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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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Form 10-K
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For The Fiscal Year Ended September 30, 2000
OR
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __ to __
Commission File No. 000-
26283
DIGITAL ISLAND, INC.
(Exact name of Registrant as specified in its charter)
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Delaware 68-0322824
(State or other jurisdiction of (I.R.S. Employer
incorporation of organization) Identification No.)
45 Fremont Street, 12th Floor 94105
San Francisco, California (Zip Code)
(Address of principal executive
offices)
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Registrant's telephone number, including area code: (415) 738-4100
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the past 12 months (or for such shorter period that the Registrant
was required to file such reports, and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference to Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of voting stock held by non-affiliates of the
Registrant was approximately $380 million as of November 28, 2000, based upon
the closing price of the Registrant's Common Stock on the Nasdaq National
Market reported for November 28, 2000. Shares of Common Stock held by each
executive officer and director and by each person who beneficially owns more
than 5% of the outstanding Common Stock have been excluded in that such persons
may under certain circumstances be deemed to be affiliates. This determination
of affiliate status is not necessarily a conclusive determination of affiliate
status for any other purpose.
79,781,332 shares of the Registrant's $0.001 par value Common Stock were
outstanding at November 28, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
The following documents (or portions thereof) are incorporated by reference
into the Parts of this Form 10-K noted:
Part III incorporates by reference from the definitive proxy statement for
the Registrant's 2001 Annual Meeting of Stockholders to be filed with the
Commission pursuant to Regulation 14A not later than 120 days after the end of
the fiscal year covered by this Form.
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PART I
ITEM 1. BUSINESS
Except for the historical financial information contained herein, the
matters discussed in this Annual Report on Form 10-K may be considered
"forward-looking" statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Act of
1934, as amended. Such statements include declarations regarding the intent,
beliefs or current expectations of Digital Island and our management. Such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties. Actual results could differ materially
from those indicated by such forward-looking statements. We undertake no
obligation to publicly release the results of any revision to these forward-
looking statements which may be made to reflect events or circumstances after
the dates hereof or to reflect the occurrence of unanticipated events. Our
actual results could differ materially from those anticipated in these forward-
looking statements for many reasons, including risks faced by us described in
this Report, including the "Risk Factors That May Affect Future Results"
section contained in Item 7 of this Annual Report, and the other documents we
file with the Securities and Exchange Commission ("SEC"), including our most
recent reports on Form 8-K and Form 10-Q, and amendments thereto.
Overview
We provide a global e-Business delivery network and suite of services for
enterprises that use the Internet to deploy critical business applications and
conduct e-commerce worldwide. We offer a managed Internet infrastructure that
integrates content delivery, hosting, intelligent networking and applications
services. We target global enterprises that increasingly rely on the Internet
to conduct business, but are constrained by the unreliability, slow performance
and limited range of functions of the public Internet. Our customers use our
services and proprietary technology to facilitate the deployment of a wide
variety of electronic commerce applications, including online marketing and
sales, customer service, fulfillment, software, document and multimedia
distribution and online training. As of September 30, 2000, we had contracts
with 949 customers, of which 811 were deployed, including AOL, Autodesk, Canon,
Charles Schwab & Co., Cisco Systems, CNBC.com, E*TRADE, Blue Mountain, FT.com,
Intuit, Microsoft, National Semiconductor, UBS Warburg, Reuters, Hewlett-
Packard, Glaxo Wellcome, Universal Music Group, and BMG Entertainment.
The Internet, a network of hundreds of interconnected, separately
administered public and private networks, was not originally designed to handle
either the large traffic levels or the vast array of content types being
transmitted today. Organizations cannot predict or control the network path
that their data will travel over the Internet and, as a result, are unable to
avoid network congestion or bottlenecks that degrade performance. For companies
conducting business over the Internet, poor website performance, such as failed
commerce transactions, slow downloads or site crashes, can create dissatisfied
users and result in lost customer goodwill and revenue opportunities. In
addition, for enterprises using the Internet for global operations, the U.S.-
centric nature of the public Internet may result in poor response times.
Businesses are increasingly demanding Internet networks that operate with the
functionality and performance levels previously available only on private
corporate networks.
Our solution includes a global e-Business delivery network consisting of a
high speed network that connects our eight geographically dispersed data
centers and a suite of services that integrates content delivery services,
hosting, intelligent networking and application services. Our core network
architecture has 233 different connection points to the Internet and connects
directly to local Internet service providers in 23 countries. The network is
supplemented by over 2,000 content distributors, which provide improved reach
to countries not directly accessed by our network. This minimizes the number of
separate transmissions necessary to transmit data, resulting in greater speed
and reliability for our customers' end-users. We 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.
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We offer service level guarantees, customized billing and security services
to protect the integrity of data transmissions, network management and other
high quality services designed to improve the content and applications
delivered through our network. In addition, we manage Internet applications
and computer servers and maintain networking equipment for our customers in
our advanced network data centers, and offer a range of data transport options
which allow customers to reserve network capacity consistent with their
expected network usage. 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 of applications over the Internet.
Our objective is to become the leading managed Internet infrastructure
provider. In order to achieve this objective, we intend to continue to:
. focus on leading global e-Business customers in targeted industries that
rely on the Internet to provide critical business applications;
. develop and implement new technologies and services that will allow our
customers to improve the deployment and operation of their Internet
applications globally;
. expand the size and reach of our e-Business delivery network;
. expand strategic technology and marketing/reselling relationships and
establish new relationships with systems integrators, hardware and
software vendors and application service providers; and
. expand our sales capabilities in the U.S., Asia and Europe.
The Digital Island Solution
We provide managed Internet infrastructure that integrates content
delivery, hosting, intelligent networking and applications services. We have
created an open platform that supports multiple data types including voice,
text, graphics, file transfer, and streaming audio and video broadcast
services as well as different access methods including dial-up, Digital
Subscriber Line (or DSL), cable and wireless. Customers can choose between
component solutions tailored to meet specific needs or a fully integrated
comprehensive solution, both of which are backed by industry-leading service
level agreements.
We believe that our global e-Business delivery network provides the
following benefits to its customers:
Faster End-user Experience. Our dedicated global private network and
Footprint(R) content delivery services greatly enhance the performance of e-
Business applications. Using our proprietary technology, we are able to store
and deliver content in an optimal manner. For content that is repeatedly
delivered to many users, we operate over 2,000 content distributors located
throughout the Internet under the Footprint brand. For real-time transactions
and content that is unique or specific to a user and must therefore be stored
centrally, we utilize proprietary networking technology and we operate a
global high-speed private network that acts as a backbone connecting directly
to 23 countries.
Increased Reliability, Security and Consistency. We design solutions for
our customers that minimize downtime. By locating servers within any of our
eight strategically located data centers (Hong Kong, Tokyo, Honolulu, Medford,
Marina Del Rey, San Jose, New York and London), our customers can take
advantage of a fully redundant data center and network infrastructure. We
currently offer both Windows NT(TM), Windows 2000(TM) and Solaris(TM) service
level agreements that guarantee origin server uptime and network reliability
on our backbone and peering circuits. For customers using Footprint,
reliability levels are further increased as Footprint can reroute around
failures of any of the over 2,000 content distributors that form our network.
We back our e-Business content delivery network with continuous on-site
personnel in each data center, two fully redundant network operations centers,
and a wide variety of fault detection, isolation and recovery applications and
expertise.
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Global Reach, Scalability and Relevant Content. Our intelligent network
currently has direct connection points in 23 countries in Africa, Asia, Europe,
North America, South America and Australia. This network is supplemented by
over 2,000 content distributors, which provide improved reach to countries not
directly accessed by our network. We believe that this global reach provides
our customers with direct access to the majority of existing Internet users and
indirect access to every Internet user in the world, allowing them to deliver a
fast, reliable and consistent end-user experience regardless of market served.
Our network architecture can scale to accommodate millions of simultaneous
users, multiple access devices and all forms of content. We also provide
customers with the ability to serve multiple geographies with content relevant
to end-users in specific locations. Through our TraceWare(TM) technology, we
are able to detect the IP address of the end-user and determine, with over 96%
accuracy, the country where the end-user is located. This technology allows our
customers to develop country-specific advertising campaigns, target specific
content to countries, develop and manage multiple price lists and check payment
information for fraudulent behavior.
Comprehensive, Cost-Effective Outsourcing Solution. Our customers directly
benefit from the significant investments of technical expertise, capital and
other resources that we have made to develop our e-Business delivery network.
Our comprehensive offering, including content delivery, hosting, intelligent
networking and application services, provides a high performance one-stop
solution allowing customers to manage both content and transactions. Most
enterprises today do not have the infrastructure that mission-critical Internet
operations require, including strategic, globally distributed data centers,
network redundancy for reliability, continuous operations and specialized
Internet technology expertise. Our network and suite of services allows
customers to overcome shortages of technical resources and keep up with
continuously changing technologies, including the ability to satisfy peak
period capacity requirements and accommodate one-time events, while
substantially lowering the costs of deploying and maintaining Internet
applications. Our solution is based on an open architecture that allows our
customers to easily integrate their existing applications with our delivery
network. We believe that our solutions and economies of scale are significantly
more cost-effective than most in-house alternatives. By providing a one-stop
solution that goes beyond traditional outsourcing, we substantially reduce the
administrative and logistical costs that come from managing multiple
outsourcing vendors.
Services
We offer a comprehensive suite of services designed to help enterprises
deploy and manage e-Business applications. Our e-Business delivery network is
the foundation to providing solutions that are scalable, flexible and cost-
effective, and to guaranteeing fast, consistent and relevant end-user
experiences. Currently, our integrated network services platform includes
content delivery, hosting, intelligent networking and application and
professional services. We work with each of our customers to optimize cost and
performance requirements. Our software and network engineering teams provide
our customers with global expertise and consultation in the design and
deployment of their applications on the Digital Island e-Business delivery
network. We also provide continuous 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
further ongoing product and service delivery.
Content Delivery Services
Our Footprint content delivery services support all types of content,
including streamed audio and video. Customers of our content delivery services
benefit from having their content and applications intelligently served from a
network of more than 2,000 enterprise class servers located at the edges of the
Internet.
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Our Footprint content delivery services avoid network congestion and
significantly improve web site performance, scalability and reliability. Our
content delivery services also provide the scalability to meet the demand
requirements of special events and peak-usage periods. Our streaming content
delivery services provide comprehensive solutions for both live and on-demand
events, and support multiple streaming formats, including QuickTime(TM), Real
Audio(R) G2, Real Video(R) G2 and the Microsoft(R) Windows Media(TM) Player.
FootprintSecure(TM) provides a distributed platform for secure, encrypted
content delivery. The companies that use our content delivery services can
leverage our computing infrastructure and avoid the need to invest in the
hardware and other infrastructure necessary to serve content on their own.
Footprint Interactive. Footprint Interactive(TM) allows companies to Webcast
live videoconferences from any corporate office to any site on the Internet--
without prior scheduling with a service provider.
Footprint Secure. Footprint Secure(TM) enables secure Content Distributors
to deliver shared content--like images and banner ads--for secure (SSL) pages
from points close to end-users throughout the world. Combining SSL-complaint
shared content with unique origin-server SSL content at the network edge
accelerates delivery of these secure pages.
Footprint-on-Demand. Footprint-on-Demand(TM) delivers video, audio and
animation on-demand so companies can store entire libraries of video and audio
content at worldwide locations closest to the end-user.
Footprint Live. Footprint Live(TM) employs multicast and satellite
technologies to reliably deliver highest quality streaming media.
Footprint Media Services. Footprint Media Services(TM) is a comprehensive
package of streaming media support. Packages are customized to meet customers'
technical and production needs, including syndication, sponsorship, custom
marketing, production, encoding, custom database development, custom Web site
development and event production analysis.
Hosting Services
Our Hosting Services allow companies to quickly implement e-Business
networking and computing initiatives without prohibitive costs for equipment,
telecommunications networks and maintenance. Hosting e-Business applications
with Digital Island reduces these expenses, while providing access to an
engineering team with global networking expertise, an operations team that is
always on call, security experts, dedicated servers, network reporting and
monitoring, and superior, proactive customer service. We provide a suite of
hosting services to support our customers' business environment. These services
include:
CustomHost Package. The CustomHost(TM) Package is a complete outsourcing
solution with a high degree of site architecture flexibility. It provides a
dedicated network infrastructure that is customized to customer requirements,
allowing for several levels of firewall security and backend connectivity.
Complete system management and equipment leasing is also available.
TotalHost Package. The TotalHost(TM) Package is an all-inclusive solution
for outsourcing day-to-day operating system and hardware administration.
ExtendedHost Package. The ExtendedHost(TM) Package enables companies to
outsource operating hardware and server maintenance and allows IT staff with
systems access to perform system administration functions and tuning.
Furthermore, the ExtendedHost-Content Hosting Option offers companies a cost-
effective and reliable method of deploying static content to a global audience
without requiring a significant investment in time or equipment.
TrustedHost Package. The TrustedHost(TM) Package allows companies to house
their servers in one of Digital Island's world-class data centers, providing a
secure, production-ready environment designed to deliver maximum uptime around
the clock.
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PrivateHost Package. The PrivateHost(TM) Package is a physically secure
hosting environment for customers' networking equipment, servers and Ethernet
connectivity to the Digital Island global network.
Intelligent Network Services
We provide a dedicated network, combining advanced networking technology
with a global fiber optic network, to provide optimum reach and performance. We
have built an infrastructure that delivers content directly to multiple
countries, instead of relying on public networks to transport critical e-
Business applications. Our Intelligent Network services are available in two
different packages.
GlobePort. We provide local connectivity to Digital Island's network for
customers needing secure, dedicated access for server administration (admin
GlobePort) as well as access to Digital Island's content delivery network for
self-hosted customers (content GlobePort).
Data Transport. Data Transport provides high-performance global delivery of
customer data via Digital Island's secure, dedicated private network on a
usage-based billing model with service level agreements for network
availability, packet loss and latency.
Application Services
We provide application services that help e-Business applications run more
effectively. Application services help to shield e-Businesses from the
complexity associated with managing mission-critical distributed computing
systems, and enable them to leverage the intelligence of our e-Business
delivery network.
TraceWare. TraceWare, our flagship application service offering, helps e-
Businesses provide relevant experiences by determining end user's geographical
location. Through our proprietary mapping technology, TraceWare can assure 96%
accuracy.
VistaWare. VistaWare is an integrated performance and traffic-monitoring
service that lets our customers track web-site traffic, server performance and
network utilization through a simple portal, replacing a variety of customer-
operated diagnostic tools.
Professional Services
Digital Island's integrated offering allows customers to outsource
components of their e-business infrastructure. Our Professional Services group
bridges the gap between a customer's unique needs and Digital Island's standard
suite of products and services, providing project management capabilities as
well as customized value-added services such as security, load testing,
architecture and data base solutions.
Network
Architecture
Our Intelligent Network consists of an asynchronous transfer mode, or ATM,
backbone that connects geographically dispersed data centers. This ATM backbone
core serves as a high-speed network that offers a highly scalable, reliable and
cost effective path with minimal latency or delay. This architecture, unlike
typical Internet backbones, provides a predictable path between major
continents, which improves the speed of content transfer. Each regional data
center acts as a distribution hub within its region. Our Intelligent Network
forms a distributed architecture that minimizes the number of separate
transmissions necessary to transmit data, resulting in greater speed and
reliability for our customers' end-users. Our 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. Our 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.
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Under our Footprint brand, we operate two forms of edge-computing
technologies: Commerce Content Distributors, or CCDs, and Content Distributors,
or CDs. Both technologies allow our customers' content to be stored throughout
the Internet, improving performance and lowering the cost of operating web
sites. CCDs have the following characteristics:
. the CCD is directly connected to Digital Island's Intelligent Network;
. the CCD is privately peered with multiple access networks within the same
geography; and
. the CCD includes processing and storage technology optimized to support
larger metropolitan locations.
CDs are located deeper at the edge of the Internet, do not have a direct
connection to our network and are sized to support fewer simultaneous
technologies.
We believe our architecture is superior to traditional networks for the
distribution of applications because of the combination of regional data
centers, dedicated network connections and content distribution sites.
Infrastructure
We currently have direct connections in 23 countries with one or more local
Internet service providers, providing customers with direct access to local
markets worldwide. Currently, we purchase dedicated capacity and transit from
AT&T, GTE, Sprint and MCI WorldCom in the United States, as well as numerous
carriers internationally. At this point in time, we are privately peered with
233 major access networks in the 23 countries comprising our Intelligent
Network. Unlike traditional peering relationships, these network service
providers carry the Internet traffic of our customers without any reciprocal
transit agreement. While we pay 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.
