<PAGE>
FILED PURSUANT TO RULE 424(b)(4)
REGISTRATION NO. 333-78813
PROSPECTUS
5,000,000 Shares
[LOGO OF DRUGSTORE.COM]
COMMON STOCK
---------------
drugstore.com, inc. is offering 5,000,000 shares of common stock. This is our
initial public offering and no public market currently exists for our shares.
---------------
Our common stock has been approved for quotation on the Nasdaq National Market
under the symbol "DSCM."
---------------
Investing in our common stock involves risks. See "Risk Factors" beginning on
page 7.
---------------
PRICE $18 A SHARE
---------------
<TABLE>
<CAPTION>
Underwriting
Price to Discounts and Proceeds to
Public Commissions drugstore.com
-------- ------------- -------------
<S> <C> <C> <C>
Per Share............................... $18.00 $1.26 $16.74
Total................................... $90,000,000 $6,300,000 $83,700,000
</TABLE>
The Securities and Exchange Commission and state securities regulators have
not approved or disapproved these securities, or determined if this prospectus
is truthful or complete. Any representation to the contrary is a criminal
offense.
drugstore.com, inc. has granted the underwriters the right to purchase up to
an additional 750,000 shares to cover over-allotments. Morgan Stanley & Co.
Incorporated expects to deliver the shares to purchasers on August 2, 1999.
---------------
MORGAN STANLEY DEAN WITTER
DONALDSON, LUFKIN & JENRETTE
THOMAS WEISEL PARTNERS LLC
July 27, 1999
<PAGE>
The first page of the gatefold includes:
drugstore.com
What Every Body Needs-TM-
[PICTURE OF DRUGSTORE.COM HOMEPAGE]
Lines pointing to specific items on the picture of the homepage connect to the
following text:
<TABLE>
<CAPTION>
<S> <C>
Five stores in one: health, beauty, wellness, Detailed product, topical and health
personal care and pharmacy. information to make purchase decisions.
Personalized service, shopping lists and Licensed pharmacy with home delivery.
reminders.
Choose from thousands of products in A high-quality selection of brand-name and
drugstore.com. specialty products organized in easy-to-shop
departments.
Shop for high-quality items in privacy.
</TABLE>
The following text is placed to the left of the picture of the homepage:
CONVENIENCE AND PRIVACY
drugstore.com has created a leading online drugstore and information site where
customers can shop in privacy from the convenience of their home or office.
More than a buying experience, drugstore.com offers useful information to assist
in the thinking and buying process.
Our store is designed to make What Every Body Needs easier for our customers to
acquire. At drugstore.com, customers never have to park the car, stand in line
or bump into nosy neighbors.
FIVE STORES IN ONE
drugstore.com is five stores in one, offering health, beauty, wellness, personal
care and pharmacy products, which we believe offers a superior customer
experience not found at store-based retailers. Through the Internet,
drugstore.com offers:
. Convenient, personalized service
. Shopping 24 hours a day, seven days a week
. Helpful information to make purchase decisions
. Secure credit card payment
. Direct delivery to home or office
. Private shopping from home or work
. Licensed pharmacy
. Personal access to pharmacists to answer questions
. Specialized customer care
[LOGO] drugstore.com-TM-
What Every Body Needs-TM-
<PAGE>
The second page of the gatefold includes:
drugstore.com
Five Stores in One
The following text is placed at the top left of the page:
A FAMILIAR, COMFORTABLE WAY TO SHOP
Our store is designed to be a familiar, comfortable place with product
categories organized like the aisles and shelves of a traditional drugstore,
beauty counter or wellness store. Customers can easily browse through the store
departments, quickly view promotions and featured products and select products
according to their brand or unique attributes.
[PICTURE OF THE BEAUTY PAGE]
[PICTURE OF THE HEALTH PAGE]
[PICTURE OF THE BOUTIQUE PAGE]
The following text appears under the picture of the Health page:
HEALTH
Along with browsing for health tips and information, customers can quickly
compare and purchase antacids, pain relievers, and family planning, first aid
and other health products.
The following text appears under the picture of the Beauty page:
BEAUTY
Customers can find their favorite beauty products, and our Ask Your Beauty
Expert feature answers their questions via e-mail.
The following text appears under the picture of the Boutique page:
BOUTIQUE
Combining the prestige of department-store beauty counters with online shopping
convenience, the boutique offers high-end cosmetics, fragrance and skin and spa
products.
[LOGO]
The following text appears on the same line as the logo and spans both the
second and third pages of the gatefold:
drugstore.com-TM-
WHAT EVERY BODY NEEDS-TM-
The third page of the gatefold includes:
[WATERMARK OF THE LOGO]
[PICTURE OF THE PERSONAL CARE PAGE]
The following text appears to the right of the Personal Care page:
-2-
<PAGE>
PERSONAL CARE
drugstore.com provides fast, convenient purchase of toothpaste, shampoo,
tampons, diapers, shaving needs and more.
[PICTURE OF THE WELLNESS PAGE]
[PICTURE OF THE PHARMACY PAGE]
[PICTURE OF THE DRUG INDEX PAGE]
The following text appears below the picture of the Wellness page:
WELLNESS
drugstore.com offers a wide, high-quality selection of wellness products,
including vitamins, supplements, herbs and homeopathy and other natural
products.
The following text appears below the picture of the Pharmacy page:
PHARMACY
Licensed pharmacists fill/refill prescriptions, which are then delivered to the
customer's door. Our pharmacists can provide personal guidance, by phone or e-
mail, about prescription usage.
The following text appears below the picture of the Drug Index page:
DRUG INDEX
In the pharmacy's Drug Index, customers can get easy access to information about
particular medications, including prices and usage.
-3-
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page Page
---- ----
<S> <C> <C> <C>
Prospectus Summary.................. 4 Management.......................... 50
Risk Factors........................ 7 Certain Relationships and Related
Sale of Shares to Amazon.com........ 21 Transactions....................... 59
Use of Proceeds..................... 21 Principal Stockholders.............. 62
Dividend Policy..................... 21 Description of Capital Stock........ 64
Capitalization...................... 22 Shares Eligible for Future Sale..... 67
Dilution............................ 23 Underwriters........................ 69
Selected Consolidated Financial Legal Matters....................... 71
Data............................... 24 Experts............................. 71
Management's Discussion and Analysis Where You Can Find More
of Financial Condition and Results Information........................ 71
of Operations...................... 25 Index to Consolidated Financial
Business............................ 33 Statements......................... F-1
</TABLE>
You should rely only on the information contained in this prospectus. We
have not authorized anyone to provide you with information different from that
contained in this prospectus. We are offering to sell, and seeking offers to
buy, shares of common stock only in jurisdictions where offers and sales are
permitted. The information contained in this prospectus is accurate only as of
the date of this prospectus, regardless of the time of delivery of the
prospectus or of any sale of the common stock.
Until August 22, 1999, 25 days after commencement of the offering, all
dealers effecting transactions in our common stock, whether or not
participating in this offering, may be required to deliver a prospectus. This
delivery requirement is in addition to the dealers' obligation to deliver a
prospectus when acting as underwriters and with respect to their unsold
allotments or subscriptions.
3
<PAGE>
PROSPECTUS SUMMARY
You should read the following summary together with the more detailed
information regarding our company and the common stock being sold in this
offering and our Consolidated Financial Statements and Notes to Consolidated
Financial Statements appearing elsewhere in this prospectus.
drugstore.com
drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products. As of
July 4, 1999, we have sold our products to approximately 168,000 customers. We
designed our store to provide a convenient, private and informative shopping
experience that encourages consumers to purchase products essential to healthy,
everyday living. We believe that our online store delivers a superior customer
experience, making buying What Every Body Needs(TM) less of a chore.
International Data Corporation estimates that worldwide business-to-consumer
sales over the Internet will increase from approximately $11 billion in 1998 to
approximately $93 billion by 2002. The Internet has also become an important
personal tool for accessing health and medical information. According to a
recent Forrester Research report, 31.6% of Internet users surveyed had shopped
for healthcare products online in the previous six months.
We believe there is a significant market opportunity for an online store
that can offer consumers an enhanced shopping experience for health, beauty,
wellness, personal care and pharmacy products. We seek to attract and retain
consumers by emphasizing the following key attributes:
. Convenience. We feature 24 hour a day access to our user-friendly Web
store, direct home or office delivery, a personalized shopping list and
confidential access to a personal medication profile.
. Selection. With over 17,000 SKUs (stock keeping units, a term used in
the retail industry to describe distinct products), we believe we offer
a significantly greater number of products than are available in a
typical traditional chain drugstore.
. Information. We have assembled a broad array of product information. We
offer full product packaging information, extensive drug information,
and a Solutions area, which includes buying guides, reference
information, shopping advisors and beauty information.
. Communication. We can communicate with customers on a regular basis
through the convenience of e-mail. We also offer our popular "Ask Your
Pharmacist" and "Ask Your Beauty Expert" features.
. Privacy. Consumers can shop in the privacy of their own homes or offices
and can obtain answers to questions that they might otherwise be
uncomfortable asking in public.
Our objective is to become one of the world's leading retailers of health,
beauty, wellness, personal care and pharmacy products. Key elements of our
strategy include: strengthening the drugstore.com brand, continuously improving
our Web store and service, developing strategic relationships, and taking
advantage of repeat purchasing patterns. In addition, we will also continue to
make significant investments in technology and distribution.
Consistent with our strategy of developing strategic relationships, we
recently entered into relationships with Rite Aid Corporation and General
Nutrition Companies, Inc. (GNC). Potential benefits of our Rite Aid
relationship may include additional revenue and traffic generated by Rite Aid
customers who may visit our Web site, the pharmacy benefit coverage provided by
the insurance companies and pharmacy benefit management companies (PBMs) with
which Rite Aid has a relationship, including PCS Health Systems, Inc., the co-
promotion and co-branding activities both companies will undertake and our
ability to offer Rite Aid customers the opportunity to order refills of their
existing Rite Aid prescriptions on our Web site and receive local delivery at
4
<PAGE>
Rite Aid stores nationwide or delivery to the customer's home or office. The
benefits of our GNC relationship include the opportunity to be the exclusive
online provider of GNC-branded products and the reciprocal co-promotion of each
party's products in traditional and online marketing efforts.
We face many risks and challenges in our business. Some consumers may prefer
to shop at traditional retail stores, especially consumers who do not have easy
access to the Internet or who need products immediately. As part of our
relationship with Rite Aid, we have agreed not to operate physical stores. An
investment in our common stock involves risks and uncertainties, including the
fact that we are an early stage company in a new market and that we expect
continuing losses for the forseeable future. See "Risk Factors" below for
further information.
The Offering
<TABLE>
<C> <S>
Common stock offered....................... 5,000,000 shares
Common stock to be outstanding after the
offering.................................. 42,346,555 shares
Use of proceeds............................ We intend to use the proceeds for general
corporate purposes, including working
capital and capital expenditures. See "Use
of Proceeds."
Proposed Nasdaq National Market symbol..... DSCM
</TABLE>
The number of shares of our common stock to be outstanding immediately after
the offering is based on the number of shares outstanding at July 16, 1999,
including the sale of 555,555 shares of common stock to Amazon.com at a price
per share equal to the initial public offering price, in a private placement
transaction to be closed concurrently with the closing of this offering. This
number does not include 11,502,000 shares of our common stock subject to
options and warrants outstanding or reserved for issuance under our stock plans
at July 16, 1999. In addition, except as otherwise noted, all information in
this prospectus (1) gives effect to the conversion of all outstanding shares of
preferred stock into shares of common stock effective upon the closing of the
offering, (2) assumes no exercise of the underwriters' overallotment option,
and (3) excludes the issuance of 200,000 shares of common stock to a charitable
foundation that we established on July 23, 1999.
drugstore.com(TM), the drugstore.com logo, the boutique(TM), What Every Body
Needs(TM), Where Every Body Shops(TM), What Your Body Needs(TM), and HEALTH .
BEAUTY . WELLNESS(TM) are our trademarks. This prospectus also includes trade
dress, trade names, trademarks and service marks of other companies. Use or
display by drugstore.com of other parties' trademarks, trade dress or products
is not intended to and does not imply a relationship with, or endorsement or
sponsorship of drugstore.com by, the trademark or trade dress owners.
5
<PAGE>
Summary Consolidated Financial Data
(in thousands, except share and per share data)
The balance sheet data displayed in the "pro forma" column reflects the
issuance of 12,282,599 shares of Series E preferred stock issued in July 1999
in exchange for $10 million in cash and other consideration, including
exclusive marketing commitments and other obligations valued at $233.9 million
based on the estimated fair value of $19.86 per share. The "pro forma as
adjusted" column reflects our capitalization as of July 4, 1999 with
adjustments to give effect to:
. the conversion of all shares of outstanding preferred stock into
34,468,000 shares of common stock upon the closing of this offering; and
. the receipt of the estimated proceeds from the sale of 5,000,000 shares
of our common stock at the initial public offering price of $18.00 per
share, after deducting the underwriting discount and estimated offering
expenses, including the sale of $10 million of our common stock to
Amazon.com. See "Use of Proceeds" for a description of how we intend to
use the net proceeds of this offering.
<TABLE>
<CAPTION>
Period from
April 2, 1998
(Inception) through Six Months
December 31, Ended July 4,
1998 1999
------------------- -------------
<S> <C> <C>
Consolidated Statement of Operations Data:
Net sales................................... $ -- $ 4,202
Gross profit (loss)......................... -- (1,349)
Total operating expenses.................... 8,201 29,997
Operating loss.............................. (8,201) (31,346)
Net loss.................................... (8,027) (30,353)
Pro forma basic and diluted net loss per
share (1).................................. $ (.98) $ (1.46)
Weighted average shares outstanding used to
compute pro forma basic and diluted net
loss per share (1)......................... 8,167,570 20,796,875
</TABLE>
<TABLE>
<CAPTION>
At July 4, 1999
---------------------------
Pro Pro Forma
Actual Forma as Adjusted
------- ------- -----------
<S> <C> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents.......................... $68,087 $78,087 $171,124
Working capital.................................... 62,400 72,400 165,437
Total assets....................................... 84,736 328,668 421,705
Capital lease obligations, less current portion.... 1,099 1,099 1,099
Total stockholders' equity......................... 72,564 316,496 409,146
</TABLE>
- --------
(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the determination of the number of weighted average shares used to
compute pro forma net loss per share amounts.
We were incorporated in Delaware in April 1998. Our principal executive
offices are located at 13920 Southeast Eastgate Way, Suite 300, Bellevue,
Washington 98005, and our telephone number is (425) 372-3200. Our World Wide
Web site is www.drugstore.com. The information contained on our Web site is not
part of this prospectus.
6
<PAGE>
RISK FACTORS
You should carefully consider the risks described below, together with all
of the other information included in this prospectus, before making an
investment decision. If any of the following risks actually occurs, our
business, financial condition or operating results could be materially
adversely affected. In such case, the trading price of our common stock could
decline, and you may lose all or part of your investment.
Risks Related to Our Business
We Are an Early Stage Company in a New and Rapidly Evolving Market, Which
Makes It Difficult for Investors to Determine Whether We Will Accomplish
Our Objectives
Because drugstore.com was founded in April 1998 and we only began selling
products in February 1999, we have a limited operating history on which
investors can base an evaluation of our business strategy. We have limited
insight into trends that may emerge and affect our business. An investor in
our common stock must consider the risks and difficulties frequently
encountered by early stage companies, as well as the risks we face due to our
participation in a new and rapidly-evolving market. These challenges include
our:
. Need to increase our brand awareness;
. Need to attract and retain customers at a reasonable cost;
. Dependence on Web site and transaction processing performance and
reliability;
. Need to compete effectively;
. Need to establish ourselves as an important participant in the evolving
market for healthcare products and services on the Internet; and
. Need to establish and develop relationships in the healthcare industry,
particularly in the areas of reimbursement and managed care.
Consumers of Health, Beauty, Wellness, Personal Care and Pharmacy Products
May Not Accept Our Solution, Which Would Reduce Our Revenues and Prevent Us
From Becoming Profitable
If we do not attract and retain a high volume of online customers to our
store at a reasonable cost, we will not be able to increase our revenues or
achieve profitability. We may not be able to convert a large number of
customers from traditional shopping methods to online shopping for health,
beauty, wellness, personal care and pharmacy products. Even if we are
successful at attracting online customers, we expect it will take several
years to build a critical mass of these customers. Specific factors that could
prevent widespread customer acceptance include:
. Shipping charges, which do not apply to shopping at traditional
drugstores;
. Delivery time associated with Internet orders, as compared to the
immediate receipt of products at a physical store;
. Pricing that does not meet customer expectations of "finding the lowest
price on the Internet;"
. Additional steps and delays in ensuring insurance coverage for
prescription products;
. Lack of coverage of customer prescriptions by some insurance carriers;
. Lack of consumer awareness of our online pharmacy;
. Customer concerns about the security of online transactions and the
privacy of their personal health information;
. Product damage from shipping or shipments of wrong or expired products
from our fulfillment partners or other vendors, resulting in a failure
to establish customers' trust in buying drugstore items online;
7
<PAGE>
. Delays in responses to customer inquiries or in deliveries to customers;
. Inability to serve the acute care needs of customers, including
emergency prescription drugs and other urgently needed products; and
. Difficulties in returning or exchanging orders.
We Expect Significant Increases in Our Operating Expenses and Continuing
Losses for the Next Several Years
We incurred net losses of $38.4 million for the period from inception
through July 4, 1999. We have not achieved profitability. We only began
selling products in February 1999 and cannot be certain that we will obtain
enough customer traffic or a high enough volume of purchases to generate
sufficient revenues and achieve profitability. We believe that we will
continue to incur operating and net losses for at least the next four years
(and possibly longer) and that the rate at which we will incur such losses
will increase significantly from current levels. We intend to increase our
operating expenses substantially as we:
. Increase our sales and marketing activities, particularly advertising
efforts;
. Provide our customers with promotional benefits, such as selling
selected products or offering shipping below our actual costs;
. Increase our general and administrative functions to support our growing
operations;
. Expand our customer and pharmacist support organizations to better serve
customer needs;
. Develop enhanced technologies and features to improve our Web site;
. Enhance our distribution fulfillment processes; and
. Possibly buy or build our own distribution facilities.
Because we will spend these amounts before we receive any incremental
revenues from these efforts, our losses will be greater than the losses we
would incur if we developed our business more slowly. In addition, we may find
that these efforts are more expensive than we currently anticipate, which
would further increase our losses.
We May Not Succeed in Establishing the drugstore.com Brand, Which Would
Adversely Affect Customer Acceptance and Our Revenues
Due to the early stage and competitive nature of the online market for
drugstore products, if we do not establish our brand quickly, we may lose the
opportunity to build a critical mass of customers. Promoting and positioning
our brand will depend largely on the success of our marketing efforts and our
ability to provide consistent, high quality customer experiences. To promote
our brand, we will incur substantial expense in our advertising efforts on
major Internet destinations such as Amazon.com, America Online, Excite and
Yahoo! and other Web sites our customers are likely to visit, as well as other
forms of media such as television and magazines. We will also need to spend
money to attract and train customer service personnel. If these brand
promotion activities do not yield increased revenues, we will incur additional
losses.
We Expect Our Quarterly Financial Results to Fluctuate And Our Early Stage
of Development Limits Our Ability to Predict Revenues and Expenses
Precisely
Historical trends and quarter-to-quarter comparisons of our operating
results are not a good indicator of our future performance. It is likely that
in some future quarter our operating results may be below the expectations of
public market analysts and investors. In this event, the price of our common
stock may fall. Our revenues and operating results are expected to vary
significantly from quarter to quarter due to a number of factors, including:
. Demand for our products;
8
<PAGE>
. Our ability to attract visitors to our Web store and convert those
visitors into customers;
. The frequency of repeat purchases by customers;
. Shifts in the nature and amount of publicity about us or our
competitors;
. Changes in the growth rate of Internet usage;
. Average order size;
. The mix of products sold;
. Our ability to enhance our technology to accommodate any future growth
in our operations or customers;
. Our ability, and that of our fulfillment partners, to ensure sufficient
product supply;
. Changes in our pricing policies or the pricing policies of our
competitors;
. Changes in government regulation;
. The availability of reimbursement for pharmacy products; and
. Costs related to potential acquisitions of technology or businesses.
Our operating expenses are largely based on anticipated revenue trends and
a high percentage of our expenses are fixed in the short term. As a result, a
delay in generating or recognizing revenue for any reason could result in
substantial additional operating losses. The volume and timing of orders of
health, beauty, wellness, personal care and pharmacy products on our Web store
are difficult to predict because the online market for such products is in its
infancy. Due to the limited operating history of our Web store, we do not have
a material amount of repeat business from regular customers. Because our Web
site is designed to encourage repeat business and we do not yet have
sufficient historical data on how successful this strategy will be, we cannot
currently forecast revenue from regular customers or overall anticipated
revenue trends.
A portion of our revenues may also be seasonal in nature, especially with
respect to the sale of certain beauty products, which depend to some extent on
seasonal product changes and seasonal purchasing patterns. Consumer "fads" and
other changes in consumer trends may cause shifts in purchasing patterns,
resulting in significant fluctuations in our operating results from one
quarter to the next. Our limited operating history makes it difficult to fully
assess the impact of these factors.
Limited Insurance Reimbursement Coverage May Reduce Our Ability to Sell
Pharmacy Products Online, Which Would Reduce Our Revenues
To obtain reimbursement on behalf of our customers for the prescription
products that they purchase on our Web site, we need to obtain contracts with
numerous insurance companies and PBMs. Other than our contract with PCS Health
Systems, Inc., which is a 10-year agreement, many of our agreements are short-
term and may be terminated with less than 30 days' prior notice. Our ability
to obtain additional contracts with other insurance companies and PBMs, or
retain our existing contracts for an extended period of time, is uncertain for
the following reasons:
. Many of these companies are in the early stages of evaluating the impact
of the Internet and online pharmacies on their businesses. These
companies may delay their decisions to contract with online pharmacies or
may decide to develop their own Internet capabilities that may compete
with us.
. Many insurance companies have existing contracts with chain drugstores
and PBMs that have announced their intentions to establish online
pharmacies.
. Some insurance companies and PBMs will likely contract with only one or a
limited number of online pharmacies. If our online competitors obtain
these contracts and we do not, we would be at a competitive disadvantage.
9
<PAGE>
In addition, we must process each insurance application individually, which
may raise the costs of processing prescription orders and delay our order
processing time. Customers may not initially embrace our online insurance
coverage procedure.
We Depend on a Limited Number of Distribution Partners; If They Do Not
Perform, We Will Not Be Able to Effectively Ship Orders
We rely to a large extent on rapid distribution by third parties. We
currently purchase all of our pharmaceutical products from one vendor,
RxAmerica L.L.C. and in the future may be required to purchase all of our
pharmaceutical products from Rite Aid once we establish our own distribution
center. We also purchase a substantial majority of our nonpharmaceutical
products from one vendor, Walsh Distribution, Inc., which accounted for 78% of
our nonpharmaceutical cost of sales from launch of our Web store to July 4,
1999. Our business could also be significantly disrupted if RxAmerica, Rite
Aid or Walsh Distribution were to breach their contracts or suffer adverse
developments that affect their ability to supply products to us. In addition,
RxAmerica is a joint venture owned by American Stores Company (which was
recently acquired by Albertson's, Inc.) and Longs Drugs, both of which are
potential competitors of drugstore.com, and actual competitors with Rite Aid,
one of our principal stockholders and business partners. If for any reason
RxAmerica, Rite Aid or Walsh Distribution is unable or unwilling to supply
products to us in sufficient quantities and in a timely manner, we may not be
able to secure alternative fulfillment partners on acceptable terms in a
timely manner, or at all.
Because we rely on third parties to fulfill orders, we depend on their
systems for tracking inventory and financial data. If our distribution
partners' systems fail or are unable to scale or adapt to changing needs, or
if we cannot integrate information systems with any new distributors, we may
not have adequate, accurate or timely inventory or financial information.
We also rely on third-party carriers for shipments to and from distribution
facilities. We are therefore subject to the risks, including employee strikes
and inclement weather, associated with our distribution partners and of our
carriers' ability to provide product fulfillment and delivery services to meet
our distribution and shipping needs. Failure to deliver products to our
customers in a timely and accurate manner would harm our reputation, the
drugstore.com brand and our results of operations.
Increasing Our Product Distribution Capacity Will Require Significant
Investments in Cash and Management Resources
We expect to establish our own distribution center within the next 12
months to achieve greater control over the distribution process and to ensure
adequate supplies of products to our customers. Opening one or more
distribution centers will require significant capital investments in
facilities and equipment, will require us to hire and train a significant
number of new employees, will require us to establish a significant number of
direct relationships with manufacturers and could divert management attention
from other issues. In addition, we may be unable to obtain products on terms
as favorable as our distribution partners. We will need to develop or license
distribution software to ensure timely and accurate shipments. In addition, if
we establish our own pharmacy operations we will become subject to additional
regulatory requirements and related costs.
To obtain funds for this expansion, we may need to raise funds through the
issuance of equity, equity-related or debt securities or through obtaining
credit from financial institutions in addition to the funds we are raising in
the offering. We cannot be certain that such additional financing will be
available to us on favorable terms when required, or at all. In addition, if
we issue equity or equity-related securities, such issuance would dilute the
ownership interest of existing stockholders and could adversely affect our
stock price.
Any Errors in the Filling or Packaging of the Prescription Drugs We
Dispense May Expose Us to Liability and Negative Publicity
Pharmacy errors relating to prescriptions, dosage and other aspects of the
medication dispensing process can produce liability for us that our insurance
may not cover. For example, a study of community pharmacies
10
<PAGE>
appearing in the December 1995 issue of American Pharmacy found that 24% of
prescriptions contained dispensing errors and 4% of prescriptions contained
errors that were clinically significant. Because we distribute pharmaceutical
products directly to the consumer, we are the most visible participant in the
medication distribution chain and therefore have more exposure to liability
claims.
Our pharmacists are required by law to offer counseling, without additional
charge, to our customers about medication, dosage, delivery systems, common
side effects and other information deemed significant by the pharmacists. Our
pharmacists may have a duty to warn customers regarding any potential adverse
effects of a prescription drug if the warning could reduce or negate such
effects. This counseling is in part accomplished through e-mail and inserts
included with the prescription, which may increase the risk of
miscommunication because the customer is not personally present or may not
have provided all relevant information. We also post product information on
our Web store. Providing information on pharmaceutical and other products
creates the potential for claims to be made against us for negligence,
personal injury, wrongful death, product liability, malpractice, invasion of
privacy or other legal theories based on our product or service offerings. Our
general liability, product liability and professional liability insurance may
not cover potential claims of this type or may not be adequate to protect us
from all liability that may be imposed.
Pharmacy errors either by drugstore.com or our competitors may also produce
significant adverse publicity either for us or the entire online pharmacy
industry. Because of the significant amount of recent press coverage on
Internet retailing, we believe that we will be subject to a higher level of
media scrutiny than other pharmacy product channels. The amount of negative
publicity that we or the online pharmacy industry receive as a result of
pharmacy or prescription processing errors could be disproportionate in
relation to the negative publicity received by other pharmacies making similar
mistakes. We have no control over the pharmacy practices of our competitors,
and we cannot ensure that our pharmacists or our prescription processing will
be able to operate without error. We believe customer acceptance of our online
shopping experience is based in large part on consumer trust, and negative
publicity could erode such trust, or prevent it from growing. This could
result in an immediate reduction in the amount of orders we receive and
adversely affect our revenue growth.
We Face the Risk of Systems Interruptions and Capacity Constraints on Our
Web Site, Possibly Resulting in Adverse Publicity, Revenue Losses and
Erosion of Customer Trust
The satisfactory performance, reliability and availability of our recently-
opened Web site, transaction processing systems and network infrastructure are
critical to our reputation and our ability to attract and retain customers and
to maintain adequate customer service levels. Any future systems interruption
that results in the unavailability of our Web site or reduced order
fulfillment performance could result in negative publicity and reduce the
volume of goods sold and the attractiveness of our Web store, which could
negatively affect our revenues. From time to time, we have experienced
temporary system interruptions for a variety of reasons, including power
failures, software bugs and an overwhelming number of visitors trying to reach
our Web site. We may not be able to correct any problem in a timely manner.
Because we outsource certain aspects of our system and because some of the
reasons for a systems interruption may be outside of our control, we also may
not be able to exercise sufficient control to remedy the problem quickly or at
all.
We opened our site for customers in February 1999 and to the extent that
customer traffic grows substantially, we will need to expand the capacity of
our systems to accommodate a larger number of visitors. Any inability to scale
our systems may cause unanticipated system disruptions, slower response times,
degradation in levels of customer service, impaired quality and speed of order
fulfillment, or delays in reporting accurate financial information. We are not
certain that we will be able to project the rate or timing of increases, if
any, in the use of our Web site accurately or in a timely manner to permit us
to effectively upgrade and expand our transaction-processing systems or to
integrate smoothly any newly developed or purchased modules with our existing
systems.
11
<PAGE>
We Have Grown Very Rapidly, and We Need to Manage Changing and Expanding
Operations
We have rapidly and significantly expanded our operations, and anticipate
that we will continue to expand. From July 1998 to July 4, 1999 we grew from 3
to 245 employees. This growth has placed, and our anticipated future
operations will continue to place, a significant strain on our management
systems and resources. We will not be able to implement our business strategy
in a rapidly evolving market without an effective planning and management
process. We will not be able to increase revenues unless we continue to
improve our transaction-processing, operational, financial and managerial
controls and reporting systems and procedures, expand, train and manage our
work force and manage multiple relationships with third parties. Many of our
senior management have no prior senior management experience at public
companies, and none of our executive officers have prior management experience
in the healthcare or retail drugstore industry.
Expanding the Breadth and Depth of Our Product and Service Offerings Is
Expensive and Difficult, and We May Receive No Benefit From Our Expansion
We intend to expand the breadth and depth of our product and service
offerings by promoting new or complementary products or sales formats. We
cannot be certain that these new offerings will generate sufficient revenues
for the costs involved. Expansion of our offerings in this manner could
require significant additional expenditures and could strain our management,
financial and operational resources. For example, we may need to incur
significant marketing expenses, develop relationships with new fulfillment
partners or manufacturers, or comply with new regulations. We cannot be
certain that we will be able to expand our product and service offerings in a
cost-effective or timely manner. Furthermore, any new product or service
offering or sales format that is not favorably received by consumers could
damage the reputation of our brand. The lack of market acceptance of such
efforts or our inability to generate satisfactory revenues from such expanded
offerings to offset their cost could harm our business.
We have an agreement with Amazon.com that prohibits us from selling
advertising to, linking our Web site to or promoting on our Web site any
company that sells products or services competitive with those which
Amazon.com offers or which Amazon.com is preparing to produce or market. While
we retain the ability to sell products and services in these markets
ourselves, this prohibition would limit our ability to work with other
companies in the markets for books, music products, video products, software,
magazines, consumer electronics, gift centers or registries, and auctions. If
Amazon.com expands into other areas, this expansion may further limit the
number of companies we can promote on our Web site.
Our Limited Relationship With Amazon.com May Restrict Our Ability to Sell
Advertising or Promote Other Web Sites
Our limited relationship with Amazon.com may restrict our activities and is
subject to change. We entered into a technology license and advertising
agreement in August 1998 with Amazon.com, currently our largest stockholder.
Jeffrey P. Bezos, Amazon.com's chairman of the board and chief executive
officer, is a member of our board of directors. Our relationship with
Amazon.com has received significant media attention, but the parties'
obligations to provide support to each other are limited. Under the agreement,
each party has committed to providing the other with advertising on our
respective Web sites through the term of the agreement.
We have also agreed not to sell advertising on our Web site to, link our
Web site to or promote on our Web site any company that sells products or
services competitive with those which Amazon.com offers or which Amazon.com is
preparing to produce or market. We are currently restricted with respect to
books, music products, video products, gift centers, toys, games, electronics,
cards and auctions. If Amazon.com expands into other areas, this expansion may
further limit the number of companies we can promote on our Web site. If we
were acquired by a competitor of Amazon.com and Amazon.com did not vote in
favor of the transaction, we would lose our rights to advertise on
Amazon.com's Web site and to use Amazon.com's technology (if we are then using
any).
