<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 10-Q/A
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 1999.
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 Number: 000-26283
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Digital Island, Inc.
(Exact name of Registrant as specified in its charter)
----------------
<TABLE>
<S> <C>
Delaware 68-0322824
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
</TABLE>
45 Fremont Street, Suite 1200, San Francisco, California 94105
(Address of principal executive offices) (zip code)
Registrant's telephone number, including area code: (415) 228-4100
----------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), Yes [X] No [_]
and (2) has been subject to such filing requirements for the past 90 days.
Yes [_] No [X]
As of January 31, 2000, there were 61,994,223 shares of the Registrant's
Common Stock outstanding, par value $0.001.
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<PAGE>
DIGITAL ISLAND, INC.
Form 10-Q Quarterly Report
For the Quarter Ended December 31, 1999
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
Number
------
<C> <S> <C>
PART I. Financial Information
Item 1 Financial Statements........................................ 3
Condensed Consolidated Balance Sheets as of September 30,
1999 and December 31, 1999 (unaudited)..................... 3
Condensed Consolidated Statements of Operations for the
three months ended December 31, 1998 and 1999 (unaudited).. 4
Condensed Consolidated Statements of Cash Flows for the
three months ended December 31, 1998 and 1999 (unaudited).. 5
Notes to Condensed Consolidated Financial Statements........ 6
Item 2 Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................. 8
Item 3 Quantitative and Qualitative Disclosures About Market Risk.. 13
PART II. Other Information
Item 1 Legal Proceedings........................................... 30
Item 2 Changes in Securities and Use of Proceeds................... 30
Item 3 Defaults Upon Senior Securities............................. 32
Item 4 Submission of Matters to a Vote of Security Holders......... 32
Item 5 Other Information........................................... 33
Item 6 Exhibits and Reports on Form 8-K............................ 33
Signatures............................................................ 35
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM I FINANCIAL STATEMENTS
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
<TABLE>
<CAPTION>
September 30, December 31,
1999 1999
------------- ------------
(Unaudited)
ASSETS
------
<S> <C> <C>
Current assets:
Cash and cash equivalents......................... $ 43,315 $ 18,181
Investments....................................... 31,691 18,923
Accounts receivable, net.......................... 3,557 6,964
Restricted cash................................... 763 763
Prepaid expenses and other........................ 1,825 5,213
-------- ----------
Total current assets............................ 81,151 50,044
Property and equipment, net......................... 25,273 54,297
Goodwill, net....................................... -- 847,998
Intangible assets, net.............................. -- 124,279
Other assets, net................................... 1,224 1,731
-------- ----------
Total assets.................................... $107,648 $1,078,349
======== ==========
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
<S> <C> <C>
Current liabilities:
Bank borrowings................................... $ 801 $ 840
Capital lease obligations......................... 3,916 5,520
Accounts payable.................................. 8,621 14,167
Accrued liabilities............................... 4,931 19,508
Cash overdraft.................................... 3,058 --
Deferred revenue.................................. 318 413
-------- ----------
Total current liabilities....................... 21,645 40,448
Bank borrowings, less current portion............... 314 216
Capital lease obligations, less current portion..... 6,061 7,553
Deferred revenue.................................... 410 335
Other liabilities................................... -- 50
-------- ----------
Total liabilities............................... 28,430 48,602
-------- ----------
Stockholders' equity:
Preferred stock, $0.001 par value: Authorized:
10,000,000 shares; no shares issued and
outstanding...................................... -- --
Common stock, $0.001 par value: Authorized:
100,000,000 shares; issued and outstanding:
35,941,727 shares at September 30, 1999 and
60,684,804 shares at December 31, 1999
(unaudited)...................................... 36 61
Additional paid-in capital........................ 156,791 1,130,430
Deferred compensation............................. (4,033) (3,278)
Stockholder notes receivable...................... (514) (424)
Accumulated deficit............................... (73,062) (97,042)
-------- ----------
Total stockholders' equity...................... 79,218 1,029,747
-------- ----------
Total liabilities and stockholders' equity...... $107,648 $1,078,349
======== ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE>
DIGITAL ISLAND, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
Three Months Ended
December 31,
-----------------------
1998 1999
----------- -----------
(Unaudited) (Unaudited)
<S> <C> <C>
Revenue............................................... $ 1,385 $ 7,600
Costs and expenses:
Cost of revenue..................................... 2,923 16,264
Sales and marketing................................. 2,046 6,315
Product development................................. 843 2,543
General and administrative.......................... 1,260 4,698
Amortization of goodwill and intangible assets...... -- 1,697
Stock compensation expense.......................... 346 755
--------- ----------
Total costs and expenses.......................... 7,418 32,272
--------- ----------
Loss from operations.............................. (6,033) (24,672)
--------- ----------
Interest income, net.................................. 96 697
--------- ----------
Loss before income taxes.......................... (5,937) (23,975)
Provision for income taxes............................ 2 5
--------- ----------
Net loss.......................................... $ (5,939) $ (23,980)
========= ==========
Basic and diluted net loss per share.................. $ (2.53) $ (0.65)
========= ==========
Weighted average shares outstanding used in per share
calculation.......................................... 2,345,984 36,676,137
========= ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
For the Three Months
Ended December 31,
--------------------
1998 1999
----------- --------
(unaudited) (unaudited)
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss......................................... $(5,939) $(23,980)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization.................. 418 3,817
Stock compensation expense..................... 346 755
Amortization of discounts on investments....... (93) (338)
Change in operating assets and liabilities, net
of business acquisition....................... (869) (6,125)
------- --------
Net cash used in operating activities........ (6,137) (25,871)
------- --------
Cash flows from investing activities:
Purchases of property and equipment.............. (89) (16,262)
Proceeds from maturities of short-term
investments..................................... 8,200 15,395
Business acquisition, cash acquired.............. -- 4,312
Purchases of short-term investments.............. (1,968) (2,289)
------- --------
Net cash provided by investing activities.... 6,143 1,156
------- --------
Cash flows from financing activities:
Repayment of stockholder note.................... -- 90
Proceeds from issuance of common stock........... 35 63
Proceeds from bank borrowings.................... 532 --
Repayments of bank borrowings.................... (141) (143)
Repayments of capital lease obligations.......... (144) (429)
------- --------
Net cash provided by (used in) financing
activities.................................. 282 (419)
------- --------
Net increase (decrease) in cash and cash
equivalents................................. 288 (25,134)
Cash and cash equivalents, beginning of period..... 5,711 43,315
------- --------
Cash and cash equivalents, end of period........... $ 5,999 $ 18,181
======= ========
Supplemental disclosures of cash flow information:
Cash paid for interest........................... $ 90 $ 219
======= ========
Cash paid for income taxes....................... $ 2 $ 5
======= ========
Supplemental schedule of non-cash investing and
financing activities:
Fixed asset acquired in exchange for stock....... $ -- $ 5,965
======= ========
Acquisition of subsidiary in exchange for stock.. $ -- $976,478
======= ========
Capital lease obligations for equipment.......... $ 350 $ 1,112
======= ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying condensed consolidated financial statements include the
accounts of Digital Island, Inc. and its wholly-owned subsidiaries, Sandpiper
Networks, Inc., Digital Island B.V., Digital Island, Ltd., Digital Island
(Europe) SA, Digital Island (Hong Kong), Ltd., and Digital Island (Japan) KK,
(collectively, the Company). All intercompany accounts and transactions have
been eliminated in the accompanying condensed consolidated financial
statements.
