in Delaware;
. the conversion of each outstanding share of our convertible preferred
stock into common stock immediately prior to the consummation of this
offering;
. the exercise of outstanding warrants to purchase 95,000 shares of our
common stock at an exercise price of $0.10 per share upon the
consummation of this offering; and
. no exercise of the underwriters' over-allotment option.
4
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THE OFFERING
<TABLE>
<C> <S>
Common Stock being offered.................... 6,000,000 shares
Common Stock outstanding after this offering.. 33,965,736 shares
Use of proceeds............................... We plan to use the net proceeds
from this offering for working
capital needs and up to
approximately $15 million of
capital expenditures.
Nasdaq National Market symbol................. ISLD
</TABLE>
The common stock outstanding after this offering is based on the number of
shares outstanding as of March 31, 1999, and excludes:
. 4,218,839 shares of common stock issuable upon exercise of
outstanding options with a weighted average exercise price of $2.13
per share;
. 7,544,000 shares reserved for future issuance under our 1999 stock
incentive plan; and
. 300,000 shares reserved for future issuance under our 1999 employee
stock purchase plan.
5
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SUMMARY CONSOLIDATED FINANCIAL DATA
<TABLE>
<CAPTION>
Six Months Ended
Years Ended March 31,
September 30, (unaudited)
--------------------- ---------------------
1997 1998 1998 1999
--------- ---------- --------- ----------
(in thousands, except per share data)
<S> <C> <C> <C> <C>
Statements of Operations Data:
Revenue......................... $ 218 $ 2,343 $ 691 $ 3,795
Total costs and expenses........ (5,594) (19,458) (7,547) (18,919)
Loss from operations............ (5,376) (17,116) (6,856) (15,124)
Net loss........................ (5,289) (16,764) (6,793) (14,869)
========= ========== ========= ==========
Basic and diluted net loss per
share.......................... $ (3.53) $ (7.50) $ (3.07) $ (6.28)
========= ========== ========= ==========
Shares used in basic and diluted
net loss per share............. 1,497,711 2,236,452 2,215,875 2,366,951
Basic and diluted pro forma net
loss per share................. $ (1.39) $ (0.81)
========== ==========
Shares used in basic and diluted
pro forma net loss per share... 12,042,539 18,353,258
</TABLE>
<TABLE>
<CAPTION>
March 31, 1999
-------------------
Pro Forma
Actual As Adjusted
------- -----------
(in thousands)
<S> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and short-term investments........... $50,666 $105,476
Total assets................................................ 62,359 117,169
Long-term obligations, including current portion............ 4,039 4,039
Total stockholders' equity.................................. 49,149 103,959
</TABLE>
The above balance sheet data is shown:
. on an actual basis; and
. on a pro forma basis assuming the conversion of all outstanding
shares of convertible preferred stock into common stock and the
exercise of outstanding warrants to purchase 95,000 shares of common
stock at an exercise price of $0.10 per share upon the consummation
of this offering, and as adjusted to reflect the sale of 6,000,000
shares of common stock by Digital Island at the initial public
offering price of $10.00 per share and after deducting the
underwriting discounts and commissions and estimated offering
expenses.
See notes 2 and 9 of the notes to our consolidated financial statements for
the determination of shares used in computing basic and diluted loss per share.
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RISK FACTORS
An investment in our shares is extremely risky. This section describes risks
involved in purchasing our common stock. You should consider carefully the
following risks, in addition to the other information presented in this
prospectus, in evaluating us and our business. Any of the following risks could
seriously harm our business and financial results and cause the trading price
of our common stock to decline, which in turn could cause you to lose all or
part of your investment.
Risks Related to Digital Island
We have a short operating history upon which to base your investment decision.
Our limited operating history makes it difficult for us to predict future
results of operations, and makes it difficult to evaluate us or our prospects.
We were incorporated in 1994, and began offering our global applications
network services in January 1997. Prior to such time, we were engaged in
activities unrelated to our current operations, and as a result, the results of
operations for such periods are not comparable to our results of operations for
1997 or any subsequent periods.
We have incurred operating losses since our inception and expect future
operation losses for the foreseeable future.
The revenue and income potential of our business and market is unproven.
From inception, we have experienced operating losses, negative cash flows from
operations and net losses in each quarterly and annual period. For the fiscal
year ended September 30, 1998, our operating loss, negative cash flow from
operations and net loss were $17.1 million, $15.7 million and $16.8 million,
respectively. For the six months ended March 31, 1999, our operating loss,
negative cash flow from operations and net loss was $15.1 million,
$10.4 million and $14.9 million, respectively. As of March 31, 1999, we had an
accumulated deficit of approximately $37.0 million.
Currently, we anticipate making significant investments in our network
infrastructure and product development as well as our sales and marketing
programs and personnel. Therefore, we believe that we will continue to
experience significant losses on a quarterly and annual basis for the
foreseeable future. You must consider us and our prospects in light of the
risks and difficulties encountered by companies in new and rapidly evolving
markets. Our ability to address these risks depends on a number of factors
which include our ability to:
. market our brand name effectively to companies in our target
markets;
. provide reliable and cost-effective services to attract and retain
our target customers;
. continue to grow our infrastructure to accommodate new Internet
developments and increased utilization of our network to maintain
and increase our ability to service new and existing customers; and
. expand our channels of distribution to increase our presence in our
target markets.
We may not be successful in meeting these challenges and addressing these
risks and uncertainties. If we are unable to do so, our business will not be
successful and the value of your investment in us will decline.
Although we have experienced growth in revenues in recent periods, this
growth rate may not be indicative of future operating results. We may never be
able to achieve or sustain profitability.
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Our operating results may fluctuate in future periods which may cause
volatility or a decline in the price of our stock.
Due to a variety of factors, we expect to experience significant
fluctuations in our future results of operations, and shortfalls in revenue may
cause significant variations in our operating results in any quarter. Such
fluctuations may cause the price of our stock to fall. Factors, many of which
are out of our control, that could cause our operating results to fluctuate and
our stock price to fall include:
. demand for and market acceptance of our products and services may
decline or fail to increase enough to offset our costs;
. introductions of new products and services or enhancements by us and
our competitors may increase our costs or make our existing products
or services obsolete;
. the prices we can charge our customers may decline due to price
competition with our competitors;
. utilization of our global network may increase beyond our capacity
and we may incur expenses to increase such capacity;
. continuity of our service and network availability could be
interrupted, reducing revenue;
. the availability and cost of bandwidth may reduce our ability to
increase bandwidth as necessary, reducing our revenue;
. the timing of customer installations and the timing of expansion of
our network infrastructure may vary from quarter to quarter;
. the mix of products and services we sell may change and the new mix
may generate less revenue;
. the timing and magnitude of our capital expenditures, including
costs relating to the expansion of operations may vary from quarter
to quarter;
. bandwidth used by customers may fluctuate from quarter to quarter
affecting our profits from such customers; and
. conditions specific to the Internet industry and other general
economic factors may affect the prices we can charge or the expenses
we incur.
In addition, a relatively large portion of our expenses are fixed in the
short-term, particularly with respect to telecommunications capacity,
depreciation, real estate and interest expenses and personnel, and therefore
our results of operations are particularly sensitive to fluctuations in
revenues. Due to the foregoing, we believe that period-to-period comparisons of
our operating results are not necessarily meaningful and that such comparisons
cannot be relied upon as indicators of future performance. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Quarterly Results of Operations."
We must offer services priced above the overall cost of bandwidth, and any
failure to do so would jeopardize our operating results.
If we do not obtain adequate bandwidth capacity on acceptable terms and
realize appropriate customer volume for such bandwidth, we will not achieve
positive gross profit. We purchase our bandwidth capacity on a fixed-price
basis in advance of the sale of our services for such bandwidth. We sell our
services, by contract, on the basis of actual usage. Our bandwidth costs
currently are exceeding our revenues from the sale of services, which results
in negative gross profit. In the future, we must obtain enough bandwidth to
meet our projected customer needs, and we must realize adequate volume from our
customers to support and justify such bandwidth capacity and expense.
We expect that our cost to obtain bandwidth capacity for the transport of
data over our network will decline over time as a result of, among other
things, the large amount of capital currently being invested to
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build infrastructure providing additional bandwidth. We expect the prices we
charge for data transported over our network will also decline over time as a
result of, among other things, the lower cost of obtaining bandwidth and
existing and new competition in the markets we address. As a result, our
historical revenue rates are not indicative of future revenue based on
comparable traffic volumes. If we fail to accurately predict the decline in
costs of bandwidth or, in any event, if we are unable to sell our services at
acceptable prices relative to our bandwidth costs, or if we fail to offer
additional services from which we can derive additional revenues, our revenues
will decrease and our business and financial results will suffer.
Our data replication (mirroring) and storage (caching) business is
attractive to customers primarily because these services eliminate a
significant portion of the cost of transporting data by deploying data in close
proximity to the end users. To the extent bandwidth costs decrease, the prices
we may charge for these services will decrease as well. If the cost of
bandwidth decreases in excess of our expectations, the value of these could be
substantially reduced, which would harm our business and financial results.
We must retain and expand our customer base or else we will continue to be
unprofitable.
We currently incur costs greater than our revenues, and need to increase
customer revenue in order to become profitable. We incur significant fixed
costs to purchase our bandwidth capacity and maintain our network. We also have
payroll and other working capital needs. If we are unable to retain or grow our
customer base, we will not be able to increase our sales and revenues or create
economies of scale to offset our fixed and other operating costs. Our ability
to attract new customers depends on a variety of factors, including:
. the willingness of businesses to outsource their Internet
operations;
. the reliability and cost-effectiveness of our services; and
. our ability to effectively market such services.
To attract new customers we intend to significantly increase our sales and
marketing expenditures. However, our efforts might not result in more sales as
a result of the following factors:
. we may be unsuccessful in implementing our marketing strategies;
. we may be unsuccessful in hiring a sufficient number of qualified
sales and marketing personnel; and
. any implemented strategies might not result in increased sales.
Any failure of our network infrastructure could lead to significant costs and
disruptions which could reduce our revenues and harm our business and financial
results.
Our business is dependent on providing our customers with fast, efficient
and reliable network services. To meet these customer requirements we must
protect our network infrastructure against damage from:
. human error;
. fire;
. natural disasters;
. power loss;
. telecommunications failures; and
. similar events.
Despite precautions taken by us, the occurrence of a natural disaster or
other unanticipated problems at one or more of our data centers could result in
service interruptions or significant damage to equipment. We have experienced
temporary service interruptions in the past, and we could experience similar
interruptions in the future.
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Any failure of our telecommunications providers to provide required data
communications capacity to us could result in interruptions in our services.
Our operations are dependent upon data communications capacity provided by
third-party telecommunications providers. Any failure of such
telecommunications providers to provide the capacity we require may result in a
reduction in, or termination of, services to our customers. This could cause us
to lose customers or fees charged to such customers, and our business and
financial results could suffer.
Future customer warranty claims based on service failures could exceed our
insurance coverage.
Our customer contracts currently provide a limited service level warranty
related to the continuous availability of service on a 24 hours a day, seven
days per week basis, except for certain scheduled maintenance periods. This
warranty is generally limited to a credit consisting of free service for a
specified limited period of time for disruptions in Internet transmission
services. To date, we have had no material expense related to such service
level warranty. Should we incur significant obligations in connection with
system downtime, our liability insurance may not be adequate to cover such
expenses. Although our customer contracts typically provide for no recovery
with respect to incidental, punitive, indirect and consequential damages
resulting from damages to equipment or disruption of service, in the event of
such damages, we may be found liable, and, in such event, such damages may
exceed our liability insurance.
Our failure to make timely upgrades to increase the capacity of our network may
reduce demand for our services.
Due to the limited deployment of our services to date, the ability of our
network to connect and manage a substantially larger number of customers at
high transmission speeds is as yet unknown. Our network may not be able to be
scaled up to expected customer levels while maintaining superior performance or
that additional network capacity will be available from third-party suppliers
as it is needed by us. In addition, as customers' usage of bandwidth increases,
we will need to make additional investments in our infrastructure to maintain
adequate downstream data transmission speeds, the availability of which may be
limited or the cost of which may be significant. Upgrading our infrastructure
may cause delays or failures in our network. As a result, our network may be
unable to achieve or maintain a sufficiently high capacity of data transmission
as usage by our customers increases. Our failure to achieve or maintain high
capacity data transmission could significantly reduce demand for our services,
reducing our revenues and causing our business and financial results to suffer.
We cannot accurately predict the size of our market, and if our market does not
grow as we expect, our revenues will be below our expectations and our business
and financial results will suffer.
We are a new company engaging in a developing business with an unproven
market. Accordingly, we cannot accurately estimate the size of our market or
the potential demand for our services. If our customer base does not expand or
if there is not widespread acceptance of our products and our services, our
business and prospects will be harmed. For the six months ended March 31, 1999,
we had 48 billing customers, of which one, E*TRADE, accounted for approximately
16% of our revenues. We believe that our potential to grow and increase our
market acceptance depends principally on the following factors, some of which
are beyond our control:
. the effectiveness of our marketing strategy and efforts;
. our product and service differentiation and quality;
. the extent of our network coverage;
. our ability to provide timely, effective customer support;
. our distribution and pricing strategies as compared to our
competitors;
. our industry reputation; and
. general economic conditions such as downturns in the computer or
software markets.
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We will require significant additional capital, which we may not be able to
obtain.
The expansion and development of our business will require significant
capital in the future to fund our operating losses, working capital needs and
capital expenditures. We may not be able to obtain future equity or debt
financing on satisfactory terms or at all. Our failure to generate sufficient
cash flows from sales of services or to raise sufficient funds may require us
to delay or abandon some or all of our development and expansion plans or
otherwise forego market opportunities. In addition, our credit agreements
contain covenants restricting our ability to incur further indebtedness, and
future borrowing instruments such as credit facilities and lease agreements are
likely to contain similar or more restrictive covenants and will likely require
us to pledge assets as security for borrowings thereunder. Our inability to
obtain additional capital on satisfactory terms may delay or prevent the
expansion of our business, which could cause our business and financial results
to suffer.
Our principal capital expenditures and lease payments include the purchase,
lease and installation of network equipment such as switches, routers, servers
and storage devices. Our working capital is primarily comprised of accounts
receivable, accounts payable and accrued expenses. The timing and amount of our
future capital requirements may vary significantly depending on numerous
factors, including regulatory, technological, competitive and other
developments in our industry. Due to the uncertainty of these factors, our
actual revenues and costs may vary from expected amounts, possibly to a
material degree, and such variations are likely to affect our future capital
requirements. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources."
Rapid growth in our business could strain our resources and harm our business
and financial results.
The planned expansion of our operations will place a significant strain on
our management, financial controls, operations systems, personnel and other
resources. We expect that our customers increasingly will demand additional
information and reports with respect to the services we provide. To handle
these demands and enable future traffic growth, we must develop and implement
an automated customer service system. In addition, if we are successful in
implementing our marketing strategy, we also expect the demands on our network
infrastructure and technical support resources to grow rapidly, and we may
experience difficulties responding to customer demand for our services and
providing technical support in accordance with our customers' expectations. We
expect that these demands will require not only the addition of new management
personnel, but also the development of additional expertise by existing
management personnel and the establishment of long-term relationships with
third-party service vendors. We may not be able to keep pace with any growth,
successfully implement and maintain our operational and financial systems or
successfully obtain, integrate and utilize the employees, facilities, third-
party vendors and equipment, or management, operational and financial resources
necessary to manage a developing and expanding business in our evolving and
increasingly competitive industry. If we are unable to manage growth
effectively, we may lose customers or fail to attract new customers and our
business and financial results will suffer. See "Business--Business Strategy."
We could lose customers and expose our company to liability if breaches of our
network security disrupt service to our customers or jeopardize the security of
confidential information stored in our computer systems.
Despite the implementation of network security measures, our network
infrastructure is vulnerable to computer viruses, break-ins and similar
disruptive problems caused by our customers or Internet users. Any of these
acts could lead to interruptions, delays or cessation in service to our
customers and subscribers. Furthermore, such inappropriate use of the network
by third parties could also potentially jeopardize the security of confidential
information stored in our computer systems and our customers computer systems,
which may result in liability to and may also deter potential customers.
Although we intend to continue to implement industry-standard security
measures, any measures we implement may be circumvented in the future. The
costs and resources required to eliminate computer viruses and alleviate other
security problems may result in interruptions or delays to our customers that
could cause our business and financial results to suffer.
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The integration of key new employees and officers into our management team has
and will continue to interfere with our operations.
We have recently hired a number of key employees and officers including our
Chief Financial Officer and Vice President of Sales, each of whom has been with
us for less than six months. To integrate into our company, such individuals
must spend a significant amount of time learning our business model and
management system, in addition to performing their regular duties. Accordingly,
the integration of new personnel has resulted and will continue to result in
some disruption to our ongoing operations. If we fail to complete this
integration in an efficient manner, our business and financial results will
suffer.
We must retain and attract key employees or else we may not grow or be
successful.
We are highly dependent on key members of our management and engineering
staff, including, without limitation, our President and Chief Executive
Officer, Chief Technology Officer and Vice President of Marketing. The loss of
one or more of these officers might impede the achievement of our business
objectives. Furthermore, recruiting and retaining qualified technical personnel
to perform research, development and technical support work is critical to our
success. If our business grows, we will also need to recruit a significant
number of management, technical and other personnel for our business.
Competition for employees in our industry is intense. We may not be able to
continue to attract and retain skilled and experienced personnel on acceptable
terms. See "Business--Employees" and "Management."
We depend on a limited number of third party suppliers for key components of
our network infrastructure, and the loss of one or more suppliers may slow our
growth or cause us to lose customers.
We are dependent on other companies to supply key components of our
infrastructure, including bandwidth capacity leased from telecommunications
network providers and networking equipment that, in the quantities and quality
demanded by us, are available only from sole or limited sources. While we have
entered into various agreements for carrier line capacity, any failure to
obtain additional capacity, if required, would impede the growth of our
business and cause our financial results to suffer. The routers and switches
used in our infrastructure are currently supplied primarily by Cisco Systems.
We purchase these components pursuant to purchase orders placed from time to
time, we do not carry significant inventories of these components and, we have
no guaranteed supply arrangements with this vendor. Any failure to obtain
required products or services on a timely basis and at an acceptable cost would
impede the growth of our business and cause our financial results to suffer. In
addition, any failure of our sole or limited source suppliers to provide
products or components that comply with evolving Internet and
telecommunications standards or that interoperate with other products or
components used by us in our communications infrastructure could cause our
business and financial results to suffer.
Our failure to adequately protect our proprietary rights may harm our
competitive position.
We rely on a combination of copyrights, trademark, service mark and trade
secret laws and contractual restrictions to establish and protect proprietary
rights in our products and services. However, we will not be able to protect
our intellectual property if we are unable to enforce our rights or if we do
not detect unauthorized use of our intellectual property.
Although we have filed a patent application with respect to our TraceWare
technology with the United States Patent and Trademark Office, such application
is pending and we currently have no patented technology that would preclude or
inhibit competitors from entering our market. Moreover, none of our technology
is patented abroad, nor do we currently have any international patent
applications pending. We cannot be certain that any pending or future patent
applications will be granted, that any future patent will not be challenged,
invalidated or circumvented, or that rights granted under any patent that may
be issued will provide competitive advantages to us.
We have applied for trademarks and service marks on certain terms and
symbols that we believe are important for our business. In addition, we
generally enter into confidentiality or license agreements with our
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employees and consultants and with our customers and corporations with whom we
have strategic relationships, and we attempt to maintain control over access to
and distribution of our software documentation and other proprietary
information. However, the steps we have taken to protect our technology or
intellectual property may be inadequate. Our competitors may independently
develop technologies that are substantially equivalent or superior to ours.
Moreover, in other countries where we do business, there may not be effective
legal protection of patents and other proprietary rights that we believe are
important to our business. See "Business--Intellectual Property Rights."
We may be unable to license necessary technology, and we may be subject to
infringement claims by third parties.
Our commercial success will also depend in part on our not infringing the
proprietary rights of others and not breaching technology licenses that cover
technology used in our products. It is uncertain whether any third party
patents will require us to develop alternative technology or to alter our
products or processes, obtain licenses or cease activities that infringe on
third party's intellectual property rights. If any such licenses are required,
we may not be able to obtain such licenses on commercially favorable terms, if
at all. Our failure to obtain a license to any technology that we may require
to commercialize our products and services could cause our business and
prospects to suffer. Litigation, which could result in substantial cost to us,
may also be necessary to enforce any patents issued or licensed to us or to
determine the scope and validity of third party proprietary rights. See
"Business--Intellectual Property Rights."
We are subject to risks associated with entering into joint ventures, including
inconsistent goals and exposure to unknown liabilities and unexpected
obligations.
Our strategy is to pursue international expansion through relationships and
joint ventures with local Internet service providers and telecommunications
carriers in other countries. We may not have a majority interest or control of
the governing body of any such local operating joint venture. In any such joint
venture in which we may participate, there will be a risk that the other joint
venture partner may at any time have economic, business or legal interests or
goals that are inconsistent with those of the joint venture or us. The risk
also will be present that a joint venture partner may be unable to meet its
economic or other obligations and that we may be required to fulfill those
obligations. In addition, in any joint venture in which we do not have a
majority interest, we may not have control over the operations or assets of
such joint venture. We may not be able to establish peering relationships or
joint ventures with local Internet service providers and telecommunications
carriers in other countries on favorable terms or at all. Our failure to
establish these relationships may cause us to lose customers or slow our growth
and our business and financial results would suffer.
Risks Related to Our Industry
We may not be able to compete in our market since it is highly competitive and
has many more established competitors, and we may lose market share as a
result.
Our market is highly competitive and this competition could harm our ability
to sell our services and products on prices and terms favorable to us. There
are few substantial barriers to entry and we expect that we will face
additional competition from existing competitors and new market entrants in the
future. We compete against information technology and Internet outsourcing
firms, national and regional Internet service providers, and global, regional
and local telecommunications companies.
Our competitors include companies such as AboveNet Communications, Inc.,
AT&T Corp., Exodus Communications, Inc., GTE Corporation, MCI WorldCom, Inc.
and business units of Frontier GlobalCenter, Inc. Many of our competitors have
substantially greater financial, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. Our larger competitors
may be able to provide customers with additional benefits in
13
<PAGE>
connection with their Internet systems and network solutions, including reduced
communications costs. As a result, these companies may be able to price their
products and services more competitively than we can and respond more quickly
than us to new or emerging technologies and changes in customer requirements.
If we are unable to compete successfully against our current or future
competitors, we may lose market share, and our business and prospects would
suffer. See "Business--Competition."
Our market changes rapidly due to changing technology and evolving industry
standards. If we do not adapt to meet the sophisticated needs of our customers,
our business and prospects will suffer.
The market for our services is characterized by rapidly changing technology,
evolving industry standards and frequent new service introductions. Our future
success will depend to a substantial degree on our ability to offer services
that incorporate leading technology, address the increasingly sophisticated and
varied needs of our current and prospective customers and respond to
technological advances and emerging industry standards and practices on a
timely and cost-effective basis. You should be aware that:
. our technology or systems may become obsolete upon the introduction
of alternative technologies;
. we may not have sufficient resources to develop or acquire new
technologies or to introduce new services capable of competing with
future technologies or service offerings; and
. the price of the services provided by us is expected to decline as
rapidly as the cost of any competitive alternatives.
We may not be able to effectively respond to the technological requirements
of the changing market. To the extent we determine that new technologies and
equipment are required to remain competitive, the development, acquisition and
implementation of such technologies and equipment are likely to continue to
require significant capital investment by us. Sufficient capital may not be
available for this purpose in the future, and even if it is available,
investments in new technologies may not result in commercially viable
technological processes and there may not be commercial applications for such
technologies. However, if we do not develop and introduce new products and
services and achieve market acceptance in a timely manner, our business and
prospects may suffer.
Our business and prospects depend on demand for and market acceptance of the
Internet and its infrastructure development.
The increased use of the Internet for retrieving, sharing and transferring
information among businesses, consumers, suppliers and partners has only begun
to develop in recent years, and our success will depend in large part on
continued growth in the use of the Internet. Critical issues concerning the
commercial use of the Internet, including security, reliability, cost, ease of
access, quality of service, regulatory initiatives and necessary increases in
bandwidth availability, remain unresolved and are likely to affect the
development of the market for our services. The adoption of the Internet for
information retrieval and exchange, commerce and
communications generally will require the acceptance of a new medium of
conducting business and exchanging information. Demand for and market
acceptance of the Internet are subject to a high level of uncertainty and are
dependent on a number of factors, including:
. the growth in consumer access to and acceptance of new interactive
technologies;
. the development of technologies that facilitate interactive
communication between organizations; and
. increases in user bandwidth.
If the Internet as a commercial or business medium fails to develop or
develops more slowly than expected, our business and prospects would suffer.
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<PAGE>
Liability laws are unsettled in our industry and potential liability associated
with information disseminated through our network could harm our business and
prospects.
The law relating to the liability of online services companies and Internet
access providers for information carried on or disseminated through their
networks is currently unsettled. It is possible that claims could be made
against online services companies and Internet access providers under both
United States and foreign law for defamation, negligence, copyright or
trademark infringement, or other theories based on the nature of the data or
the content of the materials disseminated through their networks. Several
private lawsuits seeking to impose such liability upon online services
companies and Internet access providers are currently pending. In addition,
some countries, such as China, regulate or prohibit the transport of telephony
data in their territories. The imposition upon us and other Internet network
providers of potential liability for information carried on or disseminated
through their systems could require us to implement measures to reduce our
exposure to such liability, which may require the expenditure of substantial
resources, or to discontinue some of our service or product offerings. Our
ability to limit the types of data or content distributed through our network
is limited. Failure to comply with such regulation in a particular jurisdiction
could result in fines or penalties or the termination of our service in such
jurisdiction. The increased attention focused upon liability issues as a result
of these lawsuits and legislative proposals could impact the growth of Internet
use. Our professional liability insurance may not be adequate to compensate or
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 such liability or asserted liability could harm our business and
prospects.
Risks associated with operating in international markets could restrict our
ability to expand globally and harm our business and prospects.
We market and sell our network services and products in the United States
and internationally. While we received no revenues from foreign sources in
fiscal year 1998, we are planning to establish additional operations and form
business partnerships in other parts of the world. However, we may not be able
to successfully market, sell, deliver and support our networking services and
products internationally. We presently conduct our international sales through
local subsidiaries in the United Kingdom and the Netherlands and through
distributor relationships with third parties in countries where have no
physical presence. Our failure to manage our international operations
effectively could limit the future growth of our business. There are certain
risks inherent in conducting our business internationally, such as:
. changes in telecommunications regulatory requirements could restrict
our ability to deliver services to our international customers;
. export restrictions, tariffs, differing regulatory regimes and other
trade barriers could impede us from adequately equipping our network
facilities;
. challenges in recruiting, retaining, and managing qualified staff
who understand the highly technical aspects of our business that
could hinder our ability to grow and compete;
. differing technology standards across countries that may impede our
ability to integrate our product offerings across international
borders;
. our United States centered accounting operations have limited
international collection experience and could have difficulty
collecting accounts receivable in foreign jurisdictions;
. political and economic instability could lead to appropriation of
our physical assets, impeding our ability to deliver our services to
customers and harming our financial results;
. protectionist laws and business practices favoring local competition
may give unequal bargaining leverage to key vendors in countries
where competition is scarce, significantly increasing our operating
costs; and
. potentially adverse tax consequences due to unfavorable changes in
tax laws or our physical presence in foreign countries.
15
<PAGE>
Any of these risks could harm our international operations. For example,
some European countries already have laws and regulations related to content
distributed on the Internet and technologies used on the Internet that are more
strict than those currently in force in the United States. Furthermore, there
is an on-going debate in Europe as to the regulation of certain technologies we
use, including caching and mirroring. The European Parliament has recently
adopted a directive relating to the reform of copyright in the European
Community which will, if made into law, restrict caching and mirroring. Any or
all of these factors could cause our business and prospects to suffer. In
addition, we may not be able to obtain the necessary telecommunications
infrastructure in a cost-effective manner or compete effectively in
international markets. See "Business--Business Strategy" and "--Government
Regulation."
Foreign exchange fluctuations could decrease our revenues or cause us to lose
money, especially since we do not hedge against currency fluctuations.
Although, to date, all of our customers have paid for our services in U.S.
dollars, we currently pay some of our suppliers in foreign currencies which
subjects us to currency fluctuation risks. For fiscal 1998 and the first six
months of fiscal 1999, costs denominated in foreign currencies were nominal and
we had no foreign currency losses during those periods. However, we believe
that in the future an increasing portion of our revenues and costs will be
denominated in foreign currencies. In particular, we expect that with the
introduction of the Euro, an increasing portion of our international sales may
be Euro-denominated. Fluctuations in the value of the Euro or other foreign
currencies may cause our business and prospects to suffer. We currently do not
engage in foreign exchange hedging activities and, although we have not yet
experienced any material losses due to foreign currency fluctuation, our
international revenues are currently subject to the risks of foreign currency
fluctuations and such risks will increase as our international revenues
increase.
Year 2000 computer complications could disrupt our operations and harm our
business.
Many currently installed computer systems are not able to distinguish 21st
century dates from 20th century dates. As a result, computer systems and
software that fail to recognize the proper date at the end of this year may
suffer major system failures or miscalculations. Our inability to correct a
significant Year 2000 problem, if one exists, could result in an interruption
in, or a failure of, certain of our normal business activities and operations,
harming our business and financial results. We have completed our Year 2000
compliance testing for all of our internal network equipment, systems and
applications and believe that they are compliant. We received an independent
third-party evaluation of the Year 2000 compliance of our network equipment and
carriers in March 1999. However, the third-party evaluation of our systems and
applications has yet to commence. We expect this work to be completed by the
end of August 1999, and we plan to implement all necessary remediation measures
by October 1999. We are also seeking verification from our telecommunication
carriers, vendors and other significant suppliers that they are Year 2000
compliant. Following the assessment study and after contacting these third
parties, we will be better able to make a complete evaluation of our Year 2000
readiness to determine what costs will be necessary to be Year 2000 compliant,
and to determine whether contingency plans need to be developed. Any
significant Year 2000 problem could require us to incur significant
unanticipated expenses to remedy these problems and could divert management's
time and attention, either of which could harm our business and financial
results. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Year 2000 Compliance" for information on our state of
readiness, potential risks and contingency plans regarding the Year 2000 issue.
Government regulation and legal uncertainties could limit our business or slow
our growth.
Our services include the transmission of data over public telephone lines.
These transmissions are subject to the regulatory authority of the Federal
Communications Commission and the state public utility commissions. However, to
date, neither the FCC nor the state public utility commissions has elected to
exercise such authority. Our services could be affected by changes in federal
and state law or regulation in the telecommunications arena, especially changes
relating to telecommunications markets in general and the
16
<PAGE>
Internet in particular. Such changes could directly or indirectly affect our
costs, limit usage or subscriber-related information, and increase the
likelihood or scope of competition from Regional Bell Operating Companies or
other telecommunications companies.
As our services become available over the Internet in foreign countries, and
as we facilitate sales by our customers to end users located in such foreign
countries, these foreign jurisdictions may decide that we are required to
qualify to do business in the particular foreign country. Such decisions could
subject us to taxes and other costs. It is also possible that claims could be
made against online service companies and Internet service providers under
foreign law for defamation, negligence, copyright or trademark infringement, or
other theories based on the nature and content of the materials disseminated
through their networks.