12
<PAGE>
In addition, due to Amazon.com's significant ownership of our common stock,
it will be able to significantly influence all matters requiring approval by
our stockholders, including the election of directors and the approval of
mergers or other business combination transactions. For more information about
our relationship with Amazon.com, see "Business--Relationship with
Amazon.com." See also "Executive Officers and Directors" for background on
Jeffrey P. Bezos, "Certain Relationships and Related Transactions" for a
description of our agreements with Amazon.com and "Principal Stockholders" for
a description of Amazon.com's stock ownership relative to other stockholders.
Our Relationships with Rite Aid and GNC are Complex, Involve Many Risks,
And May Restrict Our Ability to Promote, Contract With, or Operate
Traditional Retail Stores
In June 1999, we entered into a series of agreements with Rite Aid and GNC.
These agreements involve many aspects of our business and include the sale of
equity securities to these companies as well as various arrangements relating
to the operation of our respective Web sites, the fulfillment of orders and
the extension of Rite Aid's insurance relationships to cover prescriptions
processed by us. This type of arrangement is complex and will require a great
deal of effort to operate successfully. As a result, there are many risks
related to these arrangements, including some that we may not have foreseen.
It is difficult to assess the likelihood of occurrence of these risks,
including the lack of success of the overall arrangement to meet the parties'
objectives. In the event that we do not realize the intended benefits of these
relationships, we will have expended a great deal of time and effort that
could have been directed to more beneficial activities. In addition, customer
perceptions and our business may be adversely impacted if these relationships
are not successful.
We must integrate Rite Aid's pharmacy product ordering system with our Web-
based systems so consumers can order their pharmacy products on our Web site
and pick them up at a Rite Aid store. Integrating different information
systems is technically difficult and may be delayed, which would delay our
receipt of revenues from these sales and could adversely affect customer
acceptance of online pharmacy orders. While Rite Aid has committed to
promoting drugstore.com in its stores and in its advertising, we do not
control the choice of ads that will feature us and this form of advertising
may not result in additional drugstore.com customers. While the Rite Aid
relationship substantially broadens our ability to provide prescription
medications to consumers with insurance reimbursement plans, it may not allow
all of our potential customers to purchase these medications from
drugstore.com and receive insurance reimbursement, which could adversely
affect consumer perceptions and our revenues.
We have agreed not to promote any other traditional chain drugstore or
operate one ourselves. We have also agreed not to contract with another
traditional retail store to fill pharmacy product orders we receive unless a
Rite Aid store is not conveniently located. These restrictions could limit our
flexibility and ability to grow our business if our relationship with Rite Aid
does not develop successfully.
Due to Rite Aid's significant ownership of our common stock, it will be
able to significantly influence all matters requiring approval by our
stockholders, including the election of directors and the approval of mergers
or other business combination transactions.
For more information about our relationships with Rite Aid and GNC, see
"Business--Relationships with Rite Aid" and "Business--Relationship with GNC."
See also "Certain Relationships and Related Transactions" for a description of
our agreements with Rite Aid and GNC and "Principal Stockholders" for a
description of Rite Aid's and GNC's stock ownership relative to other
stockholders.
We Enter Into Strategic Relationships to Help Promote Our Web Site; If We
Fail to Maintain or Enhance These Relationships, Our Development Could Be
Hindered
We believe that our ability to attract customers, facilitate broad market
acceptance of our products and the drugstore.com brand and enhance our sales
and marketing capabilities depends on our ability to develop and maintain
strategic relationships with portals, distributors, Amazon.com, Rite Aid and
GNC. If we are unable to develop or maintain key relationships, we may have
difficulty attracting customers.
13
<PAGE>
We Face Uncertainty Related to Pharmaceutical Costs and Pricing, Which
Could Affect Our Revenues and Margins
We expect that pharmacy sales will account for a significant percentage of
our total sales. Sales of our products will depend in part on the availability
of reimbursement from third-party payors such as government health
administration authorities, private health insurers, health maintenance
organizations (HMOs), PBMs and other organizations. Because these
organizations are traditionally focused on reduced cost to employer groups,
whereas we are focused more on direct customer service, we must devote time
and resources to develop third-party payor confidence in our approach.
In addition, third-party payors are increasingly challenging the price and
cost-effectiveness of medical products and services. The efforts of third-
party payors to contain costs will place downward pressures on gross margins
from sales of prescription drugs. Our revenues from prescription drug sales
may also be affected by health care reform initiatives of federal and state
governments, including proposals designed to significantly reduce spending on
Medicare, Medicaid and other government programs, changes in programs
providing for reimbursement for the cost of prescription drugs by third-party
payors and regulatory changes related to the approval process for prescription
drugs. Such initiatives could lead to the enactment of federal and state
regulations that may adversely impact our prescription drug sales.
We cannot be certain that our products or services will be considered cost
effective or that adequate third-party reimbursement will be available to
enable us to maintain price levels sufficient to realize adequate profit
margins.
Competition From Both Traditional and Online Retailers May Result in Price
Reductions and Decreased Demand for Our Products and Services
We compete in a market that is highly competitive and expect competition to
intensify in the future. We currently or potentially compete with a variety of
companies, many of which have significantly greater financial, technical,
marketing and other resources. These competitors include (1) various online
stores that sell pharmaceutical as well as over-the-counter drug and health,
wellness, beauty and personal care items; (2) PBMs that sell pharmaceuticals
directly; and (3) existing drugstores. Most of these drugstores, which include
national, regional and local drugstore chains, discount drugstores,
supermarkets, combination food and drugstores, discount general merchandise
stores, mass market retailers, independent drugstores and local merchants,
have existed for a longer period, have greater financial resources, have
established marketing relationships with leading manufacturers and
advertisers, and have secured greater presence in distribution channels. Some
of these companies may also commence or expand their presence on the Internet.
We also compete with hospitals, HMOs and mail order prescription drug
providers, all of whom are or may begin offering products and services over
the Internet. Finally, we are aware of numerous other smaller entrepreneurial
companies that are focusing significant resources on developing and marketing
products and services that will compete directly with those offered at
drugstore.com.
We believe that there may be a significant advantage in establishing a
large customer base before our competitors do so. If we fail to attract and
retain a large customer base and our competitors establish a more prominent
market position relative to ours, this could inhibit our ability to grow.
We also believe we may face a significant competitive challenge from our
competitors forming alliances with each other. For instance, one of our direct
online competitors may form a partnership with a major PBM, major HMO or chain
drugstore. The combined resources of these partnerships could pose a
significant competitive challenge to drugstore.com. In addition, certain PBMs
and HMOs could form alliances with our competitors that would prevent them
from also entering into relationships with drugstore.com. Our inability to
partner with a major PBM or HMO could be a major competitive disadvantage to
us.
We believe the principal factors that will draw end users to an online
shopping application include brand availability, selection, personalized
services, convenience, price, accessibility, customer services, quality of
14
<PAGE>
search tools, quality of content, and reliability and speed of fulfillment for
products ordered. We will have little or no control over how successful our
competitors are in addressing these factors. In addition, with little
difficulty, our online competitors can duplicate many of the products,
services and content offered on our site.
Increased competition could result in price reductions, fewer customer
orders, fewer search queries served, reduced gross margins and loss of market
share.
Our Systems and Operations, and Those of Our Distributors, Are Vulnerable
to Natural Disasters and Other Unexpected Problems
Substantially all of our computer and communications hardware is located at
our leased facility in Bellevue, Washington and our systems infrastructure is
hosted at an Exodus Communications facility in Tukwila, Washington. Our
systems and operations are vulnerable to damage or interruption from fire,
flood, power loss, telecommunications failure, earthquakes and similar events.
In addition, our servers are vulnerable to computer viruses, physical or
electronic break-ins and similar disruptions, which could lead to
interruptions, delays, loss of data or the inability to accept and fulfill
customer orders. We do not currently have redundant systems or a formal
disaster recovery plan and do not carry sufficient business interruption
insurance to compensate for losses that may occur. Our current fulfillment
partners, Walsh and RxAmerica, are both located in Texas and also face these
risks. In particular, RxAmerica only has a single location and no back-up
facility.
We depend on the efficient operation of Internet connections from customers
to our systems. These connections, in turn, depend on the efficient operation
of Web browsers, Internet service providers and Internet backbone service
providers, all of which have had periodic operational problems or experienced
outages. Any system delays, failures or loss of data, whatever the cause,
could reduce customer satisfaction with our applications and services and harm
our sales.
We retain confidential customer and patient information in our processing
centers. Therefore, it is critical that our facilities and infrastructure
remain secure and that our facilities and infrastructure are perceived by the
marketplace to be secure. A material security breach could damage our
reputation or result in liability to us.
Governmental Regulation of Our Business Could Require Significant Expenses,
and Failure to Comply With Certain Regulations Could Result in Civil and
Criminal Penalties
Our business is subject to extensive federal, state and local regulations,
many of which are specific to pharmacies and the sale of over-the-counter
drugs. Please see "Business--Governmental Regulation" for detailed information
about these regulations. Regulations in this area often require subjective
interpretation, and we cannot be certain that our attempts to comply with
these regulations will be deemed sufficient by the appropriate regulatory
agencies. Violations of any regulations could result in various civil and
criminal penalties, including suspension or revocation of our licenses or
registrations, seizure of our inventory, or monetary fines, which could
adversely effect our operations.
We are also subject to laws and regulations regarding homeopathic drugs,
and we may face enforcement actions, lawsuits or claims asserting that we have
not complied with these laws and regulations. As we expand our product and
service offerings, more of our products and services will likely be subject to
regulation by the FDA, which regulates drug advertising and promotion.
Complying with FDA regulations is time consuming, burdensome and expensive,
and could delay our introduction of new products or services.
The U.S. House of Representatives Committee on Commerce and the General
Accounting Office are currently investigating online pharmacies and online
prescribing. We believe that any regulations resulting from the investigations
will likely result in increased reporting and monitoring requirements, which
could increase our expenses. Other legislation and regulations currently being
considered at the federal and state level could affect our business, including
legislation or regulations relating to confidentiality of patient records,
electronic access and storage as well as the inclusion of prescription drugs
as a Medicare benefit. In addition, various state
15
<PAGE>
legislatures are considering new legislation related to the regulation of
nonresident pharmacies. Compliance with new laws or regulations could increase
our expenses.
The Health Insurance Portability and Accountability Act of 1996 mandates
the use of standard transactions, standard identifiers, security and other
provisions by the year 2000. Regulations have been proposed to implement these
requirements, and we are designing our applications to comply with the
proposed regulations. However, until these regulations become final, possible
changes in these regulations could cause us to use additional resources and
lead to delays as we revise our Web site and operations.
Until recently, Health Care Financing Administration guidelines prohibited
transmission of Medicare eligibility information over the Internet. We are
also subject to extensive regulation relating to the confidentiality and
release of patient records. Additional legislation governing the distribution
of medical records exists or has been proposed at both the state and federal
level. It may be expensive to implement security or other measures designed to
comply with any new legislation. Moreover, we may be restricted or prevented
from delivering patient records electronically. This could have an adverse
impact on our ability to gain and retain customers.
We are assisting the National Association of Boards of Pharmacy (NABP), a
coalition of state pharmacy boards, in developing a program, the Verified
Internet Pharmacy Practice Sites (VIPPS), as a model for self-regulation for
online pharmacies. We intend to comply with the VIPPS criteria for
certification, and compliance with these requirements could require
substantial expenses, which could increase our losses.
Failure to Attract and Retain Experienced Personnel and Senior Management
Could Hurt Our Ability to Grow Our Business
We intend to continue to hire a significant number of additional sales,
support and marketing personnel, as well as pharmacists and software
developers. Competition for these individuals is intense, and we may not be
able to attract, assimilate or retain additional highly qualified personnel in
the future. Our future success also depends upon the continued service of our
executive officers and senior management. None of our employees is bound by an
employment agreement for any specific term. We do not have "key person" life
insurance policies covering any of our employees. In addition, none of the
members of our senior management team have prior experience in the healthcare
industry or in drugstore operations.
We Cannot Be Certain That We Will Be Able to Protect Our Intellectual
Property, and We May Be Found to Infringe Proprietary Rights of Others,
Which Could Harm Our Business
We rely or may in the future rely on a combination of patent, trademark,
trade secret and copyright law and contractual restrictions to protect our
intellectual property. These afford only limited protection. Despite our
efforts to protect our proprietary rights, unauthorized parties may attempt to
copy aspects of our sales formats or to obtain and use information that we
regard as proprietary, such as the technology used to operate our Web site,
our content and our trademarks.
In February 1999, we filed an application for a U.S. trademark registration
for "drugstore.com." We have also applied for U.S. trademark registrations for
the drugstore.com logo, "the boutique," "What Every Body Needs," "Where Every
Body Shops," "What Your Body Needs" and "HEALTH . BEAUTY . WELLNESS." We may
be unable to secure these registrations. It is also possible that our
competitors or others will adopt service names similar to ours, thereby
impeding our ability to build brand identity and possibly leading to customer
confusion. In addition, there could be potential trade name or trademark
infringement claims brought by owners of other registered trademarks or
trademarks that incorporate variations of the term drugstore.com or our other
trademark applications. Any claims or customer confusion related to our
trademarks, or our failure to obtain any trademark registration, would
negatively affect our business.
Litigation or proceedings before the U.S. Patent and Trademark Office may
be necessary in the future to enforce our intellectual property rights, to
protect our trade secrets and domain name and determine the validity and scope
of the proprietary rights of others. Any litigation or adverse priority
proceeding could result in substantial costs and diversion of resources and
could seriously harm our business and operating results. Finally, we may in
16
<PAGE>
the future sell our products internationally, and the laws of many countries
do not protect our proprietary rights to as great an extent as do the laws of
the United States.
Third parties may also claim infringement by us with respect to past,
current or future technologies. We expect that participants in our markets
will be increasingly subject to infringement claims as the number of services
and competitors in our industry segment grows. Any such claim, whether
meritorious or not, could be time-consuming, result in costly litigation,
cause service upgrade delays or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements might not be available on
terms acceptable to us or at all.
We May Not Be Able to Protect Our Domain Names In All Countries or Against
All Infringers, Which Could Decrease the Value of Our Brand Name and
Proprietary Rights
We currently hold the Internet domain name "drugstore.com," as well as
various other related names. Domain names generally are regulated by Internet
regulatory bodies. The regulation of domain names in the United States and in
foreign countries is subject to change. Regulatory bodies could establish
additional top-level domains, appoint additional domain name registrars or
modify the requirements for holding domain names. As a result, we may not
acquire or maintain the "drugstore.com" domain name in all of the countries in
which we conduct business.
The relationship between regulations governing domain names and laws
protecting trademarks and similar proprietary rights is unclear. Therefore, we
could be unable to prevent third parties from acquiring domain names that
infringe or otherwise decrease the value of our brand name, trademarks and
other proprietary rights.
We May Face Liability for Content on Our Web Site
Because we post product information and other content on our Web site, we
face potential liability for negligence, copyright, patent, trademark,
defamation, indecency and other claims based on the nature and content of the
materials that we post. Such claims have been brought, and sometimes
successfully pressed, against Internet content distributors. In addition, we
could be exposed to liability with respect to the unauthorized duplication of
content or unauthorized use of other parties' proprietary technology. Although
we maintain general liability insurance, our insurance may not cover potential
claims of this type or may not be adequate to indemnify us for all liability
that may be imposed. Any imposition of liability that is not covered by
insurance or is in excess of insurance coverage could harm our business.
Our Operations May Be Disrupted If We or Our Vendors Experience Systems
Failure or Data Corruption From the Year 2000 Issue
Any failure of our material systems, our vendors' material systems or the
Internet to be year 2000 compliant would have material adverse consequences
for us. Such consequences would include difficulties in operating our Web site
effectively, taking product orders, making product deliveries or conducting
other fundamental parts of our business. We are currently assessing the year
2000 readiness of the software, computer technology and other services that we
use which may not be year 2000 compliant. At this time, we have not yet
developed a contingency plan to address situations that may result if our
vendors or we are unable to achieve year 2000 compliance. The cost of
developing and implementing such a plan, if necessary, could be significant.
We also understand that at least one of our distributors, RxAmerica, has not
yet completed its assessment of the year 2000 readiness of its software,
computer technology and other services or finalized any contingency plan to
address year 2000 problems that may arise.
We also depend on the year 2000 compliance of the computer systems and
financial services used by consumers. A significant disruption in the ability
of consumers to reliably access the Internet or portions of it or to use their
credit cards would have an adverse effect on demand for our products and
services. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Year 2000" for a further description of the issues we
face with regard to the year 2000.
17
<PAGE>
Our Officers, Directors and Certain Existing Stockholders Control the
Majority of Our Common Stock, Which Could Discourage an Acquisition of Us
or Make Removal of Incumbent Management More Difficult
Executive officers, directors and entities affiliated with them will, in
the aggregate, beneficially own approximately 58.1% of our outstanding common
stock following the completion of this offering. These stockholders, if acting
together, would be able to significantly influence all matters requiring
approval by our stockholders, including the election of directors and the
approval of mergers or other business combination transactions. In addition,
after this offering, Amazon.com will beneficially own approximately 26.7% and
Rite Aid will beneficially own 22.0% of our outstanding common stock.
Therefore, Amazon.com and Rite Aid will each be able to significantly
influence all matters requiring approval by our stockholders, including the
election of directors and the approval of mergers or other business
combination transactions. Amazon.com's and Rite Aid's substantial equity
stakes in drugstore.com could also make us a much less attractive acquisition
candidate to potential acquirors, because either Amazon.com or Rite Aid alone
could have sufficient votes to prevent the tax-free treatment of an
acquisition. See "Principal Stockholders" for a description of Amazon.com's
and Rite Aid's stock ownership relative to other stockholders.
Our Net Sales Would Be Harmed if We Experience Significant Credit Card
Fraud
A failure to adequately control fraudulent credit card transactions would
harm our net sales and results of operations because we do not carry insurance
against this risk. Under current credit card practices, we are liable for
fraudulent credit card transactions because we do not obtain a cardholder's
signature.
Certain Antitakeover Provisions and Significant Equity Ownership by
Amazon.com and Rite Aid Could Preclude an Acquisition
Provisions of our certificate of incorporation, bylaws, Washington law and
Delaware law could make it more difficult for a third party to acquire us,
even if doing so would be beneficial to our stockholders. Further, because
Amazon.com and Rite Aid each own a significant percentage of our capital
stock, a competitor of Amazon.com or Rite Aid as well as other potential
acquirors could determine not to merge with or acquire us. In addition, if we
were acquired by an Amazon.com competitor and Amazon.com did not vote in favor
of the transaction, we would lose our rights to promotional placements on
Amazon.com's website, and to use Amazon.com's technology (if we are then using
any). The potential loss of these rights could inhibit offers to acquire us.
Risks Related to Internet Commerce
We Depend on Continued Use of the Internet and Growth of the Online
Drugstore Market
Our future revenues and profits, if any, substantially depend upon the
widespread acceptance and use of the Internet as an effective medium of
business and communication by our target customers. Rapid growth in the use of
and interest in the Internet has occurred only recently. As a result,
acceptance and use may not continue to develop at historical rates, and a
sufficiently broad base of consumers may not adopt, and continue to use, the
Internet and other online services as a medium of commerce.
In addition, the Internet may not be accepted as a viable long-term
commercial marketplace for a number of reasons, including potentially
inadequate development of the necessary network infrastructure or delayed
development of enabling technologies and performance improvements. Our success
will depend, in large part, upon third parties maintaining the Internet
infrastructure to provide a reliable network backbone with the speed, data
capacity, security and hardware necessary for reliable Internet access and
services.
Further, the online market for drugstore products is in its infancy. The
market is significantly less developed than the online market for books,
auctions, music, software and numerous other consumer products. Even if use of
the Internet and electronic commerce continues to increase, the rate of
growth, if any, of the online drugstore market could be significantly less
than the online market for other products. Our rate of revenue growth could
therefore be significantly less than other online merchants.
18
<PAGE>
Our Sales Could be Negatively Affected if We Are Required to Charge Taxes
on Purchases
We do not collect sales or other similar taxes in respect of goods sold by
drugstore.com, except from purchasers located in Washington and Texas.
However, one or more states or the federal government may seek to impose sales
tax collection obligations on out-of-state companies (such as drugstore.com)
which engage in or facilitate online commerce, and a number of proposals have
been made at the state and local level that would impose additional taxes on
the sale of goods and services through the Internet. Such proposals, if
adopted, could substantially impair the growth of electronic commerce, and
could adversely affect our opportunity to derive financial benefit from such
activities. Moreover, one or more states could begin to impose sales taxes on
sales of prescription products (which are not generally taxed at this time);
if so, customers who order prescriptions at our Web site and pick them up at a
local Rite Aid store would be required to pay state sales tax. A successful
assertion by one or more states or the federal government that we should
collect further sales or other taxes on the sales of products through
drugstore.com could negatively affect our revenues and business.
If We Do Not Respond to Rapid Technological Changes, Our Services Could
Become Obsolete and Our Business Would Be Seriously Harmed
As the Internet and online commerce industry evolve, we must license
leading technologies useful in our business, enhance our existing services,
develop new services and technology that address the increasingly
sophisticated and varied needs of our prospective customers and respond to
technological advances and emerging industry standards and practices on a
cost-effective and timely basis. We may not be able to successfully implement
new technologies or adapt our Web store, proprietary technology and
transaction-processing systems to customer requirements or emerging industry
standards. If we are unable to do so, it could adversely impact our ability to
build the drugstore.com brand and attract and retain customers.
Governmental Regulation of the Internet and Data Transmission Over the
Internet Could Affect Our Business
Laws and regulations directly applicable to communications or commerce over
the Internet are becoming more prevalent. The most recent session of the U.S.
Congress resulted in Internet laws regarding children's privacy, copyrights,
taxation and the transmission of sexually explicit material. The European
Union recently enacted its own privacy regulations. In particular, many
government agencies and consumers are focused on the privacy and security of
medical and pharmaceutical records. The law of the Internet, however, remains
largely unsettled, even in areas where there has been some legislative action.
It may take years to determine whether and how existing laws such as those
governing privacy, libel and taxation apply to Internet stores such as ours.
The rapid 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, that may impose additional burdens on companies conducting
business online and in particular companies that fill prescriptions maintain
medical or pharmaceutical records. The adoption or modification of laws or
regulations relating to the Internet business could adversely affect our
ability to attract and serve customers.
Risks Related to this Offering
Our Stock Price Will Fluctuate After This Offering, Which Could Result in
Substantial Losses for Investors
Although the initial public offering price will be determined based on
several factors, the market price for our common stock will vary from the
initial offering price after this offering. This could result in substantial
losses for investors. The market price of our common stock may fluctuate
significantly in response to a number of factors, some of which are beyond our
control. These factors include:
. Quarterly variations in operating results;
. Changes in financial estimates by securities analysts;
19
<PAGE>
. Announcements by us or our competitors, of new products, significant
contracts, acquisitions or strategic relationships;
. Publicity about our company, our products and services, our competitors,
or e-commerce in general;
. Additions or departures of key personnel;
. Any future sales of our common stock or other securities; and
. Stock market price and volume fluctuations of publicly-traded companies
in general and Internet-related companies in particular.
The trading prices of Internet-related companies and e-commerce companies
in particular have been especially volatile and many are at or near historical
highs. Investors may be unable to resell their shares of our common stock at
or above the offering price. In the past, securities class action litigation
has often been brought against a company following periods of volatility in
the market price of its securities. We may be the target of similar litigation
in the future. Securities litigation could result in substantial costs and
divert management's attention and resources, which could seriously harm our
business and operating results.
Future Sales of Shares by Existing Stockholders Could Affect Our Stock
Price
If our stockholders sell substantial amounts of our common stock in the
public market following this offering, the market price of our common stock
could fall, potentially resulting in substantial losses to investors. Such
sales also might make it more difficult for us to sell equity or equity-
related securities in the future at a time and price that we deem appropriate.
Based on shares outstanding as of July 16, 1999, upon completion of this
offering, we will have outstanding 42,346,555 shares of common stock, assuming
no exercise of the underwriters' over-allotment option. Other than the shares
of common stock sold in this offering, no shares will be eligible for sale in
the public market immediately. Holders of 37,346,555 shares will be subject to
agreements with the underwriters or us that restrict their ability to transfer
their stock for 180 days from the date of this prospectus. After these
agreements expire, an additional 17,769,268 shares will be eligible for sale
in the public market assuming no exercise of options. See "Shares Eligible for
Future Sale" for a further description regarding shares that will become
eligible for sale at future dates after this offering.
New Stockholders Will Incur Substantial Dilution as a Result of This
Offering
The initial public offering price is expected to be substantially higher
than the book value per share of our outstanding common stock. As a result,
investors purchasing common stock in this offering will incur immediate
substantial dilution. In addition, we have issued options to acquire common
stock at prices significantly below the initial public offering price. To the
extent such outstanding options are ultimately exercised, there will be
further dilution to investors in this offering. See "Dilution" for a more
detailed description of how new stockholders will incur dilution.
Special Note Regarding Forward-Looking Statements
This prospectus contains forward-looking statements. These statements
relate to future events or our future financial performance. In some cases,
you can identify forward-looking statements by terminology such as may, will,
should, expect, plan, intend, anticipate, believe, estimate, predict,
potential or continue, the negative of such terms or other comparable
terminology. These statements are only predictions. Actual events or results
may differ materially. In evaluating these statements, you should specifically
consider various factors, including the risks outlined in the Risk Factors
section above. These factors may cause our actual results to differ materially
from any forward-looking statement.
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Moreover, neither we nor any other
person assumes responsibility for the accuracy and completeness of the
forward-looking statements. We are under no duty to update any of the forward-
looking statements after the date of this prospectus to conform such
statements to actual results or to changes in our expectations.
20
<PAGE>
SALE OF SHARES TO AMAZON.COM
Concurrently with the closing of this offering, we are selling in a
separate private placement transaction 555,555 shares of our common stock to
Amazon.com at a price per share equal to the initial public offering price.
Such offering is made in connection with a letter agreement we entered into
with Amazon.com. As of July 16, 1999, Amazon.com owned 10,733,523 shares of
our capital stock. Jeffrey P. Bezos, chairman of the board and chief executive
officer of Amazon.com, is a director of drugstore.com. See "Business--
Relationship with Amazon.com," "Management," "Certain Relationships and
Related Transactions" and "Principal Stockholders" for further discussion of
our relationship with Amazon.com.
USE OF PROCEEDS
Our net proceeds from the sale of the shares of common stock we are
offering hereby are estimated to be $82.7 million after deducting the
underwriting discounts and commissions and estimated offering expenses. If the
underwriters' over-allotment option is exercised in full, we estimate that our
net proceeds will be approximately $95.2 million.
The principal purposes of this offering are to increase our working
capital, to create a public market for our common stock, to facilitate our
future access to the public capital markets, and to increase our visibility in
the retail marketplace. We expect to use approximately $30 million of the net
proceeds of this offering for capital expenditures associated with technology
and system upgrades and the establishment of our distribution operations. We
have no specific plans for the remaining proceeds. The remainder of the net
proceeds will be used for general corporate purposes and working capital. This
allocation is only an estimate and we may adjust it as necessary to address
our operational needs in the future. We may also use a portion of the net
proceeds to acquire complementary technologies or businesses; however, we
currently have no commitments or agreements and are not involved in any
negotiations with respect to any such transactions. Pending use of the net
proceeds of this offering, we intend to invest the net proceeds in interest-
bearing, investment grade securities.
DIVIDEND POLICY
We have never declared or paid cash dividends on our capital stock. We
currently intend to retain all available funds and any future earnings for use
in the operation and expansion of our business and do not anticipate paying
any cash dividends in the foreseeable future.
21
<PAGE>
CAPITALIZATION
The following table sets forth our capitalization as of July 4, 1999 on an
actual, pro forma and pro forma as adjusted basis:
. The "actual" column reflects our capitalization as of July 4, 1999,
without any adjustments to reflect subsequent events or anticipated
events;
. The "pro forma" column reflects the issuance of 12,282,599 shares of
Series E preferred stock issued in July 1999 in exchange for $10 million
in cash and other consideration, including exclusive advertising
commitments and other obligations valued at $233.9 million based on the
estimated fair value of $19.86 per share; and
. The "pro forma as adjusted" column reflects our capitalization as of
July 4, 1999 with adjustments to give effect to (1) the conversion of
all shares of outstanding preferred stock into 34,468,000 shares of
common stock upon the closing of this offering; (2) the receipt of the
estimated proceeds from the sale of our common stock offered hereby
(after deducting the estimated offering expenses and underwriting
discounts and commissions), including the sale of shares of our common
stock to Amazon.com; and (3) the change in the par value and the
authorized number of shares and upon the completion of this offering.
This table should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and the
consolidated financial statements and related notes thereto included elsewhere
in this prospectus.
<TABLE>
<CAPTION>
At July 4, 1999
---------------------------------
Pro Forma
Actual Pro Forma As Adjusted
-------- ----------- -----------
(unaudited) (unaudited)
(in thousands)
<S> <C> <C> <C>
Capital lease obligations, less current
portion..................................... $ 1,099 $ 1,099 $ 1,099
Stockholders' equity:
Convertible preferred stock, $.001 par value
actual and pro forma, $.0001 pro forma as
adjusted; authorized 60,000,000 shares
actual and pro forma and 10,000,000 shares
pro forma as adjusted
Series A--issued and outstanding: 10,000,000
shares actual and pro forma and none pro
forma as adjusted.......................... 7,986 7,986 --
Series B--issued and outstanding: 5,446,268
shares actual and pro forma and none pro
forma as adjusted.......................... 18,237 18,237 --
Series C--issued and outstanding: 4,472,844
shares actual and pro forma and none pro
forma as adjusted.......................... 34,981 34,981 --
Series D--issued and outstanding: 2,266,289
shares actual and pro forma and none pro
forma as adjusted.......................... 44,982 44,982 --
Series E--issued and outstanding: none
actual, 12,282,599 shares pro forma and
none pro forma as adjusted................. -- 243,932 --
Common stock, $.001 par value actual and pro
forma, $.0001 pro forma as adjusted;
authorized 250,000,000 actual, pro forma
and pro forma as adjusted; issued and
outstanding 2,323,000 shares actual and pro
forma and 42,346,555 pro forma as adjusted
(1)........................................ 2 2 4
Additional paid-in capital.................. 15,745 15,745 458,511
Deferred stock-based compensation........... (10,989) (10,989) (10,989)
Accumulated deficit......................... (38,380) (38,380) (38,380)
-------- -------- --------
Total stockholders' equity............... 72,564 316,496 409,146
-------- -------- --------
Total capitalization................... $ 73,663 $317,595 $410,245
======== ======== ========
</TABLE>
- --------
(1) Excludes (a) 11,492,000 shares of common stock reserved for issuance under
drugstore.com's stock option and stock purchase plans, of which 3,606,859
shares were subject to outstanding options as of July 16, 1999 at a
weighted average exercise price of $2.92 per share, (b) 10,000 shares of
common stock issuable upon exercise of an outstanding warrant at an
exercise price of $7.83 per share, (c) 750,000 shares issuable to the
underwriters at their option to cover over-allotments of shares and (d)
the issuance of 200,000 shares common stock to a charitable foundation
that we established. See "Management--Incentive Stock Plans," "Description
of Capital Stock" and Note 5 and 7 of Notes to Consolidated Financial
Statements.