In the opinion of management, the condensed consolidated financial
statements reflect all normal and recurring adjustments that are necessary for
a fair presentation of the results for the periods shown. The results of
operations for such periods are not necessarily indicative of the results
expected for the full fiscal year or for any future period.
2. Restatement
The balance sheet at December 31, 1999 has been restated to record certain
warrants issued by Sandpiper Networks, Inc. prior to its acquisition by the
Company in conjunction with strategic agreements. Previously, these warrants
were not recorded on Sandpiper's books. The effect of this restatement on the
Company's financial statements was a reduction of deferred revenue and
goodwill of $2.9 million. This restatement has no effect on recorded revenue
or expense amounts.
3. Acquisitions
On December 28, 1999, the Company acquired Sandpiper Networks, Inc.
(Sandpiper) through the merger of a wholly owned subsidiary of the Company
with Sandpiper. In the merger, each outstanding share of Sandpiper capital
stock was exchanged for 1.0727 shares of the Company's common stock and all
outstanding stock options and warrants were assumed. The Company issued 24.6
million shares of common stock and 3.1 million stock options and warrants. The
total purchase price of approximately $967.6 million was allocated primarily
to intangible assets and goodwill which will be amortized over 5 years.
Pro Forma Disclosure of Sandpiper Networks, Inc. Acquisition
The following summary, prepared on a pro forma basis, combines the results
of the Company as if the acquisition had been made on the first day of the
quarter presented October 1, 1999, after including the impact of certain pro
forma adjustments such as increased amortization expense due to recording of
intangible assets:
<TABLE>
<CAPTION>
Three Months
Ended December 31,
(unaudited)
--------------------
1998 1999
--------- ---------
(in thousands
except per share
data)
<S> <C> <C>
Revenues............................................... $ 1,391 $ 8,230
Net Loss............................................... (56,801) (78,996)
Basic and diluted loss per share....................... (2.11) (1.31)
</TABLE>
On January 18, 2000, the Company acquired Live On Line, Inc. (LOL) through
the merger of a wholly owned subsidiary of the Company with and into LOL. A
total of 799,989 shares of the Company's common stock and $5.3 million in cash
were exchanged for all outstanding shares of LOL common stock and the
assumption of all outstanding warrants of LOL.
4. Purchase of Technology
In December 1999, the Company agreed to purchase patented technology from
SRI International (SRI). Under terms of the agreement, the Company is to
acquire the technology in exchange for $6 million of common
6
<PAGE>
DIGITAL ISLAND, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
stock, to be distributed upon the occurrence of certain milestones. As of
December 31, 1999, a total of 120,434 shares of common stock with a value of
$6 million had thus far been issued. The Company also will issue common stock
equal to $4 million in exchange for consulting services from SRI. The value of
stock issued under the agreement is recorded as network equipment and
technology. The company guarantees that the value of the stock issued to SRI
will have a value of $10 million at the time of issuance, and at the time that
SRI can dispose of the stock.
5. Strategic Relationship
In December 1999, the Company entered into a memoranda of understanding with
Sun Microsystems, Inc. (Sun) and Inktomi Corporation (Inktomi) providing for a
joint strategic relationship. Under the terms of the arrangement, the Company
has agreed to purchase up to $150 million of Sun equipment. Sun is to provide
the Company with $100 million in lease financing for the acquisition of the
equipment, to be made available upon the achievement of certain milestones. In
addition, there is to be joint sales and marketing efforts between the
Company, and Sun and Inktomi. Sun also received warrants to purchase up to $10
million of the Company's common stock at points in time corresponding to the
achievement of certain milestones.
In connection with this strategic relationship, Sun purchased 391,869 shares
of the Company's common stock for $20 million, and Inktomi purchased 117,561
shares for $6 million in January 2000.
6. Calculation of Net Loss Per Share
Shares used in computing basic and diluted net loss per share are based on
the weighted average shares outstanding in each period. The effect of
outstanding stock options and warrants is excluded from the calculation of
diluted net loss per share as their inclusion would be antidilutive.
The following is a reconciliation of the numerator and denominator of the
basic and diluted earnings per share (EPS) calculation (in thousands, except
for share and per share amounts):
<TABLE>
<CAPTION>
Three Months Ended
December 31,
-----------------------
1998 1999
----------- -----------
(Unaudited) (Unaudited)
<S> <C> <C>
Numerator--Basic and Diluted EPS net loss...... $ (5,939) $ (23,980)
========= ==========
Denominator--Basic and Diluted EPS
Weighted average Common Stock outstanding.... 2,558,433 36,829,358
Common Stock subject to repurchase........... (212,449) (153,221)
--------- ----------
Total weighted average Common Stock
outstanding................................. 2,345,984 36,676,137
========= ==========
Basic and diluted loss per share............... $ (2.53) $ (0.65)
========= ==========
</TABLE>
7. Subsequent Events
In January 2000, the Company filed a registration statement with the
Securities and Exchange Commission for a proposed offering of 4.5 million
shares of Common Stock, of which 3.5 million shares will be offered by the
Company and 1 million shares will be offered by existing stockholders. In
addition, the underwriters will be granted an option to purchase up to 675,000
shares of common stock to cover over-allotments, if any. As of the date of
this filing, the price has not yet been determined.
Also, the Company has filed a separate registration statement for a $175
million offering of convertible subordinated notes. The notes will be
convertible into shares of the Company's common stock at a conversion price
yet to be determined.
7
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Forward-Looking Statements
THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF DIGITAL ISLAND CONTAINS FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1993 AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934. DIGITAL ISLAND'S ACTUAL RESULTS AND THE
TIMING OF CERTAIN EVENTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN
THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING,
BUT NOT LIMITED TO, THOSE SET FORTH UNDER "RISK FACTORS" AND ELSEWHERE IN THIS
QUARTERLY REPORT AND IN OTHER DOCUMENTS FILED BY THE COMPANY WITH THE
SECURITIES AND EXCHANGE COMMISSION.
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 comprehensive solution 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 December 31, 1999, we
had contracts with 169 customers, of which 132 were deployed, including
Activision, AOL, Autodesk, Blue Mountain, Canon, Cisco Systems, CNBC.com,
E*TRADE, ft.com, Intuit, Microsoft, National Semiconductor, NetGravity,
PBS.org and Value America.