Our distributed data centers peer with multiple backbone networks within the
local geography. In addition to the U.S., we have established private Internet
connection relationships in 22 other countries as listed below:
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Australia Italy South Korea
Brazil Japan Spain
Canada Malaysia Sweden
China Mexico Switzerland
France Netherlands Taiwan
Germany Russia United Kingdom
Ireland Singapore
Israel South Africa
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In China, we have connections in both Hong Kong and Beijing. With 233
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 eight data centers located in Hong Kong, Tokyo, Honolulu,
Medford, Marina Del Rey, San Jose, New York and London. We also have two
advanced state-of-the-art network operations centers, headquartered in Honolulu
and London, which provide continuous real time end-to-end monitoring of our
network. The network operations centers help us to ensure the efficient and
reliable performance of our e-Business delivery 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 centers enable us to schedule and conduct maintenance with minimal
interference to the network. In addition to our two network operations centers,
we maintain a Level 2 support center located in San Francisco. Level 2 support
acts as an escalation point for each of the primary network operations centers
as well as a third redundant location capable of managing our worldwide
network.
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We currently lease lines or bandwidth from multiple telecommunications
carriers. These carriers include AT&T, MCI WorldCom, GTE and Sprint, as well as
several international carriers such as British Telecom, Cable & Wireless, IDC,
Telstra and Singapore Telecom. Redundant leasing from multiple carriers assists
us in achieving competitive pricing and provides us with a diversity of routes
and 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 we
may extend the term to three years, such as when there is a significant cost
advantage or when the route served is bandwidth constrained. The company has
also begun a program of obtaining bandwidth under indefeasible right-of-use
(IRU) agreements which we expect to significantly improve gross profit margins
for our Intelligent Networking business.
Network Reach
We currently have over 2000 content distributors deployed in more than 195
networks, and 33 countries. Our content distributors are built on a computing
platform that includes Sun enterprise servers and storage devices, Inktomi
traffic servers and Cisco and Alteon network switches. Building out our content
distribution infrastructure on such hardware and software allows us to maintain
high levels of performance, scalability and reliability for our customers. We
also deploy and manage Intel-based servers running Microsoft NT and Windows
2000 in connection with our streaming service offerings and support of
Microsoft's Windows Media technologies. We will continue to build out our
content delivery network in order to maintain geographic coverage, achieve
leading performance and meet the needs of our customers. In addition to
deploying servers, we will continue to invest in and develop our Best
Distributor Selection software, which serves content from the best performing
server.
Open Platform with Integrated Solutions
Our open architecture enables customers to easily integrate their existing
application and publishing environment with our global e-Business delivery
network. Our open Application Programming Interfaces, or APIs, allow the
integration of our solution with other value-added services and applications,
whether created by us, by our customers or by third parties. Content providers
benefit from several third party applications that have been integrated into
our e-Business delivery network. These applications enable services such as
global ad-delivery, turnkey publishing networks, advanced reporting services,
broadcast-quality streaming services and content transformation services. The
architecture has been designed to shield complexity and add new services to
develop a best-in-class commerce platform for customers so that they can
accelerate time-to-revenue.
Customers
We have designed our network to address the sophisticated needs of medium-to
large-size global enterprises that increasingly rely on the Internet to provide
critical business applications globally and require consistent levels of high
performance and reliability. We target leading e-Business customers in
financial services, high technology manufacturing, application service
provisioning, software, media publishing, entertainment and other vertical
markets whose constituents are heavy users of the Internet for their
businesses. We have tailored our services to enhance the performance of our
multinational customers in electronic commerce and services, such as digital
media distribution and high volume transaction processing. Our customers use
our services and proprietary technology to facilitate the deployment of a wide
variety of electronic commerce applications, including online marketing and
sales, customer service, fulfillment, software, document and multimedia
distribution and online training. As of September 30, 2000, we had contracts
with 949 customers, of which 811 were deployed, including AOL, Autodesk, Canon,
Charles Schwab & Co., Cisco Systems, CNBC.com, E*TRADE, Blue Mountain, FT.com,
Intuit, Microsoft, National Semiconductor, UBS Warburg, Reuters, Hewlett-
Packard, Glaxo Wellcome, Universal Music Group and BMG Entertainment.
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Sales and Marketing
We plan to extend our leadership in the market for global Internet
application services by continuing to expand our base of customers. We target
our customers predominantly through a direct sales force complemented by a
range of strategic alliances and indirect channels. We currently have
approximately 237 people in our sales and marketing organization in offices in
the U.S., Asia and Europe and intend to grow our sales organization
substantially over the next year. We co-market with other companies to increase
the effectiveness of our direct channel sales force and to serve market
segments and geographies that are better served through alternative
distribution channels. In addition to co-marketing, we conduct sales activities
through a growing number of other sales agents or resellers in countries where
we do not sell directly. Furthermore, our strategic relationships with
companies such as Compaq, Intel, Microsoft, Sun, Inktomi and AOL provide us
with references and leads arising from their sales forces.
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 September 30, 2000, we had strategic relationships with 22 companies in
Europe and Asia to whom we pay commissions to refer customers.
Our marketing organization is responsible for strategy and business
planning, product management, product marketing, public relations, sales
support 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 managed Internet
infrastructure services.
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, quickly resolve 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 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. After commencing services, primary technical support is
provided by our network operations centers, which operate 24 hours a day, seven
days a week, and are staffed by highly trained technicians who respond to
customer calls, monitor site and network operations and refer problems to our
engineering staff 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.
We employ network engineers who collaborate with customers to design and
maintain their applications across the network. Our network engineers are
trained on Windows NT(TM), Windows 2000(TM), Solaris(TM) and other UNIX
platforms, as well as Cisco routers and switches, and they help 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.
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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, 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.
Our current and potential competitors in the market include:
. content delivery service providers;
. hosting companies;
. 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, Adero, Akamai, AT&T, XO
Communications, Digex, Exodus Communications, Genuity, iBeam, InterNAP, MCI
WorldCom and Qwest. In particular, Akamai and Exodus provide services that
directly compete 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, including reduced communications costs. 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 competition on pricing and other
terms 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 been issued a patent with
respect to the technology underlying our TraceWare product and have filed
patent applications with the United States Patent and Trademark Office with
respect to our Footprint technology, as well as some Internet technology
recently acquired from SRI International, such applications and any patents
that have or may issue in connection therewith may not be sufficient to
preclude or inhibit competitors from entering our market. In addition, we have
registered the marks "Digital Island," "Footprint" and "Footprint Manager," and
we have pending trademark applications for the "TraceWare" and other marks with
the Patent and Trademark Office. Our "Digital Island," "Footprint" and other
marks also are 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
10
<PAGE>
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.
From time to time, Digital Island receives notices from or is sued by third-
parties regarding patent claims. Digital Island is currently in legal
proceedings with Akamai Technologies, Inc. These suits are described more
specifically in Item 3 below. We expect that participants in our market 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 may not be available on terms
acceptable to us, or at all.
Acquisitions, Investments and Alliances
Acquisitions
We have expanded our global e-Business delivery network and suite of
services by acquiring various companies in our industry since 1999. In November
1999, we acquired certain patent-pending Internet technology from SRI
International which is designed to improve download times for Internet content
by intelligently avoiding network congestion. In December 1999, we acquired
Sandpiper Networks, Inc. We pursued this merger to enhance our comprehensive
network services for providing global e-Business applications. In January 2000,
we acquired Live On Line, Inc., a provider of internet content and streaming
media technology through its high-bandwidth, worldwide server network to
clients in the entertainment, media, consumer products, pharmaceutical and
education industries. In September 2000, we acquired SoftAware, Inc., a
provider of a global network for highly interactive Internet applications.
Strategic Relationships
We believe that strategic technology and marketing/reselling relationships
enhance our ability to reach new customers. Strategic relationships with our
customers in our target markets, such as with E*TRADE and AOL, 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 also have strategic
relationships with companies that can enhance our ability to develop and
deliver new application services, such as AOL, Compaq, Inktomi, Intel,
Microsoft, SRI International and Sun. Certain of these strategic relationships
provide powerful additional sales channels for us; for example we will be
promoted by Sun's sales force. Additionally, we hope to leverage these
enterprises' research and development expertise to develop new networking,
content delivery and applications services. As opportunities arise, we look to
establish new relationships with system integrators, hardware and software
vendors and application service providers that provide network equipment,
software and consulting services to companies. We have a dedicated team focused
on creating new, and expanding existing, relationships to enhance the success
of current and future products.
Employees
As of September 30, 2000, we had 900 employees, including 237 people in
sales and marketing, 81 people in professional services, 153 people in
engineering, 276 people in operations and 153 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
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 are represented by a labor union, and management believes
that our employee relations are good.
ITEM 2. PROPERTIES
We currently have the following facilities: our corporate headquarters in
San Francisco, regional offices in Thousand Oaks (California), Marina Del Rey
(California), Westlake Village (California), New York City and
11
<PAGE>
Honolulu, and data centers in Honolulu, San Jose (California), Marina Del Rey
(California), Santa Clara (California), New York City, Medford (Massachusetts),
Tokyo, Hong Kong and London. In addition, we have sales offices in Boston, New
York City, Minneapolis, Chicago, Philadelphia, Dallas, Houston, St. Louis,
Atlanta, Reston (Virginia), Los Angeles, Hudson (Ohio), Cary (North Carolina),
Hudson (New Hampshire), Minnetonka (Minnesota), Japan, the Netherlands,
Brussels, Paris, Germany, Switzerland, Hong Kong and the United Kingdom.
ITEM 3. LEGAL PROCEEDINGS
On September 13, 2000, Akamai Technologies, Inc. ("Akamai") and
Massachusetts Institute of Technology ("MIT") filed a Complaint in the U.S.
District Court of Massachusetts (No. 00ev1181RWZ) alleging that Digital Island
infringes U.S. Patent No. 6,108,703 (the "703 Patent"). Based on our
preliminary investigation, we believe that we have meritorious defenses to
Akamai and MIT's claim and intend to vigorously defend ourselves in any
litigation that arises from this claim. In addition, because we believe that we
were the first to invent the technologies claimed in the 703 Patent, we have
instituted proceedings with the U.S. Patent and Trademark Office to confirm our
ownership of any such inventions.
On September 20, 2000, Akamai filed a Motion in U.S. District Court of
Massachusetts requesting Leave to File A Second Amended Complaint in which it
alleges that Digital Island infringes U.S. Patent No. 6,003,030 (the "030
Patent"), which Motion was granted by the Court. Based on our preliminary
investigation, we believe that we have meritorious defenses to Akamai's claim
and intend to vigorously defend ourselves in any litigation that arises from
this claim. On October 18, 2000 Akamai and MIT filed a motion in the U.S.
District Court of Massachusetts requesting that Digital Island be enjoined from
offering for sale its Footprint 2.0 content delivery service. We believe that
we have meritorious defenses to Akamai and MIT's request for preliminary
injunctive relief and intend to vigorously oppose Akamai and MIT's request.
On September 21, 2000, Akamai filed a Compliant in the U.S. District Court,
Northern District of California, alleging that Digital Island's distribution of
certain marketing materials constituted False Advertising, Unfair Competition,
Intentional Interference With Contractual Relationships and Intentional
Interference With Prospective Business Advantage and requesting, among other
things, a Temporary Restraining Order prohibiting Digital Island from
disseminating the materials at issue and publicly commenting on certain related
issues. Based on our preliminary investigation, we believe that we have
meritorious defenses to Akamai's claims and intend to vigorously defend
ourselves in any litigation that arises from these claims. On October 13, 2000,
the Court denied Akamai's request for a Temporary Restraining Order. On October
26, 2000, we filed counterclaims in this case for equitable relief and damages,
alleging that Akamai's distribution of certain marketing material constituted
false advertising, unfair competition, interference with contract and
interference with prospective economic relationships.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders of Digital Island
during the fourth quarter of the fiscal year covered by this Annual Report.
12
<PAGE>
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
We have not paid cash dividends on our common stock since our incorporation
and anticipate that for the foreseeable future, we will continue to retain any
earnings for use in our business.
Our common stock has traded on the Nasdaq National Market under the symbol
"ISLD" since June 29, 1999. The following table sets forth the range of high
and low sales prices reported on the Nasdaq National Market for our common
stock for the periods indicated.
<TABLE>
<CAPTION>
High Low
------- ------
<S> <C> <C>
Fiscal 2001
First Quarter (thru December 28, 2000)..................... $ 21.63 $ 2.94
Fiscal 2000
First Quarter.............................................. $156.94 $20.44
Second Quarter............................................. $129.50 $54.88
Third Quarter.............................................. $ 61.25 $15.50
Fourth Quarter............................................. $ 57.38 $18.00
Fiscal 1999
Third Quarter.............................................. $ 20.50 $13.00
Fourth Quarter............................................. $ 40.44 $12.75
</TABLE>
Recent Closing Prices
On December 28, 2000, the latest practicable trading day before the printing
of this annual report, the closing price per share of our common stock was
$4.00. As of November 28, 2000, there were 765 holders of record of our common
stock. Because the market price of our common stock is subject to fluctuation,
the market value of the shares of our common stock may increase or decrease.
Sales of Unregistered Securities
In June and July 2000, we issued an aggregate of 45,000 shares of common
stock to Protege Virtual Management Limited pursuant to the terms of a
settlement agreement.
Pursuant to the terms of an agreement previously executed in November 1999
with SRI International, in August and November 2000, we issued an additional
430,846 shares of common stock to SRI as payment for consulting services
related to the acquired Internet technology.
In September 2000, we issued 72,316 shares of common stock to Kinetech, Inc.
in connection with the acquisition of certain technology from Kinetech.
None of the foregoing transactions involved any underwriters, underwriting
discounts or commission or any public offering, and we believe that each
transaction was exempt from the registration requirements of the Securities
Exchange Act of 1933, as amended by virtue of Section 4(2) thereof. The
recipients in such transactions represented their intention to acquire the
securities for distribution thereof, and appropriate legends were affixed to
the share certificates and instruments issued in such transactions. All
recipients had adequate access, through their relationships with us, to all
relevant information necessary.
13
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA
SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
Five Years Ended September 30, 2000
(in thousands, except share and per share data)
The following selected historical consolidated financial information should
be read in conjunction with our consolidated financial statements and related
notes and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" included elsewhere in this Annual Report on Form 10-K.
The consolidated statement of operations information for each of the years in
the three year period ended September 30, 2000, and the balance sheet data at
September 30, 1999 and 2000, are derived from our financial statements that
have been audited by PricewaterhouseCoopers LLP, independent accountants,
included elsewhere in this filing. The statement of operations data for the
years ended September 30, 1996 and 1997, and the balance sheet data at
September 30, 1996, 1997, and 1998, are derived from our audited financial
statements that are not included in this filing. Historical results are not
necessarily indicative of the results to be expected in the future.
<TABLE>
<CAPTION>
Year Ended September 30,
-----------------------------------------------------
1996 1997 1998 1999 2000
------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Consolidated Statement
of Operations Data:
Revenue................. $ -- $ 218 $ 2,343 $ 12,431 $ 59,055
Total costs and
expenses............... 26 5,594 19,459 64,918 401,489
Loss from operations.... (26) (5,376) (17,116) (52,487) (342,434)
Net loss................ $ (27) $ (5,289) $ (16,764) $ (50,938) $ (329,875)
------- --------- --------- ---------- ----------
Basic and diluted loss
per share............ $ (0.10) $ (3.53) $ (7.50) $ (4.58) $ (5.59)
======= ========= ========= ========== ==========
Shares used in basic
and diluted loss per
share calculation.... 275,000 1,497,711 2,236,452 11,127,462 58,996,935
<CAPTION>
September 30,
-----------------------------------------------------
1996 1997 1998 1999 2000
------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Consolidated Balance
Sheet Data:
Cash and cash
equivalents............ $ 344 $ 4,584 $ 5,711 $ 43,315 $ 176,929
Investments............. -- 1,983 10,123 31,691 413,671
Working capital......... 76 4,613 12,883 59,506 443,411
Total assets............ 432 9,223 22,617 107,648 2,116,126
Long-term obligations,
including current
portion................ -- 705 3,992 11,092 365,236
Total stockholders'
equity................. $ 84 $ 6,265 $ 15,490 $ 79,218 $1,681,985
======= ========= ========= ========== ==========
</TABLE>
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Except for the historical financial information contained herein, the
matters discussed in this Annual Report on Form 10-K may be considered
"forward-looking" statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Act of
1934, as amended. Such statements include declarations regarding the intent,
beliefs or current expectations of Digital Island and our management. Such
forward-looking statements are not guarantees of future performance and involve
a number of risks and uncertainties. Actual results could differ materially
from those indicated by such forward-looking statements. We undertake no
obligation to publicly release the results of any revision to these forward-
looking statements which may be made to reflect events or circumstances after
the dates hereof or to reflect the occurrence of unanticipated events. Our
actual results could differ materially from those anticipated in these forward-
looking statements for many reasons, including risks faced by us described in
this Report, including the "Risk Factors That May Affect Future Results"
section contained in this Item 7, and the other documents we file with the
Securities and Exchange Commission ("SEC"), including our most recent reports
on Form 8-K and Form 10-Q, and amendments thereto.