Implementation of any future changes in law or regulation, including those
discussed herein, could cause our business and prospects to suffer. Our
business and prospects may also be harmed by the imposition of certain tariffs,
duties and other import restrictions on facilities and resources that we obtain
from non-domestic suppliers. As a result, changes in law or regulation in the
United States or elsewhere could cause our business and prospects to suffer.
For a more detailed discussion of the possible risks associated with changes in
law or regulation, please see "Business--Government Regulation."
We have anti-takeover defenses that could delay or prevent a takeover that
stockholders may consider favorable.
Certain provisions of our certificate of incorporation and bylaws and the
provisions of Delaware law could have the effect of delaying, deferring or
preventing an acquisition of Digital Island. For example, our board of
directors is divided into three classes to serve staggered three-year terms, we
may authorize the issuance of up to 10,000,000 shares of "blank check"
preferred stock, our stockholders may not take actions by written consent and
our stockholders are limited in their ability to make proposals at stockholder
meetings. See "Description of Capital Stock" for a further discussion of these
provisions.
Risks Related to Our Offering
Our stock will likely be subject to substantial price and volume fluctuations
due to a number of factors, some of which are beyond our control.
Stock prices and trading volumes for many Internet companies fluctuate
widely for a number of reasons, including some reasons which may be unrelated
to their businesses or results of operations. This market volatility, as well
as general domestic or international economic, market and political conditions,
could materially adversely affect the price of our common stock without regard
to our operating performance. In addition, our operating results may be below
the expectations of public market analysts and investors. If this were to
occur, the market price of our common stock would likely significantly
decrease.
After this offering, our executive officers, directors, and parties related to
them, in the aggregate, will control 39% of our voting stock and may have the
ability to control matters requiring stockholder approval.
Our executive officers, directors and parties related to them own a large
enough stake in us to have an influence on the matters presented to
stockholders. As a result, these stockholders may have the ability to control
matters requiring stockholder approval, including the election and removal of
directors, the approval of significant corporate transactions, such as any
merger, consolidation or sale of all or substantially all of Digital Island's
assets, and the control of the management and affairs of Digital Island.
Accordingly, such concentration of ownership may have the effect of delaying,
deferring or preventing a change in control of Digital Island, impede a merger,
consolidation, takeover or other business combination involving Digital Island
or discourage a potential acquirer from making a tender offer or otherwise
attempting to obtain control of Digital Island, which in turn could have an
adverse effect on the market price of Digital Island's common stock.
17
<PAGE>
Shares eligible for future sale in the open market could depress our stock
price.
Sales of substantial amounts of our common stock (including shares issued
upon the exercise of outstanding options and warrants) in the public market
following this offering, or the appearance that a large number of shares is
available for sale, could depress the market price for our common stock. The
number of shares of common stock available for sale in the public market will
be limited by agreements under which Digital Island and our executive offices,
directors and the holders of substantially all of our outstanding shares of
common stock and options and warrants to purchase common stock have agreed not
to sell or otherwise dispose of any of their shares for a period of 180 days
after the date of this prospectus, subject to certain consents and exceptions.
Bear, Stearns & Co. Inc., may in its sole discretion and at anytime without
notice, release all or any portion of the shares subject to such agreements. In
addition to the adverse effect a price decline could have on holders of our
common stock, that decline would likely impede our ability to raise capital
through the issuance of additional shares of common stock or other equity
securities. In addition, the holders of 25,248,511 restricted shares of our
stock are entitled to certain rights with respect to registration of such
shares for sale in the public market. If these holders sell in the public
market, such sales could have a material adverse effect on the market price of
our common stock. See "Shares Eligible for Future Sale" and "Certain
Transactions--Investors' Rights Agreement."
Our management will have broad discretion in allocating proceeds from this
offering, which it may not use effectively.
The net proceeds to us from this offering, after deducting underwriting
commissions and expenses payable by us, are estimated to be approximately $54.8
million. The primary purposes of this offering are to fund operating losses,
working capital needs and capital expenditures expected to be incurred in
connection with the execution of our business plan, including the expansion of
our operations. A portion of the net proceeds also may be used to repay
currently outstanding or future indebtedness, or to acquire or invest in
complementary businesses or products. Accordingly, our management will retain
broad discretion as to the allocation of most of the proceeds of this offering.
The failure of management to apply these funds effectively could negatively
impact our business and prospects. See "Use of Proceeds."
The liquidity of our common stock is uncertain since it has not been publicly
traded and may have a limited market.
There has not been a public market for our common stock. We cannot predict
the extent to which investor interest in our company will lead to the
development of an active, liquid trading market. In this offering, we intend to
sell our common stock primarily to a limited number of institutional investors,
which could limit the development of an active trading market. Active trading
markets generally result in lower price volatility and more efficient execution
of buy and sell orders for investors. The initial public offering price will be
determined by negotiations between Digital Island and the representatives of
the Underwriters and may bear no relationship to the price at which the common
stock will trade upon completion of this offering. See "Underwriting" for a
discussion of the factors to be considered in determining the initial public
offering price.
We make many forward-looking statements in this prospectus, which depend on
factors outside our control and may turn out to be wrong.
Some of the matters discussed under the captions "Prospectus Summary," "Risk
Factors," "Management's Discussion and Analysis of Financial Condition and
Results of Operations," "Business" and elsewhere in this prospectus include
forward-looking statements. We have based these forward-looking statements on
our current expectations and projections about future events, including, among
other things,
. implementing our business strategy;
. obtaining and expanding market acceptance of the services we offer;
. forecasts of Internet and our market size and growth;
18
<PAGE>
. predicting pricing trends in domestic and foreign telecommunications;
. meeting our requirements under key contracts; and
. competition in our market.
In some cases, you can identify forward-looking statements by terminology
such as "may," "will," "should," "potential," "continue," "expects,"
"anticipates," "intends," "plans," "believes," "estimates" and similar
expressions. These statements are based on our current beliefs, expectations
and assumptions and are subject to a number of risks and uncertainties. Actual
results and events may vary significantly from those discussed in the forward-
looking statements. A description of risks that could cause our results to vary
appears under the caption "Risk Factors" and elsewhere in this prospectus.
These forward-looking statements are made as of the date of this prospectus,
and we assume no obligation to update them or to explain the reasons why actual
results may differ. In light of these assumptions, risks and uncertainties, the
forward-looking events discussed in this prospectus might not occur.
19
<PAGE>
USE OF PROCEEDS
The net proceeds from this offering, at the initial public offering price of
$10.00 per share, are estimated to be approximately $54.8 million ($63.0
million if the underwriters' over-allotment option is exercised in full), after
deducting estimated underwriting discounts and commissions and expenses payable
by us. We expect to use the net proceeds from this offering, together with
existing cash, to fund operating losses, working capital needs and up to
approximately $15 million of capital expenditures expected to be incurred in
connection with our operations. Our management will retain broad discretion in
the allocation of such net proceeds. Although we may use a portion of the net
proceeds to pursue possible acquisitions of, or enter into joint ventures with
respect to, complementary businesses, technologies or products in the future,
there are no present understandings, commitments or agreements with respect to
any such acquisitions or joint ventures. Pending the use of such net proceeds,
we intend to invest these funds in short-term, investment grade securities.
DIVIDEND POLICY
We have not declared or paid any dividends since our inception and do not
intend to pay cash dividends on our capital stock in the foreseeable future. We
anticipate that we will retain all future earnings, if any, for use in our
operations and the expansion of our business. Our credit agreements restrict
our ability to declare or pay any dividends. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Liquidity and
Capital Resources."
20
<PAGE>
CAPITALIZATION
The following table sets forth, as of March 31, 1999:
. Our actual capitalization;
. Our pro forma capitalization, assuming the conversion of outstanding
shares of our convertible preferred stock into common stock and the
exercise of warrants to purchase 95,000 shares of our common stock;
and
. Our pro forma capitalization, as adjusted to give effect to the sale
of 6,000,000 shares of common stock offered by us in this offering
at the initial public offering price of $10.00 per share, after
deducting the underwriting discounts and commissions and estimated
offering expenses payable by us, and the application of the
estimated net proceeds from this offering.
This information should be read in conjunction with our consolidated
financial statements and the notes related thereto appearing elsewhere in this
prospectus. See "Use of Proceeds."
<TABLE>
<CAPTION>
March 31, 1999
--------------------------------
(unaudited)
Actual Pro Forma As Adjusted
-------- --------- -----------
(in thousands, except share
data)
<S> <C> <C> <C>
Long-term obligations, less current portion.... $ 2,219 $ 2,219 $ 2,219
Stockholders' equity:
Convertible preferred stock, $0.001 par
value, Series A, Series B, Series C, Series
D and Series E, 30,000,000 shares
authorized, $86,894,973 aggregate
liquidation preference, 25,070,363 shares
issued and outstanding on an actual basis
and no shares issued and outstanding
pro forma and as adjusted................... 25 -- --
Preferred stock, $0.001 par value, 10,000,000
shares authorized; no shares issued and
outstanding on an actual and pro forma basis
and as adjusted............................. -- -- --
Common stock, $0.001 par value, 40,000,000
shares authorized, 2,622,225 shares issued
and outstanding on an actual basis and
27,965,736 issued and outstanding on a pro
forma basis; $0.001 par value, 100,000,000
shares authorized, 33,965,736 shares issued
and outstanding on an as adjusted basis .... 3 28 34
Stockholder note receivable.................. (110) (110) (110)
Common stock warrants........................ 29 -- --
Additional paid-in capital................... 92,158 92,197 146,991
Deferred compensation........................ (5,963) (5,963) (5,963)
Accumulated deficit.......................... (36,993) (36,993) (36,993)
-------- -------- ---------
Total stockholders' equity................. 49,149 49,159 103,959
-------- -------- ---------
Total capitalization....................... $ 51,368 $ 51,378 $ 106,178
======== ======== =========
</TABLE>
The table above excludes 4,218,839 shares of common stock issuable upon
exercise of options outstanding with a weighted average exercise price of $2.13
per share and 7,544,000 shares reserved for future issuances under our 1999
stock incentive plan. See "Executive Compensation and Other Information--
Employee Benefit Plans."
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<PAGE>
DILUTION
Our net tangible book value as of March 31, 1999 was approximately $49.1
million, or $1.76 per share of common stock. Net tangible book value per share
is calculated by subtracting our total liabilities from our total tangible
assets, which equals total assets less intangible assets, and dividing this
amount by the number of shares of common stock outstanding as of March 31,
1999. Assuming the sale by us of 6,000,000 shares of common stock offered in
this offering at the initial public offering price of $10.00 per share and the
application of the estimated net proceeds from this offering, our net tangible
book value as of March 31, 1999 would be $104.0 million, or $3.06 per share of
common stock. Assuming completion of this offering, there will be an immediate
increase in the net tangible book value of $1.30 per share to our existing
stockholders and an immediate dilution in the net tangible book value of $6.94
per share to new investors. The following table illustrates this per share
dilution:
<TABLE>
<S> <C> <C>
Assumed initial public offering price per share............... $10.00
Pro forma net tangible book value per share as of March 31,
1999....................................................... $1.76
Pro forma increase attributable to new investors............ $1.30
-----
Pro forma net tangible book value per share after the
offering..................................................... $ 3.06
------
Pro forma dilution per share to new investors................. $ 6.94
======
</TABLE>
The following table summarizes the total number of shares of common stock
purchased from us, the total consideration paid to us and the average price per
share paid by existing stockholders and by new investors, in each case based
upon the number of shares of common stock outstanding as of March 31, 1999.
<TABLE>
<CAPTION>
Shares Purchased Total Consideration
------------------ -------------------- Average Price
Number Percent Amount Percent Per Share
---------- ------- ------------ ------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders... 27,965,736 82.3% $ 84,719,867 58.5% $ 3.03
New investors........... 6,000,000 17.7% $ 60,000,000 41.5% $10.00
---------- ---- ------------ ----
Total................. 33,965,736 100% $144,719,867 100%
========== ==== ============ ====
</TABLE>
If the underwriters' over-allotment is exercised in full, the number of
shares of common stock held by existing stockholders will be reduced to 80.2%
of the total number of shares of common stock to be outstanding after this
offering, and will increase the number of shares of common stock held by the
new investors to 6,900,000, or 19.8% of the total number of shares of common
stock to be outstanding immediately after this offering. See "Principal
Stockholders."
The tables and calculations above assume no exercise of outstanding options.
At March 31, 1999, there were 4,218,839 shares of common stock issuable upon
exercise of options outstanding with a weighted average exercise price of $2.13
per share and 7,544,000 shares reserved for future issuance under our 1999
Stock Incentive Plan. To the extent that these options are exercised, there
will be further dilution to new investors. See "Executive Compensation and
Other Information--Employee Benefit Plans."
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<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data should be read in
conjunction with our consolidated financial statements and notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this prospectus. The statement of operations
data for each of the years in the three-year period ended September 30, 1998
and the balance sheet data at September 30, 1997 and 1998, are derived from our
financial statements that have been audited by PricewaterhouseCoopers LLP,
independent accountants, included elsewhere in this prospectus. The statement
of operations data for the period ended September 30, 1994 and the year ended
September 30, 1995 and the balance sheet data at September 30, 1994, 1995 and
1996, are derived from our audited financial statements that are not included
in this prospectus. The statement of operations data for the six months ended
March 31, 1998 and 1999, and the balance sheet data at March 31, 1999, are
derived from our unaudited financial statements included elsewhere in this
prospectus. We did not begin offering our global network services until January
1997; prior to such time, we were engaged in activities unrelated to our
current operations. Accordingly, our results of operations prior to 1997 are
not comparable to our results of operations for 1997 or any subsequent periods.
<TABLE>
<CAPTION>
Period from Six Months Ended
inception to Years Ended September 30, March 31,
September 30, -------------------------------------- --------------------
1994 1995 1996 1997 1998 1998 1999
------------- ------- ------- --------- --------- --------- ---------
(in thousands, except per share
data) (unaudited)
<S> <C> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenue................. $ -- $ -- $ -- $ 218 $ 2,343 $ 691 $ 3,795
Costs and expenses:
Cost of revenue........ -- -- -- 2,508 9,039 4,026 7,750
Sales and marketing.... -- -- -- 1,205 4,847 1,787 5,171
Product development.... -- -- -- 378 1,694 571 2,010
General and
administrative........ 33 7 26 1,502 3,392 1,164 2,963
Stock compensation
expense............... -- -- -- -- 487 -- 1,026
------- ------- ------- --------- --------- --------- ---------
Total cost and
expenses............. 33 7 26 5,594 19,458 7,547 18,919
------- ------- ------- --------- --------- --------- ---------
Loss from operations.... (33) (7) (26) (5,376) (17,116) (6,856) (15,124)
Interest income
(expense), net......... -- (2) (1) 87 353 64 257
------- ------- ------- --------- --------- --------- ---------
Loss before income
taxes.................. (33) (9) (26) (5,288) (16,763) (6,792) (14,867)
Provision for income
taxes.................. -- 1 1 1 2 1 2
------- ------- ------- --------- --------- --------- ---------
Net loss................ $ (33) $ (10) $ (27) $ (5,289) $ (16,764) $ (6,793) $ (14,869)
======= ======= ======= ========= ========= ========= =========
Basic and diluted loss
per share(1)........... $ (0.12) $ (0.04) $ (0.10) $ (3.53) $ (7.50) $ (3.07) $ (6.28)
======= ======= ======= ========= ========= ========= =========
Shares used in basic and
diluted loss per
share(1)............... 275,000 275,000 275,000 1,497,711 2,236,452 2,215,875 2,366,951
Other Data:
Depreciation and
amortization........... -- -- -- $ 158 $ 811 $ 293 $ 924
Capital
expenditures(2)........ -- -- $ 2 $ 2,128 $ 3,640 $ 412 $ 3,024
</TABLE>
<TABLE>
<CAPTION>
September 30,
----------------------------- March 31,
1994 1995 1996 1997 1998 1999
---- ---- ---- ------ ------- -----------
(in thousands) (unaudited)
<S> <C> <C> <C> <C> <C> <C>
Balance Sheet Data:
Cash and cash equivalents........... $ 20 $ 7 $344 $4,584 $ 5,711 $29,751
Investments......................... -- -- -- 1,983 10,123 20,915
Working capital..................... 10 5 76 4,613 12,883 44,010
Total assets........................ 102 93 432 9,223 22,617 62,359
Long-term obligations, including
current portion.................... -- -- -- 705 3,992 4,039
Total stockholders' equity.......... $ 92 $ 86 $ 84 $6,265 $15,490 $49,149
</TABLE>
- ----------
(1) See notes 2 and 9 of the notes to our consolidated financial statements for
the determination of shares used in computing basic and diluted loss per
share.
(2) Capital expenditures represent purchases of property and equipment,
including non-cash transactions such as the acquisition of equipment under
capital leases.
23
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of
operations of Digital Island should be read in conjunction with the
consolidated financial statements and notes thereto included elsewhere in this
prospectus. This discussion contains forward-looking statements that involve
risks and uncertainties. Our actual results could differ from those anticipated
in these forward-looking statements as a result of various factors including
but not limited to, those discussed in "Risk Factors," "Business" and elsewhere
in this prospectus.
Overview
We offer a global network and related services for companies that are using
the Internet to deploy key business applications worldwide. We target
corporations that are increasingly relying on the Internet to conduct business
but are constrained by the unreliability, slow performance and limited range of
functions of the public Internet. The Digital Island Global IP Applications
Network and our services enable customers to effectively deploy and manage
global Internet applications by combining the reliability, performance and
broad range of functions of private intranets with the global access of the
public Internet. We also offer service level guarantees, customized billing,
security services, network management and other application services designed
to improve the performance of applications deployed on our network.
We did not begin offering our Global IP Applications Network services until
January 1997; prior to such time we were engaged in activities unrelated to our
current operations and, accordingly, comparisons for the periods ended
September 30, 1997 and 1996 are not meaningful and have not been made. Since
inception, we have incurred net losses and experienced negative cash flow from
operations. We expect to continue to operate at a net loss and to experience
negative cash flows at least through the year 2000. Our ability to achieve
profitability and positive cash flow from operations will be dependent upon our
ability to grow our revenues substantially and achieve other operating
efficiencies.
We derive our revenues from a family of services, which include Application
Hosting and Content Distribution Services, consisting of server management,
hardware management and co-location services, and Network Services, consisting
of the sale of open, reserved and managed bandwidth. We currently sell our
services under contracts having terms of one or more years.
Cost of revenues consists primarily of the cost of contracting for lines
from telecommunication providers worldwide and, to a lesser extent, the cost of
our network operations. We lease lines under contracts of one year or more. The
leasing of transoceanic lines comprises the largest component of our
telecommunications expense, with additional costs arising from leasing local
circuits between our data centers and points of presence in the United States
and international markets. In the future, we expect to increase the size and
number of circuits leased based on increases in network volume and geographic
expansion. The cost of our network operations is comprised primarily of data
centers, equipment maintenance, personnel and related costs associated with the
management and maintenance of the network.
Some options granted and common stock issued from May 1, 1998 to March 31,
1999 have been considered to be compensation. Total stock compensation expense
associated with such equity transactions as of March 31, 1999 amounted to $7.5
million. These amounts are being amortized over the vesting periods of such
securities. Of the total stock compensation expense, $487,000 was amortized in
the year ended September 30, 1998 and $1.0 million was amortized in the six
months ended March 31, 1999. We expect amortization of $3.2 million and $2.2
million in the years ending September 30, 1999 and 2000, respectively, relating
to these grants.
Six Months Ended March 31, 1999 and 1998
Revenue. Revenue increased to $3.8 million for the six months ended March
31, 1999 from $0.7 million for the six months ended March 31, 1998. The
increase in revenue was due primarily to an increase in the number of billing
customers to 48 from 16.
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<PAGE>
Cost of Revenue. Cost of revenue increased to $7.7 million for the six
months ended March 31, 1999 from $4.0 million for the six months ended March
31, 1998. The increase in cost of revenue was due to $3.3 million of spending
for additional network capacity as well as $0.4 million in recruitment and
compensation costs relating to the addition of network operations personnel. We
anticipate that our cost of revenue will grow significantly in future periods
in order to accommodate planned increases in the number of customers and
increased usage by existing customers.
Sales and Marketing. Sales and marketing expenses consist primarily of
staffing and marketing personnel and marketing programs, salespeople, sales
engineering, customer service personnel and administrative personnel. Sales and
marketing expenses increased to $5.2 million for the six months ended March 31,
1999 from $1.8 million for the six months ended March 31, 1998. This increase
was due to $3.2 million of recruitment and compensation expense relating to the
addition of sales and marketing personnel and $0.2 million of program and other
expenses, including new collateral, competitive analysis and partnering
programs. We expect sales and marketing expenses to increase in future periods.
Product Development. Product development expenses consist primarily of costs
associated with personnel and related costs and those costs associated with new
product introductions. Product development expenses increased to $2.0 million
for the six months ended March 31, 1999 from $0.6 million for the six month
period ended March 31, 1998. This increase was due primarily to $1.3 million of
growth in personnel and $0.1 million in related costs arising from new product
initiatives including TraceWare, mirroring and caching. We expect product
development expenses to increase in future periods.
General and Administrative. General and administrative expenses consist of
personnel related expenses and other costs associated with office facilities,
professional services and other administrative related expenses. General and
administrative expenses increased to $3.0 million for the six months ended
March 31, 1999 from $1.2 million for the six months ended March 31, 1998. This
increase was due to $0.8 million of growth in personnel and related expenses,
$0.6 million of depreciation of network equipment and $0.4 million of office
facility expenses, legal and accounting fees and other administrative related
expenses. We expect general and administrative expenses to increase in future
periods to support expected growth in future revenues and costs related to
being a public company.
Interest Income, net. Interest income, net, includes interest income from
our cash and cash equivalents, and investments. Interest expense relates to our
financing obligations, including bank borrowings and borrowings associated with
equipment leasing. Interest income, net, increased to $257,000 for the six
months ended March 31, 1999 from $64,000 for the six months ended March 31,
1998. This increase was due to a higher average cash balance as a result of the
proceeds of the issuance of shares of our preferred stock.
Provision for Income Taxes. Digital Island has had net operating losses for
every period through March 31, 1999. We may not be able to utilize all or any
of these tax loss carry-forwards as a result of this offering and prior
financings. We have not recognized a provision for income taxes due to the
uncertainty surrounding the realization of the favorable tax attributes in
future tax returns and we have placed a valuation allowance against our net
deferred tax assets.
Fiscal Years Ended September 30, 1998 and 1997
We did not begin offering our Global IP Applications Network services until
January 1997; prior to such time we were engaged in activities unrelated to our
current operations. Additionally, during the periods prior to January 1997, we
had no revenues and our operating expenses, although not material, consisted of
general and administrative expenses associated with an unrelated technology
business venture. Accordingly, our results of operations prior to 1997 are not
comparable to our results of operations for 1997 or any subsequent periods, and
comparisons to periods prior to 1997 have not been made.
Revenue. Revenue increased to $2.3 million for the year ended September 30,
1998 from $0.2 million for the year ended September 30, 1997. The increase in
revenue was due primarily to an increase in the number of billing customers to
31 from 6.
25
<PAGE>
Cost of Revenue. Cost of revenue increased to $9.0 million for the year
ended September 30, 1998 from $2.5 million for the year ended September 30,
1997. The increase in cost of revenue was due to $5.7 million of spending for
additional network capacity and $0.8 million in recruitment and compensation
costs relating to the addition of network operations personnel.
Sales and Marketing. Sales and marketing expenses increased to $4.8 million
for the year ended September 30, 1998 from $1.2 million for the year ended
September 30, 1997. This increase was due to $3.1 million of growth in
personnel and related costs and $0.5 million of program expenses.
Product Development. Product development expenses increased to $1.7 million
for the year ended September 30, 1998 from $0.4 million for the year ended
September 30, 1997. This increase was due primarily to $1.2 million in growth
of personnel and related costs and $0.1 million of costs arising from new
product initiatives, including TraceWare, mirroring and caching technologies.
General and Administrative. General and administrative expenses increased to
$3.4 million for the year ended September 30, 1998 from $1.5 million for the
year ended September 30, 1997. This increase was due to $0.7 million of
depreciation of network equipment, $0.7 million of growth in personnel and
related expenses, and $0.5 million office facility expenses, legal and
accounting fees and other administrative related expenses.
Interest Income, net. Interest income, net, increased to $353,000 for the
year ended September 30, 1998 from $87,000 for the year ended September 30,
1997. This increase was due to a higher average cash balance as a result of the
proceeds of the issuance of shares of our preferred stock.
Quarterly Results of Operations
The following tables set forth certain unaudited statements of operations
data for the six quarters ended March 31, 1999. This data has been derived from
the unaudited interim financial statements prepared on the same basis as the
audited consolidated financial statements contained in this prospectus, and in
the opinion of management include, all adjustments consisting only of normal
recurring adjustments that we consider necessary for a fair presentation of
such information when read in conjunction with the consolidated financial
statements and notes thereto appearing elsewhere in this prospectus. The
operating results for any quarter should not be considered indicative of
results of any future period.
<TABLE>
<CAPTION>
Three Months Ended
---------------------------------------------------------
(unaudited)
Mar.
Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, 31,
1997 1998 1998 1998 1998 1999
-------- -------- -------- --------- -------- -------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenue................. $ 277 $ 414 $ 725 $ 927 $ 1,385 $ 2,411
Costs and expenses:
Cost of revenue....... 1,961 2,065 2,267 2,746 2,923 4,827
Sales and marketing... 860 927 1,296 1,764 2,046 3,125
Product development... 214 357 538 585 843 1,167
General and
administrative....... 531 632 902 1,326 1,260 1,703
Stock compensation
expense.............. -- -- 132 355 346 680
------- ------- ------- ------- ------- -------
Total cost and
expenses........... 3,566 3,981 5,135 6,776 7,418 11,502
Loss from operations.... (3,289) (3,567) (4,410) (5,849) (6,033) (9,091)
Interest income
(expense), net......... 45 19 123 166 96 160
------- ------- ------- ------- ------- -------
Loss before income
taxes.................. (3,244) (3,548) (4,287) (5,683) (5,937) (8,931)
Provision for income
taxes.................. -- 1 -- 1 2 --
------- ------- ------- ------- ------- -------
Net loss................ $(3,244) $(3,549) $(4,287) $(5,684) $(5,939) $(8,931)
======= ======= ======= ======= ======= =======
</TABLE>
26
<PAGE>
We expect to experience significant fluctuations in our future results of
operations due to a variety of factors, many of which are outside of our
control, including:
. demand for and market acceptance of our products and services may
decline or fail to increase enough to offset our costs;
. introductions of new products and services or enhancements by us and
our competitors may increase our costs or make our existing products
or services obsolete;
. the prices we can charge our customers may decline due to price
competition with our competitors;
. utilization of our global network may increase beyond our capacity
and we may incur expenses to increase such capacity;
. continuity of our service and network availability could be
interrupted, reducing revenue;
. the availability and cost of bandwidth may reduce our ability to
increase bandwidth as necessary, reducing our revenue;
. the timing of customer installations and the timing of expansion of
our network infrastructure may vary from quarter to quarter;
. the mix of products and services we sell may change and the new mix
may generate less revenue;
. the timing and magnitude of our capital expenditures, including
costs relating to the expansion of operations may vary from quarter
to quarter;
. bandwidth used by customers may fluctuate from quarter to quarter
affecting our profits from such customers; and
. conditions specific to the Internet industry and other general
economic factors may affect the prices we can charge or the expenses
we incur.
In addition, a relatively large portion of our expenses are fixed in the
short-term, particularly with respect to telecommunications capacity,
depreciation, real estate and interest expenses and personnel, and therefore
our results of operations are particularly sensitive to fluctuations in
revenues. Due to the foregoing factors, we believe that period-to-period
comparisons of our operating results are not necessarily meaningful and that
such comparisons cannot be relied upon as indicators of future performance.
Liquidity and Capital Resources
From inception through March 31, 1999, we financed our operations primarily
through private equity placements of $86.9 million dollars and borrowings under
notes payable and capital leases from financial institutions of $5.7 million.
At March 31, 1999, we had an accumulated deficit of $37.0 million and cash and
cash equivalents and short-term investments of $50.7 million.
Net cash used in our operating activities for the six months ended March 31,
1999 was $10.4 million. The net cash used by operations was primarily due to
working capital requirements and net losses, offset by increases in accounts
payable and accrued expenses. Net cash used in investing activities was $12.9
million for the period ended March 31, 1999 and is comprised of equipment
purchases of $2.3 million and investments of $10.6 million in commercial paper
with maturities of less than one year. Net cash provided by financing
activities was $47.3 million and is related primarily to the issuance of our
Series E Preferred Stock, as well as net borrowing under our bank and leasing
lines of credit.
We have a $750,000 revolving line of credit with a commercial bank for the
purpose of financing equipment purchases. As of March 31, 1999, $451,000 was
outstanding thereunder. The loan contains standard
27
<PAGE>
covenants including minimum working capital, minimum tangible net worth, debt
to equity ratio and financial reporting requirements. Interest on borrowings
thereunder accrues at the lender's prime rate plus 0.75% (which was 8.5% at
March 31, 1999), and is payable monthly. No further advances were permitted
following October 18, 1997, and any outstanding amounts are payable on or
before October 18, 2000.
We also have a $7.5 million line of credit with a commercial bank,
consisting of a revolving credit facility of up to $5 million and other
facilities of up to $2.5 million. As of March 31, 1999, approximately $230,000
was outstanding under the revolving credit facility, and approximately $718,000
was outstanding under equipment loan facilities. No further amounts may be
borrowed under the equipment loan facilities. Advances under the line of credit
are limited to a percentage of our recurring contract revenue. The loan
contains standard covenants, including minimum working capital, minimum
tangible net worth, debt to equity ratio and financial reporting requirements.
Interest on borrowings thereunder accrues at the lender's prime rate plus 0.25%
(which was 8.00% at March 31, 1999), and is payable monthly. Under the terms of
the equipment loan facilities, interest is charged at the lender's prime rate
plus 0.75%, which was 8.5% at March 31, 1999. The loans mature at various times
in 2001. Between October 1, 1998 and January 31, 1999, we did not comply with
the minimum tangible net worth and financial reporting covenants. However, we
obtained waivers for all covenant violations. We have complied with all
covenants since January 31, 1999. Additionally, we have two lease lines of
credit totaling $4.4 million for equipment purchased. Total borrowings under
these two lease lines of credit were $2.6 million at March 31, 1999.
We believe that the estimated net proceeds from this offering, together with
our existing cash and funds available under our existing credit facilities,
will be sufficient to fund our operating losses, working capital needs and
capital expenditures, for at least the next 12 months. The execution of our
business plan will require substantial additional capital to fund our operating
losses, working capital needs, sales and marketing expenses, lease payments and
capital expenditures thereafter. While we currently have no material
commitments for capital expenditures, we anticipate making up to approximately
$15.0 million of capital expenditures for network expansion, facilities and
personnel related costs in the next 12 months. We intend to continue to
consider our future financing alternatives, which may include the incurrence of
indebtedness, additional public or private equity offerings or an equity
investment by a strategic partner. Actual capital requirements may vary based
upon the timing and success of the expansion of our operations. Our capital
requirements may change based upon technological and competitive developments.
In addition, several factors may affect our capital requirements:
. demand for our services or our anticipated cash flow from operations
being less than expected;
. our development plans or projections proving to be inaccurate;
. our engaging in acquisitions or other strategic transactions; or
. our accelerating deployment of our network services or otherwise
altering the schedule of our expansion plan.