We did not begin offering our e-Business delivery network services until
January 1997; prior to such time we were engaged in activities unrelated to
our current operations. 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 fiscal year 2000. Our ability to achieve profitability and positive cash
flow from operations will be dependent upon our ability to grow our revenues
substantially and achieve other operating efficiencies.
We derive our revenues from services, which include content delivery and
network services, hosting services and application and professional services.
We currently sell our services under contracts with terms of one or more
years.
Cost of revenues consists primarily of the cost of contracting for lines
from telecommunication service providers worldwide and, to a lesser extent,
the cost of our network operations. We lease lines under contracts of one year
or more. The leasing of transoceanic lines comprises the largest component of
our telecommunications expense, with additional costs arising from leasing
local circuits between our data centers and points of presence in the United
States and international markets. In the future, we expect to increase the
size and number of circuits leased, based on increases in network volume and
geographic expansion. The cost of our network operations is comprised
primarily of data centers, equipment maintenance, personnel and related costs
associated with the management and maintenance of the network.
Some options granted and common stock issued from May 1, 1998 to June 30,
1999 have been accounted for as compensation. Total stock compensation expense
associated with such equity transactions as of September 30, 1999 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
8
<PAGE>
September 30, 1998 and $3.2 million was amortized in the year ended September
30, 1999. For the quarter ended December 31, 1999 and 1998 stock compensation
expense amortization was $755,000 and $346,000, respectively. We expect
amortization of $2.4 million and $1.2 million in the years ending September
30, 2000 and 2001, respectively, relating to these grants.
In December 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 value of $857.0 million, 3.1 million vested and unvested
stock options and warrants with a fair value of $96.6 million and estimated
direct transaction costs of approximately $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.
In connection with the Sandpiper merger, we expect amortization costs over
the next five years as follows (in thousands):
<TABLE>
<CAPTION>
Year ending
September 30,
-------------
<S> <C>
2000.............................................................. $147,650
2001.............................................................. 194,770
2002.............................................................. 194,770
2003.............................................................. 194,770
2004.............................................................. 194,770
2005.............................................................. 47,123
</TABLE>
In addition, in January 2000, we acquired Live On Line, Inc. The transaction
will be accounted for using the purchase method of accounting. The acquisition
price included 799,989 shares of Digital Island common stock with a fair value
of approximately $63.5 million and $5.2 million in cash. We expect annual
amortization costs of approximately $14 million over the next five years in
conjunction with this acquisition.
The following discussion comparing our historical results of operations for
the three months ended December 31, 1999 and 1998 reflects the results of
three days of operations of Sandpiper, which we acquired in December 1999.
Results of Operations
Three Months Ended December 31, 1999 and 1998
Revenue. Revenue increased to $7.6 million for the three months ended
December 31, 1999 from $1.4 million for the three months ended December 31,
1998. The increase in revenue was primarily due to increased usage per
customer and an increase in the number of billing customers to 132 from 40.
Cost of revenue. Cost of revenue increased to $16.3 million for the three
months ended December 31, 1999 from $2.9 million for the three months ended
December 31, 1998. The increase in cost of revenue was due to $11.1 million of
spending for additional network capacity and $2.3 million in recruitment and
compensation costs relating to the addition of network operations personnel.
Sales and Marketing. Sales and marketing expenses increased to $6.3 million
for the three months ended December 31, 1999 from $2.0 million for the three
months ended December 31, 1998. This increase was due to $3.5 million of
growth in personnel and related costs and $0.8 million of program expenses.
Product Development. Product development expenses increased to $2.5 million
for the three months ended December 31, 1999 from $0.8 million for the three
months ended December 31, 1998. This increase was due to $1.5 million in
growth of personnel and related costs and $0.2 million of costs arising from
new product initiatives, including development of our TraceWare, mirroring and
caching technologies.
9
<PAGE>
General and Administrative. General and administrative expenses increased to
$4.7 million for the three months ended December 31, 1999 from $1.3 million
for the three months ended December 31, 1998. This increase was due to $1.7
million of depreciation of network equipment, $1.1 million of growth in
personnel and related expenses, and $0.6 million office facility expenses,
legal and accounting fees and other administrative related expenses.
Interest Income. Interest income increased to $0.7 million for the three
months ended December 31, 1999 from $96,000 for the three months ended
December 31, 1998. This increase was due to a higher average cash balance
resulting primarily from the proceeds of the issuance of shares of our common
stock in our initial public offering.
Liquidity and Capital Resources
From inception through our initial public offering in June 1999, we financed
our operations primarily through private equity placements of $86.9 million
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. At December 31, 1999, we had cash and cash
equivalents and short-term investments of $37.1 million.
Net cash used in our operating activities for the three months ended
December 31, 1999 was $25.9 million. The net cash used by operations was
comprised primarily of working capital requirements and net losses. Net cash
provided by in investing activities was $1.1 million for the three months
ended December 31, 1999 and was comprised primarily of equipment purchases of
$16.3 million and investments of $2.3 million in commercial paper with
maturities of less than one year, which was offset by proceeds from
investments which matured of $15.4 million and cash acquired through business
acquisitions of $4.3 million. Net cash used in financing activities was
$419,000 and was related primarily to repayments of debt obligations.
We have a $750,000 revolving line of credit with a commercial bank for the
purpose of financing equipment purchases. As of December 31, 1999, $259,000
was outstanding thereunder. The loan contains standard covenants including
minimum working capital, minimum tangible net worth, debt to equity ratio,
assets to liabilities ratio and financial reporting requirements. Interest on
borrowings thereunder accrues at the lender's prime rate plus 0.75%, which was
9.25% at December 31, 1999, and is payable monthly. No further advances were
permitted following October 18, 1997. At that date, the unpaid principal
balance plus interest became payable over 36 months in equal installments.
We also have a $7.5 million line of credit with a commercial bank,
consisting of a revolving credit facility of up to $5 million and equipment
loan facilities of up to $2.5 million. As of December 31, 1999, approximately
$230,000 was outstanding under the revolving credit facility, and
approximately $483,000 was outstanding under equipment loan facilities. No
further amounts may be borrowed under the equipment loan facilities. Advances
under the line of credit are limited to a percentage of our recurring contract
revenue. The loan contains standard covenants, including minimum working
capital, minimum tangible net worth, debt to equity ratio, assets to
liabilities ratio and financial reporting requirements. Interest on borrowings
under the revolving credit facility accrues at the lender's prime rate plus
0.25%, which was 8.75% at December 31, 1999, and is payable monthly. Under the
terms of the equipment loan facilities, interest is charged at the lender's
prime rate plus 0.75%, which was 9.25% at December 31, 1999, and is payable
monthly. The loans mature at various times in 2001. Between October 1, 1998
and January 31, 1999, we did not comply with the minimum tangible net worth
and financial reporting covenants. However, we obtained waivers for all
covenant violations. We have complied with all covenants since January 31,
1999.