Overview
We provide a global e-Business delivery network and suite of services for
enterprises that use the Internet to deploy critical business applications and
conduct e-commerce worldwide. We offer a managed Internet infrastructure that
integrates content delivery, hosting, intelligent networking and applications
services. We target global enterprises that increasingly rely on the Internet
to conduct business, but are constrained by the unreliability, slow performance
and limited range of functions of the public Internet. Our customers use our
services and proprietary technology to facilitate the deployment of a wide
variety of electronic commerce applications, including online marketing and
sales, customer service, fulfillment, software, document and multimedia
distribution and online training. As of September 30, 2000, we had contracts
with 949 customers, of which 811 were deployed, including AOL, Autodesk, Canon,
Charles Schwab & Co., Cisco Systems, CNBC.com, E*TRADE, Blue Mountain, FT.com,
Intuit, Microsoft, National Semiconductor, UBS Warburg, Reuters, Hewlett-
Packard, Glaxo Wellcome, Universal Music Group, and BMG Entertainment.
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 2001. 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 suite of services, which include content
delivery, hosting, intelligent networking and application services. We
currently sell our services under contracts with terms of one or more years.
Revenues are comprised primarily of bandwidth charges, equipment co-location
and storage fees, professional services, streaming events, equipment sales and
one-time fees for installation if required to provide services. Bandwidth
charges are billed and recognized monthly based on customer usage. Professional
services and fees for streaming events are billed and recognized as the related
services are performed. Equipment sales are recognized when the equipment is
delivered. All other revenues are based on flat-rate monthly charges and
recognized as the related services are performed. Installation fees are
generally paid in advance, and are recognized ratably over the term of the
related contract, generally one to three years.
Cost of revenues consists primarily of the cost of contracting for lines
from telecommunication service providers worldwide and the cost of our network
and data center 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
15
<PAGE>
number of circuits leased based on increases in network volume and geographic
expansion. The cost of our network and data center operations is comprised
primarily of data centers, equipment maintenance, personnel and related costs
associated with the management and maintenance of the network.
We have recently begun a program of obtaining bandwidth under indefeasible-
right-of-use (IRU) agreements, which we expect to significantly increase the
gross profit margins in our Intelligent Networking business.
Some options granted and common stock issued to employees have been
accounted for as compensation. Total stock compensation expense associated with
such equity transactions as of September 30, 2000 amounted to $7.7 million.
These amounts are being amortized over the vesting periods of the relevant
securities. Of the total stock compensation expense, $487,000 was amortized in
the year ended September 30, 1998, $3.2 million was amortized in the year ended
September 30, 1999 and $2.4 million was amortized in the year ended September
30, 2000. We expect amortization of $1.2 million and $455,000 in the years
ending September 30, 2001 and 2002, respectively, relating to these grants.
On December 28, 1999, we merged with Sandpiper Networks, Inc. The
transaction was accounted for using the purchase method of accounting. The
acquisition price included approximately 24.6 million shares of Digital Island
common stock with a fair market value of $857.0 million, 3.1 million vested and
unvested stock options and warrants with a fair market value of $96.6 million
and direct transaction costs of $14.0 million. Costs associated with the merger
of Digital Island and Sandpiper that impact future earnings include the
amortization of assembled workforce costs of $2.0 million, core technology
costs of $121.1 million and $850.8 million of goodwill to be amortized over a
period of 5 years. Amortization costs related to the Sandpiper merger for the
year ended September 30, 2000 were $147.6 million.
On January 18, 2000, we acquired Live On Line, Inc. The transaction was
accounted for using the purchase method of accounting. The acquisition price
included 799,989 shares of Digital Island common stock with a fair market value
of $65.9 million and $5.2 million in cash. Costs associated with the merger of
Digital Island and Live On Line that impact future earnings include the
amortization of assembled workforce costs of $500,000, core technology costs of
$3.1 million and $67.4 million of goodwill to be amortized over a period of 5
years. Amortization costs related to the Live On Line acquisition for the year
ended September 30, 2000 were $10.0 million.
On February 23, 2000, we completed a secondary offering of 5,657,090 shares
of our common stock. 1,642,818 of those shares were sold by certain selling
stockholders and 4,014,272 shares were sold by us. The offering price of our
common stock was $107.00 per share and resulted in aggregate proceeds to us
after underwriter discounts of approximately $410,218,455. We received no
proceeds from the sale of our common stock by the selling stockholders.
Goldman, Sachs & Co. and Bear, Stearns & Co. were the lead underwriters and all
the underwriters received an underwriting discount of $4.81 per share. We use
the net proceeds from the offering, together with existing cash, to fund
operating losses, working capital needs and capital expenditures in connection
with our operations.
On February 23, 2000, we issued an aggregate of $345 million of our 6%
convertible subordinated notes. The notes mature on February 15, 2005 and may
be converted at any time prior to their maturity or redemption by us. If the
notes are converted into shares of our common stock, the holder will receive
approximately 7.5 shares (subject to certain adjustments) for each $1,000 in
notes that are converted. We pay interest on the notes semi-annually on
February 15th and August 15th. We have the option to redeem some or all of the
notes on or after February 15, 2003. Goldman, Sachs & Co. was the lead
underwriter and all the underwriters received an underwriting discount of 3%.
We use the net proceeds from the offering, together with existing cash, to fund
operating losses, working capital needs and capital expenditures in connection
with our operations.
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<PAGE>
On September 15, 2000, we acquired SoftAware, Inc. The transaction was
accounted for using the purchase method of accounting. The acquisition price
included 9,301,892 shares of Digital Island common stock with a fair market
value of $390.5 million, 73,108 vested and unvested stock options with a fair
market value of $3.0 million, $20.0 million in cash and estimated direct
transaction costs of approximately $5.2 million. Costs associated with the
merger of Digital Island and SoftAware that impact future earnings include the
amortization of customer relationships of $44.0 million, software and
technology of $10.3 million, assembled workforce of $2.1 million, trademarks
and tradenames of $3.4 million, and $343.2 million of goodwill to be amortized
over a period of 5 years. In addition, deferred compensation costs of $11.9
million will be amortized over the vesting terms of the related securities.
Amortization costs and stock compensation expense related to the SoftAware
acquisition for the year ended September 30, 2000 were $3.7 million.
The following discussion comparing our historical results of operations does
not reflect the results of operations of Sandpiper, Live On Line or SoftAware
for the year ended September 30, 1999. The discussion comparing the year ended
September 30, 2000 reflects the results of operations of Sandpiper from the
date of acquisition, December 28, 1999, Live On Line from the date of
acquisition, January 18, 2000 and SoftAware from the date of acquisition,
September 15, 2000.
Fiscal Years Ended September 30, 2000 and 1999
Revenue. Revenue increased to $59.1 million for the year ended September 30,
2000 from $12.4 million for the year ended September 30, 1999. The increase in
revenue was primarily due to increased usage per customer and an increase in
the number of deployed customers to 811 from 83. Of the 811 billing customers
at year-end, 461 were acquired in connection with the SoftAware acquisition
which occurred on September 15, 2000.
Cost of Revenue. Cost of revenue increased to $111.7 million for the year
ended September 30, 2000 from $29.5 million for the year ended September 30,
1999. The increase in cost of revenue was due to $52.7 million of spending for
additional network capacity, $16.4 million in recruitment and compensation
costs relating to the addition of network and data center operations personnel
and $13.1 million in additional costs associated with expansion of existing
data center facilities, the deployment of the San Jose and Japan data center
facilities and equipment-related costs.
Sales and Marketing. Sales and marketing expenses increased to $50.9 million
for the year ended September 30, 2000 from $16.0 million for the year ended
September 30, 1999. This increase was due to $20.8 million of growth in
personnel and related costs and $14.1 million of program expenses.
Product Development. Product development expenses increased to $21.6 million
for the year ended September 30, 2000 from $6.3 million for the year ended
September 30, 1999. This increase was due to $12.4 million in growth of
personnel and related costs and $2.9 million of costs arising from new product
initiatives, developing intellectual property in content aware routing and
developing new technologies to support our Content Delivery and Managed Hosting
service offerings.
General and Administrative. General and administrative expenses increased to
$24.5 million for the year ended September 30, 2000 from $6.6 million for the
year ended September 30, 1999. This increase was due to $10.3 million of growth
in personnel and related expenses and $7.6 million office facility expenses,
legal and accounting fees and other administrative related expenses.
Depreciation. Depreciation expense increased to $27.6 million for the year
ended September 30, 2000 from $3.2 million for the year ended September 30,
1999. This increase was entirely attributed to a significant increase in
property and equipment balances.
Amortization of intangible assets. Amortization expense increased to $162.6
million for the year ended September 30, 2000 from $18,000 for the year ended
September 30, 1999. This increase was primarily due to
17
<PAGE>
the amortization of the goodwill and intangibles related to the acquisitions of
Sandpiper, Live On Line and SoftAware during the year ended September 30, 2000.
Interest Income and Other Income, Net. Interest income and other income,
net, increased to $12.6 million for the year ended September 30, 2000 from $1.6
million for the year ended September 30, 1999. This increase was due to a
higher average cash balance remaining primarily from proceeds of the issuance
of shares of our common stock in our secondary stock offering and the issuance
of convertible subordinated notes, and was offset by accrued interest expense
on the convertible notes.
Fiscal Years Ended September 30, 1999 and 1998
Revenue. Revenue increased to $12.4 million for the year ended September 30,
1999 from $2.3 million for the year ended September 30, 1998. The increase in
revenue was due primarily to an increase in the number of billing customers to
83 from 31.
Cost of Revenue. Cost of revenue increased to $29.5 million for the year
ended September 30, 1999 from $9.0 million for the year ended September 30,
1998. The increase in cost of revenue was due to $17.5 million of spending for
additional network capacity and $3.0 million in recruitment and compensation
costs relating to the addition of network and data center operations personnel.
Sales and Marketing. Sales and marketing expenses increased to $16.0 million
for the year ended September 30, 1999 from $4.8 million for the year ended
September 30, 1998. This increase was due to $10.6 million of growth in
personnel and related costs and $0.6 million of program expenses.
Product Development. Product development expenses increased to $6.3 million
for the year ended September 30, 1999 from $1.7 million for the year ended
September 30, 1998. This increase was due to $3.7 million in growth of
personnel and related costs and $0.9 million of costs arising from new product
initiatives, including TraceWare, mirroring and caching technologies.
General and Administrative. General and administrative expenses increased to
$6.6 million for the year ended September 30, 1999 from $2.8 million for the
year ended September 30, 1998. This increase was due to $2.2 million of growth
in personnel and related expenses and $1.6 million office facility expenses,
legal and accounting fees and other administrative related expenses.
Depreciation. Depreciation expense increased to $3.2 million for the year
ended September 30, 1999 from $547,000 for the year ended September 30, 1999.
This increase was entirely attributed to an increase in property and equipment
balances.
Interest Income, net. Interest income, net, increased to $1.6 million for
the year ended September 30, 1999 from $354,000 for the year ended September
30, 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 and common stock
in our initial public offering in July 1999.
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Quarterly Results of Operations
The following tables set forth certain unaudited statements of operations
data for the eight quarters ended September 30, 2000. 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 annual
report, 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 annual
report. The operating results for any period should not be considered
indicative of results of any future period. Certain fiscal year 2000 quarterly
amounts have been reclassified to conform to the September 30, 2000
presentation.
<TABLE>
<CAPTION>
Three Months Ended
---------------------------------------------------------------------------------
Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30,
1998 1999 1999 1999 1999 2000 2000 2000
-------- -------- -------- --------- -------- -------- --------- ---------
(in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenue................. $ 1,385 $ 2,411 $ 3,700 $ 4,935 $ 7,600 $ 11,329 $ 16,061 $ 24,065
Costs and expenses:
Cost of Revenue........ 2,923 4,827 8,055 13,691 15,868 23,378 32,503 39,946
Sales and Marketing.... 2,046 3,125 4,525 6,314 6,315 13,777 14,586 16,223
Product development.... 843 1,167 1,853 2,494 2,543 4,492 6,192 8,359
General and
Administrative........ 843 1,196 1,593 2,963 2,966 5,626 6,612 9,246
Depreciation........... 416 506 868 1,445 2,241 6,130 8,384 10,817
Amortization of
Intangible Assets..... 1 1 8 8 1,584 51,799 53,064 56,176
Stock compensation
expense............... 346 680 1,248 933 755 628 528 751
------- ------- -------- -------- -------- -------- --------- ---------
Total cost and
expenses............ 7,418 11,502 18,150 27,848 32,272 105,830 121,869 141,518
Loss from operations.... (6,033) (9,091) (14,450) (22,913) (24,672) (94,501) (105,808) (117, 453)
Other income (expense),
net.................... 96 160 387 908 697 1,792 5,650 4,436
------- ------- -------- -------- -------- -------- --------- ---------
Loss before income
taxes.................. (5,937) (8,931) (14,063) (22,005) (23,975) (92,709) (100,158) (113,017)
------- ------- -------- -------- -------- -------- --------- ---------
Provision for income
taxes.................. 2 -- -- -- 5 2 10 (1)
------- ------- -------- -------- -------- -------- --------- ---------
Net loss............. $(5,939) $(8,931) $(14,063) $(22,005) $(23,980) $(92,711) $(100,168) $(113,016)
======= ======= ======== ======== ======== ======== ========= =========
</TABLE>
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;
19
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. bandwidth used by customers may fluctuate from quarter to quarter
affecting our revenues 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 our initial public offering on June 29, 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. We raised $63.1 million in net proceeds
from our initial public offering. In February 2000, we raised $744.0 million in
net proceeds from our secondary offering of our common stock and issuance of
convertible subordinated notes. As of September 30, 2000, we had cash, cash
equivalents, short-term investments and long-term investments totaling $590.6
million.
Net cash used in our operating activities for the year ended September 30,
2000 was $161.4 million. The net cash used by operations was primarily due to
working capital requirements and net losses, net of amortization of
intangibles. Net cash used in investment activities was $530.9 million for the
year ended September 30, 2000 and was comprised primarily of equipment
purchases of $130.5 million, investments of $517.9 million, cash paid in the
acquisition of Live On Line of $5.3 million, cash paid in the acquisition of
SoftAware of $20.0 million and a $10.1 million increase in restricted cash,
which were offset by proceeds from investments which matured of $146.8 million
and cash acquired through business acquisitions of $6.1 million. Net cash
provided by financing activities was approximately $825.9 million and was
related primarily to the issuance of stock and notes of $834.6 million and an
increase in the cash overdraft balance of $5.9 million, which were offset by
repayments of debt and capital leases of $14.6 million.
We had a $750,000 revolving line of credit with a commercial bank for the
purpose of financing equipment purchases. The loan contained standard covenants
including minimum working capital, minimum tangible net worth, debt to equity
ratio and financial reporting requirements. Interest on borrowings thereunder
accrued at the lender's prime rate plus 0.75% and was payable monthly. No
further advances were permitted following October 18, 1997, and any outstanding
amounts were payable on or before October 18, 2000. The line of credit expired
in May 2000. We chose not to extend the term on this line of credit.
We also had a $7.5 million revolving 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. Advances under the line of credit were
limited to a percentage of our recurring contract revenue. The loan contained
standard covenants, including minimum working capital, minimum tangible net
worth, debt to equity ratio and financial reporting requirements. Interest on
borrowings under the revolving credit facility accrued at the lender's prime
rate plus 0.25%, and was payable monthly. Under the terms of the equipment loan
facilities, interest was charged at the lender's prime rate plus 0.75% and was
payable monthly. These lines of credit expired in May 2000. We chose not to
extend the terms on these lines of credit.
Pursuant to the merger with Sandpiper, we assumed from Sandpiper a
$1,000,000 line of credit with a bank. The line of credit has a variable rate
of interest, based on the bank's prime rate plus 0.5%. At September 30, 2000,
no amounts were extended under this facility. Pursuant to the merger with
Sandpiper, we assumed from Sandpiper a promissory note with a financial
institution in the amount of $84,000 at a stated interest rate of 7% per annum,
principal and interest due monthly for 36 months and collateralized by
equipment on August 31, 1998.
20
<PAGE>
In December 1999, Sun Microsystems agreed to provide $100 million of lease
financing, subject to certain milestones, for the acquisition of equipment. As
of September 30, 2000, $30 million of lease financing has been made available
under this agreement. Total borrowings under this lease line were $1.8 million
at September 30, 2000.
In June 2000, Compaq Computer Corporation agreed to provide $50 million,
which may be increased to $80 million under certain circumstances, of lease
financing for the acquisition of equipment. We have not drawn any amounts under
the financing agreement.
In addition, we have several other lease lines of credit. Total borrowings
under these other lease lines of credit were $18.4 million at September 30,
2000, of which $580,000 was assumed pursuant to the merger with Sandpiper.