Other than the current bank note payable and lease financing, we have no
present commitments or arrangements assuring us of any future equity or debt
financing, and there can be no assurance that any such equity or debt financing
will be available to us on favorable terms, or at all. If we do not obtain
additional financing, we believe that our existing cash resources will be
adequate to continue expanding operations on a reduced scale.
Recent Accounting Pronouncements
On March 4, 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants (AICPA) issued Statement of
Position No. 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use" (SOP 98-1). SOP 98-1 requires computer software
costs related to internal software that are incurred in the preliminary project
stage should be expensed as incurred. Once the capitalization criteria of SOP
98-1 have been met, external direct costs of materials and services consumed in
developing or obtaining internal-use computer software; payroll and payroll-
related costs for
28
<PAGE>
employees who are directly associated with and who devote time to the internal-
use computer software project (to the extent of the time spent directly on the
project); and interest costs incurred when developing computer software for
internal use should be capitalized. SOP 98-1 is effective for financial
statements for fiscal years beginning after December 15, 1998. Accordingly, we
will adopt SOP 98-1 in our consolidated financial statements for the year
ending September 30, 2000.
On April 3, 1998, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 98-5 (SOP 98-5), "Reporting on the Costs of
Start-Up Activities", which provides guidance on the financial reporting of
start-up costs and organization costs. SOP 98-5 requires costs of start-up
activities and organization costs to be expensed as incurred. SOP 98-5 is
effective for financial statements for fiscal years beginning after December
15, 1998. As we have not capitalized such costs, the adoption of SOP 98-5 is
not expected to have a material impact on our consolidated financial
statements.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging
Activities." SFAS 133 establishes accounting and reporting standards for
derivative instruments and for hedging activities. SFAS 133 is effective for
fiscal years beginning after June 15, 1999. We do not believe the adoption of
SFAS 133 will have a material effect on our consolidated results of operations
or financial condition.
Year 2000 Compliance
Many currently installed computer systems are not able to distinguish 21st
century dates from 20th century dates. As a result, computer systems and
software that fail to recognize the proper date at the end of this year may
suffer major system failures or miscalculations. If we or our key third party
suppliers fail to achieve Year 2000 compliance, we may experience operating
difficulties, including impaired ability to transport data over our network and
impaired ability to bill for our services. We recognize the need to ensure that
our operations will not be adversely affected by Year 2000 software failures.
We are assessing the potential overall impact of the impending century change
on our operations.
Based on our assessment to date, we believe the current versions of our
software products and services are Year 2000 compliant, that is, they are
capable of adequately distinguishing 21st century dates from 20th century
dates. However, our products are generally integrated into enterprise systems
involving sophisticated hardware and complex software products, which may not
be Year 2000 compliant. We may in the future be subject to claims based on Year
2000 problems in others' products, or issues arising from the integration of
multiple products within an overall system. Although we have not been a party
to any litigation or arbitration proceeding to date involving our products or
services and related to Year 2000 compliance issues, there can be no assurance
that we will not in the future be required to defend our products or services
in such proceedings, or to negotiate resolutions of claims based on Year 2000
issues. The costs of defending and resolving Year 2000-related disputes,
regardless of the merits of such disputes, and any potential liability on our
part for Year 2000-related damages, including consequential damages, could
cause our business and financial results to suffer. In addition, we believe
that purchasing patterns of customers and potential customers may be affected
by Year 2000 issues as companies expend significant resources to correct or
upgrade their current software systems for Year 2000 compliance. These
expenditures may reduce funds available to purchase software products such as
those offered by us. To the extent that Year 2000 issues cause significant
delay in, or cancellation of, decisions to purchase our products or services,
our business and financial results could suffer.
Thus far, we have not formulated a contingency plan should we or any of our
key third parties sustain business interruptions caused by Year 2000 problems.
However, the cost of developing and implementing such a plan, if necessary,
could be material. We are reviewing our internal management information and
other systems in order to identify and modify any products, services or systems
that are not Year 2000 compliant. To date, we have not encountered any material
Year 2000 problems with our computer systems, applications or any other
equipment which might be subject to these problems. In addition, we received an
independent third-party evaluation of the Year 2000 compliance of our network
equipment and carriers in March 1999. However,
29
<PAGE>
the third-party evaluation of our computer systems and applications has yet to
commence. We expect this evaluation to begin in July 1999, and to be completed
by the end of August 1999. In the event that any Year 2000 remedial actions are
necessary for the computer systems and applications, we plan to implement all
reasonable and necessary measures by October 1999. Finally, we will continue to
monitor Year 2000 compliance for our new products and services as they arise
throughout the remainder of the year.
Our plan for the Year 2000 calls for compliance verification of external
vendors supplying software and information systems to us and communication with
significant suppliers to determine their ability to remediate their own Year
2000 issues. As part of our assessment, we are evaluating the level of
validation we will require of third parties to ensure their Year 2000
readiness. In the event that any of these third parties cannot timely provide
us with products, services or systems that meet the Year 2000 requirements, we
may incur unexpected expenses to remedy any problems. These expenses could
potentially include purchasing replacement hardware or software. In addition,
our business and our ability to deliver our products and services could be
severely affected, at least for a certain period of time, in the event that
Year 2000 related problems were to cause disruption or failure in the Internet
as a means of delivery of our products and services or more generally,
disruption to the infrastructure. The total cost of these Year 2000 compliance
activities has not been, and is not anticipated to be, material to our
business, results of operations and financial condition. These costs and the
timing in which we plan to complete our Year 2000 modification and testing
processes are based on our management's estimates. We may not be able to
remediate all significant Year 2000 problems on a timely basis. Our remediation
efforts may involve significant time and expense, and could cause our business
and prospects to suffer.
Qualitative and Quantitative Disclosure About Market Risk
We develop global network and related services and sell such services in
North America, Asia and Europe. As a result, our financial results could be
affected by factors such as changes in foreign currency exchange rates or weak
economic conditions in foreign markets. As all sales are currently made in U.S.
dollars, a strengthening of the dollar could make our services less competitive
in foreign markets. We do not use derivative instruments to hedge our foreign
exchange risks. Our interest income is sensitive to changes in the general
level of U.S. interest rates, particularly since the majority of our
investments are in short-term instruments. Due to the nature of our short-term
investments, we have concluded there is no material market risk exposure.
Therefore, no quantitative tabular disclosures are required.
30
<PAGE>
BUSINESS
Overview
We offer a global network and related services for companies that are using
the Internet to deploy key business applications worldwide. Our services make
it easier for companies to globalize their operation and to provide a higher
quality of service and more functions than in the public Internet. We target
corporations that are increasingly relying on the Internet to conduct business
but are constrained by its unrealiability, slow performance and limited range
of functions. Our global private network and expert services enable customers
to effectively deploy and manage global applications by combining the
reliability, performance and broad range of functions available in private
intranets operated by individual companies for their own users, with the global
access of the public Internet. We also offer service level guarantees,
customized billing, security services to protect the integrity of data
transmissions, network management and other high quality services designed to
improve the applications deployed on our network. Our customers, which include
multinational corporations such as Autodesk, Cisco Systems, E*TRADE Group and
National Semiconductor, use our services and proprietary technology to
facilitate the deployment of a wide variety of applications, including
electronic commerce, online customer service, software, document and multimedia
distribution, sales force automation and online training. As of March 31, 1999,
we had contracts with 62 customers, of which 48 were deployed and generating
revenues.
We developed our global network to help companies globalize their
applications. We operate Web sites and Internet applications, manage computer
servers and maintain networking equipment for our customers in our state-of-
the-art network data centers, and provide network management expertise to our
customers for their own network data centers. The business applications
delivered through our network services are accessed globally in the same way as
any Web site, but with a significant difference: these business applications
are highly available and are designed to operate substantially faster and with
a greater range of functions than sites that rely solely on the public
Internet.
Our global private network consists of a centralized high-speed network
which acts as a backbone connecting four strategically located data centers in
Honolulu, London, New York City and Santa Clara, California. This core network
architecture connects over dedicated lines directly to local Internet service
providers in 18 countries. This enables our customers to transmit Internet
traffic seamlessly over our network with dedicated capacity and to connect
directly to international users through local Internet service providers. We
also help our customers distribute content over the Internet by mirroring
(replicating) and caching (storing) their applications in multiple locations
close to their end-users. This allows our customers to benefit from the lower
overall cost of data storage versus transport and to provide a better online
experience for their end-users. For example, Digital Island Local Content
Managers enable us to help customers readily store files which are repeatedly
accessed in specific geographic regions.
We offer a variety of services that allow customers to benefit from the
Digital Island global private network. We manage computer servers, maintain Web
sites and Internet applications for our customers in our four network data
centers, and offer a range of data transport options which allow customers to
reserve network capacity consistent with their expected network usage on
request. These services are designed to allow customers to outsource Internet
activities to us, thereby transferring to us the burden of attracting and
retaining scarce technical staff and adopting continuously changing
technologies, while lowering their operating costs and speeding deployment.
Industry Background
The Internet continues to experience rapid growth and expansion as an
important global medium for communications and electronic business.
International Data Corporation, known as IDC, has estimated that the total
number of Internet users in the world reached approximately 69 million in 1997
and will increase to approximately 319 million in 2002, a 36% compound annual
growth rate. As the numbers of Internet users has grown, enterprises have
increasingly viewed the Internet as an opportunity to interact rapidly with a
larger
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<PAGE>
number of geographically distributed offices, employees, customers, suppliers
and partners. Many enterprises that focus solely on delivering services over
the Internet have emerged as well as offline businesses that have implemented
Internet sites incorporating e-commerce applications. As the Internet has
emerged as a strategic component of business, investment in Internet services
has begun to increase dramatically. According to IDC, the demand for U.S.
Internet and e-commerce services was $2.9 billion in 1997 and is expected to
grow to $22.1 billion by 2002, a 50% compound annual growth rate. In addition,
demand for data transport services is growing rapidly as evidenced by IDC's
estimate that Internet service providers' corporate access revenues are
expected to grow from $2.9 billion in 1998 to $12.0 billion by 2003, a 33%
compound annual growth rate.
Increasing Reliance on Internet Business Applications. As use of the
Internet grows, enterprises are increasing the breadth and depth of their
Internet product and service offerings. Businesses have begun to use the
Internet for an expanding variety of commercial applications, including
customer service, electronic sales, software and multimedia document
distribution, sales force automation and distance learning. For many
enterprises, loss of the availability of such business-critical applications
often results in loss of revenue and impairment of customer good will. As a
result, enterprises are increasingly demanding that their networks deliver
consistent, fast global performance, remain easy to upgrade as the scale and
complexity of applications grows and technologies change, operate continuously
24 hours per day, seven days per week, and offer the applications support and
functionality (e.g. security, user location, identification and usage patterns)
previously provided only in wide area networks.
Inherent Problems with the Internet/Need for a Robust Global Solution. The
public Internet infrastructure was designed for applications requiring limited
communications bandwidth capacity and was not designed with the quality
necessary for core business uses such as electronic commerce. For enterprises
requiring global solutions, the U.S.-centric nature of the public Internet
results in poor response times, particularly for applications requiring large
file transfers, instantaneous interaction between networked users and overseas
transport. This occurs because data transmittal between countries must travel
through telecommunications lines in the U.S. where the Internet originated and
where most of its infrastructure is still located, and make a large number of
connections through various regional and national Internet service providers
before reaching its destination. Data packets often become lost in the transfer
process, especially for data-intensive transfers involving large software
downloads, multimedia document distribution and audio or video content. The
response time for users is also often slow.
Trend Toward Outsourcing of Internet Operations. In seeking to address the
performance issues of the public Internet, enterprises have increasingly found
that investing in the resources and personnel required to maintain in-house
private networks is cost-prohibitive and extremely difficult given the shortage
of technical talent and risk of technological obsolescence. With the failure of
in-house solutions to address their needs, today's enterprises have
increasingly sought third party providers to support their Internet
applications deployment, operations and ongoing maintenance. Regional and
national Internet service providers, however, often fail to provide an adequate
solution because they lack the geographically distributed network capability
necessary to deliver content globally using replication and caching
technologies, which are becoming increasingly important as the Internet usage
and bandwidth demand increase. IDC estimates that corporate spending on web
hosting services will increase from approximately $414 million in 1997 to $11.8
billion by 2002, a 95% compound annual growth rate. Enterprises are
increasingly seeking companies that combine hosting services and geographically
dispersed data centers that deploy the enterprise's applications closer to the
end-user to provide value-added solutions.
The Digital Island Solution
Digital Island offers a global private network and related services for
companies that need worldwide deployment of key business applications over the
Internet. Our solution provides the following key advantages:
Global Connectivity and Availability. The Digital Island Global IP
Applications Network currently has connection point in 18 countries in Asia,
Europe, North America, South America and Australia. We believe that this global
reach provides our customers with local access to the majority of existing
Internet users.
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High Performance and Scalability. The Digital Island Global IP Applications
Network bypasses the primary congestion points of the public Internet to
provide fast, consistent performance for our customers. By routing and managing
Internet traffic over a centralized high-speed network directly between our
strategic, globally distributed data centers and local points of presence, our
solution avoids transmission of data over multiple routers and switches
(systems that relay data in networks) and network access points (locations at
which Internet service providers exchange traffic) in the public Internet,
thereby substantially reducing transmission time and improving network security
and performance. Our network architecture is reliable, can scale to many users
and enables a consistent end user experience independent of time of day and
geography.
Local Content Management. We own and operate a growing number of Digital
Island Local Content Managers in high volume markets around the world. We have
created "digital warehouses" where we help customers readily store files which
are repeatedly accessed within the regional area. This solution is a more cost
effective and scalable solution when supporting high volume global access to
information. It also allows for a more geographically localized experience
(e.g. language and currency). We currently operate Digital Island Local Content
Manager sites in Germany, Japan, Australia, the U.S., and the United Kingdom
and plan to continue our current expansion.
Cost-Effective Outsourcing Solution. Our customers directly benefit from the
significant investments of technical expertise and other resources that we have
made to develop our unique Digital Island Global IP Applications Network. Most
enterprises today do not have the infrastructure that mission-critical Internet
operations require, including strategic, globally distributed data centers, 24
hours per day, seven days per week operations and specialized Internet
technology expertise. Our solution allows customers to address shortages of
technical resources and continuously changing technologies, while substantially
lowering the application deployment and operational costs of new Internet
applications. We believe that our solutions and economies of scale are
significantly more cost-effective than most in-house alternatives.
Innovative Solutions. We believe that, as a result of our advanced network
architecture and highly experienced product development team, we are able to
provide a unique set of value-added product offerings. For example, we offer
open, reserved and managed bandwidth products that enable our customers to
allocate their bandwidth purchases according to their changing needs. In
addition, our proprietary technology enables us to bill our customers according
to the number of bits of data transmitted over our network, geographic
destination of transmission and time of day, as opposed to traditional flat-
rate billing. This allows us to provide more flexible service pricing, and
benefits the customer by more accurately correlating network cost to actual
network utilization by geography. We are developing and deploying our
proprietary TraceWare technology that enables customers to identify the source
of Internet requests. Being able to correlate the source and destination (where
the data enters and exits our network) provides our customers with significant
service and product opportunities, such as flexible pricing plans, localization
of content and currency, assistance in fraud detection, authentication and
compliance with export regulations and the enhancement of other applications
deployed across our network.
Business Strategy
Our objective is to be the leader in offering network services for
globalizing Internet business applications. In order to achieve this objective,
we are implementing a business strategy focused on the following key elements:
Target Multinational Corporations. We have designed our network to address
the sophisticated needs of multinational customers, who are increasingly
relying on the Internet to conduct business and require consistent levels of
high performance and reliability. We primarily target leading customers in
industries which are early adopters of Internet technologies, such as the
financial services, technology, media publishing, entertainment and other
Internet-centric sectors. We have tailored our services to enhance the
performance of our customers in electronic commerce and services, such as
digital media distribution. The Digital Island Global IP Applications Network
has connection points in 18 countries worldwide, providing our customers with
access to
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a significant majority of existing Internet users, and we plan to expand our
global reach through additional connection points in the future.
Expand Customer Relationships. We plan to extend our leadership in the
market for global Internet application services by continuing to expand our
base of customers. By integrating other Internet services into the Digital
Island Global IP Applications Network, and by providing high-quality customer
support, we believe that businesses will increasingly rely on us for their
Internet business needs, which in turn should enhance customer retention and
increase demand for both application services and network usage. For example,
Autodesk initially used our network to deploy applications in a single country;
subsequently, Autodesk chose to deploy applications in other countries served
by Digital Island and added additional applications and extended usage of our
services to key subsidiaries.
Develop Additional Network Services. We seek to be a leader in designing and
deploying a global business network that enables customers to capture the
benefits of ubiquitous access to applications and the performance and range of
functions of private intranets operated by individual companies for their own
users. We are committed to investing resources to implement new Internet
technology and services that will allow our customers to optimize their
deployment and operation of applications globally. To this end, we collaborate
with providers of leading Internet technologies to develop and deploy
proprietary technologies in order to enhance our service offerings and to
address our customers' evolving needs. Some of our recent innovations have
included reserved and managed bandwidth technologies that allow customers to
tailor bandwidth to their individual needs and benefit from usage-based
billing, and our TraceWare technology, which is not yet commercially released,
that enables customers to identify the source of Internet traffic. Our Digital
Island Local Content Managers enable customers to readily store files which are
repeatedly accessed within specific geographical regions. We believe that
continuing leading edge innovation is the key to differentiating Digital
Island's products and services in the long term.
Expand Strategic Relationships. We believe that strategic relationships
should enhance our ability to reach new customers. Potential partners include
system integrators, software vendors and application service providers that
provide network equipment and services to companies. Further, strategic
relationships with our customers in our target markets, such as with E*TRADE,
bring not only a high level of understanding of the specific needs of that
market but also credibility and visibility with potential new customers. We are
also targeting partners which can enhance our ability to develop and deliver
new application services. Through these relationships we hope to leverage these
enterprises' research and development expertise to cost effectively develop new
network services.
Expand Global Sales Capabilities. We target our customers predominately
through a direct sales channel complimented by a range of external alliances
and channels. We currently have 52 professionals in our sales organization in
offices in the U.S., Asia and Europe and intend to grow our sales organization
substantially over the next year. Our Global Partner Program is targeted at
increasing the effectiveness of our direct channel. In addition to co-
marketing, we have a growing number of sales channel partners which represent
our products and services either as a sales agent or a reseller.
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The Digital Island Intelligent Network
[GRAPHIC APPEARS HERE]
The graphic above illustrates the Digital Island Intelligent Network, which
utilizes four data centers with an asynchronous transfer mode backbone (a
centralized high-speed network) to connect to local connection points in 18
countries with the assistance of major international network service providers.
Network Architecture
The Digital Island Intelligent Network consists of an asynchronous transfer
mode, or "ATM," backbone that connects four geographically dispersed data
centers. This ATM backbone router core is a centralized high-speed network that
connects to local Internet service providers in 18 countries forming a
distributed network architecture that minimizes the number of separate
transmissions, necessary to transmit data, resulting in greater speed and
reliability for our customers' end-users. Our four distributed data centers
permit us to disseminate information reliably on a global basis and, using our
sophisticated data tracking capability, allow us to optimize data transmissions
internationally, minimizing the use of expensive transoceanic fiber optic
circuits. The Digital Island network is designed to increase the speed and
reliability of data transmission and circumvents a design weakness of the
public Internet, which requires transmission of information over numerous
routers and network inter-exchange points, often leading to delays and loss of
data. Local Content Managers, where customers can store files which are
repeatedly accessed within the regional area, are located in Australia, Japan,
Germany, the United Kingdom and all three U.S. data centers. We believe our
architecture is superior to traditional networks for the distribution of
applications because of its manageability, ability to scale to many users and
connectivity over dedicated lines to local Internet service providers and
network service providers through dedicated connection points.
We currently have direct connections in 18 countries with one or more local
Internet service providers, providing customers with direct access to local
markets worldwide. Currently, we purchase transit from AT&T, GTE, Sprint and
MCI WorldCom in the United States and have established transport relationships
in 17 other countries, giving us a total of 26 different direct points of
connection to the Internet. Unlike traditional peering
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relationships, these network service providers carry the Internet traffic of
our customers without any reciprocal transit agreement. While Digital Island
pays a fee to the network service providers for this arrangement, it gives us
access to thousands of Internet service providers without the obligation of
carrying traffic originating outside of our network. Both the Santa Clara and
New York data centers have direct connections through circuits with each of the
four network service providers. In addition to the U.S., we have established
private Internet connection relationships in 17 other countries as listed
below:
<TABLE>
<S> <C> <C>
Australia Israel South Korea
Brazil Japan Sweden
Canada Mexico Switzerland
China Netherlands Taiwan
France Russia United Kingdom
Germany Singapore
</TABLE>
In China, we have connections in both Hong Kong and Beijing. With 26
different connection points to the Internet, we believe we offer our customers
one of the most diverse, redundant and reliable networks for the deployment of
business applications globally.
We currently have a state-of-the-art network operations center,
headquartered in Honolulu, Hawaii, which provides real time end-to-end
monitoring of our network 24 hours per day, seven days a week, 365 days per
year. The network operations center helps us to ensure the efficient and
reliable performance of our network, enabling us to identify, and often
prevent, potential network disruptions and to respond immediately to actual
disruptions. In addition, through traffic management and forecasting, line
performance reporting and alarm monitoring, remote link restoration and
coordination, and provisioning of network services, the network operations
center enables us to schedule and conduct maintenance with minimal
interferences to the network.
We currently lease lines or bandwidth from multiple telecommunications
carriers. These carriers include MCI WorldCom, GTE and Sprint, as well as
several international carriers such as Cable & Wireless, IDC, Telstra and
Singapore Telecom. Leasing from multiple carriers assists us in achieving
competitive pricing, provides us with diversity of routes and redundancy and
provides access to multiple sources of bandwidth on different cable systems
globally. Our lease contract term with a carrier is typically one year, which
allows us to benefit from declining bandwidth costs over time. In some cases
the term may extend to three years where we determine there is a significant
cost advantage implicit in such arrangement or that the route served by such
line is bandwidth constrained.
Services
We offer a family of services designed to allow companies to deploy their
Internet applications globally without developing or acquiring their own global
network. Our services are especially suited to Internet applications requiring
a high performance end user experience which is consistent and reliable when
downloading files (e.g., software, documentation and video clips), downloading
graphic-intensive web content or engaging in real-time transactions (e.g.,
transaction clearing and video conferencing) across a range of access speeds.
We work with each of our customers to optimize cost and performance
requirements. Our content hosting, mirroring and caching services allow
customer applications to be replicated throughout the network to lower costs
and improve response times and our transport services guarantee bandwidth into
local markets. Our network engineering team provides our customers with global
networking expertise and consultation in the design and deployment of their
applications on the Digital Island Global IP Applications Network. We also
provide 24 hours per day, seven days per week, 365 days per year operations
support and security experts to keep their applications up and running on a
global basis.
We currently offer service level guarantees, customized billing, network
security services, network management and other application services designed
to improve the performance of applications deployed on our network. We plan to
continue to develop or acquire extensions to our application services to fuel
ongoing
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product and service delivery. For example, we believe that our proprietary
TraceWare technology, which is not yet commercially released, enables our
customers to identify the source of Internet protocol requests as well as the
destinations of Internet traffic. This technology will be predominantly used
for targeted advertising and local language content delivery.
Application Hosting and Content Distribution Services
Our application hosting and content distribution services, including
mirroring and caching, enable customers to gain the benefit of having their
application (whether on a server on their site or on a server in one of our
data centers) appear to be located in every country where we have a connection
point. Leveraging our network architecture and technologies, our application
hosting services provide end users globally with what we believe, based on our
past experience, to be fast, reliable and seamless access to our customers'
content. Each of our data centers has state-of-the-art power management,
security, and fire suppression systems. Customers have access to our network
operations center and our on-site personnel for ongoing maintenance services.
Customers can choose from the following packages:
Server Management Package. This is an all-inclusive solution for customers
seeking to outsource their day-to-day hardware and server administration. We
operate two production-ready environments: Sun Solaris(TM) and Windows NT(TM)
operating on Compaq servers. We host these servers, as well as servers provided
by our customers, in our data centers and provide the network infrastructure as
well as application monitoring, performance optimization, server administration
and security services. This package provides a production-ready environment
with maximum uptime.
Hardware Management Package. This enables our customers to outsource day-to-
day hardware maintenance, while allowing our customers' IT staff unhindered
access to perform any needed system administration functions. This package
includes services from our data center personnel for hardware management and
repair plus access to our network infrastructure. Our centrally managed network
architecture provides optimized routing, resulting in the uptime, performance,
and reliability required by our customers.
Co-location Package. This allows our customers to house their own servers in
one of our data centers, and provides a secure environment designed to deliver
maximum uptime for the server plus access to our Global IP Applications
Network.
Globeport. For customers choosing to maintain content at their own data
centers, we will arrange dedicated connections from the client's site to our
closest point of presence. This package includes network services enabling our
customers to extend their reach globally.
Network Services
We offer a range of network services to be used with our Application Hosting
and Content Distribution Services:
Open Bandwidth. Customers pay a minimum monthly fee for access to our
network and are charged based on actual usage (per gigabit) above these minimum
levels. Customers may also pay for services based on distance traveled.
Customers can generate utilization reports which allow them to determine usage
flows by country.
Reserved Bandwidth. Reserved Bandwidth is a network service that guarantees
a minimum throughput level, expressed in kilobytes per second to a specified
connection point. Our customer is billed for a pre-specified minimum amount of
data transfer to that specified connection point. Unlike other methods of
relaying Internet traffic such as frame relay services, our network is
engineered to accommodate peaks in traffic above the minimum guaranteed levels.
Gigabytes in excess of the reserved monthly amount are billed at the applicable
data transfer rate.
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Managed Bandwidth. Managed Bandwidth is our premium network transport
service offering. Using a web browser interface, IT professionals can readily
allocate bandwidth by geographic region at any time from any location. Through
this service, IT professionals can configure the Digital Island network to meet
their organization's international throughput requirements.
Professional Services
We augment our primary product and service offerings with a range of
professional service options for customers. Professional services include
helping our customers to provide security on their networks, making
recommendations for network equipment and consulting as to Internet application
deployment.
Customers
We primarily target leading customers in industries which are early adopters
of Internet technologies, such as the financial services, technology, media and
other Internet-centric sectors. Within our target markets, we have tailored our
services to enhance the performance of our customers in electronic commerce,
electronic services and electronic fulfillment, such as digital media
distribution. Our customers use our services and proprietary technology to
facilitate the deployment of commercial applications, including electronic
commerce, online customer service, software distribution, multimedia document
distribution, sales management and distance learning. As of March 31, 1999, we
had contracts with 62 customers including Autodesk, Cisco Systems, Diamond
Multimedia Systems, E*TRADE, Mastercard International, National Semiconductor,
Novell, and Platinum Technology.
The following examples, which are based on information furnished by the
companies listed below, illustrate how some of our customers use our global
private network for deployment of business applications:
Autodesk. Autodesk is a supplier of design software and multimedia tools
that address several markets including architectural and mechanical design,
filmmaking, videography and geographic information systems. Autodesk selected
Digital Island's Server Management Package and Managed Bandwidth services to
distribute their technical documentation and software to customers in over 150
countries.
Cisco Systems. Cisco Systems is a leading provider of networking software
and hardware for the Internet. Cisco employed our services and technology for
engineers to access the Cisco customer care online website in order to download
Cisco software and to upgrade routers in the field. Using a combination of our
Globeport, Hardware and Server Management Packages and our Open Bandwidth
services and mirroring technology, Cisco was able to increase customer service
by allowing the field engineers and customers to access critical information
and download software while working at the client site.
E*TRADE. E*TRADE is an online financial services company that has engaged
Digital Island to provide a broad range of network solutions to deliver
mission-critical applications in 32 countries and provide their customers with
consistent performance online. E*TRADE customers rely on the Internet for their
trading and research requests, making the applications that provide these
services mission-critical to E*TRADE's business. The applications serving these
requests also require high levels of consistent bandwidth. By utilizing our
Globeport Package and customized network services, E*TRADE has advised us that
it provides its customers worldwide with a more consistent, fast and high
quality online experience.
National Semiconductor. National Semiconductor is a multinational company
that develops and manufactures semiconductor products for high growth markets
in the electronics equipment industry. Utilizing Digital Island's Co-location
Package and network services, National Semiconductor is able to globally deploy
technical documents to customers on a real-time basis, thereby greatly reducing
documentation delivery times and costs. Digital Island's network also enables
National Semiconductor to communicate with its global sales force on a real-
time basis to assess demand and forecast production levels.
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Except for National Semiconductor, each of the customers referenced in the
above examples accounted for more than 3% of revenues for fiscal year ended
September 30, 1998, and the six months ended March 31, 1999.
Sales and Marketing
Our sales and marketing strategy is designed to target multinational
businesses that depend on the Internet for core business operations.
To reach these enterprises, we utilize a multi-tiered channel approach. In
North America, we primarily rely on direct sales and augment this effort with
resellers, agents or co-marketing partners where appropriate. In Europe, Asia
and Latin America, we are hiring direct sales personnel and developing agents
and reseller channels. Our channel partners also provide services to us in the
form of data center capacity, connectivity to local backbones or service
providers and router installation/repair.
We are actively seeking to increase our sales and distribution capabilities
globally. Currently, most of our sales are derived from the efforts of our
direct sales force. We have begun developing indirect sales channels targeting
content developers (such as firms that develop Web sites), system integrators,
consulting companies, suppliers and international Internet service providers.
As of March 31, 1999, we had five channel partners in Europe and Asia who we
pay commissions to refer customers.
Our marketing organization is responsible for product management, product
marketing, public relations and marketing communications. Product management
includes defining the product plan and bringing to market our products and
services. These activities include product strategy and definition, pricing,
competitive analysis, product launches, channel program development and product
life cycle management. We stimulate product demand through a broad range of
marketing communications and public relations activities. Primary marketing
communications activities include public relations, collateral, advertising,
direct response programs and management of our Web site. Our public relations
focuses on cultivating industry analyst and media relationships with the goal
of securing broad media coverage and recognition as a leader and innovator in
global Internet application deployment.
While we have not entered into any material partnering arrangements, a key
element of our marketing strategy includes identifying and partnering with
component suppliers, customers and other application service companies. We have
a dedicated team focused on creating new, and expanding existing, relationships
which will be critical to the ongoing success of future product developments.
Customer Support
We seek to provide superior customer service by understanding the technical
requirements and business objectives of our customers and fulfilling their
needs proactively on an individual basis. By working closely with the customer,
we seek to optimize the performance of our customers' Internet operations,
avoid downtime, resolve quickly any problems that may arise and make
adjustments in services as customer needs change over time.
Before sales are made, we provide technical advice to customers in order to
help them understand their networking needs and how our products and services
can provide solutions for particular needs. During the installation phase, we
assign a support team led by our Customer Advocacy group which also retains
support responsibility for the account after the customer's application is
installed and operational, to assist the customer through the installation
process. After commencing services, primary technical support is provided by
our network operation center, which is operated 24 hours per day, seven days
per week by highly trained technicians who respond to customer calls, monitor
site and network operations and escalate problems to engineering to solve
problems quickly and professionally. Our Customer Advocacy personnel are also
available to assist with billing and business issues and to assist in planning
for additional customer applications usage on the network.
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Finally we employ network engineers who collaborate with customers to design
and maintain their application across the network. Our network engineers are
trained on Windows NT, Solaris and other UNIX platforms, as well as Cisco
routers and switches, and they serve as the escalation path to resolve customer
problems. We also employ a team of network backbone engineers that constantly
monitor the network design and effectiveness to optimize performance for
customers, rerouting and redesigning their applications as conditions require.