Pursuant to the merger with Sandpiper, we assumed from Sandpiper a line of
credit with a bank for $1 million, with a variable rate of interest, based on
the bank's prime rate plus 0.5%. At December 31, 1999, no amounts were
borrowed under this facility.
10
<PAGE>
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, with principal and interest due monthly
for 36 months and collateralized by equipment on August 31, 1998.
In addition, we have several lease lines of credit. Total borrowings under
these lease lines of credit were $13.1 million at December 31, 1999, of which
$2.4 million was assumed pursuant to the merger with Sandpiper.
On December 7, 1999, we entered into memoranda of understanding with Sun
Microsystems, Inc. and Inktomi Corporation providing for a joint strategic
relationship. Under the relationship, we have agreed to purchase, over a two
year period, up to $150 million of Sun servers, storage operating systems and
server software, using Inktomi network caching applications. The total
purchase would consist of 5,000 Sun servers. Sun and Inktomi also agreed to
participate and invest in joint marketing and sales activities with us to
support broadband and streaming media content delivery over the Internet. Sun
agreed to provide $100 million of lease financing for the acquisition of the
equipment, consisting of:
. a $30 million initial line of credit:
. a $30 million line of credit available in nine months upon meeting
specified working capital maintenance and financing milestones; and
. a $40 million line of credit available in fifteen months upon meeting
specified additional working capital maintenance and financing
milestones.
In exchange for this lease financing, we agreed to grant Sun warrants to
purchase up to $10 million of our common stock in three tranches corresponding
on a pro rata basis with the above three lines of credit; the warrants will be
exercisable at the five-day average trading price preceding the grant dates,
and will expire in 48 months (in the case of the first warrant) and 36 months
(in the case of the second and third warrant). The lease financing facility
and the marketing and sales relationship are subject, in part, to definitive
documentation.
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. In order to
rapidly improve our competitive position, we anticipate making up to
approximately $80.0 million to $100.0 million of capital expenditures for
network expansion, facilities and related costs in the next 12 months. This
substantial increase in the level of our anticipated capital expenditures will
require up to $100.0 million to $150.0 million of additional financing, which
we expect to receive from the net proceeds of our follow-on offering of common
stock and the net proceeds of the $175 million in aggregate principal amount
of convertible subordinated notes we plan to sell in a separate public
offering. We intend to consider future financing alternatives, which may
include the incurrence of indebtedness, additional public or private equity
offerings or an equity investment by a strategic partner. Actual capital
requirements may vary, based upon the timing and success of the expansion of
our operations. Our capital requirements may change based upon technological
and competitive developments. In addition, several factors may affect our
capital requirements:
. demand for our services or our anticipated cash flow from operations
being less than expected;
. our development plans or projections proving to be inaccurate;
. our engaging in acquisitions or other strategic transactions; or
. our accelerating deployment of our network services or otherwise altering
the schedule of our expansion plan.
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.
11
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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. SFAS 133 is effective for
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 December 31, 2000. The
Company does not expect that the adoption of SAB 101 will have a material
effect on the consolidated financial statements.
Year 2000 Compliance
The "Year 2000 issue" contemplates that many currently installed computer
systems may be unable to distinguish 21st century dates from 20th century
dates. As a result, such computer systems and software may suffer major system
failures or miscalculations. If we or our key third party suppliers fail to
achieve Year 2000 compliance, we may experience operating difficulties,
including impaired ability to transport data over our network and impaired
ability to bill for our services. We recognize the need to ensure that our
operations will not be adversely affected by Year 2000 software failures. We
continue to assess the potential overall impact of this issue on our
operations.
Based on our assessment to date, we believe the current versions of our
software products and services are Year 2000 compliant, that is, they are
capable of adequately distinguishing 21st century dates from 20th century
dates. However, our products are generally integrated into enterprise systems
involving sophisticated hardware and complex software products, which may not
be Year 2000 compliant. We may in the future be subject to claims based on
Year 2000 problems in others' products, or issues arising from the integration
of multiple products within an overall system. Although we have not been a
party to any litigation or arbitration proceeding to date involving our
products or services and related to Year 2000 compliance issues, there can be
no assurance that we will not in the future be required to defend our products
or services in such proceedings, or to negotiate resolutions of claims based
on Year 2000 issues. The costs of defending and resolving Year 2000-related
disputes, regardless of the merits of such disputes, and any potential
liability on our part for Year 2000-related damages, including consequential
damages, could cause our business and financial results to suffer. In
addition, we believe that purchasing patterns of customers and potential
customers may be affected by Year 2000 issues as companies may continue to
expend significant resources to correct or upgrade their current software
systems for Year 2000 compliance. These expenditures may reduce funds
available to purchase software products such as those offered by us. To the
extent that Year 2000 issues cause significant delay in, or cancellation of,
decisions to purchase our products or services, our business and financial
results could suffer.
We have formulated a contingency plan should we or any of our key third
parties sustain business interruptions caused by year 2000 problems. We are
reviewing our internal management information and other systems in order to
identify and modify any products, services or systems that are not year 2000
compliant. To date, we have not encountered any material year 2000 problems
with our computers, applications or any other equipment which might be subject
to these problems. In addition, we received an independent third-party
evaluation of the year 2000 compliance of our network equipment and carriers
in March 1999 and of our computer systems and applications in October 1999. We
will continue to monitor year 2000 compliance for our new products and
services as they arise.
In the event that any of our external vendors cannot timely provide us with
products, services or systems that meet the Year 2000 requirements, we may
incur unexpected expenses to remedy any problems. These expenses could
potentially include purchasing replacement hardware or software. In addition,
our business and
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our ability to deliver our products and services could be severely affected,
at least for a certain period of time, in the event that Year 2000 related
problems were to cause disruption or failure in the Internet as a means of
delivery of our products and services or more generally, disruption to the
infrastructure. The total cost of these Year 2000 compliance activities has
not been, and is not anticipated to be, material to our business. results of
operations and financial condition. These costs and the timing in which we
plan to complete our Year 2000 modification and testing processes are based on
our management's estimates. We may not be able to remediate all significant
time and expense, and could cause our business and prospects to suffer.
To date, we have experienced no material complications to our operations due
to Year 2000 issues.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We provide a global e-Business delivery network and suite of services and
sell such services in North America, Asia and Europe. As a result, our
financial results could be affected by factors such as changes in foreign
currency exchange rates or weak economic conditions in foreign markets. As all
sales are currently made in U.S. dollars, a strengthening of the dollar could
make our services less competitive in foreign markets. We do not use
derivative instruments to hedge our foreign exchange risks. Our interest
income is sensitive to changes in the general level of U.S. interest rates,
particularly since the majority of our investments are in short-term
instruments. Due to the nature of our short-term investments, we anticipate no
material market risk exposure. Therefore, no quantitative tabular disclosures
are required.
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RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Risks Related to Digital Island
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. Prior to such time, we were engaged in
activities unrelated to our current operations, and as a result, the results
of operations for such periods are not comparable to our results of operations
for 1997 or any subsequent periods.