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. We intend 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
. altering deployment of our network services or the schedule of our
expansion plan.
Other than the 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
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. In June 1999, the FASB
issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities
Deferral of Effective Date of FASB Statement No. 133," which deferred the
effective date of SFAS 133 to all fiscal quarters of fiscal years beginning
after June 15, 2000. We do not believe the adoption of SFAS 133 will have a
material effect on our consolidated results of operations or financial
condition.
In December 1999, the Securities Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101").
SAB 101 is effective no later than the quarter ended September 30, 2001. The
Company has not completed its assessment but does not expect that the adoption
of SAB 101 will have a material effect on our consolidated results of
operations or financial position.
21
<PAGE>
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Risks related to us
We have a short operating history.
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 e-Business delivery
network services in January 1997.
We completed a merger with Sandpiper Networks, Inc. in December 1999, an
acquisition of Live on Line, Inc. in January 2000 and an acquisition of
SoftAware, Inc. in September 2000. Sandpiper commenced operations in December
1996 and introduced its service in September 1998, and therefore also has a
limited operating history. Live On Line commenced operations and introduced its
service in December 1995. SoftAware commenced operations and introduced its
service in January 1994. The limited operating history of the combined company
and the limited operating histories of Digital Island, Sandpiper, Live On Line
and SoftAware as individual entities may limit your ability to evaluate our
prospects and performance, due to:
. our unproven potential to generate profits;
. our limited historical financial data;
. our limited experience in operating as a combined entity; and
. our limited experience in addressing emerging trends that may affect our
combined business.
You should consider our prospects in light of the risks, expenses and
difficulties we may encounter as an early stage company in the new and rapidly
evolving market for Internet content delivery solutions. As a result of such
risks, expenses and difficulties, we may not be able to:
. successfully market our content delivery solution;
. maintain and expand our market share in the highly competitive market for
Internet content delivery solutions;
. timely and effectively introduce new services and service enhancements
that are responsive to the needs of our customers; and
. attract, train and retain qualified sales, technical and customer support
personnel.
We have incurred operating losses since our inception and expect continued
operating 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, 1999, our operating loss, negative cash flow from
operations and net loss were $52.5 million, $39.7 million and $50.9 million,
respectively. For the fiscal year ended September 30, 2000, our operating loss,
negative cash flow from operations and net loss were $342.4 million, $161.4
million and $329.9 million, respectively.
Our operating expenses are largely based on anticipated revenue trends, and
a high percentage of our expenses are, and will continue to be, fixed in the
short term. In addition, we expect to continue to incur increasing expenses in
order to:
. expand sales and marketing activities through new programs and additional
personnel;
. increase product development activities;
. continue to grow our network infrastructure to maintain and increase our
ability to service new and existing customers;
22
<PAGE>
. obtain access to additional bandwidth for the transport of increasing
volumes of data over our network; and
. expand our channels of distribution to increase our presence in our
target markets.
We will need to generate significantly higher revenues to achieve and
maintain profitability. 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.
Our quarterly results have varied significantly and we expect this to continue.
We expect our revenues and operating results to vary significantly from
quarter to quarter due to a number of factors, many of which we cannot control.
These factors include the following:
. demand for and market acceptance of our products and services may decline
or fail to increase enough to offset our costs;
. the introduction 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 significant 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;
. the length of our sales cycle and timing of customer installations and
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; and
. conditions specific to the Internet industry and other general economic
factors may affect the prices we can charge or the expenses we incur.
Because 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, 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. It is likely that, in some future quarters,
our operating results may not meet the expectations of public market analysts
and investors. In that event, the price of our common stock may fall and our
ability to obtain additional financing may be impaired.
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 a
positive gross margin. We purchase our bandwidth capacity on a fixed-price
basis in advance of the sale of our services. We sell our services, by
contract, on the basis of actual usage. Our bandwidth costs currently exceed
our revenues from the sale of services, which results in negative gross profit.
23
<PAGE>
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 more than we expect, the value of these services could be
substantially reduced, which would harm our business and financial results.
We expect that the cost of obtaining bandwidth 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 build infrastructure. 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.
If we fail to accurately predict the decline in costs of bandwidth, are unable
to sell our services at acceptable prices, or fail to offer additional services
from which we can derive additional revenues, our revenues may decrease or fail
to increase as anticipated, and our business and financial results will suffer.
We must retain and expand our customer base or else we will continue to be
unprofitable.
For the fiscal year ended September 30, 1999, we had contracts with 83
billing customers, of which one, E*TRADE, accounted for approximately 35% of
our revenues. As of September 30, 2000, we had contracts with 949 customers of
which 811 were deployed. E*TRADE accounted for approximately 24% of our
revenues during the fiscal year ended September 30, 2000. We currently incur
costs greater than our revenues and need to increase customer revenue to become
profitable. If we are unable to retain or grow our customer base, we will not
be able to achieve the economies of scale necessary to offset our fixed and
variable 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
. our marketing strategies may not result in increased sales.
Our network infrastructure may be subject to failure or disruptions, which
would seriously harm our business.
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;
. sabotage or vandalism;
. telecommunications failures; and
. similar events.
24
<PAGE>
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. We may be subject to legal claims and be liable
for losses suffered by our customers for disruptions resulting from failures on
our network. Our agreements with our customers generally attempt to eliminate
our liability for consequential or punitive damages not caused by our gross
negligence or willful acts. However, those provisions may not protect us from
being held liable for such damages. If our disruption rate is high, clients may
seek to terminate their contracts with us and our reputation could be harmed,
which would materially harm our business.
Our Internet content delivery service is complex and may have errors or defects
that could seriously harm our business.
Our Internet content delivery service is highly complex and is designed to
be deployed in very large and complex networks. Because of the nature of this
service, we can only fully test it when it is fully deployed in very large
networks with high traffic. We and our customers have from time to time
discovered errors and defects during the deployment of our service. In the
future, there may be additional errors and defects that may adversely affect
our service. If we are unable efficiently to fix errors or other problems that
may be identified in the future, we could experience:
. loss of or delay in revenue;
. loss of customers;
. failure to attract new customers or achieve market acceptance;
. diversion of development resources;
. loss of reputation and credibility;
. increased service costs; and
. legal actions by our customers.
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 24 hours a day, seven days
per week, except for certain scheduled maintenance periods. This warranty is
generally limited to a credit consisting of free service for a specified period
of time for disruptions in Internet transmission services. To date, we have
incurred 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 such damages may exceed our liability insurance.
Our business will suffer if we do not anticipate and meet specific customer
requirements or respond to technological change.
The market for Internet content delivery and network services is
characterized by rapid technological change, frequent new product introductions
and changes in customer requirements. We may be unable to respond quickly or
effectively to these developments. 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;
25
<PAGE>
. 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 our services is likely to decline as rapidly as the cost of
any competitive alternatives.
The development of new or enhanced services through technology development
activities is a complex and uncertain process that requires the accurate
anticipation of technological and market trends. We may experience design,
manufacturing, marketing and other difficulties that could delay or prevent the
development, introduction or marketing of new services and enhancements. In
addition, our inability to effectively manage the transition from older
services to newer services could cause disruptions to customer orders and harm
our business and prospects.
If we do not successfully increase the capacity of our network and data
centers, demand for our services may decrease.
Our network and data centers may not be able to serve expected customer
levels or meet performance expectations and we may be unable to obtain
additional network capacity from third-party suppliers or build or expand data
centers. 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 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 which could significantly reduce demand for our
services, reducing our revenues and adversely affecting our business.
If our market does not grow as we expect, our revenues will be below our
expectations and our business and financial results will suffer.
The market for our services is new and unproven. If our customer base does
not expand or if there is not a widespread acceptance of our products and our
services, our business and prospects will be harmed. The market for our
services depends on several uncertain events and factors, including:
. 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 e-Business or
software markets.
If the market for our services fails to develop, or develops more slowly
than expected, our business will be adversely affected.
We will require significant additional capital, and if we cannot obtain this
financing on commercially reasonable terms, our business will suffer.
Our ability to meet our planned growth will require substantial cash
resources. The timing and amount of future capital requirements may vary
significantly depending on numerous factors including regulatory,
technological, competitive and other developments in our industry. We do not
expect to generate sufficient cash flow from operations in the near term.
Accordingly, our ability to meet additional future capital needs will depend on
future equity or debt financing, which we may not be able to obtain on
satisfactory terms or at all. 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.
26
<PAGE>
Additional equity financing may not be available and/or may be dilutive to
existing stockholders. Our inability to obtain additional capital on
satisfactory terms may delay or prevent the expansion of our business and cause
us to forego market opportunities, which could materially adversely affect our
growth and ability to compete.
Rapid growth in our business could cause a significant strain on our business.
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
and data center infrastructure and technical support resources to grow rapidly.
We expect that these demands will require investments in our infrastructure,
the addition of new management personnel, 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 such 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, our business and financial results will suffer.
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 us and may 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 divert resources from other activities and may result in
interruptions or delays to our customers that could cause our business and
financial results to 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. The loss of one or more of these individuals 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 additional management, technical and
other personnel. 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. The loss of the services of any of our key employees, the
inability to integrate new employees or our failure to attract or retain
qualified personnel in the future in a timely manner could harm our business.
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 third party providers 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
27
<PAGE>
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 suppliers to
provide products or components that comply with evolving Internet and
telecommunications standards 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 pending patent applications with the United States Patent
and Trademark Office with respect to our Footprint, as well as certain Internet
technology acquired from SRI International, and were recently issued a U.S.
patent with respect to TraceWare, we currently may not have sufficient patented
technology to preclude or substantially inhibit competitors from entering our
market. Moreover, none of our technology is patented abroad, although we do
currently have 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 (and in some instances, received) 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 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.
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.
Unauthorized use of any of our proprietary information could seriously harm our
business.
If we do not effectively manage the integration of future acquisitions, it
could disrupt our business and cause increased losses.
Part of our expansion strategy includes acquiring businesses and
technologies that we believe will complement our existing business. In the
event of any future acquisitions, we may:
. issue stock that would dilute the ownership of our stockholders;
. incur debt;
. assume liabilities;
. incur amortization expenses related to goodwill and other intangible
assets; and
. incur large and immediate write-offs.
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<PAGE>
Acquisition transactions require a significant commitment of resources and are
accompanied by a number of risks, including:
. the difficulty of assimilating the operations and personnel of the
acquired companies;
. the potential disruption of our ongoing business and distraction of
management;
. the difficulty of incorporating acquired technology and rights into our
products and services;
. unanticipated expenses related to technology integration;
. the maintenance of uniform standards, controls, procedures and policies;
. the impairment of relationships with employees and customers as a result
of any integration of new management personnel; and
. potential unknown liabilities associated with acquired businesses.
We may need to complete these transactions to remain competitive. We cannot
be sure that we will succeed in addressing these risks or any other problems
encountered in connection with potential business combinations and
acquisitions.
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.
We may be unable to license necessary technology, and we may be subject to
infringement claims by third parties.
In addition to the risks inherent in the litigation with Akamai Technologies
described in Item 3 above, 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, 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.
Companies in the Internet market are increasingly bringing suits alleging
infringement of their proprietary rights, particularly patent rights. Any
litigation or claims, whether or not valid, could result in substantial costs
and diversion of resources. Intellectual property litigation or claims could
force us to do one or more of the following:
. cease selling, incorporating or using products or services that
incorporate the challenged intellectual property;
. obtain a license from the holder of the infringed intellectual property
right, which license, if available at all, may not be available on
commercially favorable terms; and
. redesign products or services.
If we are forced to take any of the foregoing actions, our business may be
seriously harmed. We expect that our insurance may not cover potential claims
of this type or may not be adequate to indemnify us in the event we are found
liable.
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<PAGE>
Our participation in joint ventures and strategic relationships may involve
risk associated with inconsistent goals, exposure to unknown liabilities and
unexpected obligations.
As part of our international expansion, we pursue 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 and there is 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 harm our business.
Sandpiper entered into strategic relationships with America Online, or AOL,
in April 1999 and with Microsoft in October 1999 for the joint development of
technology, services and/or products. We may not be successful in developing
such products. The AOL agreement expires in December 2001 and the agreement
with Microsoft expires in August 2002. Each agreement may be terminated by
either party if the other party materially breaches the agreement. A
termination of, or significant adverse change in our relationship with AOL or
Microsoft could have a material adverse effect on our business.
We entered into strategic relationships with Sun Microsystems, Inc. and
Inktomi Corporation in December 1999 to expand the global electronic business
content delivery network through deployment of up to 5,000 Sun servers equipped
with Inktomi's Traffic Server and Content Delivery Suite. We may not be
successful in such an expansion. A termination of, or significant adverse
change in our relationship with Sun or Inktomi could have a material adverse
effect on our business.
We entered into strategic relationship with Compaq Computer Corporation,
Intel Corporation and Microsoft Corporation in June 2000 to extend our
infrastructure and to provide broadcast-scale streaming media over the
Internet. We may not be successful in such an extension of our infrastructure.
A termination of, or significant adverse change in our relationship with
Compaq, Intel or Microsoft could have a material adverse effect on our
business.
Risks Related To The SoftAware Merger.
If we do not successfully integrate SoftAware's operations and personnel or
effectively manage the combined company, we may not achieve the benefits of the
merger and may lose key personnel and customers.
We undertook the merger with the expectation that the merger will result in
significant benefits. Achieving the benefits of the merger depends on the
timely, efficient and successful execution of a number of post-merger events,
including the current efforts to integrate the operations and personnel of
SoftAware. We will need to overcome significant obstacles, however, in order to
realize any benefits or synergies from the merger. The successful execution of
these post-merger events will involve considerable risk and may not be
successful.
Our business may be adversely affected as a result of the SoftAware merger
if:
. the integration of Digital Island and SoftAware is unsuccessful;
. Digital Island does not achieve the perceived benefits of the merger as
rapidly or to the extent anticipated by financial or industry analysts;
or
. the effect of the merger on Digital Island's financial results is not
consistent with the expectations of financial or industry analysts.
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<PAGE>
Our failure to complete the integration successfully could also result in
the loss of key personnel and customers. In addition, the attention and effort
devoted to the integration of the two companies will significantly divert
management's attention from other important issues.
Risks Related to Our Industry.
Competition in our industry is intense and growing and we may be unable to
compete effectively.
Our market is highly competitive and fragmented. Our competitors include
companies such as AboveNet Communications, Adero, Akamai, AT&T, XO
Communications, Digex, Exodus Communications, Genuity, iBeam, InterNAP, MCI
WorldCom and Qwest. 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. Some of our current and potential
competitors have the financial resources to withstand substantial price
competition, and many may be able to respond more quickly than we can to new or
emerging technologies and changes in customer requirements. Our competitors
with more extensive customer bases, broader customer relationships and broader
industry alliances may be able to use such resources to their advantage in
competitive situations, including relationships with many of our current and
potential customers. In particular, certain competitors have strategic
alliances with entities that have entered into similar alliances with us,
including Microsoft.
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 larger competitors may be able to
provide customers with additional benefits in 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.
We face competition, and in the future may face additional competition, from
providers of Internet content delivery services, including networking hardware
and software manufacturers, content distribution providers, traditional
hardware manufacturers, telecommunications providers, software database
companies, and large diversified software and technology companies. Some of
these competitors may bundle their services with other software or hardware in
a manner that may discourage website owners from purchasing our services or
Internet service providers from installing our servers. In addition, if those
third party telecommunications providers upon which we are currently dependent
for transmission capacity determine to compete with us in the Internet content
delivery market, their refusal to provide us with capacity, could result in a
degradation or termination of service to certain of our customers. As a result,
we could lose customers or generate reduced revenue from such customers, and
our business and financial results could suffer.
In addition, no assurances can be given that the Internet content delivery
market will develop in a way that we currently anticipate. For example, while
we currently intend to offer our customers the most comprehensive solution
available in the marketplace today, there currently exists an array of
competitors that offer partial solutions to the problems that we address or
intend to address, and a number of these companies have been and are likely to
continue to be quite successful. To the extent Internet service providers
utilize other technology that reduces the need for content delivery solutions,
demand for our services could decrease.
Increased competition could result in:
. price and revenue reductions and lower profit margins;
. increased cost of service from telecommunications providers;
. loss of customers or failure to obtain additional customers; and
. loss of market share.
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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 communications and commerce carried on or disseminated
through their networks is currently unsettled. The United States Congress has
already enacted Internet laws regarding children's privacy, copyrights,
taxation and the transmission of sexually explicit material. The European Union
issued a directive in December 1997 that required member states to initiate the
process for the adoption of privacy regulations by October 1998. The European
Union is also currently considering copyright legislation that may extend the
right of reproduction held by copyright holders to include the right to make
temporary copies for any reason. 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, the growth and development of the market for online commerce
may prompt calls for more stringent consumer protection laws, both in the
United States and abroad, which may impose additional burdens on companies
conducting business online. Some countries may 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 our 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 the United States currently represents the majority
of our revenues, we expect the percentage of our international sales to
increase over time and expect to commit significant resources to expand our
international sales and marketing activities throughout fiscal year 2001.