Competition
Our market is highly competitive. There are few substantial barriers to
entry and we expect that we will face additional competition from existing
competitors and new market entrants in the future. The principal competitive
factors in this market include Internet system engineering expertise, customer
service, network capability, reliability, quality of service and ability to
scale to many users, broad geographic presence, brand name recognition,
technical expertise and range of functions, the variety of services offered,
the ability to maintain and expand distribution channels, price, the timing of
introductions of new services, network security, financial resources and
conformity with industry standards. We may not have the resources or expertise
to compete successfully in the future.
Our current and potential competitors in the market include:
. information technology and Internet outsourcing firms;
. national and regional Internet service providers; and
. global, regional and local telecommunications companies.
Our competitors may operate in one or more of these areas and include
companies such as AboveNet Communications, Inc., AT&T Corp., Exodus
Communications, Inc., GTE Corporation, MCI WorldCom, Inc. and business units of
Frontier GlobalCenter, Inc. In particular, Exodus and GlobalCenter provide
services that are directly competitive with services that we provide.
Many of our competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories, greater
name recognition and more established relationships in the industry than we do.
As a result, these competitors may be able to develop and expand their network
infrastructures and service offerings more quickly, adapt to new or emerging
technologies and changes in customer requirements more quickly, take advantage
of acquisition and other opportunities more readily, devote greater resources
to the marketing and sale of their products and adopt more aggressive pricing
policies than we can. In addition, these competitors have entered and will
likely continue to enter into joint ventures or consortiums to provide
additional services competitive with those that we provide.
Some of our competitors may be able to provide customers with additional
benefits in connection with their Internet system and global applications
network solutions, including reduced communications costs, which could reduce
the overall costs of their services relative to the cost of our services. We
may not be able to offset the effects of any such price reductions. In
addition, we believe that the businesses in which we compete are likely to
encounter consolidation in the near future, which could result in increased
price and other competition that could cause our business and prospects to
suffer.
Intellectual Property Rights
We rely on a combination of copyright, trademark, service mark and trade
secret laws and contractual restrictions to establish and protect proprietary
rights in our products and services. Although we have filed a patent
application with respect to our TraceWare technology with the United States
Patent and Trademark Office, such application is pending and we currently have
no patented technology that would preclude or inhibit
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competitors from entering our market. In addition, we have registered the mark
"Digital Island" with the Patent and Trademark Office, and we have a pending
trademark application for the mark "TraceWare" with the Patent and Trademark
Office. Our "Digital Island" mark is either registered or pending in several
foreign countries. We have entered into confidentiality and invention
assignment agreements with our employees, and nondisclosure agreements with our
suppliers, distributors and appropriate customers in order to limit access to
and disclosure of our proprietary information. These contractual arrangements
or the other steps that we take to protect our intellectual property may not be
sufficient to prevent misappropriation of our technology or to deter
independent third-party development of similar technologies. The laws of
foreign countries may not protect our products, services or intellectual
property rights to the same extent as do the laws of the United States.
To date, we have not been notified that our products infringe the
proprietary rights of third parties, but third parties may in the future claim
that our current or future products infringe upon their proprietary rights. We
expect that participants in our markets will be increasingly subject to
infringement claims as the number of products and competitors in our industry
segment grows. Any such claim, whether meritorious or not, could be time
consuming, result in costly litigation, cause product installation delays or
require us to enter into royalty or licensing agreements. Such royalty or
licensing agreements might not be available on terms acceptable to us, or at
all. As a result, any such claim could harm our business and prospects.
Government Regulation
Federal Regulation. The FCC does not currently regulate network software or
computer equipment-related services that transport data or voice messages on
telecommunications facilities, except when provided by any of the Regional Bell
Operating Companies. However, we provide network services including
transmitting data over public telephone lines, and those transmissions are
governed to some extent by federal regulatory policies establishing charges and
terms for wireline communications. Operators of those types of networks that
provide access to regulated transmission facilities only as part of a data
services package currently are not subject to direct regulation as
"telecommunications carriers" by the FCC or any other federal agency, other
than regulations generally applicable to businesses.
The absence of direct FCC regulation reflects, in part, the status of
Internet services as a relatively recent phenomenon. The federal legal and
regulatory framework for such services is therefore in its nascent state of
development.
The evolving state of federal law and regulation is reflected in the FCC's
April 10, 1998 Report to Congress. In the April 1998 Report, the FCC discussed
whether Internet service providers should be classified as telecommunications
carriers, and, on that basis, be required to contribute to the Universal
Service Fund which was created by federal statute and funded by interstate
telecomunications carriers for the purpose of ensuring that all segments of the
population of the United States have access to basic telecommunications
services. The report concluded that Internet access service which the FCC
defined as an offering combining computer processing, information storage,
protocol conversion, and routing transmissions is an "information service"
under the Telecommunications Act of 1996 and thus not subject to regulation. In
contrast, the FCC found that the provision of transmission capabilities to
Internet service providers and other information service providers does
constitute "telecommunications services" under the Telecommunications Act of
1996. Consequently, parties providing those latter services are presently
subject to FCC regulation (and the corresponding Universal Service Fund
obligations).
New federal laws and regulations may be adopted in the future that would
subject the provision of our Internet services to government regulation.
Legislative initiatives currently being considered in Congress, for example,
may require taxation of Internet-related services like those that we offer or
impose access charges on Internet service providers. Any new laws regarding the
Internet, particularly those that impose regulatory or financial burdens, could
cause our business and prospects to suffer. We cannot predict the impact, if
any, that any future changes in law or regulation may have on our business.
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Certain changes in federal law and regulations could cause our business and
prospects to suffer. Changes of particular concern include those that directly
or indirectly affect the regulatory status of Internet services, increase the
cost telecommunications services (including the application of access charges
or Universal Service Fund contribution obligations to Internet services), or
increase the competition from the RBOCs and other telecommunications companies.
We cannot predict the impact, if any, that such legislative or regulatory
changes may have on our business. For instance, the FCC could determine through
any one of its ongoing or future proceedings that the Internet is subject to
regulation. In that event, we could be required to comply with:
. FCC entry or exit regulations;
. tariff filing, reporting, fee, and record-keeping requirements;
. marketing restrictions;
. access charge obligations; and
. contributions to the Universal Service Fund obligations.
Any one or more of those changes could adversely impact our ability to
provide services. The FCC could similarly conclude that providing Internet
transport or telephony services over an Internet protocol-based network is
subject to regulation. For example, the FCC currently has ongoing proceedings
in which it is considering whether to regulate certain transmissions provided
via the Internet, such as services functionally equivalent to traditional two-
way voice telephony. Such determination could cause our business and prospects
to suffer.
Another major and unresolved regulatory issue concerns the obligation of
information service providers, including Internet service providers, to pay
access charges to Incumbent Local Exchange Carriers. A proceeding initiated by
the FCC in December 1996 that raises the issue whether Incumbent Local Exchange
Carriers, which are local telephone companies that began providing service
prior to the enactment of the Telecommunications Act of 1996, can assess
interstate access charges on information service providers, including Internet
service providers. Unlike basic services, enhanced services, which the FCC has
concluded are synonymous with information services and include Internet access
services, are exempt from interstate access charges. The FCC has reaffirmed
that information service providers are exempt from access charges, and a United
States Court of Appeals has affirmed this decision by the FCC.
Another major regulatory issue concerns Internet-based telephony. In its
April 1998 Report, the FCC observed that Internet protocol telephony appears to
be a telecommunications service rather than an unregulated information service.
The FCC explained that it would determine on a case-by-case basis whether to
regulate the service and thereby require providers of Internet protocol
telephony to contribute to the Universal Service Fund. The ultimate resolution
of Internet protocol telephony issues could negatively impact the regulatory
status, cost and other aspects of our service offerings.
Another major and unresolved regulatory proceeding that could affect the
benefit and cost of our service offerings (to the extent we become involved in
the exchange of communications traffic) involves reciprocal compensation.
Reciprocal compensation relates to the fees paid by one carrier to terminate
traffic on another carrier's network. In July 1997, the FCC was asked to
determine whether Competitive Local Exchange Carriers (local telephone
companies that provide service in competition with Incumbent Local Exchange
Carriers) that serve Internet service providers are entitled to reciprocal
compensation under the Telecommunications Act of 1996 for calls originated by
customers of an Incumbent Local Exchange Carriers to an Internet service
provider served by a Competitive Local Exchange Carriers within the same local
calling area. Prior to the time the FCC addressed the issue, every state that
addressed the issue from an intrastate perspective (at least twenty-nine in
number) determined that calls to Internet service providers are to be treated
as local for purposes of reciprocal compensation. In February 1999, the FCC
concluded that it would regulate in the future calls to Internet service
42
<PAGE>
providers as interstate traffic. The FCC sought comment on how this traffic
should be compensated prospectively between carriers. The FCC's ultimate
resolution of the compensation issue could increase Internet service provider
costs in the future by increasing telephone charges if the FCC adopts a rule
that precludes compensation for calls to Internet service providers or
prescribes a rate that is substantially less than the reciprocal compensation
rates that were paid in the past and are being paid under some existing inter-
carrier agreements.
We could also be harmed by federal (as well as state) laws and regulations
relating to the liability of on-line services companies and Internet access
providers for information carried on or disseminated through their networks.
Several private lawsuits seeking to impose such liability upon on-line services
companies and Internet access providers are currently pending. In addition,
legislation has been enacted and new legislation has imposed liability for the
transmission of, or prohibits the transmission of certain types of, information
on the Internet, including sexually explicit and gambling information. The
United States Supreme Court has already held unconstitutional certain sections
of the Communications Decency Act of 1996 that, among other provisions,
proposed to impose criminal penalties on anyone distributing "indecent"
material to minors over the Internet. Congress subsequently enacted legislation
that imposes both criminal and civil penalties on persons who knowingly or
intentionally make available materials through the Internet that are "harmful"
to minors. However, the new law generally excludes from the definition of
"person" Internet service providers that are not involved in the selection of
content disseminated through their networks. Congress also enacted legislation
recently that limits liability for online copyright infringement. That latter
law includes exemptions which enable Internet service providers to avoid
copyright infringement if they merely transmit material produced and requested
by others. It is possible that other laws and regulations could be enacted in
the future that would place copyright infringement liability more directly on
Internet service providers. The imposition of potential liability on us and
other Internet access providers for information carried on or disseminated
through their systems could require us to implement measures to reduce our
exposure to such liability, which may in turn require us to expend substantial
resources or to discontinue service or product offerings. The increased
attention to liability issues as a result of lawsuits and legislative action,
could similarly impact the growth of Internet use. While we carry professional
liability insurance, such insurance may not be adequate to compensate claimants
or 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 such liability or asserted liability could cause our business
and prospects to suffer.
State Regulation. The proliferation of Internet use in the past several
years has prompted state legislators and regulators to consider the adoption of
laws and regulations to govern Internet usage. Much of the legislation that has
been proposed to date may, if enacted, handicap further growth in the use of
the Internet. It is possible that state legislatures and regulators will
attempt to regulate the Internet in the future, either by regulating
transactions or by restricting the content of the available information and
services. While state public utility commissions generally have declined to
directly regulate enhanced or information services, some states have continued
to regulate particular aspects of enhanced services in limited circumstances,
such as where they are provided by local telecommunications carriers. Moreover,
the public utility commissions of several states continue to consider potential
regulation of such service. Enactment of such legislation or adoption of such
regulations could cause our business and prospects to suffer.
Another area of adverse potential state regulation concerns taxes. The
United States Congress recently enacted a three-year moratorium on new state
and local taxes on the Internet (those not generally imposed or actually
enforced prior to October 1, 1998) as well as on taxes that discriminate
against commerce through the Internet. Congress also established an advisory
commission to study and make recommendations on the federal, state and local
taxation of Internet-related commerce. These recommendations are due to
Congress by April 2000 and could serve as the basis for additional legislation.
Previous to the enactment of the tax moratorium a significant number of bills
had been introduced in state legislatures that would have taxed commercial
transactions on the Internet. Future laws or regulatory changes that lead to
state taxation of Internet transactions could cause our business and prospects
to suffer.
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<PAGE>
One issue of growing importance revolves around contract law. Although
customer-level use of the Internet to conduct commercial transactions is still
in its infancy, a growing number of corporate entities are engaging in Internet
transactions. This Internet commerce has spawned a number of state legal and
regulatory issues, such as whether and how provisions of the Uniform Commercial
Code (adopted by 49 states) apply to transactions carried out on the Internet
and how to decide which jurisdiction's laws are to be applied to a particular
transaction. It is not possible to predict how state law will evolve to address
new transactional circumstances created by Internet commerce or whether the
evolution of such laws will cause our business and prospects to suffer.
State legislators and regulators have also sought to restrict the transition
or limit access to certain materials on the Internet. For example, in the past
several years, various state legislators have sought to limit or prohibit:
. certain communications between adults and minors;
. anonymous and pseudonymous use of the Internet;
. on-line gambling; and
. the offering of securities on the Internet.
Enforcement of such limitations or prohibitions in some states could affect
transmission in other states. State laws and regulations that restrict access
to such materials on the Internet could inadvertently block access to other
permissible sites. We cannot predict the impact, if any, that any future laws
or regulatory changes in this area may have on our business.
Some states have also sought to impose tort liability or criminal penalties
on certain conduct involving the Internet, such as the use of "hate" speech,
invasion of privacy, and fraud. The adoption of such laws could adversely
impact the transmission of non-offensive material on the Internet and, to that
extent, could cause our business and prospects to suffer.
Local Regulation. Although local jurisdictions generally have not sought to
regulate the Internet and related services, it is possible that such
jurisdictions will seek to impose regulations in the future. In particular,
local jurisdictions may attempt to tax various aspects of Internet access or
services, such as transactions handled through the Internet or subscriber
access, as a way of generating municipal revenue. The imposition of local taxes
and other regulatory burdens by local jurisdictions could cause our business
and prospects to suffer. Our networks may also be subject to numerous local
regulations such as building codes and licensing. Such regulations vary on a
city by city and county by county basis.
Foreign Regulation. As our services become available over the Internet in
foreign countries, and as we facilitate sales by our customers to end users
located in such foreign countries, these foreign jurisdictions may decide that
we are required to qualify to do business in the particular foreign country or
to obtain permits or licenses to provide permits or licenses to provide value-
added network services. Such decisions could subject us to taxes and other
costs and could result in our inability to enforce contracts in such
jurisdictions. It is possible that claims could be made against online service
companies and Internet service providers under foreign law for defamation,
negligence, copyright or trademark infringement, or other theories based on the
nature and content of the materials disseminated through their networks. Any
such new legislation or regulation, or the application of laws or regulations
from jurisdictions whose laws do not currently apply to our business, could
cause our business and prospects to suffer.
Employees
As of March 31, 1999, we had 146 employees, including 64 people in sales and
marketing, 34 people in engineering, 32 people in operations and 16 people in
finance and administration. We believe that our future success will depend in
part on our continued ability to attract, hire and retain qualified personnel.
The
44
<PAGE>
competition for such personnel is intense, and there can be no assurance that
we will be able to identify, attract and retain such personnel in the future.
None of our employees is represented by a labor union, and management believes
that our employee relations are good.
Facilities
We currently have the following facilities: our corporate headquarters in
San Francisco, and data centers in Honolulu, Santa Clara (California), New York
City, and London. We have entered into a lease for new corporate headquarters
in San Francisco, and plan to move to the new location in July 1999. We plan to
open an additional data center in Hong Kong in September 1999. In addition, we
have sales offices in Boston, New York City, Minneapolis, Chicago,
Philadelphia, Dallas, Houston, St. Louis, Japan, Malaysia, the Netherlands,
Switzerland and the United Kingdom.
Legal Proceedings
We are not party to any material legal proceeding.
45
<PAGE>
MANAGEMENT
Officers, Directors and Senior Management
The following table sets forth the names and ages of our executive officers
and directors and certain members of our senior management as of March 31,
1999.
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Ron Higgins........................ 41 Chairman of the Board of Directors
Ruann F. Ernst(1)(4)(5)............ 52 Chief Executive Officer and President
and Director
T.L. Thompson...................... 52 Chief Financial Officer and Secretary
Paul Evenson....................... 38 Vice President of Operations
Sanne Higgins...................... 49 Vice President of Corporate
Communications
Allan Leinwand..................... 32 Vice President of Engineering and Chief
Technology Officer
Bruce Pinsky....................... 35 Vice President of Solutions Engineering
and Chief Information Officer
Michael T. Sullivan................ 48 Vice President of Finance
Rick Schultz....................... 40 Vice President of North American Sales
Tim Wilson......................... 39 Vice President of Marketing and
International Sales
Charlie Bass(2).................... 57 Director
Christos Cotsakos(4)............... 50 Director
Marcelo A. Gumucio(2)(3)(4)........ 61 Director
Cliff Higgerson (1)(3)............. 57 Director
Shahan Soghikian(1)................ 40 Director
David Spreng....................... 37 Director
</TABLE>
- ----------
(1) Member of Executive Committee
(2) Member of Compensation Committee
(3) Member of Audit Committee
(4) Member of Nominating Committee
(5) Member of Special Stock Option Committee
Each director will hold office for the term described below in "--Classified
Board" and until such director's successor is elected and qualified or until
such director's earlier resignation or removal. Each officer serves at the
discretion of the board of directors of Digital Island. Ron and Sanne Higgins
are husband and wife. There are no other family relationships among any of the
directors, officers or key employees of Digital Island.
Ron Higgins has served as Chairman of the board of directors since June 1998
and as a director since February 1994, when he founded Digital Island. Mr.
Higgins served as President and Chief Executive Officer from February 1994
until June 1998 and as Chairman of the board of directors from February 1994
until January 1998. For the past 18 years, Mr. Higgins has been involved in
developing high technology companies in the areas of networking,
communications, desktop publishing and multimedia. Mr. Higgins holds a B.S. in
Business Administration from the University of Southern California.
Ruann F. Ernst has served as President and Chief Executive Officer and as a
director since June 1998. Prior to joining Digital Island, Ms. Ernst served
with Hewlett Packard, a computer equipment and services
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<PAGE>
company, for over ten years, most recently as general manager of the Financial
Services Business Unit. Ms. Ernst has also served as Director, Medical
Computing Services Division and Assistant Professor, Medicine and Computer
Science at The Ohio State University and as a Congressional Fellow in the
Office of Technology Assessment. Ms. Ernst serves on the Board of Directors of
The Institute for the Future, Phoenix International and Advanced Fibre
Communications, Inc. Ms. Ernst holds a B.S. in Mathematics, a Masters Degree in
Computer Science and a Ph.D. in Technology and Organizational Change from The
Ohio State University.
T.L. Thompson has served as Chief Financial Officer since January 1999. Mr.
Thompson served as Chief Financial Officer of Narrowline, an Internet marketing
firm, from October 1996 to November 1998. From 1989 to 1996 he served in
various financial capacities at Ziff-Davis Publishing Company, most recently as
Vice President of Business Development. Mr. Thompson holds a B.S. in Economics
and an M.B.A. from Northwestern University.
Paul Evenson has served as Vice President of Operations since November 1998.
From 1996 to 1998, Mr. Evenson served as Vice President of Sales and Operations
at Westech Communications, Inc., a communications services firm. From 1986 to
1996, Mr. Evenson served as Vice President of Information Technology at
Montgomery Securities, an investment banking firm. Mr. Evenson studied
Engineering at Oregon State University.
Sanne Higgins joined Digital Island in June 1996 and has served as Vice
President of Corporate Communications since October 1997. From March 1990 to
June 1996, Ms. Higgins served as an independent marketing consultant to
companies with a broad range of products, including local area networking,
hardware, computer displays, video and computer entertainment, software
productivity tools, robotics and in-circuit test equipment. Ms. Higgins holds a
B.A. from the California College of Arts & Crafts.
Allan Leinwand has served as Vice President of Engineering and Chief
Technology Officer of Digital Island since January 1997 and as a director from
January 1997 to February 1999. Prior to joining Digital Island, from August
1990 to February 1997, Mr. Leinwand served as Manager, Consulting Engineer at
Cisco Systems, a network equipment provider, where he designed and deployed
global internetworks for large corporations, governments and institutions. Mr.
Leinwand also served as a network design and implementation engineer at Hewlett
Packard from 1988 to 1990. Mr. Leinwand holds a B.S. in Computer Science from
the University of Colorado, Boulder.
Bruce Pinsky has served as Vice President of Solutions Engineering and Chief
Information Officer since March 1997. From August 1992 to March 1997, Mr.
Pinsky worked in Customer Engineering and Global Support Engineering for Cisco
Systems. Mr. Pinsky holds a B.S. in Computer Science from California State
University, Hayward.
Michael T. Sullivan has served as Vice President of Finance since May 1997
and served as Chief Financial Officer from October 1997 to January 1999. From
July 1993 to May 1996 Mr. Sullivan served as Vice President of Operations and
Chief Financial Officer for Tut Systems, a network equipment provider.
Mr. Sullivan holds a B.S. in Business Administration from the University of
California, Berkeley. Mr. Sullivan is a certified public accountant.
Rick Schultz has served as Vice President of North American Sales since
March 1999. From December 1995 to February 1999, Mr. Schultz served as Vice
President of Sales at Pacific Bell Network Integration, a subsidiary of Pacific
Bell, a telecommunications company. Mr. Schultz also held various senior
management positions at AT&T from June 1980 to November 1995 in Sales, Product
Management and Sales Management. Mr. Schultz holds a B.S. in Commerce from De
Paul University and an M.B.A. from the University of San Francisco.
Tim Wilson has served as Vice President of Marketing and International Sales
since March 1998. From January 1996 to March 1998, Mr. Wilson served as general
manager within the Business Communications Systems Division of Lucent
Technologies, a telecommunications equipment supplier. Mr. Wilson also served
as
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Executive Director and General Manager of the Business Communications Systems
Division of AT&T Australia from November 1993 to December 1995. From August
1983 to October 1993, Mr. Wilson held several management positions in
engineering, sales and marketing at AT&T Corp. and AT&T Bell Laboratories. Mr.
Wilson holds a B.A. in Physics from Bowdoin College and an M.B.A. from the
Fuqua School of Business at Duke University.
Charlie Bass has served as a director since March 1997. Dr. Bass is Trustee
of The Bass Trust, General Partner of Bass Associates and a Consulting
Professor of Electrical Engineering at Stanford University. He is also Chairman
of the board of directors of Meridian Data, Inc., Socket Communications, Inc.
and SoloPoint, Inc. and serves on the board of directors of several private
communications companies. Prior to co-founding Ungermann-Bass in 1979, Dr. Bass
was at Zilog, Inc., and prior to the formation of Zilog, Inc. in 1975, he was
on the Electrical Engineering and Computer Sciences faculty at the University
of California at Berkeley from 1972 to 1975. Dr. Bass holds a Ph.D. in
Electrical Engineering from the University of Hawaii where he participated in
the Aloha System research in radio frequency-based computer networks.
Christos Cotsakos has served as a director of Digital Island since July
1998. Mr. Cotsakos joined E*TRADE, an online financial services company, in
March 1996 as the President and Chief Executive Officer and as a director.
Before joining E*TRADE, he served as President, Chief Operating Officer, Co-
Chief Executive Officer and a director of AC Nielsen Inc., a marketing research
company. Prior to joining AC Nielsen, Mr. Cotsakos spent 19 years with Federal
Express Corporation, where he held a number of senior executive positions. In
addition to E*TRADE, Mr. Cotsakos serves on the boards of directors of Fox
Entertainment Group, Inc., National Processing, Inc., Omega Research, Inc. and
Critical Path, Inc., as well as several private companies. A decorated Vietnam
veteran, he received a B.A. from William Paterson College and an M.B.A. from
Pepperdine University. Mr. Cotsakos is currently pursuing a Ph.D. degree in
economics at the University of London.
Marcelo A. Gumucio has served as a director since January 1998, and served
as Chairman of the board of directors from January 1998 until May 1998. He is
the managing partner of Gumucio Burke & Associates, a private investment firm.
In April 1996, Mr. Gumucio joined Micro Focus PLC, an enterprise software
provider, as its Chief Executive Officer. He had served as a non-executive
director of Micro Focus' board of directors since January 1996. Prior to
joining Micro Focus, from 1992 to 1996, Mr. Gumucio was President, Chief
Executive Officer and Chairman of the board of directors of Memorex Telex NV.
Mr. Gumucio's professional experience in the computer and communications
industry spans almost 30 years and includes senior management positions at Cray
Research, Inc., Northern Telecom Limited, Memorex Corporation and Hewlett-
Packard Company. Mr. Gumucio serves on the board of directors of BidCom Inc.,
E-Stamp Corporation and Burr Brown Corporation. Mr. Gumucio graduated cum laude
with a B.S. in mathematics from the University of San Francisco in 1961. He
received an M.S. in applied mathematics and operations research in 1963 from
the University of Idaho, where he was named a National Science Fellow and
graduated with honors. In 1982, he graduated from the Harvard Business School
Advanced Management Program.
Cliff Higgerson has served as a director since March 1997. Mr. Higgerson has
over 20 years experience with venture capital investments. Prior to forming
Communications Ventures II in the summer of 1997, he was a General Partner of
Vanguard Venture Partners, where he has been since 1993 and where he continues
to manage several portfolio companies. His 25 years of involvement in the
communications field include research, consulting, planning, investment
banking, and venture capital. Mr. Higgerson serves on the board of directors of
Advanced Fibre Communications, Inc., Ciena Corp. and Digital Microwave Corp.,
as well as several private companies. Mr. Higgerson holds a B.S. in electrical
engineering and an M.B.A. from the Haas School of Business at the University of
California at Berkeley.
Shahan Soghikian has served as a director since February 1999. Mr. Soghikian
has over nine years experience with venture capital investments and is a
General Partner of Chase Capital Partners, where he has been since 1990, and
where he develops, executes and monitors investments in private companies.
Mr. Soghikian serves on the board of directors of two private companies, Nextec
Applications, Inc. and AFS
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Holdings. Mr. Soghikian graduated with a B.A. in Biology from Pitzer College
and an M.B.A. from Anderson School of Business at the University of California
at Los Angeles.
David Spreng has served as a director since July 1997. Mr. Spreng has over
10 years of venture capital investment experience, primarily in communications,
and served as President of IAI Ventures, the private equity arm of Investment
Advisers, Inc. from 1992 until September 1998, when Mr. Spreng became the
Managing Member of the General Partners of the successor in interest to IAI
Ventures and IAI, the Crescendo Funds and its management company. Mr. Spreng
serves on the board of directors of Tut Systems, Inc. and several private
companies. Mr. Spreng graduated from the University of Minnesota with a B.S. in
Accounting.
Director Compensation
Our directors do not currently receive compensation for their services as
members of the board of directors. All directors are reimbursed for their
reasonable out-of-pocket expenses in serving on the board of directors or any
committee thereof. Employee directors are eligible to participate in our 1998
stock option/stock issuance plan and will also be eligible to receive equity
incentives, in the form of stock option grants or direct stock issuances, under
our 1999 stock incentive plan.
Non-employee board members will receive option grants at periodic intervals
under the automatic option grant program of the 1999 stock incentive plan and
will also be eligible to receive discretionary option grants under the
discretionary option grant program of such plan. See "Executive Compensation
and Other Information--Employee Benefit Plans."
Classified Board
Our certificate of incorporation provides for a classified board of
directors consisting of three classes of directors, each serving staggered
three-year terms. As a result, a portion of our board of directors will be
elected each year. To implement the classified structure, prior to the
consummation of the offering, two of the nominees to the board will be elected
to one-year terms, three will be elected to two-year terms and three will be
elected to three-year terms. Thereafter, directors will be elected for three-
year terms. Ron Higgins and David Spreng have been designated Class I directors
whose term expires at the 2000 annual meeting of stockholders. Charlie Bass,
Cliff Higgerson and Shahan Soghikian have been designated Class II directors
whose term expires at the 2001 annual meeting of stockholders. Christos
Cotsakos, Ruann Ernst and Marcelo Gumucio have been designated Class III
directors whose term expires at the 2002 annual meeting of stockholders. See
"Description of Capital Stock--Antitakeover Effects of Provisions of Certain
Charter Provisions, Bylaws and Delaware Law."
Board Committees
The executive committee of the board of directors consists of Ruann Ernst,
Cliff Higgerson and Shahan Soghikian. The executive committee, subject to the
following limitations, acts upon all matters concerning our interests, and
manages our business when the full board of directors is not in session. Our
executive committee may not:
. Adopt, amend or repeal the bylaws;
. Elect directors to fill vacancies on the board;
. Fill vacancies on the executive committee, or change its membership;
. Elect to remove officers of Digital Island;
. Amend the corporate charter;
. Act on matters assigned to other committees of the board;
. Appoint standing committees of the board;
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<PAGE>
. Recommend to the stockholders any action requiring their approval;
or
. Approve the acquisition or disposal of any capital asset or assets
to be used by us or any subsidiary in an amount exceeding an
aggregate $3,000,000 in any interim period between meetings of the
board.
The audit committee of the board of directors consists of Marcelo Gumucio
and Cliff Higgerson. The audit committee reviews our financial statements and
accounting practices, makes recommendations to the board of directors regarding
the selection of independent auditors and reviews the results and scope of our
annual audit and other services provided by our independent auditors.
The compensation committee of the board of directors consists of Charlie
Bass and Marcelo Gumucio. The compensation committee makes recommendations to
the board of directors concerning salaries and incentive compensation for our
officers and employees and administers our employee benefit plans including the
grant of options under those plans.
The nominating committee of the board of directors consists of Christos
Cotsakos, Ruann Ernst and Marcelo Gumucio. The nominating committee makes
recommendations to the board of directors concerning candidates for
directorships.
The special stock option committee of the board of directors consists solely
of Ruann Ernst. The special stock option committee has the authority, separate
from the compensation committee, to make discretionary option grants to
eligible individuals other than officers or non-employee members of the board
of directors.
Compensation Committee Interlocks and Insider Participation
None of the members of the compensation committee of the board of directors
was at any time since the formation of Digital Island an officer or employee of
Digital Island. No executive officer of Digital Island serves as a member of
the board of directors or compensation committee of any entity that has one or
more executive officers serving on our board of directors or our compensation
committee of the board of directors.
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EXECUTIVE COMPENSATION AND OTHER INFORMATION
Summary of Cash and Certain Other Compensation
The following table sets forth the compensation earned by our named
executive officers which include our Chief Executive Officer and our three
other executive officers whose salary and bonus for services rendered in all
capacities to Digital Island for the fiscal year ended September 30, 1998
exceeded $100,000. Since such date, certain of these executive officers have
been succeeded by new persons and we have added additional officers. For a list
of our current executive officers and certain members of senior management, see
"Management."
The options listed in the following table were originally granted under
either our 1997 stock option and incentive plan or our 1998 stock option/stock
issuance plan. These options have been incorporated into the new 1999 stock
incentive plan, but will continue to be governed by their existing terms. See
"Executive Compensation and Other Information--Employee Benefit Plans."
Summary Compensation Table
<TABLE>
<CAPTION>
Long Term
Annual Compensation Compensation Awards
---------------------------------- --------------------
Name and Principal Other Annual Number of Securities
Position(s) Year Salary Bonus Compensation Underlying Options
------------------ ---- -------- ------- ------------ --------------------
<S> <C> <C> <C> <C> <C>
Ruann F. Ernst(1)...... 1998 $ 50,000 $ -- $9,080(4) 794,159
President and Chief
Executive Officer
Allan Leinwand ........ 1998 124,167 41,000 -- 288,000
Chief Technology
Officer
Michael T.