We completed a merger with Sandpiper Networks, Inc. in December 1999.
Sandpiper commenced operations in December 1996 and introduced its service in
September 1998, and therefore also has a limited operating history. The
limited operating history of the combined company and the limited operating
histories of Digital Island and Sandpiper as individual entities may limit
your ability to evaluate our prospects and performance, and an investment in
our common stock, 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 future
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 three
months ended December 31, 1999, our operating loss, negative cash flow from
operations and net loss were $24.7 million, $25.9 million, and $24.0 million,
respectively. Sandpiper has never been profitable and has incurred significant
losses since inception. Sandpiper reported a net loss of approximately
$54.0 million for the period from October 1, 1999 to December 28, 1999.
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;
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. continue to grow our network infrastructure to maintain and increase our
ability to service new and existing customers;
. 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 have substantially increased the level of our anticipated capital
expenditures for network expansion, facilities and related costs over the next
12 months to approximately $80 million to $100 million. As a result, we
believe that we will continue to experience significant losses for the
foreseeable future.
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.
The unpredictability of our quarterly results may adversely affect the trading
price of our stock.
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
and any of which may cause our stock price to fluctuate. 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;
. 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 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.
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We must offer services priced above the overall cost of bandwidth, and any
failure to do so would jeopardize our operating results.
If we do not obtain adequate bandwidth capacity on acceptable terms and
realize appropriate customer volume for such bandwidth, we will not achieve
positive gross profit. We purchase our bandwidth capacity on a fixed-price
basis in advance of the sale of our services. 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.
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
will decrease and our business and financial results will suffer.
We must retain and expand our customer base or else we will continue to be
unprofitable.
As of December 31, 1999, we had contracts with 169 customers, of which 132
were deployed. E*TRADE accounted for approximately 34% of our revenues during
the quarter ended December 31, 1999, and another customer, ft.com, account for
approximately 12% of our revenues during the same period. We currently incur
costs greater than our revenues and need to increase customer revenue to
become profitable. We incur significant fixed costs to purchase our bandwidth
capacity and maintain our network. We also have payroll and other working
capital needs. If we are unable to retain or grow our customer base, we will
not be able to achieve the economies of scale necessary to offset our fixed
and other operating costs. Our ability to attract new customers depends on a
variety of factors, including:
. the willingness of businesses to outsource their Internet operations;
. the reliability and cost-effectiveness of our services; and
. our ability to effectively market such services.
To attract new customers we intend to significantly increase our sales and
marketing expenditures. However, our efforts might not result in more sales as
a result of the following factors:
. we may be unsuccessful in implementing our marketing strategies;
. we may be unsuccessful in hiring a sufficient number of qualified sales
and marketing personnel; and
. 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;
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. natural disasters;
. power loss;
. sabotage or vandalism;
. telecommunications failures; and
. similar events.
Despite precautions taken by us, the occurrence of a natural disaster or
other unanticipated problems at one or more of our data centers could result
in service interruptions or significant damage to equipment. We have
experienced temporary service interruptions in the past, and we could
experience similar interruptions in the future. 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 in our software. In the future, there may be
additional errors and defects in our software 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, in such event, such damages may exceed our
liability insurance.
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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;
. 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, demand for our
services may decrease.
Due to the limited deployment of our services to date, the ability of our
network to connect and manage a substantially larger number of customers at
high transmission speeds is as yet unknown. Our network may not be able to
serve expected customer levels or meet performance expectations and we may be
unable to obtain additional network capacity from third-party suppliers. 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 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.
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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 significant 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. Additional
equity financing may not be available 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
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 any growth,
successfully implement and maintain our operational and financial systems or
successfully obtain, integrate and utilize the employees, facilities, third-
party vendors and equipment, or management, operational and financial
resources necessary to manage a developing and expanding business in our
evolving and increasingly competitive industry. If we are unable to manage
growth effectively, 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.
In addition to key officers and employees who joined us through the
Sandpiper merger, we have recently hired a number of key employees and
officers including our Chief Executive Officer, Chief Financial Officer and
our Chief Technology Officer. Initially, such individuals must spend a
significant amount of time learning our business model and management system,
in addition to performing their regular duties. Accordingly, the integration
of new personnel has resulted and will continue to result in some disruption
to our ongoing operations.
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We are highly dependent on key members of our management and engineering
staff, including, without limitation, our Chairman and Chief Executive
Officer, President, Chief Technology Officer and Vice President of Marketing.
The loss of one or more of these officers might impede the achievement of our
business objectives. Furthermore, recruiting and retaining qualified technical
personnel to perform research, development and technical support work is
critical to our success. If our business grows, we will also need to recruit a
significant number of management, technical and other personnel. 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 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 filed patent applications with the United States Patent and
Trademark Office with respect to our Footprint and TraceWare technologies, as
well as some Internet technology recently acquired from SRI International,
such applications are pending and we currently have no patented technology
that would preclude or inhibit competitors from entering our market. Moreover,
none of our technology is patented abroad, nor do we currently have any
international patent applications pending. We cannot be certain that any
pending or future patent applications will be granted, that any future patent
will not be challenged, invalidated or circumvented, or that rights granted
under any patent that may be issued will provide competitive advantages to us.
We have applied for trademarks and service marks on certain terms and
symbols that we believe are important for our business. In addition, we
generally enter into confidentiality or license agreements with our 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.
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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,
including investors who purchase common stock in this offering;
.incur debt;
.assume liabilities;
.incur amortization expenses related to goodwill and other intangible
assets; and
.incur large and immediate write-offs.
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.
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.
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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.
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.
In addition, in December 1999 we entered into memoranda of understanding
with Sun Microsystems and Inktomi to purchase 5,000 Sun servers, as well as
storage operating systems and server software using Inktomi network caching
applications. Pursuant to this arrangement, Sun and Inktomi also agreed to
participate and invest in joint marketing and sales activities with us.
However, our strategic relationship with Sun and Inktomi is subject to
definitive documentation and the memoranda of understanding may be terminated
at any time prior to the execution of such definitive documentation. If
consummated, such relationship may not yield significant benefits, if any.
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Risks Related To The Sandpiper and Live On Line Mergers
If we do not successfully integrate Sandpiper's or Live On Line'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 Sandpiper and Live On Line mergers with the expectation
that the mergers would result in significant benefits. Achieving the benefits
of the mergers 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 the three companies. We will need to overcome
significant obstacles, however, in order to realize any benefits or synergies
from the mergers. The successful execution of these post-merger events will
involve considerable risk and may not be successful.
The market price of our common stock may decline as a result of the
Sandpiper and Live On Line mergers if:
. the integration of Digital Island, Sandpiper and Live On Line is
unsuccessful;
. Digital Island does not achieve the perceived benefits of the mergers as
rapidly or to the extent anticipated by financial or industry analysts;
or
. the effect of the mergers on Digital Island's financial results is not
consistent with the expectations of financial or industry analysts.