22
<PAGE>
DILUTION
The pro forma net tangible book value of drugstore.com as of July 4, 1999
was $72.3 million or approximately $2.95 per share. Pro forma net tangible
book value per share represents the amount of drugstore.com's total tangible
assets less total liabilities, divided by the number of shares of common stock
outstanding, after giving effect to the conversion of all shares of
outstanding preferred stock into 22,185,401 shares of common stock upon the
closing of this offering. Dilution in pro forma net tangible book value per
share represents the difference between the amount per share paid by
purchasers of shares of common stock in the offering made hereby and the net
tangible book value per share of common stock immediately after the completion
of this offering. After giving effect to (1) the sale of the shares of common
stock offered by us hereby at the initial public offering price of $18.00 per
share and after deducting the underwriting discount and estimated offering
expenses payable by us, (2) the issuance of 12,282,599 shares of Series E
preferred stock issued in July 1999 in exchange for $10 million in cash and
other consideration, including exclusive advertising commitments and other
obligations valued at $233.9 million based on the estimated fair value of
$19.86 per share and (3) the sale of 555,555 shares of common stock to
Amazon.com at the initial public offering price of $18.00 per share, the net
tangible book value of drugstore.com at July 4, 1999 would have been $201.5
million or approximately $4.76 per share. This represents an immediate
increase in net tangible book value of $1.81 per share to existing
stockholders as of July 4, 1999 and an immediate dilution of $13.24 per share
to new investors of common stock in this offering. The following table
illustrates this dilution on a per share basis:
<TABLE>
<S> <C> <C>
Initial public offering price per share.......................... $18.00
Pro forma net tangible book value per share as of July 4,
1999.......................................................... $2.95
Increase per share attributable to Series E preferred
stockholders.................................................. .01
Increase per share attributable to Amazon.com.................. .22
Increase per share attributable to new investors(1)............ 1.58
-----
Net tangible book value per share after the offering and the sale
of shares to Amazon.com(1)...................................... 4.76
------
Dilution per share to new investors(1)........................... $13.24
======
</TABLE>
- --------
(1) This table excludes (a) 11,492,000 shares of common stock reserved for
issuance under drugstore.com's stock option and stock purchase plans, of
which 3,606,859 shares were subject to outstanding options as of July 16,
1999 at a weighted average exercise price of $2.92 per share, (b) 10,000
shares of common stock issuable upon exercise of outstanding warrants at
an exercise price of $7.83 per share, (c) 750,000 shares issuable to
underwriters at their option to cover over-allotment of shares and (d)
excludes the issuance of 200,000 shares of common stock to a charitable
foundation that we established. See "Capitalization," "Management--
Incentive Stock Plans," "Description of Capital Stock" and Note 5 and 7 of
Notes to Consolidated Financial Statements.
The following table sets forth, as of July 4, 1999, the differences between
the number of shares of common stock purchased from drugstore.com, the total
consideration paid and the average price per share paid by existing holders of
common and preferred stock, by Amazon.com and by the new investors, before
deducting the underwriting discount and estimated offering expenses payable by
drugstore.com, at the initial public offering price of $18.00 per share.
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
--------------------- ----------------------- Price
Number Percentage Amount Percentage Per Share
---------- ---------- ------------ ---------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockhold-
ers(1)................. 24,508,401 57.9% $106,359,000 23.6% $ 4.34
Series E preferred
stockholders........... 12,282,599 29.0 243,932,000 54.2 19.86
Amazon.com.............. 555,555 1.3 10,000,000 2.2 18.00
New investors(1)........ 5,000,000 11.8 90,000,000 20.0 18.00
---------- ----- ------------ -----
Total................. 42,346,555 100.0% $450,291,000 100.0%
========== ===== ============ =====
</TABLE>
- --------
(1) The number of shares held by new public investors will be 5,000,000 or
approximately 11.8% (5,750,000 shares, or approximately 13.3%, if the
underwriters' over-allotment option is exercised in full) of the total
number of shares of common stock outstanding after this offering. See
"Principal Stockholders."
23
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data set forth below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Consolidated Financial Statements of
drugstore.com and the Notes thereto included elsewhere in this prospectus. The
consolidated statement of operations data set forth below for the period from
April 2, 1998 (inception) to December 31, 1998 and the selected consolidated
balance sheet data as of December 31, 1998 have been derived from the audited
financial statements of drugstore.com included elsewhere in this prospectus,
which have been audited by Ernst & Young LLP, Independent Auditors. The
unaudited financial data as of July 4, 1999 and for the periods ended June 30,
1998 and July 4, 1999 are derived from unaudited consolidated financial
statements. The unaudited financial statements include all adjustments,
consisting of normal recurring accruals, which we consider necessary for a
fair presentation of the results of operations for this period. The historical
results are not necessarily indicative of results to be expected for any
future period. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
<TABLE>
<CAPTION>
Period from Period from Six Months
April 2, 1998 April 2, 1998 Ended
(Inception) to (Inception) to July 4,
December 31, 1998 June 30, 1998 1999
----------------- -------------- -----------
(unaudited) (unaudited)
(in thousands, except share
and per share data)
<S> <C> <C> <C>
Consolidated Statement of
Operations Data:
Net sales......................... $ -- $ -- $ 4,202
Cost of sales..................... -- -- 5,551
--------- --------- ----------
Gross profit (loss)............. -- -- (1,349)
Operating expenses:
Marketing and sales............. 3,092 -- 16,517
Product development............. 2,178 104 5,942
General and administrative...... 1,894 79 3,955
Amortization of stock-based
compensation................... 1,037 166 3,583
--------- --------- ----------
Total operating expenses...... 8,201 349 29,997
--------- --------- ----------
Operating loss.................... (8,201) (349) (31,346)
Other income (expense):
Interest income................. 177 -- 1,033
Interest expense................ (3) -- (40)
--------- --------- ----------
Net loss.......................... $ (8,027) $ (349) $ (30,353)
========= ========= ==========
Basic and diluted net loss per
share............................ $ (14.70) $ (6.95) $ (30.26)
========= ========= ==========
Pro forma basic and diluted net
loss per share(1)................ $ (.98) $ (.71) $ (1.46)
========= ========= ==========
Weighted average shares
outstanding used to compute
basic and diluted net loss per
share............................ 546,149 50,211 1,003,152
========= ========= ==========
Weighted average shares
outstanding used to compute
pro forma basic and diluted net
loss per share(1)................ 8,167,570 494,031 20,796,875
========= ========= ==========
<CAPTION>
December 31, July 4,
1998 1999
-------------- -----------
(in thousands)
<S> <C> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents........................... $ 14,408 $ 68,087
Working capital..................................... 17,050 62,400
Total assets........................................ 22,517 84,736
Capital lease obligations, less current portion..... 975 1,099
Total stockholders' equity.......................... 19,347 72,564
</TABLE>
- --------
(1) See Note 1 of Notes to Consolidated Financial Statements for an
explanation of the determination of the number of weighted average shares
used to compute pro forma net loss per share amounts.
24
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and the related Notes contained elsewhere in
this prospectus. The following discussion contains forward-looking statements
that involve risks and uncertainties. Our actual results could differ
materially from the results contemplated by these forward-looking statements
as a result of certain factors, including those discussed below and elsewhere
in this prospectus.
Overview
drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products and
information. We offer a larger selection of products than typical store-based
retailers at competitive prices, along with a wealth of health-related
information, buying guides and other tools designed to help consumers make
more educated purchasing decisions.
We were incorporated in April 1998 and commercially launched our Web site
on February 24, 1999. From the period from inception through the commercial
launch of our site, our primary activities consisted of:
. Developing our business model;
. Raising funds and developing strategic alliances;
. Designing and developing our Web site;
. Recruiting and training employees;
. Selecting our fulfillment partners and integrating their systems and
processes with ours;
. Negotiating advertising contracts with several of the major Web portals;
and
. Developing the drugstore.com brand.
Since the commercial launch of our site, we have continued these operating
activities and have also focused on building sales momentum, expanding our
product offerings, building vendor relationships, promoting our brand name,
improving the efficiency of our order fulfillment processes and establishing
customer service operations.
All customer orders are processed through our Web store and either billed
to the customer's credit card or, in the case of prescriptions covered by
insurance, billed to third parties. With respect to sales attributable to
third party payors, sales of pharmaceutical products are recorded at the net
amount to be received from third parties. Generally, we collect cash from
credit card sales in two to five days from the date ordered. To date, amounts
billed to third parties have been insignificant; however, we expect such
third-party billings, as a percent of total prescription billings, to increase
over time if we are able to obtain additional contracts with PBMs. We recently
entered into an agreement with PCS, a leading PBM as measured by the number of
claimed covered lives.
We routinely offer promotional discounts and coupons to customers. In
addition, if a customer is not satisfied with a particular product or service
we provide, we generally refund all or a portion of the sale.
Currently, we purchase all of our pharmaceutical products from RxAmerica
and a substantial majority of our nonpharmaceutical products from Walsh. For
the six months ended July 4, 1999, 78% of the nonpharmaceutical cost of sales
represented products purchased from Walsh. Products are purchased from
RxAmerica and Walsh after the customer submits an order. We maintain an
inventory of nonpharmaceutical products that are not available from Walsh. In
the future, we intend to establish our own distribution center for
pharmaceutical and nonpharmaceutical products that will require us to increase
our inventory levels substantially.
We have incurred net losses of $38.4 million from inception to July 4,
1999. We believe that we will continue to incur net losses for at least the
next four years (and possibly longer) and that the rate at which we will incur
such losses will increase significantly from current levels.
25
<PAGE>
We have a limited operating history on which to base an evaluation of our
business and prospects. Our prospects must be considered in light of the
risks, expenses, and difficulties encountered by companies in their early
stage of development, particularly companies in new and rapidly-evolving
markets, such as e-commerce. See "Risk Factors" for a more complete
description of the many risks we face.
In view of our limited operating history and the rapidly evolving nature of
our business, we believe that period-to-period comparisons of our operating
results are not meaningful and should not be relied upon as an indication of
future performance. It is likely that in some future quarter our operating
results may fall below the expectations of securities analysts and investors.
In this event, the trading price of our common stock may fall significantly.
Net Sales. Net sales consist of product sales and charges to customers for
outbound shipping and handling and are net of allowances for product returns,
promotional discounts and coupons. Net sales of pharmaceutical products are
recorded at the net amount to be received from customers and third parties. We
recognize product and shipping revenues when the related product is shipped.
In the future, the level of our sales will depend on a number of factors
including, but not limited to, the following:
. The number of customers we are able to obtain;
. The frequency of our customers' purchases;
. The quantity and mix of products our customers purchase;
. The price we charge for our products;
. The amount we charge for shipping;
. The extent of sales promotions and discounts we offer;
. The extent of reimbursement available from third-party payors;
. The level of customer returns we experience; and
. The seasonality that we may experience in our business.
Cost of Sales and Gross Margins. Cost of sales consists primarily of the
costs of products sold to customers and outbound and inbound shipping costs.
We expect cost of sales to increase in absolute dollars to the extent that our
sales volume increases. We may in the future expand or increase the coupons
and discounts we offer to our customers and may otherwise alter our pricing
structures and policies. Such changes may negatively affect gross margins. Our
gross margin will fluctuate based on a number of factors, including, but not
limited to, the following:
. The cost of our products, including the extent of purchase volume
discounts that we are able to obtain from suppliers;
. Our pricing strategy relative to the cost of our products;
. The mix of products our customers purchase;
. The mix of cash payments vs. insurance reimbursement for our pharmacy
products;
. Our shipping pricing strategy relative to the cost of shipping;
. Our distribution and fulfillment strategy if we decide to open our own
distribution centers; and
. The extent to which we are able to control product damage, shrinkage and
expiration though inventory management practices.
Marketing and Sales Expenses. Marketing and sales expenses consist
primarily of advertising and promotional expenditures, distribution expenses,
including order processing and fulfillment charges, equipment and supplies,
and payroll and related expenses for personnel engaged in marketing,
merchandising, customer service and distribution and fulfillment activities.
We intend to continue to pursue an aggressive branding and marketing campaign
and, therefore, expect marketing and sales expenses to increase significantly
in absolute
26
<PAGE>
dollars. Marketing and sales expenses may also vary considerably from quarter
to quarter, depending on the timing of our advertising campaigns. To the
extent that our sales volume increases in future periods, we expect marketing
and sales expenses to increase in absolute dollars as we expand our
distribution and fulfillment activities. This includes the costs of staffing
and developing a distribution center we intend to establish to accommodate
such increases in sales volume.
Product Development Expenses. Product development expenses consist
primarily of payroll and related expenses for Web site development and
information technology personnel, Internet access and hosting charges and Web
site content and design expenses.
Over the next several months, we plan to continue to work on a significant
number of development projects that will result in increased product
development expenses. Such projects include, but are not limited to:
. Enhancing and developing our systems as necessary to operate an
independent distribution center;
. Enhancing and developing our systems as necessary to provide for in-
store prescription pickup at Rite Aid stores;
. Enhancing our Web site to display additional product offerings,
including GNC products; and
. Other Web site product and content enhancements.
We believe that continued investment in product development is critical to
attaining our strategic objectives and, as a result, we expect product
development expenses to increase significantly in absolute dollars.
General and Administrative Expenses. General and administrative expenses
consist of payroll and related expenses for executive and administrative
personnel, corporate facility expenses, professional services expenses, travel
and other general corporate expenses. We expect general and administrative
expenses to increase in absolute dollars as we expand our staff and incur
additional costs related to the anticipated growth of our business and being a
public company. In addition, subsequent to July 4, 1999 we donated 200,000
shares of our common stock to a foundation established by us. We will
recognize general and administrative expense in an amount equal to the fair
value of the donated common stock in the third quarter of 1999.
Amortization of Stock-based Compensation. We recorded total deferred stock-
based compensation of $4,966,000 for the period from April 2, 1998 (inception)
to December 31, 1998 and $10,643,000 for the six months ended July 4, 1999 in
connection with stock options granted and restricted stock issued during such
periods. The deferred stock-based compensation amounts represent the
difference between the exercise price of stock option grants and the deemed
fair value of our common stock at the time of such grants. In the case of
restricted stock, the deferred stock-based compensation represents the
difference between the purchase price of the restricted stock and the deemed
fair value of our common stock on the date of purchase. Such amounts are
amortized to expense over the vesting periods of the applicable agreements,
resulting in amortization of stock-based compensation totaling $1,037,000 for
the period from April 2, 1998 (inception) to December 31, 1998 and $3,583,000
for the six months ended July 4, 1999. The amortization expense relates to
options awarded to employees in all operating expense categories. Deferred
stock-based compensation for stock options and restricted stock issued through
July 4, 1999 that will be subsequently recognized as expense for each of the
next six fiscal years is estimated to be as follows:
<TABLE>
<CAPTION>
Fiscal Year Amount
------------ --------------
(in thousands)
<S> <C>
1999 $3,489
2000 4,067
2001 2,167
2002 1,016
2003 213
2004 37
</TABLE>
27
<PAGE>
Interest Income and Expense. Interest income consists of earnings on our
cash and cash equivalents and interest expense consists of interest associated
with capital lease obligations.
Income Taxes. There was no provision or benefit for income taxes for any
period since inception due to our operating losses. As of December 31, 1998,
we had $6,737,000 of net operating loss carryforwards for federal income tax
purposes, which expire beginning in 2018. In 1999, due to the issuance and
sale of Series D and Series E preferred stock, we incurred ownership changes
pursuant to applicable regulations in effect under the Internal Revenue Code
of 1986, as amended. Our initial public offering will not cause an additional
ownership change. Therefore, our use of losses incurred through the date of
these ownership changes will be limited during the carryforward period. We
estimate that the use of the approximately $6.7 million of net operating
losses incurred through December 31, 1998 as well as losses incurred
subsequent thereto until the date of ownership change, would be limited to
approximately $4.1 million per year in order to offset future taxable income.
To the extent that any single-year loss is not utilized to the full amount of
the limitation, such unused loss is carried over to subsequent years until the
earlier of its utilization or the expiration of the relevant carryforward
period. We have provided a full valuation allowance on the deferred tax asset,
consisting primarily of such net operating loss carryforwards, because
management has determined that it is more likely than not that we will not
earn income sufficient to realize the deferred tax assets during the
carryforward period. See Note 4 of Notes to Consolidated Financial Statements.
Rite Aid and GNC Transaction.
In July 1999, we consummated an agreement with Rite Aid and GNC to issue
12,282,599 shares of Series E preferred stock in exchange for an aggregate of
$10 million in cash and other consideration, including access to insurance
coverage, advertising commitments, exclusivity agreements, a technology
licensing agreement and other obligations with an estimated fair value of
$233.9 million. Based on our initial internal analysis, the $233.9 million
non-cash portion of the consideration from the Rite Aid and GNC agreements has
been preliminarily allocated to the following components (in millions):
<TABLE>
<S> <C>
Access to insurance coverage...................................... $188.4
Advertising commitments........................................... 26.5
Rite Aid exclusivity agreement.................................... 8.0
GNC exclusivity agreement......................................... 6.0
Rite Aid technology license....................................... 5.0
------
$233.9
======
</TABLE>
All of the items above are to be amortized on a straight-line basis over
their contractual life of 10 years, except for the GNC exclusivity agreement
which will be amortized over 3 years. We are in the process of obtaining an
independent valuation from a valuation expert in order to make our final
allocation of value among the various components of the agreements. Such
valuation is expected to be completed before the end of the third quarter of
1999 and may result in material changes to the preliminary allocation.
Quarterly Results of Operations
Because we were a development stage company during 1998 and have a short
operating history, we believe that period-to-period comparisons prior to 1999
are less meaningful than an analysis of recent quarterly operating results.
Accordingly, we are providing a discussion and analysis of our results of
operations that is focused on the five quarters ended July 4, 1999.
The following table sets forth unaudited quarterly statement of operations
data for the five quarters ended July 4, 1999. This unaudited quarterly
information has been derived from our unaudited financial statements and, in
the opinion of management, include all adjustments, consisting only of normal
recurring adjustments,
28
<PAGE>
necessary for a fair presentation of such information in accordance with
generally accepted accounting principles. The operating results for any
quarter are not necessarily indicative of the operating results for any future
period.
<TABLE>
<CAPTION>
Quarter Ended
-----------------------------------------------
June 30, Sept. 30, Dec. 31, Apr. 4, July 4,
1998 1998 1998 1999 1999
-------- --------- -------- -------- --------
(in thousands)
<S> <C> <C> <C> <C> <C>
Net sales...................... $ -- $ -- $ -- $ 652 $ 3,550
Cost of sales.................. -- -- -- 672 4,879
----- ------- ------- -------- --------
Gross profit (loss).......... -- -- -- (20) (1,329)
Operating expenses:
Marketing and sales.......... -- 313 2,779 5,189 11,328
Product development.......... 104 522 1,552 2,713 3,229
General and administrative... 79 521 1,294 1,731 2,224
Amortization of stock-based
compensation................ 166 350 521 1,257 2,326
----- ------- ------- -------- --------
Total operating expenses... 349 1,706 6,146 10,890 19,107
----- ------- ------- -------- --------
Operating loss................. (349) (1,706) (6,146) (10,910) (20,436)
Other income (expense):
Interest income.............. -- 36 141 332 701
Interest expense............. -- -- (3) (14) (26)
----- ------- ------- -------- --------
Net loss....................... $(349) $(1,670) $(6,008) $(10,592) $(19,761)
===== ======= ======= ======== ========
</TABLE>
Net Sales and Cost of Sales. We commercially launched our Web site on
February 24, 1999. There were no net sales or cost of sales prior to the
quarter ended April 4, 1999. The negative gross margins experienced in the
quarters ended April 4, 1999 and July 4, 1999 were primarily the result of
promotional sales discounts associated with the commercial launch of the Web
site. We expect to continue to offer various types of promotional discounts
for the foreseeable future as a strategy to attract new customers.
Accordingly, we may continue to experience negative margins in future periods.
Marketing and Sales. Marketing and sales expenses increased in each of the
four quarters ended July 4, 1999, primarily due to expenses associated with
the addition of marketing and sales personnel. Additionally, we recognized
$1.0 million and $2.3 million of marketing expenses related to advertising
costs under our technology license and marketing agreement with Amazon.com in
the quarters ended April 4, 1999 and July 4, 1999, respectively. We also
increased our advertising on the major Web portals, including AOL, Excite and
Yahoo!, in the quarters ended April 4, 1999 and July 4, 1999 in connection
with the commercial launch of our Web site. In the quarter ended July 4, 1999
we commenced a television, radio and billboard advertising campaign as part of
our strategy to develop our brand. We expect to continue to pursue an
aggressive branding and marketing campaign for the foreseeable future and
expect such expenditures to increase accordingly.
Product Development. Product development expenses increased in each of the
four quarters ended July 4, 1999, primarily due to increased expenses
associated with the addition of product development personnel and additional
use of consultants and contract labor.
General and Administrative. General and administrative expenses increased
in each of the four quarters ended July 4, 1999 primarily due to increased
expenses associated with the addition of general and administrative personnel,
additional professional fees and the cost of corporate facilities.
Amortization of Stock-based Compensation. Amortization of stock-based
compensation increased in each of the four quarters ended July 4, 1999,
primarily due to the grant of stock options to new employees in the four
quarters ended July 4, 1999 as well as an increase in the difference between
the grant price and the deemed fair value of our common stock, particularly in
the quarters ended April 4, 1999 and July 4, 1999. In the period from
29
<PAGE>
April 2, 1998 (inception) to December 31, 1998, employees in the marketing and
sales, product development and general and administrative expense categories
accounted for approximately 18%, 20% and 62% of amortization of stock-based
compensation, respectively. In the six months ended July 4, 1999, employees in
the marketing and sales, product development and general and administrative
expense categories accounted for approximately 40%, 33% and 27% of
amortization of stock-based compensation, respectively.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through private
sales of preferred stock which, through July 4, 1999, yielded net cash
proceeds of $97.2 million.
Net cash used in operating activities was $18.5 million for the six months
ended July 4, 1999, and $6.3 million in the period from April 2, 1998
(inception) to December 31, 1998. Net cash used in operating activities for
each of these periods primarily consisted of net losses and during the six
months ended July 4, 1999, increases in inventories.
Net cash used in investing activities was $3.2 million for the six months
ended July 4, 1999, and $1.5 million in the period from April 2, 1998
(inception) to December 31, 1998. Net cash used in investing activities for
each of these periods primarily consisted of leasehold improvements and
purchases of equipment and systems, including computer equipment and fixtures
and furniture.
Net cash provided by financing activities was $75.3 million for the six
months ended July 4, 1999, and $22.3 million in the period from April 2, 1998
(inception) to December 31, 1998. Net cash provided by financing activities
during each of those periods primarily consisted of cash proceeds from the
following issuances of preferred stock:
. In June and August 1998, we issued 10,000,000 shares of Series A
preferred stock in exchange for an aggregate of $4 million in cash
and additional non-cash consideration.
. In October, November and December 1998, we issued 5,446,268 shares
of Series B preferred stock in exchange for an aggregate purchase
price of $18.2 million.
. In January 1999, we issued 1,457,891 shares of Series C preferred
stock in exchange for an aggregate purchase price of $11.4 million.
In January 1999, we also issued two convertible promissory notes
convertible into an aggregate of 3,014,953 shares of Series C
preferred stock in exchange for an aggregate purchase price of $23.6
million. These notes were converted into 3,014,953 shares of Series
C preferred stock in March 1999.
. In May 1999, we issued a convertible promissory note convertible
into 2,266,289 shares of Series D preferred stock in exchange for
$40 million in cash and additional non-cash consideration. The note
was converted into 2,266,289 shares of Series D preferred stock in
June 1999.
. In July 1999, we issued 12,282,599 shares of Series E preferred
stock in exchange for an aggregate of $10 million in cash and
additional non-cash consideration.
As of July 4, 1999 we had $68.1 million of cash and cash equivalents. As of
that date, our principal commitments consisted of obligations outstanding
under operating leases and marketing agreements with certain Web portals,
including Yahoo!, America Online and Excite, aggregating approximately $22.1
million through 2005. Although we have no material commitments for capital
expenditures, we anticipate a substantial increase in our capital expenditures
and lease commitments consistent with anticipated growth in operations,
infrastructure and personnel. In the first half of 2000, we intend to begin
operating our own distribution center to ensure greater control over the
distribution process and to ensure adequate supplies of products to our
customers.
30
<PAGE>
The distribution center is now in the planning stages and will require
significant capital investments in facilities and equipment. For the remainder
of 1999, we also expect to devote substantial expenditures toward technology
and systems upgrades to support the new distribution center and our ability to
provide in-store prescription pick up at Rite Aid stores. We expect to use
approximately $30 million of the net proceeds from this offering toward these
technology and systems upgrades and toward the new distribution center.
We currently anticipate that the net proceeds of this offering, together
with our available funds, will be sufficient to meet our anticipated needs for
working capital and capital expenditures through at least the next 12 months.
We may need to raise additional funds prior to the expiration of such period
if, for example, we pursue business or technology acquisitions or experience
operating losses that exceed our current expectations. If we raise additional
funds through the issuance of equity, equity-related or debt securities, such
securities may have rights, preferences or privileges senior to those of the
rights of our common stock and our stockholders may experience additional
dilution. We cannot be certain that additional financing will be available to
us on acceptable terms when required, or at all.
Year 2000
Many existing computer programs use only two digits to identify a year.
These programs were designed and developed without addressing the impact of
the upcoming change in the century. If not corrected, many computer software
applications could fail or create erroneous results by, at or beyond the year
2000. We use software, computer technology and other services internally
developed and provided by third-party vendors that may fail due to the year
2000 phenomenon. For example, we are dependent on the financial institutions
involved in processing our customers' credit card payments for Internet
services and a third party that hosts our servers. We are also dependent on
telecommunications vendors to maintain our network and the United States
Postal Service and other third-party carriers to deliver products to
customers.
We are in the process of reviewing the year 2000 compliance of our
internally developed proprietary software. This review has included testing to
determine how our systems will function at and beyond the year 2000. We expect
to complete these tests during the summer of 1999. Since inception, we have
internally developed substantially all of the systems for the operation of our
Web site. These systems include the software used to provide our Web site's
search, customer interaction, and transaction-processing and distribution
functions, as well as monitoring and back-up capabilities. Based upon our
assessment to date, we believe that our internally developed proprietary
software is year 2000 compliant.
We are currently assessing the year 2000 readiness of our third-party
supplied software, computer technology and other services, which include
software for use in our accounting, database and security systems. As part of
the assessment of the year 2000 compliance of these systems, we have sought
assurances from these vendors that their software, computer technology and
other services are year 2000 compliant. We have expensed amounts incurred in
connection with year 2000 assessment since our inception through April 4,
1999. Such amounts have not been material. We expect this assessment process
to be completed during the summer of 1999. Based upon the results of this
assessment, we will develop and implement, if necessary, a corrective action
plan with respect to third-party software, third-party vendors and computer
technology and services that may fail to be year 2000 compliant. We expect to
complete any required actions during the summer of 1999. At this time, the
expenses associated with this assessment and potential corrective action plan
that may be incurred in the future cannot be determined. The failure of our
software and computer systems or those of our third-party suppliers to be year
2000 compliant could have a material adverse effect on us.
The year 2000 readiness of the general infrastructure necessary to support
our operations is difficult to assess. For example, we depend on the integrity
and stability of the Internet to provide our services. We also depend on the
year 2000 compliance of the computer systems and financial services used by
consumers. Thus, the infrastructure necessary to support our operations
consists of a network of computers and telecommunications systems located
throughout the world and operated by numerous unrelated entities and
individuals, none of which
31
<PAGE>
has the ability to control or manage the potential year 2000 issues that may
impact the entire infrastructure. Our ability to assess the reliability of
this infrastructure is limited and relies solely on generally available news
reports, surveys and comparable industry data. Based on these sources, we
believe most entities and individuals that rely significantly on the Internet
are reviewing and attempting to remediate issues relating to year 2000
compliance, but it is not possible to predict whether these efforts will be
successful in reducing or eliminating the potential negative impact of year
2000 issues. A significant disruption in the ability of consumers to reliably
access the Internet or portions of it or to use their credit cards would have
an adverse effect on demand for our products and services.
We rely to a large extent on rapid distribution by third parties. We
currently purchase all of our pharmaceutical products from one vendor,
RxAmerica, and Walsh Distribution accounted for 78% of our nonpharmaceutical
costs of sales from launch of our Web store to July 4, 1999. We will also
depend on Rite Aid and GNC pursuant to recent agreements whereby, among other
things, certain of our systems will be integrated with Rite Aid's and we will
be the exclusive online provider of GNC-branded products. The year 2000
readiness of these third parties has not been thoroughly assessed. We have
inquired at a general level as to the year 2000 readiness of these third
parties, and expect to complete a more comprehensive assessment by the end of
our third fiscal quarter. However, we have not used any independent
verification or validation processes to analyze these parties' year 2000 risk,
cost estimates or readiness. The failure of these third parties to be year
2000 compliant could significantly disrupt our business.
At this time, we have not yet developed a contingency plan to address
situations that may result if we or our vendors are unable to achieve year
2000 compliance. Such contingency plan is currently expected to be developed
in the fall of 1999 and will depend on a number of factors, including (1) the
results of our year 2000 review and assessment, (2) the extent of the
corrective actions that have been implemented and (3) the status of our
distribution facilities that we currently intend to establish. The cost of
developing and implementing such a plan, if necessary, could be significant.
Any failure of our material systems, our vendors' material systems, our
customers' computers, or the Internet to be year 2000 compliant could have
negative consequences for us. Such consequences could include difficulties in
operating our Web site effectively, taking customer orders, making product
deliveries or conducting other fundamental parts of our business.
32
<PAGE>
BUSINESS
Overview
drugstore.com is a leading online drugstore: a retail store and information
site for health, beauty, wellness, personal care and pharmacy products. As of
July 4, 1999, we have sold our products to approximately 168,000 customers. We
designed our store to provide a convenient, private and informative shopping
experience that encourages consumers to purchase products essential to
healthy, everyday living. Our Web site can be accessed 24 hours a day, seven
days a week from anywhere that a consumer has Internet access. We offer a
larger selection of products than typical store-based retailers, along with a
wealth of health-related information, buying guides and other tools designed
to help consumers make more educated purchasing decisions. Our shopping lists
and e-mail reminders are designed to make it easier for our customers to
regularly purchase their preferred products. We believe that our online store
provides a customer with a superior shopping experience, making buying What
Every Body Needs(TM) less of a chore.
Industry Background
The Growth of the Internet and Electronic Commerce
The Internet has become an important medium for communicating, finding
information and purchasing products and services. International Data
Corporation (IDC) estimates that there were approximately 51 million Web users
in the United States at the end of 1998 and, although we cannot be certain of
any future growth, IDC anticipates this number will grow to approximately 135
million users by the end of 2002. We believe this increased usage is due to a
number of factors including:
. The large installed base of personal computers in the workplace and
home;
. Advances in the performance and reductions in the cost of personal
computers and modems;
. Improvements in the ease of use and security of the Internet;
. The availability of a broader range of online products, information and
services; and
. Growing awareness among consumers and businesses of the benefits of
online shopping.
The Internet has unique and powerful characteristics that differentiate it
from traditional distribution channels and have facilitated its use as a
purchasing medium. IDC estimates that worldwide business-to-consumer sales
over the Internet will increase from approximately $11 billion in 1998 to
approximately $93 billion by 2002; however, we cannot be certain that such
projection will be achieved. We believe consumers using the Internet to
purchase goods expect a more information-intensive experience than when they
shop at a traditional retail store. We believe the ability to obtain relevant,
up-to-date information makes the consumer better prepared to make a purchase.
Accessing the Internet from a computer in the home or office allows a consumer
to easily scroll through and search articles, pages of product data and
related topics. This allows consumers to research and then purchase products
at their convenience.
Healthcare Trends on the Internet
Healthcare is one of the largest segments of the U.S. economy, representing
an annual expenditure of roughly $1 trillion, and health and medical
information is one of the fastest growing areas of interest on the Internet.
According to a recent Forrester Research report, 31.6% of Internet users
surveyed had shopped for healthcare products online in the previous six
months. Cyber Dialogue estimates that the number of adults in the United
States searching online for health and medical information will grow from
approximately 17.1 million during the 12 month period ended July 1998 to
approximately 30.0 million during the twelve month period ending July 2000;
however, we cannot be certain that such projection will be achieved.
33
<PAGE>
The drugstore.com Market
The market we address can be divided into five primary categories: health,
beauty, wellness, personal care and pharmacy. Many products in this market are
personal (being used on a person's skin or in a person's body) and essential,
and often are purchased repeatedly. In this market, vendors frequently
introduce new products, and consumers seek comprehensive product information.