Sullivan(2)........... 1998 136,250 25,750 -- 100,000
Vice President of
Finance
Ron Higgins(3)......... 1998 130,615 20,000 -- 400,000
Chairman of the Board
of Directors
</TABLE>
- ----------
(1) Ms. Ernst has served as President and Chief Executive Officer of Digital
Island since June 1998.
(2) Mr. Sullivan served as Chief Financial Officer of Digital Island in 1998
and was succeeded by T.L. Thompson in such position in January 1999.
(3) Mr. Higgins served as President and Chief Executive Officer of Digital
Island from February 1994 until June 1998.
(4) Consists of reimbursement of rent for Ms. Ernst's apartment in San
Francisco, California.
Stock Options and Stock Appreciation Rights
The following table sets forth information regarding option grants to each
of the named executive officers during the fiscal year ended September 30,
1998. No stock appreciation rights were granted to the named executive officers
during the 1998 fiscal year.
Stock Option Grants in Fiscal Year 1998
<TABLE>
<CAPTION>
Potential Realizable Value
Number of Percentage of at Assumed Annual Rates of
Securities Total Options Stock Price Appreciation
Underlying Granted to Exercise for Option Term
Options Employees Price Per Expiration ---------------------------
Name Granted (#) in 1998 Share ($/Sh) Date 5% 10%
---- ----------- ------------- ------------ ---------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C>
Ruann F. Ernst.......... 794,159 41.7% $1.50 5/31/08 $ 2,831,862 $ 5,214,876
Allan Leinwand.......... 48,000 2.5% 1.50 6/17/08 171,161 315,194
Michael T. Sullivan..... -- -- -- -- -- --
Ron Higgins............. -- -- -- -- -- --
</TABLE>
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<PAGE>
The exercise price per share of each option was determined by our board of
directors in its good faith judgment and generally reflects its best estimate
of the fair value of our common stock on the date of each grant, taking into
account factors such as our operating performance, recent sales of securities,
and market conditions.
Each option has a maximum term of 10 years, subject to earlier termination
upon the optionee's cessation of service with Digital Island. Ms. Ernst joined
Digital Island as our President and Chief Executive Officer on June 1, 1998 and
was granted an option for 794,159 shares with an exercise price of $1.50 per
share, effective on her June 1, 1998 start date. The first 635,327 shares,
subject to her options, will vest in a series of 50 successive equal monthly
installments upon her completion of each month of service over the 50-month
period measured from her hire date, and the remaining 158,832 shares will vest
in a series of 50 successive equal monthly installments over the 50-month
period measured from the first anniversary of her hire date. All the option
shares will vest upon an involuntary termination of her employment (other than
for cause) within 18 months following an acquisition of Digital Island by
merger, sale of substantially all the assets or sale of more than 50% of our
outstanding voting securities. Upon any other involuntary termination of her
employment (other than for cause), the vesting of her option shares will be
accelerated by six months. The option granted to Mr. Leinwand for 48,000 shares
will begin to vest starting April 2, 2001 in 24 successive equal monthly
installments.
The actual stock price appreciation over the 10-year option term may not be
at the above 5% and 10% assumed annual rates of compounded stock price
appreciation or at any other defined level. Unless the market price of common
stock appreciates over the option term, no value will be realized from the
option grant made to the named executive officer.
Aggregated Option/SAR Exercises and Fiscal Year-End Values
The following table sets forth information with respect to the named
executive officers concerning their exercise of stock options during the fiscal
year ended September 30, 1998 and the number of shares subject to unexercised
stock options held by them as of the close of such fiscal year. No stock
appreciation rights were exercised during the fiscal year ended September 30,
1998, and no stock appreciation rights were outstanding at the close of such
year. In the following table, "Value Realized" is equal to the difference
between the fair value of the shares at the time of exercise ($3.11 per share)
and the exercise price paid for the shares ($1.50 per share) and the "Value of
Unexercised In-The-Money Options at Year-End" is based upon the fair value per
share at the close of the 1998 fiscal year ($3.83) less the exercise price
payable per share. The fair value per share at the close of fiscal 1998 was
determined by our board of directors in its good faith judgment and generally
reflects its best estimate of the fair value of our common stock on the date of
each grant, taking into account factors such as our operating performance,
recent sales of securities, and market conditions. When the board of directors
elects to grant options at an exercise price per share below the fair value, we
recognize deferred compensation for the difference.
Aggregated Option Exercises in 1998 and Year-End Values
<TABLE>
<CAPTION>
Number of Securities Value of Unexercised
Shares Underlying Unexercised In-the-Money
Acquired on Options at Year-End Options at Year-End
Exercise Value ------------------------- -------------------------
(#) Realized ($) Exercisable Unexercisable Exercisable Unexercisable
----------- ------------ ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Ruann F. Ernst.......... 100,000 $1.61 427,492 266,667 $996,056 $621,334
Allan Leinwand.......... -- -- 132,534 155,466 454,592 533,248
Michael T. Sullivan..... -- -- 32,000 68,000 109,760 233,240
Ron Higgins............. -- -- 158,333 241,667 543,082 828,918
</TABLE>
Employee Benefit Plans
1999 Stock Incentive Plan
Our 1999 stock incentive plan is intended to serve as the successor equity
incentive program to our 1998 stock option/stock issuance plan which was the
successor equity incentive program to our 1997 stock option
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<PAGE>
and incentive plan. The 1999 stock incentive plan was adopted by the board on
April 21, 1999 and was subsequently approved by the stockholders on May 3,
1999. The 1999 stock incentive plan will become effective upon the effective
date of the offering. All outstanding options under our predecessor plan will
at that time be incorporated into the 1999 stock incentive plan, and no further
option grants will be made under that plan. The incorporated options will
continue to be governed by their existing terms, unless the plan administrator
elects to extend one or more features of the 1999 stock incentive plan to those
options. Except as otherwise noted below, the incorporated options have
substantially the same terms as will be in effect for grants made under the
discretionary option grant program of the 1999 stock incentive plan.
An initial reserve of 7,544,000 shares of common stock has been authorized
for issuance under the 1999 stock incentive plan. This share reserve consists
of (i) the number of shares estimated to remain available for issuance under
our predecessor plan, including the shares subject to outstanding options
thereunder, plus (ii) an additional increase of approximately 2,500,000 shares.
The number of shares of common stock reserved for issuance under the 1999 stock
incentive plan will automatically increase on the first trading day in January
each calendar year, beginning in calendar year 2000, by an amount equal to four
percent (4%) of the total number of shares of common stock outstanding on the
last trading day in December in the preceding calendar year, but in no event
will this annual increase exceed 2,000,000 shares. In addition, no participant
in the 1999 stock incentive plan may be granted stock options, separately
exercisable stock appreciation rights and direct stock issuances for more than
750,000 shares of common stock in the aggregate per calendar year.
The 1999 stock incentive plan is divided into five separate components:
. the discretionary option grant program, under which eligible
individuals in our employ or service (including officers, non-
employee board members and consultants) may, at the discretion of
the plan administrator, be granted options to purchase shares of
common stock at an exercise price not less than 100% of the fair
market value of those shares on the grant date;
. the stock issuance program under which eligible individuals may, in
the plan administrator's discretion, be issued shares of common
stock directly, upon the attainment of designated performance
milestones or upon the completion of a specified service requirement
or as a bonus for past services;
. the salary investment option grant program, which may, at the plan
administrator's sole discretion, be activated for one or more
calendar years and, if so activated, will allow executive officers
and other key executives selected by the plan administrator the
opportunity to apply a portion of their base salary each year to the
acquisition of special below-market stock option grants;
. the automatic option grant program, under which option grants will
automatically be made at periodic intervals to eligible non-employee
board members to purchase shares of common stock at an exercise
price equal to 100% of the fair market value of those shares on the
grant date; and
. the director fee option grant program, which may, in the plan
administrator's sole discretion, be activated for one or more
calendar years and, if so activated, will allow non-employee board
members the opportunity to apply all or a portion of the annual
retainer fee otherwise payable to them in cash each year to the
acquisition of special below-market option grants.
The discretionary option grant program and the stock issuance program will
be administered by the compensation committee. However, a secondary committee
of one or more board members will also have concurrent authority to administer
those programs with respect to individuals who are neither officers nor
directors. The compensation committee or secondary committee as plan
administrator will have complete discretion to determine which eligible
individuals are to receive option grants or stock issuances under those
programs, the time or times when the grants or issuances are to be made, the
number of shares subject to each grant or issuance, the status of any granted
option as either an incentive stock option or a non-statutory stock option
under the Federal tax laws, the vesting schedule to be in effect for the option
grant or stock issuance and the maximum term for which any granted option is to
remain outstanding. However, the board acting by a
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<PAGE>
disinterested majority will have the exclusive authority to make any
discretionary option grants or stock issuances to members of the compensation
committee. The compensation committee will also have the exclusive authority to
select the executive officers and other highly compensated employees who may
participate in the salary investment option grant program in the event that
program is activated for one or more calendar years. Neither the compensation
committee nor the board will exercise any administrative discretion with
respect to option grants under the salary investment option grant program or
under the automatic option grant or director fee option grant program for the
non-employee board members. All grants under those latter three programs will
be made in strict compliance with the express provisions of each program.
The exercise price for the shares of common stock subject to option grants
made under the 1999 stock incentive plan may be paid in cash or in shares of
common stock valued at fair market value on the exercise date. The option may
also be exercised through a same-day sale program without any cash outlay by
the optionee.
The plan administrator will have the authority to effect the cancellation of
outstanding options under the discretionary option grant program (including
options incorporated from our predecessor plan) in return for the grant of new
options for the same or different number of option shares with an exercise
price per share based upon the fair market value of the common stock on the new
grant date.
Stock appreciation rights are authorized for issuance under the
discretionary option grant program. These rights will provide the holders with
the election to surrender their outstanding options for an appreciation
distribution from us equal to the excess of (i) the fair market value of the
vested shares of common stock subject to the surrendered option over (ii) the
aggregate exercise price payable for those shares. Such appreciation
distribution may be made in cash or in shares of common stock. None of the
incorporated options from our predecessor plan contain any stock appreciation
rights.
In the event that we are acquired by merger or asset sale, each outstanding
option under the discretionary option grant program which is not to be assumed
by the successor corporation will automatically accelerate in full, and all
unvested shares under the discretionary option grant and stock issuance
programs will immediately vest, except to the extent our repurchase rights with
respect to those shares are to be assigned to the successor corporation. The
plan administrator will have complete discretion to grant one or more options
under the discretionary option grant program which will vest and become
exercisable for all the option shares in the event those options are assumed in
the acquisition and the optionee's service with us or the acquiring entity is
terminated within a designated period (not to exceed eighteen months) following
that acquisition. The vesting of outstanding shares under the stock issuance
program may be accelerated upon similar terms and conditions.
The plan administrator is also authorized to grant options and structure
repurchase rights so that the shares subject to those options or repurchase
rights will immediately vest in connection with a change in ownership or
control (whether by successful tender offer for more than fifty percent of our
outstanding voting stock or by a change in the majority of our board through
one or more contested elections for board membership). Such accelerated vesting
may occur either at the time of such change or upon the subsequent termination
of the individual's service within a designated period (not to exceed eighteen
months) following the change.
The options to be incorporated from our predecessor plan will immediately
vest and become exercisable for all the option shares if we are acquired by
merger or asset sale, unless the options are assumed by the successor
corporation and our repurchase rights with respect to the unvested shares
subject to those options are concurrently assigned to the successor entity. For
some of these options, the board also has the authority to provide for their
cancellation in return for a cash payment to the option holders in an amount
per cancelled option share equal to the excess of the price to be paid per
share of our common stock in the acquisition over the option exercise price
payable per share under the cancelled option. Other of these options contain a
special acceleration feature. Under that feature, should the optionee's service
be terminated within a designated period following an acquisition in which the
option is assumed and our repurchase rights are assigned, then the option will
vest at that time and become immediately exercisable for all the option shares,
and all unvested shares held by such individual will also vest at that time.
There are no other change in control provisions currently in effect for the
outstanding options under the predecessor plan. However, the plan administrator
will have the discretion
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<PAGE>
to extend the acceleration provisions of the 1999 stock incentive plan to any
or all of the options outstanding under our predecessor plan.
In the event the plan administrator elects to activate the salary investment
option grant program for one or more calendar years, each executive officer and
other key employee selected for participation may elect, prior to the start of
the calendar year, to reduce his or her base salary for that calendar year by a
specified dollar amount not less than $10,000 nor more than $50,000. Each
selected individual who files this timely election will automatically be
granted, on the first trading day in January of the calendar year for which
that salary reduction is to be in effect, a non-statutory option to purchase
that number of shares of common stock determined by dividing the salary
reduction amount by two-thirds of the fair market value per share of common
stock on the grant date. The option will be exercisable at a price per share
equal to one-third of the fair market value of the option shares on the grant
date. As a result, the total spread on the option shares at the time of grant
(the fair market value of the option shares on the grant date less the
aggregate exercise price payable for those shares) will be equal to the amount
of salary invested in that option. The option will vest and become exercisable
in a series of twelve equal monthly installments over the calendar year for
which the salary reduction is to be in effect.
Under the automatic option grant program, eligible non-employee board
members will receive a series of option grants over their period of board
service. Each individual who first becomes a non-employee board member at any
time at or after the effective date of this offering will receive an option
grant for 15,000 shares of common stock on the date such individual joins the
board, provided such individual has not been in our prior employ. In addition,
on the date of each annual stockholders meeting held after the effective date
of this offering, each non-employee board member who is to continue to serve as
a non-employee board member (including the individuals who are currently
serving as non-employee board members) will automatically be granted an option
to purchase 5,000 shares of common stock, provided such individual has served
on the board for at least six months. There will be no limit on the number of
such 5,000 share option grants any one eligible non-employee Board member may
receive over his or her period of continued board service, and non-employee
board members who have previously been in our employ will be eligible to
receive one or more such annual option grants over their period of board
service.
Each automatic grant will have an exercise price per share equal to the fair
market value per share of common stock on the grant date and will have a term
of 10 years, subject to earlier termination following the optionee's cessation
of board service. Each automatic option will be immediately exercisable for all
of the option shares; however, any unvested shares purchased under the 15,000-
share option will be subject to repurchase by Digital Island, at the exercise
price paid per share, should the optionee cease to serve on the board prior to
vesting in those shares. The shares subject to each initial 15,000-share
automatic option grant will vest in a series of six successive equal semi-
annual installments upon the optionee's completion of each month of board
service over the 36 month period measured from the grant date. However, the
shares will immediately vest in full upon certain changes in control or
ownership or upon the optionee's death or disability while a board member. The
shares subject to each annual 5,000-share automatic grant will be fully-vested
when granted. Following the optionee's cessation of board service for any
reason, each option will remain exercisable for a 12-month period and may be
exercised during that time for any or all shares in which the optionee is
vested at the time of such cessation of service.
The Financial Accounting Standards Board recently issued an exposure draft
of a proposed interpretation of the current accounting principles applicable to
equity incentive plans. Under the proposed interpretation, option grants made
to non-employee board members after December 15, 1998 will result in a direct
charge to the company's reported earnings based upon the fair value of the
option measured initially as of the grant date of that option and then
subsequently on the vesting date of each installment of the underlying option
shares. If the proposed interpretation is adopted, then the following changes
will be made to our automatic stock option grant program:
. The 15,000-share option grant will not be made to a newly-elected or
appointed non-employee board member until the first annual
stockholders meeting held more than 12 months after the
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<PAGE>
date of his or her initial election or appointment to the board. At
that annual meeting, the board member will also receive an option
grant for an additional 5,000 shares under the annual grant portion
of the program.
. One-third of the shares subject to the 15,000-share option grant will
be immediately vested at the time of the option grant, and the
remaining shares will vest in a series of four successive equal semi-
annual installments upon the optionee's completion of each six-month
period of board service over the twenty-four month period measured
from the grant date. However, the shares will immediately vest in
full upon certain changes in control or ownership or upon the
optionee's death or disability while a board member.
If the director fee option grant program is activated in the future, each
non-employee board member will have the opportunity to apply all or a portion
of any annual retainer fee otherwise payable in cash to the acquisition of a
below-market option grant. The option grant will automatically be made on the
first trading day in January in the year for which the retainer fee would
otherwise be payable in cash. The option will have an exercise price per share
equal to one-third of the fair market value of the option shares on the grant
date, and the number of shares subject to the option will be determined by
dividing the amount of the retainer fee applied to the program by two-thirds
of the fair market value per share of common stock on the grant date. As a
result, the total spread on the option (the fair market value of the option
shares on the grant date less the aggregate exercise price payable for those
shares) will be equal to the portion of the retainer fee invested in that
option. The option will vest and become exercisable for the option shares in a
series of twelve equal monthly installments over the calendar year for which
the election is to be in effect. However, the option will become immediately
exercisable and vested for all the option shares upon (i) certain changes in
the ownership or control or (ii) the death or disability of the optionee while
serving as a board member.
The shares subject to each option under the salary investment option grant,
automatic option grant and director fee option grant programs will immediately
vest upon (i) an acquisition of us by merger or asset sale or (ii) the
successful completion of a tender offer for more than 50% of our outstanding
voting stock or a change in the majority of our board effected through one or
more contested elections for board membership.
Limited stock appreciation rights will automatically be included as part of
each grant made under the automatic option grant, salary investment option
grant and director fee option grant programs and may be granted to one or more
officers as part of their option grants under the discretionary option grant
program. Options with this limited stock appreciation right may be surrendered
to us upon the successful completion of a hostile tender offer for more than
50% of our outstanding voting stock. In return for the surrendered option, the
optionee will be entitled to a cash distribution from us in an amount per
surrendered option share equal to the excess of (i) the highest price per
share of common stock paid in connection with the tender offer over (ii) the
exercise price payable for such share.
The board may amend or modify the 1999 stock incentive plan at any time,
subject to any required stockholder approval. The 1999 stock incentive plan
will terminate on the earliest of (i) April 15, 2009, (ii) the date on which
all shares available for issuance under the 1999 stock incentive plan have
been issued as fully-vested shares or (iii) the termination of all outstanding
options in connection with certain changes in control or ownership.
1999 Employee Stock Purchase Plan
Our 1999 employee stock purchase plan was adopted by the board on April 21,
1999 and approved by the stockholders on May 3, 1999 and will become effective
immediately upon the execution of the Underwriting Agreement for this
offering. The plan is designed to allow our eligible employees and those of
our participating subsidiaries to purchase shares of common stock, at semi-
annual intervals, through their periodic payroll deductions under the plan.
300,000 shares of common stock will initially be reserved for issuance under
the plan. The reserve will automatically increase on the first trading day in
January each year, beginning in calendar year 2000, by an amount equal to one
percent (1%) of the total number of outstanding shares of our
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<PAGE>
common stock on the last trading day in December in the prior year. In no event
will any such annual increase exceed 500,000 shares.
The plan will be implemented in a series of successive offering periods,
each with a maximum duration of 24 months. However, the initial offering period
will begin on the execution date of the Underwriting Agreement and will end on
the last business day in July 2001. The next offering period will commence on
the first business day in August 2001, and subsequent offering periods will
commence as designated by the plan administrator.
Individuals who are eligible employees (employees scheduled to work more
than 20 hours per week for more than five calendar months per year) on the
start date of any offering period may enter the plan on that start date or on
any subsequent semi-annual entry date (the first business day of February or
August each year). Individuals who become eligible employees after the start
date of the offering period may join the plan on any subsequent semi-annual
entry date within that offering period.
Payroll deductions may not exceed 15% of the participant's base salary, and
the accumulated payroll deductions of each participant will be applied to the
purchase of shares on his or her behalf on each semi-annual purchase date (the
last business day in January and July each year) at a purchase price per share
equal to 85% of the lower of (i) the fair market value of the common stock on
the participant's entry date into the offering period or (ii) the fair market
value on the semi-annual purchase date. In no event, however, may any
participant purchase more than 1,200 shares on any semi-annual purchase date,
nor may all participants in the aggregate purchase more than 200,000 shares on
any semi-annual purchase date. The initial purchase date under the plan will
occur on January 31, 2000.
If the fair market value per share of our common stock on any purchase date
is less than the fair market value per share on the start date of the two-year
offering period, then that offering period will automatically terminate, and a
new two-year offering period will begin on the next business day, with all
participants in the terminated offering to be automatically transferred to the
new offering period.
Should we be acquired by merger, sale of substantially all our assets or
sale of securities possessing more than fifty percent of the total combined
voting power of our outstanding securities, then all outstanding purchase
rights will automatically be exercised immediately prior to the effective date
of that acquisition. The purchase price will be equal to 85% of the lower of
(i) the fair market value per share of common stock on the participant's entry
date into the offering period in which the acquisition occurs or (ii) the fair
market value per share of common stock immediately prior to the acquisition.
The limitation on the maximum number of shares purchasable in the aggregate on
any one purchase date will not be in effect for any purchase date attributable
to such an acquisition.
The plan will terminate on the earlier of (i) the last business day of July
2009, (ii) the date on which all shares available for issuance under the plan
shall have been sold pursuant to purchase rights exercised thereunder or (iii)
the date on which all purchase rights are exercised in connection with an
acquisition of us by merger or asset sale.
The board may at any time alter, suspend or discontinue the plan. However,
certain amendments, such as increasing the number of shares reserved for
issuance under the plan, require stockholder approval.
401(k)Plan
We sponsor the Digital Island, Inc. 401(k) Plan (the "401(k) Plan").
Employees who complete three months of service with us are eligible to
participate in the 401(k) Plan and may contribute up to 15% of their current
compensation, but in no event may they contribute more than the maximum dollar
amount allowable per calendar year under the federal tax laws. Each participant
is fully vested in his or her salary reduction contributions. Participant
contributions are held in trust and the individual participants may direct the
trustee to invest their accounts in a number of investment alternatives. We may
make contributions to the 401(k) Plan which match a percentage of each
participant's contributions for the year, with the actual percentage match (if
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<PAGE>
any) for one or more plan years to be determined by us in our discretion. In
addition, we may make discretionary contributions for one or more plan years
which would be allocated to participants on the basis of their compensation for
the plan year. Any discretionary and matching contributions which we may make
to the 401(k) Plan would be subject to a vesting schedule tied to the
participant's years of service with us. To date, we have not made any matching
or discretionary contributions to the 401(k) Plan. We may also make fully
vested qualified non-elective contributions to the 401(k) Plan on behalf of
participants who are not "highly compensated," but have not done so to date.
Employment Contracts and Change of Control Arrangements
We have entered into employment agreements with Ms. Ernst, Mr. Leinwand, and
Mr. Sullivan, each of whom are officers of Digital Island. All outstanding
options held by the foregoing officers will automatically vest in full upon an
acquisition of Digital Island by merger, sale of substantially all the assets
or sale of more than 50% of our outstanding voting securities, unless those
options are assumed or otherwise continued in effect by a successor entity or
our repurchase rights for any unvested shares subject to those options are to
remain in force following such acquisition. The exercise price per share of the
options below were determined by our board of directors as described in "--
Stock Options and Stock Appreciation Rights."
Ruann F. Ernst. On May 20, 1998, Ruann F. Ernst, our Chief Executive Officer
and President, entered into an employment agreement with us. This agreement
provided for an annual salary of $150,000. Ms. Ernst is also entitled to
incentive compensation in an amount not less than forty percent (40%) of her
base salary upon the achievement of performance milestones mutually agreed upon
with our Board of Directors. On March 1, 1999, Ms. Ernst's annual salary was
increased to $200,000. In connection with her employment agreement we granted
Ms. Ernst options to purchase up to 794,159 shares of our common stock at a per
share exercise price of $1.50 per share.
Allan Leinwand. On February 3, 1997, Allan Leinwand, our Vice President of
Engineering and Chief Technology Officer, entered into an employment agreement
with us. This agreement provided for an annual salary of $105,000. Mr. Leinwand
is also eligible for a discretionary quarterly bonus of up to $10,000. Should
we terminate Mr. Leinwand for any lawful reason, we must pay Mr. Leinwand a
severance payment equal to one hundred percent of his then current annual base
salary. Currently, Mr. Leinwand's annual salary is $170,000, and he is eligible
for a discretionary quarterly bonus of up to $12,500. In connection with his
employment agreement, we granted to Mr. Leinwand options to purchase up to
240,000 shares of our common stock at a per share exercise price of $0.40 per
share.
Michael T. Sullivan. On May 5, 1997, Michael T. Sullivan, our Vice President
of Finance, entered into an employment agreement with us. This agreement
provided for an annual salary of $120,000. Mr. Sullivan is also eligible for a
discretionary quarterly bonus of up to $5,000. On March 16, 1998, Mr.
Sullivan's annual salary was increased to $150,000 and his discretionary
quarterly bonus was increased to $7,500. In connection with his employment
agreement, we granted to Mr. Sullivan options to purchase up to 100,000 shares
of our common stock at a per share exercise price of $0.40 per share.
Limitation of Liability and Indemnification
Our certificate of incorporation eliminates, to the fullest extent permitted
by Delaware law, liability of a director to Digital Island or our stockholders
for monetary damages for conduct as a director. Although liability for monetary
damages has been eliminated, equitable remedies such as injunctive relief or
rescission remain available. In addition, a director is not relieved of his or
her responsibilities under any other law, including the federal securities
laws.
Our certificate of incorporation requires us to indemnify our directors to
the fullest extent permitted by Delaware law. We have also entered into
indemnification agreements with each of our directors. We believe that the
limitation of liability provisions in our certificate of incorporation and
indemnification agreements may enhance our ability to attract and retain
qualified individuals to serve as directors. See "Description of Capital
Stock."
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CERTAIN TRANSACTIONS
Some of our directors, executive officers and affiliates have entered into
transactions with us as follows:
Preferred Stock Financings
Since October 1, 1997 we have sold 4,283,181 shares of our Series C
Preferred Stock at a price of $3.45 per share, 2,022,476 shares of our Series
D Preferred Stock at a price of $5.25 per share and 11,764,706 shares of our
Series E Preferred Stock at a price of $4.25 per share in a series of private
financings. We sold these securities pursuant to preferred stock purchase
agreements and an investors' rights agreement on substantially similar terms
(except for terms relating to date and price), under which we made standard
representations, warranties, and covenants, and pursuant to which we provided
the purchasers thereunder with registration rights, information rights, and
rights of first refusal, among other provisions standard in venture capital
financings. Each share of our preferred stock will automatically convert into
one share of our common stock upon the completion of the offering, except that
each share of Series D Preferred Stock will automatically convert into
1.088084 shares of our common stock after giving effect to an antidilution
adjustment resulting from the sale of the Series E Preferred Stock. The
purchasers of the preferred stock included, among others, the following
holders of 5% or more of our common stock, directors, and entities associated
with directors:
<TABLE>
<CAPTION>
Shares of Preferred Stock
Purchased
-----------------------------------
Name Series C Series D Series E
---- --------- --------- ---------
<S> <C> <C> <C>
Bass Trust U/D/T dated April 29,
1988(1)............................... 39,420 34,095 27,765
Chase Venture Capital Associates,
L.P.(2)............................... -- -- 2,823,529
The Cotsakos Revocable Trust dated
9/3/87(3)............................. -- 28,571 --
Crescendo II, L.P.(4).................. 289,855(5) 143,429(5) 463,294(5)
Crosspoint Venture Partners............ 289,855 -- 926,824
E*TRADE Group, Inc.(6)................. -- 1,333,334 562,588
FW Ventures III, LP.................... -- -- 1,822,353
Marcelo Gumucio........................ 29,000 -- --
Merrill Lynch KECALP................... -- -- 1,482,824
Tudor Global Trading, Inc.............. 1,015,000 190,476 744,470
Vanguard V, L.P.(7).................... 260,870 142,857 --
</TABLE>
- ----------
(1) Charlie Bass, a director of Digital Island, is the Trustee of the Bass
Trust U/D/T dated April 29, 1998.
(2) Shahan Soghikian, a director of Digital Island, is a General Partner of
Chase Venture Capital Associates, L.P.
(3) Christos Cotsakos, a director of Digital Island, is the Trustee of The
Cotsakos Revocable Trust dated 9/3/87.
(4) David Spreng, a director of Digital Island, is the Managing Member of
Crescendo Ventures II, LLC, the general partner of Crescendo II, L.P.
(5) Includes shares held by Eagle Ventures II, LLC pursuant to a parallel
investment agreement with Crescendo.
(6) Mr. Cotsakos, a director of Digital Island, is Chairman of the Board of
E*TRADE.
(7) Cliff Higgerson, a director of Digital Island, is the General Partner of
Vanguard V, L.P.
Investors' Rights Agreement
Pursuant to the terms of the Amended and Restated Investors' Rights
Agreement dated February 19, 1999, as amended, by and among Digital Island and
the holders of our preferred stock, the investors acquired certain
registration rights with respect to their capital stock of Digital Island. At
any time after the earlier of (i) February 19, 2001, or (ii) one year after
our initial public offering, holders of more than two-thirds of the currently
outstanding preferred stock may require us to effect registration under the
Securities Act covering the lesser of 50% of the outstanding Registrable
Securities (as defined in the Investors' Rights Agreement) or a
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number of shares of common stock yielding gross aggregate proceeds in excess of
$15.0 million, subject in either case to the board of directors' right if such
registration would harm Digital Island to defer such registration for a period
up to 60 days. In addition, if we propose to issue equity securities under the
Securities Act for our own account in an underwritten public offering, then any
of the investors has a right (subject to quantity limitations determined by the
underwriters) to request that Digital Island register such investor's
Registrable Securities. All registration expenses incurred in connection with
the first two demand registrations described above and all piggyback
registrations will be borne by Digital Island. The participating investors will
pay for underwriting discounts and commissions incurred in connection with any
such registrations. We have agreed to indemnify the investors against certain
liabilities in connection with any registration effected pursuant to the
foregoing Investors' Rights Agreement, including Securities Act liabilities.
Employment and Indemnification Agreements
We have entered into employment agreements with Ms. Ernst, Mr. Leinwand and
Mr. Sullivan, who are Named Executive Officers. We have also entered into
indemnification agreements with each of our other directors and officers. See
"Executive Compensation and Other Information--Employment Contracts and Change
of Control Arrangements," and "--Limitation of Liability and Indemnification."
On January 1, 1997, Sanne Higgins, our Vice President of Corporate
Communications, and the spouse of Ron Higgins our Chairman of the board of
directors, entered into an employment agreement with us. This agreement
provided for an annual salary of $100,000 and has been increased to $125,000.
Ms. Higgins is also eligible for a discretionary annual bonus of up to $40,000.
In connection with her employment agreement, we granted to Ms. Higgins options
to purchase up to 75,000 shares of our common stock at a per share exercise
price of $0.40 per share, being the fair market value as determined by our
board of directors after taking into account our operating performance, recent
sales of securities, market conditions and other relevant factors.
Director Arrangements and Stockholder Notes
In February 1998, Digital Island granted a nonstatutory option to purchase a
total of 183,000 shares of our common stock to Marcelo Gumucio, then the
Chairman of the board of directors and now a director of Digital Island. These
options were immediately exercisable and subject to repurchase by Digital
Island, with the right to repurchase expiring in 16 equal quarterly
installments. At the time of the option grant, Mr. Gumucio exercised the option
to purchase the entire 183,000 shares of common stock, in exchange for a
$109,800 note. Under the terms of the note, interest accrues on outstanding
amounts at 5.61% per annum. Interest is to be repaid in four equal annual
installments commencing February 24, 1999. The entire principal amount is due
and payable in one lump sum on February 24, 2002. As of March 31, 1999, the
outstanding unpaid principal balance of the shareholder note was $109,800. Mr.