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 three companies will significantly divert
management's attention from other important issues.
If we fail to successfully cross-market our products or develop new products,
we will not increase or maintain our customer base or our revenues.
With Sandpiper and Live On Line, we intend to offer our products and
services to each other's existing customers. We cannot assure you that our
respective customers will have any interest in the other company's products
and services or that the transactions or other data in Sandpiper's or Live On
Line's database will be predictive or useful in other sales channels,
including systems integrators, web site designers and Internet service
providers. The failure of these cross-marketing efforts would diminish the
benefits realized by these mergers.
In addition, we intend to develop new products and services that combine the
knowledge and resources of the Digital Island, Sandpiper and Live On Line
businesses. To date, the companies have not thoroughly investigated the
obstacles, technological, market-driven or otherwise, to developing and
marketing these new products and services in a timely and efficient way. We
cannot offer any assurances that products or services will be successful or
that there will be a market for such products and services. As a result, we
may not be able to increase or maintain our customer base. Our failure or
inability to develop and market combined products and services could have a
material adverse effect on the combined company's business, financial
condition and operating results.
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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, Concentric,
Digex, Exodus Communications, Global Crossing, GTE, 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 fees charged to 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 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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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 most recent session of the
United States Congress resulted in the enactment of 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 year 2000. 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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. 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 recent 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 in the European Community
which will, if made into law, restrict caching and mirroring. Any or all of
these factors could cause our business and prospects to suffer.
Foreign exchange fluctuations could decrease our revenues or cause us to lose
money, especially since we do not hedge against currency fluctuations.
Although, to date, all of our customers have paid for our services in U.S.
dollars, we currently pay some of our suppliers in foreign currencies, which
subjects us to currency fluctuation risks. For fiscal 1998 and fiscal 1999,
costs denominated in foreign currencies were nominal and we had no foreign
currency losses during those periods. However, we believe that in the future
an increasing portion of our revenues and costs will be denominated in foreign
currencies. In particular, we expect that with the introduction of the Euro,
an increasing portion of our international sales may be Euro-denominated. 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.
Year 2000 computer complications could disrupt our operations and harm our
business.
The "year 2000 issue" is the result of computer systems and programs using
two digits rather than four to identify a given year. Computer systems or
programs that have date sensitive software or embedded chips may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result
in system failures or miscalculations or other computer errors causing
disruptions of operations. The potential for failures encompasses all aspects
of our business, including our services, suppliers and customers. These
failures could cause, among other things, disruptions in our operations and a
temporary inability to engage in normal business activities.
The year 2000 issue creates significant risks for us including:
. potential warranty or other claims arising from our services;
. damage to our reputation;
. litigation costs;
. impairment of the systems we use to run our business; and
. impairment of the systems used by our suppliers and customers.
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Although we believe our products are year 2000 compliant, we may see an
increase in warranty and other claims as a result of the year 2000 issues
arising from undetected defects or the non-compliance of the suppliers upon
whom we rely.
We believe that the most likely worst-case year 2000 scenario would involve
the non-compliance of the third-party telecommunications carriers, vendors and
other significant suppliers upon whom we depend for transmission capacity. If
these providers do not achieve year 2000 compliance, we cannot be certain that
we will have sufficient transmission capacity to continue our service without
interruption. In the event that any of our other suppliers do not achieve year
2000 compliance in a timely manner, and we are unable to replace them with
alternate sources, our business and financial results would also be harmed.
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, especially changes relating to telecommunications
markets in general 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 Regional Bell
Operating Companies or other 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 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.
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.
After our anticipated follow-on offering of common stock, our executive
officers, directors, and parties related to them, in the aggregate, will
control 31% of our voting stock and may have the ability to control matters
requiring stockholder approval.
Our executive officers, directors and parties related to them will own
approximately 31% of our outstanding common stock following completion of our
anticipated offering of common stock, a large enough stake to have an
influence on the matters presented to stockholders. As a result, these
stockholders may have the ability to control matters requiring stockholder
approval, including the election and removal of directors, the approval of
significant corporate transactions, such as any merger, consolidation or sale
of all or substantially all of Digital
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Island's assets, and the control of the management and affairs of Digital
Island. Accordingly, such concentration of ownership may have the effect of
delaying, deferring or preventing a change in control of Digital Island,
impeding a merger, consolidation, takeover or other business combination
involving Digital Island or discouraging a potential acquirer from making a
tender offer or otherwise attempting to obtain control of Digital Island,
which in turn could have an adverse effect on the market price of Digital
Island's common stock.
Substantial leverage and debt service obligations may adversely affect our
cash flow.
We anticipate offering convertible subordinated notes in an aggregate
principal amount of $175 million, or $201.25 million if the over-allotment
option granted to the underwriters in connection with the note offering is
exercised in full. If the note offering is completed as planned, we will have
substantial amounts of outstanding indebtedness, primarily consisting of the
notes, upon the completion of this offering. As a result of this indebtedness,
our principal and interest payment obligations will increase 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 additional financing arrangements will be available on
commercially reasonable terms or at all.
Our substantial leverage could have significant negative consequences,
including:
. increasing our vulnerability to general adverse economic and industry
conditions;
. 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.
There may be a substantial amount of our common stock outstanding after our
anticipated follow-on offering of common stock that could depress our stock
price.
Sales of substantial amounts of our common stock (including shares issued
upon the exercise of outstanding options and warrants) in the public market
following our anticipated follow-on offering of common stock, or the
appearance that a large number of shares is available for sale, could depress
the market price for our common stock. All of the shares sold in the proposed
offering will be freely tradable. Our executive officers, directors and
holders of 17.5% of our common stock outstanding on December 31, 1999 have
agreed not to sell or otherwise dispose of any of their shares for a period of
90 days after the date of the proposed follow-on offer, subject in each case
to certain consents and exceptions. As a result of the Sandpiper merger,
Digital Island and Sandpiper stockholders holding approximately 57% of our
common stock following the merger entered into market standoff agreements
prohibiting them from selling or otherwise transferring shares of our common
stock. These market standoff agreements, however, will expire with the
occurrence of the proposed offering of common stock, and, as a result, all
such shares which are not subject to the foregoing lock-up agreements will
become available for sale following this offering.
In addition, the holders of up to 16,792,550 restricted shares of our stock
are entitled to certain rights with respect to registration of such shares for
sale in the public market. If these holders sell their shares in the public
market, such sales could have a material adverse effect on the market price of
our common stock. In addition to the adverse effect a price decline could have
on holders of our common stock, that decline would likely impede our ability
to raise capital through the issuance of additional shares of common stock or
other equity securities.
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The liquidity of our common stock is uncertain since it has been publicly
traded for a short period of time and may have a limited market.