Consumers currently shop for these products primarily in chain drugstores
(such as Walgreen's, CVS, Rite Aid and Eckerd), mass market retailers (such as
Wal-Mart, Kmart and Target), supermarkets, warehouse clubs and independent
drugstores. However, category-specific retailers and catalogs also serve each
of these categories. Overall, distribution of products in our primary market
categories is fragmented.
Key aspects of the primary categories of the drugstore.com market are as
follows:
Health. The health category includes over-the-counter remedies (such as
cough, cold, allergy and pain relief medications), first aid, medical devices
for home healthcare, contraceptives and other products related to the body's
health needs. Based on estimates from Information Resources, Inc. and Frost &
Sullivan, we believe that sales of health products in the U.S. we currently
offer grew from approximately $15.0 billion in 1996 to approximately $16.3
billion in 1998. We believe that the aging U.S. population, along with a
greater portion of prescription drugs becoming available as over-the-counter
medications, will contribute to growth in this market category. Consumers in
the health category often seek significant amounts of product information to
determine which products will meet their health needs. Consumers generally buy
health products from chain drugstores, mass market retailers, supermarkets,
and warehouse clubs as well as from locally-owned, independent drugstores and
convenience stores. Representative brands carried in our health product
category include Advil, Tylenol, Pepcid, Bausch & Lomb and Metamucil.
Beauty. The beauty category includes cosmetics, fragrances and a variety of
skin care products. Based on estimates from Information Resources, Inc. and
Frost & Sullivan, we believe that sales of beauty products in the U.S. we
currently offer grew from approximately $10.7 billion in 1996 to approximately
$12.8 billion in 1998. Some of the factors driving consumer demand for beauty
products include regular and seasonal new product introductions, as well as
changing fashion trends. Consumers often seek advice regarding these trends or
the functionality of new products. The beauty category can be broadly
classified into two subcategories: mass market and prestige products.
Consumers for mass market beauty products typically purchase such products in
mass market retailers, drugstores and supermarkets. Consumers for prestige
products generally shop in department stores (such as Nordstrom, Macys, May
and Dillard's), beauty specialty stores (such as Aveda or Sally's), or spas
and salons (such as Elizabeth Grady or Elizabeth Arden). Representative brands
carried in our beauty product category include Revlon, L'Oreal, Cover Girl and
Neutrogena.
Wellness. The wellness category includes vitamins, nutritional supplements,
herbs, homeopathy, and other natural products. Based on estimates from various
sources including Information Resources, Inc., Frost & Sullivan, Packaged
Facts and Beyond Data, we believe that sales of wellness products in the U.S.
we currently offer totaled approximately $9.0 billion in 1998 and is currently
growing at an annual rate of over 17%. We believe that increasing consumer
interest in nutritional and wellness products to improve physical and mental
well-being has contributed to growth in this category. We believe supplemental
product information is important to these consumers because they are
interested in the intended physiological effects of these products. Consumers
can obtain these products at chain drugstores, mass market retailers,
supermarkets, warehouse clubs, and specialty stores as well as through
catalogs or online vitamin and nutrition stores. Representative brands carried
in our wellness product category include Centrum, One-A-Day, Nature Made,
Twinlab, Natrol and Nature's Way. We will also soon be offering GNC wellness
products.
Personal Care. The personal care market category includes products related
to hair, body and eye care, shaving, oral hygiene and feminine needs. Based on
estimates from Information Resources, Inc. and Frost & Sullivan, we believe
that sales of personal care products in the U.S. we currently offer grew from
approximately $20.7 billion in 1996 to approximately $23.5 billion in 1998.
New product introductions drive
34
<PAGE>
most of the growth in this category. The personal care category is comprised
of a number of different product groups that consumers typically shop for at
mass market retailers, chain drugstores, supermarkets, warehouse clubs and
specialty stores. Representative brands carried in our personal care product
category include Gillette, Colgate, Johnson & Johnson, Rogaine and Pampers.
Pharmacy. Based on estimates from various sources including Information
Resources, Inc., Frost & Sullivan, and the National Association of Chain Drug
Stores we believe that the pharmacy category in the U.S. we address totaled
approximately $103.0 billion in 1998 and is currently growing at an annual
rate of approximately 14.8%. This category consists of prescription medication
for chronic illnesses, such as high blood pressure, osteoporosis and
depression, which represents approximately 73% of the U.S. prescription drug
market according to Advanstar Communications. AC Nielsen and IMS Health
estimate that out of the $101.7 billion of prescription sales, over 75%, or
$76.4 billion are distributed through retail channels. The number of
prescriptions written for chronic illnesses is expected to continue to grow
due to an aging population and the increasing utilization of pharmaceuticals
in medical management. The principal source of pharmaceuticals for chronic
illnesses has been retail pharmacies. However, over the past ten years, mail
order pharmacies have become an increasingly important source of
pharmaceuticals for chronic illnesses. Forrester Research estimates that as of
February 1999, 13% of HMO prescriptions will be filled by a mail-order
pharmacy by the end of 1999.
Limitations on Traditional Channels of Distribution
Traditional channels of retail distribution for health, beauty, wellness,
personal care and pharmacy products have many limitations, including:
Inconvenience. Consumers often view shopping for many of these products as
a chore. Shopping at a physical store can be highly inconvenient. It generally
involves time-consuming activities such as making a trip to the store, finding
a parking space, searching for the desired products, and waiting in line to
fill a prescription or make a purchase. This process can be especially
difficult for customers with disabilities or parents with young children. To
increase convenience for consumers, traditional store-based retailers often
need to open new stores, which is time-consuming and expensive. Each new store
results in significant investments in inventory, real estate, building
improvements and the hiring and training of store personnel. The required
investment may limit the ability of traditional store-based retailers to serve
geographic areas that are not densely populated. Also, an existing store may
face substantial added costs if it attempts to build more parking spaces or
hire more clerks in order to reduce parking and waiting inconveniences.
Narrow Selection. Consumers value the opportunity to select items from a
broad range of products that best fit their needs. However, consumers must
often choose from a narrow product selection at traditional store-based
retailers. Stores may not carry a full range of products, especially prestige,
specialty or regional products, or carry a full assortment of sizes. Desired
items may be out of stock. Overcoming these difficulties can be prohibitively
expensive for traditional retail stores, usually due to shelf space
limitations, the cost of carrying inventory and the resulting need to allocate
inventory dollars to popular products. To the extent that mass market
retailers allocate physical store space to items such as alcohol, lawn
furniture, motor oil and snack foods, they may have to reduce the number of
health, beauty, wellness and personal care products that they offer. Product
selection in traditional store-based retailers cannot be tailored to
individual needs because it is driven by aggregate demand.
Limited Information and Communication. Consumers buying health, beauty,
wellness, personal care and pharmacy products often seek information and
knowledgeable advice to assist them in making purchasing decisions. Many
traditional store-based retailers do not provide consumers with access to
useful product information or readily-available on-site experts who can
provide helpful advice. Employees at traditional store-based retailers,
especially supermarkets and mass market retailers, may have limited if any
interaction with their customers. Often there is no direct contact, except at
the check-out line. Customers may also face difficulties following up with
questions after a purchase. While traditional store-based retailers could take
steps to increase the availability of customized information and on-site
experts, such steps would involve substantial investments
35
<PAGE>
in printing and training. In addition, it is difficult for a traditional
retail store to use information about a particular consumer to personalize
that consumer's shopping experience.
Lack of Privacy. Because many health, beauty, wellness, personal care and
pharmacy products are inherently personal, consumers often desire ways to
preserve the anonymity of their purchases and the confidentiality of the
information transferred in the buying process. Many consumers may feel
uncomfortable purchasing certain drugstore products, such as birth control
devices, feminine care products, and incontinence products, in a traditional
retail store. Many consumers have encountered the unpleasant experience of
placing such a product on a checkout stand's conveyor belt in front of store
clerks and other waiting customers. Consumers may hesitate to ask store
personnel questions about which product best meets a need, or how to use a
product, especially if either the question or the answer is embarrassing or
may be overheard by others. Overcoming this limitation is very difficult for
traditional retail stores because the consumer must visit a physical store
frequented by other customers and must interact in person with store
employees.
The markets for health, beauty, wellness, personal care and pharmacy
products have grown despite the lack of convenience, selection, information
and privacy associated with a trip to a traditional store-based retailer.
Consequently, we believe there is a significant market opportunity for an
online store that can offer consumers an enhanced shopping experience through
convenient and private access to detailed information about a broad range of
products, and an easy way to buy them.
The drugstore.com Solution
We are a leading online drugstore: a retail store and information site for
health, beauty, wellness, personal care and pharmacy products. We designed our
store to provide a convenient, private and informative shopping experience
that encourages consumers to purchase products essential to healthy, everyday
living. We believe our online store provides customers with a superior
shopping experience, making buying What Every Body NeedsTM less of a chore.
We draw and retain consumers by emphasizing key attributes of our store:
Convenience. Our user-friendly Web store may be reached from wherever the
shopper has Internet access, such as the shopper's home or office. Further
convenience advantages at our store include:
. Shopping 24 hours a day, seven days a week;
. Direct delivery to the shopper's home or office, avoiding the need for a
trip to a physical store;
. A personal shopping list for every customer, allowing for quick and easy
reordering in future visits;
. Simplified searching for products and information using advanced search
technology;
. Confidential access by a customer to his or her individual medication
profiles at any time; and
. Ability to purchase and send products easily to others.
In addition, we expect to offer Rite Aid customers the ability to order
refills of their existing Rite Aid prescriptions on our Web site and pick them
up at a local Rite Aid store.
Selection. Because we do not have inventory or shelf-space limitations, we
believe we offer a significantly greater number of products than are available
in a traditional chain drugstore. Not only do we offer traditional chain
drugstore items (prescription drugs, over-the-counter medications and personal
care), we offer a broad selection of health, beauty and wellness products.
Many traditional chain drugstores do not carry a wide range of these products.
We believe that we offer one of the largest selections of drugstore products
available on the Internet, offering over 17,000 SKU's (excluding pharmacy
items). We are also the only online retailer that may offer GNC wellness
products, which we expect to begin offering this year.
36
<PAGE>
Information. Because the Web has become an increasingly important tool for
researching healthcare topics, we believe that providing useful information is
a critical aspect of enabling consumers to make informed purchasing decisions.
We have assembled a broad array of information on our Web site that can enable
our consumers to make informed purchasing decisions. This information is
produced both in-house and by third-party expert sources and is focused on key
aspects of our market segments. Consumers can either access our information
directly, through a number of content features on our Web site, or can get
free help directly from our advisors and experts by contacting them through e-
mail. Our information services include:
. Full Product Packaging Information. Almost every product available on
our Web site can be viewed in an expanded format where all package
information, including ingredients, directions and warnings, can be read
next to an enlarged photograph of the product. We believe we are the
only online retailer to provide all the information that is normally
found on the products' packaging.
. Solutions. Our Solutions area provides an easy way for customers to find
the information they need to make an informed purchasing decision. It
includes buying guides, reference information, shopping advisors and
beauty information.
. Easy Access to Drug Information and Personalized Pharmacy
Advice. Consumers can access our extensive drug information library
directly at our Web site, anytime at their own convenience. Patient
information and drugstore.com drug prices can be accessed via our drug
index. We provide information to help consumers understand generic drug
alternatives. We also provide health- and pharmacy-related editorial
content in our online Solutions area. Our pharmacists can provide
personal guidance by phone or e-mail to ensure that each customer
understands the correct usage, possible side effects and expected
beneficial outcomes of a prescription or an over-the-counter medication.
Communication. We can communicate with customers on a regular basis through
the convenience of e-mail. In addition to our Ask Your Pharmacist and Ask Your
Beauty Expert features, we offer the following means of communication with our
store:
. Reminders. We have the ability to e-mail a customer when a prescription
or non-prescription product is about to run out, reminding him or her to
order a replacement product or a prescription refill. Customers simply
tell us how often they need a product and we can send them a notice
before it is scheduled to run out.
. Specialized Customer Care. To ensure timely and high-quality customer
service, we have established specialty teams within the drugstore.com
customer care department. Our Web site, product and insurance
specialists respond to customer e-mails and calls that are related to
shopping orders, insurance, prices, and shipping. Once an order is
made, customers can view order-tracking information on our Web site.
. Personalized Communications. As customers use our Web site, they can
provide us with information about their buying preferences and habits.
We can use this information to develop personalized communications and
deliver useful newsletters, special offers and new product announcements
to our customers via e-mail and other means. In addition, we use e-mail
to alert customers to important developments and merchandising
initiatives.
Privacy. Customers can shop in the privacy of their own homes or offices.
When shopping at a physical store, many shoppers feel embarrassed or
uncomfortable buying items that may reveal personally-sensitive aspects of
their health or lifestyle to store personnel or other shoppers. Shoppers at
drugstore.com avoid these problems. Through features such as Ask Your
Pharmacist and Ask Your Beauty Expert, customers can obtain answers to
questions that they would otherwise be uncomfortable asking in public.
Although we believe we offer significant advantages over traditional chain
drugstores, certain customers may feel that traditional chain drugstores offer
several advantages over our service, and we may not be able to meet the needs
of some customers. For example, we cannot serve emergency needs and we cannot
serve
37
<PAGE>
customers who do not have access to the Internet. Some customers may also
prefer to touch and see products in person, rather than view them on a
computer screen or prefer to talk to a pharmacist in person. Some customers
may also have general concerns about the privacy and security of information
transmitted over the Internet and will therefore prefer to shop in physical
stores. See "Risk Factors--Consumers of Health, Beauty, Wellness, Personal
Care and Pharmacy Products May Not Accept Our Solution, Which Would Reduce Our
Revenues and Prevent Us From Becoming Profitable" for a further description of
the challenges we face in this area.
Business Strategy
Our objective is to become one of the world's leading retailers of health,
beauty, wellness, personal care and pharmacy products. To achieve our
objective, we intend to attract a growing base of customers and provide them a
superior shopping experience. Key elements of our strategy include:
Strengthen the drugstore.com Brand. We intend to establish drugstore.com as
the leading consumer brand for buying health, beauty, wellness, personal care
and pharmacy products. To date, we have promoted our Web site on major
Internet destinations such as Amazon.com, America Online, Excite and Yahoo!,
as well as on other sites our customers are likely to visit, including
ThirdAge, InteliHealth, OnHealth, Medscape and Women.com. To further
strengthen our brand, we intend to cultivate a reputation for excellent
quality of service and continue to pursue an aggressive marketing strategy,
both through the Internet and traditional media, as well as through our
relationships with Rite Aid and GNC.
Continuously Improve Our Web Store and Service. We seek to combine wide
product selection and helpful information with the unique aspects of the
Internet to deliver a convenient and personalized shopping experience. We
strive to develop long-term relationships with our customers to build loyalty
and encourage repeat purchases. To improve our site, we intend to continue to
expand our product selection and enhance our existing offerings such as
shopping lists, individual medication profiles, e-mail reminders and targeted
special offers, as well as develop new personalization features as we learn
more about our customers and their needs. In addition, as part of our
relationship with Rite Aid, we expect to offer Rite Aid customers the ability
to order refills of their Rite Aid prescriptions on our Web site and pick them
up at a local Rite Aid store or have them delivered to the customer's home or
office.
Take Advantage of Repeat Purchasing Patterns. We intend to maximize repeat
purchases by our customers. To achieve this objective, we have developed
personalized tools and features that are designed to allow consumers to
satisfy their replenishment purchasing needs easily. We believe that our focus
on prescriptions for chronic conditions and products that must be regularly
replenished will allow us to benefit from repeat purchase patterns. We also
plan to continue to expand the functionality of our Web site to further
facilitate repeat purchases.
Maintain Our Technology Focus and Expertise. We intend to use technology to
enhance our product and service offerings and take advantage of the benefits
of the Internet. We have developed a proprietary, scalable architecture
designed to support secure and reliable online shopping in an intuitive easy-
to-navigate format. We intend to seek ways to increase the efficiency of
pharmacy transaction processing and order fulfillment activities. We also
intend to develop features to further personalize the consumer's shopping
experience and enhance the customer's ability to find products and useful
information.
Ensure Quick and Efficient Distribution. We intend to continuously increase
the automation and efficiency of our fulfillment and distribution activities.
For example, we will seek ways to improve the efficiency of the prescription
fulfillment process in areas such as receiving prescriptions from doctors and
billing the customer or his or her insurance company. In addition, because we
currently outsource our distribution operations, we intend to work with our
distributors and vendors to find more ways to ensure prompt deliveries to our
customers. As part of this effort, we are currently reviewing and formulating
our long-term distribution strategy, which will include establishing our own
distribution center. Our goals in this area include reducing shipping costs,
ensuring adequate future capacity and ensuring reliable and prompt deliveries
to our customers.
38
<PAGE>
Enhance and Form Key Relationships. We intend to enhance our existing
strategic relationships with leading product manufacturers, content providers
and insurance and pharmacy benefit management companies, as well as develop
new strategic relationships. We also believe relationships with leading
insurance and pharmacy benefit management companies, including our new
relationship with PCS, will enhance customer awareness of our Web site and
enable an even greater number of our customers to obtain reimbursement for
their prescriptions filled through our store. We also believe having strong
relationships with product manufacturers will enable us to provide more and
better product information to our customers. In addition, as part of our long-
term distribution strategy, we may need to develop direct manufacturer
relationships to ensure the availability of adequate volumes of products
ordered by our customers. We also intend to continue to pursue key
relationships with leading providers of health, beauty and wellness
information. We believe this strategy will enhance our product offerings and
allow us to serve more customers.
Shopping at drugstore.com
Shoppers at drugstore.com see a home page that highlights our five product
departments, as well as editorial content and promotions. A shopper can browse
through the store by clicking on the permanently displayed department names,
move directly to a department's home page and view promotions and featured
products. All product lists allow a shopper to select products based on brand
or unique attributes of the category, such as tartar control or whitening for
toothpaste, or color for lipstick or eye shadow. Shoppers can also search the
site by entering text in the search box at the top of any page.
A customer can select products to purchase by clicking on the "buy" button
in the product list. The products are then added to the customer's shopping
bag. If a customer needs more information to make a purchase, we supply
interactive tools and content to aid in the decision, such as:
. Solutions. Our Solutions area provides an easy way for customers to find
the information they need to make an informed purchasing decision. Some
of the components of the Solutions area include:
Shopping Advisors. Our shopping advisors consist of interactive
tools to help consumers find the right products for their needs. We
currently feature a cold and cough advisor, a skin care advisor and
a vitamin and supplement advisor. Through an easy-to-use interactive
format, a customer provides information about what he or she needs,
and the advisor provides information that enables the customer to
choose the appropriate product.
Buying Guides. Our buying guides help consumers make informed buying
decisions. We currently feature buying guides on condoms, birth
control pills, cold and cough medicine, toothpaste, shampoo and
sunscreen. The buying guides provide helpful information about the
key benefits and characteristics of each of these products.
. Shopping List. Returning customers can easily view their previous
purchases by consulting their personalized shopping lists. The shopping
lists make buying regularly-replenished items even easier to purchase
because the customer can move products into their shopping bag directly
from their personalized shopping list, without browsing the site. If
requested by the customer, we also send e-mail reminders to consumers
when items on their lists are scheduled to run out and need to be
replenished.
. Quick Lists. Our Quick Lists feature provides customers a starting point
for finding frequently used products for different product categories,
such as a medicine cabinet, beauty essentials and a travel bag. Within
each product category, the customer can choose a specific product and
move the product into his or her shopping bag. The customer can then
move directly from his or her shopping bag back to the Quick Lists and
choose another product or list.
. Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
ask our pharmacists questions about over-the-counter and wellness
products as well as prescription drugs.
39
<PAGE>
. Ask Your Beauty Expert. Our Ask Your Beauty Expert feature allows
customers to ask our beauty experts questions about beauty needs. Our
beauty experts respond to questions via e-mail and seek to answer
questions within one business day.
. Getting Help. From every page of our Web site, a customer can click on a
"help" button to go to our customer care area. In this area, we assist
customers in searching for, shopping for, ordering and returning our
products. In addition, we provide customers with answers to the most
frequently asked questions and encourage our visitors to send us
feedback and suggestions via e-mail.
When the customer finishes selecting the desired products, he or she goes
to checkout. The only information required to checkout is an e-mail
identification, password (to protect account privacy), shipping address and a
valid credit card number. All of this information is maintained in a secure
format and remains available for the customer's future access.
Pharmacy Services
The pharmacy services at drugstore.com are provided by experienced clinical
professionals using advanced information technologies. We employ licensed
pharmacists who ensure private, personal customer service. Through our
prescription drug dispensing partner, RxAmerica, we are able to ship
prescription products to all 50 U.S. states. See "--Distribution and Order
Fulfillment" for a further description of our relationship with RxAmerica. We
are also working with Rite Aid to enable Rite Aid customers to order refills
of their prescriptions on our Web site and pick them up at any of the over
3,800 Rite Aid stores in the United States or have them delivered to their
home or office. In addition, we are an active participant in the development
of the National Association of Boards of Pharmacy's Verified Internet Pharmacy
Practice Sites program. This new program will set standards for Internet
pharmacies and inform the public of those Web sites that have agreed to comply
with these standards.
Services. We seek to provide a high level of responsiveness and customer
support. In addition to our extensive drug information, specialized customer
care features and refill reminders, our pharmacy services include:
. Ask Your Pharmacist. Our Ask Your Pharmacist feature allows customers to
ask our pharmacists questions about medication, dosage, delivery
systems, common side effects and other information about prescription
drugs and health-related products. Our pharmacists seek to provide an
initial answer via e-mail within one business day.
. Private Access to drugstore.com Prescription History. Customers who fill
their prescriptions at drugstore.com can access their secure, individual
medication profiles at any time. A written patient information document
accompanies all medications dispensed to drugstore.com customers. This
service enables customers to maintain a record of their prescription
purchases for clinical, insurance and tax reporting purposes.
Filling Prescriptions. We only accept prescriptions from licensed health
care providers. We do not prescribe medications or otherwise practice
medicine. We focus on dispensing medications used by consumers on a chronic
basis. Advanstar Communications, Inc. estimates that such medications
comprised approximately 73% of all prescription drugs taken in the United
States in 1998. For acute care needs, meaning when a customer has a single
episode of a short-term illness or an exacerbation of a chronic condition in
either case requiring immediate attention, we recommend that customers pick up
their prescriptions from a local pharmacy because the treatment of acute care
needs are extremely time sensitive and the delivery time required by online
purchases could be too slow for the customer's needs. Medications used for
acute care needs include antibiotics and pain medications. We also do not
dispense certain controlled substances known as Schedule II pharmaceuticals at
this time because there are increased risks associated with their
dispensation, such as fraud, illegal resale of prescription drugs, and special
storage shipping and handling requirements. Schedule II Pharmaceuticals are
drugs classified by the Controlled Substance Act of 1970 as having a high
potential for abuse, such as opiates
40
<PAGE>
(including morphine) and products that contain oxycodone stimulants (including
amphetamine and methylphenidate) and depressants (including secobarbital and
amobarbital). We accept, verify and cross-check prescriptions much like
traditional retail and mail service pharmacies:
. Accepting Prescriptions. For new prescriptions, customers can direct
their physicians to call or fax their prescriptions to us at 1-800-
DRUGSTORE, or request that we contact their physician directly to obtain
prescription information. For transfers, customers can direct their
pharmacy to transfer their prescriptions or request us to contact their
pharmacy to transfer the prescription to drugstore.com. For refills,
customers may order directly from our Web site or respond to one of our
e-mail refill reminders.
. Verifying Prescriptions. Our pharmacists verify the validity and
completeness of prescription drug orders utilizing the same methodology
as community-based pharmacists. The standard practice for verification
of prescription drug orders is that the pharmacist will contact the
physician's office by telephone or fax if there is any reason to
question the validity, accuracy or authenticity of any order. In
addition, our pharmacists call and verify the validity of prescription
drug orders for allowable controlled substances, i.e., Schedule III-V
drugs. In addition, our pharmacists verify that all legally required
information is recorded on the prescription drug order and utilize a
database to verify physician identifying information, if necessary.
. Drug Utilization Review. To use our prescription drug services, all
customers are asked to provide our pharmacists with information
regarding drug allergies, current medical conditions and current
medications. Our pharmacists use advanced technologies to cross-check
every prescription against the information we receive from the customer
for drug-, disease- and allergy-drug interactions.
Payment. Customers may pay for their prescriptions with cash, by credit
card or by entering insurance information that shows that they are covered by
a managed care organization, insurance plan or PBM with whom we have a
contract. To date, a substantial majority of our prescriptions have been
submitted by cash paying customers. However, as a result of our relationship
with Rite Aid, we will be able to fill prescriptions for most customers with
pharmacy benefits covered by a plan accepted by Rite Aid. In addition, we will
participate in substantially all of the current and future retail pharmacy
networks managed by PCS, one of the leading pharmacy benefit management
companies in the United States that claims to provide pharmacy benefit
management services for more than 50 million individuals in the United States.
Pharmacy Supply. All of our pharmaceutical products are currently supplied
by RxAmerica. We intend to establish our own distribution center within the
next 12 months. Once the distribution center is established, we are obligated
to purchase all of our pharmaceutical products from Rite Aid, unless we are
able to obtain better overall terms from another vendor. This purchase
commitment will continue for the term of the Rite Aid relationship.
Marketing and Promotion of Our Site
Our marketing and promotion strategy is designed to build brand
recognition, increase customer traffic to our store, add new customers, build
strong customer loyalty, maximize repeat purchases and develop incremental
revenue opportunities.
Our advertising campaigns target both online and traditional audiences and
are designed to promote an enhanced customer experience. Our online
advertising efforts have been focused on highly-visited Internet portals,
health-related Web sites and other highly-visited Web sites. We also have
strategic relationships with Amazon.com, Rite Aid and GNC, who all promote our
Web site. We believe that the marketing benefits of our relationship with
Amazon.com include their promotion of our site and the beneficial aspects of
our being associated with one of the premier e-commerce companies. In
addition, Rite Aid has agreed to include drugstore.com in a significant
portion of Rite Aid's own advertisements, as well as on shopping bags,
prescription vial caps, in-store signs and permanent links from its Web site.
In addition, we advertise on America
41
<PAGE>
Online, Excite and Yahoo!, as well on other sites where our customers are
likely to visit, including ThirdAge, InteliHealth, OnHealth, Medscape and
Women.com. We also extend our market presence through our Associates Program,
which enables associated Web sites to make our products and services available
to their audiences through a link to our Web site. We intend to continue to
use the unique resources of the Internet as a means of marketing in an effort
to drive traffic and repeat purchases. We have also used traditional marketing
and promotion efforts, including special product promotions, print advertising
in USA Today, television and radio advertising in selected markets,
promotional press releases and public appearances by our executives. We intend
to further intensify our advertising efforts through traditional media
channels to continue building our brand recognition.
Merchandising Strategy
We believe that the breadth and depth of our product selection, together
with the flexibility of our online store and our range of helpful and useful
shopping services, enables us to pursue a strong merchandising strategy.
Aspects of this strategy include:
Easy Access to a Wide Selection of Products. Our easy-to-use Web site and
robust search capabilities enable customers to browse our product selection by
brand, age, product and price, as well as combinations of these categories.
For example, a customer can easily search for all aspirin products or for
Tylenol for children without consulting store personnel or searching
traditional store shelves. Combination searching allows customers to find
desired items easily among our large selection of products.
Dynamic Product Offering. Our online store gives us flexibility to change
featured products or promotions without having to alter the physical layout of
a store. We are also able to dynamically adjust our product mix in response to
changing customer demand, new seasons or upcoming holidays and introduce
special promotions.
Specialty Stores. We are establishing specialty stores in each of our
product categories. Our first specialty store, the boutique, sells high-end
cosmetics. Our next specialty store will be the GNC LiveWell Store, which will
be dedicated to GNC nutritional products and other products typically sold in
GNC stores. We will be the exclusive distributor of GNC brand products on the
Internet subject to our meeting performance parameters during the third and
fifth years of the relationship.
Extensive Product Information. A key component of our merchandising
strategy is the ability to use information as a tool for consumers. We combine
manufacturer information with editorial information or buying guides to allow
customers to make more informed buying decisions and to more easily comparison
shop for products. In addition, our Web site allows us to market products to
customers in many different ways, such as by product category or by product
characteristics, such as price or ingredients.
Targeted Promotions. We have the ability to offer products to individual
customers based on their affinities or conditions. In addition, we can present
merchandise to a customer tailored to personal interests and shopping
histories. We also cross-sell a brand across our departments to promote
impulse buying by customers. For example, we might promote mothers' products
in our Pregnancy and Infant Center.
Sampling. We have programs that allow us to provide samples of products to
customers as trials. We may also use sampling to work with manufactures to
introduce new products.
Information Objectives
Our editorial strategy is to present helpful, value-added information to
consumers in a readable, user-friendly format. Our editors create, source and
maintain health, beauty, wellness, personal care and pharmacy related content
for our Web site. Our editors assemble content to provide both reference and
product-related information. To date, we have established relationships with
several leading information providers who provide content for our site. We
will continue to direct our editorial efforts toward enhancing existing
features as well as
42
<PAGE>
sourcing new content to help our customers. For example, we expect to expand
our health and affinity centers beyond our first center, the Pregnancy and
Infant Center, to new centers focused on specific interest areas such as
allergy, fitness or diabetes. We also plan to expand the health and affinity
centers to provide consumers a forum to provide feedback or recommendations on
products.
Delivery of Our Customer's Orders
We currently outsource our distribution and order fulfillment operations on
a non-exclusive basis through Walsh, RxAmerica and other vendors. We carry
minimal inventory relative to our total sales and rely to a large extent on
rapid distribution from these vendors.
Walsh Distribution accounted for 78% of our cost of sales for health,
beauty, wellness and personal care products from inception to July 4, 1999.
Walsh packages for shipment all customer orders, including drugstore.com
inventory purchased directly from other vendors that Walsh holds for us at
their facility. We staff our own customer care specialists at the Walsh
facility to monitor quality control and order fulfillment. Walsh provides
inventory and services under a supply and services agreement that has a three
year term (through January 2002). This agreement may be terminated earlier by
us upon accelerated payment of minimum fees that would not exceed
approximately $2.5 million.
We currently purchase all of our pharmaceutical products from one vendor,
RxAmerica, in accordance with a pharmacy services agreement. Our pharmacists
perform all aspects of the prescription fulfillment process and all aspects of
customer service, except for the physical filling and packaging of
prescription drugs, which is performed by RxAmerica pharmacists. We staff our
own pharmacists, pharmacy technicians and customer care specialists at the
RxAmerica facility. As of April 30, 1999, RxAmerica employed approximately 25
pharmacists to fill and package prescriptions and help manage quality
assurance. RxAmerica is licensed and in good standing in the State of Texas
and in every other state as a nonresident pharmacy, as required by law. The
pharmacy services agreement with RxAmerica has a one-year term (to February
2000) and will automatically renew for additional one-year terms unless either
party notifies the other that it wishes to terminate the agreement at the end
of the initial term or a successive term. The agreement is non-exclusive and
does not prevent us from using other vendors for pharmaceutical products,
although we have not done so to date. When we establish our own distribution
center, we will be obligated to buy our pharmaceutical products from Rite Aid,
unless we are able to obtain better overall terms from other vendors.
Our warehouse management system, which is integrated with RxAmerica's and
Walsh's information systems, provides us real-time data on inventory
receiving, shipping, inventory quantities and inventory location. This enables
us to notify customers on a real-time basis if the product is in stock. In
addition, we offer an order tracking system for our customers on our Web site.
The inventories of RxAmerica and Walsh consist of items typically found in
traditional chain drugstores. We charge our customers a shipping charge that
covers all or a portion of our expenses of shipping. Walsh purchases
substantially all of its inventory directly from the manufacturers of the
products. RxAmerica purchases its pharmaceutical products from a variety of
manufacturers as well as wholesalers.
We offer a variety of shipping options, including next-day delivery for
orders received during the business week. We ship to anywhere in the United
States served by the United Parcel Service or the U.S. Postal Service.
Priority orders are flagged and expedited through our fulfillment processes.
For non-prescription product orders received before 9:00 p.m. Central time
Monday through Friday or before 5:00 p.m. Central time on Saturday, our goal
is to ship the product the same day. For prescription products, our goal is to
ship the product as soon as the prescription has been verified and our
pharmacists have completed drug utilization review.