Gumucio also received an aggregate of $60,000 in 1998 in connection with his
services to us as Chairman of our board of directors.
Officer Loans
On April 21, 1999, Ms. Ernst, our President and Chief Executive Officer, and
Mr. Higgins, our Chairman of the Board, each delivered a promissory note to us
in payment of the exercise price of certain outstanding stock options they hold
under our 1998 stock option/stock issuance plan. Ms. Ernst delivered a full-
recourse promissory note in the principal amount of $199,998 in payment of the
exercise price for 133,332 shares of our common stock, and Mr. Higgins
delivered a full-recourse promissory note in the amount of $86,400 in payment
of the exercise price for 216,000 shares of our common stock. Each note bears
interest at the rate of 7.75% per annum, compounded semi-annually, and is
secured by the purchased shares. Accrued interest is due and payable at
successive quarterly intervals over the four-year term of the note, and the
principal balance will become due and payable in one lump sum at the end of
such four-year term. However, the entire unpaid balance of the note will become
due and payable upon termination of employment or failure to pay any
installment of interest when due. None of the shares serving as security for
the note may be sold unless the principal portion of the note attributable to
those shares, together with the accrued interest on that principal portion, is
paid to us.
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On June 14, 1999, Ms. Ernst borrowed an additional $128,000 from us in order
to finance the tax liability she incurred in connection with the exercise of
her stock options on April 21, 1999 for 133,332 shares of our common stock. The
loan is evidenced by a full-recourse promissory note with interest at the rate
of 7.75% per annum, compounded semi-annually, and secured by the same 133,332
shares which serve as collateral for Ms. Ernst's April 21, 1999 promissory
note. The terms of her note, including the due dates for payment of principal
and accrued interest and the acceleration provisions, are substantially the
same as the terms in effect for her April 21, 1999 note.
E*TRADE Agreements
We have entered into a global data distribution agreement with E*TRADE dated
August 1, 1997 where we provide network connectivity for E*TRADE. Mr. Costakos,
a member of our board of directors, is President, Chief Executive Officer and a
director of E*TRADE.
We believe that all of the transactions set forth above were made on terms
no less favorable to us than could have been obtained from unaffiliated third
parties. We intend that all future transactions, including loans, between us
and our officers, directors, principal stockholders and their affiliates will
be approved by a majority of the board of directors, and be on terms no less
favorable to us than could be obtained from unaffiliated third parties.
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PRINCIPAL STOCKHOLDERS
The following table sets forth certain information as of March 31, 1999
(except as indicated in the footnotes below) with respect to the beneficial
ownership of our common stock by:
. each person known by us to own beneficially more than 5%, in the
aggregate, of the outstanding shares of our common stock,
. the directors and named executive officers of Digital Island who
hold securities of Digital Island, and
. all executive officers and directors as a group.
Unless otherwise indicated, the address for each shareholder is c/o Digital
Island, Inc., 353 Sacramento Street, Suite 1520, San Francisco, California
94111. Except as indicated by footnote, we understand that the persons named in
the table below have sole voting and investment power with respect to all
shares shown as beneficially owned by them, subject to community property laws
where applicable. In the table below, "Beneficial Ownership of Shares Before
Offering" reflects the beneficial ownership of the common stock, assuming the
conversion of the preferred stock; "Beneficial Ownership of Shares After
Offering" reflects the beneficial ownership of the common stock, assuming the
conversion of the preferred stock and after giving effect to the offering.
Shares of common stock subject to options, which are currently exercisable or
exercisable within 60 days of March 31, 1999, are deemed outstanding for
computing the percentages of the person holding such options but are not deemed
outstanding for computing the percentages of any other person. The number of
shares reflects the number of shares of common stock in the aggregate assuming
the conversion of the preferred stock. Each share of preferred stock is
currently convertible into one share of common stock, with the exception of the
Series D Preferred Stock, each share of which currently converts into 1.088084
shares of common stock. Percentage ownership is based on 27,965,736 shares of
common stock and preferred stock, as converted, outstanding as of March 31,
1999. See "Description of Capital Stock--Preferred Stock."
<TABLE>
<CAPTION>
Beneficial Beneficial
Ownership of Ownership of
Shares Before the Shares After the
Offering Offering
----------------- -----------------
Name of Beneficial Owner Number Percent Number Percent
- ------------------------ --------- ------- --------- -------
<S> <C> <C> <C> <C>
Crosspoint Venture Partners(1)............ 3,246,679 11.6% 3,246,679 9.6%
Chase Venture Capital Associates,
L.P.(2).................................. 2,823,529 10.1% 2,823,529 8.3%
Vanguard V, L.P(3)........................ 2,561,310 9.2% 2,561,310 7.5%
Crescendo Venture Management, LLC(4)...... 2,109,212 7.5% 2,109,212 6.2%
E*TRADE Group, Inc.(5).................... 2,013,367 7.2% 2,013,367 5.9%
Tudor Global Trading, Inc.(6)............. 1,966,724 7.0% 1,966,724 5.8%
FW Ventures III, LP(7).................... 1,882,353 6.7% 1,882,353 5.5%
Merrill Lynch KECALP(8)................... 1,482,824 5.3% 1,482,824 4.4%
Ron Higgins(9)............................ 2,075,000 7.4% 2,075,000 6.1%
Ruann F. Ernst(10)........................ 604,574 2.1% 604,574 1.8%
T. L. Thompson............................ -- -- -- --
Paul Evenson.............................. -- -- -- --
Allan Leinwand(11)........................ 161,725 * 161,725 *
Rick Schultz.............................. -- -- -- --
Michael T. Sullivan(12)................... 83,000 * 83,000 *
Tim Wilson(13)............................ 133,366 * 133,366 *
Charlie Bass(14).......................... 419,283 1.5% 419,283 1.2
Marcelo A. Gumucio(15).................... 212,000 * 212,000 *
Christos Cotsakos(16)..................... 36,644 * 36,644 *
Cliff Higgerson(17)....................... -- -- -- --
Shahan Soghikian(18)...................... -- -- -- --
David Spreng(19).......................... -- -- -- --
All directors and executive officers as a
group (14 people)(20).................... 3,725,592 12.8% 3,725,592 10.6%
</TABLE>
- ----------
* Less than 1%.
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(1) Stock consists of 1,450,000 shares of Series A Preferred Stock held
directly by Crosspoint Venture Partners, 580,000 shares of Series B
Preferred Stock and 289,855 shares of Series C Preferred Stock held
directly by Crosspoint Venture Partners 1996 and 926,824 shares of Series
E Preferred Stock held directly by Crosspoint Venture Partners LS 1997
(collectively, with Crosspoint Venture Partners 1996 and Crosspoint
Venture Partners, the "Crosspoint Entities"). The address for the
Crosspoint Entities is 2925 Woodside Road, Woodside, California 94062.
(2) Stock consists of 2,823,529 shares of Series E Preferred Stock. Mr.
Soghikian, a director of Digital Island, is the General Partner of Chase
Capital Partners, the General Partner of Chase Venture Capital Associates,
L.P. The address for Chase Venture Capital Associates, L.P. is 50
California Street, Suite 2940, San Francisco, California 94111.
(3) Stock includes 95,000 shares subject to warrants exercisable for common
stock, 1,450,000 shares of Series A Preferred Stock, 600,000 shares of
Series B Preferred Stock, 260,870 shares of Series C Preferred Stock and
142,857 shares of Series D Preferred Stock. Mr. Higgerson, a director of
Digital Island, is the General Partner of Vanguard V, L.P. The address of
Vanguard V, L.P. is 505 Hamilton Avenue, Suite 305, Palo Alto, California
94301.
(4) Stock consists of an aggregate of 1,200,000 shares of Series B Preferred
Stock, 289,855 shares of Series C Preferred Stock, 143,429 shares of
Series D Preferred Stock and 463,294 shares of Series E Preferred Stock
held directly by Eagle Ventures II, LLC and Crescendo II, L.P.
(collectively, the "Crescendo Entities"). Mr. Spreng, a director of
Digital Island, is the President of Eagle Ventures II, LLC and the
Managing Member of Crescendo Ventures II, LLC, the General Partner of
Crescendo II, LP. The address for the Crescendo Entities is 505 Hamilton
Avenue, Suite 315, Palo Alto, California 94301.
(5) Stock consists of 1,333,334 shares of Series D Preferred Stock and 562,588
shares of Series E Preferred Stock. Mr. Cotsakos, a director of Digital
Island, is Chairman of the Board and Chief Executive Officer of E*TRADE
Group, Inc. The address of E*TRADE Group, Inc. is Four Embarcadero Place,
2400 Geng Road, Palo Alto, California 94303.
(6) Stock consists of an aggregate of 1,015,000 shares of Series C Preferred
Stock, 190,476 shares of Series D Preferred Stock and 744,470 shares of
Series E Preferred Stock held directly by Raptor Global Fund L.P., Raptor
Global Fund Ltd. and Tudor Private Equity Fund L.P. (collectively, the
"Tudor Entities"). The address for the Tudor Entities is Tudor Global
Trading, Inc., 40 Rowes Wharf, Second Floor, Boston, Massachusetts 02110.
(7) Stock consists of 1,882,353 shares of Series E Preferred Stock. The
address of FW Ventures III, LP is 2775 Sand Hill Road, Menlo Park,
California 94025.
(8) Stock consists of 1,482,824 shares of Series E Preferred Stock held
directly by KECALP, Inc., KECALP Inc., as Nominee for Merrill Lynch KECALP
International L.P. 1997 and Merrill Lynch KECALP L.P. 1997 (collectively,
the "Merrill Lynch KECALP Entities"). The address for the Merrill Lynch
KECALP Entities is World Financial Center, North Tower, New York, NY
10281.
(9) Stock consists of 1,450,000 shares of common stock held directly by Mr.
Higgins, 225,000 shares of common stock subject to options exercisable
within 60 days of March 31, 1999, of which 216,000 shares were exercised
by Mr. Higgins on April 20, 1999, 150,000 shares of common stock held
directly by the Ron and Sanne Higgins 1998 Irrevocable Trust Agreement
f/b/o Dana Espinoza (the "Espinoza Trust"), 150,000 shares of common stock
held directly by the Ron and Sanne Higgins 1998 Irrevocable Trust
Agreement f/b/o Nina Higgins (the "Higgins Trust") and 100,000 shares of
common stock held by the Ron and Sanne Higgins 1998 Irrevocable
Grandchildren's Trust Agreement (the "Grandchildren's Trust"). Mr. Higgins
is a Trustee of the Espinoza Trust, the Higgins Trust and the
Grandchildren's Trust.
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(10) Stock consists of 100,000 shares of common stock held directly by Ms.
Ernst and 504,574 shares of common stock subject to options exercisable
within 60 days of March 31, 1999, of which 133,332 shares were exercised
by Ms. Ernst on April 20, 1999.
(11) Stock consists of common stock subject to options exercisable within 60
days of March 31, 1999, of which 125,000 shares were exercised by Mr.
Leinwand on April 9, 1999.
(12) Stock consists of 25,000 shares of common stock held directly by Mr.
Sullivan and 58,000 shares of common stock subject to options exercisable
within 60 days of March 31, 1999, of which 46,000 shares were exercised by
Mr. Sullivan on April 21, 1999.
(13) Stock consists of common stock subject to options exercisable within 60
days of March 31, 1999, of which 41,400 shares were exercised by Mr.
Wilson on April 20, 1999.
(14) Stock consists of 225,000 shares of Series A Preferred Stock, 90,000
shares of Series B Preferred Stock, 39,420 shares of Series C Preferred
Stock, 34,095 shares of Series D Preferred Stock and 27,765 shares of
Series E Preferred Stock held directly by the Bass Trust U/D/T dated April
29, 1988 (the "Bass Trust"). Mr. Bass, a director of Digital Island, is
the Trustee of the Bass Trust.
(15) Stock consists of 183,000 shares of common stock and 29,000 shares of
Series C Preferred Stock.
(16) Stock consists of 5,556 shares of common stock subject to options
exercisable within 60 days of March 31, 1999 and 28,571 shares of Series D
Preferred Stock held directly by The Cotsakos Revocable Trust dated
September 3, 1987. Excludes 2,013,367 shares of preferred stock, as
converted, held by E*TRADE Group, Inc. Mr. Cotsakos, a director of Digital
Island, is the Trustee of the Cotsakos Trust and Chairman of the Board and
Chief Executive Officer of E*TRADE Group, Inc. Mr. Cotsakos disclaims
beneficial ownership of the shares of preferred stock held by E*TRADE
Group, Inc. except to the extent of his pecuniary interest therein. See
footnote 5 above.
(17) Excludes an aggregate of 2,561,310 shares comprised of warrants
exercisable for common stock and preferred stock, as converted, held by
Vanguard V, L.P. Mr. Higgerson, a director of Digital Island, is the
General Partner of Vanguard V, L.P. Mr. Higgerson disclaims beneficial
ownership of warrants exercisable for common stock and preferred stock
held by Vanguard V, L.P. except to the extent of his pecuniary interest
therein. See footnote 3 above.
(18) Excludes 2,823,529 shares of preferred stock, as converted, held by Chase
Venture Capital Associates, L.P. Mr. Soghikian, a director of Digital
Island, is the General Partner of Chase Capital Partners, the General
Partner of Chase Venture Capital Associates, L.P. Mr. Soghikian disclaims
beneficial ownership of the shares of preferred stock held by Chase
Venture Capital Associates, L.P. except to the extent of his pecuniary
interest therein. See footnote 2 above.
(19) Excludes an aggregate 2,109,212 shares of preferred stock, as converted,
held by the Crescendo Entities. Mr. Spreng, a director of Digital Island,
is the President of Eagle Ventures II, LLC and the Managing Member of
Crescendo Ventures II, LLC, the General Partner of Crescendo. Mr. Spreng
disclaims beneficial ownership of the shares of preferred stock held by
the Crescendo Entities, except to the extent of his pecuniary interest
therein. See footnote 4 above.
(20) See footnotes 9 through 19 above. Includes options exercisable for
1,088,221 shares of common stock within 60 days of March 31, 1999 under
the 1998 stock option/stock issuance plan.
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DESCRIPTION OF CAPITAL STOCK
Upon the closing of this offering, the authorized capital stock of Digital
Island will consist of 100,000,000 shares of common stock, $0.001 par value per
share, and 10,000,000 shares of preferred stock, $0.001 par value per share.
Common Stock
As of March 31, 1999, 2,622,225 shares of our common stock were outstanding
and held of record by 35 stockholders. After this offering, 33,965,736 shares
will be outstanding, assuming no exercise of the underwriters' over-allotment
option and no exercise of options after March 31, 1999. Concurrently with the
completion of this offering, each outstanding share of our preferred stock will
be exchanged for and converted into one share of our common stock, except that
each share of our Series D Preferred Stock will convert into 1.088084 shares of
our common stock to reflect a price based antidilution adjustment. The
following description of rights assumes this conversion.
Holders of common stock are entitled to receive dividends as may from time
to time be declared by our board of directors out of funds legally available
therefor. See "Dividend Policy." Holders of common stock are entitled to one
vote per share on all matters on which the holders of common stock are entitled
to vote and do not have any cumulative voting rights. Holders of common stock
have no preemptive, conversion, redemption or sinking fund rights. In the event
of a liquidation, dissolution or winding up of Digital Island, holders of
common stock are entitled to share equally and ratably in the assets of the
Digital Island, if any, remaining after the payment of all our liabilities and
the liquidation preference of any then outstanding class or series of preferred
stock. The rights, preferences and privileges of holders of common stock are
subject to any series of preferred stock that we may issue in the future, as
described below.
Preferred Stock
Our board of directors has the authority to issue preferred stock in one or
more series and to fix the number of shares constituting any such series and
the preferences, limitations and relative rights, including dividend rights,
dividend rate, voting rights, terms of redemption, redemption price or prices,
conversion rights and liquidation preferences of the shares constituting any
series, without any further vote or action by our stockholders. The issuance of
preferred stock by our board of directors could adversely affect the rights of
holders of common stock.
The potential issuance of preferred stock may have the effect of delaying or
preventing a change in control of Digital Island, may discourage bids for our
common stock at a premium over the market price of the common stock and may
adversely affect the market price of, and the voting and other rights of the
holders of, common stock. Immediately after this offering there will be no
shares of preferred stock outstanding, and we have no current plans to issue
shares of preferred stock.
Anti-Takeover, Limited Liability and Indemnification Provisions
Effect of Delaware Anti-takeover Statute. We are subject to Section 203 of
the Delaware General Corporation Law, as amended ("Section 203"), which
prohibits a Delaware corporation from engaging in any business combination with
any interested stockholder for a period of three years following the date that
such stockholder became an interested stockholder, unless:
. prior to such date, the board of directors of the corporation
approved either the business combination or the transaction that
resulted in the stockholder becoming an interested stockholder;
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<PAGE>
. upon consummation of the transaction that resulted in the
stockholder becoming an interested stockholder, the interested
stockholder owned at least 85% of the voting stock of the
corporation outstanding at the time the transaction commenced,
excluding for purposes of determining the number of shares
outstanding those shares owned (1) by persons who are directors and
also officers and (2) by employee stock plans in which employee
participants do not have the right to determine confidentially
whether shares held subject to the plan will be tendered in a tender
or exchange offer; or
. on or subsequent to such date, the business combination is approved
by the board of directors and authorized at an annual or special
meeting of stockholders, and not by written consent, by the
affirmative vote of at least 66 2/3% of the outstanding voting stock
that is not owned by the interested stockholder.
Section 203 defines business combinations to include:
. any merger or consolidation involving the corporation and any
interested stockholder;
. any sale, transfer, pledge or other disposition of 10% or more of
the assets of the corporation involving the interested stockholder;
. any transaction that results in the issuance or transfer by the
corporation of any stock of the corporation to the interested
stockholder;
. any transaction involving the corporation that has the effect of
increasing the proportionate share of the stock of any class or
series of the corporation beneficially owned by the interested
stockholder; or
. the receipt by the interested stockholder of the benefit of any
loans, advances, guarantees, pledges or other financial benefits
provided by or through the corporation.
In general, Section 203 defines an interested stockholder as any entity or
person beneficially owning 15% or more or the outstanding voting stock of the
corporation and any entity or person affiliated with or controlling or
controlled by such entity or person.
Certificate of Incorporation and Bylaw Provisions. Our certificate of
incorporation and bylaws include provisions that may have the effect of
discouraging, delaying or preventing a change in control of Digital Island or
an unsolicited acquisition proposal that a stockholder might consider
favorable, including a proposal that might result in the payment of a premium
over the market price for the shares held by stockholders. These provisions are
summarized in the following paragraphs.
Classified Board of Directors. Our certificate of incorporation and bylaws
provide for our board to be divided into three classes of directors serving
staggered, three year terms. The classification of the board has the effect of
requiring at least two annual stockholder meetings, instead of one, to replace
a majority of the members of the board of directors.
Supermajority Voting. Our certificate of incorporation requires the approval
of the holders of at least 66 2/3% of our combined voting power to effect
certain amendments to the certificate of incorporation with respect to the
bylaws, directors, stockholder meetings and indemnification or to effect any
business combination (as defined in Section 203) relating to us. Our bylaws may
be amended by either a majority of the board of directors, or the holders of a
majority of our voting stock, provided that certain amendments approved by
stockholders require the approval of at least 66 2/3% of our combined voting
power.
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Authorized but Unissued or Undesignated Capital Stock. Our authorized
capital stock consists of 100,000,000 shares of common stock and 10,000,000
shares of preferred stock. No preferred stock will be designated upon
consummation of this offering. After this offering, we will have outstanding
33,965,736 shares of common stock. The authorized but unissued (and in the case
of preferred stock, undesignated) stock may be issued by the board of directors
in one or more transactions. In this regard, our certificate of incorporation
grants the board of directors broad power to establish the rights and
preferences of authorized and unissued preferred stock. The issuance of shares
of preferred stock pursuant to the board of director's authority described
above could decrease the amount of earnings and assets available for
distribution to holders of common stock and adversely affect the rights and
powers, including voting rights, of such holders and may have the effect of
delaying, deferring or preventing a change in control of Digital Island. The
board of directors does not currently intend to seek stockholder approval prior
to any issuance of preferred stock, unless otherwise required by law or the
rules of any exchange on which our securities are then traded.
Special Meetings of Stockholders. Our bylaws provide that special meetings
of stockholders of Digital Island may be called only by the board of directors,
or by the Chairman of our board of directors or our President.
No Stockholder Action by Written Consent. Our certificate of incorporation
and bylaws provide that an action required or permitted to be taken at any
annual or special meeting of the stockholders of Digital Island may only be
taken at a duly called annual or special meeting of stockholders. This
provision prevents stockholders from initiating or effecting any action by
written consent.
Notice Procedures. Our bylaws establish advance notice procedures with
regard to all stockholder proposals to be brought before meetings of
stockholders of Digital Island, including proposals relating to the nomination
of candidates for election as directors, the removal of directors and
amendments to our certificate of incorporation or bylaws. These procedures
provide that notice of such stockholder proposals must be timely given in
writing to the Secretary of Digital Island prior to the meeting. Generally, to
be timely, notice must be received by our Secretary not less than 120 days
prior to the meeting. The notice must contain certain information specified in
the bylaws.
Other Anti-Takeover Provisions. See "Executive Compensation and Other
Information--Employee Benefit Plans" for a discussion of certain provisions of
the 1999 stock incentive plan which may have the effect of discouraging,
delaying or preventing a change in control of Digital Island or unsolicited
acquisition proposals.
Limitation of Director Liability. Our certificate of incorporation limits
the liability of our directors (in their capacity as directors but not in their
capacity as officers) to Digital Island or our stockholders to the fullest
extent permitted by Delaware law. Specifically, directors of Digital Island
will not be personally liable for monetary damages for breach of a director's
fiduciary duty as a director, except for liability:
. for any breach of the director's duty of loyalty to Digital Island
or our stockholders;
. for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
. under Section 174 of the Delaware General Corporation Law, which
relates to unlawful payments of dividends or unlawful stock
repurchases or redemptions; or
. for any transaction from which the director derived an improper
personal benefit.
Indemnification Arrangements. Our bylaws provide that the directors and
officers of Digital Island shall be indemnified and provide for the advancement
to them of expenses in connection with actual or threatened proceedings and
claims arising out of their status as such to the fullest extent permitted by
the Delaware General Corporation Law. Prior to consummation of this offering,
we will enter into indemnification
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agreements with each of our directors and executives officers that will provide
them with rights to indemnification and expense advancement to the fullest
extent permitted under the Delaware General Corporation Law.
Transfer Agent and Registrar
The transfer agent and registrar for the common stock is BankBoston, N.A.
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SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, there has not been any public market for our common
stock. Future sales of substantial amounts of common stock in the public
market, or the prospect of such sales, could adversely affect prevailing
market prices.
Upon completion of this offering, 33,965,736 shares of common stock will be
outstanding, assuming no exercise of the underwriters' over-allotment option
and no exercise of options after March 31, 1999. Of these shares, all of the
shares sold in this offering will be freely tradeable without restriction
under the Securities Act, unless purchased by an "affiliate" of Digital
Island, as that term is defined in Rule 144. The remaining 27,965,736 shares
outstanding after completion of this offering are "restricted securities" as
defined in Rule 144 and may be sold in the public market only if registered
under the Securities Act or if they qualify for an exemption from
registration, including an exemption pursuant to Rule 144.
Digital Island and our executive officers, directors and substantially all
of the holders of our outstanding common stock as of the date hereof have
agreed that, subject to certain exceptions and consents, during the period
beginning from the date of this prospectus, and continuing to and including
the date 180 days after the date of this prospectus, they will not offer,
sell, contract to sell or otherwise dispose of any securities of Digital
Island. Bear, Stearns & Co. Inc., may in its sole discretion and at any time
without notice, release all or any portion of the shares subject to such
agreements. Upon expiration of these agreements, 16,001,170 shares will be
eligible for immediate resale in the public market subject to the limitations
of Rule 144. Of such shares, approximately 9,195,875 will be eligible for
immediate resale in the public market pursuant to Rule 144(k) without regard
to the volume and manner of sale limitations in Rule 144. In addition, a total
of 75,000 shares held by several holders of our outstanding common stock as of
the date hereof will be eligible for immediate resale in the public market
immediately upon the effectiveness of this offering. Bear Stearns & Co. Inc.
has agreed to permit Digital Island to issue, sell, offer or agree to sell up
to 10% of our outstanding shares within 180 days after the date of this
prospectus in connection with third party investments in our securities or
mergers, acquisitions or other business combinations, at the higher of the
initial public offering price or the then current market price, provided that
the acquiror or buyer of such shares agrees not to issue, sell, offer or agree
to sell such shares during such 180 day period.
In general, under Rule 144, a person, including an "affiliate" of Digital
Island, who has beneficially owned restricted shares for at least one year is
entitled to sell within any three-month period a number of shares that does
not exceed the greater of 1% of the then outstanding shares of common stock
(approximately 354,657 shares immediately following this offering) or the
average weekly trading volume of the common stock during the four calendar
weeks preceding such sale. Sales under Rule 144 are subject to certain manner
of sale limitations, notice requirements and the availability of current
public information about Digital Island. Rule 144(k) provides that a person
who is not an "affiliate" of the issuer at any time during the three months
preceding a sale and who has beneficially owned shares for at least two years
is entitled to sell those shares at any time without compliance with the
public information, volume limitation, manner of sale and notice provisions of
Rule 144.
Additionally, in general, under Rule 701 of the Securities Act as currently
in effect, any of our employees, consultants or advisors who purchasers shares
from us in connection with a compensatory stock or option plan or other
written agreement is eligible to resell such shares 90 days after the
effective date of this offering in reliance on Rule 144, but without
compliance with certain restrictions, including the holding period, contained
in Rule 144.
As of March 31, 1999, options to purchase 4,218,839 shares of common stock
were outstanding under the 1998 stock option/stock issuance plan. We intend to
file as soon as practicable following completion of this offering a
registration statement on Form S-8 under the Securities Act covering shares of
common stock reserved for issuance under the 1999 stock incentive plan. Based
on the number of options expected to be outstanding upon completion of this
offering and shares reserved for issuance under the 1999 stock incentive plan,
the S-8
69
<PAGE>
registration statement would cover 11,762,839 shares. See "Executive
Compensation and Other Information-- Employee Benefit Plans". The S-8
registration statement will become effective immediately upon filing,
whereupon, subject to the satisfaction of applicable exercisability periods,
Rule 144 volume limitations applicable to affiliates and, in certain cases, the
agreements with the underwriters referred to above, shares of Common Stock to
be issued upon exercise of outstanding options granted pursuant to the 1999
stock incentive plan (to the extent that such shares were held by affiliates)
will be available for immediate resale in the open market.
70
<PAGE>
UNDERWRITING
The underwriters of this offering named below, for whom Bear, Stearns & Co.
Inc., Lehman Brothers Inc., and Thomas Weisel Partners LLC are acting as
representatives, have severally agreed with Digital Island, subject to the
terms and conditions of the Underwriting Agreement (the form of which has been
filed as an exhibit to the Registration Statement on Form S-1 of which this
prospectus is a part), to purchase from Digital Island the aggregate number of
shares of common stock set forth opposite their respective names below:
<TABLE>
<CAPTION>
Number of
Underwriter Shares
----------- ---------
<S> <C>
Bear, Stearns & Co. Inc. ........................................ 2,100,000
Lehman Brothers Inc. ............................................ 1,050,000
Thomas Weisel Partners LLC....................................... 1,050,000
Banc of America Securities LLC................................... 120,000
BancBoston Robertson Stephens Inc. .............................. 120,000
Deutsche Bank Securities Inc. ................................... 120,000
CIBC World Markets Corp. ........................................ 120,000
Hambrecht & Quist LLC............................................ 120,000
ING Baring Furman Selz LLC....................................... 120,000
PaineWebber Incorporated......................................... 120,000
SG Cowen Securities Corporation.................................. 120,000
Corinthian Partners, L.L.C....................................... 60,000
Cruttenden Roth Incorporated..................................... 60,000
Dain Rauscher Wessels............................................ 60,000
First Albany Corporation......................................... 60,000
First Security Investments, Inc. ................................ 60,000
Gerard Klauer Mattison & Co., Inc. .............................. 60,000
Jesup & Lamont Securities Corporation............................ 60,000
Legg Mason Wood Walker, Incorporated............................. 60,000
Pacific Crest Securities Inc. ................................... 60,000
Pacific Growth Equities, Inc. ................................... 60,000
Punk, Ziegel & Company, L.P. .................................... 60,000
SoundView Technology Group, Inc. ................................ 60,000
C.E. Unterberg, Towbin........................................... 60,000
Wunderlich Securities, Inc....................................... 60,000
---------
Total.......................................................... 6,000,000
=========
</TABLE>
The nature of the respective obligations of the underwriters is such that
all of the shares of common stock (other than shares of common stock covered by
the over-allotment option described below) must be purchased if any are
purchased. Those obligations are subject, however, to various conditions,
including the approval of certain matters by counsel. Digital Island has agreed
to indemnify the underwriters against certain liabilities, including
liabilities under the Securities Act, and, where such indemnification is
unavailable, to contribute to payments that the underwriters may be required to
make in respect of such liabilities.
The Company has been advised that the underwriters propose to offer the
shares of common stock directly to the public initially at the public offering
price set forth on the cover page of this Prospectus and to certain selected
dealers at such price less a concession not to exceed $0.40 per share, that the
underwriters may allow, and such selected dealers may reallow, a concession to
certain other dealers not to exceed $0.10 per share and that after the
commencement of this offering, the public offering price and the concessions
may be changed.
71
<PAGE>
Digital Island has granted to the underwriters an option to purchase in the
aggregate up to 900,000 additional shares of common stock to be sold in this
offering solely to cover over-allotments, if any. The option may be exercised
in whole or in part at any time within 30 days after the date of this
prospectus. To the extent the option is exercised, the underwriters will be
severally committed, subject to certain conditions, including the approval of
certain matters by counsel, to purchase the additional shares of common stock
in proportion to their respective purchase commitments as indicated in the
preceding table.
The underwriters have reserved for sale at the initial public offering price
up to 5% of the number of shares of common stock offered hereby for sale to
certain directors, officers, other employees, business affiliates and related
persons of Digital Island who have expressed an interest in purchasing shares.
The number of shares available for sale to the general public will be reduced
to the extent any reserved shares are purchased. Any reserved shares not so
purchased will be offered by the underwriters on the same basis as the other
shares offered hereby.
Digital Island and our executive officers, directors and substantially all
of our current securityholders have agreed that, subject to certain limited
exceptions, for a period of 180 days after the date of this prospectus, without
the prior written consent of Bear, Stearns & Co. Inc., they will not, directly
or indirectly, issue, sell, offer or agree to sell or otherwise dispose of any
shares of common stock (or securities convertible into, exchangeable for or
evidencing the right to purchase shares of common stock). Bear, Stearns & Co.
Inc., may in its sole discretion and at any time without notice, release all or
any portion of the shares subject to such agreements. In addition, Bear Stearns
& Co. Inc. has agreed to permit Digital Island to issue, sell, offer or agree
to sell up to 10% of our outstanding shares within 180 days after the date of
this prospectus in connection with third party investments in our securities or
mergers, acquisitions or other business combinations, at the higher of the
initial public offering price or the then current market price, provided that
the acquiror or buyer of such shares agrees not to issue, sell, offer or agree
to sell such shares during such 180 day period.