However, we may not be able to successfully market, sell, deliver and support
our networking services and products internationally. We presently conduct
international sales through local subsidiaries in the United Kingdom,
Switzerland, Germany, the Netherlands, Japan, Malaysia and China and through
distributor relationships with third parties in countries where we have no
physical presence. Our failure to manage our international operations
effectively could limit the future growth of our business, increase our costs,
lengthen our sales cycle and require significant management attention.
There are certain risks inherent in conducting our business internationally,
such as:
. changes in telecommunications regulatory requirements that may restrict
our ability to deliver services to our international customers;
. export restrictions, tariffs, differing regulatory regimes and other
trade barriers that may 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;
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<PAGE>
. limited international collection experience in collecting accounts
receivable in foreign jurisdictions;
. political and economic instability that 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 that
may give unequal bargaining leverage to key vendors in countries where
competition is scarce, significantly increasing our operating costs;
. increased expenses associated with marketing services in foreign
countries;
. potentially adverse tax consequences, including restrictions on the
repatriation of earnings due to unfavorable changes in tax laws or our
physical presence in foreign countries; and
. the risks related to the global economic turbulence.
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. That debate could result in a directive
relating to the reform of copyright laws in the European Community which may,
if made into law, restrict caching and mirroring. Any or all of these factors
could cause our business and prospects to suffer.
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, substantially 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,
fiscal 1999 and fiscal 2000, costs denominated in foreign currencies were
nominal and we had insignificant 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, as the Euro
has been introduced, we expect that an increasing portion of our international
sales may be Euro-denominated. 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
subject to the risks of foreign currency fluctuations and such risks will
increase as our international revenues increase.
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 although, to
date, neither has elected to exercise such authority. Our services could be
affected by changes in federal and state law or regulation in the
telecommunications arena, and the 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
telecommunications companies.
As our services become available over the Internet in additional 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 their jurisdictions, which may 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
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<PAGE>
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.
Substantial leverage and debt service obligations may adversely affect our cash
flow.
We have substantial amounts of outstanding indebtedness, primarily
consisting of the convertible subordinated notes that were issued in February
2000. As a result of this indebtedness, our principal and interest payment
obligations have increased substantially. There is the possibility that we may
be unable to generate cash sufficient to pay the principal of, interest on and
other amounts due in respect of our indebtedness when due. We may also obtain
additional long term debt and working capital lines of credit to meet future
financing needs. There can be no assurance that any financing arrangements will
be available.
Our substantial leverage could have significant negative consequences,
including:
. increasing our vulnerability to general adverse economic and industry
factors;
. limiting our ability to obtain additional financing;
. requiring the dedication of a substantial portion of our expected cash
flow from operations to service our indebtedness, thereby reducing the
amount of our expected cash flow available for other purposes, including
capital expenditures;
. limiting our flexibility in planning for, or reacting to, changes in our
business and the industry in which we compete; and
. placing us at a possible competitive disadvantage vis-a-vis less
leveraged competitors and competitors that have better access to capital
resources.
Our stock has been and will likely continue to 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 fall 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. Sales of substantial amounts of our common stock (including shares
issued upon the exercise of outstanding options and warrants) in the public, or
the appearance that a large number of shares is available for sale, could
depress the market price for our common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES 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 substantially 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 investments, we have concluded there is no material market risk
exposure. Therefore, no quantitative tabular disclosures are required.
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<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Financial Statements and Supplementary Data of Digital Island required
by this item are set forth at the pages indicated at Item 14(a).
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
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<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information concerning our directors appearing under the caption
"Proposal 1--Election of Directors" in the Company's Proxy Statement related to
the Annual Meeting of Shareholders to be held on February 28, 2001, is
incorporated herein by reference.
Executive Officers
The following table sets forth the names and ages of our executive officers
as of October 31, 2000.
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<C> <C> <S>
Ruann F. Ernst.......... 54 Chief Executive Officer and Chairman of the Board
of Directors
Leo S. Spiegel.......... 39 President and Director
T.L. Thompson........... 54 Chief Financial Officer
Charles Picasso......... 59 Chief Operating Officer
Chris Albinson.......... 33 Vice President of Corporate Development
Howard Lasky............ 48 Vice President, General Counsel and Secretary
Tim Wilson.............. 41 Vice President of Marketing and International
Sales
</TABLE>
Ruann F. Ernst has served as Chairman of the Board since December 1999 and
as Chief Executive Officer and as a director since June 1998. She was President
from June 1998 until the closing of the Sandpiper merger in December 1999.
Prior to joining Digital Island, Ms. Ernst served with Hewlett Packard, a
computer equipment and services company, for approximately 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.
Leo S. Spiegel has served as President since December 1999 and previously
served as Sandpiper's President and Chief Executive Officer and as a director
of Sandpiper since January 1998. From February 1996 to January 1998, Mr.
Spiegel served as Senior Vice President and Chief Technology Officer of
Donnelley Enterprise Solutions, Inc., an information management firm. From June
1995 to February 1996, Mr. Spiegel served as a Senior Vice President of
Donnelley Business Services, a subsidiary of R.R. Donnelley and Sons Company.
From May 1991 to June 1995, Mr. Spiegel was the Executive Vice President and
Chief Technology Officer of LANSystems, a network utilities software developer
and international systems integration firm which he co-founded. Mr. Spiegel
holds a B.A. from the University of California, San Diego.
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.
Charles Picasso has served as Chief Operating Officer since September 2000.
From 1999 to 2000, Mr. Picasso served as President at CDI Information
Technology Services. From 1996 to 1998, he served as Senior Vice President,
Worldwide Professional Services Unit, at NCR Corporation/AT&T Global Solution.
From 1995 to 1996, he served as President and Chief Executive Officer of AT&T
Istel, AT&T Solutions
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<PAGE>
Europe. Prior to that position, he served as Vice President, European and Asian
Operations with Control Data Corp. in London, and as President and CEO of the
Concept Group in Paris. Prior to that, Picasso worked at Prime Computer, Inc.
and Xerox Corp., including senior management positions in sales and marketing.
He served on the Advisory Board of the College of Engineering, Wright State
University in Ohio. He graduated from the University of Sciences at Montpellier
in France with a degree in computer science.
Chris Albinson has served as Vice President of Corporate Development since
September 1999. From 1993 to August 1999 Mr. Albinson served as Assistant Vice
President at Newbridge Networks Corp., manufacturer of digital electronic
network products. Mr. Albinson holds an M.B.A. from the University of Western
Ontario.
Howard Lasky has served as Vice President, General Counsel and Secretary
since March 2000. From 1997 through March 2000, Mr. Lasky was a partner and
from 1988 through 1997 an associate at the law firm of Howard, Rice,
Nemerovski, Canady, Falk and Rabkin.
Tim Wilson has served as Vice President of Marketing since March 1998. From
December 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 Executive
Director and General Manager of the Business Communications Systems Division of
AT&T Australia from November 1994 to December 1996. 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.
ITEM 11. EXECUTIVE COMPENSATION
The information appearing under the caption "Executive Compensation" in the
Company's Proxy Statement related to the Annual Meeting of Shareholders to be
held on February 28, 2001, is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information appearing under the caption "Beneficial Ownership" in the
Company's Proxy Statement related to the Annual Meeting of Shareholders to be
held on February 28, 2001, is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information appearing under the caption "Certain Transactions" in the
Company's Proxy Statement related to the Annual Meeting of Shareholders to be
held on February 28, 2001, is incorporated herein by reference.
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<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents are filed as a part of this Report:
<TABLE>
<CAPTION>
Page
----
<S> <C>
1.Financial Statements.
Report of Independent Accountants...................................... F-2
Consolidated Balance Sheets--As of September 30, 2000 and 1999......... F-3
Consolidated Statements of Operations--For the Three Year Period Ended
September 30, 2000.................................................... F-4
Consolidated Statements of Stockholders' Equity--For the Three Year
Period Ended September 30, 2000........................................ F-5
Consolidated Statements of Cash Flows--For the Three Year Period Ended
September 30, 2000.................................................... F-6
Notes to Consolidated Financial Statements............................. F-7
2. Financial Statement Schedule. The following Financial Statement
Schedule of the Registrant is filed as part of this report:
Schedule II--Valuation and Qualifying Accounts......................... S-2
All other schedules are omitted because they are not applicable or the
required information is shown in the Consolidated Financial Statements
or notes thereto.
3. Exhibits. The following Exhibits are filed as part of, or incorporated
by reference into, this report:
</TABLE>
<TABLE>
<CAPTION>
Exhibit
Number Exhibit Title
------- -------------
<C> <S>
2.1(A) Agreement and Plan of Reorganization dated as of October 24, 1999 by
and among the Registrant, Beach Acquisition Corp. and Sandpiper
Networks, Inc.
2.2(B) Agreement and Plan of Merger, dated as of January 18, 2000, by and
among Digital Island, Inc., LOL Acquisition Corp., the Stockholders of
Live On Line, Inc. and Live On Line, Inc.
2.3(C) Agreement and Plan of Reorganization dated as of July 17, 2000 by and
among the Registrant, Ocean Acquisition Corp. and SoftAware Networks,
Inc.
3.1(A) The Registrant's Restated Certificate of Incorporation
3.2(A) The Registrant's Restated Bylaws
4.1(A) Form of Specimen Certificate for the Registrant's Common Stock
4.2(A) Amended and Restated Investors' Rights Agreement by and among the
Registrant and various investors
4.3(A) Amendment No. 1 to the Amended and Restated Investors' Rights
Agreement
4.4(D) Amendment No. 2 to the Amended and Restated Investors' Rights
Agreement
4.5(B) Registration Rights Agreement, by and among Registrant and certain
former stockholders of Live On Line.
4.6(B) Registration Rights Agreement, by and between Registrant and SRI
International.
4.7(E) Registration Rights Agreement, by and between Registrant and Kinetech
4.8(F) Form of Indenture
10.1(A) 1997 Stock Option Agreement
10.2(A) 1998 Stock Option/Stock Issuance Agreement
10.3(A) 1999 Stock Incentive Plan
10.4(A) 1999 Employee Stock Purchase Plan
</TABLE>
38
<PAGE>
<TABLE>
<CAPTION>
Exhibit
Number Exhibit Title
------- -------------
<C> <S>
10.5(A) Form of Indemnification Agreement for Officers and Directors
10.6 Employment Agreement between the Registrant and Ruann F. Ernst, as
amended and restated.
10.7(A) Employment Agreement between the Registrant and Timothy M. Wilson
10.8(A) Employment Agreement between the Registrant and Paul Evenson
10.9(A) Employment Agreement between the Registrant and Leo S. Spiegel
10.10(A) Employment Agreement between the Registrant and Andrew Swart
10.11(A) Employment Agreement between the Registrant and David Farber
10.12(D) Employment Agreement between the Registrant and Howard Lasky
10.13 Employment Agreement between the Registrant and Charles Picasso
10.14 Employment Agreement between the Registrant and Chris Albinson
10.15 Employment Agreement between the Registrant and T. L. Thompson
10.16(A) Note Secured by Stock Pledge Agreement by Ruann F. Ernst to
Registrant
10.17 Note Secured by Deed of Trust by Charles Picasso to Registrant
10.18 Promissory Note by Charles Picasso to Registrant
10.19(A) Lease between the Registrant and Bishop Street Associates
10.20(A) Lease between the Registrant and Forty-Five Fremont Associates
10.21 Lease between the Registrant and Ogden Properties Limited
10.22 Lease between the Registrant and Corporate Technology Centre
Associates, LLC
10.23 Lease between the Registrant Telehouse International Corporation of
America
10.24 Lease for between the Registrant and Cousins/Myers II, LLC
10.25 Global Master Lease and Financing Agreement, by and between the
Company and Compaq Financial Services Corporation
10.26 Master Lease Line of Credit and Warrant Agreement, between the
Company and Sun Microsystems Finance
10.27 2000 Supplemental Stock Option Plan
10.28 Lease between the Registrant and CB Parkway Business Center VI, Ltd.
10.29 Lease between the Registrant and Refuge Assurance
10.30 Lease between the Registrant and Vanderbilt Holdings, LLC
10.31 Lease between the Registrant and E/Shelter GmbH & Co. KG
21.1 Subsidiaries of Registrant
23.1 Consent of Independent Accountants
24.1 Power of Attorney (see signature page to Form 10-K)
27.1 Financial Data Schedule
</TABLE>
--------
(A) Incorporated by reference to Exhibits of the Registrant's Registration
Statement on Form S-4, as filed with the Securities and Exchange Commission
on December 9, 1999.
(B) Incorporated by reference to Exhibits of the Registrant's Registration
Statement on Form S-3, as filed with the Securities and Exchange Commission
on July 17, 2000.
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<PAGE>
(C) Incorporated by reference to Exhibits of the Registrant's Report on Form 8-
K, as filed with the Securities and Exchange Commission on September 22,
2000.
(D) Incorporated by reference to Exhibits of the Registrant's Report on Form
10-Q, as filed with the Securities and Exchange Commission on August 14,
2000.
(E) Incorporated by reference to Exhibits to the Registrant's Registration
Statement on Form S-3, as filed with the Securities and Exchange Commission
on October 20, 2000.
(F) Incorporated by references to Exhibits to the Registrant's Registration
Statement on Form S-1, as filed with the Securities and Exchange Commission
on January 21, 2000.
(b) Reports on Form 8-K
The Company filed 3 reports on Form 8-K during the fourth quarter ended
September 30, 2000. Information regarding the items reported on is as follow:
July 6, 2000
The Company announced its strategic alliance with Compaq Computer
Corporation, Intel Corporation and Microsoft Corporation.
July 19, 2000
The Company announced the signing of the execution of the merger agreement
with SoftAware Networks, Inc.
September 22, 2000
The Company announced the completion of the acquisition of SoftAware
Networks, Inc.
40
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
Digital Island, Inc.
Date: December 29, 2000
/s/ Ruann F. Ernst
By: _________________________________
Ruann F. Ernst, Chief Executive
Officer and Chairman of the Board
of Directors
(Principal Executive Officer)
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Ruann F. Ernst and T.L. Thompson, and each of
them, his or her true and lawful attorneys-in-fact, each with full power of
substitution, for him or her in any and all capacities, to sign any amendments
to this report on Form 10-K and to file the same, with exhibits thereto and
other documents in connection therewith, with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys-in-
fact or their substitute or substitutes may do or cause to be done by virtue
hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated:
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Ruann F. Ernst Chief Executive Officer December 29, 2000
______________________________________ and Director (Principal
Ruann F. Ernst Executive Officer)
/s/ T.L. Thompson Chief Financial Officer December 29, 2000
______________________________________
T.L. Thompson
/s/ Leo S. Spiegel President and Director December 29, 2000
______________________________________
Leo S. Spiegel
/s/ Charlie Bass Director December 29, 2000
______________________________________
Charlie Bass
/s/ Christos Cotsakos Director December 29, 2000
______________________________________
Christos Cotsakos
/s/ Marcelo A. Gumudo Director December 29, 2000
______________________________________
Marcelo A. Gumucio
Director
______________________________________
G. Bradford Jones
Director
______________________________________
Shahan Soghikian
</TABLE>
41
<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. and Subsidiaries:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash flows
present fairly, in all material respects, the financial position of Digital
Island, Inc. and Subsidiaries at September 30, 2000 and 1999, and the results
of its operations and its cash flows for each of the three years in the period
ended September 30, 2000, in conformity with accounting principles generally
accepted in the United States of America. 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 auditing standards generally
accepted in the United States of America, 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 our
opinion.