In addition, Rite Aid customers will be able to order refills of their Rite
Aid prescriptions online at our Web site either for delivery through the mail
to their homes or for pickup at their choice of any one of the over 3,800 Rite
Aid stores.
43
<PAGE>
Customer Care
We believe that a high level of customer service and support is critical to
retaining and expanding our customer base. Our customer care specialists are
currently available from 6:00 a.m. to 10:00 p.m. Pacific time, Monday to
Friday, on Saturdays from 9:00 a.m. to 6:00 p.m. Pacific time, and on Sundays
from 9:00 a.m. to 4:00 p.m. Pacific time to provide assistance via e-mail or
phone. We intend to expand this availability to 24 hours a day, seven days a
week. We strive to answer all customer inquiries within 24 hours. Our customer
care specialists handle questions about orders and how to use our Web site,
assist customers in finding desired products and register customers' credit
card information over the telephone. Our customer care specialists are a
valuable source of feedback regarding user satisfaction. Our Web site also
contains a customer care page that outlines store policies and provides
answers to frequently asked questions. In addition, our pharmacists can
provide advice to our customers about medication, dosage, delivery systems,
common side effects and other information about prescription drugs.
Operations and Technology
We have implemented a broad array of services and systems for site
management, searching, customer interaction, transaction processing and
fulfillment. We use a set of software applications for:
. Accepting and validating customer orders;
. Organizing, placing and managing orders with vendors and fulfillment
partners;
. Receiving product and assigning it to customer orders; and
. Managing shipment of products to customers based on various ordering
criteria.
These services and systems use a combination of our own proprietary
technologies and commercially available, licensed technologies. We focus our
internal development efforts on creating and enhancing the specialized,
proprietary software that is unique to our business. In order to enhance the
online and offline experience for Rite Aid and drugstore.com customers, we
intend to integrate certain of our information and pharmacy systems with Rite
Aid's. Rite Aid has granted us a nonexclusive, fully-paid license to the Rite
Aid systems that will be integrated with our systems, subject to third party
rights to such technology.
We also have a technology license and advertising agreement with Amazon.com
under which we mutually agreed to license certain existing and future
technology used in the operation of our Web sites as long as we do not use the
technology to compete with each other. We currently are not using any
Amazon.com technology but could do so in the future if it would benefit us.
See "--Relationship with Amazon.com" for a further description of our
agreements with Amazon.com.
Our core merchandise catalog, customer interaction, order collection,
fulfillment and back-end systems are proprietary to drugstore.com, but are
available to Amazon.com under our agreement with them. Our software platform
and architecture are integrated with an Oracle database system. The systems
were designed to provide real-time connectivity to the distribution center
systems for pharmacy and the non-pharmacy products. These include an
inventory-tracking system, real-time order tracking system, executive
information system and replenishment system. Our Internet servers use Verisign
digital certificates to help conduct secure communications and transactions.
Our systems infrastructure is hosted at Exodus Communications in Tukwila,
Washington, which provides communication lines from multiple providers
including UUNet and AT&T, as well as 24 hour monitoring and engineering
support. Exodus has its own generators and multiple back up systems in
Tukwila.
We maintain customer care centers in our Bellevue, Washington office and in
our prescription distribution facility in Fort Worth, Texas and use a real
time interactive voice response system with transfer capabilities between our
customer care centers in Bellevue, Washington and Fort Worth, Texas. We also
operate a toll-free number, 1-800-DRUGSTORE, through which customers can place
orders and receive information. In addition,
44
<PAGE>
customers who choose not to transmit their credit card information via the
Internet have the option of submitting their credit card information by
telephone.
We incurred $2.2 million in product development expenses in the period from
inception to December 31, 1998 and $5.9 million during the six months ended
July 4, 1999. We anticipate that we will continue to devote significant
resources to product development in the future as we add new features and
functionality to our Web site.
Competition
The online commerce market is new, rapidly evolving and intensely
competitive. In particular, the health, beauty, wellness, personal care and
pharmacy categories are intensely competitive and are also highly fragmented,
with no clear dominant leader in any of our market categories. Our competitors
can be divided into several groups: chain drugstores, such as Walgreen's, CVS
and Eckerd; mass market retailers such as Wal-Mart, Kmart and Target;
supermarkets, such as Safeway, Albertson's and Kroger; warehouse clubs; online
retailers of health, beauty, wellness, personal care and/or pharmaceutical
products; mail order pharmacies; prescription benefits managers, such as
Express Scripts and Merck-Medco; Internet-portals and online service providers
that feature shopping services such as America Online, Yahoo!, Excite and
Lycos; cosmetics departments at major department stores, such as Nordstrom,
Macys and Bloomingdale's; and hair salons. Each of these competitors operate
within one or more of the health, beauty, wellness, personal care and pharmacy
product categories. In addition, nearly all of our competitors have, or have
announced their intention to have, the capability to accept orders for
products online. In particular, Walgreen's, CVS, Albertson's and Wal-Mart
already are accepting prescription refill or other orders on their Web sites.
We believe that the following are principal competitive factors in our
market:
. Brand recognition;
. Selection;
. Convenience;
. Price;
. Web site performance and accessibility;
. Customer service;
. Quality of information services; and
. Reliability and speed of order shipment.
Many of our current and potential traditional store-based and online
competitors have longer operating histories, larger customer or user bases,
greater brand recognition and significantly greater financial, marketing and
other resources than we do. Many of these current and potential competitors
can devote substantially more resources to their Web site and systems
development than we can. In addition, larger, well-established and well-
financed entities may acquire, invest in or form joint ventures with online
competitors or drugstore retailers as the use of the Internet and other online
services increases.
Some of our competitors may be able to secure products from vendors on more
favorable terms, fulfill customer orders more efficiently and adopt more
aggressive pricing or inventory availability policies than we can. Traditional
store-based retailers also enable customers to see and feel products in a
manner that is not possible over the Internet. Traditional store-based
retailers can also sell products to address immediate, acute care needs, which
we and other online sites cannot do. Some of our competitors such as
Walgreen's and Wal-mart have significantly greater experience in selling
drugstore products.
45
<PAGE>
Relationship with Amazon.com
We have a strategic relationship with Amazon.com whereby Amazon.com
advertises our Web service. We believe that the benefits of our relationship
with Amazon.com include their advertising our Web site and the beneficial
aspects of our being associated with one of the premier e-commerce companies.
Amazon.com is our largest shareholder, and Jeffrey P. Bezos, Amazon.com's
chairman of the board and chief executive officer is a member of our board of
directors. As part of our relationship with Amazon.com, we entered into a
technology license and advertising agreement. This agreement extends for ten
years and can be terminated for breach or in the event that we are acquired by
a competitor of Amazon.com. This agreement contains provisions generally
relating to the sharing of technology and technical support; however, we have
decided to develop our own technology and there has been no exchange of
technology by either party to date. Specifically, this agreement provides for
the license of substantially all of each company's technology to the other for
use within their respective businesses that may be developed through August
10, 2008. Neither company may use the other's technology to compete against
the other. In addition, each party has committed to providing the other with
advertising on our respective Web sites through the term of the agreement as
mutually agreed upon. In addition, we agreed not to place advertisements
competitive to Amazon.com's business on our site. We have also agreed not to
sell advertising on our Web site to, link our Web site to, or promote on our
Web site any company that sells products or services competitive with those
which Amazon.com offers or which Amazon.com is preparing to produce or market.
We are currently restricted with respect to books, music products, video
products, gift centers, toys, games, electronics, cards and auctions. If
Amazon.com expands into other areas this may further limit the companies we
can promote on our Web site. If we are acquired by an Amazon.com competitor
and Amazon.com does not vote in favor of the transaction, we would lose our
rights to advertise on Amazon.com's website, to restrict Amazon.com's ability
to compete in the online drugstore business, and to use Amazon.com's
technology (if we are then using any). See "Executive Officers and Directors,"
"Certain Relationships and Related Transactions" and "Principal Stockholders"
for further background on Amazon's relationship with us.
Relationship With Rite Aid
In June 1999, we entered into a strategic relationship with Rite Aid. Under
the relationship, Rite Aid customers will be able to refill existing Rite Aid
prescriptions at our site and either use our standard delivery options or pick
up the prescriptions at the more than 3,800 Rite Aid stores nationwide. We
will recognize revenues on all orders filled by us or picked up at Rite Aid
stores where our customer has used our Web site to order prescriptions. In the
case of orders from customers who have elected to pick up their prescriptions
in a Rite Aid store, we will pay Rite Aid for the cost of such products based
on a contractually agreed upon price. In addition, Rite Aid and drugstore.com
will promote each other's services both online and offline, including a link
from Rite Aid's Web site to our Web site. We believe that potential benefits
of our relationship with Rite Aid may include additional revenue and traffic
generated by Rite Aid customers who may visit our Web site, the pharmacy
benefit coverage provided by the insurance companies and PBMs with which Rite
Aid has a relationship, including PCS, and the co-promotion and co-branding
activities both companies will undertake. In connection with this
relationship, Rite Aid also became one of our largest stockholders, holding
approximately 25.4% of our outstanding common stock prior to this offering. We
expect that Martin L. Grass, Rite Aid's chairman of the board and chief
executive officer, will become a member of our board of directors after
completion of this offering.
As part of the relationship, both Rite Aid and drugstore.com agreed to
certain exclusivity provisions that will limit drugstore.com's ability to
promote or affiliate with any other physical retail drugstore and from
operating a traditional physical drugstore, and will preclude Rite Aid from
offering or selling products or services on the Internet other than through
our Web site. In addition, the agreement provides that if we establish our own
distribution center, we will be obligated to purchase all of our
pharmaceutical requirements from Rite Aid unless we are able to obtain better
overall terms from another vendor. The agreement contains additional
provisions providing for the licensing by Rite Aid to drugstore.com of
information technology systems and the integration of the information
technology and pharmacy systems of the two companies. This agreement extends
for ten
46
<PAGE>
years, but can be terminated for breach prior to such time. See "Executive
Officers and Directors," "Certain Relationships and Related Transactions" and
"Principal Stockholders" for further background on Rite Aid's relationship
with us.
Relationship With GNC
In June 1999, we entered into a relationship with General Nutrition
Companies, Inc. (GNC) whereby we will be the exclusive online provider of GNC-
branded products. We have the exclusive right to sell GNC's nutrition products
over the Internet, including the PharmAssure brand of pharmacist recommended
vitamins and nutritional supplements, subject to our meeting performance
parameters based on traffic to our Web site and sales of GNC products in the
third and fifth year of the relationship. As long as we have the exclusive
right to distribute GNC's products over the Internet, we will not promote any
other retail health food store or operate a physical retail health food store.
If the exclusivity provisions of the agreement terminate, we have the non-
exclusive right to sell these products for the remaining term of the
agreement. As part of this relationship, we will create a separate part of our
Web site called the GNC LiveWell Store that is dedicated to selling on a
consignment basis GNC products. We will be entitled to retain a percentage of
the gross revenues that we collect from sales of GNC products and will
recognize only the net amount retained as revenues. In connection with this
relationship, GNC acquired approximately 8.0% of our outstanding common stock
prior to this offering. GNC and drugstore.com also agreed to co-promote each
other's products and services in both their traditional and online marketing
efforts, including GNC's placement of a link to our Web site on their Web
site. The agreement extends for ten years, but can be terminated for breach
prior to such time. GNC recently announced it has agreed to be acquired by
Royal Numico N.V., a European maker of nutrition products. See "Certain
Relationships and Related Transactions" and "Principal Stockholders" for
further background on GNC's relationship with us.
Governmental Regulation
Our business is subject to extensive federal, state and local regulations,
many of which are specific to pharmacies and the sale of over-the-counter
drugs. For example, pursuant to the Omnibus Budget Reconciliation Act of 1990
and related state and local regulations, our pharmacists are required to offer
counseling, without additional charge, to our customers about medication,
dosage, delivery systems, common side effects, adverse effects or interactions
and therapeutic contraindications, proper storage, prescription refill, and
other information deemed significant by the pharmacists. We are also subject
to federal, state and local licensing and registration regulations with
respect to, among other things, our pharmacy operations.
We are subject to requirements under the Controlled Substances Act and
federal Drug Enforcement Agency regulations, as well as related state and
local laws and regulations, relating to our pharmacy operations, including
registration, security, recordkeeping, and reporting requirements related to
the purchase, storage and dispensing of controlled substances, prescription
drugs, and certain over-the-counter drugs. Under the Food, Drug & Cosmetic Act
of 1938 (the FDCA), a drug recognized in Homeopathic Pharmacopeia of the
United States must meet all compendial standards, or it will be considered
misbranded or adulterated. Because we sell homeopathic remedies, we are
required to comply with the FDCA.
The U.S. House of Representatives Committee on Commerce and the General
Accounting Office are currently investigating online pharmacies and online
prescribing, especially focused on those who prescribe drugs online and on
pharmacies that fill invalid prescriptions, including those that are written
online. The committee requested that the General Accounting Office undertake a
formal review of a number of issues pertaining to online pharmacies, including
an assessment of mechanisms to ensure that online pharmacies are obeying the
various state and federal regulations for the industry. Because we make every
effort only to fulfill valid prescriptions and we do not prescribe drugs, we
believe that our business will not be negatively affected by any regulations
that result from the investigations. However, we believe that any regulations
resulting from the investigations will likely result in increased reporting
and monitoring requirements.
47
<PAGE>
The National Association of Boards of Pharmacy (NABP), a coalition of state
pharmacy boards, is in the process of developing a program, the Verified
Internet Pharmacy Practice Sites (VIPPS), as a model for self-regulation for
online pharmacies. We are assisting the NABP with the development of the VIPPS
program and intend to comply with its criteria for certification.
Legislation and regulations currently being considered at the federal and
state level could affect our business, including legislation or regulations
relating to confidentiality of patient records, electronic access and storage.
In addition, various state legislatures are considering new legislation
related to the regulation of nonresident pharmacies. The Health Insurance
Portability and Accountability Act of 1996 mandates the use of standard
transactions, standard identifiers, security and other provisions by the year
2000. Regulations have been proposed to implement these requirements, and we
are designing our applications to comply with the proposed regulations.
Although the FDA does not regulate the practice of pharmacy, other than
pharmacy compounding, which we do not currently engage in, FDA regulations
impact some of our product and service offerings because the FDA regulates
drug advertising and promotion, including direct-to-consumer advertising, done
by or on behalf of drug manufacturers and marketers. As we expand our product
and service offerings, more of our products and services will likely be
subject to FDA regulation.
The inclusion of prescription drugs as a Medicare benefit has been the
subject of numerous bills in the U.S. Congress. Should legislation on
prescription drug coverage for Medicare recipients be enacted into law, we
would be subject to compliance with any corresponding rules and regulations.
Until recently, Health Care Financing Administration guidelines prohibited
transmission of Medicare eligibility information over the Internet. We are
also subject to extensive regulation relating to the confidentiality and
release of patient records. Additional legislation governing the distribution
of medical records exists or has been proposed at both the state and federal
level.
For a description of the risks we face with regard to these government
regulations, please see "Risk Factors--Governmental Regulation of the Health
Care and Pharmacy Industries Could Affect Our Business."
Intellectual Property
We regard the protection of our copyrights, service marks, trademarks,
trade dress and trade secrets as critical to our future success and rely on a
combination of copyright, trademark, service mark and trade secret laws and
contractual restrictions to establish and protect our proprietary rights in
products and services. We have entered into confidentiality and invention
assignment agreements with our employees and contractors, and nondisclosure
agreements with our vendors, fulfillment partners and strategic partners to
limit access to and disclosure of our proprietary information. We cannot be
certain that these contractual arrangements or the other steps taken by us to
protect our intellectual property will prevent misappropriation of our
technology. We have licensed in the past, and expect that we may license in
the future, certain of our proprietary rights, such as trademarks or
copyrighted material, to third parties. For example, as noted above, we have
licensed our technology to Amazon.com and we have also granted nonexclusive
rights to our trademarks in connection with advertising and affiliate
relationships. While we attempt to ensure that the quality of the
drugstore.com products brand is maintained by such licensees, we cannot assure
that such licensees will not take actions that might hurt the value of our
proprietary rights or reputation. We also rely on technologies that we license
from third parties, such as Oracle and Microsoft, the suppliers of key
database technology, the operating system and specific hardware components for
our service. As part of our relationship with Rite Aid, we have also licensed
information technology systems from Rite Aid. We cannot be certain that these
third-party technology licenses will continue to be available to us on
commercially reasonable terms. The loss of such technology could require us to
obtain substitute technology of lower quality or performance standards or at
greater cost, which could harm our business.
48
<PAGE>
We have filed applications for the registration of some of our trademarks
and service marks in the United States and in some other countries, including
for drugstore.com(TM), although we have not secured registration of any of our
marks to date. We may be unable to secure such registered marks. It is also
possible that our competitors or others will use marks similar to ours, which
could impede our ability to build brand identity and lead to customer
confusion. In addition, there could be potential trade name or trademark
infringement claims brought by owners of other registered trademarks or
trademarks that incorporate variations of the term drugstore.com(TM). Any
claims or customer confusion related to our trademark, or our failure to
obtain trademark registration, would negatively affect our business. In
addition, the laws of some foreign countries do not protect our proprietary
rights to the same extent as do the laws of the United States, and effective
copyright, trademark and trade secret protection may not be available in such
jurisdictions. Our efforts to protect our intellectual property rights may not
prevent misappropriation of our content. Our failure or inability to protect
our proprietary rights could substantially harm our business.
Professional Advisory Board
We have a professional advisory board with whom we consult on our programs,
strategies and overall store development, as well as product selection and
product presentation. Certain members contribute periodic editorial features
as well. The advisory board will meet as a whole approximately once a year and
individual members are consulted as needed.
Our professional advisory board includes the following individuals:
. Martha Stewart, a media personality who specializes in applying creative
and practical principles in the home and garden;
. Kim Alexis, a well-known fashion model, actress and athlete;
. Barry Sears, Ph.D., a scientist and author of several popular books on
health and dieting, including the New York Times best-seller, The Zone;
. Loraine Stern, M.D., an associate clinical professor of pediatrics at
the University of California at Los Angeles and spokesperson for
children's health issues;
. Jennifer Jacobs, M.D., M.P.H., a clinical assistant professor of
epidemiology at the University of Washington School of Public Health and
Community Medicine and the President-elect of the American Institute of
Homeopathy.
Charitable Contributions
In July 1999, we donated 200,000 shares of our common stock to
drugstore.com Foundation, a foundation established by us. The foundation will
make grants to charitable organizations. We intend to involve our employees in
determining the charitable purposes for this foundation.
Employees
As of July 4, 1999, we had 245 full-time employees. None of our employees
is represented by a labor union. We have not experienced any work stoppages
and consider our employee relations to be good.
Facilities
Our principal executive offices are located in Bellevue, Washington, where
we lease approximately 55,649 square feet under a lease that expires in July
2005. We also lease an approximately 18,750 square feet facility in Redmond,
Washington, which we vacated after moving to our new Bellevue facility, under
a lease that expires in September 2003. We have subleased the Redmond facility
for a period of 12 months and currently intend to sublease such space
thereafter, if possible. We anticipate that we will require additional space
as more personnel are hired and as we establish our own distribution center
and other facilities.
49
<PAGE>
MANAGEMENT
Executive Officers and Directors
The following table sets forth information with respect to our executive
officers and directors as of July 16, 1999:
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<S> <C> <C>
Peter M. Neupert(1)..... 43 Chairman of the Board of Directors, President and Chief Executive Officer
Suzan K. DelBene........ 37 Vice President, Marketing and Store Development
Kal Raman............... 31 Chief Information Officer and Senior Vice President, Operations
David E. Rostov......... 33 Vice President, Chief Financial Officer and Treasurer
Mark L. Silverman....... 34 Vice President, Health Services, General Counsel and Secretary
Jed A. Smith............ 33 Vice President, Strategic Partnerships and Director
Jeffrey P. Bezos........ 35 Director
Brook H. Byers(2)....... 53 Director
L. John Doerr........... 48 Director
William D. Savoy(2)..... 34 Director
Howard Schultz(1)....... 45 Director
</TABLE>
- --------
(1) Member of compensation committee
(2) Member of audit committee
Peter M. Neupert has served as a director and the President and Chief
Executive Officer of drugstore.com since July 1998 and as chairman of the
board of directors since July 1999. From March 1987 to July 1998, he worked
for Microsoft Corporation in several positions, most recently as Vice
President of News and Publishing for Microsoft's interactive media group. Mr.
Neupert holds an M.B.A. from the Amos Tuck School of Business at Dartmouth
College and a B.A. from Colorado College.
Suzan K. DelBene has served as Vice President, Marketing and Store
Development of drugstore.com since September 1998. From June 1989 to August
1998, she worked at Microsoft Corporation in several positions, most recently
as Director of Marketing and Business Development in Microsoft's interactive
media group. Ms. DelBene holds an M.B.A. from the University of Washington and
a B.A. from Reed College.
Kal Raman (formerly known as Kalyanaraman Srinivasan) has served as Chief
Information Officer of drugstore.com since August 1998 and as Senior Vice
President, Operations since May 1999. He served as Vice President, Technology
of drugstore.com from August 1998 to May 1999 and as Vice President,
Technology and Operations from March 1999 to May 1999. From March 1998 to
August 1998, Mr. Raman served as the Chief Information Officer and Vice
President of Nations Rent and from February 1997 to March 1998, he served as
Senior Director, Information Systems of Blockbuster Inc. From May 1992 to
February 1997, Mr. Raman served as Director, International Division of Wal-
Mart Stores Inc.
David E. Rostov has served as Vice President and Chief Financial Officer of
drugstore.com since January 1999 and as Treasurer since July 1999. From
January 1996 to January 1999, he worked for Nextel International, Inc. as
Chief Financial Officer. From 1992 to 1995, he served in various capacities at
McCaw Cellular Communications, Inc. Mr. Rostov holds an M.B.A. and a Master's
in Public Policy from the University of Chicago Graduate School of Business
and a B.A. from Oberlin College.
Mark L. Silverman has served as Secretary of drugstore.com since our
inception in April 1998, as Vice President, and General Counsel of
drugstore.com since January 1999 and as Vice President, Health Services and
General Counsel since March 1999. From December 1995 to January 1999, he was a
lawyer with the Venture Law Group, A Professional Corporation, becoming a
director in January 1998. Mr. Silverman was an attorney with Heller, Ehrman,
White & McAuliffe from December 1992 to November 1995. Mr. Silverman holds a
J.D. from the University of California, Los Angeles and a B.A. from the
University of California, Berkeley.
50
<PAGE>
Jed A. Smith, a founder of drugstore.com, has served as a director and Vice
President of Strategic Partnerships since our inception in April 1998. In
1994, he founded Cybersmith and served as Vice President of Sales and
Marketing through 1998. Mr. Smith holds an M.B.A. from Harvard University
Graduate School of Business and a B.A. from Middlebury College.
Jeffrey P. Bezos has served as a director of drugstore.com since August
1998. Mr. Bezos, a founder of Amazon.com, has served as Chairman of the Board
of Directors of Amazon.com since its inception in 1994, Chief Executive
Officer of Amazon.com since May 1996, President of Amazon.com from inception
to June 1999 and Treasurer and Secretary of Amazon.com from May 1996 to March
1997. From December 1990 to June 1994, Mr. Bezos was employed by D.E. Shaw &
Co., a Wall Street investment firm, becoming Senior Vice President in 1992.
From April 1988 to December 1990, Mr. Bezos was employed by Bankers Trust
Company, becoming Vice President in February 1990. Mr. Bezos received his B.S.
in Electrical Engineering and Computer Science from Princeton University.
Brook H. Byers has served as a director of drugstore.com since May 1998.
Mr. Byers is a partner of Kleiner Perkins Caufield & Byers, a private venture
capital firm, and has been a technology venture capital investor since 1972.
He has served on the Board of Directors of over twenty companies, and he is
currently a director of Axys Pharmaceuticals, Nanogen, Chemdex.com and several
private companies. He also served as the founding President and Chairman of
Idec Pharmaceuticals, Ligand Pharmaceuticals, Athena Neurosciences and Insite
Vision Opthalmics. Mr. Byers serves on the boards of the California Healthcare
Institute and the Foundation of the University of California at San Francisco
Medical Center. Mr. Byers received a degree in Electrical Engineering from
Georgia Institute of Technology and an M.B.A. from the Stanford Graduate
School of Business.
L. John Doerr has served as a director of drugstore.com since November
1998. Mr. Doerr has been a general partner of Kleiner Perkins Caufield &
Byers, a private venture capital firm, since September 1980. In 1974, he
joined Intel Corporation and held various engineering, marketing and
management assignments. Mr. Doerr is also a director of Amazon.com, @Home
Networks, Healtheon Corporation, Intuit, Inc., Platinum Software, Inc., and
SunMicrosystems, as well as several private companies. Mr. Doerr received his
M.E.E. and B.S.E.E. from Rice University and his M.B.A. from Harvard
University Graduate School of Business.
William D. Savoy has served as a director of drugstore.com since July 1999.
Mr. Savoy is President of Vulcan Northwest Inc., managing the personal
finances of Paul Allen, and Vice President of Vulcan Ventures Inc., a venture
capital fund wholly owned by Paul Allen. From 1987 until November 1990, Mr.
Savoy was employed by Layered, Inc. and became its President in 1988. Mr.
Savoy serves on the Advisory Board of DreamWorks SKG and also serves as
director of CNET, Inc., Go2Net, Inc., Harbinger Corporation, High Speed Access
Corporation, Metricom, Inc., Telescan, Inc., Ticketmaster Online-CitySearch,
USA Networks, Inc. and Value America, Inc. Mr. Savoy holds a B.S. in Computer
Science, Accounting, and Finance from Atlantic Union College.
Howard Schultz has served as a director of drugstore.com since November
1998. Mr. Schultz, the founder of Starbucks Corporation, has served as
Chairman of the Board and Chief Executive Officer of Starbucks since its
inception in 1985. From 1985 to June 1994, Mr. Schultz also served as
President of Starbucks. Mr. Schultz is one of two founding members of Maveron
LLC, a company providing advisory services to consumer-based businesses, and
is one of two members of a limited liability company that serves as a general
partner of its affiliated venture capital fund, Maveron Equity Partners, L.P.
Mr. Schultz is a governor on the National Association of Securities Dealers,
Inc. Board of Governors, and he is a director of Ebay, Inc. Mr. Schultz
received his B.S. degree from Northern Michigan University.
Our board of directors currently consists of nine members, including two
vacancies. Until the closing of this offering, Amazon.com has the right to
appoint one additional director to our board. In addition, under the terms of
a June 1999 voting agreement, if this offering is not completed by January 1,
2000 and Rite Aid is not represented on the board at such time, Rite Aid will
have the right to nominate one member to our board of
51
<PAGE>
directors. In addition to the directors mentioned above, we intend to appoint
the following two individuals to our board of directors after completion of
this offering:
Martin L. Grass is expected to be appointed as a director of drugstore.com
after completion of this offering. Mr. Grass has been chairman of the board and
chief executive officer of Rite Aid Corporation since March 1995. Previously,
Mr. Grass was president and chief operating officer of Rite Aid since April
1989, had been executive vice president for three years and prior thereto had
served as senior vice president. He has served Rite Aid in various capacities
since 1978. Mr. Grass has been a member of the Rite Aid board of directors
since 1982.
Melinda French Gates is expected to be appointed as a director of
drugstore.com after completion of this offering. Ms. Gates worked at Microsoft
Corporation from 1987 to May 1996 in a variety of positions, including serving
as both product manager and general manager for the development of several
multi-media products and other software programs. Since her retirement from
Microsoft in 1996, Ms. Gates has focused on philanthropic work in the Seattle
community. She is a founder of the Gates Library Foundation and is involved in
the William H. Gates Foundation. She is also a co-chair of the Governor of
Washington's Washington State Early Learning Commission and is on the advisory
board of Third Age Media. Ms. Gates holds a B.A. from Duke University and an
M.B.A. from The Fuqua School of Business at Duke University, and is a member of
the Duke University Board of Trustees.
At any stockholder meeting involving election of directors, Jed Smith,
Peter Neupert and several of our major prior investors have agreed to vote
their shares to elect one director designated by Amazon.com. The major prior
investors who are parties to this agreement are Kleiner Perkins Caufield &
Byers, Amazon.com, Vulcan Ventures, Rite Aid and GNC. The parties' obligations
to elect an Amazon.com designee terminate if Amazon.com owns less than 5% of
our voting stock.
Each director is elected for a period of one year at our annual meeting of
stockholders and serves until the next annual meeting or until his or her
successor is duly elected and qualified. The board of directors elects
executive officers on an annual basis. Executive officers serve until their
successor has been duly elected and qualified. There are no family
relationships among any of the directors, officers or key employees of
drugstore.com.
Board Committees
The board of directors has a compensation committee, a stock option
subcommittee and an audit committee.
Compensation Committee. The compensation committee of the board of
directors, which is effective upon this offering, will review and make
recommendations to the board regarding all forms of compensation and benefits
provided to our officers. In addition, the compensation committee establishes
and reviews general policies relating to the compensation and benefits of all
of our employees. The current members of the compensation committee are Peter
M. Neupert and Howard Schultz. Since the current members of the compensation
committee do not meet the definition of "non-employee directors" for purposes
of SEC Rule 16(b)(3), the full board of directors will continue to approve
stock option grants for our officers in order to qualify the option grants for
an exemption from short-swing trading rules.
Stock Option Subcommittee. The stock option subcommittee of the compensation
committee has authority to grant stock options to optionees who are not
executive officers or directors of drugstore.com. Peter M. Neupert is the sole
member of the stock option subcommittee.
ESPP Subcommittee. The ESPP subcommittee of the compensation committee has
authority to administer our 1999 employee stock purchase plan. Peter M. Neupert
is the sole member of the ESPP subcommittee.
Audit Committee. The audit committee of the board of directors reviews and
monitors our internal accounting procedures, corporate financial reporting,
external and internal audits, the results and scope of the
52
<PAGE>
annual audit and other services provided by our independent auditors, and our
compliance with legal matters that have a significant impact on our financial
reports. Brook H. Byers and William D. Savoy are the members of the audit
committee.
Compensation Committee Interlocks and Insider Participation
The board of directors established its compensation committee in May 1999.
Prior to establishing the compensation committee, the board of directors as a
whole performed the functions delegated to the compensation committee. No
interlocking relationship exists between our board of directors or our
compensation committee and the board of directors or compensation committee of
any other company, and no interlocking relationship existed in the past.
Director Compensation
We currently do not provide any cash compensation to our directors for
their service as members of the board of directors, although we do reimburse
the directors for certain expenses in connection with attendance at board and
committee meetings. Under our 1998 stock plan, nonemployee directors are
eligible to receive stock option grants at the discretion of the board or any
other administrator of the plan. See "--Stock Plans" for a description of
option grants under the 1998 stock plan.
Executive Compensation
The following table sets forth the compensation received for services
rendered to drugstore.com for the fiscal year ended December 31, 1998 by our
Chief Executive Officer and our only other executive officer who earned more
than $100,000 in salary and bonus during the fiscal year ended December 31,
1998.
Summary Compensation Table
<TABLE>
<CAPTION>
Long-Term
Compensation
Awards
Annual Compensation Securities
-------------------- Underlying All Other
Name and Principal Position Salary ($) Bonus ($) Options (#) Compensation($)
- --------------------------- ---------- --------- ------------ ---------------
<S> <C> <C> <C> <C>
Peter M. Neupert.............. $107,692 -- -- $ 170(1)
President, Chief Executive
Officer and Chairman of the
Board of Directors
Kal Raman..................... $ 60,577 $120,000 150,000 $5,895(2)
Chief Information Officer and
Senior Vice President,
Operations
</TABLE>
- --------
(1) Represents premium paid for term life insurance for the benefit of Peter
M. Neupert.
(2) Represents reimbursement for relocation expenses and premium paid for term
life insurance for the benefit of Kal Raman.
53
<PAGE>
Option Grants
The following table provides summary information regarding stock options
granted to our chief executive officer and our only other officer earning more
than $100,000 in salary and bonus during the fiscal year ended December 31,
1998.