Prior to this offering, there has been no public market for the common
stock. Consequently, the initial public offering price will be determined
through negotiations among Digital Island and the representatives of the
underwriters. Among the factors considered in making such determination were
Digital Island's financial and operating history and condition, market
valuations of other companies engaged in activities similar to ours, our
prospects and prospects for the industry in which we do business in general,
the management of Digital Island, prevailing equity market conditions and the
demand for securities considered comparable to those of Digital Island.
In order to facilitate this offering, certain persons participating in this
offering may engage in transactions that stabilize, maintain or otherwise
affect the price of the common stock during and after this 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 have been sold to them by Digital Island. The underwriters
may elect to cover any such 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 this
offering are reclaimed if shares of common stock previously distributed in this
offering are repurchased in connection with stabilization transactions or
otherwise. The effect of these transactions may be to stabilize or maintain the
market price of the common stock 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 thereof. No
representation is made as to the magnitude or effect of any such stabilization
or other transactions. Such transactions may be effected on the Nasdaq National
Market or otherwise and, if commenced, may be discontinued at any time.
72
<PAGE>
Thomas Weisel Partners LLC, one of the representatives of the underwriters,
was organized and registered as a broker-dealer in December 1998. Since
December 1998, Thomas Weisel Partners has been named as a lead or co-manager on
40 filed public offerings of equity securities, of which 21 have been
completed, and has acted as a syndicate member in an additional 17 public
offerings of equity securities. Thomas Weisel Partners does not have any
material relationship with us or any of our officers, directors or other
controlling persons, except with respect to its contractual relationship with
us pursuant to the underwriting agreement entered into in connection with this
offering.
LEGAL MATTERS
The validity of the issuance of the common stock offered in this offering
will be passed upon for us by Brobeck, Phleger & Harrison LLP, Palo Alto,
California, and will be passed upon for the underwriters by Skadden, Arps,
Slate, Meagher & Flom LLP, Palo Alto, California. As of the date of this
prospectus, attorneys of Brobeck, Phleger & Harrison LLP beneficially own an
aggregate of 41,750 shares of our common stock.
EXPERTS
The Financial Statements of Digital Island as of September 30, 1998 and 1997
and for each of the years in the three-year period then ended included in this
prospectus have been audited by PricewaterhouseCoopers LLP, independent
auditors, as stated in their report appearing herein.
ADDITIONAL INFORMATION
Digital Island has filed with the Securities and Exchange Commission,
Washington, D.C. 20549, a Registration Statement on Form S-1 under the
Securities Act with respect to the common stock offered in this offering. This
prospectus omits certain information set forth in the Registration Statement
and the exhibits and schedules thereto. For further information with respect to
Digital Island and the common stock offered in this offering, reference is made
to such Registration Statement, exhibits and schedules. Statements contained in
this prospectus as to the contents of any contract or other document referred
to are complete in all material respects, and you should refer to the copy of
such contract or other document filed as an exhibit to the Registration
Statement. After consummation of this offering we will be subject to the
informational requirements of the Securities Exchange Act of 1934, as amended,
and in accordance therewith, will be required to file annual and quarterly
reports, proxy statements and other information with the Commission. The
Registration Statement, including the exhibits and schedules filed therewith,
as well as such reports and other information filed by us may be inspected
without charge at the public reference facilities maintained by the Securities
and Exchange Commission at Room 1024, 450 Fifth Street, N.W., Washington, D.C.
20549 and at the regional offices of the Securities and Exchange Commission
located at Seven World Trade Center, Suite 1300, New York, New York 10048 and
Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661.
Copies of such materials may be obtained from the Public Reference Section of
the Securities and Exchange Commission, Room 1024, 450 Fifth Street, N.W.,
Washington, D.C. 20549 at prescribed rates and from the Commission's Internet
Web site at http://www.sec.gov.
73
<PAGE>
DIGITAL ISLAND, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Accountants........................................... F-2
Consolidated Balance Sheets................................................. F-3
Consolidated Statements of Operations....................................... F-4
Consolidated Statements of Stockholders' Equity............................. F-5
Consolidated Statements of Cash Flows....................................... F-6
Notes to Consolidated Financial Statements.................................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Digital Island, Inc.:
In our opinion, the accompanying balance sheets and the related statements
of operations, stockholders' equity and cash flows present fairly, in all
material respects, the financial position of Digital Island, Inc. (the Company)
at September 30, 1998 and 1997, and the results of its operations and its cash
flows for each of the three years in the period ended September 30, 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.
/s/ PricewaterhouseCoopers LLP
San Francisco, California
June 23, 1999
F-2
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
September 30, March 31,
------------------------- --------------------------
1999
1997 1998 1999 pro forma
----------- ------------ ------------ ------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
ASSETS
Current assets:
Cash and cash
equivalents........... $ 4,583,771 $ 5,710,937 $ 29,750,924 $ 29,760,424
Investments............ 1,982,664 10,122,631 20,915,423
Accounts receivable,
net of allowance of
$0, $55,000, and
$168,655
respectively.......... 73,558 662,491 2,707,374
Restricted cash........ 383,862 263,082 263,082
Loan receivable........ -- 531,553 --
Deferred offering
costs................. -- 132,119 --
Prepaid expenses and
other................. 53,539 151,819 1,364,409
----------- ------------ ------------ ------------
Total current assets... 7,077,394 17,574,632 55,001,212 55,010,712
Property and equipment,
net.................... 2,109,485 4,937,717 7,039,207
Other assets............ 36,007 104,455 318,948
----------- ------------ ------------ ------------
Total assets.......... $ 9,222,886 $ 22,616,804 $ 62,359,367 $ 62,368,867
=========== ============ ============ ============
LIABILITIES AND
STOCKHOLDERS' EQUITY
Current liabilities:
Bank borrowings........ $ 211,393 $ 800,579 $ 800,579
Capital lease
obligations........... -- 756,091 1,019,000
Accounts payable....... 1,922,101 2,407,828 4,774,686
Accrued liabilities.... 322,132 716,133 3,943,669
Deferred revenue....... 8,742 11,000 453,395
----------- ------------ ------------
Total current
liabilities........... 2,464,368 4,691,631 10,991,329
Bank borrowings, less
current portion........ 493,361 884,282 599,192
Capital lease
obligations, less
current portion........ -- 1,550,648 1,619,730
----------- ------------ ------------
Total liabilities...... 2,957,729 7,126,561 13,210,251
----------- ------------ ------------
Commitments (Note 8).
Stockholders' equity:
Series A through E
convertible preferred
stock, $0.001 par
value:
Authorized: 7,000,000
shares in 1997,
14,000,000 shares in
1998 and 30,000,000
shares at March 31,
1999 (unaudited);
issued and
outstanding: 7,000,000
shares in 1997,
13,305,657 shares in
1998, and 25,070,363
shares at March 31,
1999 (unaudited);
(liquidation value:
$86,894,973 at March
31, 1999); pro forma--
no shares authorized,
issued, and
outstanding........... 7,000 13,305 25,070 $ --
Common stock, $0.001
par value:
Authorized: 13,000,000
shares in 1997,
30,000,000 shares in
1998, and 40,000,000
shares at March 31,
1999 (unaudited);
issued and
outstanding: 2,215,875
shares in 1997,
2,519,835 shares in
1998 and 2,622,225
shares at March
31,1999 (unaudited);
pro forma--70,000,000
shares authorized and
27,965,736 shares
issued and
outstanding........... 2,216 2,520 2,622 27,966
Additional paid-in
capital............... 11,586,366 39,182,179 92,158,254 92,196,582
Deferred compensation.. -- (1,503,166) (5,963,168) (5,963,168)
Stockholder note
receivable............ -- (109,800) (109,800) (109,800)
Common stock warrants.. 29,102 29,102 29,102 --
Accumulated deficit.... (5,359,527) (22,123,897) (36,992,964) (36,992,964)
----------- ------------ ------------ ------------
Total stockholders'
equity................ 6,265,157 15,490,243 49,149,116 49,158,616
----------- ------------ ------------ ------------
Total liabilities and
stockholders'
equity............... $ 9,222,886 $ 22,616,804 $ 62,359,367 $ 62,368,867
=========== ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
F-3
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
Six Months Ended
Years Ended September 30, March 31,
----------------------------------- -------------------------
1996 1997 1998 1998 1999
-------- ----------- ------------ ----------- ------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Revenue................. $ -- $ 218,186 $ 2,342,759 $ 691,183 $ 3,795,487
Costs and expenses:
Cost of revenue........ -- 2,508,351 9,038,678 4,025,661 7,749,903
Sales and marketing.... -- 1,205,448 4,846,722 1,786,816 5,170,560
Product development.... -- 378,241 1,693,962 571,030 2,010,387
General and
administrative........ 25,669 1,501,659 3,392,135 1,163,693 2,962,877
Stock compensation
expense............... -- -- 486,903 -- 1,025,508
-------- ----------- ------------ ----------- ------------
Total costs and
expenses............. 25,669 5,593,699 19,458,400 7,547,200 18,919,235
-------- ----------- ------------ ----------- ------------
Loss from operations.. (25,669) (5,375,513) (17,115,641) (6,856,017) (15,123,748)
-------- ----------- ------------ ----------- ------------
Interest income
(expense), net......... (578) 87,349 353,340 64,000 256,572
-------- ----------- ------------ ----------- ------------
Loss before income
taxes................ (26,247) (5,288,164) (16,762,301) (6,792,017) (14,867,176)
Provision for income
taxes.................. 800 800 2,069 1,269 1,891
-------- ----------- ------------ ----------- ------------
Net loss.............. $(27,047) $(5,288,964) $(16,764,370) $(6,793,286) $(14,869,067)
======== =========== ============ =========== ============
Basic and diluted net
loss per share......... $ (0.10) $ (3.53) $ (7.50) $ (3.07) $ (6.28)
======== =========== ============ =========== ============
Weighted average shares
outstanding used in per
share calculation...... 275,000 1,497,711 2,236,452 2,215,875 2,366,951
======== =========== ============ =========== ============
Pro forma basic and
diluted net loss per
share.................. $ (1.39) $ (0.81)
============ ============
Weighted average shares
outstanding used in pro
forma per share
calculation............ 12,042,539 18,353,258
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
F-4
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Convertible
Preferred Stock Common Stock Additional Stockholder Common
------------------- ----------------- Paid-in Deferred Note Stock Accumulated
Shares Amount Shares Amount Capital Compensation Receivable Warrants Deficit
---------- ------- --------- ------ ----------- ------------ ----------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balances,
September 30,
1995............ 2,000,000 $ 2,000 275,000 $ 275 $ 129,025 $ -- $ -- $ -- $ (43,516)
Warrants issued
in connection
with convertible
note ........... -- -- -- -- -- -- -- 22,975 --
Net loss........ -- -- -- -- -- -- -- -- (27,047)
---------- ------- --------- ------ ----------- ----------- --------- ------- ------------
Balances,
September 30,
1996............ 2,000,000 2,000 275,000 275 129,025 -- -- 22,975 (70,563)
Common stock
issued for
professional
services........ -- -- 70,875 71 28,279 -- -- -- --
Conversion of
preferred stock
into common
stock........... (2,000,000) (2,000) 2,000,000 2,000 -- -- -- -- --
Repurchase of
common stock.... -- -- (130,000) (130) (1,170) -- -- -- --
Series A
preferred stock
issued for cash,
net of issuance
costs of
$16,569......... 3,341,546 3,342 -- -- 3,321,635 -- -- -- --
Series B
preferred stock
issued for cash,
net of issuance
costs of
$46,199......... 3,000,000 3,000 -- -- 7,450,801 -- -- -- --
Warrants issued
in connection
with convertible
note ........... -- -- -- -- -- -- -- 6,127 --
Conversion of
notes payable
into Series A
preferred
stock........... 658,454 658 -- -- 657,796 -- -- -- --
Net loss........ -- -- -- -- -- -- -- -- (5,288,964)
---------- ------- --------- ------ ----------- ----------- --------- ------- ------------
Balances,
September 30,
1997............ 7,000,000 7,000 2,215,875 2,216 11,586,366 -- -- 29,102 (5,359,527)
Series C
preferred stock
issued for cash,
net of issuance
costs of
$34,011......... 4,283,181 4,283 -- -- 14,738,680 -- -- -- --
Series D
preferred stock
issued for cash,
net of issuance
costs of
$33,293......... 2,022,476 2,022 -- -- 10,582,684 -- -- -- --
Issuance of
stockholder note
in exchange for
common stock.... -- -- 183,000 183 109,617 -- (109,800) -- --
Common stock
issued for
professional
services........ -- -- 6,000 6 18,894 -- -- -- --
Common stock
issued for cash
upon exercise of
options......... -- -- 114,960 115 155,869 -- -- -- --
Deferred
compensation in
connection with
issuance of
stock options... -- -- -- -- 1,990,069 (1,990,069) -- -- --
Amortization of
deferred
compensation.... -- -- -- -- -- 486,903 -- -- --
Net loss........ -- -- -- -- -- -- -- -- (16,764,370)
---------- ------- --------- ------ ----------- ----------- --------- ------- ------------
Balances,
September 30,
1998............ 13,305,657 13,305 2,519,835 2,520 39,182,179 (1,503,166) (109,800) 29,102 (22,123,897)
Series E
preferred stock
issued for cash,
net of issuance
costs of
$2,538,580...... 11,764,706 11,765 -- -- 47,449,655 -- -- -- --
Common stock
issued for cash
upon exercise of
options......... -- -- 102,390 102 40,910 -- -- -- --
Deferred
compensation in
connection with
issuance of
stock options... -- -- -- -- 5,485,510 (5,485,510) -- -- --
Amortization of
deferred
compensation.... -- -- -- -- -- 1,025,508 -- -- --
Net loss........ -- -- -- -- -- -- (14,869,067)
---------- ------- --------- ------ ----------- ----------- --------- ------- ------------
Balances, March
31, 1999
(unaudited)..... 25,070,363 $25,070 2,622,225 $2,622 $92,158,254 $(5,963,168) $(109,800) $29,102 $(36,992,964)
========== ======= ========= ====== =========== =========== ========= ======= ============
<CAPTION>
Total
Stockholders'
Equity
-------------
<S> <C>
Balances,
September 30,
1995............ $ 87,784
Warrants issued
in connection
with convertible
note ........... 22,975
Net loss........ (27,047)
-------------
Balances,
September 30,
1996............ 83,712
Common stock
issued for
professional
services........ 28,350
Conversion of
preferred stock
into common
stock........... --
Repurchase of
common stock.... (1,300)
Series A
preferred stock
issued for cash,
net of issuance
costs of
$16,569......... 3,324,977
Series B
preferred stock
issued for cash,
net of issuance
costs of
$46,199......... 7,453,801
Warrants issued
in connection
with convertible
note ........... 6,127
Conversion of
notes payable
into Series A
preferred
stock........... 658,454
Net loss........ (5,288,964)
-------------
Balances,
September 30,
1997............ 6,265,157
Series C
preferred stock
issued for cash,
net of issuance
costs of
$34,011......... 14,742,963
Series D
preferred stock
issued for cash,
net of issuance
costs of
$33,293......... 10,584,706
Issuance of
stockholder note
in exchange for
common stock.... --
Common stock
issued for
professional
services........ 18,900
Common stock
issued for cash
upon exercise of
options......... 155,984
Deferred
compensation in
connection with
issuance of
stock options... --
Amortization of
deferred
compensation.... 486,903
Net loss........ (16,764,370)
-------------
Balances,
September 30,
1998............ 15,490,243
Series E
preferred stock
issued for cash,
net of issuance
costs of
$2,538,580...... 47,461,420
Common stock
issued for cash
upon exercise of
options......... 41,012
Deferred
compensation in
connection with
issuance of
stock options... --
Amortization of
deferred
compensation.... 1,025,508
Net loss........ (14,869,067)
-------------
Balances, March
31, 1999
(unaudited)..... $49,149,116
=============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
F-5
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
For the Six Months
Years Ended September 30, Ended March 31,
----------------------------------- -------------------------
1996 1997 1998 1998 1999
-------- ----------- ------------ ----------- ------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Cash flows from
operating activities:
Net loss............... $(27,047) $(5,288,964) $(16,764,370) $(6,793,286) $(14,869,067)
Adjustments to
reconcile net loss to
net cash used in
operating activities:
Depreciation and
amortization.......... -- 158,247 547,376 285,283 435,275
Amortization of
capital lease
obligations........... -- -- 263,433 7,705 488,402
Stock compensation
expense............... -- -- 486,903 -- 1,025,508
Non-cash revenue in
connection with
barter agreement...... -- (131,912) -- -- --
Debt discount in
conjunction with
convertible notes..... -- 29,102 -- -- --
Amortization of
discounts on
investments........... -- (23,908) (227,280) (30,249) (170,668)
Professional services
in exchange for
common stock.......... -- 28,350 18,900 -- --
Loss on disposal of
property and
equipment............. -- -- 1,373 -- --
Change in operating
assets and
liabilities:
Accounts receivable... -- (73,558) (588,933) (239,983) (2,044,883)
Prepaids expenses and
other................ 1,949 27,137 (98,280) (238,586) (1,212,590)
Deferred offering
costs................ -- -- (132,119) -- 132,119
Accounts payable...... 14,372 1,901,036 485,727 (136,994) 2,366,858
Accrued liabilities... -- 322,132 394,001 41,378 3,227,536
Deferred revenue...... -- 8,742 2,258 (8,742) 442,395
Other assets.......... -- (36,007) (68,448) 24,582 (216,093)
-------- ----------- ------------ ----------- ------------
Net cash used in
operating
activities.......... (10,726) (3,079,603) (15,679,459) (7,088,892) (10,395,208)
-------- ----------- ------------ ----------- ------------
Cash flows from
investing activities:
Purchases of property
and equipment......... (2,327) (2,128,376) (1,234,005) (160,417) (2,283,814)
Proceeds from
maturities of short-
term investments...... -- 1,000,000 5,600,000 2,000,000 12,200,000
Decrease (increase) in
restricted cash....... -- (383,862) 120,780 61,983 --
Purchases of short-term
investments........... -- (2,958,756) (13,512,687) (4,684,688) (22,822,124)
-------- ----------- ------------ ----------- ------------
Net cash used in
investing
activities.......... (2,327) (4,470,994) (9,025,912) (2,783,122) (12,905,938)
-------- ----------- ------------ ----------- ------------
Cash flows from
financing activities:
Proceeds from issuance
of preferred stock,
net................... -- 10,778,778 25,327,669 11,000,100 47,461,420
Proceeds from issuance
of common stock....... -- -- 155,984 -- 41,012
Proceeds from issuance
of notes payable...... 350,000 308,454 -- -- --
Proceeds from bank
borrowings............ -- 704,754 647,378 527,417 531,553
Repayments of bank
borrowings............ -- -- (198,824) (42,712) (285,090)
Repayments of capital
lease obligations..... -- -- (99,670) (16,015) (407,762)
Repurchase of common
stock................. -- (1,300) -- -- --
-------- ----------- ------------ ----------- ------------
Net cash provided by
financing
activities.......... 350,000 11,790,686 25,832,537 11,468,790 47,341,133
-------- ----------- ------------ ----------- ------------
Net increase in cash
and cash
equivalents........ 336,947 4,240,089 1,127,166 1,596,776 24,039,987
Cash and cash
equivalents, beginning
of period.............. 6,735 343,682 4,583,771 4,583,771 5,710,937
-------- ----------- ------------ ----------- ------------
Cash and cash
equivalents, end of
period................. $343,682 $ 4,583,771 $ 5,710,937 $ 6,180,547 $ 29,750,924
======== =========== ============ =========== ============
Supplemental disclosures
of cash flow
information:
Cash paid for
interest.............. $ 1,814 $ 27,219 $ 128,850 $ 45,213 $ 167,604
======== =========== ============ =========== ============
Cash paid for income
taxes................. $ -- $ 1,600 $ 2,069 $ 1,269 $ 1,891
======== =========== ============ =========== ============
Supplemental schedule of
noncash investing and
financing activities:
Common stock issued for
professional
services.............. $ -- $ 28,350 $ 18,900 $ -- $ --
======== =========== ============ =========== ============
Receivable on bank
borrowings............ $ -- $ -- $ 531,553 $ -- $ --
======== =========== ============ =========== ============
Notes payable converted
into preferred stock.. $ -- $ 658,454 $ -- $ -- $ --
======== =========== ============ =========== ============
Conversion of preferred
stock into common
stock................. $ -- $ 21,300 $ -- $ -- $ --
======== =========== ============ =========== ============
Note receivable issued
in exchange for common
stock................. $ -- $ -- $ 109,800 $ 109,800 $ --
======== =========== ============ =========== ============
Capital lease
obligations for
equipment............. $ -- $ -- $ 2,406,409 $ 251,443 $ 739,753
======== =========== ============ =========== ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
F-6
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
1. The Company:
Digital Island, Inc. (the Company) offers a global internet protocol
applications network designed to deploy business-critical applications
worldwide. The Company also offers services such as network management and
application services to customers deployed on its network. The Company was
incorporated in February 1994 under the name Smartvision, Inc. Together, these
services provide a product offering that enables multinational corporations to
reach end users in worldwide local markets.
2. Summary of Significant Accounting Policies:
Initial Public Offering and Unaudited Pro Forma Balance Sheet (unaudited)
In April 1999, the Board of Directors of the Company authorized the filing
of a registration statement with the Securities and Exchange Commission (the
SEC) that would permit the Company to sell shares of the Company's common stock
in connection with a proposed initial public offering (IPO). If the offering is
consummated under the terms presently anticipated, all the outstanding shares
of the Company's convertible preferred stock will automatically convert into
shares of common stock upon the closing of the proposed IPO and the exercise of
outstanding warrants to purchase 95,000 shares of common stock at an exercise
price of $0.10 per share. These warrants expire upon an IPO. The conversion of
the convertible preferred stock and the exercise of the warrants has been
reflected in the accompanying unaudited pro forma balance sheet as if it had
occurred on March 31, 1999.
Principles of Consolidation:
The accompanying interim consolidated financial statements of the Company
include the accounts of Digital Island, Inc. and its wholly-owned subsidiaries,
Digital Island B.V. and Digital Island Ltd., which were established in December
1998 and March 1999, respectively. All significant intercompany accounts and
transactions are eliminated in consolidation.
Use of Estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Unaudited Interim Financial Information:
The accompanying interim consolidated financial statements as of and for the
six months ended March 31, 1998 and 1999, together with the related notes are
unaudited but include all adjustments, consisting of only normal recurring
adjustments, which the Company considers necessary to present fairly, in all
material respects, the consolidated financial position, and consolidated
results of operations and cash flows for the six month periods ended March 31,
1998 and 1999. Results for the six months ended March 31, 1999 are not
necessarily indicative of results for the entire year.
Revenue Recognition:
Revenues are comprised primarily of bandwidth charges, equipment co-location
and storage fees, and one-time fees for installation. Bandwidth charges are
billed and recognized monthly based on customer usage. All
F-7
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
other revenues are based on flat-rate monthly charges. Installation fees are
typically recognized at the time that installation occurs. To date, such
revenues have not significantly exceeded the direct costs of installation.
Computation of Historical Net Loss Per Share and Pro Forma Net Loss Per Share:
The Company has adopted Statement of Financial Accounting Standards No. 128,
(SFAS 128) "Earnings Per Share." In accordance with SFAS 128, basic earnings
per share is computed using the weighted average number of common shares
outstanding during the period. Diluted earnings per share is computed using the
weighted average number of common and dilutive common equivalent shares
outstanding during the period, using either the as if converted method for
convertible preferred stock or the treasury stock method for options and
warrants. Pursuant to SEC Staff Accounting Bulletin No. 98, common stock and
convertible preferred stock issued for nominal consideration, prior to the
anticipated effective date of an IPO, are included in the calculation of basic
and diluted net loss per share, as if they were outstanding for all periods
presented. To date, the Company has not had any issuances for nominal
consideration.
Diluted net loss per share for the years ended September 30, 1996, 1997 and
1998, and the six months ended March 31, 1998 and 1999 does not include the
effect of 0, 0, 639, 0 and 0 stock options, respectively, and 0, 67,420,
71,250, 71,250, and 71,250 common stock warrants, respectively, or 2,000,000,
7,000,000, 13,305,657, 11,283,181, and 25,070,363 shares of convertible
preferred stock on an "as if converted" basis, respectively, as the effect of
their inclusion is antidilutive during each period.
Pro forma basic and diluted net loss per share is presented to reflect per
share data assuming the conversion of all outstanding shares of convertible
preferred stock into common stock as if the conversion had taken place at the
beginning of fiscal 1998 or at the date of issuance, if later. This data is
unaudited.
Cash and Cash Equivalents:
Cash and cash equivalents are stated at cost, which approximates fair value.
The Company includes in cash equivalents all highly liquid investments which
mature within three months of their purchase date.
Fair Value of Financial Instruments:
The carrying amounts of certain of the Company's financial instruments
including cash and cash equivalents, accounts receivable, notes payable,
accounts payable and accrued liabilities approximate fair value due to their
short maturities.
Investments:
At September 30, 1997 and 1998, and March 31, 1999 the Company's investments
consisted of commercial paper. Remaining maturities at the time of purchase are
generally less than one year.
Investments are accounted for in accordance with Statement of Financial
Accounting Standards No. 115 (SFAS 115) "Accounting for Certain Investments in
Debt and Equity Securities." This statement requires that securities be
classified as "held to maturity," "available for sale" or "trading," and the
securities in each classification be accounted for at either amortized cost or
fair market value, depending upon their classification. The Company has the
intent and the ability to hold investments until maturity. Therefore, all such
investments are classified as held to maturity investments and carried at
amortized cost in the accompanying consolidated financial statements.
F-8
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
The Company's investments consist of the following:
<TABLE>
<CAPTION>
March 31, 1999
September 30, 1997 September 30, 1998 (unaudited)
--------------------- ----------------------- -----------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
---------- ---------- ----------- ----------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Commercial paper........ $1,982,664 $1,982,000 $10,122,631 $10,124,557 $20,915,423 $20,798,002
</TABLE>
Restricted Cash:
Restricted cash consists of irrevocable standby letters of credit issued by
the Company's banks. Funds are generally held in certificates of deposit at the
Company's bank, and have been established in favor of a third party
beneficiary. The funds are released to the beneficiary in the event that the
Company fails to comply with certain specified contractual obligations.
Provided the Company meets these contractual obligations, the letter of credit
is discharged and the Company is no longer restricted from use of the cash.
Property and Equipment:
Property and equipment are recorded at cost and depreciated using the
straight-line method over their useful lives. Equipment recorded under capital
leases is amortized using the straight-line method over the shorter of the
respective lease term or the estimated useful life of the asset. Network and
communications equipment is depreciated over five years, computer equipment and
software is depreciated over three years, and furniture and fixtures are
depreciated over seven years. Maintenance and repairs are charged to expense as
incurred, and improvements and betterments are capitalized. When assets are
retired or otherwise disposed of, the cost and accumulated depreciation are
removed from the accounts and any resulting gain or loss is reflected in
operations in the period realized.
Long-lived Assets:
The Company evaluates the recoverability of its long-lived assets in
accordance with Statement of Financial Accounting Standards No. 121, (SFAS 121)
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to be Disposed Of." SFAS 121 requires recognition of impairment of long-lived
assets in the event the net book value of such assets exceeds the future
undiscounted cash flows attributable to such assets. No such impairments have
been identified to date. The Company assesses the impairment of long-lived
assets when events or changes in circumstances indicate that the carrying value
of an asset may not be recoverable.
Income Taxes:
The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards No. 109, (SFAS 109) "Accounting for Income
Taxes." Under SFAS 109, deferred tax liabilities and assets are determined
based on the difference between the financial statement and tax bases of assets
and liabilities using enacted tax rates in effect for the year in which the
differences are expected to reverse. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be realized.
Income tax expense represents the tax payable for the current period and the
change during the period in the deferred tax assets and liabilities.
Software Development Costs:
Software development costs have been accounted for in accordance with
Statement of Financial Accounting Standards No. 86, (SFAS 86) "Accounting for
the Costs of Computer Software to be Sold, Leased
F-9
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
or Otherwise Marketed." Under the standard, capitalization of software
development costs begins upon the establishment of technological feasibility.
To date, all such amounts have been insignificant, and accordingly, the Company
has charged all such costs to research and development expenses.
Deferred Revenues:
Deferred revenues primarily represent advanced billings to customers, or
prepayments by customers prior to completion of installation or prior to
provision of contractual bandwidth usage.
Concentration of Credit Risk:
Financial instruments which potentially subject the Company to
concentrations of credit risk consist primarily of temporary cash investments
and accounts receivable. The Company places its temporary investments with one
major financial institution.
The Company performs ongoing credit evaluations, does not require
collateral, and maintains reserves for potential credit losses on customer
accounts when deemed necessary. For the year ended September 30, 1997, three
customers accounted for approximately 56%, 20%, and 10%, respectively, of all
revenue generated by the Company, and 0%, 57%, and 31% of accounts receivable
at September 30, 1997, respectively. For the year ended September 30, 1998, the
same customers accounted for approximately 13%, 20%, and 4%, respectively, of
all revenue generated by the Company, and 19%, 5%, and 0% of accounts
receivable at September 30, 1998, respectively. In addition, a fourth customer
accounted for 12% of all revenues generated by the Company for the year ended
September 30, 1998, and 14% of accounts receivable at September 30, 1998. For
the six months ended March 31, 1998, the same four customers accounted for
approximately 15%, 31%, 9%, and 16%, respectively, of all revenues generated by
the Company. For the six months ended March 31, 1999, the same customers
accounted for 5%, 16%, 1%, and 7%, respectively, of all revenues generated by
the Company, and 3%, 35%, 0%, and 6%, respectively, of accounts receivable at
March 31, 1999.
Risks and Uncertainties:
Factors that may materially and adversely affect the Company's future
operating results include: demand for and market acceptance of the Company's
products and services; introductions of products and services or enhancements
by the Company and its competitors; competitive factors that affect our
pricing; capacity utilization of the Digital Island Global IP applications
network; reliable continuity of service and network availability; the ability
and cost of bandwidth and our ability to increase bandwidth as necessary; the
timing of customer installations; the mix of products and services sold by the
Company; customer retention; the timing and success of marketing efforts and
product and service introductions by the Company; the timing and magnitude of
capital expenditures, including costs relating to the expansion of operations;
the timely expansion of its network infrastructure; fluctuations in bandwidth
used by customers; the retention of key personnel; conditions specific to the
Internet industry and other general economic factors; and new government
legislation and regulation.
Comprehensive Income:
The Company has adopted the accounting treatment prescribed by Financial
Accounting Statement No. 130, "Comprehensive Income." The adoption of this
statement had no impact on the Company's financial statements for the periods
presented.
F-10
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
Segment Information:
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information." This
statement establishes standards for the way companies report information about
operating segments in financial statements. It also establishes standards for
related disclosures about products and services, geographic areas, and major
customers. In accordance with the provisions of SFAS No. 131, the Company has
determined that it does not currently have any separately reportable operating
segments.
Recently Issued Accounting Pronouncements:
On March 4, 1998, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants (AICPA) issued Statement of
Position No. 98-1 (SOP 98-1), "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use." SOP 98-1 requires computer software
costs related to internal software that are incurred in the preliminary project
stage should be expensed as incurred. Once the capitalization criteria of SOP
98-1 have been met, external direct costs of materials and services consumed in
developing or obtaining internal-use computer software; payroll and payroll-
related costs for employees who are directly associated with and who devote
time to the internal-use computer software project (to the extent of the time
spent directly on the project); and interest costs incurred when developing
computer software for internal use should be capitalized. SOP 98-1 is effective
for financial statements for fiscal years beginning after December 15, 1998.