/s/ PricewaterhouseCoopers LLP
San Francisco, California
November 10, 2000
F-2
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
September 30,
--------------------
1999 2000
-------- ----------
<S> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents.............................. $ 43,315 $ 176,929
Investments............................................ 31,691 289,458
Accounts receivable, net of allowance of $380 and
$2,329, respectively.................................. 3,557 21,298
Inventory.............................................. -- 554
Restricted cash........................................ 763 10,838
Prepaid expenses and other............................. 1,825 22,785
-------- ----------
Total current assets................................. 81,151 521,862
Investments.............................................. -- 124,213
Property and equipment, net.............................. 25,273 166,766
Goodwill, net of accumulated amortization of $0 and
$141,462, respectively (Note 3)......................... -- 1,119,174
Intangible assets, net of accumulated amortization of $18
and $19,456, respectively (Note 3)...................... 147 170,080
Unamortized convertible note issuance costs.............. -- 9,695
Other assets............................................. 1,077 4,336
-------- ----------
Total assets......................................... $107,648 $2,116,126
======== ==========
LIABILITIES AND STOCKHOLDERS EQUITY
-----------------------------------
Current liabilities:
Bank borrowings ....................................... $ 801 $ --
Capital lease obligations.............................. 3,916 10,159
Accounts payable....................................... 8,621 32,325
Accrued liabilities.................................... 4,931 21,852
Cash overdraft......................................... 3,058 8,922
Interest payable....................................... -- 2,588
Deferred revenue....................................... 318 2,605
-------- ----------
Total current liabilities............................ 21,645 78,451
Bank borrowings less current portion..................... 314 --
Convertible notes........................................ -- 345,000
Capital lease obligations, less current portion.......... 6,061 10,077
Deferred revenue......................................... 410 --
Other liabilities........................................ -- 613
-------- ----------
Total liabilities.................................... 28,430 434,141
-------- ----------
Commitments and contingencies (Note 9)
Stockholders' equity:
Preferred stock, $0,001 par value:
Authorized: 10,000,000 shares in 1999 and 2000; no
shares issued and outstanding......................... -- --
Common stock, $0.001 par value:
Authorized: 100,000,000 shares in 1999 and 2000: issued
and outstanding: 35,941,727 shares in 1999 and
79,683,686 shares in 2000............................. 36 80
Additional paid-in capital............................... 156,791 2,094,566
Deferred stock compensation.............................. (4,033) (13,310)
Stockholder note receivable.............................. (514) (2,264)
Common stock warrants.................................... -- 5,850
Accumulated deficit...................................... (73,062) (402,937)
-------- ----------
Total stockholders' equity........................... 79,218 1,681,985
-------- ----------
Total liabilities and stockholders' equity......... $107,648 $2,116,126
======== ==========
</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
(In thousands, except share and per share data)
<TABLE>
<CAPTION>
Year Ended September 30,
---------------------------------
1998 1999 2000
--------- ---------- ----------
<S> <C> <C> <C>
Revenue.................................... $ 2,343 $ 12,431 $ 59,055
Costs and expenses:
Cost of revenue.......................... 9,039 29,496 111,695
Sales and marketing...................... 4,847 16,010 50,901
Product development...................... 1,694 6,357 21,586
General and administrative............... 2,845 6,595 24,450
Depreciation............................. 547 3,235 27,572
Amortization of intangible assets........ -- 18 162,623
Stock compensation expense............... 487 3,207 2,662
--------- ---------- ----------
Total costs and expenses............... 19,459 64,918 401,489
--------- ---------- ----------
Loss from operations................... (17,116) (52,487) (342,434)
Interest income............................ 482 2,040 26,286
Interest expense........................... (128) (494) (13,571)
Other income (expense)..................... -- 5 (140)
--------- ---------- ----------
Loss before income taxes............... (16,762) (50,936) (329,859)
Provision for income taxes................. 2 2 16
--------- ---------- ----------
Net loss............................... $ (16,764) $ (50,938) $ (329,875)
========= ========== ==========
Basic and diluted net loss per share....... $ (7.50) $ (4.58) $ (5.59)
========= ========== ==========
Weighted average shares outstanding used in
per share calculation..................... 2,236,452 11,127,462 58,996,935
========= ========== ==========
</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
(In thousands)
<TABLE>
<CAPTION>
Convertible
Preferred
Stock Common Stock Additional Deferred Stockholder Common Total
--------------- ------------- Paid-in Stock Note Stock Accumulated Stockholders
Shares Amount Shares Amount Capital Compensation Receivable Warrant Deficit Equity
------- ------ ------ ------ ---------- ------------ ----------- ------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balances September
30, 1997........... 7,000 $ 7 2,216 $ 2 $ 11,586 $ -- $ -- $ 29 $ (5,360) $ 6,264
Series C preferred
stock issued for
cash, net of
issuance costs of
$34................ 4,283 4 -- -- 14,739 -- -- -- -- 14,743
Series D preferred
stock issued for
cash, net issuance
of cost of $33..... 2,023 2 -- -- 10,583 -- -- -- -- 10,585
Issuance of
stockholder note in
exchange for common
stock.............. -- -- 183 1 110 -- (110) -- -- 1
Common stock issued
for professional
service............ -- -- 6 -- 18 -- -- -- -- 18
Common stock issued
for cash upon
exercise of
options............ -- -- 115 -- 156 -- -- -- -- 156
Deferred
compensation in
connection with
issuance of stock
options............ -- -- -- -- 1,990 (1,990) -- -- -- --
Amortization of
deferred
compensation....... -- -- -- -- -- 487 -- -- -- 487
Net loss........... -- -- -- -- -- -- -- -- (16,764) (16,764)
------- ---- ------ ---- ---------- -------- -------- ------ --------- ----------
Balances, September
30, 1998........... 13,306 13 2,520 3 39,182 (1,503) (110) 29 (22,124) 15,490
Series E preferred
stock issued for
cash, net of
issuance cost of
$2,539............. 11,765 12 -- -- 47,450 -- -- -- -- 47,462
Common stock issued
for cash upon
exercise of
options............ -- -- 829 1 964 -- -- -- -- 965
Deferred
compensation in
connection with
issuance of stock
options............ -- -- -- -- 5,737 (5,737) -- -- -- --
Amortization of
deferred
compensation ...... -- -- -- -- -- 3,207 -- -- -- 3,207
Issuance of
stockholder note in
exchange for common
stock.............. -- -- 349 -- 286 -- (286) -- -- --
Common stock issued
for cash upon
exercise of
warrants........... -- -- 95 -- 38 -- -- (29) -- 9
Additional shares
of Series D
preferred stock
issued upon
convension......... 178 -- -- -- -- -- -- -- -- --
Conversion of
preferred stock ... (25,249) (25) 25,249 25 -- -- -- -- -- --
Issuance of common
stock in public
offering, net of
issuance costs of
$5,858............. -- -- 6,900 7 63,134 -- -- -- -- 63,141
Notes issued to
officers in
exchange for cash.. -- -- -- -- -- -- (228) -- -- (228)
Repayment of
stockholder note... -- -- -- -- -- -- 110 -- -- 110
Net loss........... -- -- -- -- -- -- -- (50,938) (50,938)
------- ---- ------ ---- ---------- -------- -------- ------ --------- ----------
Balances September
30, 1999........... -- -- 35,942 36 156,791 (4,033) (514) -- (73,062) 79,218
Common stock issued
for cash upon
exercise of
options............ -- -- 1,327 1 2,390 -- -- -- -- 2,391
Common stock issued
for cash upon
purchase of shares
under the employee
stock purchase
plan............... -- -- 305 1 2,979 -- -- -- -- 2,980
Common stock issued
in exchange for
fixed assets....... -- -- 286 -- 9,965 -- -- -- -- 9,965
Common stock issued
in connection with
Sandpiper Networks
acquisition........ -- -- 24,559 25 967,609 -- -- -- -- 967,634
Common stock issued
in connection with
Live-on-Line
acquisition........ -- -- 800 1 65,878 -- -- -- -- 65,879
Common stock issued
in connection with
SoftAware
acquisition........ -- -- 9,302 9 392,367 -- -- -- -- 392,376
Issuance of common
stock in public
offering, net of
issuance costs of
$20,237............ -- -- 4,014 4 409,293 -- -- -- -- 409,297
Issuance of common
stock to strategic
alliance partners
net of issuance
costs of $91....... -- -- 3,104 3 85,906 -- -- -- -- 85,909
Common stock issued
pursuant to a
settlement
agreement.......... -- -- 45 -- 1,388 -- -- -- -- 1,388
Warrants issued in
connection with a
co-location
agreement.......... -- -- -- -- -- -- -- 2,785 -- 2,785
Warrants issued in
connection with a
line of credit
agreement.......... -- -- -- -- -- -- -- 3,065 -- 3,065
Deferred
compensation in
connection with
SoftAware
acquisiton......... -- -- -- -- -- (11,939) -- -- -- (11,939)
Amortization of
deferred
compensation....... -- -- -- -- -- 2,662 -- -- -- 2,662
Stockholder notes
in exchange for
common stock in
connection with
SoftAware
acquisition ....... -- -- -- -- -- -- (1,847) -- -- (1,847)
Repayment of
stockholder note... -- -- -- -- -- -- 86 -- -- 86
Forgiveness of
stockholder note... -- -- -- -- -- -- 11 -- -- 11
Net loss........... -- -- -- -- -- -- -- -- (329,875) (329,875)
------- ---- ------ ---- ---------- -------- -------- ------ --------- ----------
Balances September
30, 2000........... -- $-- 79,684 $80 $2,094,566 $(13,310) $(2,264) $5,850 $(402,937) $1,681,985
======= ==== ====== ==== ========== ======== ======== ====== ========= ==========
</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
(In thousands)
<TABLE>
<CAPTION>
Year Ended September 30,
------------------------------
1998 1999 2000
-------- -------- ----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss $(16,764) $(50,938) $(329,875)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization................. 547 1,735 190,180
Amortization of capital lease obligations..... 263 1,507 951
Stock compensation expense.................... 487 3,207 2,662
Bad debt expense.............................. 111 472 2,244
Amortization of discounts on investments...... (227) (817) (5,935)
Common stock issued pursuant to a settlement
agreement.................................... 18 -- 1,388
Loss on disposal of property and equipment.... 2 5 --
Change in operating assets and liabilities:
Accounts receivable.......................... (700) (3,367) (16,571)
Inventory.................................... -- -- 326
Prepaid expenses and other................... (98) (1,673) (21,875)
Deferred offering costs...................... (132) 132 --
Other assets................................. (68) (1,138) (1,014)
Accounts payable ............................ 486 6,213 13,383
Accrued liabilities.......................... 394 4,215 (1,447)
Deferred revenue............................. 2 717 984
Interest payable............................. -- -- 2,588
Other liabilities............................ -- -- 613
-------- -------- ----------
Net cash used in operating activities....... (15,679) (39,730) (161,398)
-------- -------- ----------
Cash flows from investing activities:
Purchases of property and equipment........... (1,234) (14,337) (130,523)
Proceeds from maturities of investments....... 5,600 31,478 146,787
Decrease (increase) in restricted cash........ 121 (500) (10,075)
Business acquisitions. net of cash acquired... -- -- (19,136)
Purchases of investments...................... (13,513) (52,229) (517,932)
-------- -------- ----------
Net cash used in investing activities....... (9,026) (35,588) (530,879)
-------- -------- ----------
Cash flows from financing activities:
Proceeds from issuance of preferred stock,
net.......................................... 25,328 47,462 --
Proceeds from issuance of common stock, net... 156 64,115 500,574
Proceeds from bank borrowings................. 647 532 --
Repayments of bank borrowings................. (199) (570) (5,699)
Repayments of capital lease obligations....... (100) (1,557) (9,004)
Repayment of stockholder note................. -- 110 97
Issuance of notes to officers................. -- (228) --
Proceeds from issuance of convertible notes,
net.......................................... -- -- 334,059
Cash overdraft................................ -- 3,058 5,864
-------- -------- ----------
Net cash provided by financing activities... 25,832 112,922 825,891
-------- -------- ----------
Net increase in cash and cash
equivalents.............................. 1,127 37,604 133,614
Cash and cash equivalents, beginning of
period..................................... 4,584 5,711 43,315
-------- -------- ----------
Cash and cash equivalents, end of period....... $ 5,711 $ 43,315 $ 176,929
======== ======== ==========
Supplemental disclosures of cash flow
information:
Cash paid for interest........................ $ 129 $ 494 $ 10,983
======== ======== ==========
Cash paid for income taxes.................... $ 2 $ 2 $ 16
======== ======== ==========
Supplemental schedule of noncash investing and
financing activities:
Common stock issued pursuant to a settlement
agreement.................................... $ 18 $ -- $ 1,388
======== ======== ==========
Receivable on bank borrowings................. $ 532 $ -- $ --
======== ======== ==========
Conversion of preferred stock into common
stock........................................ $ -- $ 25 $ --
======== ======== ==========
Note receivable issued in exchange for common
stock........................................ $ 110 $ 286 $ --
======== ======== ==========
Capital lease obligations for equipment....... $ 2,406 $ 9,227 $ 16,267
======== ======== ==========
Fixed asset acquired in exchange for stock.... $ -- $ -- $ 7,965
======== ======== ==========
Patent acquired in exchange for stock......... $ -- $ -- $ 2,000
======== ======== ==========
Acquisition of subsidiaries in exchange for
stock........................................ $ -- $ -- $1,425,892
======== ======== ==========
Long-term bank borrowings assumed from
SoftAware acquisition........................ $ -- $ -- $ 4,500
======== ======== ==========
Warrants issued in exchange for services...... $ -- $ -- $ 2,785
======== ======== ==========
Warrants issued under financing arrangements.. $ -- $ -- $ 3,065
======== ======== ==========
</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
1. The Company:
Digital Island, Inc. and Subsidiaries (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:
Principles of Consolidation:
The accompanying consolidated financial statements ot the Company include
the accounts of Digital Island, Inc. and its wholly-owned subsidiaries,
Sandpiper Networks, Inc., Live On Line, Inc., SoftAware, Inc., Digital Island
B.V., Digital Island Ltd., Digital Island (Europe) SA, Digital Island (Hong
Kong), Ltd., Digital Island (Japan) KK and Digital Island GmbH, (collectively,
"Digital Island"). All 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.
Revenue Recognition:
Revenues are comprised primarily of bandwidth charges, equipment co-location
and storage fees, professional services, streaming events, equipment sales and
one-time fees for installation if required to provide services. Bandwidth
charges are billed and recognized monthly based on customer usage. Professional
services and fees for streaming events are billed and recognized as the related
services are performed. Equipment sales are recognized when the equipment is
delivered. All other revenues are based on flat-rate monthly charges and
recognized as the related services are performed. Installation fees are
generally paid in advance, and are recognized ratably over the term of the
related contract, generally one to three years.
Computation of Historical Net Loss Per Share:
In accordance with Statement of Financial Accounting Standards No. 128 (SFAS
128), "Earnings per Share", 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.
Diluted net loss per share for the years ended September 30, 1998, 1999 and
2000 does not include the effect of 2,993,765, 3,847,569, and 11,475,880 stock
options, respectively, and 95,000, 0, and 120,393 common stock warrants,
respectively, or 13,305,657, 0, and 0 shares of convertible preferred stock on
an "as if converted" basis, respectively, as the effect of their inclusion is
antidilutive during each period.
F-7
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 that
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, accounts payable and
accrued liabilities approximate fair value due to their short maturities.
The Company estimates the fair value of the convertible notes using those
interest rates that are currently available to it for issuance of debt with
similar terms and remaining maturities. At September 30, 2000, the estimated
fair value of the convertible notes approximated carrying value.
Investments:
Investments in marketable securities 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 debt 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.
The Company's investments in marketable securities consist of the following
(in thousands):
<TABLE>
<CAPTION>
September 30, 1999 September 39, 2000
-------------------- ------------------
Amortized Amortized Fair
Cost Fair Value Cost Value
--------- ---------- --------- --------
<S> <C> <C> <C> <C>
Corporate debt securities........... $31,691 $31,683 $271,931 $271,994
Government treasury and agency ..... -- -- 140,790 140,901
</TABLE>
The Company has made minority investments in preferred stock of technology
companies. None of these investments represent an ownership exceeding 10% and
the Company does not have the ability to exercise significant influence over
the operating activities of the investees. The Company carries these
investments at the lower of cost or market. The cost of these investments was
$950,000 at September 30, 2000.
Inventory:
Inventory is stated at the lower of cost (first-in, first-out) or market.
All inventory is classified as raw materials.
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.
F-8
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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. 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.
Goodwill:
Goodwill as of September 30, 1999 and 2000 was $0 and $1.1 billion,
respectively. Goodwill is being amortized on a straight-line basis over its
estimated useful life of 5 years. If it became probable that the projected
future undiscounted cash flows of acquired assets were less than the carrying
value of the goodwill, the Company would recognize an impairment loss in
accordance with the provisions of SFAS 121.
Amortization of goodwill, was $0, $18,000 and $141.5 million for the years
ended September 30, 1998, 1999 and 2000, respectively. Goodwill has increased
in the year ended September 30, 2000 due to the acquisitions of Sandpiper, Live
On Line and SoftAware as discussed in Note 3.
Intangible Assets:
Intangible assets as of September 30, 1999 and 2000 were $147,000 and $170.1
million, respectively, and consist primarily of acquisition-related items and
patents. Intangible assets are being amortized on a straight-line basis over
their estimated useful lives of 5 years. Amortization of intangible assets was
$0, $18,000 and $19.9 million for the years ended September 30, 1998, 1999 and
2000, respectively. Intangible assets have increased in the year ended
September 30, 2000 due to the acquisitions of Sandpiper, Live On Line and
SoftAware as discussed in Note 3.
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.
F-9
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 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
installation fees paid by customers that are recognized ratably over the term
of the related contract.