Option Grants in Last Fiscal Year
<TABLE>
<CAPTION>
Individual Grants
---------------------
Potential Realizable
% of Total Value at Assumed
Number of Options Annual Rates of
Securities Granted to Stock Appreciation
Underlying Employees Exercise For Option Term ($)(2)
Options in Fiscal Price Expiration -----------------------
Name Granted(#) Year(1) ($/share) Date 5% ($) 10% ($)
- ---- ---------- ---------- --------- ---------- ----------- -----------
<S> <C> <C> <C> <C> <C> <C>
Peter M. Neupert........ -- -- -- -- -- --
Kal Raman............... 150,000 8.91% $.04 9/01/2008 $4,392,000 $6,997,000
</TABLE>
- --------
(1) Based on an aggregate of 1,683,584 shares underlying options granted by
drugstore.com during the fiscal year ended December 31, 1998 to our
employees and consultants.
(2) Based on the initial public offering price of $18.00 per share.
Option Exercises and Holdings
The following table provides summary information with respect to our chief
executive officer and our only other officer earning more than $100,000 in
salary and bonus during the 1998 fiscal year concerning exercisable and
unexercisable options held as of December 31, 1998. No options were exercised
by the individuals in the fiscal year ended December 31, 1998.
Option Exercises in Last Fiscal Year and Fiscal Year-End Option Values
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options at In-the-Money Options at
Fiscal Year-End (#) Fiscal Year-End ($)(1)
------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
- ---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Peter M. Neupert............ -- -- -- --
Kal Raman................... -- 150,000 -- $2,694,000
</TABLE>
- --------
(1) Based on a value of $18.00 per share, the initial public offering price,
minus the per share exercise price, multiplied by the number of shares
issued upon exercise of the option.
Stock Plans
1998 Stock Plan. Our 1998 stock plan provides for the grant of incentive
stock options to employees and nonstatutory stock options and stock purchase
rights to employees, directors and consultants to acquire shares of common
stock. The purposes of the 1998 stock plan are to attract and retain the best
available personnel, to provide additional incentives to our employees and
consultants and to promote the success of our business. Our board of directors
originally adopted the 1998 stock plan in July 1998 and our stockholders
approved the plan in July 1998. The 1998 stock plan was amended in January
1999, April 1999 and July 1999 to increase the total number of shares of
common stock reserved for issuance to 11,000,000 shares and to incorporate
certain other changes. We have submitted these amendments to the 1998 stock
plan for approval by our stockholders. Unless terminated earlier by the board
of directors, the 1998 stock plan will terminate in July 2008. As of July 16,
1999, options to purchase 3,606,859 shares of common stock were outstanding at
a weighted average exercise price of $2.92 per share, 8,000 shares had been
issued pursuant to restricted stock purchase agreements, no shares had been
issued upon exercise of outstanding options, and 7,385,141 shares remained
available for future grant.
54
<PAGE>
The 1998 stock plan may be administered by the board of directors, a
committee appointed by the board of directors or a combination of the board of
directors and a committee, as determined by the board of directors. The
administrator determines the terms of options granted under the 1998 stock
plan, including the number of shares subject to the option, exercise price,
term and exercisability. In no event, however, may an individual receive
option grants for more than 2,500,000 shares of common stock under the 1998
stock plan in any fiscal year. Incentive stock options granted under the 1998
stock plan must have an exercise price of at least 100% of the fair market
value of the common stock on the date of grant and at least 110% of such fair
market value in the case of an optionee who holds more than 10% of the total
voting power of all classes of our stock. Nonstatutory stock options granted
under the 1998 stock plan will have an exercise price as determined by the
administrator. Payment of the exercise price may be made in cash or such other
consideration as determined by the administrator.
The administrator determines the term of options, which may not exceed 10
years or 5 years in the case of an incentive stock option granted to a holder
of more than 10% of the total voting power of all classes of our stock. No
option may be transferred by the optionee other than by will or the laws of
descent or distribution, provided, however, that the administrator may in its
discretion provide for the transferability of nonstatutory stock options
granted under the 1998 stock plan if the common stock is listed or approved
for listing on a national securities exchange or designated as a national
market system security by the National Association of Securities Dealers, Inc.
Each option may be exercised during the lifetime of the optionee only by such
optionee or permitted transferee. The administrator determines when options
become exercisable. Options granted under the 1998 stock plan generally must
be exercised within 3 months after the termination of the optionee's status as
an employee, director or consultant of drugstore.com, or within 6 months if
such termination is due to the death or within 12 months if such termination
is due to disability of the optionee, but in no event later than the
expiration of the option's term. Options granted under the 1998 stock plan
generally vest over a four-year or five-year period at a rate of 1/4 of the
total number of shares subject to the option twelve months after the date of
grant, with the remaining shares vesting in equal installments at the end of
each six month period thereafter.
In the event of our merger with or into another corporation, the successor
corporation may assume each option and outstanding stock purchase right or may
substitute an equivalent option or stock purchase right. However, if the
successor corporation does not agree to this assumption or substitution, the
option or stock purchase right will terminate. The board of directors has the
authority to amend or terminate the 1998 stock plan provided that no action
that impairs the rights of any holder of an outstanding option may be taken
without the holder's consent. In addition, we will obtain requisite
stockholder approval for any action requiring stockholder approval under the
applicable law.
In addition to stock options, the administrator may issue stock purchase
rights under the 1998 stock plan to employees, directors and consultants. The
administrator determines the number of shares, price, terms, conditions and
restrictions related to a grant of stock purchase rights and the purchase
price of a stock purchase right granted under the 1998 stock plan. The
administrator also determines the period during which the stock purchase right
is held open, but in no case shall such period exceed 30 days. Unless the
administrator determines otherwise, the recipient of a stock purchase right
must execute a restricted stock purchase agreement granting an option to
repurchase the unvested shares at cost upon termination of such recipient's
relationship with us.
1999 Employee Stock Purchase Plan. Our board of directors adopted the 1999
employee stock purchase plan in April 1999 and our stockholders approved the
employee stock purchase plan in July 1999. A total of 500,000 shares of common
stock has been reserved for issuance under the purchase plan plus an annual
increase on the first day of each of our fiscal years beginning in 2000, 2001,
2002, 2003 and 2004 equal to the lesser of the following:
. 500,000 shares;
. 3% of our shares outstanding on the last day of the immediate preceding
fiscal year; or
. such lesser number of shares as is determined by the board.
55
<PAGE>
The purchase plan, which is intended to qualify under Section 423 of the
Internal Revenue Code, will be implemented by an offering period commencing on
the date of the closing of this offering and ending on January 31, 2000. Each
subsequent offering period will have a duration of six months. Each offering
period after the first offering period will commence on February 1 and August
1 of each year. The board of directors or a committee appointed by the board
will administer the purchase plan. Employees, including officers and employee
directors, of drugstore.com or of any majority-owned subsidiary designated by
the board, are eligible to participate in the purchase plan if they are
employed by drugstore.com or any such subsidiary for at least 20 hours per
week and more than 5 months per year. The purchase plan permits eligible
employees to purchase common stock through payroll deductions, which may not
exceed 20% of an employee's compensation, at a price equal to the lower of 85%
of the fair market value of our common stock at the beginning or end of the
offering period. Employees may end their participation in the offering at any
time during the offering period, and participation ends automatically on
termination of employment. If not terminated earlier, the purchase plan will
have a term of 10 years.
The purchase plan provides that in the event of our merger with or into
another corporation or a sale of all or substantially all of our assets, the
successor corporation will assume each right to purchase stock under the
purchase plan or will substitute an equivalent right. If the successor
corporation does not agree to an assumption or substitution, the offering
period then in progress will be shortened so that employees' rights to
purchase stock under the purchase plan are exercised prior to the merger or
sale of assets. The board of directors has the power to amend or terminate the
purchase plan as long as that action does not adversely affect any outstanding
rights to purchase stock under the plan. We may, however, terminate the
purchase plan or an offering period if continuation of the purchase plan or
the offering period would cause us to incur adverse accounting charges.
401(k) Plan
Effective April 1999, we adopted the drugstore.com, inc. 401(k) plan
covering our full-time employees. The 401(k) plan is intended to qualify under
Section 401(k) of the Internal Revenue Code of 1986, as amended, so that
contributions to the 401(k) plan by employees or by drugstore.com, and the
investment earnings thereon, are not taxable to employees until withdrawn from
the 401(k) plan, and so that contributions by drugstore.com, if any, will be
deductible by drugstore.com when made. Under the 401(k) plan, employees may
elect to reduce their current compensation by up to the statutorily prescribed
annual limit ($10,000 in 1999) and to have the amount of such reduction
contributed to the 401(k) plan. The 401(k) plan permits, but does not require,
additional matching contributions to the 401(k) plan by drugstore.com on
behalf of all participants in the 401(k) plan. To date, we have not made any
matching contributions to the 401(k) plan.
Employment Offer Letters
Peter M. Neupert's employment offer letter provides for an initial annual
salary of $250,000 and an initial annual bonus of up to $125,000. We also
granted Mr. Neupert a one-time right to purchase 1,260,000 shares of our
common stock at a purchase price of $.04 per share. We have a lapsing right to
repurchase Mr. Neupert's unvested shares. As of July 16, 1999, our right to
repurchase has lapsed with respect to 315,000 shares of stock and will lapse
with respect to 19,688 shares each month after the one-year anniversary of his
start date of June 27, 1998 while he remains employed, with all of these
shares becoming fully vested on the 27th of the month following his fifth
anniversary of employment. If we are acquired by another entity or sell
substantially all our assets, and Mr. Neupert is not offered a position with
the surviving corporation with responsibilities similar to those held at
drugstore.com, our right of repurchase will lapse with respect to all of these
shares. Mr. Neupert's employment is for no specified length of time, and
either party has the right to terminate Mr. Neupert's employment at any time
for any reason. If we terminate Mr. Neupert's employment other than for
"cause" (which is defined in his agreement to mean gross negligence or willful
misconduct in the performance of his duties, the failure to obey our board of
directors, defrauding or stealing from drugstore.com, or being convicted of a
crime that harms the business or reputation of drugstore.com), our right of
repurchase will lapse on an additional 236,250 shares of the then-unvested
portion. The offer letter also provides that in the event
56
<PAGE>
Mr. Neupert's employment is terminated for any reason, he will continue to
receive his then-current base salary and benefits for a period of nine months.
Kal Raman's employment offer letter provides for an initial annual salary
of $175,000, a $100,000 signing bonus (which was grossed up to $120,000 to
negate the effect of applicable taxes), reimbursement of $5,000 for a lost
down payment on a house in Florida and an annual bonus of up to 15% of his
salary. We also offered Mr. Raman an option to purchase shares of common stock
under our 1998 stock plan. In the offer letter, we agreed to guarantee a loan
from a bank in the amount of $250,000. However, instead of guaranteeing a bank
loan, we and Mr. Raman agreed that we would loan $250,000 directly to Mr.
Raman. See "Certain Relationships and Related Transactions" for a description
of our loan arrangement with Mr. Raman. Mr. Raman's employment is for no
specified length of time, and either party has the right to terminate the
agreement at any time for any reason.
Jed A. Smith's employment offer letter provides for an initial annual base
salary of $125,000 and an initial bonus of $25,000 contingent on drugstore.com
reaching agreed milestones. Mr. Smith's employment is for no specified length
of time, and either party has the right to terminate Mr. Smith's employment at
any time for any reason. The offer letter also provides that, in the event Mr.
Smith's employment is terminated for other than "cause" (which is defined in
his agreement to mean gross negligence or willful misconduct in the
performance of his duties, the failure to obey our board of directors or chief
executive officer, defrauding or stealing from drugstore.com, or being
convicted of a crime that harms the business or reputation of drugstore.com),
he will continue to receive his then-current base salary and benefits for a
period of six months.
Mark L. Silverman's employment offer letter provides for an initial annual
base salary of $175,000, a $35,000 signing bonus and a bonus at the discretion
of the chief executive officer commensurate with other officers of
drugstore.com. We also offered Mr. Silverman an option to purchase shares of
our common stock under our 1998 stock plan. If we are acquired by another
entity or sell substantially all of our assets and Mr. Silverman is not
offered a position with the surviving corporation with responsibilities
similar to those held at drugstore.com or if his employment is terminated for
other than "cause" (which is defined in his agreement to mean gross negligence
or willful misconduct in the performance of his duties, the failure to obey
our board of directors or chief executive officer, defrauding or stealing from
drugstore.com, or being convicted of a crime that harms the business or
reputation of drugstore.com), the option with respect to all then-unvested
shares shall vest. Mr. Silverman's employment is for no specified length of
time, and either party has the right to terminate Mr. Silverman's employment
at any time for any reason. The offer letter also provides that, in the event
Mr. Silverman's employment is terminated without cause, he will continue to
receive his then-current base salary and benefits for a period of twelve
months.
Limitations on Directors' Liability and Indemnification
Our certificate of incorporation limits the liability of directors to the
maximum extent permitted by Delaware law. Delaware law provides that directors
of a corporation will not be personally liable for monetary damages for breach
of their fiduciary duties as directors, except liability for:
. any breach of their duty of loyalty to the corporation or its
stockholders;
. acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
. unlawful payments of dividends or unlawful stock repurchases or
redemptions; or
. any transaction from which the director derived an improper personal
benefit.
This limitation of liability does not apply to liabilities arising under the
federal securities laws and does not affect the availability of equitable
remedies such as injunctive relief or rescission.
57
<PAGE>
Our certificate of incorporation and bylaws provide that drugstore.com
shall indemnify our directors and executive officers and may indemnify our
other officers and employees and other agents to the fullest extent permitted
by law. We believe that indemnification under our bylaws covers at least
negligence and gross negligence on the part of indemnified parties. Our bylaws
also permit us to secure insurance on behalf of any officer, director,
employee or other agent for any liability arising out of his or her actions in
such capacity, regardless of whether the bylaws would permit indemnification.
We have entered into agreements to indemnify our directors and officers, in
addition to indemnification provided for in our bylaws. These agreements,
among other things, provide for indemnification of our directors and officers
for expenses specified in the agreements, including attorneys' fees,
judgments, fines and settlement amounts incurred by any such person in any
action or proceeding arising out of such person's services as a director or
officer of drugstore.com, any subsidiary of drugstore.com or any other company
or enterprise to which the person provides services at the request of
drugstore.com. We believe that these provisions and agreements are necessary
to attract and retain qualified persons as directors and officers.
58
<PAGE>
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Since our inception in April 1998, we have issued and sold shares of our
capital stock as follows: a total of 2,265,000 shares of common stock at a
price of $.04 per share in June, July and August 1998, a total of
10,000,000 shares of Series A preferred stock at a price of $.80 per share in
June and August 1998, a total of 5,446,268 shares of Series B preferred stock
at a price of $3.35 per share in October, November and December 1998, a total
of 4,472,844 shares of Series C preferred stock at a price of $7.825 per share
in January and March 1999, a total of 2,266,289 shares of Series D preferred
stock at a price of $17.65 per share in June 1999, and a total of 12,282,599
shares of Series E preferred stock in July 1999. All shares of our preferred
stock will convert into common stock on a 1-for-1 basis upon the closing of
this offering. The following table summarizes the shares of capital stock
purchased by executive officers, directors and five-percent stockholders and
their affiliates in these transactions:
<TABLE>
<CAPTION>
Series A Series B Series C Series D Series E
Common Preferred Preferred Preferred Preferred Preferred
Investor(1) Stock Stock Stock Stock Stock Stock
- ----------- --------- --------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C> <C>
Kleiner Perkins Caufield &
Byers(2)(3)........................ -- 4,937,500 1,582,089 511,182 -- --
Amazon.com, Inc.(2)(4).............. -- 5,000,000 3,177,612 2,555,911 -- --
Maveron Equity Partners,
L.P.(2)(5)......................... -- -- 417,910 766,773 -- --
Peter M. Neupert(2)(6).............. 1,260,000 -- 268,657 319,489 -- --
Vulcan Ventures Incorporated(2)(7).. -- -- -- -- 2,266,289 --
Rite Aid Corporation(2)(8).......... -- -- -- -- -- 9,334,746
General Nutrition Investment Company
(2)(9)............................. -- -- -- -- -- 2,947,853
</TABLE>
- --------
(1) Shares held by affiliated persons and entities have been added together
for the purposes of this chart. See "Principal Stockholders" for a chart
of beneficial owners.
(2) Holder of 5% or more of a class of our capital stock.
(3) Includes shares held by Kleiner Perkins Caufield & Byers VIII, L.P. (KPCB
VIII), KPCB VIII Founders Fund, L.P., and KPCB Life Sciences Zaibatsu Fund
II, L.P. KPCB VIII and KPCB VIII Founders Fund, L.P. are wholly controlled
by KPCV VIII Associates, L.P. KPCB Life Sciences Zaibatsu Fund II, L.P. is
wholly controlled by KPCB VII Associates, L.P., Brook H. Byers and L. John
Doerr, each a general partner of KPCB VIII Associates and KPCB VII
Associates, L.P., are both directors of drugstore.com. Mr. Byers and Mr.
Doerr each disclaim beneficial ownership of shares held by these entities
except to the extent of their pecuniary interest therein. In November
1998, drugstore.com and Kleiner Perkins Caufield & Byers agreed to rescind
the purchase of 89,552 of such shares and refund the $299,999.20 purchase
price. As a result, after November 1998, Kleiner Perkins Caufield & Byers
held 1,582,089 shares of Series B preferred stock.
(4) In consideration of Amazon.com's obligations under a technology license
and advertising agreement, we issued Amazon.com 5,000,000 shares of our
Series A preferred stock. We issued these shares primarily in exchange for
Amazon.com's early marketing and support efforts in connection with and
after our launch. Jeffrey P. Bezos, chairman of the board and chief
executive officer of Amazon.com, became a director of drugstore.com upon
completion of the issuance.
(5) Howard Schultz, a director of drugstore.com, is one of the two founding
members of Maveron LLC, and is one of two members of a limited liability
company that serves as a general partner of its affiliated venture capital
fund, Maveron Equity Partners, L.P.
(6) Mr. Neupert's shares of preferred stock are held jointly by Mr. Neupert
and Sheryl Neupert.
(7) In May 1999, we issued a convertible promissory note convertible into
2,266,289 shares of Series D preferred stock to Vulcan Ventures in
exchange for $40 million in cash and an obligation to provide cable
television advertising valued at $5 million. The note was converted into
2,266,289 shares of Series D
59
<PAGE>
preferred stock in June 1999. William D. Savoy, vice president of Vulcan
Ventures, became a director of drugstore.com in July 1999.
(8) In July 1999, we issued Rite Aid 9,334,746 shares of Series E preferred
stock in exchange for $7.6 million in cash and additional consideration.
Martin L. Grass, whom we expect to be appointed as a director of
drugstore.com after completion of this offering, is chairman of the board
and chief executive officer of Rite Aid.
(9) In July 1999, we issued General Nutrition Investment Company, a wholly
owned subsidiary of GNC, 2,947,853 shares of Series E preferred stock for
$2.4 million in cash and additional consideration.
A provision of the investors' rights agreement dated May 19, 1999 between
drugstore.com and some of our stockholders precludes Kleiner Perkins Caufield &
Byers, Amazon.com and Maveron Equity Partners from purchasing additional shares
of our common stock without our prior approval if the purchase would cause any
of them to hold individually more than 40% of our outstanding common stock
(calculated on a fully diluted basis to include outstanding options and shares
reserved under our stock plans). This restriction lasts until August 2002.
Pursuant to a June 17, 1999 addendum, Rite Aid and GNC were made parties to
this agreement and are subject to its provisions.
In May 1999, we issued a convertible promissory note convertible into
2,266,289 shares of Series D preferred stock to Vulcan Ventures in exchange for
$40 million in cash and an obligation by Vulcan to provide cable television
advertising valued at $5 million based on comparable transactions with
unaffiliated third parties. The advertising is expected to be aired over a
three-year period and will be expensed in the period in which the airtime is
used. The note was converted into 2,266,289 shares of Series D preferred stock
in June 1999. William D. Savoy, vice president of Vulcan Ventures, became a
director of drugstore.com in July 1999.
We are selling 555,555 shares of our common stock to Amazon.com concurrent
with this offering in a separate private placement transaction at a price per
share equal to the initial public offering price. Such offering is made in
connection with a letter agreement we entered into with Amazon.com.
In June 1999, we entered into a strategic relationship with Rite Aid whereby
Rite Aid customers will be able to refill prescriptions at our Web site and
either use our standard delivery options or pick up the prescriptions at Rite
Aid stores. In addition, Rite Aid and drugstore.com will promote each others'
services both online and offline, including a link from Rite Aid's Web site to
our Web site. In connection with this relationship, Rite Aid acquired
approximately 25.4% of our outstanding common stock prior to this offering. We
expect that Martin L. Grass, Rite Aid's chief executive officer and chairman of
its board of directors, will be appointed a member of our board of directors
after the completion of this offering. In addition, we will participate in
substantially all of the current and future retail pharmacy networks managed by
PCS Health Systems, Inc., a wholly-owned subsidiary of Rite Aid, which claims
to provide pharmacy benefit management services for more than 50 million
individuals in the United States. As part of the relationship, both Rite Aid
and drugstore.com agreed to certain exclusivity provisions that will limit our
ability to promote or affiliate with any other physical retail drugstore and
from operating a traditional physical drugstore, and will preclude Rite Aid
from offering or selling products or services on the Internet other than
through our Web site. In addition, the agreement provides that if we establish
our own distribution center, we will purchase all of our pharmaceutical
requirements from Rite Aid. The agreement contains additional provisions
providing for the licensing by Rite Aid to drugstore.com of information
technology systems and the integration of the information technology and
pharmacy systems of the two companies. This agreement extends for ten years,
but can be terminated for breach prior to such time.
In June 1999, we entered into a relationship with GNC whereby we will be the
exclusive online provider of GNC-branded products. We have the exclusive right
to sell GNC's nutrition products over the Internet, including the PharmAssure
brand of pharmacist recommended vitamins and nutritional supplements, subject
to our meeting performance parameters based on traffic to our Web site and
sales of GNC's products over the Internet in the third and fifth year of the
relationship. As long as we have the exclusive right to distribute GNC's
products over the Internet, we will not promote any other retail health food
store or operate a physical retail health food store.
60
<PAGE>
If the exclusivity provisions of the agreement terminate, we have the non-
exclusive right to sell these products for the remaining term of the
agreement. As part of this relationship, we will create a separate part of our
Web site called the GNC LiveWell Store which is dedicated to selling on a
consignment basis GNC products. In connection with this relationship, GNC
acquired approximately 8.0% of our outstanding common stock prior to this
offering. As part of our relationship with GNC, GNC and drugstore.com agreed
to co-promote each other's products and services in both their traditional and
online marketing efforts, including GNC putting a link to our Web site on
their Web site. The agreement extends for ten years, but can be terminated for
breach prior to such time.
We have entered into offer letters with several of our executive officers.
See "Management--Employment Offer Letters" for a description of the offer
letters.
On December 3, 1998, we loaned $250,000 to Kal Raman, our Senior Vice
President, Technology and Operations. In our offer letter to Mr. Raman, we
agreed to guarantee a loan for $250,000, and, in connection with this
obligation, chose to provide the loan directly to Mr. Raman. The loan bears
interest at 7% and is secured by the shares issuable upon exercise of Mr.
Raman's stock option. All principal and accrued interest under the loan
remains outstanding and is due and payable on the earlier of December 3, 1999,
or within 15 days after ceasing to provide substantial services to
drugstore.com. As of July 4, 1999, the outstanding balance of Mr. Raman's loan
was $260,212. See "Management--Employment Offer Letters" for a description of
our loan arrangement with Mr. Raman.
All future transactions, including any loans from us to our officers,
directors, principal stockholders or affiliates, will be approved by a
majority of our board of directors, including a majority of the independent
and disinterested members of the board, and if required by law, a majority of
disinterested stockholders.
In the event that drugstore.com merges or is acquired by another company
and Peter M. Neupert or Jed A. Smith is not offered a similar position with
similar responsibilities, respectively, by the surviving entity, or if the
surviving entity's principal office is located more than 50 miles from their
respective residences, all of Mr. Neupert's and Mr. Smith's unvested shares
will be released from our option to repurchase these shares.
61
<PAGE>
PRINCIPAL STOCKHOLDERS
The following table sets forth information regarding the beneficial
ownership of our common stock as of July 16, 1999, and as adjusted to reflect
the sale of common stock offered hereby, by:
. each stockholder known by us to own beneficially more than 5% of our
common stock;
. each director;
. our chief executive officer and our only other officer earning more
than $100,000 in salary and bonus during the 1998 fiscal year; and
. all directors and executive officers as a group.
As of July 16, 1999, there were 36,791,000 shares of common stock
outstanding and 31 stockholders of drugstore.com. Beneficial ownership is
determined in accordance with the rules of the SEC. In computing the number of
shares beneficially owned by a person and the percentage ownership of that
person, shares of common stock subject to options or warrants held by that
person that are currently exercisable or will become exercisable within 60
days after July 16, 1999 are deemed outstanding, while such shares are not
deemed outstanding for purposes of computing percentage ownership of any other
person. Unless otherwise indicated in the footnotes below, the persons and
entities named in the table have sole voting and investment power with respect
to all shares beneficially owned, subject to community property laws where
applicable.
<TABLE>
<CAPTION>
Shares Beneficially Shares Beneficially Owned
Owned Prior to this Offering After this Offering(1)(2)
----------------------------------------------------------------
Name and Address of Beneficial Owner Number Percentage Number Percentage
- ------------------------------------ ----------------- ------------------------------- --------------
<S> <C> <C> <C> <C>
Amazon.com, Inc.(1)....... 10,733,523 29.2% 11,289,078 26.7%
1516 2nd Avenue
Seattle, WA 98101
Rite Aid Corporation(2)... 9,334,746 25.4 9,334,746 22.0
30 Hunter Lane
Camp Hill, PA 17011
Kleiner Perkins Caufield &
Byers(3)................. 7,030,771 19.1 7,030,771 16.6
2750 Sand Hill Road
Menlo Park, CA 94025
General Nutrition
Investment Company(4).... 2,947,853 8.0 2,947,853 7.0
1002 South 63rd Avenue
At Buckeye
Phoenix, AZ 15222
Vulcan Ventures,
Incorporated(5).......... 2,266,289 6.2 2,266,289 5.4
110 110th Avenue NE,
Suite 550
Bellevue, WA 98004
Peter M. Neupert(6)....... 1,848,146 5.0 1,848,146 4.4
13920 Southeast Eastgate
Way Suite 300
Bellevue, WA 98005
Maveron Equity Partners,
L.P.(7).................. 1,184,683 3.2 1,184,683 2.8
Jeffrey P. Bezos(1)....... 10,733,523 29.2 11,289,078 26.7
Brook H. Byers(3)......... 7,030,771 19.1 7,030,771 16.6
L. John Doerr(3).......... 7,030,771 19.1 7,030,771 16.6
William Savoy(5).......... 2,266,289 6.2 2,266,289 5.4
Howard Schultz(7)......... 1,184,683 3.2 1,184,683 2.8
Jed A. Smith(8)........... 950,000 2.6 950,000 2.2
Kal Raman(9).............. 37,500 * 37,500 *
All directors and officers
as a group (11
persons)(10)........... 24,092,912 65.4 24,648,467 58.1
</TABLE>
- --------
* Less than 1%
(1) Jeffrey P. Bezos is a director of drugstore.com and is the chairman of the
board and chief executive officer of Amazon.com, Inc.
62
<PAGE>
(2) Under the terms of the Third Amended and Restated Voting Agreement dated
June 17, 1999, Rite Aid will have the right to nominate one member to our
board of directors.
(3) Consists of 6,313,633 shares held by Kleiner Perkins Caufield & Byers
VIII, L.P. (KPCB VIII), 365,600 shares held by KPCB VIII Founders Fund,
L.P., and 351,538 shares held by KPCB Life Sciences Zaibatsu Fund II, L.P.
KPCB VIII and KPCB VIII Founders Fund, L.P. are wholly controlled by KPCB
VIII Associates, L.P. KPCB Life Sciences Zaibatsu Fund II, L.P. is wholly
controlled by KPCB VII Associates, L.P. Brook H. Byers and L. John Doerr,
each a general partner of KPCB VIII Associates and KPCB VII Associates,
L.P., are both directors of drugstore.com. Mr. Byers and Mr. Doerr each
disclaim beneficial ownership of shares held by these entities except to
the extent of his pecuniary interest in those shares.
(4) On July 5, 1999, General Nutrition Companies, Inc., the parent company of
General Nutrition Investment Company, announced that it agreed to merge
with Royal Numico N.V., a European maker of nutrition products.
(5) William D. Savoy is a director of drugstore.com and is the vice president
of Vulcan Ventures, a venture capital firm wholly-owned by Paul Allen. Mr.
Savoy disclaims beneficial ownership of shares held by Vulcan Ventures
except to the extent of his pecuniary interest in those shares.
(6) As of July 16, 1999, 945,000 of such shares are subject to a right of
repurchase at cost in the event Peter M. Neupert ceases to be an employee
of drugstore.com. Mr. Neupert's shares of preferred stock are held jointly
by Mr. Neupert and Sheryl Neupert.
(7) Howard Schultz is a director of drugstore.com and one of two founding
members of Maveron LLC and is one of two members of a limited liability
company that serves as a general partner of its affiliated venture capital
fund, Maveron Equity Partners, L.P. Mr. Schultz disclaims beneficial
ownership of shares held by these entities except to the extent of his
pecuniary interest in those shares.
(8) As of July 16, 1999, 304,688 of such shares are subject to a right of
repurchase at cost in the event Jed A. Smith ceases to be an employee of
drugstore.com. Includes 40,000 shares held by The Jed Smith 1998
Irrevocable Trust.
(9) During 1998 and 1999, Kal Raman was granted options to purchase 225,000
shares of our common stock. As of 60 days after July 16, 1999, 37,500 of
these shares were vested.
(10) Does not include shares that will be beneficially owned by Rite Aid's
nominee to the board of directors since such nominee has not yet been
appointed to the board. 75,000 shares subject to options held by the
directors and officers are exercisable within 60 days of July 16, 1999.
63
<PAGE>
DESCRIPTION OF CAPITAL STOCK
As of July 16, 1999, there were 36,791,000 shares of common stock
outstanding. Upon completion of this offering, drugstore.com will be
authorized to issue 250,000,000 shares of common stock, $.0001 par value, and
10,000,000 shares of undesignated preferred stock, $.0001 par value.
The following description of drugstore.com's capital stock is not complete
and is qualified in its entirety by drugstore.com's certificate of
incorporation and bylaws, which are included as exhibits to the registration
statement of which this prospectus forms a part, and by the provisions of
applicable Delaware law.
Common Stock
The holders of common stock are entitled to one vote per share on all
matters to be voted on by the stockholders. Subject to preferences that may be
applicable to any outstanding preferred stock, the holders of common stock are
entitled to receive ratably such dividends, if any, as may be declared from
time to time by the board of directors out of funds legally available for that
purpose. See "Dividend Policy" for a description of drugstore.com's policy of
distribution of dividends. In the event of a liquidation, dissolution or
winding up of drugstore.com, the holders of common stock are entitled to share
ratably in all assets remaining after payment of liabilities, subject to prior
distribution rights of preferred stock, if any, then outstanding. The common
stock has no preemptive or conversion rights or other subscription rights.
There are no redemption or sinking fund provisions applicable to the common
stock. All outstanding shares of common stock are fully paid and
nonassessable, and the shares of common stock to be issued upon the closing of
this offering will be fully paid and nonassessable.
Preferred Stock
Upon the closing of this offering, the board of directors will have the
authority, without action by the stockholders, to designate and issue
preferred stock in one or more series and to designate the rights, preferences
and privileges of each series, any or all of which may be greater than the
rights of the common stock. It is not possible to state the actual effect of
the issuance of any shares of preferred stock upon the rights of holders of
the common stock until the board of directors determines the specific rights
of the holders of such preferred stock. However, the effects might include,
among other things, restricting dividends on the common stock, diluting the
voting power of the common stock, impairing the liquidation rights of the
common stock and delaying or preventing a change in control of drugstore.com
without further action by the stockholders. drugstore.com has no present plans
to issue any shares of preferred stock.