Accordingly, the Company will adopt SOP 98-1 in its consolidated financial
statements for the year ending September 30, 2000. The adoption of SOP 98-1 is
not expected to have a material effect on the consolidated financial statements
of the Company.
On April 3, 1998, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 98-5 (SOP 98-5), "Reporting on the Costs of
Start-Up Activities," which provides guidance on the financial reporting of
start-up costs and organization costs. SOP 98-5 requires costs of start-up
activities and organization costs to be expensed as incurred. SOP 98-5 is
effective for financial statements for fiscal years beginning after December
15, 1998. As the Company has not capitalized such costs, the adoption of SOP
98-5 is not expected to have an impact on the consolidated financial statements
of the Company.
In June 1998, the FASB issued Statement of Financial Accounting Standards
No. 133 (SFAS 133), "Accounting for Derivative Instruments and Hedging
Activities." SFAS 133 establishes accounting and reporting standards for
derivative instruments and for hedging activities. SFAS 133 is effective for
fiscal years beginning after June 15, 1999. The Company does not believe the
adoption of SFAS 133 will have a material effect on the Company's consolidated
results of operations or financial condition.
F-11
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
3. Property and Equipment:
Property and equipment consists of the following:
<TABLE>
<CAPTION>
September 30,
--------------------- March 31,
1997 1998 1999
---------- ---------- -----------
(unaudited)
<S> <C> <C> <C>
Network equipment........................... $1,503,352 $2,299,279 $4,129,370
Communications equipment.................... 167,571 194,106 197,378
Computer equipment and software............. 301,980 514,651 816,119
Furniture, fixtures, and leasehold
improvements............................... 294,829 491,388 640,371
Equipment and fixtures under capital
leases..................................... -- 2,406,409 3,146,162
---------- ---------- ----------
2,267,732 5,905,833 8,929,400
Less accumulated depreciation and
amortization............................... 158,247 968,116 1,890,193
---------- ---------- ----------
Total property and equipment, net........... $2,109,485 $4,937,717 $7,039,207
========== ========== ==========
</TABLE>
4. Income Taxes:
For the years ended September 30, 1996, 1997, and 1998, the provision for
income taxes consists of state taxes.
The primary components of the net deferred tax asset are as follows:
<TABLE>
<CAPTION>
September 30,
------------------------
1997 1998
----------- -----------
<S> <C> <C>
Net operating loss carryforwards, federal and
state.......................................... $ 2,140,000 $ 8,635,000
Accrued employee benefits....................... 41,000 61,000
Sales tax....................................... 11,000 1,000
Accounts receivable allowance................... -- 22,000
Property and equipment.......................... (49,000) (358,000)
----------- -----------
2,143,000 8,361,000
Less valuation allowance........................ (2,143,000) (8,361,000)
----------- -----------
$ -- $ --
=========== ===========
</TABLE>
Due to the uncertainty surrounding the realization of the favorable tax
attributes in future tax returns, the Company has placed a valuation allowance
against its otherwise recognizable net deferred tax assets. The valuation
allowance increased by $2,121,000 and $6,218,000 for the years ended September
30, 1997 and 1998, respectively. The effective income tax rate differs from the
statutory federal income tax rate primarily due to the inability to recognize
the benefit of net operating losses.
At September 30, 1998, the Company had NOL carryforwards of approximately
$21,587,000 and $21,584,000 for federal and state income tax purposes,
respectively. These carryforwards expire beginning 2009 and 2002, respectively.
Pursuant to the provisions of Section 382 of the Internal Revenue Code,
utilization of the NOLs are subject to annual limitations through 2013 due to a
greater than 50% change in the ownership of the Company which occurred during
fiscal 1998.
F-12
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
5. Bank Borrowings:
Bank borrowings consist of:
<TABLE>
<CAPTION>
September 30,
--------------------- March 31,
1997 1998 1999
--------- ---------- -----------
(unaudited)
<S> <C> <C> <C>
Line of credit........................... $ -- $ 230,400 $ 230,400
Revolving credit facility................ 704,754 579,150 451,013
Equipment term facility.................. -- 875,311 718,358
--------- ---------- ----------
704,754 1,684,861 1,399,771
Current maturities....................... (211,393) (800,579) (800,579)
--------- ---------- ----------
Long-term bank borrowings................ $ 493,361 $ 884,282 $ 599,192
========= ========== ==========
</TABLE>
On November 21, 1996, the Company entered into a revolving credit agreement
(the Revolving Agreement) with a commercial lender. The aggregate credit under
the Revolving Agreement was originally $250,000, and was increased to $750,000
on April 18, 1997. Interest under the Revolving Agreement is 0.75% over the
"Prime Rate" as announced from time to time by the lender. At both September
30, 1997 and 1998, and March 31, 1999, the effective interest rate was 9.25%,
9.25%, and 8.50%, respectively. The weighted average interest rates for the
years ended September 30, 1997 and 1998, and the six months ended March 31,
1999 were 9.24%, 9.25%, and 8.55%, respectively. Under the terms of the
Revolving Agreement, advances could be made for the purchase of equipment until
October 18, 1997. At that date, the unpaid principal balance of equipment
advances plus interest became payable over 36 months in equal installments.
Outstanding borrowings under the Revolving Agreement at September 30, 1997 and
1998, and March 31, 1999 were $704,754, $579,150, and $451,013, respectively.
All amounts outstanding related to advances for equipment purchases.
On November 19, 1997, the Company entered into a loan agreement (the Loan
Agreement) with the same commercial lender associated with the Revolving
Agreement. Under the terms of the Loan Agreement, the Company was extended a
$5,000,000 line of credit, as well as an equipment loan term facility for
$2,500,000. Any borrowings under this line of credit are collateralized by
substantially all assets of the Company. Certain of the Loan Agreement's
provisions restrict the ability of the Company to declare or pay any dividends
while the credit agreement is in effect.
Advances under the line of credit are limited to a percentage of the
Company's recurring contract revenues, as defined in the Loan Agreement. The
Loan Agreement contains certain standard covenants. At September 30, 1998 and
March 31, 1999, $230,400 and $230,400, respectively, was outstanding under the
line of credit. Interest on borrowings are charged at the lender's prime rate
plus 0.25%, which was 8.75% and 8.00% at September 30, 1998 and March 31, 1999,
respectively. The weighted average interest rate for the year ended September
30, 1998 and the six months ended March 31, 1999, was 8.75% and 8.04%,
respectively. Advances under the line of credit can be repaid and reborrowed at
any time until the maturity date of May 31, 1999.
Under the terms of the equipment loan term facility, the Company had the
ability to borrow up to $1,250,000 for equipment purchases from November 19,
1997 to May 19, 1998 (Equipment Line A), as well as borrow an additional
$1,250,000 from February 1, 1998 to September 30, 1998 (Equipment Line B). At
September 30, 1998 and March 31, 1999, $223,796 and $181,835, respectively was
outstanding related to
F-13
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
advances made under Equipment Line A, and $651,515 and $536,523, respectively,
was outstanding related to advances made under Equipment Line B. Interest on
these borrowings are charged at the lender's prime rate plus 0.75%, which was
9.25% and 8.50% at September 30, 1998 and March 31, 1999, respectively. The
weighted average interest rate for the year ended September 30, 1998 and the
six months ended March 31, 1999 was 9.25% and 8.55%, respectively. Repayments
of advances on Equipment Line A commenced on June 19, 1998, with the unpaid
principal balance as of May 19, 1998, plus interest, being repaid in 36 equal
monthly installments. Repayments of advances on Equipment Line B commenced on
October 19, 1998 in 34 monthly installments of principal and interest.
The Loan Agreement was due to mature on November 19, 1998. On November 18,
1998, the Loan Agreement was modified to extend the maturity date to February
15, 1999. On February 15, 1999 the Loan Agreement was modified again to extend
the maturity date to May 31, 1999.
The Company did not comply with certain financial covenants as of September
30, 1997 and at various points during fiscal 1998, and accordingly, received an
amendment and waiver dated October 6, 1998 from its lender, which waived
covenant violations for periods prior to September 30, 1998 and eliminated one
financial covenant with respect to a minimum profitability threshold.
Subsequent to September 30, 1998, the Company did not comply with certain
financial covenants. The Company obtained waivers for all covenant violations
from October 1, 1998 to January 31, 1999. Through April 22, 1999 the Company
has been in compliance with all covenants.
Interest expense for the years ended September 30, 1997 and 1998, and the
six months ended March 31, 1998 and 1999 was $35,673, $94,400, $42,602, and
$65,738, respectively.
Principal maturities of bank borrowings are as follows:
<TABLE>
<CAPTION>
Year ending September 30,
-------------------------
<S> <C>
1999.............................. $ 800,579
2000.............................. 570,181
2001.............................. 314,101
----------
$1,684,861
==========
</TABLE>
6. Notes Payable:
Between September 27, 1996 and January 31, 1997, the Company issued three
convertible notes totalling $600,000 to a commercial lender. These notes had a
simple interest rate of 6%. In March 1997, all three notes plus accrued
interest of $8,454 were converted into 608,454 shares of Series A preferred
stock.
Prior to October 1, 1996, the Company had issued a $50,000 convertible note
to a related party. In March 1997, this note was converted into 50,000 shares
of Series A preferred stock.
F-14
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
7. Accrued Liabilities:
Accrued liabilities consist of the following:
<TABLE>
<CAPTION>
September 30,
----------------- March 31,
1997 1998 1999
-------- -------- -----------
(unaudited)
<S> <C> <C> <C>
Employee compensation......................... $209,275 $595,975 $1,146,930
Accrued sales tax............................. 38,851 2,346 32,637
Travel and entertainment...................... 47,505 52,000 365,500
Series E preferred stock financing costs...... -- -- 2,200,000
Other accrued liabilities..................... 26,501 65,812 198,602
-------- -------- ----------
Total....................................... $322,132 $716,133 $3,943,669
======== ======== ==========
</TABLE>
8. Commitments:
Leases:
The Company leases office space under noncancelable operating leases
expiring through May 2002. Rent expense for the years ended September 30, 1996,
1997, and 1998, and the six months ended March 31, 1998 and 1999 was $0,
$136,678, $715,115, $189,617, and $335,646, respectively.
The Company also leases network equipment under capital leases agreements.
These capital leases are governed by master lease agreements with two separate
lessors. The total credit extended to the Company under these master lease
agreements totalled $3,500,000 and $4,423,169 at September 30, 1998 and March
31, 1999, respectively, of which $2,306,739 and $2,638,730, respectively, had
been borrowed and was outstanding.
The Company's future minimum lease payments under noncancelable operating
leases having an initial or remaining term of more than one year, and capital
leases are as follows:
<TABLE>
<CAPTION>
Year ending September 30, Operating Capital
------------------------- ---------- ----------
<S> <C> <C>
1999................................................. $ 649,204 $ 896,061
2000................................................. 660,380 896,061
2001................................................. 558,708 751,944
2002................................................. 257,718 --
---------- ----------
Total minimum lease payments......................... $2,126,010 2,544,066
==========
Less amounts representing interest................... (237,327)
----------
Present value of minimum lease payments.............. 2,306,739
Less current portion of capital lease obligations.... (756,091)
----------
Long-term portion of capital lease obligations....... $1,550,648
==========
</TABLE>
Carrier Line Agreements:
The Company has entered into various bandwidth capacity agreements with
domestic and foreign carriers. These agreements are generally cancellable and
provide for termination fees if cancelled by the Company prior to expiration.
F-15
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
9. Earnings Per Share:
The following is a reconciliation of the numerator and denominator of basic
and diluted earnings per share (EPS):
<TABLE>
<CAPTION>
Six Months Ended
Years Ended September 30, March 31,
----------------------------------- -------------------------
1996 1997 1998 1998 1999
-------- ----------- ------------ ----------- ------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Numerator--Basic and
Diluted EPS
Net Loss............... $(27,047) $(5,288,964) $(16,764,370) $(6,793,286) $(14,869,067)
======== =========== ============ =========== ============
Denominator--Basic and
Diluted EPS
Weighted average Common
Stock outstanding..... 275,000 1,497,711 2,361,010 2,250,062 2,586,201
Common Stock subject to
repurchase............ -- -- (124,558) (34,187) (219,250)
-------- ----------- ------------ ----------- ------------
Total weighted average
Common Stock
outstanding........... 275,000 1,497,711 2,236,452 2,215,875 2,366,951
======== =========== ============ =========== ============
Basic and diluted loss
per share.............. $ (0.10) $ (3.53) $ (7.50) $ (3.07) $ (6.28)
======== =========== ============ =========== ============
Pro forma:
Denominator--Basic and
Diluted EPS
Weighted Average Common
Stock................. 2,361,010 2,586,201
Conversion of Preferred
Stock................. 9,711,087 15,891,307
Conversion of
Warrants.............. 95,000 95,000
Common Stock subject to
repurchase............ (124,558) (219,250)
------------ ------------
Total weighted average
Common Stock
outstanding pro
forma................ 12,042,539 18,353,258
============ ============
Basic and diluted pro
forma loss per share... $ (1.39) $ (0.81)
============ ============
</TABLE>
10. Stockholders' Equity:
Convertible Preferred Stock:
As of March 31, 1999, the Company had five series of preferred stock
authorized and outstanding. The holders of the various series of preferred
stock generally have the same rights unless specified.
Liquidation Preference:
In the event of any liquidation, dissolution, or winding up of the Company,
either voluntary or involuntary and including a sale, merger, or
reorganization, the holders of preferred stock retain liquidation preference
over common stockholders. If consideration received in the event of liquidation
of the Company is in the form of cash and/or publicly traded securities with a
fair value of at least $3.00, $7.50, $10.35, $15.75, and $12.75 per share of
Series A, Series B, Series C, Series D, and Series E, respectively, then the
consideration paid in such a transaction shall be distributed among the holders
of all common and preferred stock on a pro rata basis based on the number of
common stock equivalent shares owned by the holder. In the event of a
liquidation in which the fair value of the consideration received is less than
$3.00, $7.50, $10.35, $15.75, and $12.75 per share of Series A, Series B,
Series C, Series D, and Series E, respectively, the holders of Series A, Series
B, Series C, Series D, and Series E preferred stock are entitled to a
distribution of $1.00, $2.50, $3.45, $5.25, and $4.25 per share, respectively.
In the event that the consideration is inadequate to cover the preferential
amounts of $1.00, $2.50, $3.45, $5.25, and $4.25 per share of Series A, B, C,
D, and E, respectively, then the consideration is distributed rateably to all
preferred stockholders. If the consideration received is in excess of these
preferential amounts, then the excess is distributed among the holders of all
common and preferred stock on a pro rata basis based on the number of common
stock equivalent shares owned by the holder.
F-16
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
Voting Rights:
Holders of Series A, Series B, Series C, Series D, and Series E preferred
stock are entitled to vote together with holders of common stock. The number of
votes equal the number of full shares of common stock into which Series A,
Series B, Series C, Series D, and Series E preferred stock could be converted
into.
Conversion:
At the option of the holder, preferred shares are convertible at any time
into shares of common stock at a ratio of the conversion price divided by the
initial purchase price. The conversion price is $1.00 per share for Series A,
$2.50 per share for Series B, $3.45 per share for Series C, and $4.25 per share
for Series E. Series D shares were originally convertible at a price of $5.25
per share. Pursuant to anti-dilution provisions triggered by the issuance of
Series E, Series D shares are now convertible at a price of $4.82 per share.
The conversion price of each series of preferred stock is subject to adjustment
as described in the Company's Articles of Incorporation. All Series A, Series
B, Series C, Series D, and Series E preferred shares will automatically be
converted into shares of common stock upon (1) the election of holders of at
least two-thirds of the outstanding shares of preferred stock, or (2) upon the
closing of an underwritten public offering pursuant to an effective
registration statement under the Securities Act of 1933 at an offering price of
not less than $7.00 per share (adjusted to reflect stock splits, reverse stock
splits, or stock dividends), and $25,000,000 in the aggregate. In the event the
Company proposes to undertake a dilutive issuance, holders of preferred stock
who do not agree to become participating investors in the dilutive issuance are
deemed non-participating investors. Additionally, in the event that shares of
preferred stock (New Series) are issued for a consideration per share that is
less than the conversion price per share with respect to any previously issued
series of preferred stock (Previous Series), then the conversion price per
share shall be reduced for the Previous Series concurrent with the issuance of
the New Series. The Company has reserved 30,000,000 shares of common stock for
the conversion of the outstanding shares of preferred stock.
Dividends:
Each fiscal year, holders of preferred stock are entitled to receive, when
and if declared by the board of directors, out of any funds legally available,
a preferential non-cumulative dividend of $0.07, $0.18, $0.24, $0.37, and
$0.2975 per share for Series A, Series B, Series C, Series D, and Series E,
respectively. In addition, preferred stockholders are entitled to participate
in cash dividends paid to common stockholders in an amount per share as would
be payable on the number of shares of common stock into which each share of
preferred stock could be converted. As of March 31, 1999 and in accordance with
the Loan Agreement, the board of directors had not declared any dividends.
Convertible preferred stock issued and outstanding as of March 31, 1999 was
as follows:
<TABLE>
<CAPTION>
Shares Issued and Liquidation
Series Designated Outstanding Value
------ ---------- ----------- -----------
<S> <C> <C> <C>
A........................................ 4,000,000 4,000,000 $ 4,000,000
B........................................ 3,000,000 3,000,000 $ 7,500,000
C........................................ 4,300,000 4,283,181 $14,776,974
D........................................ 2,700,000 2,022,476 $10,617,999
E........................................ 11,764,706 11,764,706 $50,000,000
---------- ---------- -----------
25,764,706 25,070,363 $86,894,973
========== ========== ===========
</TABLE>
F-17
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
11. Stock Option and Stock Issuance Plan:
In January 1997, the Company established the 1997 Stock Option and Incentive
Plan (the 1997 Plan) and reserved up to 1,689,125 shares of common stock
issuable upon exercise of options granted to certain employees, directors, and
consultants. In May 1998, the Company adopted the 1998 Stock Option/Stock
Issuance Plan (the 1998 Plan). The 1998 Plan was designed to serve as the
successor to the 1997 Plan. Upon adoption of the 1998 Plan the existing share
reserve under the 1997 Plan was transferred to the 1998 Plan, and all
outstanding options under the 1997 Plan were incorporated into the 1998 Plan.
The Company increased the maximum number of shares issuable to a total of
3,833,284. In November 1998, the Company increased the stock option pool by
another 600,000 shares, bringing the total to 4,433,284. This number of shares
has been reserved for issuance under the 1998 Plan.
Under the terms of the 1998 Plan, the Company has the ability to grant
incentive and nonstatutory stock options, as well as issue vested and unvested
shares of the Company's common stock. Exercise prices of stock options are
generally not less than 100% and 85% of the fair value of the common stock on
the date of grant of incentive stock options and nonstatutory stock options,
respectively, and have a term of up to ten years. Options generally vest
rateably over a period of up to fifty months after the grant date, subject to
accelerated vesting in connection with certain changes in control or ownership
of the Company. In certain instances employees have been granted the right to
exercise options prior to vesting. Upon termination of an employee's employment
with the Company for any reason, the Company has the right to repurchase all or
any portion of the unvested shares acquired by the employee upon exercise of
options at a repurchase price that is equal to the exercise price, within 90
days following the date of termination. At March 31, 1999, 219,250 shares of
common stock were subject to repurchase by the Company. In addition, the
Company has a thirty day right of first refusal if an optionee intends to sell
shares acquired pursuant to options.
A summary of the activity under the 1997 Plan and the 1998 Plan is as
follows:
<TABLE>
<CAPTION>
Weighted
Exercise Aggregate Average
Price Per Exercise Exercise
Shares Share Price Price
--------- ------------ ---------- --------
<S> <C> <C> <C> <C>
Outstanding at September 30,
1996......................... -- -- -- --
Granted..................... 1,688,500 $0.40 $ 675,400 $0.40
Terminated.................. (105,000) $0.40 (42,000) 0.40
--------- ------------ ---------- -----
Outstanding at September 30,
1997......................... 1,583,500 $0.40 633,400 0.40
Granted..................... 1,903,009 $0.40--$3.35 3,283,649 1.73
Exercised................... (297,960) $0.40--$1.50 (265,784) 0.89
Terminated.................. (194,784) $0.40--$3.25 (91,564) 0.47
--------- ------------ ---------- -----
Outstanding at September 30,
1998......................... 2,993,765 $0.40--$3.35 3,559,701 1.19
Granted..................... 1,503,900 $3.35--$4.25 5,987,675 3.98
Exercised................... (102,390) $0.40--$0.60 (41,012) 0.40
Terminated.................. (176,436) $0.40--$3.75 (510,699) 2.89
--------- ------------ ---------- -----
Outstanding at March 31, 1999
(unaudited).................. 4,218,839 $0.40--$4.25 $8,995,665 $2.13
========= ============ ========== =====
</TABLE>
The Company accounts for the 1998 Plan and the 1997 Plan using the intrinsic
value based method in accordance with Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees," and related interpretations.
For financial reporting purposes, the Company has determined that the deemed
fair
F-18
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
value on the date of grant of employee stock options granted between May 1,
1998 and March 31, 1999 was in excess of the exercise price of the options.
Consequently, the Company recorded deferred compensation of $1,990,069 for the
year ended September 30, 1998, and an additional $5,485,510 for the six-month
period ended March 31, 1999. Of the total deferred compensation, $486,903 was
amortized during the year ended September 30, 1998 and $1,025,508 was
amortized during the six months ended March 31, 1999.
At March 31, 1999 options to purchase 1,904,273 shares of common stock were
exercisable.
At September 30, 1998 and March 31, 1999, options to purchase 541,559 and
814,095 shares of common stock, respectively, remain available for issuance.
The following summarizes information with respect to stock options
outstanding at September 30, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
-------------------------------------- -----------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life (Years) Prices Exercisable Prices
- ------------ ----------- ------------ -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.40--$0.60 1,587,356 8.54 $0.42 518,978 $0.40
$0.90--$1.50 951,659 9.67 $1.50 427,492 $1.50
$2.50--$3.35 454,750 9.93 $3.23 124,519 $3.15
</TABLE>
The following information concerning the Company's 1998 Plan is provided in
accordance with Statement of Financial Accounting Standards No. 123 (SFAS
123), "Accounting for Stock-Based Compensation."
The fair value of each option grant has been estimated on the date of grant
using the minimum value method with the following weighted average assumptions
used for grants in the years ended September 30, 1997 and 1998:
<TABLE>
<CAPTION>
September September
30, 30,
1997 1998
------------ ------------
<S> <C> <C>
Risk-free interest rates........................... 5.85%--6.86% 4.23%--6.08%
Expected life...................................... 5 years 5 years
Expected dividend yield............................ -- --
Expected volatility................................ -- --
</TABLE>
The weighted average fair value for options granted was $0.10 and $0.36 for
the years ended September 30, 1997 and 1998, respectively.
The pro forma net loss for the Company for the years ended September 30,
1997 and 1998 following the provisions of SFAS 123, was $5,312,228 and
$16,840,010, respectively. The pro forma basic and diluted net loss per share
for the years ended September 30, 1997 and 1998 was $3.55 and $7.53,
respectively.
12. Stockholder Note Receivable:
On February 25, 1998, the Company granted a nonstatutory option to purchase
a total of 183,000 shares of the Company's common stock to a director of the
Company (the Director). These options were immediately exercisable and the
shares purchased thereunder are subject to repurchase by the Company, with the
right to repurchase expiring in 16 equal quarterly installments. At the time
of the option grant, the
F-19
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
Director exercised the option to purchase the entire 183,000 shares of common
stock, in exchange for a $109,800 note. The note is secured by the 183,000
shares of common stock and by other assets of the Director. Under the terms of
the note, interest is accrued at 5.61% per annum. Interest is to be repaid in
four equal annual installments commencing February 24, 1999. The entire
principal amount is due and payable in one lump sum on February 24, 2002. At
March 31, 1999, the Company had not elected to repurchase any of these shares.
13. Warrants:
In connection with the issuance of certain convertible notes (see Note 6),
the Company issued warrants to purchase shares of the Company's common stock to
the note holders. Warrants to purchase 75,000 and 20,000 shares of the
Company's common stock were granted in September 1996 and January 1997,
respectively. The exercise price of the warrants is equal to $0.10 per share.
The warrants expire upon the earlier of i) five years from the date of grant,
ii) the closing of a underwritten public offering of the Company's common stock
for not less than $2.50 per share and gross proceeds of at least $10,000,000,
or iii) the closing of a consolidation or merger of the Company. At March 31,
1999, none of the warrants had as yet been exercised. The fair value of the
warrants was determined using the Black-Scholes model and was accounted for as
interest expense over the time period the notes were outstanding.
14. Related Party Transactions:
One of the parties who has extended credit to the Company under the terms of
a master lease agreement (see Note 8), also is a significant customer of the
Company. For the years ended September 30, 1997 and 1998, and the six month
periods ended March 31, 1998 and 1999, the Company earned $122,000, $309,943,
$104,849, and $207,428, respectively, in revenue from sales to this customer,
and had $138,593 and $75,540 in total receivables at September 30, 1998 and
March 31, 1999, respectively. The Company owed this customer $991,522 and
$1,173,493 at September 30, 1998 and March 31, 1999, respectively, under terms
of the master lease agreement, and also owed another $93,841 and $239,300,
respectively, in other trade-related payables.
An investor, who participated in the Company's Series D and Series E
preferred stock offerings, is also a customer of the Company. For the years
ended September 30, 1997 and 1998, and the six month periods ended March 31,
1998 and 1999, the Company earned $43,000, $457,513, $217,714, and $604,472,
respectively, in revenue from sales to this customer, and had $38,565 and
$957,516 in total receivables at September 30, 1998 and March 31, 1999,
respectively. In addition, $443,395 of the deferred revenue balance at March
31, 1999 related to this customer.
15. Retirement Savings Plan:
On November 1, 1997, the Company established the Digital Island Retirement
Savings Plan (Retirement Plan), a defined contribution plan, covering all
eligible employees. Employees may elect to contribute from 1%-15% of their
annual compensation to the Retirement Plan. Matching contributions by the
Company are discretionary. The Company has made no contributions during the
year ended September 30, 1998, or the six month period ended March 31, 1999.
16. Subsequent Events:
On April 20, 1999, executive officers of the Company exercised stock options
to purchase 349,332 shares of common stock in exchange for full-recourse notes.
The total principal amount of these notes is $286,398.
F-20
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of and relating to the six months
ended March 31, 1999 and 1998 is unaudited)
The notes bear interest at the rate of 7.75% per annum, compounded
semiannually. Accrued interest is due and payable at successive quarterly
intervals over the four-year term of the note, and the principal balance will
become due and payable in one lump sum at the end of the four year term. None
of the shares purchased with the notes may be sold unless the principal portion
of the note attributable to those shares, together with the accrued interest on
that principal portion, is paid in full.
On April 21, 1999, the Board of Directors approved the reincorporation of
the Company in the state of Delaware. Pursuant to the reincorporation, each
share of common and preferred stock of the Company's California predecessor
entity is exchanged for one share of common and preferred stock of the newly
formed Delaware entity. Pursuant to the reincorporation, the number of
authorized shares of common stock will increase to 100,000,000 with a par value
of $0.001 per share. Additionally, 10,000,000 shares of undesignated preferred
stock were authorized with a par value of $0.001 per share. These consolidated
financial statements have been restated for the reincorporation of the Company
in Delaware.
Also, on April 21, 1999, the Board of Directors adopted the 1999 Stock
Incentive Plan (the 1999 Plan). The 1999 Plan is to serve as the successor to
the 1998 Plan. Upon the initial public offering of the Company's common stock,
all outstanding options under the 1998 Plan, together with the remaining share
reserved under that plan, are to be incorporated into the 1999 Plan, with no
further grants of common stock options to be made under the 1998 Plan. Upon
implementation of the 1999 Plan, an additional 2,500,000 shares of common stock
will be reserved for issuance.
Additionally, on April 21, 1999, the Board of Directors adopted the 1999
Employee Stock Purchase Plan (1999 ESPP). Under the 1999 ESPP, eligible
employees are allowed to have salary withholdings of up to a certain specified
percentage of their base compensation to purchase shares of common stock at a
price equal to 85% of the lower of the market value of the stock at the
beginning or end of defined purchase periods. The initial purchase period
commences upon the execution and final pricing of the underwriting agreement
for the initial public offering of the Company's common stock. The 1999 ESPP
will become effective upon the initial public offering of the Company's common
stock. A total of 300,000 shares will be reserved for issuance under the 1999
ESPP.
On April 21, 1999, options to purchase 104,500 shares of common stock were
granted at an exercise price of $7.50 per share. Deferred compensation
associated with these shares is $250,800.
On May 5, 1999, the Company entered into an agreement to lease office space
under the terms of a five year lease. The annual base rent is $1.3 million. As
security for performance, the Company was required to deliver an irrevocable
standby letter of credit in the amount of $500,000. The lease agreement
contains a provision that allows the Company to replace the letter of credit
with a $110,372 security deposit in the event the Company becomes a publicly
held corporation.
On May 19, 1999, options to purchase 109,700 shares of common stock were
granted at an exercise price of $9.90 per share.
On June 14, 1999, an executive officer of the Company borrowed an additional
$128,000 in order to finance the tax liability she incurred in connection with
the exercise of her stock options on April 21, 1999 for 133,332 shares of our
common stock. The loan is evidenced by a full-recourse promissory note with
interest at the rate of 7.75% per annum, compounded semi-annually, and secured
by the same 133,332 shares which serve as collateral for the April 21, 1999
promissory note. The terms of her note, including the due dates for payment of
principal and accrued interest and the acceleration provisions, are
substantially the same as the terms in effect for her April 21, 1999 note.
F-21
<PAGE>
[LOGO OF DIGITAL ISLAND]
<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
Prospective investors may rely only on the information contained in this
prospectus. Neither Digital Island, Inc. nor any underwriter has authorized
anyone to provide prospective investors with 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 correct only as
of the date of this prospectus, regardless of the time of the delivery of this
prospectus or any sale of these securities.
------------------
TABLE OF CONTENTS
------------------
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary....................................................... 3
The Offering............................................................. 5
Summary Consolidated Financial Data...................................... 6
Risk Factors............................................................. 7
Use of Proceeds.......................................................... 20
Dividend Policy.......................................................... 20
Capitalization........................................................... 21
Dilution................................................................. 22
Selected Consolidated Financial Data..................................... 23
Management's Discussion and Analysis of Financial Condition and Results
of Operations........................................................... 24
Business................................................................. 31
Management............................................................... 46
Executive Compensation and Other Information............................. 51
Certain Transactions..................................................... 59
Principal Stockholders................................................... 62
Description of Capital Stock............................................. 65
Shares Eligible for Future Sale.......................................... 69
Underwriting............................................................. 71
Legal Matters............................................................ 73
Experts.................................................................. 73
Additional Information................................................... 73
Index to Consolidated Financial Statements............................... F-1
</TABLE>
Until July 24, 1999 (25 days after the date of this prospectus), all dealers
that effect transactions in these securities, whether or not participating in
this offering, may be required to deliver a prospectus. This is in addition to
the dealers' obligation to deliver a prospectus when acting as underwriters
and with respect to their unsold allotments or subscriptions.
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
6,000,000 Shares
[DIGITAL ISLAND LOGO]
Digital Island, Inc.
Common Stock
------------
PROSPECTUS
------------
Bear, Stearns & Co. Inc.
Lehman Brothers
Thomas Weisel Partners LLC
June 29, 1999
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- -------------------------------------------------------------------------------