Concentration of Credit Risk:
Financial instruments that 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 four major
financial institutions.
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, 1998, three
customers accounted for approximately 13%, 20%, and 12%, respectively, of all
revenue generated by the Company. For the year ended September 30, 1999, the
same customers accounted for approximately 4%, 35%, and 4%, respectively, of
all revenues generated by the Company, and 6%, 41%, and 3%, respectively, of
accounts receivable at September 30, 1999. For the year ended September 30,
2000, the same customers accounted for approximately 1%, 24%, and 1%,
respectively, of all revenues generated by the Company, and 2%, 11%, and 4%,
respectively, of accounts receivable at September 30, 2000.
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 service introductions
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 has had no impact on the Company's financial statements for the
periods presented, as net loss equals comprehensive loss.
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
F-10
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
As of September 30, 2000, the Company had property and equipment of $140.7
million and $26.1 million located in the U.S.A. and in foreign locations,
respectively. As of September 30, 1999, the Company had property and equipment
of $20.9 million, $2.8 million and $1.6 million located in the U.S.A., United
Kingdom and in other foreign locations, respectively. Due to the nature of the
Company's business, it is difficult to determine the country in which revenues
are sourced. Therefore, it is impracticable to report revenues by geographic
segment.
Reclassifications:
Certain reclassifications have been made to the prior year balances in order
to conform to the September 30, 2000 presentation.
Recently Issued Accounting Pronouncements:
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. In June 1999, the FASB
issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities
Deferral of Effective Date of FASB Statement No. 133," which deferred the
effective date of SFAS 133 to all fiscal quarters of fiscal years beginning
after June 15, 2000. We do not believe the adoption of SFAS 133 will have a
material effect on our consolidated results of operations or financial
condition.
In December 1999, the Securities Exchange Commission issued Staff Accounting
Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101").
SAB 101 is effective no later than the quarter ended September 30, 2001. The
Company has not completed its assessment but does not expect that the adoption
of SAB 101 will have a material effect on our consolidated results of
operations or financial position.
3. Acquisitions:
On December 28, 1999, the Company merged with Sandpiper Networks, Inc.
(Sandpiper). The acquisition price included approximately 24.6 million shares
of the Company's common stock with a fair market value of $857.0 million, 3.1
million vested and unvested stock options and warrants with a fair market value
of $96.6 million and direct transaction costs of $14.0 million. The transaction
was accounted for as a purchase and resulted in intangible assets of $2.0
million of assembled workforce. $121.1 million of core technology and $850.8
million of goodwill, which are being amortized on a straight-line basis over a
period of 5 years.
On January 18, 2000, the Company acquired Live On Line, Inc. (Live On Line).
The acquisition price included 799,989 shares of the Company's common stock
with a fair market value of $65.9 million and $5.2 million in cash. The
transaction was accounted for as a purchase and resulted in intangible assets
of $500,000 of assembled workforce, $3.1 million of core technology and $67.4
million of goodwill, which are being amortized on a straight-line basis over a
period of 5 years. Had the acquisition occurred at the beginning of the fiscal
year in which the acquisition was completed, or the beginning of the
immediately preceding year, combined pro forma revenue and net income would not
have been materially different from that currently being reported.
F-11
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
On September 15, 2000, the Company acquired SoftAware, Inc. (SoftAware). The
acquisition price included 9,301,892 shares of the Company's common stock with
a fair market value of $390.5 million, 73,108 vested and unvested stock options
with a fair market value of $3.0 million, $20.0 million in cash and estimated
direct transaction costs of approximately $5.2 million. The fair value of the
common stock options was estimated using the value of the underlying common
stock of $41.98, risk-free interest rate of 5.8%, expected life of 4.5 years,
expected dividend rate of 0% and volatility rate of 205%. The transaction was
accounted for as a purchase and resulted in intangible assets of $44.0 million
of customer relationship, $10.3 million of software and technology, $2.1
million of assembled workforce, $3.4 million of trademarks and tradenames,
$343.2 million of goodwill and $11.9 million of deferred compensation. The
acquired intangible assets will be amortized over their estimated useful lives
of five years. Deferred compensation will be amortized over the remaining
vesting terms of the related unvested common shares and unvested options using
the amortization method under FIN 28.
The following unaudited pro forma combined summary financial information is
based on the historical consolidated results of operations of the Company,
Sandpiper, and SoftAware as if the Sandpiper and SoftAware acquisitions had
occurred as of the beginning of each year presented. This pro forma financial
information is presented for informational purposes only and may not be
indicative of what the actual consolidated results of operations would have
been if the acquisitions had been effective as of the beginning of the years
presented. Pro forma adjustments were applied to the respective historical
financial statements to account for the Sandpiper and SoftAware acquisitions as
purchases. Under purchase accounting, the purchase price is allocated to
acquired assets and liabilities based on their estimated fair values at the
date of acquisition, and any excess is allocated to goodwill.
<TABLE>
<CAPTION>
Pro Forma
September 30,
--------------------
1999 2000
--------- ---------
(in thousands,
except
per-share amounts)
<S> <C> <C>
Revenue............................................... $ 19,306 $ 73,232
Net loss from operations.............................. $(350,018) $(537,698)
Net loss.............................................. $(348,184) $(525,187)
Basic and diluted net loss per share.................. $ (18.29) $ (7.69)
</TABLE>
4. Property and Equipment:
Property and equipment consists of the following (in thousands):
<TABLE>
<CAPTION>
September 30,
----------------
1999 2000
------- --------
<S> <C> <C>
Network equipment and technology........................... $ 7,404 $ 66,180
Communications equipment................................... 217 2,826
Computer equipment and software............................ 3,316 40,265
Furniture, fixtures, and leasehold improvements............ 6,339 59,262
Equipment and fixtures under capital leases................ 12,189 29,916
------- --------
29,465 198,449
Less accumulated depreciation and amortization............. 4,192 31,683
------- --------
Total property and equipment, net.......................... $25,273 $166,766
======= ========
</TABLE>
F-12
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Income Taxes:
For the years ended September 30, 1998, 1999, and 2000, the provision for
income taxes consists of state taxes.
The primary components of the net deferred tax asset are as follows (in
thousands):
<TABLE>
<CAPTION>
September 30,
------------------
1999 2000
-------- --------
<S> <C> <C>
Deferred tax asset:
Net operating loss carryforwards, federal and state... $ 26,999 $ 95,725
Accrued employee benefits............................. 274 1,031
Sales tax............................................. 2 160
Accounts receivable allowance......................... 152 932
Deferred revenue...................................... 267 --
-------- --------
Deferred tax asset.................................... 27,964 97,848
Deferred tax liability:
Property and equipment................................ 1,628 807
Intangible assets..................................... -- 67,174
-------- --------
Deferred tax liability................................ 1,628 67,981
-------- --------
Net deferred tax asset.................................. 26,066 29,867
Less valuation allowance................................ (26,066) (29,867)
-------- --------
$ -- $ --
======== ========
</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 $17.7 million in the year ended September 30, 1999 and
increased by $3.8 million for the year ended September 30, 2000.
The effective income tax rate differs from the statutory federal income tax
rate primarily due to the Company's full valuation allowance against its
deferred tax assets.
At September 30, 2000, the Company had NOL carryforwards of approximately
$257.8 million and $134.7 million 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 limitations due to a greater than 50%
change in the ownership of the Company which occurred during fiscal 2000.
F-13
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
6. Bank Borrowings:
Bank borrowings consist of (in thousands):
<TABLE>
<CAPTION>
September
30,
-------------
1999 2000
------ -----
<S> <C> <C>
Line of credit............................................... $ 230 $ --
Revolving credit facility.................................... 323 --
Equipment term facility...................................... 562 --
------ -----
1,115 --
Current maturities........................................... (801) --
------ -----
Long-term bank borrowings.................................... $ 314 $ --
====== =====
</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. The Revolving Agreement expired in May 2000. At that time,
the Company chose not to extend the term on this line of credit. Interest under
the Revolving Agreement was 0.75% over the "Prime Rate" as announced from time
to time by the lender. At September 30, 1999, the effective interest rate was
9.00% . The weighted average interest rates for the years ended September 30,
1999 and 2000, were 8.61%, and 9.23%, 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, 1999 and
2000 were $323,000, and $0, respectively. All amounts outstanding related to
advances for equipment purchases. All balances related to the Revolving
Agreement were fully paid during the year ended September 30, 2000.
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
million line of credit, as well as an equipment loan term facility for $2.5
million. Any borrowings under this line of credit were 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. Outstanding borrowings
under the Revolving Agreement at September 30, 1999 and 2000 were $230,000 and
$0, respectively. Interest on borrowings was charged at the lender's prime rate
plus 0.25%, which was 8.50% at September 30, 1999. The weighted average
interest rates for the years ended September 30, 1999 and 2000 were 8.13% and
8.95%, respectively. Advances under the line of credit could be repaid and
reborrowed at any time until the maturity date of May 31, 2000. All balances
related to this line of credit were fully paid during the year ended September
30, 2000.
Under the terms of the equipment loan term facility, the Company had the
ability to borrow up to $1.25 million for equipment purchases from November 19,
1997 to May 19, 1998 (Equipment Line A), as well as borrow an additional $1.25
million from February 1, 1998 to September 30, 1998 (Equipment Line B). At
September 30, 1999 and 2000, $140,000 and $0, respectively, was outstanding
related to advances made under Equipment Line A, and $422,000 and $0,
respectively, was outstanding related to advances made under Equipment Line B.
Interest on these borrowings were charged at the lender's prime rate plus
0.75%, which was 9.00% at September 30, 1999. The weighted average interest
rates for the years ended September 30, 1999 and
F-14
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
2000 were 8.61% and 9.24%, 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. All balances related to the
equipment loan term facility were fully paid during the year ended September
30, 2000.
The Company did not comply with certain financial covenants 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. Since the date of this most recent waiver the Company has been in
compliance with all covenants.
Upon the acquisition of Sandpiper, the Company assumed from Sandpiper a $1
million line of credit with a bank. The line of credit has a variable rate of
interest, based on the bank's prime rate plus 0.5%. At September 30, 2000, no
amounts were extended under this facility.
Interest expense related to bank borrowings for the years ended September
30, 1998, 1999 and 2000 was $94,000, $123,000, and $257,000, respectively.
7. Convertible Notes:
On February 23, 2000, the Company completed an offering of convertible
subordinated notes. The Company issued convertible subordinated notes for net
proceeds of approximately $334.3 million. The notes bear interest at a rate of
6% per annum, which is paid twice a year, on each February 15 and August 15.
The notes mature on February 15, 2005. The notes are convertible into the
Company's common stock at any time prior to the maturity date at a conversion
price of approximately $131.61 per share. If notes are converted into shares of
common stock, the holder will receive approximately 7.5 shares (subject to
certain adjustments) for each $1,000 in notes that are converted. Interest
expense related to convertible notes for the year ended September 30, 2000 was
$12.1 million.
Debt issuance costs related to the convertible notes are being amortized
over the term of the notes. The amortized convertible note issuance costs at
September 30, 1999 and 2000 was $0 and $9.7 million, respectively. Amortization
of convertible note issuance costs was $0, $0 and $l.2 million, for the years
ended September 30, 1998, 1999 and 2000, respectively.
8. Accrued Liabilities:
Accrued liabilities consist of the following (in thousands):
<TABLE>
<CAPTION>
September 30,
--------------
1999 2000
------ -------
<S> <C> <C>
Employee compensation........................................ $2,254 $ 5,629
Fixed asset purchases........................................ -- 9,591
Other accrued liabilities.................................... 2,677 6,632
------ -------
Total...................................................... $4,931 $21,852
====== =======
</TABLE>
F-15
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
9. Commitments and Contingencies:
Leases:
The Company leases office space under noncancelable operating leases
expiring through September 2020. Rent expense for the years ended September 30,
1998, 1999, and 2000, was $715,000, $3.2 million, and $12.6 million,
respectively.
The Company also leases equipment and fixtures under capital leases
agreements. At September 30, 1999 and 2000, $10.0 million and $20.2 million,
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 (in thousands):
<TABLE>
<CAPTION>
Year ending September Operating Capital
--------------------- --------- --------
<S> <C> <C>
2001..................................................... $ 20,938 $ 10,859
2002..................................................... 25,583 7,895
2003..................................................... 24,408 2,441
2004..................................................... 22,031 --
2005..................................................... 18,441 --
Thereafter............................................... 141,706 --
-------- --------
Total minimum lease payments............................. $253,107 $ 21,195
======== ========
Less amounts representing interest....................... 959
--------
Present value of minimum lease payments.................. 20,236
Less current portion of capital lease obligations........ 10,159
--------
Long-term portion of capital lease obligations........... $ 10,077
========
</TABLE>
Carrier Line Agreements:
The Company has entered into various bandwidth capacity agreements with
domestic and foreign carriers. These agreements are generally cancelable and
provide for termination fees if cancelled by the Company prior to expiration.
Litigation:
In the normal course of business, the Company is subject to various legal
matters. In the opinion of management, the resolution of these matters will not
have a material adverse effect on the operations, cash flows, and financial
position of the Company.
On September 13, 2000, Akamai Technologies, Inc. ("Akamai") and
Massachusetts Institute of Technology ("MIT") filed a Complaint in the U.S.
District Court of Massachusetts (No. 00ev1181RWZ) alleging that the Company
infringes U.S. Patent No. 6,108,703 (the "703 Patent"). Based on a preliminary
investigation, the Company believes that it has meritorious defenses to Akamai
and MIT's claim and intends to vigorously defend itself in any litigation that
arises from this claim. In addition, because the Company believes that it was
the first to invent the technologies claimed in the 703 Patent, it has
instituted proceedings with the U.S. Patent and Trademark Office to confirm its
ownership of any such inventions.
On September 20, 2000, Akamai filed a Motion in U.S. District Court of
Massachusetts requesting Leave to File A Second Amended Complaint in which it
alleges that the Company infringes U.S. Patent No. 6,003,030 (the "030
Patent"), which Motion was granted by the Court. Based on a preliminary
F-16
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
investigation, the Company believes that it has meritorious defenses to
Akamai's claim and intends to vigorously defend itself in any litigation that
arises from this claim. On October 18, 2000 Akamai and MIT filed a motion in
the U.S. District Court of Massachusetts requesting that the Company be
enjoined from offering for sale its Footprint 2.0 content delivery service. The
Company believes that it has meritorious defenses to Akamai and MIT's request
for preliminary injunctive relief and intends to vigorously oppose Akamai and
MIT's request.
10. Earnings Per Share:
The following is a reconciliation of the numerator and denominator of basic
and diluted earnings per share (EPS):
<TABLE>
<CAPTION>
Years Ended September 30,
------------------------------------
1998 1999 2000
---------- ----------- -----------
<S> <C> <C> <C>
Numerator--Basic and Diluted EPS
Net Loss (in thousands)................ $ (16,764) $ (50,938) $ (329,875)
========== =========== ===========
Denominator--Basic and Diluted EPS
Weighted average Common Stock
outstanding........................... 2,361,010 11,280,534 59,911,136
Common Stock subject to repurchase..... (124,558) (153,072) (914,201)
---------- ----------- -----------
Total weighted average Common Stock
outstanding........................... 2,236,452 11,127,462 58,996,935
========== =========== ===========
Basic and diluted loss per share......... $ (7.50) $ (4.58) $ (5.59)
========== =========== ===========
</TABLE>
11. Stockholders' Equity:
In June 1999, the Company completed its initial public offering (IPO) of
6,000,000 shares of its common stock. Subsequent to the IPO, the underwriters
purchased an additional 900,000 shares to cover over-allotments. The net
proceeds to the Company after deducting underwriting discounts and commissions
and offering expenses, was approximately $63.1 million. In conjunction with the
IPO, all shares of Series A, B, C, D, and E convertible preferred stock were
converted to common stock. Immediately prior to this conversion, an additional
178,138 shares of Series D preferred stock were issued in accordance with
certain anti-dilution provisions. All of these additional shares were converted
into common stock. In addition, all outstanding warrants were exercised prior
to the IPO for 95,000 shares of common stock.
In June 1999, the Company was reincorporated in the state of Delaware.