Warrants
At July 16, 1999, we had one warrant outstanding to purchase a total of
10,000 shares of common stock at $7.825 per share. The warrant expires on
February 1, 2002.
Registration Rights
The holders of 35,023,555 shares of common stock (the "registrable
securities") or their permitted transferees are entitled to certain rights
with respect to registration of such shares under the Securities Act. These
rights are provided under the terms of an agreement between drugstore.com and
the holders of registrable securities. Under these registration rights,
beginning on the earlier of June 22, 2003, or six months after the effective
date of the offering contemplated by this prospectus, holders of at least 33%
of the then-outstanding registrable securities may require on two occasions
that drugstore.com register their shares for public resale. We are obligated
to register these shares only if the shares to be registered would have an
anticipated public offering price of at least $5,000,000. In addition, holders
of then-outstanding registrable securities with an aggregate offering price of
at least $40 million may require that we register their shares for public
resale on Form S-3 or similar short-form registration, provided we are
eligible to use Form S-3 or similar short-form registration statement and
provided further that the value of the securities to be registered is at least
$500,000. Furthermore,
64
<PAGE>
in the event we elect to register any of our shares of common stock for
purposes of effecting any public offering, the holders of registrable
securities are entitled to include their shares of common stock in the
registration, subject however to our right to reduce the number of shares
proposed to be registered in view of market conditions. All expenses in
connection with any registration (other than underwriting discounts and
commissions) will be borne by us. All registration rights will terminate five
years after the date of this public offering or, with respect to each holder
of registrable securities, at such time as the holder is entitled to sell all
of its shares in any three month period under Rule 144 of the Securities Act.
A provision of the investors' rights agreement between drugstore.com and
some of our stockholders precludes Kleiner Perkins Caufield & Byers,
Amazon.com, Maveron Equity Partners, Rite Aid and GNC from purchasing
additional shares of our common stock without our prior approval if the
purchase would cause them to hold more than 40% of our outstanding common
stock (calculated on a fully-diluted basis to include outstanding options and
shares reserved under our stock plans). This restriction lasts until August
2002.
Delaware and Washington Antitakeover Law and Certain Charter and Bylaw
Provisions
Provisions of Delaware law and our certificate of incorporation and bylaws
could make more difficult the acquisition of drugstore.com by a third party
and the removal of incumbent officers and directors. These provisions,
summarized below, are expected to discourage certain types of coercive
takeover practices and inadequate takeover bids and to encourage persons
seeking to acquire control of drugstore.com to first negotiate with us. We
believe that the benefits of increased protection of our ability to negotiate
with the proponent of an unfriendly or unsolicited proposal to acquire or
restructure drugstore.com outweigh the disadvantages of discouraging such
proposals because, among other things, negotiation of such proposals could
result in an improvement of their terms.
We are subject to Section 203 of the Delaware General Corporation Law,
which regulates corporate acquisitions. In general, Section 203 prohibits a
publicly held Delaware corporation from engaging in a "business combination"
with an "interested stockholder" for a period of three years following the
date the person became an interested stockholder, unless:
. the board of directors approved the transaction in which such
stockholder became an interested stockholder prior to the date the
interested stockholder attained such status;
. upon consummation of the transaction that resulted in the stockholder's
becoming an interested stockholder, he or she owned at least 85% of the
voting stock of the corporation outstanding at the time the transaction
commenced, excluding shares owned by persons who are directors and also
officers and shares in employee stock plans in which the participants
have no right to determine confidentially whether shares held subject to
the plan will be tendered in a tender or exchange offer; or
. on or subsequent to such date the business combination is approved by
the board of directors and authorized by 66 2/3% vote at an annual or
special meeting of stockholders.
A business combination generally includes a merger, asset or stock sale, or
other transaction resulting in a financial benefit to the interested
stockholder. In general, an "interested stockholder" is a person who, together
with affiliates and associates, owns, or within three years prior to the
determination of interested stockholder status, did own, 15% or more of a
corporation's voting stock.
The laws of the State of Washington, where our principal executive offices
are located, also impose restrictions on certain transactions between certain
foreign corporations and significant stockholders. Chapter 23B.19 of the
Washington Business Corporation Act (the WBCA) prohibits a "target
corporation," with certain exceptions, from engaging in certain "significant
business transactions" with a person or group of persons who beneficially own
10% or more of the voting securities of the target corporation (an "acquiring
person") for a period of five years after such acquisition, unless the
transaction or acquisition of such shares is approved by a majority of the
members of the target corporation's board of directors prior to the time of
acquisition. Such prohibited transactions include, among other things, a
merger or consolidation with, disposition of assets to, or issuance or
redemption of stock to or from, the acquiring person, termination of 5% or
more of the employees of
65
<PAGE>
the target corporation as a result of the acquiring person's acquisition of
10% or more of the shares or allowing the acquiring person to receive
disproportionate benefit as a stockholder. After the five-year period, a
significant business transaction may take place as long as it complies with
certain fair price provisions of the statute.
A "target corporation" includes a foreign corporation if (1) the
corporation has a class of voting stock registered pursuant to Section 12 or
15 of the Exchange Act, (2) the corporation's principal executive office is
located in Washington, (3) any of (a) more than 10% of the corporation's
stockholders of record are Washington residents, (b) more than 10% of its
shares are owned of record by Washington residents, or (c) 1,000 or more of
its stockholders of record are Washington residents, (4) a majority of the
corporation's employees are Washington residents or more than 1,000 Washington
residents are employees of the corporation, and (5) a majority of the
corporation's tangible assets are located in Washington or the corporation has
more than $50.0 million of tangible assets located in Washington. A
corporation may not "opt out" of this statute and, therefore, we anticipate
this statute will apply to us. Depending upon whether we meet the definition
of a target corporation, Chapter 23B.19 of the WBCA may have the effect of
delaying, deferring or preventing a change in control of us.
Our certificate of incorporation permits the board of directors to issue
preferred stock with voting or other rights without any stockholder action.
The authorization of undesignated preferred stock makes it possible for the
board of directors to issue preferred stock with voting or other rights or
preferences that could impede the success of any attempt to change control of
drugstore.com. These and other provisions may have the effect of deterring
hostile takeovers or delaying changes in control or management of
drugstore.com.
Transfer Agent and Registrar
The transfer agent and registrar for our common stock is ChaseMellon
Shareholder Services LLC.
66
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, there has been no market for our common stock.
Future sales of substantial amounts of common stock in the public market could
adversely affect prevailing market prices. Furthermore, since only a limited
number of shares will be available for sale shortly after this offering
because of certain contractual and legal restrictions on resale, as described
below, sales of substantial amounts of our common stock in the public market
after the restrictions lapse could adversely affect the prevailing market
price and impair our ability to raise equity capital in the future.
Upon completion of the offering, we will have outstanding 42,346,555 shares
of common stock. Of these shares, the 5,000,000 shares sold in the offering,
plus any shares issued upon exercise of the underwriters' over-allotment
option, will be freely tradable without restriction under the Securities Act,
unless purchased by our "affiliates" as that term is defined in Rule 144 under
the Securities Act (generally, officers, directors or 10% stockholders).
The remaining 37,346,555 shares outstanding are "restricted securities"
within the meaning of Rule 144 under the Securities Act. Restricted shares may
be sold in the public market only if registered or if they qualify for an
exemption from registration under Rules 144, 144(k) or 701 promulgated under
the Securities Act, which are summarized below. Sales of the restricted shares
in the public market, or the availability of such shares for sale, could
adversely affect the market price of the common stock.
Our directors, officers and securityholders have entered into lock-up
agreements in connection with this offering generally providing that they will
not offer, sell, contract to sell or grant any option to purchase or otherwise
dispose of our common stock or any securities exercisable for or convertible
into our common stock owned by them for a period of 180 days after the date of
this prospectus without the prior written consent of Morgan Stanley & Co.
Incorporated, the representative of the underwriters. As a result of these
contractual restrictions, notwithstanding possible earlier eligibility for
sale under the provisions of Rules 144, 144(k) and 701, shares subject to
lock-up agreements will not be salable until such agreements expire or are
waived by the designated underwriters' representative. Morgan Stanley & Co.
Incorporated has notified us that it currently has no plans to release any
portion of the securities subject to lock-up agreements. Taking into account
the lock-up agreements, and assuming Morgan Stanley & Co. Incorporated does
not release stockholders from these agreements, the following shares will be
eligible for sale in the public market at the following times:
. Beginning on the effective date of this prospectus, only the shares sold
in the offering will be immediately available for sale in the public
market except for that portion of the shares sold in the offering
reserved for sale to directors, officers, employees, business associates
and related persons of drugstore.com that will be subject to lock-up
agreements.
. Beginning 180 days after the effective date, approximately 17,769,268
shares will be eligible for sale pursuant to Rule 701 and Rule 144,
assuming no exercise of options, of which all but 146,000 shares are
held by affiliates.
. An additional 4,472,844 shares will be eligible for sale pursuant to
Rule 144 after January 29, 2000. Further, an additional 2,266,289 shares
will be eligible for sale pursuant to Rule 144 after May 19, 2000.
12,282,599 shares will become eligible for sale pursuant to Rule 144 on
July 8, 2000. We intend to sell to Amazon.com, Inc. 555,555 shares of
common stock at the initial public offering price concurrently with the
closing of this offering that will become eligible for sale pursuant to
Rule 144 one year from the date of the closing of this offering. Shares
eligible to be sold by affiliates pursuant to Rule 144 are subject to
volume restrictions as described below. In conjunction with the sale of
Series A preferred stock, Jed A. Smith granted us a right to repurchase
731,250 shares of common stock held by him at the original purchase
price of $0.04 per share if his employment terminates under certain
circumstances. Our right of repurchase lapses at the rate of 20,313 per
month ending September 1, 2000. In conjunction with the sale of Series A
preferred stock, Peter M. Neupert granted us a right to repurchase
945,000 shares of common stock held by him at the original purchase
price of $0.04 per share if his employment terminates under
67
<PAGE>
certain circumstances. Our right of repurchase lapses at the rate of
19,688 shares per month ending June 27, 2003. At July 16, 1999,
1,249,688 shares held by Mr. Smith and Mr. Neupert were subject to
repurchase under this agreement.
In general, under Rule 144, and beginning after the expiration of the lock-
up agreements 180 days after the date of this prospectus, a person, or persons
whose shares are combined, who has beneficially owned restricted securities
for at least one year would be entitled to sell within any three-month period
a number of shares that does not exceed the greater of the following:
. one percent of the number of shares of common stock then outstanding
(which will equal approximately 427,910 shares immediately after this
offering); or
. the average weekly trading volume of the common stock during the four
calendar weeks preceding the sale.
Sales under Rule 144 are also subject to certain manner of sale provisions and
notice requirements and to the availability of current public information
about us. Under Rule 144(k), a person who is not deemed to have been our
affiliate at any time during the three months preceding a sale, and who has
beneficially owned the shares proposed to be sold for at least two years, is
entitled to sell such shares without complying with the manner of sale, public
information, volume limitation or notice provisions of Rule 144.
Rule 701, as currently in effect, permits resales of shares in reliance
upon Rule 144 but without compliance with certain restrictions, including the
holding period requirement, of Rule 144. Any of our employees, officers,
directors or consultants who purchased shares pursuant to a written
compensatory plan or contract may be entitled to rely on the resale provisions
of Rule 144. Rule 701 permits affiliates to sell their Rule 701 shares under
Rule 144 without complying with the holding period requirement of Rule 144.
Rule 701 further provides that non-affiliates may sell such shares in reliance
on Rule 144 without having to comply with the holding period, public
information, volume limitation or notice provisions of Rule 144. In addition,
we intend to file registration statements under the Securities Act as promptly
as possible after the effective date to register shares to be issued pursuant
to our employee benefit plans. As a result, any options exercised under the
1998 stock plan, the 1999 employee stock purchase plan or any other benefit
plan after the effectiveness of such registration statement will also be
freely tradable in the public market, except that shares held by affiliates
will still be subject to the volume limitation, manner of sale, notice and
public information requirements of Rule 144 unless otherwise resalable under
Rule 701. As of July 16, 1999, there were outstanding options for the purchase
of 3,606,859 shares of our common stock under the 1998 stock plan and
7,385,141 shares were available for future grant.
68
<PAGE>
UNDERWRITERS
Under the terms and subject to conditions contained in the underwriting
agreement dated the date of this prospectus, the underwriters named below, for
whom Morgan Stanley & Co. Incorporated, Donaldson, Lufkin & Jenrette
Securities Corporation and Thomas Weisel Partners LLC are acting as
representatives, have severally agreed to purchase, and drugstore.com has
agreed to sell to them, severally, the respective number of shares of common
stock set forth opposite the names of such underwriters below:
<TABLE>
<CAPTION>
Number
Name of Shares
---- ---------
<S> <C>
Morgan Stanley & Co. Incorporated.................................. 2,087,500
Donaldson, Lufkin & Jenrette Securities Corporation................ 1,252,500
Thomas Weisel Partners LLC......................................... 835,000
A.G. Edwards & Sons, Inc........................................... 150,000
Edward D. Jones & Co., L.P......................................... 150,000
SG Cowen Securities Corporation.................................... 150,000
D.A. Davidson & Co., Incorporated.................................. 75,000
First Union Capital Markets........................................ 75,000
Pacific Crest Securities, Inc...................................... 75,000
Ragen MacKenzie Incorporated....................................... 75,000
Raymond James & Associates......................................... 75,000
---------
Total............................................................ 5,000,000
=========
</TABLE>
The underwriters are offering the shares subject to their acceptance of the
shares from drugstore.com and subject to prior sale. The underwriting
agreement provides that the obligations of the several underwriters to pay for
and accept delivery of the shares of common stock offered hereby are subject
to the approval of legal matters by their counsel and to certain other
conditions. The underwriters are obligated to take and pay for all of the
shares of common stock offered by this prospectus, other than those covered by
the over-allotment option described below, if any such shares are taken.
The underwriters initially propose to offer part of the shares of common
stock directly to the public at the public offering price set forth on the
cover page of the prospectus and part to certain dealers at a price that
represents a concession not in excess of $.76 a share under the public
offering price. Any underwriter may allow, and the dealers may reallow, a
concession not in excess of $.10 a share to other underwriters or to certain
other dealers. After the initial offering of the shares of common stock, the
offering price and other selling terms may from time to time be varied by the
representatives of the underwriters.
drugstore.com has granted to the underwriters an option, exercisable for 30
days from the date of this prospectus, to purchase up to an aggregate of
750,000 additional shares of common stock at the public offering price set
forth on the cover page hereof, less underwriting discounts and commissions.
The underwriters may exercise this option solely for the purpose of covering
over-allotments, if any, made in connection with this offering of common
stock. To the extent this over-allotment option is exercised, each underwriter
will become obligated, subject to certain conditions, to purchase
approximately the same percentage of additional shares of common stock as the
number set forth next to each underwriter's name in the preceding table bears
to the total number of shares of common stock set forth next to the names of
all underwriters in the preceding table.
At the request of drugstore.com, the underwriters have reserved up to 10%
of the shares of common stock to be issued by drugstore.com and offered hereby
for sale, at the initial public offering price, to directors, officers,
employees, business associates and related persons of drugstore.com. The
number of shares of common stock available for sale to the general public will
be reduced to the extent these individuals purchase such reserved shares. Any
reserved shares which are not so purchased will be offered by the underwriters
to the general public on the same basis as the other shares offered by this
prospectus.
69
<PAGE>
Each of drugstore.com and the officers, directors, and stockholders of
drugstore.com has agreed that, without the prior written consent of Morgan
Stanley & Co. Incorporated on behalf of the underwriters, or otherwise during
the period ending 180 days after the date of this prospectus it will not: (1)
offer, pledge, sell, contract to sell, sell any option or contract to
purchase, purchase any option or contract to sell, grant any option, right or
warrant to purchase, lend or otherwise transfer or dispose of, directly or
indirectly, any shares of common stock or any securities convertible into or
exercisable or exchangeable for common stock; or (2) enter into any swap or
similar arrangement that transfers to another, in whole or in part, any of the
economic consequences of ownership of the common stock; whether any such
transaction described above is to be settled by delivery of common stock or
such other securities after the date of this prospectus. Morgan Stanley & Co.
Incorporated informed drugstore.com that they do not presently intend to
release any person from these agreements.
The underwriters have informed drugstore.com that they do not intend sales
to discretionary accounts to exceed five percent of the total number of shares
of common stock offered by them.
Our common stock has been approved for quotation on the Nasdaq National
Market under the symbol "DSCM."
In order to facilitate the offering of the common stock, the underwriters
may engage in transactions that stabilize, maintain or otherwise affect the
price of the common stock. Specifically, the underwriters may over-allot in
connection with the offering, creating a short position in the common stock
for their own account. In addition, to cover any over-allotments or to
stabilize the price of the common stock, the underwriters may bid for, and
purchase, shares of common stock in the open market. Finally, the underwriting
syndicate may reclaim selling concessions allowed to an underwriter or a
dealer for distributing the common stock in the offering if the syndicate
repurchases previously distributed common stock in transactions to cover
syndicate short positions, in stabilization transactions or otherwise. Any of
these activities may stabilize or maintain the market price of the common
stock above independent market levels. The underwriters are not required to
engage in these activities, and may end any of these activities at any time.
drugstore.com and the underwriters have agreed to indemnify each other
against certain liabilities, including liabilities under the Securities Act.
Thomas Weisel Partners LLC, one of the representatives of the underwriters,
was organized and registered as a broker-dealer in December 1998. Since
December 1998, Thomas Weisel Partners LLC has been named as a lead or co-
manager on 49 filed public offerings of equity securities, of which 27 have
been completed, and has acted as a syndicate member in an additional 20 public
offerings of equity securities. Thomas Weisel Partners LLC does not have any
material relationship with us or any of our officers, directors or controlling
persons, except with respect to its contractual relationship with us under the
underwriting agreement entered into in connection with this offering.
Pricing of the Offering
Prior to this offering, there has been no public market for the shares of
common stock. The initial public offering price has been determined by
negotiations between drugstore.com and the representatives. Among the factors
considered in determining the initial public offering price were:
. the future prospects of drugstore.com and our industry in general;
. sales, earnings and certain other financial operating information of
drugstore.com in recent periods; and
. the price-earnings ratios, price-sales ratios, market prices of
securities and financial and operating information of companies engaged
in activities similar to those of drugstore.com.
70
<PAGE>
LEGAL MATTERS
The validity of the common stock offered hereby will be passed upon for
drugstore.com by Venture Law Group, A Professional Corporation, Menlo Park,
California. Certain legal matters will be passed upon for the underwriters by
Wilson Sonsini Goodrich & Rosati, Professional Corporation, Palo Alto,
California. As of the date of this prospectus, an investment partnership
associated with Venture Law Group owns an aggregate of 21,000 shares of our
common stock, and one director of Venture Law Group beneficially owns 4,500
shares of our common stock.
EXPERTS
Ernst & Young LLP, independent auditors, have audited our consolidated
financial statements as of December 31, 1998 and for the period from April 2,
1998 (inception) to December 31, 1998, as set forth in their report. We have
included our financial statements in the prospectus and elsewhere in the
registration statement in reliance on Ernst & Young LLP's report, given on
their authority as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the SEC, a registration statement on Form S-1 under the
Securities Act with respect to the shares of common stock offered hereby. This
prospectus does not contain all the information set forth in the registration
statement and the exhibits thereto. For further information with respect to
drugstore.com and such common stock, we refer you to the registration
statement and to the exhibits filed therewith. Statements contained in this
prospectus as to the contents of any contract or other document referred to
are not necessarily complete, and in each instance reference is made to the
copy of such contract or other document filed as an exhibit to the
registration statement, each such statement being qualified in all respects by
such reference. A copy of the registration statement may be inspected by
anyone without charge at the Public Reference Section of the SEC at Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of all
or any portion of the registration statement may be obtained from the Public
Reference Section of the SEC, 450 Fifth Street, N.W., Washington, D.C. 20549,
upon payment of prescribed fees. The SEC maintains a web site at
http://www.sec.gov that contains reports, proxy and information statements and
other information regarding registrants that file electronically with the SEC.
71
<PAGE>
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Ernst & Young LLP, Independent Auditors........................... F-2
Consolidated Balance Sheets................................................. F-3
Consolidated Statements of Operations....................................... F-4
Consolidated Statements of Stockholders' Equity............................. F-5
Consolidated Statements of Cash Flows....................................... F-6
Notes to Consolidated Financial Statements.................................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
drugstore.com, inc.
We have audited the accompanying consolidated balance sheet of drugstore.com,
inc. as of December 31, 1998, and the related consolidated statements of
operations, stockholders' equity, and cash flows for the period from April 2,
1998 (inception) to December 31, 1998. These financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
from material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of drugstore.com,
inc. at December 31, 1998, and the consolidated results of its operations and
its cash flows for the period from April 2, 1998 (inception) to December 31,
1998, in conformity with generally accepted accounting principles.
Ernst & Young LLP
Seattle, Washington
January 29, 1999, except for Note 7
as to which the date is
July 16, 1999
F-2
<PAGE>
DRUGSTORE.COM, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
<TABLE>
<CAPTION>
Pro Forma
Stockholders'
Equity
December 31, July 4, July 4,
1998 1999 1999
------------ ----------- -------------
(unaudited) (Note 7)
(unaudited)
<S> <C> <C> <C>
Assets
Current assets:
Cash and cash equivalents.............. $14,408 $ 68,087
Accounts receivable.................... -- 272
Inventories............................ -- 1,498
Prepaid marketing expenses............. 4,317 2,605
Other prepaid expenses and current
assets................................ 520 1,011
------- --------
Total current assets..................... 19,245 73,473
Fixed assets, net of accumulated
depreciation of $66 and $932............ 2,616 6,221
Intangible assets, net of accumulated
amortization of $33 and $71............. 230 246
Prepaid marketing expenses............... -- 3,334
Note receivable from officer............. 250 260
Deposits and other assets................ 176 1,202
------- --------
Total assets............................. $22,517 $ 84,736
======= ========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable....................... $ 1,254 $ 6,727
Accrued compensation................... 327 1,320
Accrued marketing expenses............. -- 1,578
Other current liabilities.............. 142 141
Current portion of capital lease
obligations........................... 472 1,307
------- --------
Total current liabilities................ 2,195 11,073
Capital lease obligations, less current
portion................................. 975 1,099
Commitments and contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par
value ($.0001 pro forma):
Authorized shares--60,000,000
(10,000,000 pro forma)
Series A preferred stock, designated
10,000,000 shares
Issued and outstanding shares--
10,000,000 (none pro forma)
(aggregate liquidation preference of
$8,000)............................. 7,986 7,986
Series B preferred stock, designated
5,500,000 shares
Issued and outstanding shares--
5,446,268 (none pro forma)
(aggregate liquidation preference of
$18,245)............................ 18,237 18,237
Series C preferred stock, designated
5,000,000 shares
Issued and outstanding shares--
4,472,844 (none pro forma)
(aggregate liquidation preference of
$35,000)............................ -- 34,981
Series D preferred stock, designated
2,300,000 shares
Issued and outstanding shares--
2,266,289 (none pro forma)
(aggregate liquidation preference of
$40,000)........................... -- 44,982
Common stock, $.001 par value ($.0001
pro forma):
Authorized shares--250,000,000
(250,000,000 pro forma)
Issued and outstanding shares--
2,323,000 (24,508,401 pro forma)...... 2 2 $ 2
Additional paid-in capital.............. 5,078 15,745 121,931
Deferred stock-based compensation....... (3,929) (10,989) (10,989)
Accumulated deficit..................... (8,027) (38,380) (38,380)
------- -------- --------
Total stockholders' equity............... 19,347 72,564 $ 72,564
------- -------- ========
Total liabilities and stockholders'
equity.................................. $22,517 $ 84,736
======= ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
DRUGSTORE.COM, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Period from Period from Six Months
April 2, 1998 April 2, 1998 Ended
(Inception) to (Inception) to July 4,
December 31, 1998 June 30, 1998 1999
----------------- -------------- -----------
(unaudited) (unaudited)
<S> <C> <C> <C>
Net sales........................ $ -- $ -- $ 4,202
Cost of sales.................... -- -- 5,551
--------- ------- ----------
Gross profit (loss)............ -- -- (1,349)
Operating expenses:
Marketing and sales............ 3,092 -- 16,517
Product development............ 2,178 104 5,942
General and administrative..... 1,894 79 3,955
Amortization of stock-based
compensation.................. 1,037 166 3,583
--------- ------- ----------
Total operating expenses..... 8,201 349 29,997
--------- ------- ----------
Operating loss................... (8,201) (349) (31,346)
Other income (expense):
Interest income................ 177 -- 1,033
Interest expense............... (3) -- (40)
--------- ------- ----------
Net loss......................... $ (8,027) $ (349) $ (30,353)
========= ======= ==========
Basic and diluted net loss per
share........................... $ (14.70) $ (6.95) $ (30.26)
========= ======= ==========
Pro forma basic and diluted net
loss per share.................. $ (.98) $ (.71) $ (1.46)
========= ======= ==========
Weighted average shares
outstanding used to compute
basic and diluted net loss per
share........................... 546,149 50,211 1,003,152
========= ======= ==========
Weighted average shares
outstanding used to compute
pro forma basic and diluted net
loss per share.................. 8,167,570 494,031 20,796,875
========= ======= ==========
</TABLE>
See accompanying notes.
F-4
<PAGE>
DRUGSTORE.COM, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands, except share data)
<TABLE>
<CAPTION>
Convertible Preferred Stock
-----------------------------------------------------------------------
Series A Series B Series C Series D Common Stock Additional Deferred
----------------- ----------------- ----------------- ----------------- ---------------- Paid-in Stock-based
Shares Amount Shares Amount Shares Amount Shares Amount Shares Amount Capital Compensation
---------- ------ --------- ------- --------- ------- --------- ------- --------- ------ ---------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Initial issuance
of common shares
to founders in
exchange for
cash and
intellectual
property........ -- $ -- -- $ -- -- $ -- -- $ -- 2,315,000 $ 2 $ 111 $ --
Issuance of
Series A
preferred stock
in June and
August, net of
offering costs
of $14.......... 5,000,000 3,986 -- -- -- -- -- -- -- -- -- --
Issuance of
Series A
preferred stock
in August in
exchange for
Technology
License and
Advertising
Agreement....... 5,000,000 4,000 -- -- -- -- -- -- -- -- -- --
Issuance of
Series B
preferred stock
in October,
November and
December, net of
offering costs
of $8........... -- -- 5,446,268 18,237 -- -- -- -- -- -- -- --
Exercise of
common stock
options......... -- -- -- -- -- -- -- -- 8,000 -- 1 --
Deferred stock-
based
compensation.... -- -- -- -- -- -- -- -- -- -- 4,966 (4,966)
Amortization of
stock-based
compensation ... -- -- -- -- -- -- -- -- -- -- -- 1,037
Net loss and
comprehensive
loss............ -- -- -- -- -- -- -- -- -- -- -- --
---------- ------ --------- ------- --------- ------- --------- ------- --------- --- ------- -------
Balance at
December 31,
1998............ 10,000,000 7,986 5,446,268 18,237 -- -- -- -- 2,323,000 2 5,078 (3,929)
Issuance of
Series C
preferred stock
in January and
March, net of
offering costs
of $19
(unaudited)..... -- -- -- -- 4,472,844 34,981 -- -- -- -- -- --
Issuance of
Series D
preferred stock
in June, net of
offering costs
of $18
(unaudited)..... -- -- -- -- -- -- 2,266,289 44,982 -- -- -- --
Issuance of
warrants to
purchase common
stock
(unaudited)..... -- -- -- -- -- -- -- -- -- -- 24 --
Deferred stock-
based
compensation
(unaudited)..... -- -- -- -- -- -- -- -- -- -- 10,643 (10,643)
Amortization of
stock-based
compensation
(unaudited)..... -- -- -- -- -- -- -- -- -- -- -- 3,583
Net loss and
comprehensive
loss
(unaudited)..... -- -- -- -- -- -- -- -- -- -- -- --
---------- ------ --------- ------- --------- ------- --------- ------- --------- --- ------- -------
Balance at July
4, 1999
(unaudited)..... 10,000,000 $7,986 5,446,268 $18,237 4,472,844 $34,981 2,266,289 $44,982 2,323,000 $ 2 $15,745 $10,989
========== ====== ========= ======= ========= ======= ========= ======= ========= === ======= =======
<CAPTION>
Accumulated
Deficit Total
----------- --------
<S> <C> <C>
Initial issuance
of common shares
to founders in
exchange for
cash and
intellectual
property........ $ -- $ 113
Issuance of
Series A
preferred stock
in June and
August, net of
offering costs
of $14.......... -- 3,986
Issuance of
Series A
preferred stock
in August in
exchange for
Technology
License and
Advertising
Agreement....... -- 4,000
Issuance of
Series B
preferred stock
in October,
November and
December, net of
offering costs
of $8........... -- 18,237
Exercise of
common stock
options......... -- 1
Deferred stock-
based
compensation.... -- --
Amortization of
stock-based
compensation ... -- 1,037
Net loss and
comprehensive
loss............ (8,027) (8,027)
----------- --------
Balance at
December 31,
1998............ (8,027) 19,347
Issuance of
Series C
preferred stock
in January and
March, net of
offering costs
of $19
(unaudited)..... -- 34,981
Issuance of
Series D
preferred stock
in June, net of
offering costs
of $18
(unaudited)..... -- 44,982
Issuance of
warrants to
purchase common
stock
(unaudited)..... -- 24
Deferred stock-
based
compensation
(unaudited)..... -- --
Amortization of
stock-based
compensation
(unaudited)..... -- 3,583
Net loss and
comprehensive
loss
(unaudited)..... (30,353) (30,353)
----------- --------
Balance at July
4, 1999
(unaudited)..... $ 38,380 $72,564
=========== ========
</TABLE>
See accompanying notes.
F-5
<PAGE>
DRUGSTORE.COM, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Period from Period from
April 2, 1998 April 2, 1998 Six Months
(Inception) to (Inception) to Ended
December 31, 1998 June 30, 1998 July 4, 1999
----------------- -------------- ------------
(unaudited) (unaudited)
<S> <C> <C> <C>
Operating Activities:
Net loss......................... $(8,027) $ (349) $(30,353)
Adjustments to reconcile net loss
to net cash used in operating
activities:
Depreciation and amortization.. 90 -- 993
Amortization of stock-based
compensation.................. 1,037 166 3,583
Technology license and
advertising agreement-related
expenses...................... 58 -- 3,314
Changes in:
Accounts receivable........... -- -- (272)
Inventories................... -- -- (1,498)
Prepaid marketing expenses.... (552) (300) 122
Other prepaid expenses and
current assets............... (484) -- (535)
Deposits and other assets..... (176) (2) (1,026)
Accounts payable and accrued
expenses..................... 1,723 39 7,225
Other......................... -- -- (10)
------- ------ --------
Net cash used in operating
activities...................... (6,331) (446) (18,457)
Investing Activities:
Purchase of fixed assets......... (1,202) -- (3,176)
Addition of intangible assets.... (90) (90) (30)
Issuance of note receivable to
officer......................... (250) -- --
------- ------ --------
Net cash used in investing
activities...................... (1,542) (90) (3,206)
Financing Activities:
Proceeds from sales of common
stock........................... 90 39 --
Proceeds from exercise of stock
options......................... 1 -- --
Net proceeds from sales of Series
A preferred stock............... 3,986 3,936 --
Net proceeds from sales of Series
B preferred stock............... 18,237 -- --
Net proceeds from sales of Series
C preferred stock............... -- -- 34,981
Net proceeds from sales of Series
D preferred stock............... -- -- 39,982
Proceeds from capital lease
obligations..................... -- -- 538
Principal payments on capital
lease obligations............... (33) -- (159)
------- ------ --------
Net cash provided by financing
activities...................... 22,281 3,975 75,342
------- ------ --------
Net increase in cash and cash
equivalents..................... 14,408 3,439 53,679
Cash and equivalents at beginning
of period....................... -- -- 14,408
------- ------ --------
Cash and equivalents at end of
period.......................... $14,408 $3,439 $ 68,087
======= ====== ========
Supplemental Cash Flow
Information:
Cash paid for interest........... $ 48 $ -- $ 22
Equipment acquired through
capital lease agreements........ $ 1,480 $ -- $ 595
Issuance of common stock in
exchange for intellectual
property........................ $ 23 $ -- $ --
Issuance of Series A preferred
stock in exchange for technology
license and advertising
agreement....................... $ 4,000 $ -- $ --
Issuance of Series D preferred
stock in exchange for cable
television advertising.......... $ -- $ -- $ 5,000
Issuance of warrants to purchase
common stock in exchange for
intangible asset................ $ -- $ -- $ 24
</TABLE>
See accompanying notes.