Prior to our initial public offering in June 1999, there was no public
market for our common stock. We cannot predict the extent to which investor
interest in our company will lead to the development of an active, liquid
trading market. In our anticipated follow-on offering, we intend to sell our
common stock primarily to a limited number of institutional investors, which
could limit the development of an active trading market. Active trading
markets generally result in lower price volatility and more efficient
execution of buy and sell orders for investors.
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PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
None.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
(c) Recent Sales of Unregistered Securities
SRI International Transaction
On November 22, 1999, we acquired Internet technology from SRI
International, a California nonprofit public benefit corporation, for 120,454
shares of our common stock worth $6 million. Additionally, pursuant to the
agreement, we will obtain consulting services from SRI International for an
additional $4 million. SRI's patent-pending technology is designed to improve
download times for Internet content by intelligently avoiding network
congestion. We will incorporate SRI technology into our e-Business delivery
network to help ensure fast performance for e-Business applications, including
transactions and other forms of dynamic processing. The shares were issued
pursuant to an exemption from registration under Section 4(2) of the
Securities Act of 1933, as amended.
Strategic Relationship with Sun Microsystems and Inktomi
On December 7, 1999, we entered into memoranda of understanding with Sun
Microsystems, Inc. and Inktomi Corporation providing for a joint strategic
relationship. Under the relationship, we have agreed to purchase, over a two
year period, up to $150 million of Sun servers, storage operating systems and
server software, using Inktomi network caching applications. The total
purchase would consist of 5,000 Sun servers. Sun and Inktomi also agreed to
participate and invest in joint marketing and sales activities with us to
support broadband and streaming media content delivery over the Internet. Sun
agreed to provide $100 million of lease financing for the acquisition of the
equipment, consisting of:
. a $30 million initial line of credit;
. a $30 million line of credit available in nine months upon meeting
specified working capital maintenance and financing milestones; and
. a $40 million line of credit available in fifteen months upon meeting
specified additional working capital maintenance and financing
milestones.
In exchange for this lease financing, we agreed to grant Sun warrants to
purchase up to $10 million of our common stock in three tranches corresponding
on a pro rata basis with the above three lines of credit; the warrants will be
exercisable at the five-day average trading price preceding the grant dates,
and will expire in 48 months (in the case of the first warrant) and 36 months
(in the case of the second and third warrant). The lease financing facility
and the marketing and sales relationship are subject, in part, to definitive
documentation.
In connection with this strategic relationship, in January 2000, Sun
purchased 391,869 shares of our common stock for $20 million, and Inktomi
purchased 117,561 shares of our common stock for $6 million. The shares were
issued pursuant to an exemption from registration under Section 4(2) of the
Securities Act of 1933, as amended. The transaction qualifies for an exemption
under Section 4(2).
Live On Line Acquisition
On January 18, 2000, we acquired Live On Line, Inc., a privately-held
company located in New York City, through the merger of a subsidiary of
Digital Island into Live On Line. As a result of the merger, Live On Line
became a wholly owned subsidiary of Digital Island. Live On Line provides
internet content and streaming media
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technology through its high-bandwidth, worldwide server network to clients in
the entertainment, media, consumer products, pharmaceutical and education
industries. In connection with this acquisition, the former shareholders of
Live On Line were issued a total of 799,989 shares of our common stock, and
will receive a total of $5.3 million in exchange for all outstanding shares of
Live On Line common stock and our assumption of all outstanding warrants of
the company. The former shareholders of Live On Line received fifty percent of
the cash consideration on the closing date and the remaining fifty percent
will be paid upon the completion of the next public offering of stock or July
18, 2000, if earlier. In addition, the former shareholders of Live On Line are
entitled to require us to file a registration statement on Form S-3 with the
Securities and Exchange Commission to register the offering of shares of
common stock issued to them in the merger on or before July 17, 2000 or, if we
are not permitted to use Form S-3 at such date, as soon as practicable after
we become eligible to use such form. The shares were issued pursuant to an
exemption from registration under Section 4(2) of the Securities Act of 1933,
as amended.
(d) Use of Proceeds. Paragraph references herein refer to the respective
paragraphs of Item 701(f) of Regulations S-K.
(1) Effective date of the Registration Statement and Commission File No.:
June 28, 1999; 333-77039.
(2) Offering Date: June 29, 1999.
(3) N/A.
(4) Information regarding the offering.
(i) The offering has terminated and all registered shares were
sold.
(ii) Managing Underwriters: Bear, Stearns & Co. Inc., Lehman
Brothers Inc. and Thomas Weisel Partners LLC.
(iii) Title of Securities Registered: Common Stock.
(iv) 6,900,000 shares were registered, all on behalf of the Company;
all shares were sold for an aggregate offering price of $69,000,000.
(v) Amount of expenses incurred for the Company's account:
. underwriting discount: $4,830,000
. other expenses: estimated at approximately $1,000,000
. total expenses: : estimated at approximately $5,830,000
A. All of such total expenses were payments to others (i.e.,
not to directors, officers, and 10% stockholders of the
Company.)
(vi) Net proceeds: $63,170,000
(vii) Actual amount of net proceeds used for:
. construction of plant, building and facilities: $14,742,000
. purchase and installation of machinery and equipment: $
9,853,000
. purchases of real estate: $0
. acquisition of other businesses: $0
. repayment of indebtedness: $1,540,000
. working capital: $37,035,000
. temporary short-term investments: $0
. Total: $63,170,000
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A. N/A. No payments were made from the effective date of the
Registration Statement to the end of the reporting period
(viii) N/A
ITEM 3. DEFAULTS UPON SENIOR SECURITIES.
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On December 28, 1999, a Special Meeting of the Stockholders of the Company
was held to vote to (1) approve the issuance of shares of common stock, par
value $0.001 per share, of the Company pursuant to the merger agreement among
the Company, Sandpiper Networks, Inc. and Beach Acquisition Corp., as
described more fully below, and (2) grant the Board of Directors discretionary
authority to adjourn the special meeting to solicit additional votes for
approval of the share issuance.
Both proposals were approved at the Special Stockholders Meeting. There were
a total of 29,597,647 votes in favor of proposal one regarding the issuance of
shares of common stock in connection with the merger with Sandpiper, with
5,585 shares voting against the proposal, and 7,110 abstaining from voting on
the proposal. There were a total of 28,238,386 votes in favor of proposal two
regarding the grant of discretionary authority to the Board of Directors to
adjourn the meeting to solicit additional votes for approval of the share
issuance, with 1,364,766 shares voting against this proposal, and 7,190
abstaining from voting on the proposal.
Sandpiper Merger
On December 28, 1999, we completed our acquisition of Sandpiper Networks,
Inc. through the merger of a wholly owned subsidiary of Digital Island with
and into Sandpiper, in which Sandpiper survived as a wholly owned subsidiary
of Digital Island. We pursued this merger to enhance our comprehensive network
services for providing global e-Business applications.