Pursuant to the reincorporation, each share of common and preferred stock of
the Company's California predecessor entity was 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 increased 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
Convertible preferred stock issued and outstanding prior to the IPO was as
follows:
<TABLE>
<CAPTION>
Liquidation
Shares Issued and Value (in
Series Designated Outstanding thousands)
------ ---------- ----------- -----------
<S> <C> <C> <C>
A......................................... 4,000,000 4,000,000 $ 4,000
B......................................... 3,000,000 3,000,000 $ 7,500
C......................................... 4,300,000 4,283,181 $14,777
D......................................... 2,700,000 2,200,614 $10,618
E......................................... 11,764,706 11,764,706 $50,000
---------- ---------- -------
25,764,706 25,248,501 $86,895
========== ========== =======
</TABLE>
F-17
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
In December 1999, Sun Microsystems, Inc. (Sun) purchased 391,869 shares in
the Company for $20.0 million. Sun also extended to the Company a $100 million
credit facility for the acquisition of Sun equipment, under the terms of the
Master Lease Line of Credit and Warrant Agreement (the Sun Agreement). The
terms of the Sun Agreement calls for the credit to be made available upon the
achievement of certain milestones. As of September 30, 2000, $30 million of
lease financing has been made available under this agreement. The achievement
of these milestones also triggers granting of warrants to Sun to purchase up to
a maximum of $10 million worth of the Company's common stock (see Note 14). Sun
and the Company have also agreed to a joint marketing campaign to be partially
funded by Sun. The credit facility and the acquisition of Sun equipment are
accounted for as a capital lease. The fair value of warrants granted under the
agreement is recorded as debt discount. At September 30, 2000, $1.8 million was
owed by the Company under the Sun Agreement.
In December 1999, Inktomi Corporation (Inktomi) purchased 117,561 shares in
the Company for $6.0 million under the terms of a Strategic Alliance agreement.
The terms of this agreement also call for a joint marketing campaign to be
partially funded by lnktomi. The Company has previously licensed certain
products from Inktomi in the ordinary course of business, under the terms of
the Inktomi License Agreement (License Agreement) which was executed in January
1999. The Company has agreed to license additional products under the terms of
an amendment to the License Agreement that was executed in December 1999.
Payments made by the Company under the joint marketing campaign are recorded as
sales and marketing expenses as incurred.
In December 1999, the Company agreed to purchase patented technology from
SRI International (SRI). Under the terms of the agreement, the Company acquired
the technology in exchange for $6.0 million of common stock, to be distributed
upon the occurrence of certain milestones. In November 1999, the Company issued
120,434 shares of common stock with a value of $6.0 million in accordance with
the agreement. In addition, the Company agreed to issue $4.0 million of common
stock in exchange for consulting services from SRI. In August 2000, the Company
issued 92,219 shares with a value of $2.0 million in accordance with the
agreement. The value of stock issued under the agreement is recorded as network
equipment and technology.
In February 2000, the Company completed a public offering of its common
stock. The Company issued 4,014,273 shares of common stock for net proceeds of
approximately $409.7 million.
In June 2000, Compaq Computer Corporation (Compaq), Microsoft Corporation
(Microsoft) and Intel Corporation (Intel) each purchased 618,556 shares in the
Company for approximately $15.0 million under the terms of a Strategic Alliance
agreement. The terms of this agreement also calls for joint marketing campaigns
to be partially funded by Compaq, Microsoft and Intel. The agreement centers
around the build-out of the Company's infrastructure to support expanded
streaming media services. The Company had committed to the deployment of 8,000
Compaq servers that will contain Intel architecture and be powered by Microsoft
technology. Compaq, Microsoft and Intel each received warrants to purchase up
to 185,567 shares of Company's common stock at an exercise price of $24.25 per
share which become exercisable only if the Company fails to meet certain
milestones connected to the infrastructure build-out. If these warrants become
exercisable, they will be valued using the Black-Scholes model and recorded as
infrastructure expense in cost of revenue. Compaq also agreed to extend to the
Company a $50 million equipment credit facility, which may be increased to $80
million under certain circumstances, for the purchase of Compaq servers, as
well as providing a $50 million in lease financing to customers of the Company.
The credit facility and the acquisition of Compaq equipment will be accounted
for as a capital lease.
In June 2000, the Company issued 738,688 shares of common stock for
approximately $15 million in cash to UBS O'Connor LLC. These shares were issued
at fair market value.
In September 2000, the Company purchased a 50% undivided interest in
patented technology from Kinetech, Inc. (Kinetech). Under the terms of the
agreement, the Company acquired the interest in the patent in
F-18
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
exchange for 72,316 shares of common stock valued at $2.0 million at the date
of the agreement. The value of stock issued under the agreement was recorded as
an intangible asset.
12. Stock Plans:
Stock Option Plans:
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 and February 1999, the Company increased the stock
option pool by another 600,000 shares and 1,000,000 shares, respectively,
bringing the total to 5,433,284. This number of shares was reserved for
issuance under the 1998 Plan. In June 1999, concurrent with the IPO, the
Company adopted the 1999 Stock Incentive Plan (the 1999 Plan). The 1999 Plan
was designed 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, were
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 2,110,716 shares of common stock were reserved for issuance. In
January 2000 and April 2000, another 2,000,000 and 3,000,000 shares,
respectively, were reserved for issuance. A total of 12,544,000 shares are now
reserved for issuance.
Under the terms of the 1999 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
ratably 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. The plan provides that management can grant employees 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 September 30, 1998,
1999 and 2000, 254,125, 205,700 and 914,201 shares of common stock were subject
to repurchase by the Company.
F-19
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A summary of the activity under the 1997 Plan, the 1998 Plan and the 1999
Plan for the three years ended September 30, 2000 is as follows:
<TABLE>
<CAPTION>
Weighted
Aggregate Average
Exercise Price Exercise Exercise
Shares Per Share Price Price
---------- --------------- ------------ --------
<S> <C> <C> <C> <C>
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................... 2,412,350 $3.35 - $26.00 19,109,274 7.92
Exercised................. (1,178,391) $0.40 - $9.90 (1,142,950) 0.97
Terminated (380,155) $0.40 - $10.00 (1,167,204) 3.07
---------- --------------- ------------ -------
Outstanding at September 30,
1999....................... 3,847,569 $0.40 - $26.00 20,358,821 5.29
Granted................... 6,811,752 $4.67 - $137.69 245,173,384 35.99
Assumed in business
acquisitions............. 3,124,685 $0.07 - $9.09 18,206,306 5.83
Exercised................. (1,328,496) $0.07 - $67.15 (2,607,255) 1.96
Terminated................ (979,630) $0.07 - $137.69 (18,035,086) 18.41
---------- --------------- ------------ -------
Outstanding at September 30,
2000....................... 11,475,880 $0.07 - $137.69 $263,096,170 $ 22.93
========== =============== ============ =======
</TABLE>
The Company accounts for the 1997 Plan, the 1998 Plan, and the 1999 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 value on the date of grant of employee stock
options granted between May 1, 1998 and April 21, 1999 was in excess of the
exercise price of the options. Consequently, the Company recorded deferred
compensation of $2.0 million for the year ended September 30, 1998, and an
additional $5.7 million for the year ended September 30, 1999. Of the total
deferred compensation, $487,000, $3.2 million, and $2.4 million was amortized
during the years ended September 30, 1998, 1999 and 2000, respectively.
At September 30, 2000 options to purchase 2,075,631 shares of common stock
were exercisable with a weighted average exercise price of $9.73.
At September 30, 2000, options to purchase 1,387,958 shares of common stock
remain available for issuance.
The following summarizes information with respect to stock options
outstanding at September 30, 2000:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------- --------------------
Weighted Average Weighted Weighted
Remaining Average Average
Range of Number Contractual Exercise Number Exercise
Exercise Prices Outstanding Life (Years) Prices Exercisable Prices
--------------- ----------- ------------------- -------- ----------- --------
<S> <C> <C> <C> <C> <C>
$0.07 - $1.72 1,593,858 7.45 $ 0.93 637,742 $ 1.12
$1.87 - $4.25 1,742,516 8.52 $ 3.52 655,123 $ 3.76
$4.67 - $10.00 1,233,083 9.06 $ 6.79 349,290 $ 9.38
$17.19 - $17.19 1,970,416 9.65 $ 17.19 79,315 $ 17.19
$18.34 - $25.38 1,277,298 9.65 $ 22.16 82,097 $ 21.08
$25.88 - $28.69 1,234,594 9.57 $ 26.32 74,923 $ 25.90
$29.69 - $49.44 1,357,664 8.89 $ 40.02 177,184 $ 39.28
$54.46 -
$110.19 926,951 9.29 $ 87.40 18,898 $ 85.56
$116.13 -
$116.13 99,000 9.41 $116.13 217 $116.13
$137.69 -
$137.69 40,500 9.21 $137.69 842 $137.69
</TABLE>
F-20
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following information concerning the Company's 1999 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, 1998, 1999 and 2000:
<TABLE>
<CAPTION>
September 30, September 30, September 30,
1998 1999 2000
------------- ------------- -------------
<S> <C> <C> <C>
Risk-free interest rates........... 4.23%-6.08% 5.80% 6.20%
Expected life...................... 5 years 4 years 4 years
Expected dividend yield............ -- -- --
Expected volatility................ -- 80% 189%
</TABLE>
The weighted average fair value for options granted was $0.36, $1.71 and
$33.92 for the years ended September 30, 1998, 1999 and 2000, respectively.
The pro forma net loss for the Company for the years ended September 30,
1998, 1999 and 2000, following the provisions of SFAS 123, was $16.8 million,
$51.6 million and $364.6 million, respectively. The pro forma basic and diluted
net loss per share for the years ended September 30, 1998, 1999 and 2000 was
$7.53, $4.63 and $6.18, respectively.
Employee Stock Purchase Plan:
In June 1999, the Company 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 commenced on July 1, 1999. A total of 300,000
shares are reserved for issuance under the 1999 ESPP. At September 30, 2000 a
total of $788,000 had been withheld from employees for future purchases under
this plan.
13. Stockholder Notes 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 Director exercised the option to purchase the entire
183,000 shares of common stock, in exchange for a $109,800 note (the Note). The
Note was secured by the 183,000 shares of common stock and by other assets of
the Director. Under the terms of the note, interest was accrued at 5.61% per
annum. Interest was to be repaid in four equal annual installments commencing
February 24, 1999. The entire principal amount was due and payable in one lump
sum on February 24, 2002. In August 1999, the Director extinguished the Note by
paying the full amount of principal and accrued interest. At September 30,
2000, a total of 68,625 shares of the Director's stock were subject to
repurchase. The Company has not elected to repurchase any of these shares.
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. 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
F-21
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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. In December 1999, one of the executive
officers repaid the entire principal balance of this Note. The amount repaid,
$86,400, related to 216,000 shares.
On June 14, 1999, one of the executive officers who had exercised options on
April 20, 1999 in exchange for a full-recourse note, 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 20, 1999 for 133,332 shares of
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 20, 1999
promissory note, as well as other assets. 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 20,
1999 note.
In July 1999, the Company loaned an officer of the Company $100,000. The
loan is interest free, with $50,000 being forgiven ratably over a period of
five years. At the end of the five-year term, the $50,000 portion of the loan
that has not been forgiven is to be repaid in one lump sum. In the event that
the officer's employment terminates during the five-year period, the
outstanding unforgiven balance of the loan is to be repaid at the time of the
termination. The amount being forgiven, plus imputed interest are charged to
operations.
In September 2000, the Company acquired $1.8 million of full-recourse notes
payable in connection with the acquisition of SoftAware (see Note 3). The full-
recourse notes payable were issued for the exercise of 861,677 SoftAware stock
options and accrue interest at a rate of 6.5% per annum, compounded semi-
annually. The principal balance will become due and payable in one lump sum at
the end of the three-year term of each note. The notes payable are secured by
the shares as well as other assets. The common stock issued in those
transactions is subject to a four year vesting term. The notes payable were
issued at a below market interest rate. Aggregate compensation expense of
$53,000 will be recorded over the vesting term of the common stock.
14. Warrants:
In connection with the issuance of certain convertible notes, 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 was equal to $0.10 per share. The warrants were
due to 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. 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. In June 1999,
prior to the IPO, the warrants were exercised.
In December 1999, the Company entered into a Co-Location and Content
Distribution Agreement with ServiceCo LLC (ServiceCo). The agreement allows the
Company to physically locate its servers in ServiceCo regional data center
facilities. The term of the agreement is two years. In connection with the
agreement, the Company granted warrants to ServiceCo to purchase 53,634 shares
of common stock of the Company upon the achievement of specified performance
criteria. The exercise price is $96.95 per share. The charge associated with
the warrants, determined based on the use of the Black-Scholes valuation
method, is currently valued at
F-22
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
$2.8 million. The charge will be amortized over the term the services are
rendered, which is the term of the agreement, and is subject to remeasurement
at the end of each accounting period. In the year ended September 30, 2000, a
charge of $652,000 was recorded.
In connection with the achievement of certain milestones in the Master Lease
Line of Credit and Warrant Agreement with Sun (see Note 11), the Company issued
warrants to purchase shares of the Company's common stock. Warrants to purchase
66,759 shares of the Company's common stock were granted in July 2000 at an
exercise price of $44.9375 per share. The warrants are exercisable for a period
of four years from the date of grant. The fair value of the warrants was
determined using the Black-Scholes model and is accounted for as interest
expense over the term of the Sun Agreement. In the year ended September 30,
2000, a charge of $253,000 was recorded.
15. Related Party Transactions:
One equipment supplier also is a significant customer of the Company. For
the years ended September 30, 1998, 1999, and 2000, the Company earned
$310,000, $524,000, and $830,000, respectively, in revenue from sales to this
customer, and had $200,000, and $419,000 in total receivables at September 30,
1999 and 2000, respectively. The Company owed this customer $3.8 million and
$14.7 million at September 30, 1999 and 2000, respectively, under terms of a
master lease agreement, and also owed another $68,000 and $1.6 million,
respectively, in other trade-related payables. In addition, $0 and $9,000 of
the deferred revenue balance at September 30, 1999 and 2000, respectively,
related to this customer.
Another significant shareholder is also a customer of the Company. For the
years ended September 30, 1998, 1999, and 2000, the Company earned $458,000,
$4.4 million, and $14.3 million, respectively, in revenue from sales to this
customer, and had $1.4 million and $2.5 million in total receivables at
September 30, 1999 and 2000, respectively. In addition, $715,000 and $80,000 of
the deferred revenue balance at September 30, 1999 and 2000, respectively,
related to this customer.
16. 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 l%-15% of their
annual compensation to the Retirement Plan. Matching contributions by the
Company are discretionary. The Company has made no contributions during the
years ended September 30, 1998, 1999 and 2000.
17. Subsequent Events:
In November 2000, the Company issued 338,627 shares of common stock to SRI
International pursuant to the terms of the technology acquisition agreement
previously executed in November 1999 (see Note 11). This issuance of such
shares to SRI is an additional partial payment for consulting services related
to the acquired Internet technology.
In November 2000, the Company loaned an executive officer of the Company
$600,000 through the execution of 2 promissory notes. The first promissory note
is for $150,000 and accrues interest at 8% per annum. The first principal
payment of $100,000 is due upon the sale of the officer's previous residence.
The final principal payment, together with accrued interest is due in November
2001. The second promissory note is for $450,000 and accrues interest at 8% per
annum. Principal payments commence in November 2002 on a monthly basis until
the final payment date in November 2004. The proceeds of the loan are secured
by the officer's principal residence.
F-23
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Stockholders of Digital Island, Inc. and
Subsidiaries
We have audited the consolidated financial statements of Digital Island,
Inc. and Subsidiaries as of September 30, 2000 and 1999, and for each of the
three years in the period ended September 30, 2000, and have issued our report
thereon dated November 10, 2000. Our audits also included the financial
statement schedule listed in Item 14(a) of this Annual Report. This schedule is
the responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits.
In our opinion, the financial statement schedule referred to above, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information required to be
included therein.
/s/ PricewaterhouseCoopers LLP
San Francisco, California
November 10, 2000
S-1
<PAGE>
DIGITAL ISLAND, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Balance at Charged to Balance at
Beginning of Costs and End of
Description Period Expenses Deductions Period
----------- ------------ ----------- ---------- -----------
<S> <C> <C> <C> <C>
Year ended September 30, 1998:
Allowance for doubtful
accounts.................... $ -- $ 111,104 $ 56,104 $ 55,000
Deferred tax valuation
allowance................... $ 2,143,000 $ 6,218,000 $ -- $ 8,361,000
----------- ----------- --------- -----------
Total...................... $ 2,143,000 $ 6,329,104 $ 56,104 $ 8,416,000
=========== =========== ========= ===========
Year ended September 30, 1999:
Allowance for doubtful
accounts.................... $ 55,000 $ 471,602 $ 146,192 $ 380,410
Deferred tax valuation
allowance................... $ 8,361,000 $17,705,000 $ -- $26,066,000
----------- ----------- --------- -----------
Total...................... $ 8,416,000 $18,176,602 $ 146,192 $26,446,410
=========== =========== ========= ===========
Year ended September 30, 2000:
Allowance for doubtful
accounts.................... $ 380,410 $ 2,345,676 $ 396,617 $ 2,329,469
Deferred tax valuation
allowance................... $26,066,000 $ 3,801,000 $ -- $29,867,000
----------- ----------- --------- -----------
Total...................... $26,446,410 $ 6,146,676 $ 396,617 $32,196,469
=========== =========== ========= ===========
</TABLE>
S-2