F-6
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
1. Organization and Summary of Significant Accounting Policies
General
drugstore.com, inc. and its wholly-owned subsidiary, DS Pharmacy, Inc.,
(collectively, the Company) are engaged in the development of Internet-based
retailing opportunities focused on filling needs for health, wellness, beauty,
personal care and pharmacy products and related information. The Company was
incorporated on April 2, 1998 and launched its Web site and commenced
commercial operations on February 24, 1999. The Company was previously
considered a development stage company.
The Company has incurred significant operating losses since inception of
operations and has limited working capital. The Company has financed its
operations to date through the issuance of equity securities. Further
development and establishment of the Company's business will require
additional equity financing. The Company believes that equity financing can be
obtained from existing or new investors. However, there can be no assurance
that the Company will be able to obtain such equity financing on acceptable
terms, if at all.
Interim Financial Statements
The accompanying balance sheet as of July 4, 1999 and the statements of
operations and cash flows for the period from April 2, 1998 (inception) to
June 30, 1998 and the six months ended July 4, 1999 are unaudited. In the
opinion of management, the unaudited financial statements have been prepared
on the same basis as the audited financial statements and include all
adjustments, consisting of normal recurring adjustments, necessary for a fair
presentation of the results of operations and cash flows for the interim
periods. Operating results for the six months ended July 4, 1999 are not
necessarily indicative of the results that may be expected for the year ending
January 2, 2000.
Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include those of
drugstore.com, inc. and its wholly-owned subsidiary, DS Pharmacy, Inc. All
material intercompany transactions and balances have been eliminated.
On January 1, 1999, the Company adopted a 52/53 week fiscal year ending on
the Sunday closest to December 31. The 1999 fiscal year ends on January 2,
2000, with each of the fiscal quarters representing a 13-week period. The
effect of the change on prior periods is insignificant.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts of assets and liabilities and disclosure
of contingent assets and liabilities at the date of the financial statements.
Actual results could differ from those estimates.
Cash Equivalents
The Company considers all highly liquid investments with a maturity of
three months or less at the date of purchase to be cash equivalents.
Concentration of Credit Risk
The Company is subject to concentrations of credit risk from its cash
investments. The Company's credit risk is managed through monitoring the
stability of the financial institutions utilized and diversification of its
financial resources.
F-7
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Financial instruments consist of cash and cash equivalents and capital
lease obligations. The fair value of all financial instruments approximates
the carrying amount based on the current rate offered for similar instruments.
Inventories
Inventories are stated at the lower of cost (using the weighted average
cost method) or market. The Company has contracts with RxAmerica L.L.C. to
purchase and distribute all of its pharmaceutical products and Walsh
Distribution, Inc. to purchase a substantial majority and distribute all of
its non-pharmaceutical products. The agreement with RxAmerica is for a one-
year term ending February 2000, which will automatically extend for an
additional year unless either party gives written notice of termination. The
agreement with Walsh Distribution, Inc. is for a three-year term ending
January 2002, but may be terminated by the Company earlier upon accelerated
payment of minimum fees that would not exceed $2.5 million.
Fixed Assets
Fixed assets are stated at cost less accumulated depreciation and
amortization, which includes the amortization of assets recorded under capital
leases. Depreciation and amortization is provided using the straight-line
method over the estimated useful lives of the related assets, which range from
two to seven years. Fixed assets purchased under capital leases and leasehold
improvements are amortized over the shorter of the lease term or estimated
useful life.
Long-Lived Assets
Long-lived assets and intangible assets are reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount
may not be recoverable. Impairment is measured by comparing the carrying value
of the long-lived assets to the estimated undiscounted future cash flows
expected to result from use of the assets and their ultimate disposition. In
circumstances where impairment is determined to exist, the Company will write
down the asset to its fair value based on the present value of estimated
expected future cash flows. To date, no such impairment has been indicated.
Revenue Recognition
The Company recognizes revenue from product sales, net of discounts, when
the products are shipped to customers. Outbound shipping and handling fees are
also included in net sales upon shipment. The Company generally refunds all or
a portion of the net sales in the event a customer is not satisfied with the
product or service provided. The Company provides an estimated allowance for
such sales returns in the period of sale. Sales returns to date have been
insignificant.
Product Development
Product development expenses consist primarily of payroll and related
expenses for Web site development and systems personnel and consultants,
system infrastructure and costs of Web site content. Expenditures relating to
product development have been expensed as incurred.
Income Taxes
The Company accounts for income taxes under the liability method. Under the
liability method, deferred tax assets and liabilities are determined based on
differences between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to be recovered. Valuation
allowances are established, when necessary, to reduce deferred tax assets to
the amounts expected to be realized.
F-8
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Advertising
Advertising production costs are expensed as incurred. Costs of
communicating advertising associated with television, radio, print and other
media are expensed when such services are used. Costs associated with Web
portal advertising contracts are amortized on a straight-line basis over the
period such advertising is expected to be used. Advertising expense for the
period ended December 31, 1998 and the six months ended July 4, 1999 was
$1,638,000 and $9,248,000, respectively.
Stock-Based Compensation
The Company has elected to follow Accounting Principles Board Opinion No.
25, Accounting for Stock Issued to Employees (APB No. 25), and related
interpretations, in accounting for employee stock options rather than the
alternative fair value accounting allowed by Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation (SFAS No. 123). APB
No. 25 provides that the compensation expense relative to the Company's
employee stock options is measured based on the intrinsic value of the stock
option. SFAS No. 123 requires companies that continue to follow APB No. 25 to
provide a pro forma disclosure of the impact of applying the fair value method
of SFAS No. 123 (see Note 5). The Company accounts for stock issued to non-
employees in accordance with the provisions of SFAS No. 123 and the Emerging
Issues Task Force consensus in Issue No. 96-18, Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services. With respect to all of its
employees, the Company utilized a co-employment arrangement with an
independent company. The Company considers all of its employees to be common
law employees and has accounted for stock options granted to such employees
under APB No. 25.
Net Loss Per Share
Net loss per share is computed using the weighted average number of shares
of common stock outstanding less the number of shares subject to repurchase.
Shares associated with stock options, warrants and the convertible preferred
stock are not included in the calculation of diluted net loss per share
because they are antidilutive.
Pro Forma Net Loss Per Share (Unaudited)
Pro forma net loss per share is computed using the weighted average number
of common shares outstanding, including the pro forma effects of the automatic
conversion of all outstanding convertible preferred stock into shares of
common stock effective upon the closing of the Company's initial public
offering as if such conversion occurred at the date of original issuance.
F-9
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
The following table sets forth the computation of basic and diluted net
loss per share and pro forma basic and diluted net loss per share for the
periods indicated:
<TABLE>
<CAPTION>
Period from Period from
April 2, 1998 April 2, 1998 Six Months
(Inception) to (Inception) to Ended
December 31, 1998 June 30, 1998 July 4, 1999
----------------- -------------- ------------
(unaudited) (unaudited)
<S> <C> <C> <C>
Numerator:
Net loss...................... $(8,027,000) $(349,000) $(30,353,000)
=========== ========= ============
Denominator:
Weighted average common shares
outstanding.................. 1,462,311 120,506 2,323,000
Less weighted average common
shares issued subject to
repurchase agreements........ (916,162) (70,295) (1,319,848)
----------- --------- ------------
Denominator for basic and
diluted calculation.......... 546,149 50,211 1,003,152
Weighted average effect of pro
forma conversion of
securities:
Series A convertible
preferred stock............ 6,124,313 443,820 10,000,000
Series B convertible
preferred stock............ 1,497,108 -- 5,446,268
Series C convertible
preferred stock............ -- -- 3,771,695
Series D convertible
preferred stock............ -- -- 575,760
----------- --------- ------------
Denominator for pro forma
basic and diluted
calculation.................. 8,167,570 494,031 20,796,875
=========== ========= ============
Net loss per share:
Basic and diluted............. $ (14.70) $ (6.95) $ (30.26)
=========== ========= ============
Pro forma basic and diluted... $ (.98) $ (.71) $ (1.46)
=========== ========= ============
</TABLE>
At December 31, 1998, there were 1,515,334 stock options that were excluded
from the computation of actual and pro forma diluted net loss per share as
their effect was antidilutive. If the Company had reported net income, the
calculation of these per share amounts would have included the dilutive effect
of these common stock equivalents using the treasury stock method.
Segment Information
In January 1999, the Company adopted SFAS No. 131, Disclosures About
Segments of an Enterprise and Related Information. This standard established
interim and annual reporting standards for an enterprise's operating segments
and related disclosures about its products, services, geographic areas and
major customers. Since commencement of operations in February 1999, the
Company's business consists of a single retail drug segment that sells health,
beauty, wellness, personal care and pharmacy products on-line and provides
related product information on the Company's Web site.
New Accounting Pronouncements
In March 1998, the Accounting Standards Executive Committee issued
Statement of Position 98-1, Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use. SOP 98-1 requires all costs related to
the development of internal use software other than those incurred during the
application development stage to be expensed as incurred. Costs incurred
during the application development stage are required to be capitalized and
amortized over the estimated useful life of the software. The Company adopted
SOP 98-1 in the quarter ended April 4, 1999 and there was no significant
impact upon adoption.
F-10
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. SFAS No. 133 is effective for fiscal years
beginning after June 15, 2000. SFAS No. 133 requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in
the fair value of derivatives are recorded each period in current earnings or
other comprehensive income, depending on whether a derivative is designed as
part of a hedge transaction and, if it is, the type of hedge transaction. The
Company does not expect that the adoption of SFAS No. 133 will have a material
impact on its financial statements because it does not currently hold any
derivative instruments.
2. Fixed Assets
Fixed assets consists of the following:
<TABLE>
<CAPTION>
December 31,
1998
--------------
(In thousands)
<S> <C>
Computers and equipment....................................... $1,862
Purchased software............................................ 711
Furniture and fixtures........................................ 20
Leasehold improvements........................................ 89
------
2,682
Less accumulated depreciation................................. (66)
------
$2,616
======
</TABLE>
Included in computers and equipment and purchased software are assets
acquired under capital leases with an original cost of approximately
$1,115,000 and $365,000, respectively, as of December 31, 1998. Accumulated
amortization on the leased assets was approximately $10,000 as of December 31,
1998. Approximately $1,370,000 of computers and equipment as of December 31,
1998 were not placed into service until the launch of the Company's Web store
in February 1999.
3. Leases and Marketing Agreements
The Company leases office space under an operating lease, which calls for
fixed rental payments through 2003. In addition, the Company leases various
office equipment under operating leases. Total rent expense under operating
leases for the periods ended December 31, 1998 and July 4, 1999 approximated
$127,000 and $972,000, respectively.
Capital lease obligations bear interest at rates ranging from 4% to 7% and
mature 24 to 36 months from the date of funding. At December 31, 1998, the
Company had no additional financing available under the agreements.
The Company has also entered into certain non-cancelable advertising
agreements with various Web portals, including Yahoo!, America On-Line and
Excite, which require the Company to make fixed payments to such portals over
the term of the agreements. In exchange, the portals have committed to display
the agreed-upon advertisement a minimum number of times on such portal's Web
site over the term of the contract. The costs associated with Web portal
advertising contracts are amortized on a straight-line basis over the period
such advertising is expected to be used.
F-11
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Future minimum commitments at December 31, 1998 are as follows:
<TABLE>
<CAPTION>
Capital Operating Marketing
Leases Leases Agreements
------- --------- ----------
(In thousands)
<S> <C> <C> <C>
1999......................................... $ 534 $ 1,539 $ 4,402
2000......................................... 620 1,541 3,230
2001......................................... 398 1,574 2,970
2002......................................... -- 1,600 3,710
2003......................................... -- 1,603 --
Thereafter................................... -- 2,238 --
------ ------- -------
Total minimum lease payments................. 1,552 $10,095 $14,312
======= =======
Less amounts representing interest........... (105)
------
Present value of minimum payments............ 1,447
Less current portion of capital lease
obligations................................. (472)
------
Noncurrent portion of capital lease
obligations................................. $ 975
======
</TABLE>
On January 28, 1999, the Company signed a seven-year lease for a new
corporate headquarters in Bellevue, Washington, which is expected to commence
no later than March 12, 1999. The minimum lease payments associated with this
lease are included in the commitments above. The Company has the option to
extend the lease for two additional three-year terms. The Company provided a
letter of credit totaling $640,000 as security for the lease. The letter of
credit may be reduced annually by specified amounts in the lease agreement
upon our achievement of certain economic goals. At December 31, 1998, there
were no letters of credit outstanding.
The Company has an agreement with Walsh Distribution, Inc. that provides
inventory and certain order fulfillment services for three years ending
January 2002. This agreement may be terminated earlier by the Company upon an
accelerated payment of minimum fees that would not exceed $2.5 million.
4. Income Taxes
The Company did not provide any current or deferred United States federal
income tax provision or benefit for any of the periods presented because it
has experienced operating losses since inception. The Company provided a full
valuation allowance on the net deferred tax asset, consisting primarily of net
operating loss carryforwards and research and development credit
carryforwards, because management has determined that it is more likely than
not that the Company will not earn income sufficient to realize the deferred
tax assets during the carryforward period.
At December 31, 1998, the Company had net operating loss carryforwards and
research and development credit carryforwards of approximately $6,737,000 and
$32,000, respectively. These carryforwards will expire in 2018. In 1999, due
to the issuance and sale of Series D and Series E preferred stock, the Company
incurred ownership changes pursuant to applicable regulations in effect under
the Internal Revenue Code of 1986, as amended. The initial public offering
will not cause an additional ownership change. Therefore, the Company's use of
losses incurred through the date of these ownership changes will be limited
during the carryforward period. The Company estimates that the use of the
approximately $6.7 million of net operating losses incurred through December
31, 1998 as well as losses incurred subsequent thereto until the date of the
ownership change would be limited to approximately $4.1 million per year in
order to offset future taxable income. To the extent that any single-year loss
is not utilized to the full amount of the limitation, such unused loss is
carried over to subsequent years until the earlier of its utilization or the
expiration of the relevant carryforward period.
F-12
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Deferred tax assets reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Since the Company's
utilization of these deferred tax assets is dependent on future profits which
are not assured, a valuation allowance equal to the deferred tax assets has
been provided. Significant components of the Company's deferred tax assets as
of December 31, 1998 are as follows (in thousands):
<TABLE>
<S> <C>
Deferred tax assets:
Net operating loss carryforward................................... $ 2,291
Research and development credit carryforward...................... 32
Other temporary differences....................................... 79
-------
Total gross deferred tax assets..................................... 2,402
Less valuation allowance............................................ (2,402)
-------
Net deferred tax assets............................................. $ --
=======
A reconciliation of income taxes computed at the statutory rate to the
income tax amount recorded for the period ended December 31, 1998 is as
follows (in thousands):
Income tax benefit at statutory rate................................ $ 2,729
Stock-based compensation............................................ (351)
Other permanent differences......................................... (8)
Research and development credit..................................... 32
Increase in valuation allowance..................................... (2,402)
-------
Income tax benefit.................................................. $ --
=======
</TABLE>
5. Stockholders' Equity
Convertible Preferred Stock
In June and August 1998, the Company issued 10,000,000 shares of Series A
preferred stock in a private placement offering in exchange for gross cash
proceeds of $4,000,000, and a Technology License and Advertising Agreement
with Amazon.com that provides for the right to license certain technology and
receive certain technological and advertising support from Amazon.com. In
addition, the Company agreed to license its technology to Amazon.com and
participate in mutually agreed upon advertising activities. No cash payments
are required under the Technology License and Advertising Agreement with
Amazon.com. The Company valued the right to license certain technology and
receive such technological and advertising support at $4,000,000 based on the
value of Series A preferred stock issued concurrently for cash. Such value was
allocated to prepaid marketing expense, license rights and prepaid technical
consulting services in the amount of $3,765,000, $150,000 and $85,000,
respectively, based on their estimated fair value. The prepaid marketing
expense will be amortized over five months commencing in February 1999. The
license rights and prepaid technical consulting are being amortized over five
years and approximately eight months, respectively, commencing on the date of
the agreement. During the period ended December 31, 1998 and the six months
ended July 4, 1999, the Company recognized expenses under such agreement
totaling $58,000 and $3,314,000, respectively.
In October, November and December 1998, the Company issued 5,446,268 shares
of Series B preferred stock in a private placement offering in exchange for
gross cash proceeds of $18,245,000.
F-13
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
In January and March 1999, the Company issued 4,472,844 shares of Series C
preferred stock in a private placement offering in exchange for gross cash
proceeds of $35,000,000.
Each share of Series A, Series B and Series C preferred stock is
convertible into one share of common stock at the option of the holder,
subject to certain antidilution adjustments, in accordance with the conversion
formula provided in the Company's certificate of incorporation (currently on a
1:1 ratio). Outstanding preferred shares automatically convert into common
stock, at the Company's option, upon the closing of an initial public offering
of the Company's common stock in which gross proceeds exceed $15.0 million and
a per share price of not less than $10.00 per share. Holders of each share of
preferred stock are entitled to the number of votes per share that would be
equivalent to the number of shares of common stock into which a share of
preferred stock is convertible and are entitled to dividends if and when
declared by the board of directors. No dividends have been declared. In the
event of any consolidation, merger, or liquidation, the holders of the Series
A, Series B and Series C preferred stock shall be entitled to receive $0.80,
$3.35 and $7.825 per share of preferred stock, respectively, plus cumulative
dividends, if and when declared, at the annual rate of 10%. The Company
granted the preferred stockholders certain registration rights and also agreed
not to carry out certain actions without prior approval of the holders of not
less than two-thirds of the outstanding preferred shares, voting together as a
single class.
Common Stock
The Company and its common and Series A, Series B and Series C stockholders
entered into an agreement, which, among other issues, addresses election of
directors, restrictions on transfer of equity securities by stockholders,
sales of new securities by drugstore.com, and covenants related to transfer of
shares. All provisions of the agreement, with the exception of covenants
related to transfer of shares, expire upon the closing of an initial public
offering.
In conjunction with the sale of Series A preferred stock, the Company's
founder granted the Company a right to repurchase 731,250 shares of common
stock held by him at the original purchase price of $0.04 per share if his
employment terminates under certain circumstances. The Company's right of
repurchase lapses at the rate of 20,313 per month ending September 1, 2000. In
conjunction with the sale of Series A preferred stock, the Company's Chief
Executive Officer granted the Company a right to repurchase 945,000 shares of
common stock held by him at the original purchase price of $0.04 per share if
his employment terminates under certain circumstances. The Company's right of
repurchase lapses at the rate of 19,688 shares per month ending June 27, 2003.
At December 31, 1998, 1,391,875 shares held by the founder and the CEO were
subject to repurchase under these agreements. The restricted stock agreements
also provide that in the event of a change of control whereby the individual
was not offered a position with similar responsibilities or termination of
employment for other than cause, additional shares would vest to the
individual. These shares are also subject to a right of first refusal in favor
of the Company whereby the Company has the right to buy the shares on the same
price and terms as offered to the founder or CEO by a third party. This right
expires upon the Company's initial public offering.
1998 Stock Plan
Under the terms of the 1998 stock plan, the board of directors may grant
incentive and nonqualified stock options to employees, officers, directors,
agents, consultants, and independent contractors of the Company. In connection
with the introduction of the 1998 stock plan, 2,735,000 shares of common stock
were reserved for future issuance. In January 1999 and April 1999, the Company
increased the number of shares reserved for future issuance under such plan by
1,500,000 and 3,592,000 shares, respectively (see Note 7). Generally, the
Company grants stock options with exercise prices equal to the fair market
value of the common stock on the date of grant,
F-14
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
as determined by the board of directors. Options generally vest over a four to
five year period and expire ten years from the date of grant.
A summary of stock option activity follows:
<TABLE>
<CAPTION>
Outstanding Options
---------------------------
Shares Available Number of Weighted-Average
for Grant Shares Exercise Price
---------------- --------- ----------------
<S> <C> <C> <C>
1998 Stock Plan
introduction............... 2,735,000 --
Options granted............. (1,683,584) 1,683,584 $ 0.17
Options exercised........... -- (8,000) 0.12
Options canceled............ 160,250 (160,250) 0.04
---------- ---------
Outstanding at December 31,
1998......................... 1,211,666 1,515,334 0.18
1998 Stock Plan amendments.. 5,092,000 -- --
Options granted ............ (1,683,600) 1,683,600 3.12
Options canceled............ 166,125 (166,125) 0.91
---------- ---------
Outstanding at July 4, 1999... 4,786,191 3,032,809 $ 1.77
========== =========
</TABLE>
The following table summarizes information regarding stock options
outstanding and exercisable as of December 31, 1998:
<TABLE>
<CAPTION>
Outstanding Options
-----------------------------------------
Weighted-Average Exercisable
Exercise Number Remaining Number of
Price of Shares Contractual Life Shares
-------- --------- ---------------- -----------
<S> <C> <C> <C>
$0.04 505,834 9.7 years 19,167
$0.12 618,500 9.8 years --
$0.45 391,000 9.9 years --
--------- ------
1,515,334 19,167
========= ======
</TABLE>
Under APB No. 25, no compensation expense is recognized when the exercise
price of the Company's employee stock options equals the fair value of the
underlying stock on the date of grant. Deferred stock-based compensation is
recorded for those situations where the exercise price of an option or the
purchase price of restricted stock was lower than the deemed fair value for
financial reporting purposes of the underlying common stock. The Company
recorded aggregate deferred stock-based compensation of $4,966,000 during 1998
and $10,643,000 in the six months ended July 4, 1999. The deferred stock-based
compensation is being amortized over the vesting period of the underlying
options and restricted stock. Total amortization of stock-based compensation
recognized was $1,037,000 during 1998 and $3,583,000 in the six months ended
July 4, 1999. Amortization of stock-based compensation is allocable to
employees in the following expense categories:
<TABLE>
<CAPTION>
Period from
April 2, 1998 Six Months
(Inception) to Ended
December 31, 1998 July 4, 1999
----------------- ------------
<S> <C> <C>
Marketing and sales......................... 18% 40%
Product development......................... 20 33
General and administrative.................. 62 27
--- ---
100% 100%
=== ===
</TABLE>
F-15
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Had the stock-based compensation for the Company's stock option plan and
restricted stock agreements been determined based on the Black-Scholes model
using the multiple-option approach, the Company's net loss would have been
adjusted to the following pro forma amount for the period ended December 31,
1998 (in thousands):
<TABLE>
<S> <C>
Net loss--as reported........................................... $ (8,027)
Incremental pro forma compensation expense under SFAS No. 123... (12)
--------
Net loss--pro forma............................................. $ (8,039)
========
Basic and diluted net loss per share--as reported............... $ (14.70)
========
Basic and diluted net loss per share--pro forma................. $ (14.72)
========
Pro forma basic and diluted net loss per share--as reported..... $ (.98)
========
Pro forma basic and diluted net loss per share--pro forma....... $ (.98)
========
</TABLE>
The fair value at each option grant is estimated on the date of grant using
the Black-Scholes option pricing model, assuming no expected dividends and
assuming a measure of a volatility based on a review of a peer group of
Internet companies at a comparable developmental stage utilizing the following
weighted average assumptions at December 31, 1998:
<TABLE>
<S> <C>
Average risk-free interest rate.................................. 4.5%
Average expected life............................................ 3.0 years
Volatility....................................................... 50%
</TABLE>
For purposes of the pro forma disclosures, the estimated weighted average
fair value of the options granted, estimated to be $1.42 per share at December
31, 1998, is amortized to expense over the options' vesting period. This
amount has been reduced by the amount of amortization of deferred stock-based
compensation already recorded in the accompanying statements of operations
that has a weighted average value of $1.40 per share. Compensation expense
recognized in providing pro forma disclosures may not be representative of the
effects on pro forma earnings for future years because the amounts above
include only the amortization for the fair value of 1998 grants.
Common Stock Reserved for Future Issuance
The following shares of common stock were reserved at December 31, 1998:
<TABLE>
<S> <C>
1998 Stock Plan................................................. 2,727,000
Conversion of Series A preferred stock.......................... 10,000,000
Conversion of Series B preferred stock.......................... 5,446,268
----------
18,173,268
==========
</TABLE>
6. Note Receivable from Officer
On December 3, 1998, the Company loaned an officer $250,000 evidenced by a
note receivable bearing 7% interest, secured by the officer's stock options to
purchase an aggregate of 150,000 shares of common stock at $.04 per share,
none of which are vested at December 31, 1998.
F-16
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
7. Subsequent Events
Issuance of Warrant
In February 1999, the Company issued a warrant to purchase 10,000 shares of
its common stock at $7.83 per share in exchange for the right to use the 1-
800-DRUGSTORE and related iterations of telephone numbers. Such warrant is
exercisable immediately and expires in February 2002. The fair value of such
warrant was estimated at $24,000 and was recorded as an intangible asset.
Proposed Initial Public Offering of Common Stock
In April 1999, the board of directors authorized the Company to proceed
with an initial public offering of its common stock. The board of directors
also approved a change in the par value of the common and preferred stock to
$.0001 per share and change in the total number of authorized shares to
260,000,000 shares, of which 250,000,000 will be common stock and 10,000,000
will be undesignated preferred stock. This increase in the number of
authorized shares and change in par value is expected to become effective upon
the completion of the offering. If the offering is consummated as presently
anticipated, all of the outstanding preferred stock will automatically convert
into common stock. The unaudited pro forma stockholders' equity at July 4,
1999 gives effect to the conversion of all outstanding shares of convertible
preferred stock at July 4, 1999 into 22,185,401 shares of common stock upon
completion of the offering and the change in the capital structure of the
Company.
1998 Stock Plan
In April 1999, the board of directors increased the number of shares
reserved under the 1998 stock plan by 3,592,000 shares to 7,827,000 shares. As
of July 4, 1999 the Company has reserved a total of 7,819,000 shares of common
stock for future issuance of stock options to employees, officers, directors,
or consultants under the 1998 stock plan. Additionally, on July 16, 1999, the
board of directors increased the number of shares under the 1998 stock plan by
3,173,000 shares.
1999 Employee Stock Purchase Plan
The Company's 1999 employee stock purchase plan was adopted by the board of
directors in April 1999, subject to stockholder approval, to be effective upon
the completion of the Company's initial public offering of its common stock. A
total of 500,000 shares of common stock has been reserved for issuance under
the employee stock purchase plan plus an annual increase on the first day of
each of the fiscal years beginning in 2000, 2001, 2002, 2003 and 2004 equal to
the lesser of (1) 500,000 shares, (2) three percent (3%) of our shares
outstanding on the last day of the immediate preceding fiscal year, or (3)
such lesser number of shares as is determined by the board of directors.
Eligible employees may purchase common stock at 85% of the lesser of the fair
market value of the Company's common stock on the first or the last day of the
applicable six month purchase period.
Defined Contribution Plan
Effective April 1999, the Company adopted a defined contribution retirement
plan under Section 401(k) of the Internal Revenue Code which covers
substantially all employees. Eligible employees may contribute amounts to the
plan, via payroll withholding, subject to certain limitations. Under the
401(k) plan, employees may elect to reduce their current compensation by up to
the statutorily prescribed annual limit ($10,000 in 1999) and to have the
amount of such reduction contributed to the 401(k) plan. The 401(k) plan
permits, but does not require, additional matching contributions to the 401(k)
plan by the Company on behalf of all participants in the 401(k) plan. To date,
the Company has not made any matching contributions to the 401(k) plan.
F-17
<PAGE>
DRUGSTORE.COM, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of July 4, 1999 and for the six months ended July 4, 1999 is
unaudited)
Issuance of Series D Convertible Preferred Stock
In June 1999, the Company issued 2,266,289 shares of Series D preferred
stock to a new investor in exchange for $40 million in cash and an obligation
to provide cable television advertising valued at $5 million based on
comparable transactions with unaffiliated third parties. The advertising is
expected to be aired over a three year period and will be expensed in the
period in which the airtime is used. The Series D preferred stock carries
substantially the same terms and conditions as the Series A, B and C preferred
stock and is convertible into common stock at a one-to-one ratio upon an
initial public offering subject to certain conditions.
Issuance of Series E Convertible Preferred Stock
On July 8, 1999, the Company consummated an agreement with Rite Aid
Corporation and General Nutritional Companies, Inc. ("GNC") to issue
12,282,599 shares of Series E preferred stock in exchange for an aggregate of
$10 million in cash and other consideration, including access to insurance
coverage, advertising commitments, exclusivity agreements, a technology
licensing agreement and other obligations with an estimated fair value of
$233.9 million. Based on the Company's initial internal analysis, the $233.9
million non-cash portion of the consideration from the Rite Aid and GNC
agreements has been preliminarily allocated to the following components (in
millions):
<TABLE>
<S> <C>
Access to insurance coverage........................ $188.4
Advertising commitments............................. 26.5
Rite Aid exclusivity agreement...................... 8.0
GNC exclusivity agreement........................... 6.0
Rite Aid technology license......................... 5.0
------
$233.9
======
</TABLE>
All of the items above are to be amortized on a straight-line basis over
their contractual life of 10 years, except for the GNC exclusivity agreement
which will be amortized over 3 years. The Company is in the process of
obtaining an independent valuation from a valuation expert in order to make
its final allocation of value among the various components of the agreements.
Such valuation is expected to be completed before the end of the third quarter
of 1999 and may result in material changes to the preliminary allocation.
The Series E preferred stock carries substantially the same terms as the
Series A, B, C and D preferred stock and is convertible into common stock at a
one-to one ratio upon an initial public offering subject to certain
conditions. In connection with the issuance of the Series E preferred stock,
the certificate of incorporation was amended on July 7, 1999 to increase the
total authorized number of preferred and common stock to 310,000,000 shares
and the accompanying financial statements reflect the increase in the
capitalization.
F-18
<PAGE>
The inside back cover includes:
drugstore.com
Makes Shopping Easy
The following text is placed at the top left of the page:
HELP ON A PERSONAL LEVEL
The advantage of the Internet allows drugstore.com to offer customers help on a
personal level. Customers can shop from their home or office any time of the
day or night. They can get useful information to make informed product
decisions. They can ask a pharmacist questions in privacy. drugstore.com
provides the information and interaction that makes shopping easy.
[PICTURE OF SKIN CARE ADVISOR PAGE]
[PICTURE OF RESOURCE CENTER PAGE]
[PICTURE OF PREGNANCY AND INFANT CENTER PAGE]
[PICTURE OF QUICK LISTS PAGE]
The following text appears to the left of the picture of the Skin Care Advisor
page:
SHOPPING ADVISOR
drugstore.com helps customers who are not sure about what product to buy. The
customer provides information about what he or she needs and the Shopping
Advisors help identify the right products.
The following text appears to the right of the picture of the Resource Center
page:
SOLUTIONS
An easy way for customers to find the information they need in order to make
informed product decisions, the Solutions area includes Ask Your Pharmacist,
Health and Wellness Guides, Shopping Advisors and more.
The following text appears to the left of the picture of the Quick Lists page:
QUICK LISTS
An easy way to find what you need and assist you in stocking up on frequently
used items.
The following underneath the picture of the Pregnancy Center page:
PREGNANCY
Whether it's the first child or the fifth, the Pregnancy and Infant Center helps
families prepare for childbirth and child rearing.
Until August 22, 1999, 25 days after commencement of the offering, all dealers
effecting transactions in our common stock, whether or not participating in this
offering, may be required to deliver a prospectus. This delivery requirement is
in addition to the dealers' obligation to deliver a prospectus when acting as
underwriters and with respect to their unsold allotments or subscriptions.
The back cover of the prospecuts contains the company's logo.
-4-
<PAGE>
[drugstore.com logo]