In the merger, each outstanding share of Sandpiper capital stock was
converted into the right to receive 1.0727 shares of our common stock. We also
assumed outstanding options and warrants to acquire Sandpiper common stock and
converted those options and warrants into options and warrants to acquire our
common stock at the same exchange ratio. Overall, we issued or have reserved
for issuance approximately 24.6 million shares of our common stock in
connection with the merger.
Under the merger agreement, the former Sandpiper shareholders agreed to
indemnify and hold harmless Digital Island and some related parties from and
against losses, costs, damages, liabilities and expenses arising from any
breach of or default in any representation, warranty, covenant or agreement
made by Sandpiper in the merger agreement or related agreements and
instruments. To secure this indemnification obligation, 10% of the total
number of shares of our common stock issued in the merger to Sandpiper
shareholders have been deposited in escrow for a period of one year; the
escrow will be our sole recourse for any such breach or default absent fraud,
intentional misrepresentation or willful breach.
In connection with the merger, Digital Island and Sandpiper stockholders
holding approximately 57% of our common stock outstanding immediately after
the merger entered into market standoff agreements restricting them from
selling or otherwise transferring any of our equity securities. These market
standoff agreements expire by their terms upon the closing of this offering.
However, as further described in "Underwriting", a number of these holders
have entered into lockup agreements in connection with this offering.
In addition, we entered into employment agreements with Leo Spiegel, Andrew
Swart and David Farber, former executive officers of Sandpiper. Mr. Spiegel
became our President and agreed to restructure the vesting schedule of his
unvested shares of Digital Island common stock so that 50% will vest on March
24, 2000 and
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the balance will vest on November 24, 2000, the expiration date of his
employment agreement. Mr. Swart became our Vice President of Software
Engineering and Mr. Farber became our Chief Scientist. Each agreed to remain
with us for one year following the merger, and was granted a stock option
(vesting over a 50-month period following the merger) to purchase 150,000
shares. For a more detailed description of these arrangements, see "Certain
Transactions."
Upon completion of the merger, Leo Spiegel, the former president and chief
executive officer of Sandpiper, and G. Bradford Jones and Robert Kibble,
former directors of Sandpiper, became directors of Digital Island as Sandpiper
designees under the merger agreement.
ITEM 5. OTHER INFORMATION.
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
<TABLE>
<C> <S>
2.1* Agreement and Plan of Reorganization dated as of October 24, 1999,
by and among the Registrant, Beach Acquisition Corp. and Sandpiper
Network, Inc.
3.1* Amended and Restated Certificate of Incorporation
3.2* Bylaws, as amended to date
4.1 Reference is made to Exhibit 3.1
4.2 Reference is made to Exhibit 3.2
4.3* Specimen Common Stock Certificate
4.4* Amended and Restated Investors' Rights Agreement, among the
Registrant and the parties listed on the signature pages thereto,
dated February 19, 1999
4.5* Amendment No. 1 to Amended and Restated Investors' Rights Agreement,
dated April 9, 1999.
10.1* 1997 Stock Option and Incentive Plan
10.2* 1998 Stock Option/Stock Issuance Plan, as amended to date
10.3* 1999 Stock Incentive Plan
10.4* 1999 Employee Stock Purchase Plan
10.5* Form of Indemnification Agreement for Officers and Directors
10.6* Employment Agreement between the Registrant and Ruann Ernst
10.7* Employment Agreement between the Registrant and Allan Leinwand
10.8* Employment Agreement between the Registrant and Timothy M. Wilson
10.9* Employment Agreement between the Registrant and Paul Evenson
10.10** Employment Agreement between the Registrant and Michael T. Sullivan
10.11* Employment Agreement between the Registrant and Leo S. Spiegal
10.12* Employment Agreement between the Registrant and Andrew Swart
10.13* Employment Agreement between the Registrant and David Farber
10.14* Lease between the Registrant and Bishop Street Associates, dated
October 21, 1996, as amended to date.
10.15* Lease Agreement between the Registrant and Forty-Five Fremont
Associates, dated May 5, 1999.
</TABLE>
33
<PAGE>
<TABLE>
<C> <S>
10.16* Note Secured by Stock Pledge Agreement by Ruann Emst to
Registrant, dated April 21, 1999.
21.1**** Subsidiaries of the Registrant
27.1 Financial Data Schedule
99.1***** Press Release, dated October 25, 1999
99.2****** Press Release, dated December 8, 1999
</TABLE>
- --------
* Incorporated by reference to Exhibits of the Registrant's Registration
Statement on Form S-4 (File No. 333-92393), filed on December 9, 1999.
** Incorporated by reference to Exhibit of the Registrant's Registration
Statement on Form S-1 (File No. 333-77039) filed on April 26, 1999.
*** Incorporated by reference to Exhibit of the Registrant's Annual Report
on Form 10-K, filed on December 28, 1999.
**** Incorporated by reference to Exhibit of the Registrant's Registration
Statement on Form S-1 (File No. 333-95121), as amended, filed on
February 1, 2000.
***** Incorporated by reference to Exhibit of the Registrant's Special Report
on Form 8-K, filed October 27, 1999.
****** Incorporated by reference to Exhibit of the Registrant's Special Report
on Form 8-K, filed on December 9, 1999.
27 Financial Statement Schedule
(b) Reports on Form 8-K.
On October 27, 1999, the Company filed a Current Report on Form 8-K,
relating to an acquisition agreement with Sandpiper Networks, Inc. pursuant to
which Digital Island will be merged with Sandpiper. Under the terms of the
agreement, Sandpiper shareholders would receive 1.0727 shares of Digital
Island common stock for each share of Sandpiper capital stock. Following the
merger, which is expected to be accounted for as a purchase accounting,
Sandpiper shareowners will own approximately 40 percent of Digital Island's
fully diluted common stock.
On December 9, 1999, the Company filed a Current Report on Form 8-K,
relating to the memoranda of understanding with Sun Microsystems, Inc. and
Inktomi Corporation providing for a joint strategic relationship. Under the
relationship, Digital Island has agreed to purchase, over a two year period,
up to $150 million of Sun servers, storage operating systems and server
software, using Inktomi network caching applications. In connection with the
alliance, Sun has agreed to make a $20 million investment, and Inktomi has
agreed to make a $6 million investment, in Digital Island common stock at a
price per share equal to the lesser of the average closing price of the common
stock as quoted on the Nasdaq National Market for the ten trading days before
December 7, 1999 or for the five trading days before the closing of the
investment. Sun and Inktomi have agreed to not sell or otherwise dispose of
such shares until the first anniversary of their purchase. The Sun investment
is conditioned, among other things, upon customary governmental approvals and
the Inktomi investment is conditioned upon consummation of the Sun investment.
34
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
Date: February 22, 2000 DIGITAL ISLAND, INC.
(Registrant)
/s/ Ruann F. Ernst
Date: February 22, 2000 By: _________________________________
Ruann F. Ernst,
Chief Executive Officer and
President
(Principal Executive Officer)
/s/ T.L. Thompson
Date: February 22, 2000 By: _________________________________
T.L. Thompson,
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
35
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